Discuss the factors that the Hewlett Foundation's investment committee should consider regarding the proposals to make the 5% commitment to Sirius V:

Sirius Investment As part of the expanded absolute-return strategy, Hoagland and his investment team were considering a proposal to commit up to $300 million to Sirius V, a global distressed investment fund targeted at $5 billion with a projected net return of 20%. HF had a long-established relation with Sirius, dating back to 1995. HF had most recently invested with Sirius in 2001, when it committed $200 million to Sirius IV. 27 (Exhibit 10 shows returns from funds Sirius 0 through IV.) Sirius's primary strategy was investing globally in mainly nonperforming loans28 (NPLs), backed by real estate, that resulted from banking crises. During such crises, banks often sold NPLs in bulk at a discount to their face value. This discount was typically 30% to 50% of face value, but sometimes it was 90% or more. After winning a bid on a pool of NPLs, Sirius resolved each loan by foreclosing on the loan and seizing the collateral or by restructuring the loan with the borrower and then selling either the underlying collateral or the loan. Sometimes, Sirius invested directly in real estate, such as office towers and golf courses. It also invested in operating companies, such as banks, valued not by the potential of their operations but primarily by their underlying real estate value. Leverage was used in the funds. For Sirius V, leverage was targeted at 60%-70%, similar to that in Sirius IV. Founded in 1995, Sirius first began investing in NPLs arising from the U.S. savings and loan crisis and subsequently invested in South Korea, Japan, Canada, France, and Germany. For funds Sirius IIIV, the majority of investments were in Japan and in South Korea, after the financial crises that began in those countries in 1992 and 1997, respectively.29 In Japan and South Korea, banks' troubled lending was primarily in real estate and credit card loans. In Germany, NPLs were primarily in mortgages and loans to energy groups and airlines. For Fund V, Sirius expected to invest mainly in NPLs in Japan and Germany and in corporate restructuring in South Korea. Target allocations by geographical areas were 40%-50% in Japan, 15%-25% in South Korea, 5%-10% in other Asian countries, 10%-30% in Europe, and 5%-15% in North America. Sirius had three important strengths. The first was its skill in underwriting real estate. Since inception, Sirius had generated a large multicountry database of comparison properties, which allowed Sirius to appropriately price properties in a pool of NPLs. The second strength was Sirius's skill in servicing NPLs. Sirius had local servicing groups in each country in which it invested. This facilitated foreclosures and renegotiation of loan terms, improving Sirius's bid on NPLs, since banks often maintained continuing relationships with its distressed borrowers. The third strength was the stability of Sirius's investment team. Of the five top employees, three (James Green, Elliot Shawn, and Samuel Lorsch) had worked together since Sirius I, and the other two joined in the two subsequent funds. Green had ultimate control of the general partnership and, along with Shawn, determined the global asset allocation. Given their pivotal role, Green and Shawn were part of the key-man clause whereby if either left, any limited partner had the option of suspending future investments. At the regional offices (North America, Japan, South Korea, and Europe), there was little employee turnover. The employees in these offices were compensated on the performance of their region. The performance of investments of substantially liquidated NPL investments and non-NPL investments had been strong since 1995. (See Exhibit 11 for a scatter plot of returns over time.) Gross returns for 71% of the NPL investments exceeded 25%, and only one out of 51 NPL investments experienced a gross return of less than 10%. Gross returns for 64% of the non-NPL investments exceeded 25%, and 11 out of 53 non-NPL investments experienced a gross return of less than 10% (six were negative). Investing in Sirius was not risk free. By year 2004, competition had greatly intensified in the NPL business, particularly in Japan, which adversely affected discounts and fees. The economic recovery in Japan, and the drop in commercial land prices in six main Japanese urban centers (from a price index level of 496 in 1991 to 72 in 2003, as measured by an index published in the Japan Real Estate Securitization Handbook), had attracted many overseas investment banks and private equity firms to enter the market. But since Sirius had consistently invested in Japan, HF felt that Sirius's focused strategy and early dominance gave Sirius a competitive advantage over other funds. Another risk was the large investments in operating companies or hard assets that Sirius had made in recent funds. These investments increased the overall risk of the portfolio. For example, one of the largest investments in Sirius IV was the purchase of a large South Korean bank. The sale of such an investment could greatly affect the fund's total return and the timing of cash flow break-even for investors such as HF. (See Exhibit 12a for HF's actual and projected contributions to and distributions from Sirius IV, and Exhibit 12b for projected cash flows for Sirius V.) The amount committed to a fund was not drawn immediately, and thus the exposure to Sirius at any given point in time was not necessarily equal to the total amount of funds committed. HF expected that, if the investment in Sirius V was approved, the maximum capital exposure to Sirius would peak around the third quarter of 2006 at $225 million (about 3.5% of HF's diversified portfolio value in late 2004), 28% of which was attributable to Sirius IV. (See Exhibit 13 for a plot of the combined net cash flows for Sirius IV and V.) Over time, as funds from Sirius IV were returned, capital exposure would be entirely from Sirius V. Maximum capital exposure to Sirius V was expected around the second quarter of 2007, at $200 million.

Exhibit 10 Sirius Fund Historical Performance Projected Actual capital return Projected capital return Fund Inception Size ($ millions) Net IRR' multiple, as of 3/31/04 multiple Sirius 0 1995 247 28.0% 1.64 1.51 Sirius I 1996 396 9.1% 1.06 1.31 Sirius Il 1998 1,228 18.2% 1.18 1.39 Sirius Ill 2000 2.262 25.9%b 0.81 1.80 Sirius IV 2001 4.208 20.0%b 0.14 1.54b Source: Hewlett Foundation. "The internal rate of return was calculated by Sirius and it excluded fees, country taxes, and hedging costs on realized and unrealized cash flows. Unrealized cash flows were based on an average 25%% gross IRR, updated quarterly. HF believed that final fund return and multiple would be slightly higher than projected.Exhibit 11 Sirius Investment Performance (1995-February 2004) Sirius Substantially Liquidated NPL Investments Gross Return Realized es. 25% Underwriting Target > 70% O 50% O Returns (IRR %) 20%% O 10%