Assessed whether continued investment in private equity is justifiable and to identify conditions under which investment in private equity would contribute positively to returns given the portfolio’s specific constraints.

1. REPORT TO ASRS
!!!!!!
The Arizona State Retirement System (ASRS) is a $28 billion public
pension fund that invests up to $4.2 billion in alternative asset classes,
including private equity and venture capital. ASRS has asked
Thunderbird to provide recommendations regarding its strategic asset
allocations, specifically to private equity. The purpose of this paper is to
assess whether ASRS’ continued investment in private equity is justifiable
and to identify conditions under which investment in private equity would
contribute positively to ASRS’ returns given the portfolio’s specific
constraints.
Djoudie Etoundi Essomba
Fikremariam Gurja
Kazuki Hida
Daniel Martin
Karan Shah
Dhinesh Kumar Shanmugam
Kathryn Spada
Lacey Yoder

2. Table&of&Contents !
Introduction*......................................................................................................................................................................................................*2!
Three0part*Analysis*........................................................................................................................................................................................*3!
PART%I.%Arizona%State%Retirement%System’s%Investment%Portfolio!......................................................................!3!
1.1 Contribution of PE to the ASRS portfolio!......................................................................................................................!3!
1.2 An Efficient Investment Frontier for ASRS!..................................................................................................................!6!
.
1.3 Costs of PE!................................................................................................................................................................................!8!
1.4 Risk Management!.................................................................................................................................................................!11!
1.5 Conclusion!...............................................................................................................................................................................!13!
PART%II.%Accounting%Issues%in%Private%Equity!................................................................................................................!14!
2.1 Influence of valuation rules!...............................................................................................................................................!14!
2.3 The structure of entities and incentive compensation!...............................................................................................!21!
2.4 Dodd-Frank Act!.....................................................................................................................................................................!22!
2.5 Conclusions!.............................................................................................................................................................................!24!
PART%III.%Private%Equity%In%Practice!....................................................................................................................................!25!
3.1 Trends in Private Equity!.....................................................................................................................................................!25!
3.2 Trends in Private Equity investing for large-scale investments!............................................................................!28!
3.3 Social Responsibility!...........................................................................................................................................................!30!
3.4 Conclusions!.............................................................................................................................................................................!31!
Conclusions*and*Recommendations*.....................................................................................................................................................*32!
Appendix*..........................................................................................................................................................................................................*33!
PAGE 1 OF 42

3. Introduction
The Arizona State Retirement System (ASRS), is a $28 billion public pension fund that invests
up to $4.2 billion in alternative asset classes, including private equity (PE) and venture
capital. ASRS has asked Thunderbird to provide recommendations regarding its strategic asset
allocations, specifically to PE. The purpose of this paper is to assess whether or not ASRS’
continued investment in PE is justifiable and to identify conditions under which PE would
contribute positively to ASRS’ returns given the portfolio’s specific constraints.
Questions Under Consideration
ASRS submitted a list of questions and requested an analysis of the following characteristics
associated with PE: liquidity, marketability, fee structure, risk-return ratios, legal and regulatory
framework, current and future trends, main players, investment strategies, and social
responsibility. This paper will utilize these characteristics in order to answer the following
questions:
First, what is the rationale for investing in PE as it relates to ASRS?
• How does PE interact with other elements in ASRS’ portfolio?
• Is there an efficient frontier that includes PE and what is it?
• How are PE fees established?
• Are those fees justified or excessive?
• How does illiquidity influence investment framework from investment to returns?
• How is risk in PE managed?
• What are the frameworks to manage risk?
Second, what is the impact of accounting rules on PE?
• How do valuation rules affect returns and what potential problems are thus raised?
• Are the GASB rules on reporting for alternatives well-conceived?
Third, what are the trends in PE, including considerations of social responsibility?
• What are the main trends in PE investment by government pensions systems, endowments,
and sovereign wealth funds?
• Is PE socially responsible?
PAGE 2 OF 42

4. Three-part Analysis
PART I. Arizona State Retirement System’s Investment Portfolio
We recommend that ASRS not only continue to invest in PE, but also that it will benefit from
increasing its investments in PE. Even though PE is strongly illiquid compared to other options,
the PE asset class as an investment strategy provides greater returns for the ASRS portfolio and
reduces risk by increasing overall diversification by sector, geography, and stage. PE also
reduces the portfolio’s correlation with its asset invested in public equity markets. A survey of
US state retirement funds indicates that ASRS’ PE allocation is below the norm. An increase in
PE investments would position ASRS nearer the country’s average. The fees associated with PE
funds can negatively impact PE returns when too high. However, with proper due diligence and
sustained oversight of General Partners (GPs), fees and costs can be contained and high returns
preserved.
1.1 Contribution of PE to the ASRS portfolio
Critics of PE advise against investing in the asset class due to its illiquidity, high costs, and high
risk. This section analyzes the arguments and research in regards to these issues, highlighting the
rationale for investing in PE. This section also includes a discussion of an efficient frontier the
ASRS’s portfolio with and without PE. Despite negative characteristics that PE critics
emphasize, recent studies have found that a portfolio that includes PE optimizes the risk-return
ratio compared to investments in public equity. Finally, this section will also provide
recommendations on liquidity and risk management strategies.
Liquidity Risk
A key factor that restricts investment in PE is liquidity risk. Generally investors expect a greater
reward the longer assets are committed to an investment, known as liquidity risk premium. The
period of illiquidity for PE is usually ten years. To address ASRS’ liquidity needs we began by
measuring the current level of liquidity in the portfolio and compared it to three other US
retirement pension funds. An analysis of liquidity measurement methodologies, our
methodology, and a table that applies our methodology to the ASRS portfolio are below.
Liquidity Measurement Methodology
Liquidity measurement methodology has been a subject of discussion for over 100 years. Despite
continuous research and debate, the common understanding of liquidity can be attributed to Carl
Menger (1892). Menger assess liquidity based on three characteristics: an established market,
tightness, and depth. In recent years, industry experts have proposed methods to define and
measure liquidity; however, there is no universally accepted process. While most argue that a
systematic method for measuring liquidity is important in the market, there is not yet a
predominant method. Anson (2010) states that liquidity risk arises from investing in an asset that
“cannot be sold in a timely manner” unless it is sold at a large discount. He further argues that
liquidity risk is the mismatch between the holding period of an asset and the time interval over
which liquidity is needed.
In their measure of liquidity, most methods include observable factors such as trading time,
tightness, depth, and resilience (Zimmerman, et al, 2004). A recent report published by Santa
PAGE 3 OF 42

5. Clara University argues that these traditional factors include elements that do not relate to
liquidity and therefore produce measurements that are “incorrectly diluted” (Chacko, Das, and
Fan, 2012). Chacki, Das, and Fan recommend using an index-based measurement that analyzes a
portfolio which is long Exchange Traded Funds (ETF) and short the underlying securities. In
completely efficient markets the difference in yield would be zero; in imperfect markets, the
difference in yield is attributed to the lack of liquidity.
Although this approach would result in a less diluted liquidity measurement, it is not feasible
to apply this method to the ASRS portfolio. Therefore, we have used Menger’s definition, using
three of the most commonly accepted, measureable factors for each asset class within ASRS’
portfolio: presence of an established market, tightness, and depth. Tightness is the market’s
ability to match supply and demand at a low cost and is measured by the bid-ask spread. Depth is
the market’s ability to absorb a large amount of activity without being reflected in the price.
(Committee on the Global Financial Systems, 2001)
Using these three factors, we classified each of the asset classes into three levels, level 1
assets being most liquid and level 3 assets being least liquid (see Table 1.1.1). We then
calculated a weighted score for ASRS’ portfolio (see Table 1.1.2). According to these
classifications ASRS’ portfolio has a liquidity score of 2.45 out of 3.00, which indicates that the
portfolio is relatively liquid. In comparison, the Teacher Retirement System of Texas portfolio
scores 2.39, Public Employees’ Retirement Association of Colorado scores 2.67 and Public
Employees’ Retirement System of Mississippi scores 2.82 (see Exhibit 1 in Appendix).
Table 1.1.1 Liquidity Asset Classification for ASRS’ Portfolio
LEVEL 1 LEVEL 2 LEVEL 3
ASRS ASSET CLASSES
HIGHLY LIQUID SOMEWHAT LIQUID HIGHLY ILLIQUID
INVESTMENT IN US EQUITY
Large Cap Equities 23.00%
Mid Cap Equities 5.00%
Small Cap Equities 5.00%
TOTAL 33.00%
INVESTMENT IN NON-US EQUITY
Int'l Developed Large Cap Equities 14.00%
Int'l Developed Small Cap Equities 3.00%
Emerging Int'l Equities 6.00%
TOTAL 23.00%
INVESTMENT IN ALTERNATIVE ASSETS
PE 7.00%
Opportunistic Equity 0.00%
Equity Long-Short
TOTAL 7.00%
INVESTMENT IN US FIXED INCOME
Core Bonds 13.00%
High-Yield Bonds 5.00%
TOTAL 13.00% 5.00%
INVESTMENT IN OTHER FIXED INCOME
PAGE 4 OF 42

6. Emerging Market Debt 4.00%
Opportunistic Debt 0.00%
Private Debt 3.00%
TOTAL 4.00% 3.00%
INVESTMENT IN INFLATION LINKED ASSETS
Commodities 4.00%
Real Estate 8.00%
Infrastructure
Farmland and Timber
Opportunistic Inflation-Linked Assets
TOTAL 4.00% 8.00%
TOTAL PERCENTAGE 73.00% 4.00% 18.00%
Table 1.1.2 Liquidity Score
LIQUIDITY LEVEL WEIGHT WEIGHTED SCORE
Level 1 – Highly Liquid 3 points 0.73*3 = 2.19
Level 2 – Somewhat Liquid 2 points 0.04*2 = 0.08
Level 3 – Highly Illiquid 1 point 0.18*1 = 0.18
TOTAL WEIGHTED SCORE 2.45
The ASRS portfolio is relatively liquid compared to other pension funds. However, ASRS can
decrease the risk associated with liquidity. Some studies have shown that the diversification
gains expected by PE investors may not materialize because PE is “significantly exposed to the
same liquidity risk factors as public equity” (Netspar, 2011). Therefore, institutional investors
such as ASRS should adopt strategies to manage liquidity. We recommend that ASRS ladder its
PE investments by investing in funds in a way that allows ASRS to receive cash returns at
staggered time intervals. When laddering, ASRS should manage the GPs cash return
distributions so that the timing and amounts received serve the needs of the organization.
PE investments function as limited partnerships, with a GP managing the contributions of the
LP in a fund for seven to ten years on average. Most often the lifecycle of the fund begins with
an investing period in the first two to four years, followed by a maturing and realization period
when the fund starts to earn returns, ending with a liquidation period of the fund’s assets, which
is when returns are maximized and assets converted into cash. Most managing partners raise a
new fund within three to four years, thus diversifying investments by the year of formation, the
vintage year. This time diversification is the means by which a fund overcomes the time
illiquidity inherent in this asset class: layering the vintage years across several years allows the
GPs to limit exposure to a specific time period while spreading the periods of initial returns, thus
producing continuous returns for LPs from various funds in spite of the immobilized nature of
the assets. Given the cyclical nature of the economic environment, layering vintage years is also
a way to maximize returns from best performing years while limiting the impact of the less
performing ones.
PAGE 5 OF 42

7. 1.2 An Efficient Investment Frontier for ASRS
This section assesses how the inclusion of PE affects the risk and return of the overall portfolio.
PE is both an asset class and a strategy, which poses challenges when integrating it into an
investment portfolio. As an asset class, PE investments are managed most efficiently by using a
basket of all privately held companies, weighted according to their inherent value. However PE
is also a choice in favor of the skill-based strategy of a specific PE fund. Most of the time, this
strategy relies on leveraged buyouts and/or venture capital investments. The fragmented
structure of the private equity market is such that private equity investors cannot fully-
diversify away from private company specific risk; thus, all private equity investments
are a mixture of systematic risk exposure to the private equity asset class and to private
company specific risk (Ibbotson Associates, 2007).
We incorporated ASRS’ portfolio and allocation1 in the various asset classes and constructed
an efficient frontier analysis, both with and without PE. The optimization inputs were the
expected returns, the standard deviation, and correlation between the different asset classes. The
optimization result for ASRS’ portfolio with and without PE is shown in Chart 1.2.1.
Chart 1.2.1 ASRS’ Efficient Frontier With and Without PE
The red line represents the portfolio’s efficient frontier without PE. In this particular case the
expected return is 9.1% with a standard deviation of 15.8%. The standard deviation indicates the
risk of the portfolio for a certain expected return. The gray line represents the efficient frontier
with PE. The 9.1% expected return can be achieved with 13.4% standard deviation. This
indicates that a portfolio that includes PE has the same expected returns with a lower degree of
risk. Therefore, holding returns constant, the standard deviation of the portfolio is lower when
PE is included.
1
In order to understand the current combination of expected return and risk for the ASRS portfolio, we would need
to obtain exact allocation percentage of all asset classes. This assessment uses aggregated asset classes.
PAGE 6 OF 42

8. Similarly, the efficient frontier with PE has a higher expected return for the same amount of
risk. If standard deviation is fixed at 15.36% for both without PE and with PE, the portfolio
without PE yields an expected return of 9.04%, while the portfolio with PE yields an expected
return of 9.53%, which is a 49 bases point advantage. Therefore, though PE may have a higher
standard deviation as an isolated asset class, it actually reduces risk for a given expected return
when considered in a portfolio.
However, based on the findings of a recent study, the standard deviation and expected return
for PE reported by ASRS is too conservative. The study assessed PE performance compared to
the S&P 500 and found that the standard deviation of both asset classes is overstated (see Table
1.2.1).
Table 1.2.1 Risk-Return Analysis of PE & S&P500 (2000-2011)
CAPITAL WEIGHTED UNWEIGHTED S&P 500 S&P TR
Average (annualized) 6.3724% 4.1041% 1.3215% 3.2319%
Standard Deviation 5.00505% 4.2311% 9.33% 9.34764%
Coefficient of Variation 3.14169% 1.0260% 28.23% 11.57%
Source: Gary Gibbons, Ph.D. and Olga Kugatkina, Ph.D., unpublished research (2013)
This study includes data from the two recent recessions of the last decade. Despite the financial
crisis in early 2000s and in 2008, investments in private equity have proven to be less risky and
earned more return than the public markets. However, it is still important to consider the
liquidity implications of investing in private equity, which is discussed in the liquidity risk
section.
Based on new data from Gibbons’ study regarding the standard deviation and expected
returns of private and public equity, ASRS’ portfolio can be optimized according to Chart 1.2.2.
Chart 1.2.2 ASRS’ Efficient Frontier Based on New Return and Risk Data
When the volatility for PE, Large Cap Equities, and small/mid cap equities are changed, the new
efficient frontier is drastically different. Due to PE’s low standard deviation and high expected
PAGE 7 OF 42

9. returns, this new frontier favors PE over all other asset classes. For instance, to achieve a
standard deviation of less than 5%, the portfolio will be nearly 100% allocated to PE. However,
due to the illiquidity and advantages of diversification we do not recommend investing 100% in
PE. Therefore, the allocation percentages should be defined in such a way that maximizes the
return within the institution’s accepted level of risk for each asset class. For example, according
to the ASRS asset allocation table, PE should be between 5 and 9%. If all asset classes’
allocation percentages are set, these constraints would be applied to the output during the
optimization process. These constraints, according to the investment policies of ASRS
management, would help to obtain institutionally acceptable efficient frontier recommendations.
However, it is important to note that adding PE to the portfolio contributes positively to the
overall ASRS portfolio. Even in a constrained basis, PE increases the expected return and
decreases risk.
1.3 Costs of PE
Some critics point to the high fees associated with PE as support for their argument that it is not
an attractive or financially rewarding asset class. GPs have been severely scrutinized for these
high fees. The fixed portion fee charged by GPs, in particular, has become a substantial
percentage of overall compensation, spurring accusations that PE does not yield LPs enough
return to compensate for the fees. In addition to standard fees, there are some hidden fees that
add to the overall cost of PE. This section provides an overview of the various types of fixed and
hidden fees.
Types of Fees in PE
At the inception of a fund, GPs and LPs sign a contract that specifies compensation. There are
two types of standard fees: management fee and carried interest. The standard management fee is
2% of the total committed funds. Recently, there has been increased pressure to reduce this
amount, but the only changes that have been made are in Asia.
In addition to a management fee, GPs receive carried interest, usually 20% of profits. The
carried interest is viewed as an incentive mechanism or a reward for good performance. The
rationale behind this incentive is that PE locks up a GP’s assets for ten years or more; therefore,
LPs must motivate or incentivize GPs to facilitate high returns.
Academic literature debates the effect that carried interest has on the overall performance of
the fund. According to a report from Duke University, “the terms of management contracts
provide insufficient incentives, and, as such, allow PE GPs to charge excessive fees for the
performance they deliver” (Robinson and Berk). Another report by PE International rebukes this
argument, stating, “management contracts reflect agency considerations and the productivity of
managerial skills” (April 2012). Experts claim that funds with higher compensation packages
take on more systemic risk to earn back fees. Others conclude that these fund managers add more
value rather than taking on more risk.
Various reports indicate that as a GP increases its fees, IRRs decrease. Due to numerous
management fees many investors favor smaller funds that yield a higher IRR. “Carried interest is
higher in larger funds, while management fees are lower. These findings imply that the elasticity
of GP compensation to performance is higher in larger funds” (Robinson and Berk). Critics of
high fees argue that if fees are reduced, the alpha would increase dramatically. A more recent
report by Gibbons and Kugatkina purports the previous claims and concludes that a fund’s size
has no correlation to the level of return.
PAGE 8 OF 42

10. Hidden Fees
In addition to management fees and carried interest, there are hidden fees that GPs receive,
which can increase the cost of PE as an alternative investment. A personal interview with Erik
Sebusch of UPS Investments revealed several different types of hidden fees. In the event that
either party decides to dissolve the contract before its contracted date, the GP usually will refund
some of the fees, though 12% of funds do not refund anything. Out of the funds that do refund
something, one-third refund all of the transaction fees, one-third refund 50% of the transactions,
and one-third refund some amount in between. Typically, all funds refund 80% of the monitoring
fees. Phallipou indicates that if hidden fees are included in the total cost of PE, they total 50 to
80% of the total committed funds (2009), though this amount is not verified by other sources.
Table 1.2.2 outlines some PE fees.
Table 1.2.2 PE Fees
FEE AMOUNT (RANGE) COMMENTS
STANDARD FEES
Some countries and firms are applying pressure to
Management 2%
reduce this amount
Incentive mechanism that is considered a reward for
Carried Interest 20%
good performance
QUANTIFIABLE HIDDEN FEES
Organizational Expenses: Paid at beginning of
Fund Set-Up $1M
commitment
Expenses related to the purchase, holding and sale of
Portfolio Expenses 50%
portfolio companies
Director Fee’s 100%
OTHER “HIDDEN FEES” AMOUNT VARIES
• Marketing Budget • Restructuring
• Deal Fee • Fund Expenses (Legal, travel budget,
• Break Up Fee annual meetings, entertainment, etc.)
• Wind down
These particular fees are not mentioned in academic literature; therefore, we are unable to quantify or analyze
their effect on the overall cost of PE.
Are these high costs justified?
Critics of PE point to the high fees, illiquidity, and lack of marketability as justification for
labeling PE as an inferior asset class. Countless reports have been published to identify whether
or not the level of PE return justifies its negative traits. There is a lack of agreement among
scholars as to whether or not there is consistent data to support the claim that PE has consistently
outperformed the S&P 500, thereby introducing less volatility and higher returns than the public
markets. This section will briefly discuss a few of these reports.
Harris, Jenkinson, and Kaplan (2012) reviewed 1,400 US PE funds (buyout and venture
capital) from 1980 to 2008. Their research indicates that although buyout funds have
significantly outperformed public markets during this time period, there is a negative correlation
between the buyout funds’ performance and the aggregate commitment to the fund. Harris,
Jenkinson, and Kaplan analyzed the relation of the fund size to performance. Buyout fund sizes
have increased from “$390 million in the 1980s to $782 million in the 1990s to $1.4 billion in
PAGE 9 OF 42

11. the 2000s.” Venture capital fund sizes have increased from $77 million to $191 million to $358
million. Their research indicates that smaller funds outperform larger funds.
Robinson and Sensoy (2011) analyzed quarterly cash flow data for 837 buyout and venture
capital funds from 1984 to 2010. Their findings imply that “high PE fundraising forecasts both
low PE cash flows and low market returns, suggesting a positive correlation between PE net cash
flows and public equity valuations.” This conclusion is supported in other reports. PE returns are
consistently higher than public equity markets.
Higson and Stucke (2012) surveyed over 4,000 PE and venture capital funds from 1980 to
2010. Their research shows that “liquidated funds from 1980 to 2000 have delivered excess
returns of about 450 basis points per year. Adding partially liquidated funds up to 2005, excess
returns rise to over 800 basis points.” Only 60% of these funds net of fees and 70% at the gross
level outperformed the S&P 500. During the 1980s funds yielded IRRs of 25% or above but the
1990s showed significantly lower returns in the single digits. Funds that fully liquidated during
the economic boom at the end of the 1990s once again showed IRRs of 25%. According to
Higson and Stucke, “the evident inverse correlation between the performance cycles and equity
and debt capital market cycles, and with the business cycle suggests that wider economic factors
have a significant impact.” Robinson and Sensoy support this conclusion. Despite these
economic cycles, US buyout funds have consistently outperformed the S&P 500 almost every
year since 1980. The average IRR for 1980 to 2000 is 544 basis points higher than the S&P 500
and this number rises to 809 basis points in 2010. The average for 1980 to 2010 is 468 basis
points higher than the S&P 500.i
A more recent, unpublished study by Gibbons and Kugatkina (2013) analyzes data from
Prequin that accounts for 70% of all worldwide funds. The report assesses the performance of
5500 funds from 1600 fund managers from March 2001 through December 2011. Gibbons and
Kugatkina’s research contradicts many of the previous reports that favored capital weighted
results and indicates that smaller funds actually may not perform better than larger funds. The
average return for an un-weighted fund was 4.10% compared to 6.37% return for a capital
weighted fund. Whereas many reports only analyze buyout or venture funds, the Prequin data
encompasses nine different fund types.
Chart 1.3.1 Risk-Adjusted Returns, Net of Fees
Cumm Return S&P 500 Over Time (IRR
to data Point)
Cumm Return Over Time Capital
1.2 Weighted
Cumm Return S&P 500 TR Over Time
1 (IRR to data Point)
Cumm Return Over Time Unweighted
0.8
0.6
0.4
0.2
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45
-0.2
-0.4
-0.6
Source: Gary Gibbons, Ph.D. and Olga Kugatkina, Ph.D., unpublished research (2013)
PAGE 10 OF 42

12. Despite critics’ claims that PE returns do not justify the negative characteristics, data supports
the opposite conclusion. PE risk-adjusted returns, net of fees, are consistently higher than those
of public markets.
1.4 Risk Management
There are three mainstream ways to mitigate risk in terms of investment strategies: Correlation,
Diversification and Hedging. Private Equity offers opportunities to strongly reinforce the two
former, while it offers almost no advantage for the latter.
Correlation
As a separate asset class, Private Equity can enhance the risk profile of the ASRS portfolio
thanks to a lower correlation with the public equity markets and asset classes. This is an issue
where arguments are still ongoing over the proper methodology to be used. A number of
structural factors may influence positively or negatively PE’s correlation to public equity:
infrequent valuations and the tendencies to report investment values close to initial costs until the
time of exit may contribute to making this correlation lower than it actually is. Alternatively, one
can infer from the PE asset class’s dependence on many of the same systematic and economic
risks as public equity, that the two are very closely correlated. Marthendal (2010), based on
analysis of listed Private Equity with public equity stock markets indexes, brings intriguing and
subtle conclusions: Private Equity seems to have little to no correlation with bond indices,
whereas with stock market indices there is a low correlation, of 0.35 on average (Cohen, 1988).
This indicates that PE has a strong diversification potential. Although further simulations from
Marthendal with different asset allocation models fail to yield a decisive conclusion on Private
Equity’s contribution to an overall portfolio, Gibbons (2012) puts PE’s correlation to the S&P
5000 in a range between 0.62 and 0.72 over the period 2001-2011. This PE correlation rate,
coupled with a lower volatility over the period aforementioned, produces a risk/return profile
which makes Private Equity particularly attractive as an asset class to diversify into for the
ASRS portfolio.
Diversification
Since Private Equity is also a strategy, it can also contribute positively to diversification. Four
main levers can be employed.
1. Time Diversification
The first lever is time diversification: Private equity investments function as limited partnerships
with a GP managing the contributions of the LP immobilized in the fund for a specific duration,
of seven to ten years on average. Most often the lifecycle of the fund is divided around an
investing period, during the first two to four years, followed by a maturing and realization period
when the fund starts to actually earn returns; until the time of liquidation of the fund’s assets,
when returns are maximized and assets converted into cash. Most managing partners raise a new
fund within 3 to 4 years, diversifying their investments by the year of formation.
Hence, time diversification is the means by which a fund overcomes the time illiquidity
inherent in this asset class: layering the vintage years across several years allows the GPs to limit
exposure to a specific time period while spreading the periods of initial returns, thus producing
continuous returns for their LPs from various funds in spite of the immobilized nature of the
assets. What’s more, given the cyclical nature of the economic environment and Private Equity
PAGE 11 OF 42

13. returns’ dependence on it, layering vintage years is also a way to maximize returns from the best
performing years while limiting the impact of the less performing ones.
2. Strategy diversification
The second lever relate to various mixes of PE strategies: a GP will use a mix of strategies with
low correlation to each other to reduce exposure to risk and increase returns, such as mixing
Venture Capital and Buy-out funds for example. Different PE strategies will also yield differing
sectorial exposures: Venture Capital portfolios because of their focus on growth investing tend to
be exposed to technology industries including information technology, communications,
healthcare and biotechnology. Buy-out funds on the other hand are more diversified across major
industries such as consumer/retail, communications/media, industrial, energy and others.
3. Stage Diversification
Stage investment can also be calibrated both in Venture Capital and Buy-out funds: for venture
capital this is achieved through targeting companies at early stage, late stage, diversified Venture
and growth equity funds. Buy-out funds use fund size as a proxy to differentiate between stages:
less than $250 million for small buy-outs, $250 to $500 million for mid-market, $500 million to
$1 billion for large buy-outs, and over $1 billion for the mega buy-outs. However, the scale of
these buy-outs has grown in recent years.
4. Geographic Diversification
Geographic diversification can be pursued either through region-focused funds or at the portfolio
company level by assessing the underlying exposure of the fund. Various funds specialize on
North America, Europe (EU), Emerging Markets (EM), or Frontier Markets. The evidence of the
last 30 years however points to higher returns in US focused funds than EU ones, and it must be
noted that returns from EM focused funds have risen although with a very high volatility.
Hedging
While hedging is a classic risk control for portfolio managers, private equity provides almost no
risk control through hedging. Hedging is a method of coverage, where one investment is used to
offset losses from another investment. One of the most ancient and basic forms of Hedging was
wheat farmers’ futures contracts, which provided coverage against the potential wheat price
fluctuations by guaranteeing the selling price of the commodity. What’s more, the future contract
itself had a value whose fluctuation might offset that of wheat prices. Hence, the overall hedging
method here was to long the futures contract and to short the actual wheat. These basic levers
hold over with today’s financial markets and translate into various hedging strategies: some rely
on low correlation with public equity (market neutral) or strong correlation with them (market
directional); others leverage risk to generate excess revenues with increased volatility (return
enhancers), or offer positive excess returns while reducing risk (risk reducers) (Gregory Connor
and Leo Lasarte). PE, given its very nature as an asset class with strong illiquidity, thus offers
few advantages in most of these strategies, except with the market neutral ones based on lower
correlation.
Private equity, however, may hedge slightly in down markets because it has a Beta that is
less than 1 (Gibbons 2013). It should also be noted that there seems to be a convergence between
PE and hedging: many hedge funds use investment in PE funds or funds of funds as part of a
market neutral strategy or betting on a specific corporate or industry event. Hence, with regard to
the chosen risk management strategy of the ASRS portfolio, we can conclude that PE can
contribute positively and strongly to two of the established methods of risk management—
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14. correlation and diversification—while it offers few identifiable advantages for hedging in
general and none for the ASRS portfolio specifically.
1.5 Conclusion
Despite the high fees and risk associated with PE the ASRS portfolio will achieve lower risk and
higher returns overall. The efficient frontier illustrates that by including PE in the portfolio that
ASRS can achieve higher levels of return for the same level of risk or reduce overall risk and
receive the same level of returns. In addition, PE funds invest in a variety of industries,
geographies, and company growth stages, which increases the total portfolio’s diversification
which ultimately results in lower risk. Currently the ASRS portfolio has a below average
liquidity rating (2.45 out of 3.00). PE is one of the most illiquid assets but the ASRS can
maintain the same level of PE investment and increase its liquidity by laddering the various PE
fund investments and matching expected future cash flows with the ASRS’s liquidity needs.
Therefore, since PE contributes to diversification, lower risk and higher returns, the ASRS
should continue to allocate to PE and complete an optimization of all the asset classes to achieve
the highest return possible for the accepted amount of risk.
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15. PART II. Accounting Issues in Private Equity
Section two will discuss the accounting rules that impact PE and how certain rules result in other
assets appearing to perform better than PE. For example, the valuation rules may require the
ASRS to disclose management fees, which will cause PE to appear as a less rewarding
investment. It is crucial for ASRS to understand the valuation rules and methods in order to
guarantee the accuracy of its returns and to manage its fee payments. This section discusses
several valuation rules and methods, reporting rules, and fiduciary duties, which force GPs to
fairly value and disclose fees and returns. In addition we will address valuation, FASB, GASB,
and Dodd-Frank as it relates to the ASRS’s needs.
2.1 Influence of valuation rules
To address the question, “How do valuation rules affect returns and is this a problem?” it is
important to assess valuation rules for PE, valuation methods, and their impact on PE
investments in practice. One way can increase the value of the assets in a PE fund is to value
them unfairly: LPs get will more returns, but they might not be real, whereas LPs have to pay
more management fees to GPs. The fairly regulated valuation rules are needed, and
understanding the valuation rules and methods is important for ASRS investment decision.
2.1.1 Valuation Rules on PE
The Financial Accounting Standards Board (FASB), the regulator of financial accounting
practices, has defined the fair value of an asset or liability. ASRS must comply with its regulator.
This section outlines the valuation methods for assets or liabilities invested in PE funds, as well
as an asset allocation table in accordance with SFAS (Statement of Financial Accounting
Standards) 157 (est. 2006) valuation guidelines categorizing ASRS assets. SFAS is the
accounting standards issued by FASB.
FASB Fair Value Measurement
FASB stipulates accounting and financial reporting standards for activities and transactions of
consumer and non-governmental entities. SFAS 157 establishes guidelines to measure the fair
value of investments and to disclose investments and transactions in financial statements.
According to SFAS 157, “the fair value is the price that would be received by selling an asset
in an orderly transaction between the market participants at the measurement date” (SFAS No.
157, paragraph 5). The fair value definition was changed in 2006 and now requires the “exit
price” to be recorded. Inclusion of an exit approach maximizes the use of objective inputs in the
valuation of an asset. Assets are classified and valued periodically to adjust the fair value to
current market conditions, then disclosed in financial statements per FASB standards. SFAS 157
defines three asset classes:
• Level 1: These are assets or funds that have easy access to an active principal market such as
the stock market. An active market is defined by the combination of a high average trading
volume, a high frequency of observable transaction, and a low bid-ask spread. Level 1 assets
are valued based on the market quoted prices of the asset.
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16. • Level 2: Here are assets or funds with moderate principal or secondary markets, such as
restricted stocks, some convertible bonds, and private investment in public equity. Level 2
assets are valued by comparing the market-quoted prices of the similar assets. Typically, Level
2 valuation also uses inputs other than quoted market prices.
• Level 3: These are assets or funds that have limited marketability due to lack of access to a
primary market; PE is ranked among them. The main characteristics of Level 3 assets are high
illiquidity, no readily available market data, and a large bid-ask spread. Valuation of Level 3
assets typically involves multiple valuation methods: since theydo not have an active market
to take “observable” inputs such as market data the fair value measurement for Level 3 uses
internal valuation methodologies. Usually an independent third party valuation expert values
the assets and/or the funds using internal data.
Fair Value Asset Classification
The following table was derived from assumptions and broad generalizations of asset
classification using the data provided in ASRS’ strategic asset allocation policy schematic.
Table 2.1.a FASB Fair Value Asset Classification
ASRS ASSET CLASSES LEVEL 1 LEVEL 2 LEVEL 3
INVESTMENT IN US EQUITY
Cash
Large Cap Equities 23.00%
Mid Cap Equities 5.00%
Small Cap Equities 5.00%
Total 33.00%
INVESTMENT IN NON-US EQUITY
Int’l Developed Large Cap Equities 14.00%
Int'l Developed Small Cap Equities 3.00%
Emerging Int'l Equities 6.00%
Total 23.00%
INVESTMENT IN ALTERNATIVE ASSETS
PE 7.00%
Opportunistic Equity 0.00%
Equity Long-Short
Total 7.00%
INVESTMENT IN US FIXED INCOME
Core Bonds 13.00%
High-Yield Bonds 5.00%
Total 13.00% 5.00%
INVESTMENT IN OTHER FIXED INCOME
Emerging Markets Debt 4.00%
Opportunistic Debt 0.00%
Private Debt (Credit Opportunities) 3.00%
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17. Total 4.00% 3.00%
INVESTMENT IN INFLATION LINKED ASSETS
Commodities 4.00%
Real Estate 8.00%
Infrastructure
Farmland & Timber
Opportunistic Inflation-Linked Assets
Total 4.00% 8.00%
TOTAL PERCENTAGE 73.00% 9.00% 18.00%
Source Rothstein Kass, 2010
Based on fair value classification, 73% of assets are classified as Level 1, 9% as Level 2, and
18% as Level 3. All PE assets are classified as Level 3 assets.
Valuation Methodology for PE investment
GPs use several different methodologies to value PE assets. The fund manager and the person
who evaluates make certain assumptions on the factors influencing the value of an asset and
select the valuation methodology that is most appropriate and objective for the specific
investment. Typically a third party valuation firm is used to value assets under management.
SFAS 157 defines Level 3 as follows:
Level 3 inputs are unobservable inputs for the asset or liability, that is, inputs that
reflect the reporting entity’s own assumptions about the assumptions market
participants would use in pricing the asset or liability (including assumptions about
risk) developed based on the best information available in the circumstances.
Some methodologies used for valuing Level 3 assets are as follows (IPEV Board, 2010):
• Price of Recent Investment: The basis of fair value is the cost of a recent investment in the
asset. This methodology is appropriate only for limited time period investments. The
appropriateness of the valuation diminishes in time. This methodology is commonly used for
start-up or early stage investments.
• Multiples: A business is valued by applying earnings multiples (such as P/E) to the earnings of
the business. This method is applicable for investments in established businesses with a steady
stream of earnings. An specific multiple should be used for the business being valued.
• Net Asset Value: This methodology uses the value of a net asset to derive the value of the
business. This method is used for valuating companies which do not have high returns on
assets. NAV calculates the fair value of the fund’s interest of the underlying asset. The fair
value of the fund’s interest is the summation of the estimated fair value of the investment as if
realized on the reporting date. After the investment is realized, the proceeds, which are equal
to the NAV, are given to the investors.
• Discounted Cash Flows (DCF) or Earnings (of underlying business): The value of a business
is derived by calculating the present value of expected future cash flows of the underlying
business. A DCF valuation requires a detailed cash flow forecast, terminal value and risk-
adjusted discount rate. All of these inputs require subjective assumptions.
• Discounted Cash Flows (DCF) (from the investment): The value of a business is derived by
calculating the present value of expected future cash flows from the investment. Similar to the
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18. previous method, this method requires the person who evaluates to make significant
subjective judgments.
• Industry Valuations Benchmarks: The value of the business is derived using industry specific
benchmarks such as “price per subscriber”. This is considered a reliable method to estimate
the fair value of the business if applicable.
Regardless of which valuation methodology is used, the person who evaluates must include
appropriate risk adjustments. A fair value measurement includes a risk premium reflecting the
amount market participants would demand in compensation to the risk associated with the cash
flows of the underlying business.
International Financial Reporting Standards (IFRS)
The US does not yet require compliance with International Financial Reporting Standards
(IFRS)but is considering adopting it as a reporting standard. Additionally, if ASRS holds assets
which invest in emerging markets it must be IFRS compliant. There are a few differences
between IFRS and GAAP standards that have little to no effect on PE valuation.
The US has discussed adopting the IFRS. Many expected the U.S. to adopt IFRS in 2014 or
2015, but the SEC has stated that it is content with US GAAP. The adoption is currently
expected to happen in 2017 or later. Thus, if ASRS does not hold any international assets, it is
not necessary to make any accounting or reporting adjustments at this point in time. In the event
the US adopts IFRS, the ASRS would be required to make several adjustments to its accounting
and reporting procedures. This time horizon should be monitored.
Many PE funds invest in emerging markets. If ASRS considers investments in funds focused
on emerging markets, such as China, it must be IFRS compliant. The biggest difference between
the US GAAP and IFRS is that the IFRS does not determine details of certain accounting
methods for each transaction. This difference does not have a significant impact on PE valuation.
Under IFRS, managers have the authority to decide appropriate accounting methods for their
transactions. This, in turn, allows the asset manager to choose the valuation methodology
appropriate for the particular asset.
This level of discretion results in an increased level of subjectivity in PE valuations. LPs
should be prepared for variable valuation rules and subjectivity, although several US regulations
might settle this issue.
Additionally, changing from GAAP to IFRS will result in several changes on financial
statements. Under IFRS, a fund cannot record off-balance sheet financing, such as securitization.
There is also a significant difference in the regulations for consolidating accounting. US GAAP
allows funds to extract some of their investing equities, but IFRS requires funds to include the
majority of the investment in their consolidation accounting. Thus, total assets would be larger if
a fund is IFRS compliant than if the asset is US GAAP compliant.
2.1.2 Influence of Valuation Rules on Returns
Though valuation rules intend to provide objectivity in the valuation process, subjective inputs
are still needed for valuation of PE assets. This section reflects on the subjectivity, uncertainty,
and variations in returns of PE due to valuation rules. It is mandated that private equities disclose
the values and valuation procedures for PE funds. Investors can compare the values of similar
assets among the different PE funds. They also can compare the values of PE funds and the other
potential investment options. Auditors might value PE assets conservatively, which might lower
the periodic payments to LPs.
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19. Subjectivity and uncertainty
Part of the objectives of SFAS 157 for PE is to help LPs and GPs assess differences in asset
values if PE firms reallocate assets to different asset classes. To see this, the valuation of Level 3
assets is important because it cannot be done objectively. Investors are concerned about the high
degree of uncertainty and subjectivity, so they long for more accurate and transparent
information in the assets in PE funds.
As mentioned, fair valuation of Level 3 assets is difficult because of the lack of a market
comparison. Valuation of Level 3 assets relies on fund managers’ estimates and assumptions.
Even if GPs calculated the value of some asset higher or lower, the value is not certain until the
assets are sold. Although GPs have fiduciary duties, GPs will tend to favor the interests of thr
firm over those of investors. This is reflected in how PE firms are setup in Delaware to waive
their fiduciary duties (see Section 2.3 Delaware Uncorporate Law, for detail).
Change in Returns
SFAS 157 requests PE firms to report the fair value of the assets under management in standard
format. With the SEC’s additional reporting requirement, LPs can access detailed information on
PE firms as well as comparisons with other firms and other asset classes. Accurate information
about the investment returns on PE investments is readily available. This can be used by LPs for
selecting GPs for the future investments. The more developed PE firms are equipped to provide
more accurate and reliable information to LPs. Larger firms have better processes to report
periodic asset valuations.
When GPs select the appropriate valuation methodology, each investment should be
considered individually so that GPs can value each investment properly. However, similar
investments should be valued with the same methodology. Though subjective inputs are used for
valuation, the fair value assessment guidelines insist on maximizing objective inputs. Volatility
in the estimated value of an asset is expected. GPs could arrive at a higher valuation by using
inappropriate methodology or assumptions. Under SFAS 157, both GPs and auditors have
general concepts to calculate the values of the assets. GPs must comply with the rules and
auditors can check the accuracy of GPs’ calculation according to the rules.
However, the actual returns LPs will get would not change because the actual returns are
calculated by actual transactional prices. Even if the values of the assets were properly
determined and LPs thought the asset allocation was favorable, the actual returns might be lower
than LPs’ expectation if the actual deal price is lower than the valuation.
2.2 GASB rules on reporting
This section addresses the question, “Are the GASB rules on reporting for alternatives well-
conceived?” PE funds have to disclose management fees whereas some other asset classes are
not required to do so. This section first shows the overview of GASB rules. The later parts
discuss reporting criteria and discussion about the fairness of different reporting rules among
several asset classes, as well as perceptions for the reporting rules.
Overview of GASB Rules
The Government Accounting Standards Board (GASB) provides the accounting and financial
reporting standards for activities and transactions of state and local governmental entities. All
other businesses follow FASB standards for accounting and reporting. State and local
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20. government entities use FASB pronouncements in absence of an applicable GASB
pronouncement.
Both FASB and GASB standards follow GAAP and provide standards that are important to
organizations. There has been confusion between FASB and GASB standards for decades. The
difference between FASB and GASB is significant in the format and form of financial
statements, accounting of transactions such as investments, and the footnote disclosures. The
difference is primarily due to differing purposes of each standard. GASB intends to provide
accountability since its transactions involve taxpayers’ money. On other hand, FASB intends to
help management and investors make financial decisions.
Some organizations are uncertain of which standard to follow. Because of the differences in
standards and the complexity of the business activities of governmental organizations, diligence
is required to aptly apply the various standards. GASB has the jurisdiction over FASB for
governmental entities and entities for which the government appoints and controls a majority of
the board, or of which the net asset reverts to the government if dissolved.
Disclosure in PE
One of the most important objectives of accounting standards is the ability to compare one report
with another. If ASRS increases the amount it invests in PE it will be required to disclose the
corresponding increase in management fees. Since other asset classes are not required to disclose
their management fees, PE will appear to be a more expensive investment. This section discusses
this comparison issue and outlines the PE disclosing requirement in financial reporting and
compares its requirements to those of other asset classes.
Disclosure Elements
The disclosure elements for PE and venture capital cannot be generalized because of the
confidentiality and uniqueness of each fund. For instance, investors in some funds need
investors’ capital allocation, while investors in other funds don’t disclose individuals’
information. However, some general information is disclosed regardless of the type of fund.
Some principal disclosure elements are:
• Fund information, including fund overview, executive summary, and fund status;
• Investor information, including cash flow, net IRR calculation, capital accounts, capital call
notices, and distribution notices;
• Fees, carried interest and related party transaction information, including management fees
and and carried interest;
• Investment portfolio information, including current portfolio summary, realized portfolio
summary, portfolio company detail, and movement in fair value of the portfolio.
Frequency of disclosure can differ for each element, as well. For instance, general fund
information, such as fund overview, does not necessarily need to be updated frequently. On the
other hand, capital call notice and distribution notices should be updated for each transaction.
Comparison with other asset classes about management fees
Management fees are disclosed in venture capital too. A venture capital fund has to issue
investor reports like a PE fund. The U.S. equities, which currently consist 33% of ASRS’s
investment, report their management fee in their financial reports. All companies have to report
their financial statements with footnotes. Management fees would be included in income
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21. statements or footnotes of income statement as director's remuneration or compensation for
directors. This is the same in Non-US equities, which currently consist 23% of ASRS’s
investment.
Evaluating management fees for fixed income, such as bonds, is difficult. Bonds are issued to
help governments’ or companies’ finance. Management fees for bonds cannot be calculated
separately. Thus, management fees for fixed income, which consists 25% of ASRS’s investment,
are not disclosed. Management fees for investment in commodities and real estates can be
grasped. Investors have to pay transaction fees for these investments. These transaction fees can
be regarded as management fees although they are not frequently reported.
Perception of GASB Rules
This section introduces perception of GASB rules from LPs, GPs, and other stakeholders of PE.
Other stakeholders include auditors, stakeholders of LPs, potential LPs, and consultants for LPs.
LPs General valuation rules are helpful for LPs as they have to use accurate information on their
investment for their reporting purpose. Also, LPs can determine their investment strategy
according to the result of PE investments. Accounting standards are made to protect investors
from a lack of transparency so that investors can make rational decisions. The investors are LPs
in the case of PE, and the objectives of GASB are to provide enough appropriate information to
LPs. In other words, the rules should be well-understood by LPs.
GPs The general rules for asset valuation might have a negative impact on the GPs’ operations
because they no longer are able to evaluate their assets subjectively. GPs were able to value their
investment assets with their own methods. They were able to set the value of their assets higher
using only their own rationale. However, concrete valuation rules keep GPs from valuing the
assets in PE funds by themselves. When GPs cannot increasethe values of the assets arbitrarily,
LPs may come to think the funds are not doing well, resulting in possible loss of current/future
investors. GPs would keep their fiduciary duties because of GASB.
Other stakeholders
Auditors Auditors of PE funds are tasked with judging the accuracy of the valuation of assets in
their investments. With the general valuation rules, the possibility of conflict between GPs and
auditors will decrease because both of them will have universal rules. Such rules will help
auditors calculate the appropriate values of the assets in PE funds.
Stakeholders of LPs The stakeholders of LPs, the Arizona state employees in the ASRS case,
can see the returnson LPs’ investment returns without the subjective judgment of the GPs. The
benefit to LP stakeholders is similar to that of LPs themselves.
Potential LPs and consultants If investors could remove subjectivity from PE asset valuation
they could properly estimate the results of PE investment. The general valuation rules enable
reporting to investors to be in a standard structure so comparison among several PE funds is
made easier. The general valuing rules also help consultants for LPs. Consultants can provide
proper advice to LPs when they want to make decisions for PE investments with appropriately
calculated returns of PE funds. This increases the efficiency and accuracy of consulting.
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22. 2.3 The structure of entities and incentive compensation
This section discusses the structure of entities and incentive compensation being implicitly or
explicitly stated. ASRS, as a pension fund, cannot compensate with its stocks. Therefore, ASRS
has to pay management fees in cash. On the other hand, an LLC , such as Goldman Sachs can
compensate with its stocks or in cash. This might make a difference in financial statements
between ASRS and other investment organizations.
Accounting Matching Principle
The first subject in this section is whether a stock based compensation system violates the
accounting matching principle for recording revenue and expenses. Stock based compensation
creates the difference in accounting principle between an investment bank like Goldman Sachs
and a pension fund like ASRS which invests in private equity.
Stock based compensation is essentially the same compensation system as the manager fees
paid by cash in the sense that both of them are “paid” to managers. The value of stock based
compensation at the time of payment must be the same value as what would be paid in cash.
However, these two methods have different impacts on financial statements. If a private equity
fund pays management fees in cash, that reduces assets, and expenses are booked on an income
statement. On the other hand, if a company like Goldman Sachs pays management fees as stock
based compensation, it affects shareholder’s equity. The expense is still booked on an income
statement. If this company chooses stock option, the expense would be lower at the payment day
since the amount of compensation is calculated as the value of the right to purchase stocks in the
future; the price of stock option is lower than the stock-purchasing price. Although, the total
value of the compensation is the market price of the stock.
Stock based compensation does not violate the matching principle for the recording of
revenue and expenses when management fees are paid as stock. However, when the management
fees are paid as stock option, the matching principle might be affected since the amount of
expenses is typically lower than the actual value of stock option even though the expense of
stock option is equally booked over the stock option term. Also, the change in the price of the
stock is not recorded.
Thus, stock based compensation, if paid as stock option, would make it difficult to simply
compare management fees. As ASRS is not a company but a pension fund, it cannot pay
management fees with stocks. A company such as Goldman Sachs, on the other hand, has
options. It can enjoy the benefits of stock based compensation.
The Advantages and Comparison of Compensation Systems
The second discussion in this section is what the advantages of stock based compensation over
management fees paid by cash are, and vice versa. Also, discussion about the possibility of
comparison of them follows.
The advantage of stock based compensation is that a company can save cash while
motivating managers. Also, when using a stock option, a company can lower the expenses at the
payment date and get cash for common stock later. A company can also confuse investors so
they do not see high management fees as expense.
On the other hand, the advantages of cash payment for management fees are that a company
can retain some indices such as EPS (Earning per Share) and eliminate the risk of selling stock at
an undervalued price. Also, it is easy for investors to see the actual expenses for management
fees, so paying in cash is better in terms of financial transparency.
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23. If stock based compensation is paid as stocks, it is possible for investors to compare the two
investments because the value of the stocks should be the same as the amount that would be paid
as cash. The difference is, as written above, whether it causes decrease in assets, or it is just a
change in shareholders’ equity. However, when stock based compensation is paid as stock
option, it is harder to compare because the given value of stock option is usually less than the
actual value of stocks that the stock option holder can purchase.
FASB Stance on the Balance Sheet Effect
The third discussion explores the reason FASB allows the deferral and primarily balance sheet
effects. Stock based compensation is a favorable way to motivate GPs: holding some shares of
the fund and adding value to it will benefit the GPs through the rise of the stock price. This
compensation method is globally admitted by accounting standards. Thus, a company like
Goldman Sachs can pay management fees as stock based compensation.
When stock based compensation is paid as stock option, the actual benefits the receivers gain
are unknown until the receivers exercise the stock option. Therefore, a company cannot
recognize the full amount of compensation at the time of payment. This is the reason FASB
allows the deferral accounting method.
The difference on the balance sheet occurs because the resource of payment is different
between cash payment and stock based compensation. Cash payment is from cash in current
assets in balance sheet. Stock based compensation, on the other hand, is from shareholders’
equity. Thus, the difference is not caused by the timing issue on recognition although the certain
amount of time till the exercise is part of the reason of the difference.
The Significance of GAAP
The fourth and final discussion in this section considers whether GAAP would create a disparity
between accounting for investments, and what is the intent of creating that difference. GAAP
should create a disparity between different accounting methods.
The purpose of the payment is the same between cash payment and stock based compensation,
but the accounting procedure is different. GAAP would set different accounting rules for
different accounting procedures.
Managers cannot say which method is better because both methods have pros and cons for
them. Stock based compensation can lead managers to huge benefit if managers succeed in
adding value to the company, but it is not certain; value-adding does not always increase the
price of the stock. On the other hand, cash payment can fix the benefit managers get. Managers
cannot enhance their benefits, but they do not have to take a risk to get them.
Stock based compensation has a lot of benefit for payers and payees, and it makes financial
statements look better if it is used wisely. However, it also has negative factors; it might worsen
financial statements and some financial indices in the future. Thus, different accounting methods
should be distinguished. That reflects the essence of the transactions, and it helps investors to see
what is happening in the company.
2.4 Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted to promote the
financial stability of the United States by improving accountability and transparency in the
financial system, to end the ‘‘too big to fail,’’ problem and protect the American taxpayer by
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24. ending bailouts, protect consumers from abusive financial services practices, and for other
purposes (HR 4173).
Implications of Dodd-Frank Act on PE
Dodd-Frank Act has made significant changes to the regulation of the financial sector that
directly or indirectly affects PE firms.
Registration Requirement
Dodd-Frank eliminated the “private investment advisor” exemption for Investment advisors. In
past, the Investment advisor was exempt from registration with the SEC under the Advisers Act
if he or she had fewer than 15 clients and did not serve in a registered investment company.
Many Investment advisors used this exemption to avoid complying to many SEC requirements
associated with registration including the fiduciary duties, the periodic examination and the
restrictions on fees. However, the Dodd-Frank Act provides some new exemptions such as the
Foreign Private Adviser Exemption, the Certain Private Fund and Mid-Size Private Fund
Advisers Exemption, the Venture Capital Fund advisers Exemption and the Exemption for
Advisers to family offices
Definition of “Accredited Investor” and “Qualified Client”
To become an “Accredited Investor,” the investor should have a net asset worth of more than $1
million or an individual income exceeding $200,000 over the past two years. A “Qualified
Client” is one that has at least $750,000 worth of assets under management or a net worth of $1.5
million. These changes will reduce the number of investors especially in the smaller funds.
Minimum Assets requirement
Investment advisers who manage funds of less than $100 million in assets should register with
the state regulatory bodies. This would allow the SEC to focus on larger funds. If already
registered, the smaller funds will be forced to withdraw their registration from the SEC.
Registration and reporting obligation with every state regulatory body in whose jurisdiction the
fund operates, could become more costly than being under the SEC. This will make it harder for
smaller funds to operate.
Accounting and Reporting requirement
GPs are under scrutiny from the SEC on the reporting and record keeping requirements. Private
funds are required to comply with several accounting and reporting practices such as 1) assets
under management, 2) leverage, 3) counterparty credit risk exposure, 4) valuation practices of
funds, 5) asset types held, 6) trading practices, and 7) any other information deemed necessary
by the SEC. The additional requirements increase the cost of accounting, which is usually passed
on to LPs.
Dodd Frank Act does not clearly define fiduciary duties for the PE fund managers. The SEC
does not provide clear guidance on where the fiduciary duty of the fund manager applies – to the
pooled fund or to the individual investors in the pooled fund.
Volcker Rule
The Volcker rule is a special section of the Dodd-Frank Act which limits banking institutions
from investing or sponsoring and from partnership or ownership of interest in PE funds. The
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25. purpose of the Volcker rule is to prevent any conflict of interest with the LPs and prevent
exposure to risk.
Delaware Uncorporate Law
The State of Delaware has laws which exempt financial institutions from certain federal
regulations. The LP and LLC acts of Delaware give firms the option to opt out of the fiduciary
duties. The law was intended to limit regulations and provide flexibility to partnership firms
through the contractual agreements. Delaware law could be used by fund managers to relinquish
their fiduciary duties to the fund under management. The LPs should be more comprehensive in
preparing the contractual agreement and should spend time thinking about the financial
environment in the future. Any forgotten element in the contract could be exploited by the GPs.
2.5 Conclusions
Standards and guidelines are there to protect investors’ interests and prevent firms from
manipulating their books. However, accounting in the PE business is still very subjective. The
regulations are always playing catching up with the highly evolving nature of PE in today’s
world. Investors should be aware of the risk involved in PE in terms of the possibly misleading
accounting and reporting. There are no concrete rules or incentives for the fund manager to work
completely in the interest of the investors. A fund manager will aim to maximize his profits,
whether by creating value on the investment or manipulating the value of the assets, something
investors should constantly monitor.
Even if the asset manager is honest in all his activities, he has to choose from a number of
methodologies to value the asset under management. Since there are many subjective inputs
involved in the valuation of PE assets, the value is bound to be inaccurate in many cases. It also
depends on how robust the valuation process is and whether all environmental factors and risk
adjustment have been included. Fair value guidelines are trying to bring more objectivity to
valuation. Until the subjectivity is eliminated, the valuation methodologies will have an impact
on the value of the assets, which in turn will affect the returns on investment.
FASB reporting requirements and other regulations such as the Dodd-Frank Act has made
information, especially the management fees in ASRS’s portfolio, including PE, readily available
through the SEC. ASRS can compare the management fees among its investment options. FASB
and GASB also help the stakeholders of PE in other ways, such as valuation rules and reporting
standards.
In terms of the compensation system, ASRS, as a pension fund, has limited options. Since
ASRS cannot opt for stock based compensation, it cannot enjoy its benefits. Consequently,
ASRS does not have to deal with downside of stock based compensation, such as lowering EPS
index.
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26. PART III. Private Equity In Practice
This section outlines the current trends in private equity, including typical allocation percentages
for pension funds, sovereign wealth funds (SWFs), foundations, and endowments. These trends
include amount allocated to PE, portfolio percentages allocated to PE, and growing trend to
invest in emerging markets. The purpose of analyzing the trends in private equity is to
understand how and where other portfolios are investing. The following sections breakdown the
investor attitudes of LPs, their geographical areas of interest, and private equity allocation
percentage trends amongst fund types. Finally, this section compares ASRS’s portfolio allocation
to pensions funds, endowments, foundations, and SWFs to assess its positioning among these
trends.
3.1 Trends in Private Equity
In general, aggregate investment commitments to PE bottomed out following the 2008 global
financial crisis. However, aggregate PE investment is on the upswing, especially for PE funds
investing outside North American and Europe. PE investing in Europe has taken a downturn,
likely due to this growing trend to invest in emerging Asian economies, as well as economic
instability in Europe. The emerging Asian economics are growing at significantly higher rates
than the US or European economies.
Chart 3.1.1 shows aggregate investment commitments to PE from 2003 to 2011. “Asia and
Rest of World” has seen increasing annual investment since 2009, whereas North America and
Europe have seen decreasing annual investment. Thus, the post-2008 PE investment trend has
been to direct investment dollars away from Western countries and toward high growth rate
Asian economies.
Chart 3.1.1 Aggregate Commitments to PE from 2003 to 2011, by Geographic Focus (Preqin)
Towards the end of 2011, the differences in quarterly fundraising levels among funds with
different geographic focuses narrowed. Due to the larger number of funds focused on investing
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27. in North America, fundraising levels for these vehicles are significantly higher in terms of
aggregate value when compared to other territories. However, by Q3 2011, the total capital
raised by funds in each region was the closest it’s ever been, with $28B raised for North
America, $12.8B for Europe, and $13.2B for Asia (see Chart 2.1.2).
Chart 2.1.2 Quarterly Private Equity Fundraising by Primary Geographical Focus (Preqin)
Aggregate commitments for funds in Asia in Q1 2011 grew compared to Europe by the largest
margin to date, raising $7.7B more than Europe funds. For all of 2011, Asia and Europe funds
accounted for almost the same amount of aggregate capital raised, with 187 funds garnering
$59.6B in Asia and 150 funds attracting $59.5B in Europe (see Chart 3.1.1). Fundraising for
Asia private equity funds has been more resilient throughout the 2008 global financial crisis.
From 2009 to 2010, institutional investors began aggressively investing in Asia as they perceived
the emerging Asian economies to be more attractive for PE investment than the traditional
mainstays of PE investment regions in the US and Europe. While investment dollars did not
increase by a substantial amount in 2011, the investment level remained constant.
Investor Attitudes
Recently, Preqin published a report that analyzed the percentages of 100 LPs who would invest
in PE in the various regions of the world. 34% of investors felt that North America was still the
best place for PE investment. 27% of these investors said Asia, while a slightly less 26% of the
investors said Europe. 31% of the investors were geographically indifferent.
A pension fund from the United Kingdom said, “There are interesting opportunities in all
regions so [we] cannot name one region” (Preqin). Not surprisingly, 24% of LPs said they would
invest elsewhere away from Europe. As long as there is political and financial uncertainty
concerning the current fiscal crisis, investors will shy away from Europe and continue the trend
to invest in the emerging Asian economies. This is not to belittle the true economic strength of
emerging Asian economies, for such economies would be an attractive investment region
regardless of the financial situation in Europe.
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28. Charts 2.1.3 and 2.1.4 show the most popular areas, by both fund types and geographical
locations, in which LPs seek to invest. The funds LPs are predicted to prefer for the months June
2012 through June 2013 are small to mid-market buyout funds as well as venture capital funds.
The geographical location preferences are primarily Asia, South America, and Africa. This data
reflects the same 100 LPs chosen by Preqin for its report.
Chart 2.1.3 Investor Attitudes
Chart 2.1.4 Attractive Countries and Regions for PE
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29. Appetite for Emerging Markets
As is reflected in the chart above, a “substantial 72% of LPs will invest or consider investing in
emerging markets. Furthermore, 95% of these expect to increase their exposure to these regions
over the next 12 months, and none plan to reduce their exposure in the long term” (Preqin).
3.2 Trends in Private Equity investing for large-scale investments
The next section assesses investment trends by LP type—government pension plans,
endowments, and sovereivn wealth funds (SWFs)—in order to compare target PE allocations of
the general LP population with that of ASRS. Each of the LP categories in Table 3.2.1 includes
the five investor types with the highest target allocation to PE. Most funds allocate higher
percentages of their portfolios to private equity than does ASRS. Details about each of the
selected investor types can be found in Exhibit 2.
Table 3.2.1 Asset Allocation by investor Type
TYPE TARGET ALLOCATION TO PE
Endowments 30% - 43%
Public Pension Funds 20% - 25%
Sovereign Funds 08% - 10%
ASRS 05% - 09%
In Table 3.2.2, the average percentage of deals by investment strategy is provided for the same
give funds with the highest allocations as Table 3.2.1. Most notably, ASRS has a lower
percentage allocated to add-on (stock issuances done by any mean other than an IPO) and a
higher percentage allocated to growth capital relative to other LPs. Details on the exact number
of funds in each investor type in each strategy can be found in Exhibit 2.
Table 3.2.2 Asset Allocation by Investment Strategy
GROWTH PUBLIC - RESTRUC-
TYPE ADD-ON BUYOUT MERGER PIPE RECAP
CAPITAL PRIVATE TURING
Endowments 64.93% 12.08% 3.50% 5.69% 0.42% 11.58% 1.80% 0.00%
Public Pension Funds 53.60% 23.73% 6.07% 3.13% 2.49% 7.65% 2.62% 0.62%
Sovereign Funds 49.4% 25.1% 8.8% 3.5% 1.4% 9.2% 2.4% 0.2%
ASRS 38% 28% 12% 5% 4% 7% 5% 2%
The same five investor types are again compared in Table 3.2.3, based on their geographic
preferences in in PE investment. ASRS is more North America-focused than the other investors
represented in this table. Furthermore, ASRS is steering away from Europe, which may be a
prudent strategy, given not only the continent’s stagnating growth but also the steep drop in its
PE activity, both fundraising and incesting. ASRS has similar investments in South America,
Australia, Asia, and Africa as the main investor types. LPs.
Table 3.2.3 Asset Allocation by Geographic Region
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30. NORTH SOUTH
TYPE EUROPE AUSTRALIA ASIA AFRICA
AMERICA AMERICA
Endowments 69.98% 22.27% 3.38% 3.98% 0.40% 0.00%
Public Pension Funds 65.05% 24.83% 1.16% 1.09% 7.33% 0.54%
Sovereign Funds 63.1% 30.6% 1.0% 1.1% 3.5% 0.8%
ASRS 75% 18% 1% 1% 6% 0%
Next, ASRS’ portfolio is compared to funds with fund sizes closest to its own of $28 billion.
Exhibit 2 shows that the target allocation of private equity for Endowment Funds is in the range
of 12% to 23%. This is substantially lower than ASRS’s target allocation of 5% to 9% to PE.
Exhibit 2 shows us that pension funds with assets closest to $27 billion have PE allocations
ranging from 3.5% to 25% with the average being above 12%. SWFs with fund sizes close to
$27 billion typically invest 4% to 10% of their portfolio in PE. This is closer to ASRS’ allocation
percentage.
Finally, the ASRS portfolio is compared to SWFs. The four SWFs listed in China to date are
China Investment Corporation (CIC), National Social Security Fund (NSSF), State
Administration of Foreign Exchange (SAFE), and Hong Kong Monetary Authority (HKMA).
Out of the four, SAFE is the largest fund by assets under management (AUM). It has about
$589.5 billion million AUM, 5% of which is allocated to alternatives. Its only known PE
investment is in the TPG Partners VI buyout fund for $2.500 billion. The exposure assumed in
this deal is almost all buyout and add-on and US focused.
The second biggest SWF in China by AUM is the CIC, which manages roughly $482.167
billion AUM in assets. Its current allocation to PE is $11.138 billion, or 2.3% of its total AUM.
Starting in the third quarter 2012, CIC plans to forgo liquidity issues to pursue higher returns to
boost the overall performance of its investment portfolio. The CIC is very diversified, investing
with over 15 firms in primarily add-on and buyout deal types. The CIC is most heavily invested
in Asia, with the US coming in at a distant second.
The third biggest SWF in China by AUM is the HKMA. It currently has $408.340 billion
AUM. By the end of 2011, 11.5% of its portfolio had been allocated to alternatives including PE
and real estate.
The smallest SWF in China by AUM is the NSSF, which has $151.751 million AUM. Its
current allocation to PE is 2.4%, but its target allocation is 9.3%. Its plan is to allocate a total of
$4.807 billion to PE by the end of 2012 and $8.012 billion million by the end of 2015. Even
though this SWF is partnered with many foreign GPs, it has a strong preference for growth funds
focused on China (see Table 3.2.3).
Table 3.2.4 Sovereign Wealth Funds in China
FUNDS UNDER CURRENT CURRENT TARGET
INVESTOR MGMT ALLOCATION TO ALLOCATION TO PE ALLOCATION TO
(MILLIONS) PE (MILLIONS) PE
State Administration of
$589,500 5% $29,475 -
Foreign Exchange
China Investment
$482,167 2.3% $11,138 -
Corporation
Hong Kong Monetary
$408,340 - - -
Authority
PAGE 29 OF 42

31. National Social Security
$151,751 2.4% $3,622 9.3%
Fund - China
Currently, the only two SWFs listed in Singapore are Government of Singapore Investment
Corporation (GIC) and Temasek Holdings. The larger of the two funds by AUM is Temasek
Holdings. As the sole shareholder of Singapore’s Ministry of Finance, Temasek seeks to
maximize the value of its investee companies. Temasek’s investment strategy is primarily based
on buyouts and add-ons with a heavy focus emphasis on Asia Pacific, Australia, and the US. No
figures are available concerning current or target allocations to PE.
The other fund, GIC has $247.500 billion in AUM, 27% of which is allocated to alternative
investment vehicles such as private equity. GIC’s mission is “to invest the country’s foreign
reserves so as to earn reasonable returns within acceptable risk limits over the long term”
(GIC.com). It has 400 known partnerships and typically invests between $50-$600 million with
each. Its strategy is to focus on emerging economies like China, India, and South America due to
slowing growth in developed economies. As of March 2012, GIC had 11% of its portfolio
allocated to PE and infrastructure investments. Its principal PE investments types are add-ons
and buyouts.
Table 3.2.5 Sovereign Wealth Funds in Singapore
FUNDS UNDER CURRENT CURRENT TARGET
INVESTOR MGMT ALLOCATION TO ALLOCATION TO PE ALLOCATION TO
(MILLIONS) PE (MILLIONS) PE
Temasek Holdings 248,175 - - -
Gov’t of Singapore
247,500 27 66,825 -
Investment Corporation
3.3 Social Responsibility
Many critics of PE have labeled it the quintessential capitalistic industry that is only interested in
achieving the highest rates of return on investment possible, regardless of the resulting social
impacts. The main criticism is that private equity executives live by the “greed is good” motto
because all they do is gut companies and destroy jobs. However, A study by Mercer LLC, a
global consulting firm, defines PE as the leader in investment strategies by environmental, social,
and environmental (ESG) standards.
Chart 3.3.1 outlines the distribution of the ESG ratings among asset classes, with ESG1 being the
highest rating and ESG4 being the lowest. PE resulted in the highest proportion of highly rated
ESG strategies, whereas hedge funds and fixed income placed at the lowest end of the spectrum.
In order to receive an ESG1 rating, “the investment team must have demonstrated market-
leading capabilities in integrating ESG factors and active ownership in some or all of the
following processes: generation of investment ideas, construction of portfolios, implementation
of active ownership practices, and demonstration of the degree of firm-wide commitment to ESG
issues” (Mercer, February 2012). To have been placed at the top of the list, PE strategies have
incorporated transparency and improvement of ESG performance metrics within their portfolios.
The more an investment type has ESG3 and ESG4, the worse off they are in terms being in
adherence with ESG standards.
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32. Hence, the assertion that PE professionals are capitalist pigs who prefer gutting companies to
growing them is unsubstantiated. Not only does PE lead the combined ESG1/ESG2 category, it
is on the lower end of the ESG4 category. That is an encouraging statistic for investors who
wonder if investing in PE is an act of social irresponsibility.
Table 3.3.1 ESG Ratings for All Investment Types
TYPE ESG1 ESG2 ESG3 ESG4
Equity 2.3% 6.8% 43.6% 47.2%
Fixed Income 1.1% 2.7% 18.1% 78.1%
Property 3.7% 15.9% 51.1% 29.4%
Infrastructure 0.0% 18.1% 50.0% 31.9%
Private Equity 1.6% 24.4% 31.5% 42.5%
Hedge Funds 0.5% 1.9% 17.2% 80.4%
Other 1.2% 12.7% 16.7% 69.3%
Source: Mercer, February 2012
3.4 Conclusions
Trends in PE investment have shifted dramatically post-2008. First of all, aggregate
commitments to PE plummeted in 2008 and 2009 after the financial crisis. As they did begin to
recover, investments in PE are shifting in geography from North American and Europe to Asia
and other emerging markets. In 2011 PE investment in Asia surpassed that of Europe.
Compared to other pension funds, endowment, foundations and SWFs, ASRS’ portfolio
allocated less to PE, less to add-ons and more to capital growth, and less to emerging markets.
Given its liquidity requirements, this is understandable. However, if ASRS employed a laddering
strategy to achieve required liquidity as discussed in Part I, it could increase its allocation to PE
and emerging markets, which would likely achieve greater returns with the same risk.
PE has also proven to be the most socially responsible asset class in a field of over 5,000
investment strategies via a report done by a renowned global consulting firm. Hence, not only is
private equity a great way to diversify your portfolio and achieve greater returns with essentially
the same risk as other assets, it is a leader in socially responsible investing at the same time.
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33. Conclusions and Recommendations
Low liquidity and high risk are the most criticized aspects of private equity. Both are certainly
concerns for ASRS, given its needs for moderate liquidity and stable returns. However, our
research indicates that not only are some of these claims misrepresented but, if the ASRS
integrates specific management techniques it will overcome these challenges and benefit from
the higher expected returns only PE can offer.
Currently the ASRS portfolio has a liquidity rating of 2.45 out of 3. This is slightly below
the other pension funds we analyzed and would indicate that more PE is less desirable for ASRS.
However, our analysis of the efficient frontier indicates that adding PE to a portfolio will
consistently increase expected return and decrease risk. ASRS can easily overcome liquidity
restrictions by laddering its investments to achieve a steady cash flow of returns.
In regard to the perceived risk associated with private equity, recent research by Gibbons and
Kugatkina has found that over the past 10 years the volatility of private equity compared to that
of the S&P is actually lower, indicating that private equity carries lower risk for the same returns.
This research supports the conclusion that, given the same risk, private equity delivers greater
returns than public equity.
Furthermore, as part of a larger investment portfolio, private equity offers substantive
leverage in a risk management strategy. Private equity can provide both diversification and
negative correlation to the larger portfolio. If ASRS employed a laddering strategy to achieve
required liquidity, it could increase its allocation to PE and emerging markets, which would
likely achieve greater returns with the same risk.
Recently, private equity has come under extreme scrutiny from the SEC. The financial crisis
has caused the regulatory environment to reassess the mechanisms that control the flow of capital
markets. New regulations have become a hurdle for private equity.
• The regulations are driving smaller private equity firms out of business. Investments in
PE have decreased in recent years partly because of new laws and regulations such as
Dodd-Frank Act.
• The ability to choose subjective inputs for the valuation of PE assets makes it possible for
fund managers to manipulate the value of PE assets if they want to. It is necessary for the
investors to keep monitoring the periodic reporting on asset value and valuation
techniques used.
• Additional reporting requirements have increased the cost for PE firms and investors.
Adding private equity to a portfolio would increase uncertainties on regulations and
reporting requirement.
• These trends will continue and more regulations will be introduced in the near future
driving PE businesses and investors to seek other attractive markets such as Asia and
Latin America. In 2011 PE investment in Asia surpassed that of Europe.
Compared to other pension funds, endowment, foundations and SWFs, ASRS’ portfolio
allocated less to PE, less to add-ons and more to capital growth, and less to emerging markets.
Given its liquidity requirements, this is understandable. However, if ASRS employed a laddering
strategy to achieve required liquidity, it could increase its allocation to PE and emerging markets,
which would likely achieve greater returns with the same risk.
PE has also proven to be the most socially responsible asset class in a field of over 5,000
investment strategies via a report done by a renowned global consulting firm. Hence, not only is
private equity a great way to diversify your portfolio and achieve greater returns with essentially
the same risk as other assets, it is a leader in socially responsible investing at the same time.
PAGE 32 OF 42