Private Equity: Working With Risk

Interest in private equity funds involves investing in an illiquid asset class; private equity funds have specific characteristics that make measuring their value at risk in a way similar to the risk of tradable assets very difficult. Nevertheless, and despite conceptual challenges, investors increasingly view a proper measurement of private equity risk as a necessity.

Historically, most investors have taken relatively simplistic approaches to measuring and reporting the risks of investing in private equity. However, with investors’ growing exposure to private equity, it has become important for investors to fully understand and correctly quantify the risks of investing in this asset class to strengthen their risk management capabilities. It is also important that risk measurements used for investment decisions and internal capital allocation are of high quality to reinforce the sound corporate governance from which investment policies are implemented.

The most widely used methodologies to assess the risk of private equity investments are those based on discounted cash flow (DCF) and on net asset value (NAV). For both methodologies the period over which the risk is measured depends on the particular environment in which the investor operates, e.g., duration of the portfolio, ability to hold the investment, and liquidity constraints.

NAV-based risk measurement approaches generally look at the volatility of a fund’s NAV in order to estimate the value at risk of the investment. This method has the advantages of being simple and giving a good approximation of the risks of mature funds and diversified funds of funds spread over several years.

Volatility is estimated by measuring the returns reported at different time intervals, based on quoted indices or other private equity benchmarks available in the market. The measured volatility over the relevant period is then applied to the fund’s or portfolio’s NAV.

It is important to note that NAV calculation can give an incomplete or even distorted picture of risk because:

• A fund’s NAV fluctuates naturally with the development of the fund’s underlying assets and liabilities from investment and divestment, not just because of risk exposure.
• NAV-based models need to reflect the limited partner’s exposure to the fund’s undrawn commitments and the future use of distributions. Both aspects might present a different risk profile than the one applied to the NAV.
• Publicly quoted private equity indices are rarely representative of the portfolio held by the investor, and the illiquid contractual nature of investments in private equity makes them fundamentally different from the shares of listed private equity funds.
• NAV-based methods may fail for young funds that are still in the early phases of their J-Curve[1] and for portfolios with limited diversification in their vintage years, which undermines the representativeness of the indicator used to estimate the volatility of the NAV.

Limited partners also face a number of other risks that can impact the value of their investments:

1. Funding risk

The unpredictable timing of cash flow over the life of an equity investment poses funding risk for the limited partner. Fund managers call most or all of the committed capital over the investment period of the fund, and limited partners have to meet their commitments within a fixed short-notice period. Because commitments are contractually binding, a limited partner who cannot meet the obligations is forced to default on payments and loses a substantial portion of the share in the partnership. In practice negotiations can occur between the limited partner and the fund manager to adapt the size of the fund and/or the capital-call requirement.

1. Liquidity risk

Limited partners can sell their stakes in private equity partnerships to fund their open commitments. However, the secondary market for private equity investments is relatively small and highly inefficient. The characteristics of the secondary market expose investors to liquidity risk. Moreover, secondary market prices are often influenced by factors beyond the fair value of the partnership, which can translate into a discounted price. For instance, investors selling from a distressed position often have to accept discounts to reported NAV.

1. Market risk

Since private equity is an illiquid asset, the treatment of market risk poses important challenges. There are two principal methods for valuing an asset. The first is its current market valuation, or an estimate of what that might be. The second is the present value of the estimated future cash flows from that asset. Normally, liquidity and arbitrage in the market force these two alternative methods of valuation into close alignment. Lack of liquidity and other market dysfunctions can cause these two alternative approaches to diverge—occasionally sharply; this is most clearly observed in secondary private equity transactions.