Recently I had a longer debate with the founder of a software company who argued that there is no market for sophisticated solutions (like value-at-risk) for quantifying private equity risks. I respect this person’s experience and judgment and, sadly, I tend to agree. I use the word ‘sadly’ as risk management (in the sense of balancing threats versus opportunities) is an aspect of private equity investing that continues to fascinate me – particularly because of its current underdeveloped state – but which the industry also neglects to its own disadvantage: not being able to properly quantify risks is an obstacle to attracting regulated institutional investors to the asset class.
Underdeveloped, little interest
The lack of interest in this subject is somehow surprising – notably after the 2008 financial crisis has shown that private equity performance cannot be taken for granted. Many institutions have been buying IT systems to monitor their investments more closely. We also see significant interest in solutions to assess exposures and cash-flows of portfolios over up to five year time-horizons. However, risk management, where it is not just limited to assuring formal regulatory compliance, is to a large degree associated with a quick rebalancing of portfolios, requiring liquidity and putting a premium on precise valuations. But for illiquid assets valuations are judgmental and are not prices, data – where they exist – are unreliable, precision is unachievable and traditional risk management models do not work.
From an academic perspective, the intersect between papers on risk management and those on private equity can be described as close to an empty set and financial regulation is even argued to have ‘wiped out all incentives’ to work towards better risk models for such assets. I have been first the secretary and later a member of Invest Europe’s ‘Private Equity Risk Working Group’ that strove to address this gap, but what we produced as guidelines failed to gain significant traction in regulated institutions.
Clearly private equity is a long-term oriented asset class but nevertheless we tend to look at its risks through the prism of the here and now. For instance, private equity funds show a more or less pronounced ‘J-curve’ in their value development. To draw a parallel, if you take an eight-year old child and project its average growth rate between age 2 and 8 to an age of twenty, you would come to the conclusion that the average size of an adult would be 211cm (instead of the 177cm observed in reality) – for a forecast quite a margin of error caused by ignoring changes in the growth pattern over one’s life. In the case of private equity funds, ignoring the J-curve as lifecycle induced distortion can give the impression that young funds perform catastrophically and that funds in their mid-age (when valuations rebound from their initial low) appear to show spectacular performance whereas the true picture over the fund’s full lifetime lies between these two extremes.
Auditors and regulators view a fund’s value as just the value of its underlying portfolio companies, i.e. the Net Asset Value (NAV). They do not consider the funds’ future cash-flows but want to know its value if ‘you would need to liquidate it now’. As funds initially have no portfolio (it builds up over time and is exited again as the fund approaches the end of its lifetime) from this perspective their value at the time of initial commitment should be zero (figure 1).
Is private equity just ‘equity’?
This view has to be challenged. An alternative way of looking at a fund’s value is ‘from the outside’ and as cash-flow asset: cash in-flows are followed by cash out-flows that peter out as the fund winds down. Taking this perspective, the fund looks more like a loan than an equity investment with its present value at time zero being the size of commitment. The fund’s value is not simply the aggregation of its underlying portfolio companies – it is derived from them (and other factors) but it is not identical.
Intellectually, industry practitioners may agree with this view but will tend to go with the orthodoxy that ‘private equity is of course equity’ (and: ‘Think about the effort of trying to model a fund along these lines!’). It also becomes clear from figure 2 that just by considering a fund’s NAV the significant liquidity risk is overlooked – at this point the latest the interest drops to zero as ‘private equity is already viewed as far more risky than it is’.
If a fund looks (at least a little bit) like a loan, maybe its risk could even be between debt and equity (and certainly not higher than equity). Probably it is worth taking another look at private equity fund risk, one that is more along the lines of credit ratings. Is what I am proposing here breaking new ground? No – in fact the techniques built on cash-flow risks have long been used by specialist investors who need to put their risk capital where their mouth is and structured securitizations of private equity portfolios where these cash-flow assets are converted into layers of tradeable debt. Such Collateralized Fund Obligations also give a model for quantifying private equity risks that is far more sensible than the standard risk weights and shocks imposed by regulation. Nevertheless, this is not a perspective embraced by institutional investors as regulatory requirement are different or are interpreted differently.
Denial of service attack
Regulation has helped to establish risk management in the private equity industry, but unfortunately risk management has become more of a necessity to comply with regulation but still fails to be seen as a value adding part of the investment process. Based on my observations, regulators as well as many managers believe that the key to measuring and controlling risk is asking for an ever increasing amount data and to look-through to every detail of individual portfolio companies.
Nowadays the availability of perfect information is almost seen as a given. Financial markets participants feel negligent unless their decisions are based on a complete and reliable set of figures. There is a belief that high quality – i.e., complete, timely, correct and precise – data is the solution to measuring risks. It sounds like a good idea, but in private equity at least, it is not. As inefficiencies in financial markets become exploited and saturated, investors must continuously explore new under-researched but potentially profitable niches in order to stay ahead of the game.
Unfortunately, the trend of the industry goes into the direction of ‘big data’ – maybe it will lead to something, although I have my doubts that this is useful for risk management where the question is rather ‘smart modelling’. I challenge the tendency to think that allegedly ‘sophisticated’ models requiring many data as inputs and ignoring qualitative judgment give more reliable results. Every quantification can only be based on a very simplistic view of the world anyway and the more complex the model the more pronounced is what is essentially a ‘butterfly effect’ where small variations result in significantly different outcomes that are more driven by the model’s features than by relevant changes in market conditions. But risk managers now appear to be condemned to fight more ‘for’ information for regulatory reporting. In effect this amounts to a ‘denial of service’ attack on the risk manager who should focus on the big picture, bring in independent judgment and be integrated in the investment process rather than spending his/her time pulling together figures that are largely irrelevant for investment decision making.
Rethink risk models for funds
Recent years have made it painfully clear that our economies need investors who remain committed over the long term and focus primarily on the premium that structurally illiquid asset classes may offer. Such investors are aware ex-ante of the illiquidity they will be exposed to and have (or should have) put appropriate risk management practices in place.
But regulators still see the liquid public markets – that may become illiquid in periods of financial turmoil and heightened risk aversion – as more relevant and focus on short-term liquidity needs, The private equity industry sees little value such risk management and, in my opinion, they are right about this – but this is the result of being shoehorned into the market risk framework (or wanting to be there) instead of working towards approaches that are more suitable for supporting the private equity investment process.
 Slightly sidetracking, why do we bother with funds at all? Indeed, prominent investors in recent years have been moving away from commitments to funds and shifting towards direct investments. For various reasons I see this trend misguided and, as I argue in my recent book (‘Private Equity Unchained’ by Thomas Meyer, Palgrave MacMillan, 2014), the fund structure is at the heart of the ‘true’ private equity model and its illiquidity is a critical success factor rather than an additional risk.