Understanding Risk in Private Equity
THE QUEST FOR ALTERNATIVE RETURNS
The heightened volatility in the capital market and low real returns from conventional assets compelled investors to search for alternative source of returns within the acceptable asset classes prescribed by Regulation 28 (“Reg 28”) of the pensions fund act and/or
the discussion will only be limited to private equity.
Private equity is an equity investments into non-listed companies, and it is a long-term asset class which generates strong returns for investors. Given the current
There has been a growing interest in private equity investments from institutional investors for various reasons, ranging from fulfilling social responsible investments (SRI) aspirations to participating in the nascent growth of the African continent consumers which may not be achieved through listed space.
Private equity is different from traditional asset classes because of certain intrinsic characteristics unique to the asset class, such as unobservable market prices and the typical fund structure used by investors to gain exposure to the asset class.
In the last decade there has been a great emphasis on private equity investments that focused on infrastructure at the back of the demand for such investments.
Regulation 30 (“Reg 30”) of the medical aid schemes act. The recent increase in permissible allocation to alternative assets from 2.5% to 15% on the Reg 28 prudential guidelines has reinvigorated the subject discussion to many boards of trustees. Hedge funds and private equity are regarded as alternative investments in Reg 28. For the purpose of this article, low interest rate environment (not favourable for pension fund liabilities), private equity investments may
be crucial to institutional investors who are looking for alternative source of returns. Due to its long-term investment horizon, its illiquidity and its unique structural characteristics, private equity has its own specific risks. These risks differ from those in public markets, and as such, can be more difficult to understand and capture in traditional risk models. Risk in in private equity is often perceived as being high. But how risky is private equity in reality?
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MAIN TYPES OF RISKS IN PRIVATE EQUITY
This is the risk of holding an asset which can be traded on a (secondary) market like the Johannesburg Stock Exchange (JSE) and whose value changes over time. As the main risk factors for public equity are market risk measures, practitioners often try to fit private equity into this framework as well. Due to lack of real continuous market prices for private equity, quarterly Net Asset Values (NAVs) are often used as substitutes for market prices. These substitutes must be used as the secondary market
is neither efficient nor large enough, and data is not readily available. With NAVs as substitutes, it is possible to calculate typical public market
measures such as periodic returns, their volatilies and correlations with returns to other asset classes. It should be noted through that these are not based on actual market transactions, consequently they can differ from true fair market values. In private equity, market risk is often defined on the basis of the quarterly change (return) of the net asset value adjusted by the
cash flows between two observations. Changes between two quarters are mainly due to the performance of the underlying portfolio company or the financial structure. Market factors, like stock market movement through comparison methods, also affect the short-term value of the investments. Similarly currency movement can have a large impact on the value of the company. Market risk as the quarterly change of the NAV is a shortterm risk measure and, therefore, also depends on the
short-term movement of public (through market comparison) and currency risks. As such, if the portfolio is largely diversified over various geographies, markets and industries, this volatility can be minimised.
Closely related to market risk is capital risk for the investor. Capital risk for the investor is defined as the probability of losing capital with a private equity portfolio over its entire lifetime. As a consequence, the investor would have a realised loss in their portfolio, while market risk is based on unrealised values. Similarly to market risk, capital risk is driven both by internal and external factors. It reflects the risk that an investor’s entire invested capital will not be paid back.
In the long-term, the development of the underlying companies in a fund portfolio affects the performance and the capital risk of the investments. In addition to these specific risks, the equity market, together with the level of interest rates and the availability of debt and refinancing possibilities, affect
the long-term risk for investors to lose capital.
The positive operational development of the companies and their financial situation is a substantial source of value creation for investors. As such, the fund manager spends a significant amount of time working with the management analysing and improving companies’ strategies during their holding periods in order to exit the company at the value above the investment costs. The conditions of the exit market, method and timing of the exit can also be a route through which the fund manager can create value for investors.
As many investors hold a portfolio of private equity funds and are exposed to hundreds of portfolio companies, the idiosyncratic risk for each company gets diversified.
This is the risk that an investor in unable to redeem their investment at the time of their choosing. Private equity fund structures such as limited liability partnerships (LLPs) are designed so that the investor remains in the fund for its full term (average 10 years) without an opportunity to redeem their
commitment. As a result of these structures, however, a secondary market for limited partners’ commitments (participants) has emerged and evolved. Consequently, liquidity risk may also be regarded as the risk that an investor wants to sell their private equity investments (in the form of a fund commitment) on the secondary market, but the market does not offer enough volume or efficiency for a fair trade. Moreover, secondary market prices are often significantly influenced by factors unrelated to the fair value of the partnership, which result in prices being discounted. For instance, investors selling from a distressed position often have to accept discounts to reported NAV.
Liquidity risk in private equity is difficult to reduce, although it is simpler to handle for investors in an overall asset allocation model. If an investor is solely focused on private equity assets and they need to sell in difficult market times. They cannot circumvent the liquidity risk. However if private equity is only a small part of a well-diversified asset allocation, as it is the case for many pension funds, many
other assets are more liquid and can be traded.
Funding risk, also commonly referred as default risk within the private equity industry, is the risk that an investor is not able to pay their capital commitments to the private equity fund in accordance with the terms of their obligation to do so. If this risk materialises, an investor can lose their full investment (according to a typical limited partnership agreement) including all paid-in capital, which is why it is of paramount importance for investors to manage their cash flows to meet their funding obligations effectively. But how does funding risk occur when managing a private equity portfolio? In general, there are two reasons: (1) over-commitment and (2) market distortion in capital calls and distributions. Firstly, the possible reason for running into liquidity issues is an over-commitment strategy of some investors. As private equity fund typically do not draw all of their committed capital or as some companies have already been exited before
all the commitment has to be paid in, the net liquidity need is typically smaller than commitment size. Therefore, investors need to run an over-commitment strategy to avoid being under-exposed to their strategic allocation to the asset class.
Secondly, investors who have been running private equity portfolio for some years typically use the distributions of mature private equity funds to finance the capital calls of young funds (self-funding strategy). Depending on the maturity of the existing portfolio, a private equity programme can be set-up and managed in a way that the capital calls and distributions are in a steady state and can be matched accordingly. As such, no additional capital needs to be put into the private equity programme as this is self-financing in normal market conditions. However, if a market distortion suddenly occurs and distributions are missing because exit activity on underlying companies dried up, investors may run into problems as they could require additional capital from external
sources to meet their commitments. Other external sources could be: (1) regular capital inflow from a main business; (2) availability of cash; (3) sale of liquid assets such as government bonds or corporate bonds; (4) sale of listed equities; or (5) sale of any other investments, potentially including their private equity funds, on the secondary market. If an investor has a regular and market independent source of capital inflow or only a small allocation to illiquid asset classes, this mismatch of distributions and capital calls will not have a big impact on its funding risks.
When reflecting on the last financial crisis, some investors faced severe funding issues. CalPERS (the largest US pension fund) sold some of their listed equities in order to be prepared for potentially paying future capital calls for private equity
fund according to an article in Wall Street Journal.
Investors can reduce the risk by assessing their future commitment plan with cautious planning and stress testing cash flow assumptions. Investors who have limited external capital of large allocations to illiquid assets should be more cautious on the over-commitment and self-funding strategy.
Private equity is different from traditional asset classes because certain intrinsic characteristics unique to the asset class, such as unobservable market prices and the typical fund structure used by investors to gain exposure to the asset class.
The migration of many retirement funds from defined
benefits (DB) to defined contributions (DC) has amplified the importance of the above mentioned risks when designing private equity programmes. Investors should understand that no one manager is indispensable but that diversification is an effective risk management tool not a by-product. A fund of funds model may be ideal for medical aid schemes because of the 2.5% limitation of the overall fund (as per Reg 30) they can invest in unlisted equity.
Due to the illiquid nature of the listed equities in the continent (Africa), many investors still prefer private equity to participate in the nascent consumer market growth in the continent. We urge investors to consider currency movement in their risk management strategies. Many of the countries
in the continent relied on hard and/or soft commodities to stimulate growth through infrastructure investments, however commodity prices have dropped severely in the last couple of years. This creates both challenges and opportunities as diversification in economic activities is more crucial now than ever.
The combination of unlisted property (real estate) and private equity may also exacerbate the liquidity and funding risks in any private equity programme.
These are generic views and Selekane believes in creating customised solutions for each client depending on their objectives. Please get in touch with any of our consultants on firstname.lastname@example.org for further information on how to weather the coming turbulent year.