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Risk management in Private equity

An overview
Manu Midha
11/10/2009
Abstract
The article studies various aspects of risk management, with regards to private equity investments.
Private equity investors face two basic categories of risk, one impacting their ability to raise funds from
institutional investors and the other impacting their portfolio investments and exit strategies.
The article gives an overview of the methods used commonly by private equity funds to mange each of
those risks faced by them.

Risk management is defined as identification, assessment, and prioritization of risks followed by


coordinated and economical application of resources to minimize, monitor, and control the probability
and/or impact of unfortunate events.
Private equity is an asset class which consists of investments in the equity of private businesses. Over the
past fifteen years, it has been the fastest growing market for corporate finance, far surpassing others
such as the public equity and bond markets and the market for private placement debt. Today the
private equity market is roughly one-quarter the size of both the market for commercial and industrial
bank loans and the market for commercial paper in terms of outstanding amounts (Figure 1). In recent
years, private equity capital raised by partnerships has matched, and sometimes exceeded, funds raised
through initial public offerings and gross issuance of public high-yield corporate bonds.

Figure 1: Growth of capital committed to private equity across years1995 – 2007


Source: Thomson financial and National Venture capital association
As private equity is becomes an attractive investment option for institutional investors, the risks facing
them needs to be understood and managed effectively.
Understanding risks for investors is also important, as private equity investments are not only impacted
by macroeconomic factors like interest rates, or economic conditions but also depends largely on the
business of the underlying portfolio companies.
This makes it extremely difficult for Limited partners (LP’s) to monitor and quantify risks faced by
their private equity investments.
There has been a big debate going on disclosure and reporting of material risks faced by Venture and
Private equity firms to their investors on a quarterly basis. A recent proposal under the Accounting
Standards Update (ASU) suggests that venture capital and private equity firms should identify risk
factors faced by these firms, do a sensitivity analysis of these factors on their portfolio investments; to
be disclosed to their investors on a quarterly basis. (National Venture Capital Association, 2009)
This comes in the backdrop of an effort to regulate this unregulated class of investments after the
economic meltdown of last year.
While most venture capital and private equity firms have resented such a move, they have contested
this on the basis of unquantifiable nature of the risks faced by them. Further since the value created is
not directly co-related
related with one factor of risk. They are faced with a full spectrum of risks from those
arising out of economic downturns to specific events faced by their portfolio companies.
Before we go into the risks faced by private equity firms it is important to understand the way it creates
value for its investee companies.
Sources of value creation by Private equity investments:
investment
1. Operational efficiency: Improving operations may include rationalization of costs, helping the
company increase revenues,
nues, hiring or laying off people, getting customers, etc.
2. Multiples expansion: Private equityeq investing takes place at multiples of EBITA or earnings of
the investee.. These multiples are a function of a number of factors such as attractiveness of the
industry
ustry and business segment of the investee, competitive strength of the company, capability of the
management team, etc. These multiples are often used to compare
3. Leverage or financial re-engineering:
engineering: The he capacity of a private equity investor to raise debt is
normally higher compared to the portfolio firm. This makes it to raise debt from the market and infuse
into the investee’s balance sheet.. This leverage helps to increase returns on the equity held by the
private equity investor.
Sources of risk of private equity investments
These firms face two basic kinds of risks; one of not being able to raise funds at the right point in time,
the other is not being able to extract adequate returns from its equity portfolio.
Though the two may seem independent
pendent from each other, they are impacted by factors which are quite
similar in nature.

Figure 2: Sources of risk for private equity investors


a. Funding risk: Private equity investors raise funds from big institutional investors such as
pension funds, sovereign funds, wealth funds, university endowments, insurance companies, fund of
funds, etc. Each fund raising – investing – fund close cycle is of about 10 years duration.
There are times, when private equity funds find it difficult to raise capital for new funds. Such a
situation may arise due to adverse economic conditions like the one being witnessed currently or due to
factors specific to the fund.
The ease of fund raising depends on a number of factors like the size of the fund, reputation of the
fund sponsor, past returns and the team of general partners managing it.
Managing funding risk:
• A number of private equity firms maintain a group of preferred set of limited partners of the fund,
those which are more predictable than others.
• Firms prefer raising large funds during better economic conditions and draw capital in form of
capital calls, during the life of the fund rather than raising smaller sized funds.
• Many firms tweak their compensation structure during down cycles, making it attractive for limited
partners of the fund. From the regular 2% management fee and 20% carry, firms are seen to reduce the
fixed management fee to 1 – 1.5% keeping the carry same or increasing it slightly.
• Many big firms maintain a level of overhang, or raised but not invested capital. This gives them a
competitive advantage of investing in difficult times, when there is not much capital around and
valuations are low.
b. Risks of adverse economic cycles and exit environment: The major source of this risk
comes from the fact that an economy goes through cycles, and valuations of the same cash flows may
differ considerably.
Control premium paid by private equity investors are much higher during boom times, than times of
recession. This is largely because of investing activity gains high momentum during formation of
bubbles. Figure 2 shows the total size (blue bars) and number (brown line) of buyouts during the
period from 1995 till 2009 1H. The activity levels reached during 2007 were considerably higher than
ever.

Figure 2: Total size and number buyouts in years 1995 – 2009 1H.
These cycles have a very adverse impact on valuations and therefore on the returns private equity
companies are able to realize on these investments.
A good example of the impact of this is being faced by most private equity groups today.
A close study on investments of the 2006 -07 (Table 1) vintage indicates that only a fraction of
investments of this vintage have been able to return even the premium invested by the private equity
groups. The current NAV’s and the distributed capital, is lowest at 84% of invested for investments of
vintage year 2007.
Vintage Year Return Ratio Chart
Vintage Year LP Distributions
Return Ratio + Current NAV /
Chart LP Contribution
1981-1994 3.24
1995 6.06
1996 4.45
1997 2.89
1998 1.45
1999 0.88
2000 0.92
2001 0.98
2002 1.02
2003 1.09
2004 0.98
2005 0.92
2006 0.92
2007 0.84
2008 0.88
Overall 1.53

Table 1: Vintage year return ratios


Source: National Venture capital association, report 2009 (National Venture Capital Association, 2009)
This risk is faced more by smaller and relatively new funds which do most of their fund-raising during
boom cycles and therefore make more investments during those times.
Mitigation of risk of funding cycles:
To mitigate this risk of economic cycles, the following practices are adopted by private equity groups:
• Invest uniformly across economic cycles. They do not invest in spurts.
• Invest based on valuations of future cash flows of the company and not just on comparables and
multiples as market comparables may sometimes be misleading.
• Avoid competitive bidding; co-invest in deals of large magnitude.
• Have concrete exit plans in place, with key milestones and targets for the portfolio.
c. Risks originating from the industry segments:
There are a number of private equity firms which specialize in a particular industry, or an
industry segment or even a particular product category. This is mostly to leverage their
understanding of that particular segment. It has been shown that this strategy is better compared
to a diversified investment strategy, as it is easy for investors to diversify their portfolio at their
level. But being too specific brings risks associated with that particular segment.
Companies that specialize in certain industries carry additional risks of facing downturns in that
particular industry. For instance, many PE firms invested only in high-technology companies
during the dot com bubble of 2001 when valuations were at their peak. After the bubble burst
there was little value left in their portfolio and many tech focused VC and PE firms shut down.
An evidence of this can be shown from the vintage year ratio chart; investments of the 1999 -
2001 vintage have resulted in distributions less than those of the invested capital.
Mitigation risk from investing in industry segments:
• While investing in a particular industry segment, private equity firms invest uniformly across
economic cycles.
• Diversify within the industry segment.
• Invest across seed, early and late stage companies in that particular segment.

d. Risks originating from portfolio companies: A number of risks may emerge from inside of
the investee companies. These risks include:
• Technology Risk – Risk of the technology not seeing light of the day or not being
commercially viable.
• Market Risk - Will a new market develop for this technology? How would the market respond
to the product or service offered by the company?
• Company Risk - Does the company have the right capital structure? Is the management team
capable enough for executing the strategy? Are incentives of key managers aligned rightfully?

Mitigating portfolio risks:


The way a firm deals with these risks defines its portfolio management philosophy and helps it
create a difference. Some of the best practices while dealing with the above risks are:
• Technology risks:
Invest in technologies which they understand, or get opinion from external experts.
Stage investments in parts and set milestones for the management team.
Invest in competing technologies with smaller ticket sizes.
Invest in developing an ecosystem.
Invest across different stages in their lifecycle seed, early, late and mature stage companies.

• Market risks:
Work closely with the management team, help it develop prototypes and get feedback from key
customer samples.
Help the investee develop a sustaining business model, leveraging on its industry experience.

• Company risks:
Private equity partners invest a lot of time and effort with each of their portfolio companies
managing unique risks faced by them, with respect to management and technical team, capital
structure, cost and revenue management, etc.
Incentives of management team are often re-aligned with those of the investors, usually by way
of granting equity options as part of their compensation.
Performance based milestones are often set for the management team to achieve.

References:

National Venture Capital Association. (2009). Proposed Accounting Standards Update, “Fair
Value Measurement and Disclosure (Topic 820),” issued August 28, 2009. NVCA Update , 6.

National Venture Capital Association. (2009). Venture capital performance as of Q2 2009


impacted by poor exit. NVCA Update , 3.