New Strategies for Risk Management in Private Equity, a new book from Private Equity International, is an anthology of papers on the titular subject. It is edited by Dr. Ivan Herger to offer investors in PE new perspectives on the field.
Herger, a managing director at Capital Dynamics, has a Ph.D. in theoretical physics from Universiteit Utrecht (Netherlands), on the strength of a thesis on elemental particles and string theory.
PEI has observed that, for investors in PE, risk management is too readily identified with the fund selection process. That selection is obviously important, but risk management should go far beyond that due diligence. It should include for example an assessment of the place of PE as a whole within the investors’ portfolio, consideration of co-investment as an alternative to partnership there, and some wrestling with the particulars of separate account agreements.
Separate Accounts: Out of Fashion and Back in Again
Kelly DePonte, of Probitas Partners, contributes to the book an article in “Investing in separate accounts: Advantages and risks.”
DePonte begins with some history. Beginning in the late 1980s, she reminds us, “larger institutions grew more sophisticated and began to build their own teams internally to take over the investment process, supplementing them as needed with non-discretionary consultants.” Through the course of the 1990s, “most institutions of scale came to manage their entire private equity allocation internally, building long-term fund-manager relationships and monitoring individual fund performance themselves….Separate accounts faded in importance.”
Yet everything old is new again. In this millennium, interest in separate accounts has recovered, because larger investors have found them a useful; way of addressing their specific problems.
Be Ready to Exit
DePonte further observes that there are four types of separate account in the market today. There’s the single investor fund of funds, the co-investment vehicle, the single strategy direct investment pool, and the multi-strategy direct investment pool.
The fourth of those is a recent development. The accounts involved are quite large, with commitments of $1 billion and up. Strategies involved may include hedge funds, infrastructure, credit, or real estate as well as the various sectors of private equity.
The largest investors, those looking at multi-strategy direct investment pools, want to do so to reduce their management fees and carry as well as to decrease the monitoring costs that due diligence otherwise requires, and to develop a strategic relationship with fund managers that they can leverage into insights on the market.
DePonte cautions that an investor “needs to carefully consider how it will evaluate the investment vehicle over time in order to judge whether its hopes for a sector were overrated and whether it needs to abandon plans to fund further vehicles in the sector or even sell off its exposure in a separate account.”
Listed Private Equity
In chapter five of the book, Michel Degosciu, a founding partner of LPX Groupo, discusses risk in listed private equity.
Listed PE is a hybrid beast, where values are driven in part by those of the stock market and in part by unlisted equity.
Degosciu is unkind to the “myth” that listed and unlisted equities are uncorrelated. After all, the valuations of listed entities “are usually relevant for valuing unquoted companies,” and when a previously unlisted company gets its initial public offering, it is because the stock market has been performing well, so the water’s fine and shy new swimmers come in.
At any rate, in the LPE world, major risks include the quality of deal flow, transparency, and leverage.
One would expect different volatility characteristics ikn PE vis-à-vis unlisted PE, given differences in the use of leverage. The manager of an unlisted fund typically puts the debt incurred on the balance sheet of the investment, whereas the managewr of an LPE will often put it on the LPE’s own balance sheet. The high correlation of LPE returns to stock market returns through the time period 2006 to 2009 “can mainly be explained by that leverage effect,” says Degosciu.
Another of the noteworthy contributions to this collection is a discussion of VaR (Value at Risk, or the loss under adverse market conditions over a given operiod of time and positing a certain confidence level) and its relation to diversification. This was written by Philippe Jost, a senior vice president of Capital Dynamics.