FEATURE: Capital limits

With the incoming EU Directive on Alternative Investment Fund Managers and the US Financial Reform Bill, the private equity industry finds itself in the way of a new regulatory storm.

As insurance companies and banks are large providers of capital to the private equity industry and are now actively discouraged from doing so, the recent regulatory efforts have sent shock waves through the industry. The industry has started making increased noises about lowering standard risk weights and exemptions, but these noises are increasingly falling on deaf ears. Instead regulators point to internal models as the way out.

In different European countries, various groups of insurance companies and the newly-founded risk management working group at the European Private Equity and Venture Capital Association have been formed to address the challenges brought by the new regulations and by the immature state of private equity risk management.

What is clear already is that there are significant conceptual challenges to be overcome to develop comprehensive risk management models. These include fully understanding the risks of investing into the asset class and formulating general principles that need to be considered when creating internal risk management models.

Defining the risks

But what are the risks of a long-term asset class like private equity? Many would argue that since private equity is a subset of the equity market, the asset class must be primarily exposed to market risk. However, upon close inspection, funding liquidity risks emerge as at least as important for institutional investors that invest into private equity funds.

Market risk is the risk that the value of a portfolio will decrease due to variations in stock prices, interest rates and foreign exchange rates, which affect the value of the underlying companies. When talking about market risks, the key to the debate is the definition of value. In private equity no regular observable market prices exist, but fund managers try to estimate a value for the various portfolio companies and report the NAV to their limited partners.

There are two principal methods for valuing an asset like a private equity fund interest. 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, arbitrage forces these two alternative methods of valuation into close alignment, but sometimes lack of liquidity and other market disfunctionalities cause these two alternative approaches to diverge, occasionally sharply, as observed in many secondary transactions during the financial crisis.

Fair and orderly

“Fair value” in private equity is based on the concept of an “orderly transaction”,  which assumes that buyers and sellers are not acting under any compulsion to engage into the transaction, both parties have reasonable knowledge of relevant facts and have the ability to perform sufficient due diligence in order to be able to make orderly investment decisions. Assessing the limited partner’s ability to conduct an orderly transaction is the key to assessing the risks for such an illiquid asset class. Discounts observed in the secondary markets are not necessarily caused by deterioration of the fund’s value but often rather reflect the inability of some limited partners to execute an orderly transaction as they lack liquidity. If a limited partner conducts an orderly transaction, he will not be forced to accept a price much lower than his estimated present value of the future cash flows.

In addition to the risk of losing invested capital due to liquidity constraints, private equity investors face the capital risk of not getting back their investment due to poor performance of the private equity fund. Manager quality, equity market exposure, interest rates and refinancing terms and foreign exchange rate fluctuations affect this risk. Portfolio companies often need to refinance maturing liabilities, which is influenced by the availability and prices of debt and, hence, has an effect on the long-term performance of private equity investments.

Private equity is a long-term investment, where resilience in profitability stems from the ability to develop companies over substantial time periods and to wait for the appropriate market window for an exit. As such, limited partnerships include contractual obligations that legally bind investors to honour their commitments to the fund.

Therefore, from an investor perspective, the greatest urgency is caused by funding liquidity risk which is affected by three factors. Firstly, the market environment; the second factor is the availability to mobilise cash from sources outside of the private equity portfolio. Lastly, investors can expose themselves to higher liquidity risk by pursuing a more aggressive strategy of over-committing.

Model behaviour

The interplay of the various types of risks in private equity funds is already posing headaches, but which principles do internal models have to fulfill in order to properly measure them?

Regardless of which regulatory regime applies, internal models have to fulfill a list of requirements and principles. Moreover, the manager needs to make the model an integral part of its investment process to support and verify decision making. Risk measures must be able to capture all relevant risk factors and must be forward looking so they can be incorporated into management decisions. Hence, the assessment of risks needs to be fund specific and be measurable ex-ante, during the fund’s lifetime and ex-post. It is not sufficient for limited partners to only start measuring risk after committing to a fund.

Models also need to reflect the contractual features of the limited partnership. Since investors commit to invest a defined amount into these limited partnerships, the future use of the undrawn commitments also needs to be reflected in the risk models. In this context and as discussed, monitoring liquidity risk is central to effective risk management in private equity.

The challenges of data scarcity should not stand in the way of better private equity risk management. Lastly, the accuracy and robustness of risk management frameworks needs to be assessed regularly, and be verified and validated independently. Assuming that the private equity industry will adopt and implement all these principles of risk management in the future, this might not only calm down the regulatory thunderstorm, but might also clear the air.

The regulatory environment increased the efforts of investors and the general industry in developing sound risk management principles and will probably lift risk management practices in private equity to the next level. If investors understand the risks of their portfolio better, a lot has already been achieved.

This can give tangible benefits through better liquidity management and a more active management of exposures – and will also make the industry as a whole more attractive for institutional investors who see comparable risk measurement principles already implemented for their other activities and expect the same for private equity. It may even ultimately reduce the risk weighting of the asset class.