Your Partner For Alternative Investment Solutions Private Equity Market Outlook

Your Partner For Alternative Investment Solutions 2015 Private Equity Market Outlook www.torreycove.com ©2015 TorreyCove Capital Partners Table o...
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Your Partner For Alternative Investment Solutions

2015 Private Equity Market Outlook

www.torreycove.com

©2015 TorreyCove Capital Partners

Table of Contents

3

A Macroeconomic Overview

12 Tactical Summary

Buyouts 13 North America Buyouts 20 Europe Large Buyouts

Special Situations 28 Distressed Debt 35 Mezzanine 39 Secondaries

46 Venture Capital

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from TorreyCove Capital Partners. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding whether any investment is appropriate, nor a solicitation of any type. The general information contained herein should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Generally, alternative investments involve a high degree of risk, including potential loss of principal, can be highly illiquid and can charge higher fees than other investments. Private equity investments are generally not subject to the same regulatory requirements as registered investment options. Past performance may not be indicative of future results.

2015 Outlook

A Macroeconomic Overview The developed world struck back in 2014, or at least some of it did. The U.S. economy appeared to finally make headway in shaking off the doldrums, generating sustained growth, and catching up with the roaring equity markets, as strong GDP growth and employment trends emerged in the latter half of the year. Some non-Eurozone economies within the EU, particularly the U.K., began to put up stronger growth numbers last year as well. The rest of the EU, dragged down by several weak Eurozone economies, slogged through another year of low growth punctuated by a deflation scare. And while still growing at a brisk pace, the Chinese economy continued its deceleration, clouded in uncertainty

regarding deleveraging pressures from its multiyear fixed asset binge and its shift from an investment to consumer-oriented growth model. Divergence in growth across the globe has led to divergence in policy. The Federal Reserve signaled rate tightening in 2015, while the European Central Bank announced embarkation on its own version of quantitative easing, and China cut its benchmark interest rates for the first time since 2012. In spite of rate increase talk from the Fed, the overall monetary posture of the major central banks, and therefore global liquidity, is extraordinarily expansionary. Underlying this posture is the persistence of structural imbalances in the global economy that have maintained a glut of savings and contributed to a significant demand shortfall, as well as deflationary pressures, most notably in Japan, Europe, and even the U.S. (meaning that the Fed may yet defer a rate increase). Zero or near-zero bound interest rates and quantitative easing will be features of the world economy for some time, as countries attempt to keep deflation at bay, maintain domestic asset prices and stimulate demand at home, and attempt to lure demand from their neighbors via competitive currency devaluation.

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2015 TorreyCove Capital Partners | 3

A Macroeconomic Overview 2015 Outlook

Economic Growth U.S. real GDP increased at an annualized rate of 2.6% in the fourth quarter of 2014, following a strong third quarter in which growth was up 5.0% on an annualized basis, according to the Bureau of Economic Analysis (BEA). For the full year, U.S. GDP grew by 2.4%, with a poor first quarter showing detracting from the stronger latter half of the year, but last year was still a minor improvement over 2013’s 2.2% growth. The BEA attributes growth in the last two quarters of 2014 to positive contributions from personal consumption expenditures, nonresidential fixed investment, federal government spending, residential fixed investment, and exports. Imports, which are a subtraction in the calculation, decreased. House prices in the U.S. rose at a moderate pace in 2014 compared to the double digit price appreciation seen in 2013. Between September 2013 and September 2014, the Freddie Mac House Price Index continued to rise, but at a modest 5.0%, with an outlook to moderate to around 3.0%. Overseas, European GDP growth looks to be coming out of the 2013 slump. However, the recovery is slow, with Eurostat showing full year growth of only 0.8% in the Euro Area, which is nonetheless an improvement on the -0.5% from the prior year. The larger EU posted a 1.3% annual GDP increase for 2014 after an essentially flat year in 2013. Ireland showed the strongest growth in the Eurozone and European Union, with annual growth of approximately 5.0%, though this figure may be considerably pumped up due to the effect of contract manufacturing by offshore pharmaceutical companies. GDP Growth

20%

China

United States

European Union

15% 10% 5%

0% -5% -10% 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: IMF, Eurostat ©

2015 TorreyCove Capital Partners | 4

A Macroeconomic Overview 2015 Outlook

After posting consecutive negative growth in the years following the crisis, Greece, Spain, and Portugal finally emerged from their slumps. Greece picked up steam in the latter half of the year and posted a moderate increase in GDP for 2014. Meanwhile, Spain and Portugal put up annual growth rates for 2014 of 1.4% and 0.9%, respectively. On a negative note, Italy, the Eurozone’s third largest economy, continues to struggle to generate growth and posted another flat year in 2014. In Asia, China's gross domestic product expanded 7.4% in 2014, its slowest pace in over 20 years and a slight drop from the 7.7% growth in 2013. The slowdown was driven by lower property investment, shrinking credit growth, and weakening industrial production. China’s leaders approved over 300 infrastructure projects valued at over $1.1 trillion for 2015 in order to stimulate growth and boost market confidence. In Japan, the monetary stimulus of the Japanese central bank has not shown any considerable sustainable impact on the country’s growth so far. A disastrous second quarter – the result of a major consumption tax hike taking effect – put 2014 in a hole from which it could not dig out, leading to another year of decline for Japan’s economy. In response to continuing growth challenges, the Japanese prime minister approved an emergency stimulus package worth ¥3.5 trillion ($29.1 billion) on December 27th to stimulate the economy and reach a GDP growth target of at least 0.7% in 2015 and 2016.

Unemployment The U.S. unemployment rate decreased from 6.7% in December 2013 to 5.6% in November 2014, according to the Bureau of Labor Statistics (BLS). Unemployed civilians decreased by 383,000 to 8.7 million. The number of long term unemployed, those jobless for 27 weeks or more, was essentially unchanged at 2.8 million in December compared to November, or 31.9% of the unemployed. Over the past 12 months, the number of long term unemployed declined by 1.1 million. Even though the unemployment rate fell sharply over the past year, the U.S. still has a considerable number of “involuntary part time workers” who are still counted as employed. The BLS estimates nearly 6.8 million people fall into this category. In December 2014, there were 2.3 million persons classified as “marginally attached to the labor force,” meaning they had looked for a job within the last 12 months, but not in the four weeks prior to the survey. Among the marginally attached, there were 740,000 people who dropped

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2015 TorreyCove Capital Partners | 5

A Macroeconomic Overview 2015 Outlook

out of the labor force as discouraged workers. The number of involuntary part time workers, long term unemployed, and discouraged workers suggest that, while there has been considerable improvement in the U.S. employment picture over the last 12 months or so, the labor force remains underutilized, which will figure significantly in Federal Reserve thinking regarding rate increases in 2015. The U.K. also showed meaningful growth momentum, with a 2.6% year over year increase in 2014, compared to 1.7% in the prior year. After poor performance in the years out of the labor force as discouraged workers. The Euro Area unemployment rate was 11.5% in November, unchanged from the five previous months, but down from 12.1% in November 2013. Among the member states, the lowest unemployment rates were recorded in Germany (5.0%) and Austria (4.9%). The highest unemployment rates persisted in Greece (25.8% in October 2014) and Spain (23.9%). Youth unemployment decreased by 354,000 and 58,000 in the European Union and Euro Area, respectively, compared to last year. The highest youth unemployment rates were observed in Spain (53.5%), Greece (50.6 % in October 2014), Croatia (45.5% in the third quarter 2014), and Italy (43.9%). In Asia, the Southeast Asian countries show the lowest levels of unemployment, including Thailand (0.6%), Singapore (2.0%), and Vietnam (2.1%). These are followed by Japan (3.5%), South Korea (3.5%), and China (4.1%).

30%

12%

25%

10%

20%

8%

15%

6%

10%

4%

5%

2%

0%

0%

Source: Trading Economics

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

U.S. Unemployment Rate

Greece South Africa Nigeria Spain Iraq Italy Portugal Egypt Euro Area Poland Ireland France Turkey Austria Iran Finland Belgium Netherlands Czech Republic Colombia Argentina Sweden Canada Philippines Pakistan Indonesia Venezuela United Kingdom United States

Unemployment Rates

Source: Bureau of Labor Statistics

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2015 TorreyCove Capital Partners | 6

A Macroeconomic Overview 2015 Outlook

Inflation In spite of historically low interest rates, U.S. inflation rates remained quite tame throughout 2014, failing to hit the Fed’s target rate of 2.0%. The All Items Index increased 0.8% over the 12 months ending December 2014, a notable decline from the 1.3% increase from the 12 months ending November 2014. The decline is mainly due to the energy index, which fell by 4.7% (the gasoline and fuel oil indexes fell by 9.4% and 7.8%, respectively). However, the food index has risen 3.4% over the 12 months ending December 2014. The EU inflation rate posted at -0.1% in December 2014. The highest inflation rates were recorded in Romania (1.0%) and Austria (0.8%). In fact, most EU countries had an inflation rate of less than 1.0%, with the lowest rates seen in Greece (-2.6%), Bulgaria (-2.0%), Spain (-1.1%), and Cyprus (-1.0%). The highest annual percentage changes were recorded in alcoholic beverages and tobacco (2.1%), restaurant and hotels (1.5%), and education (0.9%); while the lowest annual changes were in communications (-2.6%), transport (-2.3%), and food and non-alcoholic beverages (-0.6%). The Euro Area encountered outright deflation in December 2014, with an inflation rate of -0.2%, down from 0.3% in November. The negative overall rate is primarily due to a drop in energy prices, which fell 6.3%, compared to a 2.6% decline in November. In Asia, China's annual inflation rate slowed to 1.5% in December 2014, down from a 2.5% increase in December of last year, and touching the lowest level since January 2010. Food prices accelerated by 2.9% while non-food costs rose at a slower 0.8%. Needless to say, the Peoples Bank of China (PBOC) was far from reaching its 2014 inflation target rate of 3.5%. Global Inflation Rates

10%

U.S.

European Union

China

8% 6% 4% 2% 0% -2% -4% 2004

2005

2006

2007

Source: Bureau of Labor Statistics, EuroStat & Trading Economics

2008

2009

2010

2011

2012

2013 ©

2014

2015 TorreyCove Capital Partners | 7

A Macroeconomic Overview 2015 Outlook

Sovereign Banks In early 2014, the Federal Reserve, under its new head Janet Yellen, set out its primary policy objectives for the near to medium term– attaining maximum employment and reaching a target inflation rate of 2.0%. As expected, the Federal Reserve progressively reduced its bond buying program throughout 2014, ending quantitative easing (QE) completely in October. However, interest rate policy remained unchanged at close to zero percent in order to stimulate growth. The Fed indicated that it planned to maintain interest rates at the zero bound until observed inflation and employment levels are more in line with its objectives. In its effort to strengthen the economy, the Federal Reserve’s total liabilities reached an astonishing $4.4 trillion, an increase of over $400 billion from 2013, and $2.2 trillion from December 2008. In Europe, the ECB has been moving in the direction of further easing, due to rising concerns over deflation. Consequently, it has progressively reduced Euro Area key interest rates to close to zero in order to generate economic growth and stave off deflation. The ECB also began purchasing covered bonds and asset backed securities in the fourth quarter of 2014. These purchase programs will last for two years and will be followed by seven targeted longer term refinancing operations that are scheduled to run until June 2016. These measures are intended to move the ECB balance sheet to the size it had at the beginning of 2012 (close to $2.7 trillion). Aside from monetary policy, in October 2014 the ECB published the results of a year-long examination of the resilience of the 130 largest banks in the Euro Area, as of December 31, 2013. Central Bank Rates

20%

2012

2013

2014

15% 10%

5% 0%

Source: Trading Economics ©

2015 TorreyCove Capital Partners | 8

A Macroeconomic Overview 2015 Outlook

The 25 banks which failed the test were required to cover capital shortfalls. The measure was intended to boost public confidence and calm market concerns relating to the safety and soundness of the Continent’s banking sector, thereby making it easier for banks to source funding and subsequently increase lending. In Asia, the PBOC pursued a series of expansionary monetary policies in order to rejuvenate China’s economic growth, which has decreased significantly in recent years. One of the most significant monetary measures taken was to cut the benchmark one-year lending rate by 40 basis points to 5.6% in November 2014, which was the first rate cut in more than two years. Moreover, the PBOC injected $81 billion into the five largest Chinese banks to support credit provision. In another policy initiative – this one targeted at reducing the influence and scope of the shadow banking market - the PBOC announced a series of reforms in recent months, including tighter regulations on the usage of bond market and interbank assets for refinancing. Earlier this year, the governor of the PBOC announced its plan for 2015, which includes lowering financing costs for companies, accelerating interest rate liberalization, pushing ahead capital account convertibility, and establishing a deposit insurance system.

Public Markets1 The U.S. equity markets posted strong returns in 2014, fueled by an accelerating economic recovery and

continuing low interest rate environment. The S&P 500 and Russell 3000®2 returned 13.7% and 12.5%, respectively, in a solid year that outpaced most other major market equity indices (for example, the German DAX was up only 2.7% for the year). Alibaba, China’s biggest online commerce company, executed the largest initial public offering ever in September, issuing $25 billion of equity on the NYSE. Its shares are now 53% higher than their initial offering price. Compared with last year, volatility measured by the VIX index increased by 40.0%. In Europe, the CAC 40 was up only 2.6% and the British FTSE 100 only 1.0%, with European deflation as a possible contributing factor, especially with respect to the former. In Asia, the Japanese Nikkei 225 posted a 9.0% gain as it responded to expansionary policies. The Hong Kong Hang Seng index was up a modest 5.3%, though the A-share market was much stronger.

1 Public market returns are calculated on a dividend reinvestment basis. Returns based on price are as follows: S&P 500 11.39%; Russell 3000®2 10.45%; DAX 2.65%; CAC 40 -0.54%; FTSE 100 -2.71; Nikkei 225 7.12%; Hang Seng 1.28%. 2 Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.

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2015 TorreyCove Capital Partners | 9

A Macroeconomic Overview 2015 Outlook

The Brazilian IBOVESPA showed a 2.9% loss in 2014 against the background of a slumping Brazilian economy and slowing growth in Latin America. The decline in oil prices has not favored the high yield markets, which returned only 1.8% in 2014 (Citi US High-Yield Market Index).

The Outlook for 2015 World output is expected to increase to 3.5% in 2015 from 3.3% in 2014, according to the IMF. Advanced economies are expected to grow modestly, with a 2.4% increase in 2015, including U.S. growth of 3.6%. U.S. inflation has remained low, but is expected to rise to 2.1% in 2015. The growth expectation for the U.S. is based on an improving labor market, stronger household balance sheets, and increasing private investment. Nevertheless, the U.S. economy remains susceptible to some downside risks in the future, the main one being a higher than expected increase in interest rates. With rates still low, investors continue to show increasing risk appetite and yield-seeking behavior, which bodes well for equity and high yield markets. An extended decline in oil prices could give investors pause, at least with respect to the high yield market, as the amount of high yield energy debt has risen 155.0% since 2009 and currently accounts for about 16.0% of the high yield issuance volume, according to Fitch Ratings.

VIX Index

Public Markets Returns

350 300

S&P 500 MSCI Emerging Mkt 3 Russell 3000 ®

Dax 30 FTSE 100

140 120

250

100

200

80

150

60

100

40

50

20

0

Source: Bloomberg

0 2012

2013

2014

Source: Bloomberg

3 Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell © 2015 TorreyCove Capital Partners | 10 Investment Group.

A Macroeconomic Overview 2015 Outlook

The Euro Area is expected to recover only modestly, with the IMF estimating 1.2% GDP growth in 2015, a meaningful downward revision from earlier estimates. Prospects are also uneven across the region— stronger in Germany and Spain, weaker in France and Italy. In order to combat persistent high unemployment rates and low inflation and to reignite meaningful growth, the ECB has further loosened its monetary policy, and in the first month of 2015 announced that it is following its counterparts at the Fed and Bank of Japan in pursuing explicit quantitative easing. In Asia, the IMF projects China’s growth to moderate to 6.8% in 2015 (another downward revision) as slower credit growth through both the banking and non-banking sectors impacts investment, and the moderation in the real estate sector continues. Japan is struggling to stage a recovery, and has gone all-in on aggressive monetary policies. It is hoped that the stimulative effect of these policies will trump the negative effects of recent tax hikes and help Japan’s growth achieve at least the IMF target of 0.6% in 2015. In the rest of the world, the IMF predicts Latin America’s GDP growth to improve modestly to 1.3%, supported by improving exports and a recovery in investment. Economic activity in Sub-Saharan Africa has continued to grow at a better pace, helped by favorable external demand conditions and strong growth in public and private investment. The IMF projects the region’s growth to accelerate moderately, rising from 4.5% in 20144 to 4.9% in 2015.

4

2014 figure of 4.5% is an estimate from World Bank ©

2015 TorreyCove Capital Partners | 11

Tactical Summary

Ratings are tactical recommendations and assume a portfolio with a stable strategic allocation

North America Buyouts > page 13

12- to 18-month commitment outlook >

SMALL ($500 Million and Below) and MIDDLE MARKET ($500 Million to $5 Billion)

Favorable: Improving deal flow and investment, strong exit markets, continued strengthening of U.S. economic recovery, continued accommodating monetary stance of Fed, secondary transaction interest from larger buyout funds, lower purchase price and debt multiples in small buyout sector Unfavorable: Increasing leverage and purchase price multiples, increase in dry powder to middle market, concerns regarding longevity of equity bull market

 MODERATE OVERWEIGHT

LARGE ($5 Billion and Over)

Favorable: Improving deal flow and investment, strong exit markets, continued strengthening of U.S. economic recovery, continued accommodating monetary stance of Fed Unfavorable: High and increasing leverage levels, increasingly aggressive purchase price multiples, concerns regarding longevity of equity bull market

 NEUTRAL

Europe Large Buyouts > page 20 Favorable: Initiation of quantitative easing, some easing of flow of credit to enterprises, modest (though uneven) economic recovery projected for 2015 Unfavorable: Deflation risk, Greek debt crisis, stalled structural reforms, sustained high leverage and purchase price multiples

 NEUTRAL

Special Situations Distressed Debt, Mezzanine, Secondaries > page 28 DISTRESSED DEBT > page 28

Favorable: Declining investor risk aversion, large quantity of debt issuance in recent years, weakness in energy high yield debt sector Unfavorable: Continuing strength of credit markets, persistence of low interest rates

 MODERATE OVERWEIGHT

MEZZANINE > page 35

Favorable: Deal flow increase resulting from rising buyout fund activity and pick-up in U.S. economy, potential beginning of interest rate increase cycle Unfavorable: Minimal pricing power as a result of strength of competing sources of debt, interest rates remain low in spite of expected minor increase in 2015

 MODERATE UNDERWEIGHT

SECONDARIES > page 39

Favorable: Opportunistic selling likely to increase, portfolio rationalization by LPs persists, GP restructurings likely to increase Unfavorable: Entry of new low cost competitors, absence of allocation pressure, extension of Volcker Rule compliance, strong primary performance and distributions, increasing seller sophistication, large capital supply devoted to strategy, existing high pricing, high liquidity, and lack of selling pressure

 STRONG UNDERWEIGHT

Venture Capital > page 46 Favorable: Strong exit markets, performance over past two years, inventory of attractive enterprises Unfavorable: Stretched valuations that are rising across the board, uncertainty regarding remaining life of bull market, challenge in gaining access to best deals

 NEUTRAL

It should be noted that TorreyCove’s private equity portfolio management methodology emphasizes the equal or greater importance of manager selection in relation to other elements of the portfolio management process, such as regional or sector weightings. For this reason, a client may pursue an investment with a top-performing investment manager even when a region, sector, or strategy is deemed less attractive on a relative basis. These are guidelines; an institution’s weightings may differ based on their current portfolio composition and overall goals, objectives, and risk tolerance. © 2015 TorreyCove Capital Partners | 12

Buyouts > North America

After a period of stabilization and retrenchment in the post crisis years, the North American buyout space began to generate momentum in 2013, especially in the latter half of the year, in lockstep with strong capital markets. In 2014, buyout funds noticeably shifted into another gear, putting up solid increases across all three major activity categories (fundraising, investment, and exits). Of particular note was the increase in investment activity, as buyout funds were finally able to deploy meaningful capital after a few relatively difficult years on the deal front. Perhaps most impressive was the exit picture, driven by bullish capital markets that allowed buyout funds to return large quantities of capital to investors and set the stage for a positive feedback loop, as investors redeploy distributions back into the buyout asset class.

Fundraising The fundraising momentum from 2013 rolled into 2014 with no apparent diminution, as U.S. buyout funds gathered more than $194 billion for the year (through December 10th), a gain of at least 6% on the 2013 total of $183 billion, itself a substantial increase over the prior year. Though still only about twothirds of the level of the heights of 2007 ($292 billion), with three years of increasing fundraising totals, the buyout strategy in the U.S. can fairly be said to have fully recovered from the massive hit it took in the immediate post crisis years. At that time buyout funds saw a drop of nearly 75% in fundraising from 2008 to 2009 and subdued numbers for the next two years until breaking out again in 2012.

Buyout Fundraising

200

2007 20102 2013

150

2008 2011 2014 YTD

2009 2012

350

Mezzanine Funds Buyout Funds

300.8

300

263.6

250 200

100

229.8 190.8 165.8

200.2

160.7

150

100

50

98.7 69.3

65.8

50 0

Mega Funds ($5B or more)

Large-Medium funds ($1B to $4.99B)

Mid-Market funds ($300M to $999M)

Small funds (up to $299M)

Source: Buyout Magazine; data is through December 10, 2014; data covers U.S. sponsored funds operating anywhere in world

0

Source: Buyout Magazine; data through December 10,2014 ©

2015 TorreyCove Capital Partners | 13

Buyouts > North America

While 2013 was the year of the mega fund, last year saw leadership shift somewhat to the next tier of large and medium size funds. After falling behind the mega funds in 2013, funds targeting $1 billion to $5 billion in commitments had a banner year, pulling in approximately $111 billion in commitments, nearly an 80% increase over the prior year and well over double the amount garnered by the mega funds. Both mid-market and small fund groups held steady year over year at $26 billion and $6 billion, respectively.

Investment Activity The deployment pace of buyout funds in 2014 could be characterized as unspectacular, but improved. For the year, total pending and closed deals by U.S. sponsors (relating to deals anywhere in the world) indicated a disclosed value of approximately $207 billion (through December 10th), a meaningful increase of 24% over the 2013 value of approximately $167 billion. In terms of closed deals only, 2013 bested 2014, $146 billion to $113 billion; however, the 2013 totals were skewed by two large deals – Dell and Heinz. Excluding the two mega deals, the amount of closed deals for 2014 puts it in the same league as the prior three years. Of course, the investment pace of recent years is still not in the same universe as the peak year of 2007, when $597 billion was closed, over five times the 2014 level.

Purchase Price and Debt Multiples for North American Buyouts

1.0 0 2011

Purchase

Debt

10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0

Average Debt Multiples of Middle-Market LBO Loans ($50mm or less EBITDA) Average Debt Multiples of Large Corporate LBO Loans (Over $50mm EBITDA) LBO Purchase Price Multiple Middle-Market (Under $50mm EBITDA)

2012

2013

2014

4Q14

2011

2012

2013

2014

LBO Purchase Price Multiple Large Corp ($50mm or more EBITDA)

4Q14

Source: Standard & Poor’s Financial Services LLC ©

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Buyouts > North America

Though the total dollar value of closed and pending deals increased only modestly, the number of deals completed increased, suggesting a more broadly-based investment environment. No mega deals accounted for a large share of disclosed value. In fact, the largest deal of the year was Tim Hortons at $11.5 billion, followed by Safeway at approximately $9 billion; both significantly smaller than the Dell ($24 billion) and Heinz ($23 billion) deals from the prior year. Buyout deal pricing remained aggressive in 2014, as few of the trends that would moderate purchase price multiples were in evidence. Purchase price multiples for all deal sizes ended 2014 at just over 9.0x EBITDA. Likewise, leverage multiples remained at or near the highs achieved over the past few years, with current first lien debt multiples of over 4.0x EBTIDA. The usual trend of purchase price multiples moderating with declining deal size continued intact for 2014. But by nearly any measure, buyout deals in the North American market remain fully-priced at best. In fact, judged solely by purchase and debt multiples, the 2014 pricing environment is essentially indistinguishable from the immediate pre-crisis years – a statement that could be applied to nearly all of the post-crisis years as well. Barring a significant rate increase by the Fed, meaningful slowdown in the U.S. economy, or burn-off of a large portion of dry powder within the buyout space, this situation is not expected to measurably change in the coming year.

Exits Buyout funds returned capital to investors at a torrid pace in 2014, continuing the solid performance that started in the latter half of 2013. In total, buyout funds generated exits of $215 billion (per Preqin) for the year, a respectable 10% increase over a very favorable performance in 2013. All major routes to exit were strong, including IPOs and secondary buyouts, but the M&A route dominated, accounting for $153 billion of the total exit value, up approximately two-thirds from the prior year. The net asset values of buyout funds also increased significantly during the year, in conjunction with strong public markets and exit valuations.

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2015 TorreyCove Capital Partners | 15

Buyouts > North America Buyouts > North America Small and Middle Market 12- to 18-month commitment outlook >

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







STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

Buyouts > North America Large 12- to 18-month commitment outlook >

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







STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

Outlook After a breakout year in 2013, North American buyouts posted another solid performance in 2014, on all major fronts – fundraising, investment, and exits. The momentum behind the asset class appears set to carry it to new heights in 2015, so long as the public markets continue to cooperate. On the fundraising side, record-high equity valuations and heavy distribution flow from buyout funds have opened up plenty of room for new commitments to the asset class, while investor sentiment towards private equity remains high. In fact, Preqin’s latest investor survey notes that 79% of investors plan to maintain or increase their allocation to private equity, while 46% indicate that they are under-allocated to the asset class going into 2015 (compared to 39% in 2013). Fund managers are likely to oblige investors’ desires by coming to market while the fundraising window is fully open, even if it means moving earlier than might be necessary. These factors promise to make for another solid year of fundraising for North American buyouts, though the largesse may be spread around more broadly this year due to the relatively recent closes of most of the major mega-funds. As expected, purchase price multiples for buyout transactions remained very high during 2014, a situation that is not expected to change in the coming year. The same factors are at work: continuing low cost leverage, aggressive competition for quality deals between newly raised funds, and about $215 billion of dry powder, per Preqin, relating to North American buyout strategies (not excessive in light of 2014 closed and pending deals of over $200 billion). Add to this mix an improving economic environment in the U.S., capital markets that continue to drive upward, and the increased aggressiveness of strategic acquirers, and it is difficult to see what might take the air out of buyout valuations in 2015, short of a major economic setback.

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2015 TorreyCove Capital Partners | 16

Buyouts > North America

One thing that could put a damper on the buyout party in 2015 would be a move by the Federal Reserve to begin an interest rate increase cycle, which was widely expected to start sometime in the middle of the year. However, this increasingly looks to be off the table until some later date, due to the Fed’s concerns regarding disinflation or outright deflation, dollar strength, and continuing weakness in the global economy (as well as mixed data in the U.S.). Therefore, the availability of low cost leverage should not be substantially impeded for at least most of the coming year, which will allow buyout firms to continue to bid aggressively. Limited partner power vis-a-vis buyout general partners had already begun to slip in 2013 with the resurgence of interest in the mega funds. That trend is expected to continue and accelerate in 2015, as a result of several factors (some noted above) – large scale distributions, under-allocation to private equity, and solid performance by the asset class. For the time being, the better quality general partners are clearly in the driver’s seat regarding terms, and even average general partners will find a more conducive negotiating environment. The challenge for investors will be to maintain discipline in terms of manager quality in what is proving to be a challenging environment to deploy private equity dollars in sufficient quantity to maintain allocation. The buyout distribution machine finally got underway, logging one of its most impressive years ever in 2014. Last year saw M&A exits accelerate dramatically. Strong exit and distribution performance is expected to persist into 2015, and it would not be surprising to see a sequential increase year over year. However, while investor sentiment regarding the state of the U.S. economy generally, and the health of the markets particularly, remains buoyant, recent months have seen the return of volatility, which promises a bumpier ride than what has been experienced over the past few years. If severe enough, this volatility could derail buyout firms from beating last year’s realization totals.

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2015 TorreyCove Capital Partners | 17

Buyouts > North America

The IPO market entered 2014 with strong momentum and – in spite of recent market wobbling – should provide fund managers an attractive means to exit positions and generate sizable distributions to limited partners during the year. In many ways, the current North American buyout markets resemble the 2004 and 2005 vintages, with strengthening deal flow, investment, and exits against the backdrop of an improving economy, but before the euphoria and excess of the 2006 and 2007 vintages. In fact, what is absent from current market conditions – numerous mega deals, large public to private transactions, feeding frenzy auctions, club deals, and extremely short fundraising cycles - suggests that we are still some way from such a frothy environment. At present, buyout managers appear to be maintaining some discipline with respect to deployment of capital and leverage; however, this behavior is likely to change as the bull market continues and the U.S. economy continues to pick up speed, especially absent serious efforts by the Fed to take away the punchbowl. Our tactical rating for the large buyout sector will remain at “Neutral.” The substantially improved investment and exit environments that gained traction in 2014 put new wind at the back of all North American buyout strategies. The Fed’s continuing accommodative stance, as well as the generally improving trend of the U.S. economy (even if choppy) round out the positive backdrop for buyout strategies. However, high purchase price and leverage multiples remain as major sources of worry going into 2015 (the same as for last year). Also, the remaining life of the bull equity market in the U.S. is now a factor to take into account in assessing the time to liquidity for buyout deals made in 2015. Our tactical rating for the small and middle market buyout sectors will remain at “Moderate Overweight.” Small and medium buyouts will benefit from most of the positive factors noted above with regard to large buyout funds. While leverage and purchase price multiples at the larger end of the middle market are in the

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2015 TorreyCove Capital Partners | 18

Buyouts > North America

same territory as those for large buyouts, there is still some moderation within the smaller size deals. Also, buyout funds in the lower half of the size distribution should be able to take advantage of the acquisition appetite of their larger cousins, by exiting at attractive valuations via secondary sales. As noted above with respect to large buyouts, the time to liquidity for 2015 vintage deals is a major concern for small and middle market buyout funds as well, though perhaps not to the same degree. Within the context of a heated buyout market characterized by elevated purchase prices and leverage multiples, investors should attempt to reduce downside risk by concentrating deployments on managers that focus on complex transactions or carve-outs where somewhat lower prices may prevail, as well as those that pursue strategies that are less dependent on entry multiples, such as roll-ups and operational improvements. Buyout managers that have a demonstrated track record of maintaining discipline through frothy environments such as 2006 through 2007, or worked through challenged portfolios in the wake of such environments, should also be favored. Last year we anticipated that the trend in terms of investment, valuation, and exits would be upward, which came to pass. We expect this upward trend to continue through 2015.

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2015 TorreyCove Capital Partners | 19

Buyouts > Europe

Current and expected GDP growth in much of Europe remains anemic. Accordingly, the European Central Bank (ECB) recently announced plans to initiate a major quantitative easing (QE) program. Rolled out by ECB President Mario Draghi in January 2015, QE will pump €60 billion per month into the money supply until at least 2016. Including existing programs, total ECB monetary stimulus will now come to about €70 billion per month, indicating a dramatic balance sheet expansion of up to €1.1 trillion over the next 19 months. The addition of QE to the mix should have some stimulating effect on the Eurozone, primarily through its weakening of the euro and the resulting increase in competitiveness of its exports. Ever-present in the background - and periodically acute - the Greek debt problem remains a wild card. The latest standoff was just defused via a bailout extension agreement between Greece and its creditors in February. The agreement, which will expire in four months, is not a resolution, but simply buys time for the parties to attempt to negotiate an acceptable way forward. Therefore, the Greek debt crisis is likely to rear up again in May or June, and any blowback from its mishandling could end up swamping whatever modest gains are made in the short term by the QE program. If a deal with the newly elected Greek government can be reached this summer, the Eurozone will have bought some more time for the ECB to pursue its expansionary monetary policy, banks to recapitalize and lend more aggressively, consumers to regain confidence, and governments to work on structural reform. This is a tall order, and highlights the fact that, seven years after the financial crisis, Europe is still hampered by inadequate demand, relatively rigid labor markets, weaknesses in the banking sector, and the prospect of being derailed completely by the next outbreak of the euro crisis.

Fundraising With regard to private equity fundraising, Europe-focused buyout funds pulled in €30.6 billion in commitments in 2014. From one point of view, this was a disappointing result, as it was about 37% off from the prior year’s record-breaking total of nearly €50.0 billion raised, the best year since 2008. However, when viewed in the context of the three-year period 2012 through 2014, last year’s total demonstrates sustained investor interest in the European private equity sector.

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Buyouts > Europe

Investment Activity Deployments in Europe have proven relatively resilient, in spite of the major problems facing the region. In 2014, buyout funds invested approximately €68.0 billion, more or less the same amount as in 2011, and about 10.0% more than 2013. The years 2011 and 2014 were virtually tied at the top of the pack for all years since 2007. After the bottom fell out of investment in 2009 (less than €25 billion deployed), investment snapped back smartly to nearly €58.0 billion and only dipped moderately below €60.0 billion in 2012, one of the years in which the euro crisis became acute. Overall, buyout investment in the European theater remains quite healthy in spite of the troubles on the Continent, which is not too surprising given the size of the EU and large number of high quality enterprises operating within its borders.

Exits Buyout-related exits in Europe caught fire in 2014. As was the case with their counterparts overseas, buyout managers took full advantage of the aggressive acquisition appetites of strategic and financial buyers as well as ample availability of debt for recapitalizations, pushing the aggregate value of exits in 2014 to over €123 billion. This performance was nearly 40% better than 2013, itself a relatively good year

Deal Value of European Private Equity-Backed Buyouts

160 140 120 100 80 60 40 20 -

€ € € € € € € € €

147

155

59

58

68

59

63

68

2012

2013

2014

22

2006

2007

2008

2009

2010

2011

Source: Preqin ©

2015 TorreyCove Capital Partners | 21

Buyouts > Europe

12- to 18-month commitment outlook >











STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

for exits (€88.7 billion). The seller’s market for private equity assets is unlikely to slow appreciably in 2015, as all the elements that made 2014 a good year remain in place: large supply of low cost, accommodative debt for sizeable deals; active strategic and financial buyer interest; and buoyant capital markets. If QE can gain traction in boosting liquidity to the debt markets, 2015 looks to be set for another booming year on the exit front.

Outlook Now that the latest Greek crisis has been avoided (for a time), the spotlight shifts back to the ECB and the potential effects of its QE program, at least for the first half of 2015. It was no easy feat for ECB President Mario Draghi to pull this off, as strong objections from many ECB members, especially Germany, had effectively forestalled any movement down the QE path for some time. However, the deflationary readings that came out of the EU in December, against the backdrop of poor growth, spooked enough ECB members to allow for a majority in favor of the QE policy. Predictably, the financial markets in Europe and elsewhere greeted the announcement positively, while the euro traded down versus the U.S. dollar.

EU GDP Growth – Actual and Projected

4%

3.1% 2.1%

2%

1.7%

0.5%

1.3%

1.7%

2.1%

2014

2015*

2016*

0.0%

0% -0.4%

-2% -4%

-4.4%

-6% 2007

2008

2009

2010

2011

2012

2013

Source: Eurostat, European Commission ©

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Buyouts > Europe

Structural issues within the EU cast some doubt as to the potential efficacy of QE. For one, sovereign yields for most Eurozone countries are already at historically low rates: German bonds are now trading at or near a negative real yield and Italian 10-year bonds are trading below 2%. The question arises as to the materiality of any stimulus provided by lowering rates even further. There are also potential transmission problems. Continental enterprises obtain a much larger percentage of their financing from banks rather than capital markets, and ownership of capital market securities by households is significantly lower than it is in the Anglosphere. Therefore, the transmission of the benefits of QE - lower funding costs for enterprises and the wealth effect produced within the household sector – will be less direct and probably less substantial within the EU than they were in the U.S. and U.K. In order to avoid the perception of the ECB bailing out problem peripheral countries or socializing indebtedness, the QE program will be implemented indirectly, via each national bank purchasing its own government’s debt. This means that Germany, France, and Italy may dominate the program, while smaller hard hit peripheral countries may not get as much help as they need. The ECB’s decision this month to bar certain Greek debt as collateral is illustrative of potential implementation problems, though the move was not directly related to QE. Finally, the continued weakness of the banking systems within many peripheral countries and its dampening effect on lending may inhibit the flow of QE into these hard-pressed regions. On other fronts, the data are more mixed:

• After a year of very moderate growth in 2014, GDP growth for the EU in 2015 is projected by the European Commission at 1.7% and over 2.0% for 2016.

• Deflation has reared its head in the Eurozone, with a 0.2% year over year decline reported for December, and January following up with a 0.6% dip; however, the ECB is hopeful that its QE program will manage to increase inflation by 0.4% to 0.7% over the next two to three years.

• Senior loan sponsored volume of about €50 billion was up materially from the 2013 level, marking the second year over year increase and the highest total in over ten years, excluding the peak precrisis years of 2005 through 2007 and serving as another indicator of an improving credit environment taking hold within the EU.

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Buyouts > Europe

• The Continental banking sector, though not in top health, continues to slowly recover. The asset quality review (AQR) performed in 2014 by the European Banking Authority in coordination with the ECB, indicated that about 20% of the 130 banks involved in the stress test had failed, and identified about €25 billion in capital deficiencies that needed to be addressed. While the markets continue to be somewhat skeptical regarding the EBA’s stress tests, most of the evidence supports a slowly recovering banking sector on the Continent.

• In a related positive sign, the latest ECB lending survey (4Q 2014) saw a small but meaningful upturn in loan demand for the EU overall. Most of the major economies, including Germany, Italy, France, Spain, and the Netherlands, also posted positive increases in demand in one or more categories (enterprise, house purchase, consumer credit). Banks also reported a general relaxation of credit standards within all of the major loan categories.

• The European high yield markets have been busy over the past few years taking up some of the slack in debt provision, as evidenced by consecutive strong years of issuance. Including the U.K., a total of $156 billion in primary issues came to market, a nearly 28% increase over 2013’s $122 billion, which was also a strong improvement over the prior year. It should be noted that by the end of 2014 the high yield markets lost a good deal of the momentum that they had going into the year (December issuance was under $3 billion). Investors have become more cautious as macroeconomic events in Europe threaten. On the positive side, QE should put more air in the high yield markets once its full effects are felt. Annual Senior Loan Sponsored Volume | € Billion € BILLION

4Q

3Q

2Q

DEAL COUNT

1Q

160 140 120 100 80 60 40 20 0

320 280 240 200 160 120 80 40 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Standard & Poor’s Financial Service LLC ©

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Buyouts > Europe

QE was not the only major event that took place in January 2015. The coming to power, in strong fashion, of leftwing Greek party Syriza may eventually have a greater impact on the fortunes of the Eurozone than even QE. Alexis Tsipras, the new prime minister, ran openly on an anti-austerity platform and in his victory speech dismissed the troika (ECB, IMF, EC) responsible for the Greek bailout pact as a thing of the past. Most market observers reacted to the combative rhetoric with equanimity, assuming that most of it was meant for domestic consumption and that Syriza would eventually come to some compromise with the troika, probably along the lines of a renewed commitment to reform by the Greeks in exchange for a lengthening of repayment terms and a lowering of the interest rate on the bailout debt. But it did not work out that way. After a disastrous Greek tour to generate support for an easing of terms resulted in an unmistakable rebuff, actions and statements by Tsipras – especially his address to Parliament in which he outlined his government’s proposed rollback of the modest reforms that have been taken so far – did nothing but ratchet up the tension. For its part, the European Commission, with strong prompting from Germany, took a hard line, suggesting that no deal would be reached if the Greek government did not agree to full repayment (at some point) of the debt. Certainly this could all have simply been negotiating posture, but if so, the performances on both sides were of virtuoso caliber. Whether it is all for show or not, the previously off-limit topic of a Greek exit from the euro has forced its way back into the EU consciousness. Though many are now downplaying the significance of “Grexit,” it would clearly be damaging to both parties – especially Greece, which would see the value of its currency plummet, along with the standard of living of its citizens. There are implications for the Eurozone as well. A Greek exit might have the benefit of enforcing some discipline on its member states, but it could also lead to a larger scale breakup of the Eurozone. Uncertainty regarding the future status of several member states within the Eurozone would be destabilizing to say the least. On the other hand, if the Greeks win major concessions, it is probably just a matter of time before other states that have more or less adhered to the austerity regime decide it is time for a change. This would actually be a positive development for peripheral countries, but costly for the banks and governments in the EU core.

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2015 TorreyCove Capital Partners | 25

Buyouts > Europe

In any event, after weeks of tense negotiations accompanied by a dangerous level of fund outflows in the Greek banking system, the Tsipras government relented and asked for an extension of the loan package, which was granted for a four month period. As part of the agreement, the Greek government was required to submit a list of proposed economic and fiscal reforms that it intends to pursue in order to satisfy the creditors. The reforms include: increasing tax compliance, a commitment to reducing corruption, and various other fiscal and labor market changes. Eurozone finance ministers recently approved the extension. As noted earlier, the agreement does not resolve the Greek debt problem, but effectively buys four additional months in which the parties can attempt to develop a solution. The Eurozone will therefore have a short respite from this latest flare-up of the crisis, but the uncertainty surrounding the cohesiveness of the currency union continues. Last year we suggested that the austerity game plan favored by the core members for dealing with the debt problems of the peripheral members would not long remain viable. The election of Syriza and the latest brinksmanship over Greek debt are strong points of evidence in favor of that assessment. Until the Eurozone resolves the solvency issues within its periphery - which will ultimately require debt relief - growth will continue to elude it as the peripheral regions stagnate under deflationary policies and excessive debt burdens. Given that there does not, as of yet, seem to be sufficient political unity, will, or power within the core states to take the necessary but painful steps to resolve this matter, the Eurozone remains on a trajectory that promises slow and stumbling growth for several more years. For private equity investors, the latest developments in Europe allow for some optimism - with the major exception of the Greek debt situation. If QE functions in Europe as it has elsewhere, a rally in equity markets is in the cards, which will provide a strong exit environment into which European buyout managers can feed their existing portfolios. Further, the liquidity effect of QE combined with the slight easing of bank credit standards will make leverage both less expensive and somewhat more available, providing additional fuel for buyout deal making. Enticed by the prospect of QE-driven asset inflation, a slowly improving credit picture, and the faintest stirring of positive data from certain peripheral countries, investors are likely to seek an increase in European exposure. Dollar investors, and others with strengthening currencies, will also see an attractive currency dynamic in deployment of capital into the Eurozone. The confluence of these factors should lead to a better fundraising year in 2015, especially

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Buyouts > Europe

off the lower base from 2014. Likewise, investment should increase as buyout firms look to position themselves to take advantage of the reflationary benefits that may flow from QE in the form of higher portfolio company valuations and strong exit markets at some point in the next few years. Given what QE did for equity markets in the U.K. and the U.S., it should be expected that the ECB version will eventually have a similar, though probably more moderate, effect on European equity markets; therefore, the exit picture for the European buyout space, already solid in 2014, should have even more wind at its back in the coming year. Purchase price and leverage multiples, which have been high for years, will exhibit even more upward pressure as QE takes hold and as buyout firms become more aggressive in seeking deals. Our 2015 tactical ranking for the European buyout sector will remain at “Neutral.” Overall, we expect the European buyout sector to show improved performance over last year in terms of deployment of capital, exits, and portfolio valuations. A higher rating is not warranted due to the ongoing major challenges the EU faces with regard to growth and the stability of the euro. Positive factors in play include the imminent monetary easing via QE, solid buyout exit performance, and improving credit conditions in both capital markets and the banking sector. The primary concerns include poor macroeconomic growth within the EU, deflation risk, and continuing high purchase price and debt multiples. Overlaying all of this is the Greek debt situation, which, if handled poorly, could blunt any momentum the EU has generated so far. Within the Eurozone, investors can take advantage of the divergence of performance within the member countries by focusing their investments in the better-performing core economies while making opportunistic forays into attractive enterprises within the poorer-performing periphery. Sectors that are expected to outperform include export-oriented industries; non-Eurozone economies, particularly the U.K.; and medium and large cap companies with exposure to multiple markets (including non-EU markets). Credit-related investments should still exhibit sound risk-adjusted returns, but are somewhat less attractive going forward due to the anticipated effects of QE and the possibility of some recovery in bank lending over the next couple of years.

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2015 TorreyCove Capital Partners | 27

Special Situations > Distressed Debt

Owing to extraordinarily accommodative monetary policy, the environment for distressed strategies has remained out of favor over the post-crisis years, which have been marked by unprecedentedly low interest rates and an abundance of liquidity. The flood of capital fuelled by central bank intervention has led to record-low default rates, and, consequently, a dearth in the supply of distressed opportunities, as appetite for yield in this low interest rate environment has enabled even highly leveraged companies to postpone the day of reckoning. While this inflow of liquidity has likely sown the seeds of meaningful distress in the future, the overall credit situation continues to look benign over the next 12 months, with indicators of debtor financial stress appearing low or, at worst, neutral in the current environment. Despite this, there are early signals that the investment landscape for distressed players will become marginally more fertile in the near future, largely due to the deterioration in the energy space. With oil prices plunging to their lowest levels in half a decade, interest rates on high yield debt within the energy industry have soared in the past few months, unlocking opportunities for distressed investors, which will only accelerate in the event of a prolonged depression in oil prices. Continued anemic economic growth and bank deleveraging in Europe will likewise present some interesting opportunities for distressed players, but introductions of further quantitative easing measures by the ECB may quell this opportunity set to some extent. Higher capital market volatility and ongoing concerns surrounding global growth could spark intermittent opportunities in the absence of a sustained downturn in the credit markets. With the substantial amount of outstanding debt serving as fuel, the distressed space should offer a solid opportunity whenever the fire is lit. Ultimately, when the distressed market will fully escape from its current doldrums is impossible to predict, but it is likely to occur only when there is a shift toward a more normal monetary policy environment, however small in magnitude. With that in mind, the most likely scenario is for the remaining months of 2015 to feature a restrained distressed environment, though the default rate will likely grow slightly.

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2015 TorreyCove Capital Partners | 28

Special Situations > Distressed Debt

Fundraising In line with the trend from 2012 through 2013, fundraising for distressed vehicles continued to decline in 2014, remaining largely consistent with the levels raised from 2010 to 2011. For the year, 38 distressed funds raised $28.5 billion, roughly 20.8% less than the amount raised in 2013 ($36.0 billion), but still more capital than in four of the past ten years. Amid a buoyant market backdrop, investor appetite for distressed strategies appeared relatively low as total fundraising for all private equity strategies rose considerably over the same period. Distressed vehicles have moved from 9.8% of total fundraising in 2012 to just 5.5% in 2014. The decline does not seem to be a result of lack of supply as there were 70 distressed funds in market targeting $53 billion of capital as of January 2015. For this past year, North America-focused vehicles drove this decline, given an increase in capital allocated to Europe. On the back of weakness and accelerated sales of assets with regard to depository institutions in Europe, investor interest in distressed plays in the region appeared to be on the rise. Europe-focused funds garnered roughly $5.6 billion in 2014, surpassing the prior year by 14.3%, but still nearly half off the amount raised in 2012.

Annual Distressed Private Equity Fundraising | 2006-2014

No. of Funds

60 51.6

50 40

46

Aggregate Capital Raised (bn USD)

47 55.1

30 20

40

38

35

34

25.1 15.3

49

45 38.7

36

29.4

38 28.5

15.5

10 0 2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Preqin, as of January 2015. ©

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Special Situations > Distressed Debt

Investment Activity Amid record high yield issuance and low default rates, deploying capital continued to be a meaningful challenge for distressed investors in 2014. This is partly reflected in the record-high level of dry powder, which came in at $76.9 billion at the onset of 2015, trumping the previous high from December 2013 by 3.9%. Heading into 2015, the market for distressed investments remains highly competitive as a sizable pool of capital chases a very limited number of opportunities. Driven by the liquidity in the market, distressed asset prices have risen significantly, and that trend is projected to continue into 2015.

Outlook Unsurprisingly, the overall distressed market environment continues to appear benign, especially within the North American region. One small crack in the armor of the seemingly impregnable credit markets of the day may develop in the energy sector, which accounts for a sizable portion of the high yield markets. Other than potential problems within that sector, 2015 appears most likely to shape up as another disappointing year for distressed strategies. It is most likely that by the end of this year, we will look back and see that the most positive things that occurred during the year (at least for distressed investors) were the additional buildup of leverage and a further reduction in investor risk aversion.

Historical Default Rates | 1998-2014

14% 12% 10% 8% 6% 4% 2% 0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Altman and Kuehne (2014) “Default and Returns in the High-Yield Bond Market: Third-Quarter 2014 Review” ©

2015 TorreyCove Capital Partners | 30

Special Situations > Distressed Debt

12- to 18-month commitment outlook >











STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

There is some real indication of the latter to be found in the issuance of CCC-rated debt in the past two years: 2013 saw new CCC issuance of 21.3%, the second highest rate since at least 2005, while the figure for the first three quarters of 2014 averaged 19.8%, with a blowout second quarter of 25.9%. Of course, these figures alone do not make a trend, but recent quarters have demonstrated a more aggressive posture by investors in lower-rated high yield issues. The behavior of the high yield markets in 2015 will be critical, as a substantial upturn in issuance of CCC debt would provide strong validation of the trend toward deterioration in the overall quality of high yield debt and would be a signal that the credit cycle is nearing a peak and the distressed deluge is imminent. For now, low quality issuance has not approached the level of the past peak year of 2007, when 37.4% of issuance was CCC-rated. Volume in the high yield markets has been strong for years, which is conducive to a favorable distressed environment; however, general quality within high yield has only recently begun to slip. For now, it looks like sometime in the next two to four years there will be a sizable and lucrative opportunity in distress, but that that opportunity is not likely to develop this year.

Percentage of New High-Yield Issuance Rated B- or Below (Based on the Amount of Issuance) | 1995-2014

55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1995 1996 1997 1998 19992000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Altman and Ramayanam (April 2007) “Defaults & Returns in the High Yield Bond Markets: First Quarter 2007 Review”

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Special Situations > Distressed Debt

To illustrate the background for this assessment, some relevant metrics are outlined as follows:

• At an estimated size of $1.5 trillion as of the end of 2014, the U.S. high yield market is roughly 7.2% higher than its size just a year prior. High yield issuance came in at a healthy $316.4 billion during 2014, just off the prior year by 6.1%. Leveraged loan issuance was $529.0 billion in 2014, below the issuance in 2013 by 12.9%, but 13.8% above the amount in 2012.

• The face value of defaulted and distressed debt was roughly $1.1 trillion as of December 2014, bucking the trend of decline from 2011 to 2013, as this level was 9.3% higher than the amount seen in December 2013 ($1.0 trillion). This year-over-year increase was primarily driven by the rise in the distressed proportion of the total high yield bond market, as a result of the widening of spreads in 2014. Driven by the distressed segment as it rose from 4.5% to 9.9% year-over-year, defaulted and distressed debt as a percentage of the high yield and defaulted debt market was roughly 24.5% as of year end 2014, materially higher than the 19.2% recorded a year earlier.

• The distress ratio for high yield bonds (proportion selling at 1,000 basis points over comparable U.S. Treasury maturities) was up from 5.3% to 11.6% year-over-year, the highest level since the postrecession peak of 17.9% in 2011.

High Yield Default Rate

High Yield Issuance ($B)

400 350 300 250 200 150 100 50 0

18 16 14 12 10 8 6 4 2 0 2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Fitch Rating ©

2015 TorreyCove Capital Partners | 32

Special Situations > Distressed Debt

• High yield default rates remain near record lows. The fourth quarter 2014 rate was a mere 0.14%, just a bit lower than last year’s fourth quarter number of 0.18%. The 2013 default rate of 1.0% was much lower than the 2014 rate of 2.1%, but that is primarily due to the bankruptcy of Energy Future Holdings/TXU skewing the 2014 number upward. Overall, default rates are projected to be somewhat higher this year (Moody’s expects around 2.8% by next September), but are still very tame by historical standards. Deterioration in the energy space, which accounts for about 16% of high yield issuance outstanding, is widely expected to push the default rate up a bit, but due to a relatively small number of current maturities and reasonably easy terms, this is not expected to be a major event for 2015 (though it will worsen in 2016 and beyond, depending on the movement of oil prices).

• Liquidity is a little more mixed: Moody’s Liquidity Stress Index is generally flashing green, though there is indication that the quick ratio for corporations has deteriorated somewhat, from 51% in 2010 to 44% in 3Q14.

• Face value of defaulted debt decreased to about $635.3 billion as of December 2014 from $743.7 billion as of December 2013.

• High yield spreads have pushed out since mid-year and stood at around 5.0% in December, slightly lower than the long term average of 5.2%. The distressed space remained rather dormant in 2014 and the year was not particularly encouraging in regards to what to expect over the coming months of 2015, other than a likely continued buildup of distressed inventory. The easy stance of central banks around the globe and recent economic growth in the U.S. have so far postponed any imminent market dislocation in the near term. Further, given the favorable financial conditions that characterize the current market environment, it does not appear that the distressed market will change appreciably over the course of the year, aside from some opportunities

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2015 TorreyCove Capital Partners | 33

Special Situations > Distressed Debt

unlocked due to weakness within the energy industry. Most of the early warning signs of financial duress are rather muted and credit conditions have remained highly favorable to borrowers. Yet, one significant catalyst for the distressed environment may move the asset class toward renewed attractiveness in late 2015: the expected initiation of interest rate hikes by the Fed, perhaps by midyear. However, with inflation numbers dropping well below the Fed’s target of 2.0% in the waning months of 2014, even a modest rate increase by midyear may be off the table. Further, the rate increase would have to be higher than what the market currently expects in order to have a meaningful impact. All in all, the most likely case suggests another quiet year for distressed strategies in 2015. However, given the stage of the current credit cycle, declining investor risk aversion, and large scale credit creation, the likelihood of an attractive distressed investing environment sometime within the next two to four years continues to increase. Further, even though the outlook for the next 12 to 18 months does not look conducive to a distressed environment and the possibility of an “early” start to the distressed cycle remains low, it has increased since last year. Given the critical role of timing and liquidity for distressed investing – managers must have ample capital on hand and deploy it rapidly and opportunistically at the onset of the cycle – erring on the side of committing capital to the space too early is preferable to attempting to time the cycle with more precision. For this reason, exposure to distressed strategies in 2015, at the very least as a hedge, is desirable. Therefore our tactical rating will remain where it began last year, at “Moderate Overweight.”

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2015 TorreyCove Capital Partners | 34

Special Situations > Mezzanine

In 2014, mezzanine investors got half of what they really needed. The mainspring of their deal flow, buyout fund deal making, bounced back with a vengeance over the year, solving the primary problem that had afflicted mezzanine strategies in much of the post crisis period and breathing new life into the prospect of substantial mezzanine investment flows as the buyout cycle picks up steam. As for the other item on the mezzanine investor’s wish list – increasing interest rates – it looks like the wait could be longer than originally anticipated. Though the Federal Reserve signaled a likely increase around the second quarter of 2015, recent U.S. inflation data and concerns around global growth may stay its hand for a time. However, even without a Fed rate hike, mezzanine providers definitely won the more important prize in the return of deal flow from the buyout space. Interest rates still stuck at or near record lows certainly impact the attractiveness of mezzanine debt, but now managers have a shot at deploying capital in a more robust fashion now that their buyout enablers are back on a roll.

Fundraising The good news from the buyout sector appears not to have made it to the mezzanine sector with regard to fundraising. On a global basis, 26 mezzanine funds raised approximately $8.6 billion in commitments in 2014, only half of the amount raised in 2013, when 42 funds raised $17.2 billion. This breaks the string of three consecutive, and respectable, yearly increases spanning 2011 through 2013, and puts the 2014 haul at just above the depressed period 2009 through 2010 when fundraising did not make it above $8 billion. North American funds continued to dominate the market (every year except 2009), accounting for about 70% of capital raised during the year. Though sponsor-oriented funds continue to comprise a large portion of the mezzanine universe, more diversified strategies – including Oaktree Mezzanine Fund IV and Summit Partners Credit Fund II - have made inroads in recent years. Investor appetite for mezzanine funds cooled in 2014, perhaps as a result of three successive years of fairly decent fundraising, combined with a challenging deal flow environment, which led to a meaningful buildup of dry powder within the space. Further, the perception amongst investors that mezzanine

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2015 TorreyCove Capital Partners | 35

Special Situations > Mezzanine

strategies are subject to heavy competitive pressures and thus compression of returns is likely to have put a damper on investor demand for the strategy. Declining average fund sizes may also indicate waning investor demand in recent months. From a level of over $480 million in 2012, the average fund size dropped to nearly $400 million in 2013 and came in at around $330 million for 2014. Even though 2014 was a tough year for fundraising, the aforementioned dry powder should be sufficient to satisfy the anticipated increased demand for mezzanine funds to exploit the pickup in buyout-related deals.

Investment Activity After three years of mediocre deployments, including a dismal 2013 where less than $3 billion of capital was invested, the pace of mezzanine investment staged an impressive comeback in 2014, fueled by the rebound of buyout deal flow. At approximately $17.1 billion, the deal value for 2014 came in at over 6x the meager pace in 2013 and well over double the amount from 2012 ($5.8 billion). Though still a far cry from the $56 billion put out in 2008, the 2014 figure is well within the groove established in 2006 and 2007, both of which ended with over $20 billion in deployments. In fact, excluding the years 2006 through 2008, 2014 is the most impressive year, by far, of the last ten (per Thomson Reuters).

Annual Mezzanine Fundraising 2006-2014 | $ Billion

Aggregate Capital Raised (bn USD)

$30

50

No. of Funds

$25

40

$20

30

$15 20

$10

10

$5 $0

0 2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Preqin ©

2015 TorreyCove Capital Partners | 36

Special Situations

12- to 18-month commitment outlook >

> Mezzanine











STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

Outlook For the “traditional” sponsor-focused mezzanine fund, times got a bit better in 2014, with the continued recovery of the buyout deal flow environment, particularly within North America, where U.S.-based deals were up about 24% year over year for 2014. However, the other critical elements of the environment within which they operate generally did not move in their direction. Meaningful interest rate hikes still look to be some way off, and even the modest beginning of hikes that was anticipated for 2015 may be deferred. The high yield markets remain open and robust, while other non-banking financing avenues (BDCs, unitranche structures) have been gathering capital over the past few years in lockstep with traditional mezzanine funds. After stepping down in recent years toward 30%, equity contributions for buyout deals moved significantly higher over the course of 2014, to within striking distance of 40%. An improving U.S. economy is a mixed bag: on the plus side, it promises an increase in buyout deal flow; on the minus side, it encourages more aggressive lending and even less severe terms. Taking all of these factors into account, our assessment is that sponsor-focused funds should be able to build off of the strong momentum generated in 2014 and get more capital deployed in 2015 - perhaps substantially more. However, the market forces that have conspired to severely diminish their pricing power largely remain in place; therefore, the returns available from the asset class from the 2015 vintage are expected to remain below the long term average for the mezzanine asset class. Mezzanine funds that are primarily non-sponsor-oriented should find a more conducive investing environment, given that they often lend to special situations (stressed or distressed companies, bridge financing, etc.) and therefore have a stronger negotiating position. However, they are by no means immune to the same market factors that are compressing returns available to their sponsor-oriented cousins, and so their advantage is relative. Overall, we expect the tight pricing environment for all mezzanine strategies to persist throughout 2015, thereby putting pressure on returns available to mezzanine investors.

©

2015 TorreyCove Capital Partners | 37

Special Situations

> Mezzanine

Our tactical weighting for mezzanine strategies is moving from “Neutral” to “Moderate Underweight.” As noted, the primary positive concerning the strategy is the return of some vigor to acquisitions by buyout funds, particularly within the U.S., which should provide some wind at the back of mezzanine strategies with respect to deploying capital in 2015. The improving U.S. economy, to the extent it encourages even more deal activity, is also a net positive in this respect. An interest rate increase, should it occur, will be marginally positive, but is not likely to make a difference to the strategy this year. The negative case consists primarily of the continuing strength of competing sources of debt capital, aided and abetted by low policy rates, and the negative impact these have on pricing for the lender. This downward pressure has not lessened over the past year and is unlikely to do so over the remaining course of the current credit cycle. This dynamic, combined with the continuing sub-par overall performance of the strategy in the post crisis years, is the primary reason for the downward move in our tactical rating. Other factors include the uptick in equity contributions for buyout transactions and the lack of mega deals seen in the current market environment, though these are of relatively minor effect.

©

2015 TorreyCove Capital Partners | 38

Special Situations > Secondaries

Recent years have seen the rapid maturation of secondary investment strategies from what was once a niche market for trading shares in private equity funds to a well understood and fully accepted asset class within the private equity universe. As a result, assets under management within the secondary space have grown considerably in the past several years. The results of this growth have been mixed. While increased acceptance of the strategy has allowed for ever-larger funds to be raised by established managers, the increased transparency and efficiency of secondary markets has made achieving above par returns that much more difficult. In any event, the growth trend is still very much in force, and in terms of every major metric, 2014 was a banner year. Deal volume, fundraising, and pricing increased strongly, in some cases strikingly, from 2013, marking a record-setting year in all these categories. Regulatory changes and more active portfolio management remain as key drivers within the space and should continue to provide a solid foundation for growth in secondary assets under management for the longer term, especially as more institutional investors and their boards/management become comfortable with using secondary transactions as a portfolio management tool. However, increasing assets under management usually goes hand in hand with lower profitability. Case in point is the state of the current secondary market, which is undoubtedly exhibiting signs of frothiness. It is always possible that a major downturn in the capital markets could have the effect of sparking a dislocation in the private equity markets and shifting the advantage to the buyers’ side of the table; however, recent history is not encouraging on that front, as there has not been a robust, sustained buyer’s market for the past ten years (2009 notwithstanding). Absent such a major dislocation, secondary strategies appear poised to continue serving as providers of liquidity at a reasonable price rather than opportunistic investors capable of exerting significant pricing power and generating the high returns that were available in the earlier years of the strategy.

©

2015 TorreyCove Capital Partners | 39

Special Situations > Secondaries

Fundraising Secondary vehicles raised a record-setting $26.7 billion in 2014, surpassing even the solid 2013 total of $21.73 billion by 23.0% and besting the previous high of $22.2 billion from 2009 by 20.3%.The increase was driven in large part by the closings of several mega funds, including the Ardian Secondary Fund VI at $6.0 billon ($9.0 billion with co-investment pools). With 2014’s impressive performance, each of the past three years has exceeded the annual fundraising totals of all prior years within the last ten, with the exception of 2009. These numbers indicate that demand for exposure to secondary strategies has not waned in spite of high pricing.

Investment Activity Activity in the secondary market surged in 2014, with deal volume soaring to $42.0 billion, dwarfing the previous record from 2013 of $27.5 billion – a marked 52.7% year over year increase. A notable element was the sheer number of deals that transacted above $1.0 billion, as 12 such deals composed nearly 40% of total deal volume in 2014, compared to 19% in 2013 and more than three times the number of this size of transaction in any previous year. As sellers, drawn by strong pricing, opportunistically bring assets to market and secondary funds look to deploy large pots of fresh capital, pricing has become increasingly aggressive. In June 2014, average prices for buyout funds reached carrying value for the first time since Annual Secondary Fundraising |$ Billion

Aggregate Capital Raised (bn USD)

$30

No. of Funds

22.2

$25

26.7 21.7

30

20.1

25

$20 13.7

$15

20

12.8 9.6

7.9

$10

35

15

9.9

10

$5

5

$0

0 2006

2007

2008

2009

2010

2011

2012

2013

2014

Source: Preqin 3

The 2013 fundraising amount was recently increased by approximately $5.5 billion with the inclusion of the Goldman Sachs Vintage Fund VI. The fund began fundraising in 2012 and held a final close in late 2013; therefore, it was not included in the 2013 total until the latter half of 2014. ©

2015 TorreyCove Capital Partners | 40

Special Situations > Secondaries

2007, and the availability of cheap financing has only ratcheted prices higher. There is a clear disparity emerging in pricing between limited partner interests of sought-after management teams and those that are less favored, a bifurcation that is expected to continue.

Outlook After blowing past all previous years in 2014, there is good reason to think that the growth in secondary deal volume will moderate, and possibly decline, in 2015. Most of the factors that will influence the supply of secondary transactions in the coming year are pointing to a decrease, albeit from what looks to be a peak year in 2014. Several of these factors should collude to lessen the appetite of most limited partners to sell. For one thing, the strong public markets have had multiple positive effects on limited partners’ private equity portfolios, including increasing NAVs and robust exit activity and distributions. With portfolios performing so well, limited partners will be tempted to simply hold onto existing holdings while the current strong run plays out. Further, the pace of distributions has seen to it that liquidity concerns, if they may have existed in prior years, are certainly not a major concern now. In fact, the problem for limited partners now is more likely to come from the other end: how to deploy the liquidity windfall being generated within their private equity portfolios. High liquidity and above average performance within private equity allocations will tend to reduce limited partners’ inclination to sell, all things equal. Secondary Deal Volumes |$ Billion

$45 $40 $35 $30 $25 $20 $15 $10 $5 $0

42

25

25

27.5

21 16 7.5 1.5

2.5

3

2.5

9

8.5

11

15

12.5

3

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Cogent Partners ©

2015 TorreyCove Capital Partners | 41

Special Situations > Secondaries

12- to 18-month commitment outlook >











STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

Portfolio management issues will also come into play, as the robust performance of equity portfolios has thrown the denominator effect sharply into reverse as it applies to private equity. Where a few years ago limited partners were trying to find ways to manage over-allocation to the asset class, now they are confronting the possibility of falling behind, or have already done so. And allocation percentage targets are unlikely to begin coming down any time soon. If anything, private equity allocations look to be headed higher – according to the Coller Global Private Equity Barometer (Winter 2014), almost 40% of surveyed limited partners anticipate raising their allocation, opposed to only 7% that are considering a decrease. Finally, limited partners, buoyed by the current performance of their private equity portfolios, have become much more optimistic regarding the expected performance of the asset class. The Coller report also indicates an approximate 15% increase in the percentage (total of 93%) of surveyed limited partners that expect to receive a return of at least 11% to 16% from their private equity investments over the next three to five years. Overall, these internal factors – good current performance in regard to existing portfolio, reversal of the denominator effect, high liquidity, increasing allocation targets, and favorable view of future performance – work to significantly reduce any selling pressure on limited partners. There are also external factors working in the same direction. One of the most significant is the extension of the compliance deadline for the Volcker Rule into 2017 from the original mid-2015 date. Banks were to have brought themselves into conformity with the Rule’s restrictions on proprietary activities and Average Trailing 3-7 Year Primaries |$B

Actively Trading Primaries |$B Aggregate Capital Raised (bn USD)

500 400 350

258.1

431

450

252.6

396

$25

321

300 200

25.8

25.3

23.4

200

212

$20

243

$15

176

234.0

$10

150 100

12.6

11.7

12.9

$5

50 0

$0 2015

Source: Preqin, TorreyCove

$30

338

346

250

Forecasted Deal Volume 5-10% Turnover | $B

Source: Preqin

2016

2017

2015E

2016E

2017E

Source: Preqin ©

2015 TorreyCove Capital Partners | 42

Special Situations > Secondaries

ownership in certain covered investments (including private equity) by that date, which has been a major driving factor behind the large sales of such assets into the secondary markets over the past few years. With the pressure now off for another two years, a meaningful decline in transactions from this source should be expected. The base effect should also contribute to a slower year in volume growth. 2014 transaction volume was over 50% higher than a solid year in 2013. Also, there were several multibillion transactions behind the 2014 numbers. It will be difficult for the secondary markets to meet or beat the volume from such a standout year in 2015. There are some countervailing forces at work. For one, the increased institutional acceptance of secondary transactions has prompted a wider array of limited partners, including some smaller institutions, to seriously consider initiatives to use the secondary markets to rationalize their private equity portfolios by reducing the total number of manager relationships and ridding the portfolio of poorly performing funds. Many of these limited partners are likely to opportunistically sell assets in the next year or two, in order to take advantage of the strong seller’s market. Given all of these factors, the preponderance of weight is on the side of a reduced volume for 2015 in comparison to 2014. However, we still expect it to be a very good year on this front, and there is a good chance it exceeds 2013. On the demand side of the equation, ongoing structural changes in the secondary markets and strong fundraising over the past few years have added additional momentum to the secondary market surge, which promises to carry over into 2015. The entry of primary fund limited partners – like public pensions and insurance companies - into the secondary space continues. While traditional secondary funds still comprised around 65% of the investable capital in 2014, non-traditional sources accounted for about 35% (per Sixpoint Partners), including 15% from primary limited partners and 20% from hybrid structures (fund of funds and consultants). The primary slice, though relatively small, could have an outsized impact on pricing dynamics within the industry, as the lower return requirements of many of these institutions (like public pension plans) will allow them to be aggressive marginal bidders for secondary assets. With the Fed keeping rates low, the abundance and low cost of debt to all manner of asset managers has rarely seen better days. Secondary players have taken full advantage of this situation in recent years, and leveraged deal structures have become relatively routine, both as a way to manage sellers’ needs and as a

©

2015 TorreyCove Capital Partners | 43

Special Situations > Secondaries

way to boost returns in a highly competitive pricing environment. For these reasons, the use of leverage by secondary market players is expected to continue increasing, thereby facilitating even more aggressive bids. The hugely successful fundraising of the past three years, especially 2014, have led to an unprecedented level of dry powder within the secondary market. Cogent estimates total dry powder of approximately $84 billion going into 2015, with about $30 billion of that amount from recent fundraising. This level of dry powder works out to about what is necessary to cover two years of investment at the elevated 2014 level. Though a solid year in volume is anticipated, there is more than ample capital available to absorb the expected supply, indicating upward pressure on pricing will persist and perhaps intensify. Several recent trends further indicate the increasing diversification of the secondary market both in terms of buyers and sellers as well as type of transaction. According to Cogent, the most active sellers in both of the past two years were financial institutions and public plans (superannuation funds, public pensions, sovereign wealth funds, etc.), which accounted for 56% to 57% of volume in each year. However, Cogent projects that financial institutions will fall from around 34% to less than 20% in 2015. Some of that gap may be filled by parties normally on the buy side – fund of funds and secondary sellers – as they attempt to clean-up tail positions in existing funds or simply take advantage of an excellent pricing environment. GP recapitalizations/restructurings have become an increasingly important driver of deal flow. According to a Sixpoint survey, over half of respondents reported that 20% (by dollar value) or more of their deal flow was GP-driven. In 2014, approximately 17% of the total dollar value of secondary deals had a GP as a seller (Cogent). Given that over $100 billion of NAV is in funds that are either in, or near, their extension periods, this source of deal flow should continue to expand over the next several years. Secondary transaction pricing continued to increase in 2014, with both buyout and venture funds participating in the uplift. Buyout funds posted the largest pricing increase during the year in both absolute and relative terms, moving from 91% of NAV to 95% of NAV. Peak pricing actually occurred in the first half of the year, when buyout secondaries briefly brushed with par pricing. Venture pricing pushed up from 79% of NAV to 80% of NAV at the end of the year, with an interim high point of 82%. It is important to keep in mind that the decline in pricing from midyear is somewhat deceptive, as deals in the latter half of 2014 were priced on higher NAVs that were the result of the strong exit markets for both buyout and venture companies. ©

2015 TorreyCove Capital Partners | 44

Special Situations > Secondaries

Secondary strategies should have another good year in 2015 with respect to investment, as limited partners of all stripes continue to take advantage of the most heated secondary market since 2007 in order to accomplish whatever repositioning their portfolios may require. Distributions should also maintain a brisk pace as a result of primary fund distributions, perhaps augmented to some extent by outright sales from secondary funds themselves. Fundraising should be healthy, but is not likely to reach the record 2014 level. Our tactical rating for secondary strategies is moving to “Strong Underweight” from “Moderate Underweight” for 2015. As noted, both supply and demand side dynamics within the current secondary market are predominately exerting upward pressure on pricing. The solid performance of institutional portfolios overall, and private equity allocation in particular, have relieved whatever pressure was being exerted on institutions to sell and substantially reduced the opportunity cost of holding private equity assets. The denominator effect and over-allocation issues are a thing of the past. All of this has put limited partners in a superior negotiating position, enabling them to be opportunistic rather than forced sellers. Even the one sector that had provided more motivated sellers over the past few years – financial institutions – got a break recently with a two-year extension on the compliance deadline for the Volcker Rule. The advantages on the limited partner side are only enhanced by the dynamics on the buyers’ side of the market. Large quantities of dry powder due to strong fundraising, along with available low cost leverage, should both contribute to maintain the intense bidding posture seen over the last few years. Making matters worse is the entry of non-traditional secondary market participants into the fray in recent years, as these typically have substantially lower return targets and are able to undercut the bids of more traditional participants. Unsurprisingly, in 2014 these factors combined to produce the strongest pricing environment for secondary assets since before the financial crisis. Absent a liquidity crisis brought about by a major decline in equity market performance, it is difficult to see what might take the steam out of the secondary markets in 2015. Therefore, we expect secondary pricing to maintain at or above its current levels, on rising NAVs, through 2015. Though debt levels do not appear excessive at this time, such a pricing environment will continue to exert pressure on secondary purchasers to increase leverage to bring returns in line with investor expectations. The present environment is one wherein secondary strategies have very little pricing power, and consequently little power over the profitability of their trades. This is not expected to change appreciably in 2015, which indicates that the performance of secondary strategies will be challenged.

©

2015 TorreyCove Capital Partners | 45

Venture Capital

Powered by heated equity markets, the venture capital sector roared ahead in 2014, building on the solid performance from the prior year. Activity was up across the board for the year. Investment shifted to a new level as VCs looked to take full advantage of the best exit markets they have seen since the late 1990s, leading to ever more competitive late stage financing rounds and dramatic upturns in enterprise valuations. Most impressive was the exit performance of venture-backed companies, which put up big numbers in both IPOs and trade sales, making the venture industry the best-performing private equity asset class for two years running, a position it has not been in for years. After years of relative indifference, investors have taken notice and are now looking to rapidly ramp up exposure, especially to the late stage and growth strategies. With the major exception of a serious downturn in the U.S. capital markets, there are few dark clouds on the horizon that would temper the enthusiasm of venture capitalists or investors in the strategy. The pipeline of IPO candidates going into 2015 is robust, large technology companies remain acquisitive and are flush with cash and highly-valued equity, the Fed is unlikely to rock the monetary boat significantly, venture capital funds have more than sufficient cash to invest, and the supply of innovative investment targets is more than ample. Momentum is everything for venture capital, so the expectation for 2015 is essentially what we saw in 2014 – just more of it. In particular, it would not be surprising to see substantial increases in fundraising, capital deployed, IPO exits, and deal valuations.

Fundraising Unsurprisingly, the solid performance of the asset class in 2013 sparked intense investor enthusiasm for all things venture in 2014, leading to the best fundraising year since 2007. For the year, 254 venture funds pulled in nearly $30 billion in new commitments, breaking a small slide in fundraising that began in 2012, and posting an increase of nearly 69% over the 2013 amount of $17.7 billion. According to PitchBook, a distinct bifurcation trend was evident within the 2014 fundraising figures, whereby “mega” funds and micro funds gained share from limited partners at the expense of mid-size funds. This appears to have been the general trend over the past few years, and most likely relates to mega funds gathering capital with which to pursue large late stage deals, while micro funds focus on much earlier stage deals that are not yet the subject of intense price competition. Interestingly, about 38% of the funds raised in 2014 were new, as opposed to follow-ons; a substantial increase from the prior year and perhaps a further indication of renewed investor confidence in the venture capital space.

©

2015 TorreyCove Capital Partners | 46

Venture Capital

Investment Activity Venture capitalists put money to work at a breakneck pace in 2014, seeking to capitalize on the momentum generated by the equity market surge that began in 2013. The $48.3 billion deployed into over 4,300 deals in 2014 was fully 61% higher than the $30.0 billion invested into nearly 4,200 deals in the prior year. More impressively, these numbers rank 2014 as the best year for investment since 2000 and rank it third of all time, just behind the hot year of 1999, when $54.9 billion was deployed. As usual, the software sector reigned as the number one destination of capital, but the life sciences sector posted a notable increase of 29% year over year ($8.6 billion, 789 deals). All stages of investment put up meaningful increases from 2013, with the exception of seed stage deals, which declined by about 29% in value. Expansion stage deals more than doubled, from $9.8 billion to $19.8 billion. This was most likely driven by venture capitalists seeking to accelerate growth within the most promising of their companies in order to positon them in time to take advantage of the continuing strength of the exit environment, as well as by aggressive bidding by other VCs looking to gain access to those deals. As expected in such an environment, valuations have inflated substantially year over year. According to PitchBook, the average valuation at the Series D and later stages moved up almost 50% ($151 million in 2014). Strong increases were evident in all other rounds, especially Series B (32%) and Series C (24%), with only Seed rounds relatively restrained. The early stage numbers appear to be pushing up due to a combination of more capital flowing into the sector, and a decline in startup costs within the IT side of the sector. U.S. Venture Capital Fundraising Activity | $ Billion

$35.0

30.0

$30.0

29.8 25.1

$25.0 $20.0

16.1

$15.0

19.1

19.8

2011

2012

17.7

13.3

$10.0 $5.0 $0.0 2007

2008

2009

2010

2013

2014

Source: Thomson Reuters and National Venture Capital Association ©

2015 TorreyCove Capital Partners | 47

Venture Capital

Contributors to the increase in later stage and growth valuations include increasing competition from both large mutual funds and growth and opportunity funds raised by VC shops that had formerly only invested in early stage opportunities, as well as longer ramps to IPO for venture-backed companies, which means that more of the overall value of a company is built-up prior to going public.

Exits Last year we noted that 2013 had the appearance of a breakout year in terms of exits for the venture capital sector and expected great things from 2014 on this front. The year did not disappoint. Where 2013 turned in a solid year in comparison to all of the post crisis years, 2014 went one better and brought back echoes of the heady days of 1999 and 2000. IPOs blew past the 2013 numbers, as 115 companies floated offerings, pulling in a total of $15.3 billion in capital, a 37% increase over last year’s $11.1 billion. As was the case with 2013, last year’s IPO performance was broad-based - the number of companies going public in 2014 represented a 42% increase over the 81 that went public in 2013. Further evidence is provided by the solid IPO performance of the life sciences industry, which accounted for 59 public offerings during the year, just over 50% of the total—its best showing for this measure since the 1990s.

U.S. VC Median Pre-Money Valuations by Series| $ Millions

$40

Seed

Series A

Series B

$35 $30 $18.6

$20.2

$20.9

$23.6

$6.3

$5 $0

$2.6

2009

$6.6 $3.3

2010

Series C

89.9

$80 $7.4

$8.5 $4.3

$4.3

2011

$9.8 $4.9

Series D+

$13

$60 $20

90

101.3

65.4 48.5

71.5

$40 $5.7

151

$140 $100

$15 $10

$160 $120

$26.9

$25 $20

$35.5

29.2

38.6

2009

2010

49.7

50.1

57.7

$0 2012

2013

2014

2011

2012

2013

2014

Source: PitchBook, 2015 Annual U.S. Venture Industry Report ©

2015 TorreyCove Capital Partners | 48

Venture Capital

Trade sale exits had a banner year: the $46 billion exited via this route more than doubled 2013’s $16.9 billion (172% increase year over year) and actually totaled more than exits from all sources in every post crisis year. Of course, close to half of this total is spoken for by one deal, Whatsapp, which was acquired in the fourth quarter by Facebook for $20 billion. Nevertheless, excluding that deal from the total still leaves approximately $26 billion in trade sale exits for 454 other companies, including a handful of multibillion dollar deals. By itself, that number is good enough to put 2014’s trade sale performance at the top of the hill for the entire post crisis period.

Outlook In early 2014, we anticipated a generally positive environment for venture capital investing for the year, with the momentum from 2013 carrying through on the fundraising, investment, and exit fronts. As it transpired, 2014 accommodated in complete fashion; in fact, the surprising thing was not the direction of performance, but the magnitude, which was greater than we had expected, especially with regard to exits. Fundraising, spurred by investors desiring to take advantage of what is shaping up to be a solid run for venture capital investments, was up meaningfully for 2014, as was deal making by VCs eager to be a part of the next big IPO.

Number of U.S. - Based IPOs | $ Millions

$25

IPO Value ($B) Number of IPO's

$20 $15

Number of U.S.- Based M&A | $ Billion

120 $50

Total Disclosed M&A Value ($B) Total M&A Deals

100 $40

500

80

400

$30

300

60 $10

40

$5

20

$-

0 2009 2010 2011 2012 2013 2014

Source: Thomson Reuters & National Venture Capital Association

600

$20

200

$10

100

$-

0 2009 2010 2011 2012 2013 2014 Source: Thomson Reuters & National Venture Capital Association ©

2015 TorreyCove Capital Partners | 49

Venture Capital

12- to 18-month commitment outlook >











STRONG OVERWEIGHT

MODERATE OVERWEIGHT

NEUTRAL

MODERATE UNDERWEIGHT

STRONG UNDERWEIGHT

Equity markets, though more volatile than in prior years, are still highly receptive to venture-backed companies for IPOs. Further, high public market valuations have put massive acquisition equity into the hands of tech giants like Facebook, Google, Apple, and others, leading to a robust trade sale environment. From a venture capital perspective, the environment heading into 2015 has something of the look and feel of the years ramping up to what eventually became the Internet Bubble – years characterized by strong equity markets, increasing funds flows, and a high degree of optimism on the part of investor and venture capitalist alike. What was lacking, then and now, was the euphoria or “irrational exuberance” that came later, in 1999 and 2000. Though the venture capital markets are booming, with valuations up and investors rushing to deploy capital into the next best later stage deal, the current market looks healthier in some respects. For one thing, the fundamentals of the businesses being bought and listed are sounder than much of what came to market in the Bubble days. Also, while IT companies are still generating the most buzz and putting up the biggest numbers, life sciences deals are demonstrating some strength of their own. Along with the relatively broad-based distribution of exits in recent years, this suggests more market breadth than existed in the late 1990s. If experience is any guide, the current “bull” market for venture-backed deals could last another two to three years, barring a general economic downturn in the U.S. So long as the U.S. equity markets hold up, there does not appear to be much on the horizon to substantially blunt the momentum that the venture capital space has built up over the past two years. Therefore, the industry should have another solid year of fundraising, perhaps exceeding the 2104 level. Investment flows, especially for expansion and late stage deals, should push higher, as the focus remains on near term exits within 18 to 24 months. As in 2014, there will be strong upward pressure on valuations at all stages of investment, though late stage valuations should lead the way as VCs become even more focused on companies that are capable of exiting within the time window opened by the up leg of the current equity market cycle. Overall, there does not appear to be any shortage in the supply of capital, as venture capital funds are coming off of a good fundraising year and had built up a fair amount of dry powder in prior years.

©

2015 TorreyCove Capital Partners | 50

Venture Capital

Our tactical rating for venture capital strategies will move from “Moderate Overweight” to “Neutral” due to stretched valuations, some of which appear excessive, as well as uncertainty regarding the remaining life of the current bull market. In many ways, the story for 2015 is likely to sound very similar to the one from 2014, except perhaps a bit more exaggerated. The strong, and improving, exit performance of the past two years has set expectations at a high level for the venture space, and the familiar cycle is setting up: strong fundraising based on recent performance, venture capitalists flush with cash bidding up prices on deals in an effort to take full advantage of buoyant equity markets while they last, strong exit performance returning capital to investors who then reinvest in venture, and so on. However, while valuations and capital flows are increasing, the cycle does not yet appear to be in the “euphoric” stage, based on absolute levels of fundraising and investment, as well as investee company fundamentals and reasonable breadth within the pool of exits. Rapidly rising valuations are always a risk, and this trend has certainly been in play the last year and is highly likely to persist and accelerate in 2015. Whether venture capitalists are made to pay a price for these valuations is, as always, up to the market, which tends to bail out even difficult to justify valuations while it is running with momentum. Given that the current bull market in the U.S. is somewhat long in the tooth and fully valued (or overvalued by some measures), our generally positive outlook for venture strategies is extended only to a relatively near term time frame. For this reason, we are recommending a more neutral stance for the asset class overall, as well as a bias toward later stage investments, since those are more likely to reach liquidity prior to the exhaustion of this bull market. A significant spike in valuations in 2015 and/or indication that U.S. equity markets are peaking would weigh heavily toward a more negative outlook on the strategy next year (or sooner), even if many other factors still read positive or neutral.

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2015 TorreyCove Capital Partners | 51

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