The perception of risk management in private equity has changed dramatically over the last few years. Until fairly recently, while the majority of investors were dazzled by private equity’s seemingly unlimited return potential, only a handful of large investors (supported by their advisors) made an effort to analyse the risk of private equity portfolios.
Many investment practitioners even argued that risk management in private equity was not necessary, because they saw their selection skills as the main value driver and trusted their gut instinct. However, the financial crisis has put this perception into question and increased the awareness of risk management in private equity.
The increased interest of investors in risk management is not only based on intrinsic motivation, but also on the upcoming changes in the regulatory environment. Banks are regulated under Basel II, and the insurance industry will now be regulated under the Solvency II rules, which will sooner or later have to be applied to pension funds as well. Unfortunately, compared to public equity and other asset classes, private equity is treated unfavourably under both frameworks.
The current and proposed regulatory standard risk weightings for private equity investments are most likely excessive. Basel II requires a minimum allocation of 24% to 32% as regulatory capital, even if following an internal model approach. After successful lobbying by the European Venture Capital & Private Equity Association (EVCA), this has been relaxed under CAD III. However, Solvency II anticipates a 45% standard risk weighting. Our analyses and practical experience shows that this is far too high for a portfolio of private equity funds.
In addition, empirical studies show that the distinction between the risk of a single private equity fund at GP level and the risk of a diversified private equity portfolio at the LP level matters. Clearly, the risk of losing capital with an investment in a single fund partnership with typically 10 to 20 underlying companies is higher than with an investment into a diversified private equity fund portfolio with hundreds or even thousands of underlying companies.
Studies by Weidig & Mathonet (2004) and Diller & Herger (2008) show how dramatic the impact can be: while a fund or a portfolio of direct investments still has a very small probability of total loss, a portfolio of funds has a small probability of any loss. According to these results, the maximum diversification benefit is already sufficiently reached with a portfolio of between 20 and 30 funds spread over three to four vintage years. Hence, the risk on the LP level is actually far lower than regulators and even academics perceive them to be.
The industry can do better
A first (though probably misguided) reaction to such findings would be to lobby against the high regulatory risk weights, hoping this keeps institutional investors invested in private equity. Historically the EVCA has been able to build on the support of policy makers who wanted to promote innovation and entrepreneurship through venture capital. Indeed, a few years ago, lobbying by the EVCA successfully contributed to the easing of regulations for private equity investments, as reflected in CAD III. However, this has been criticised for counteracting the goal set by the Basel II committee, as it fails to create incentives for banks to invest in more sophisticated risk management systems.
Even if lobbying again is a feasible avenue, we believe there is a need for the industry, together with institutional investors, to take a bigger leap forward and provide regulators with a clearer framework for viewing and evaluating risks in this asset class. Consequently, the (small) community of risk managers that concentrates on developing methods for analysing the risk of private equity portfolios has to get together to define such a framework.
Proper guidance on private equity-related risk management appears to be overdue. It is not only likely to help investors build internal models and to get regulatory approval for reducing their required capital allocation, but would also enable them to manage their overall portfolio more efficiently. Sophisticated risk management tools help improve the liquidity management of the entire portfolio and help optimise the risk-return profile of the private equity portfolio.
To illustrate the point, an analysis of statistical data from Thomson Reuters shows that for the average private equity fund, the net cash requirement of an investor peaks at around 55% to 65% (depending on the market situation), leaving the remainder of the investors’ committed capital invested in short-term investments.
This dilutes the overall performance of an investor’s private equity allocation by approximately one third (e.g. even if a fund has produced an IRR of 15%, the investor will have the benefit of just 10% as the undrawn capital is not captured by the IRR measure). The extent of return dilution would be even larger if the regulatory capital that has to be reserved under Basel II and Solvency II is also included in the calculation. This effect is not negligible since the regulatory capital only generates returns equal to that of treasuries and since it is based on the total exposure of the private equity portfolio.
This can be mitigated by liquidity management that increases the overall performance of the portfolio. For instance, imagine some investors put the total amount of capital they have committed to private equity funds into an asset class like fixed income instead, which generates lower returns than private equity and has a different cash flow profile compared with private equity funds.
In order to meet capital calls, these investments would have to be sold independently from the actual market situation, lowering the overall return potential of the portfolio. As private equity funds usually do not draw all commitments in a short time frame (and sometimes not even over their entire lifetime), other investment opportunities have to be passed on.
A proper forecasting of the amount and timing of capital calls, distributions and the net cash requirement of a diversified portfolio for various market scenarios reduces the opportunity costs for investors. Due to the more efficient use of capital and the allocation to a more profitable asset class, the overall portfolio return can be increased while keeping the overall risk of the portfolio at a similar or slightly higher level.
Optimising the liquidity management for an LP portfolio is just one example of the benefits of risk management. However, a proper and prudent risk management system cannot only focus on liquidity considerations; it also has to cover a multitude of analyses, including diversification and concentration analysis, as well as the construction of a risk-return optimised portfolio. We believe that private equity-specific risk measures can be transformed and integrated into the traditional risk frameworks.
… but also many challenges
This certainly involves many challenges: can a risk management system of a long-term asset class be based on short-term-oriented measures? Are private equity fund characteristics, like the limited partnership structure, better reflected through a risk management system based on the market or one based on credit risk?
The problem with assessing private equity funds is that they are conceptually different from short-term investments. First, viewing the risks of LPs on a relatively short-term horizon (and regulatory capital as a buffer against such loses) is at odds with private equity’s long-term horizon. Second, private equity funds are blind pool investments, and their undrawn commitments need to be reflected in a risk model. In addition, it is insufficient for limited partners to start evaluating the risk of a fund only after it has started its investment activities. Regulators require risk measurements to be part of the investment process and work ex-ante (i.e. before investing in a fund). Hence, the quality of the fund managers, the expected returns and the future timing and use of outstanding commitments all have to be included in the analysis.
The complexity of modelling this and the IT implementation issues aside, many LPs would probably balk at developing risk management systems because they would see the lack of long-term data – as the basis of any back-testing required by regulators – as an insurmountable obstacle. Only a few large investors are able to cover a bigger portion of the market volume in their databases. Private equity has to be on the lookout for other solutions because a proposed internal model approach integrated into the regulatory environment has to be implementable by many investors.
Looking at the regulatory framework, private equity is not alone in its data scarcity and modelling problems. There are parallels in the treatment of operational risks. Regulators eventually had to acknowledge that there are significant sources of uncertainty in terms of data, assumptions and modelling choices. They recognised that scenario analysis has to play a significant role and that a proper process review can assure the reliability of risk measurement. We think that a comparable approach for modelling risks for private equity portfolios is feasible, and believe that this can assure an appropriate degree of conservatism in the calculation of capital requirements and allow independent reviews, and finally, that it can be integrated in a sound governance process.
Towards new guidelines
If the private equity industry does not take a fresh look at how risks are modelled and integrated into regulatory frameworks, it will not give investors the impression that there is an attractive relationship between the risks and returns of this asset class.
As regulation and the associated capital requirement are increasingly likely to become an issue and as it is unrealistic to believe that regulated institutions will continue investing in this asset class without the private equity industry providing solutions for quantifying risks, we recommend that the industry begins to work on ‘International Private Equity Risk’ guidelines that would define the framework for an advanced risk measurement approach.
Because of the scarcity of data and the limitations that arise in back-testing more sophisticated models, regulators need to be convinced that experience-based judgment, prudence and process reviews have to play a significant role in private equity risk management. Likewise, there is a need for the industry, together with its institutional investors, to provide regulators with clearer guidance on how to view risks in this asset class.
The creation of such guidelines relies on the risk management community, which should pool its competences and convince regulators to embrace a “prudent risk manager rule” for private equity, comparable to the “prudent man rule”. Such principles could provide greater certainty to investors, while assuring regulators that risk managers measure risk in a clear and transparent way.
Christian Diller is head of portfolio & risk management and structuring activities at Capital Dynamics. Thomas Meyer’s latest book (co-authored with Pierre-Yves Mathonet) is J-Curve Exposure.