This year’s Oxford Symposium (13-14 December) on Risk Management in Private Equity asks how investors can balance risks versus opportunities in order to maximize risk-adjusted returns – in other words, risk management as a value add.
This article gives insights into the focus topics of the symposium and provides food for thought to investors on how to maximize risk-adjusted returns.
Mind the gap
In my experience, many GPs tend to consider risk management, in the first instance, in the context of regulatory compliance, rather than for its benefits to the risk-return dynamic. However, this understandable focus on regulation has been detrimental to the advancement of risk management practices and has resulted in what is essentially a denial of service attack – flooding a thinly resourced function with disclosure requests that have little value for the investment process.
The Symposium aims to leave the technicalities of regulatory compliance aside and rather focus on the question how investors can balance risks versus opportunities in order to maximize risk-adjusted returns to investors – in other words, risk management as a value add.
The event will kick-off with a pre-dinner strategy ‘war gaming’ session, from the leading authority in this field, Professor Philip Sabin from King’s College.
Making the case for private equity
Historically, the discussion of risk in private equity has been focused on risk-adjusted returns and the Symposium will kick-off with the question of whether private equity returns are (still) worth the risk. Most private equity analyses have implicitly tried to make the case for allocations to this asset class – and generally have been successful in this exercise.
Despite the financial crisis starting in 2008, the asset class has been booming, with inflows of large amounts of capital to be invested. Private equity moved from an exotic alternative asset to an established part of institutional portfolios. For instance, it is now, after real estate, the most significant alternative asset class for pension funds. Having said this, most research has put a strong emphasis on returns whereas regarding risks generally over-simplistic assumptions are made and short-cuts are taken.
Measuring risk requires reliable data and not surprisingly, the private equity industry has also moved forward on this. We should assume that our knowledge and particularly the statistics on private equity becomes better over time – yes, it has improved, but limitations remain. As we found in last year’s Symposium, most LPs still collect minimal information and data was described as a ‘mess’ – aggregating data in a timely, accurate, and complete format is difficult and painful, if not ‘mission impossible’. Therefore another session will deal with giving a status report on private equity industry data, discussing recent developments, remaining challenges and limitations.
A huge part of the value proposition provided by intermediaries in this asset class is being able to look through the veil of private data and poor data quality, and being able to intelligently fill the gaps. One example is the RATZ IRR (reconstructed average time zero internal rate of return) methodology to estimate the portfolio IRR from portfolio constituents, which will be presented in another session.
Is the edge becoming blunt?
The increasing popularity of private equity comes at a price: with larger allocations not always finding suitable opportunities, the historically high average returns cannot be taken as a given anymore. Many industry practitioners point to the ability to select outperforming fund managers as a counterargument. It is believed that private equity funds still present an attractive opportunity for exercising manager selection compared to public equities. Consequently, we will look at this aspect in a session on fund manager characteristics and its impact on portfolio companies’ performance. Indeed, selection is still seen to be the ‘magic bullet’, but the industry has matured significantly: practices that were previously followed by few sophisticated investors have now made it into the mainstream and as an edge are increasingly becoming blunt.
Can risk management add value?
A panel discussion will look at the role for risk management in private equity: how to maximise the value added? Typically centred on post investment analysis, risk management still struggles to establish concrete influence. A major factor is the private equity industry’s culture where risk management is usually perceived as a threat to investment management that just costs and adds no value. Interestingly and as mentioned before, regulatory requirements (that could be seen as a driver and support for risk management) have been seen as more of a distraction.
One example of the questions in this context is whether risk management should complement or monitor investment management. As risk management is a late-comer to private equity, one school of thought is to focus this energy to the areas not covered so far, which – basically by definition – are those where little value was seen before, e.g. non-financial operational risks or additional responsibilities such as compliance. According to the ‘do something different than investment management’ philosophy risk managers are supposed to deal with the downside only. Just considering the downside makes little sense particularly in the case of venture capital, where few transactions with high upside need to compensate for many failures. If a fund is having too few hits, no amount of protecting the other assets will make a difference.
Other risk managers try to position themselves as the ‘über-investment manager’, respected by peers in the investment field because of his/her experience and track record. In this context, ‘veto-powers’ are discussed quite often, but risk managers always admit that they are never actually able to exercise them – probably because the rationale for this ‘nuclear option’ is in all regularity too shaky. I daresay that these powers would not be exercised more than once – due diligences are too expensive to come with a last minute veto. Personally, I would also question the wisdom of risk management participating in (shadowing) the due diligence, a practice some risk managers are increasingly pushing through within their organisation. It is increasing due diligence expenses and risk managers become as much involved with the deals as the investment managers. In other words, we are looking forward to a lively debate…
Cash-flow assets rather than markets
The growing maturity of the private equity asset class points to increasing efficiency and associated with this a fascination with the secondary market. But liquidity comes at a steep price, particularly in the context of risk management, where markets dry up, particularly when liquidity is needed. What is so specific about this asset class? By definition, private equity assets are not publicly traded on an exchange. As there is no trading that could efficiently rebalance a portfolio, the typical risk management tools do not work. Because of private equity’s non-standardisation and the extreme uncertainty it is operating under, the tools for transferring risks are less developed and face fundamental obstacles.
Private equity belongs to the cash-flow assets, i.e., assets that usually cannot be traded profitably and where investors are mainly exposed to the uncertainty regarding the timing and amounts of cash-flows. Instead of being obsessed by secondary markets one session will look at the role of interim financing as a, arguably more realistic, avenue to provide liquidity.
While one can change the risk before the private investment is done, absent of an illiquid market it is not really possible afterwards. The main risk management tool is striking an appropriate portfolio balance, where the upside of some investments needs to compensate for losses from others. The focus of risk management shifts from active portfolio management to planning portfolios according to desired risk/return profiles ex-ante.
Chance favours the prepared
Over the long time horizons relevant for such assets, any forecasting is extremely imprecise. Portfolio management approaches suitable for quoted assets is difficult to transfer to private equity. Here risk management can add the most value before investing starts, i.e., designing, challenging and communicating the investment strategy. There is a tendency to also look at private markets as big, static, subject to mathematical rules, and with anonymous players. Despite significant growth, the market for alternative assets remains small – large institutional investors increasingly fight for ‘territory’ as they need to put large amounts of capital to work. Market dynamics are significantly changing with capital in- and outflows; rather than being anonymous, the specific market players and their interests need to be taken into account – they are not only rivals but often allies, for instance, investing in the same funds. Private equity’s poor data quality and the investment landscape’s complexity make the search for ‘optimal’ portfolios futile. In this situation, developing investment strategies can benefit from the collective judgment of teams.
Therefore one of the Symposium’s highlights will be a pre-dinner discussion on simulating strategies under uncertainty in a competitive environment and under resource constraints – aka ‘war gaming’. Despite its martial undertone, war gaming is an important tool increasingly run by various businesses – they trigger the association of large-scale and expensive exercises that requires sophisticated computer models. However, this is not the case: war games can be run quickly and cheaply, they do not need computer support, quite the opposite. The value stems from role playing and discussing various perspectives. ‘War gaming’ is still rarely used in private equity – important tool for risk management as it establishes the link to strategy. This helps in testing competitive plans, thinking investment strategies through, and, importantly, making the case to potential investors, as many angles have been looked at in the course of the exercise.
As there are many parallels to military war games – search for intelligence, secrecy, flexibly reacting to uncertainty and changes, understanding the motivations of other players, such as limited partners, general partners, politicians, regulators, businesses, the public, the leading authority in this field, Professor Philip Sabin from King’s College will conduct with the Symposium’s participants a case study on war gaming as tool to prepare for the unexpected.