Private Equity Risk
Private Equity RiskHow It Can Be Measured and Used to MaximizeReturnsJune 2, 2020
Albert Maass, FRMManaging Director, Financial Instruments and TechnologyAlbert is a managing director in the London office and part of the Financial Instruments and Technology serviceline within the Alternative Asset Advisory business unit.Albert’s client focus includes institutional investors and asset managers with illiquid portfolios worldwide. Albertassists such clients by providing transparent valuations of illiquid assets including private debt, structuredproducts and derivatives; providing independent model validation; and advising on building a risk framework forilliquid assets, liquidity risk and integration of risk between liquid and illiquid assets.He has three decades of risk and investment practice working for financial institutions in the UK, Americas andAsia.Duff & Phelps, Ltd.London 44 (0)207 089 4828Albert.Maass@duffandphelps.comAlbert was the head of alternative investments and risk capital allocation at Shinsei Bank in Japan. He was alsoRisk Advisor to the chief operating officer and chief risk officer of Aflac in Japan, the U.S. and more recently,Managing Director at Edelscourt, where he served as a risk management expert to asset managers, riskmanagement specialists and research firms. Prior to that, Albert was with HVB in New York, Tokyo and HongKong. He previously worked for Central Bank of Chile (Santiago), European Bank for Reconstruction andDevelopment (London), Nomura (London), Mariner Investment Group (New York) and Allied Capital (New York).Albert is a Financial Risk Manager (FRM). He holds a commercial engineering and economics degree fromUniversidad Católica de Chile.2
David L. Larsen, CPA/ABV/CEIVManaging Director, Alternative Asset AdvisoryDavid Larsen is a managing director in the Seattle office of Duff & Phelps and part of the Alternative AssetAdvisory service line. He has more than 35 years of transaction and accounting experience. He specializes infair value accounting issues, and specifically in valuation, accounting, and regulatory issues faced by AlternativeAsset managers and investors.Duff & Phelps, LLCSeattle 1 415 693 5330David.Larsen@duffandphelps.comDavid advises leading Private Equity Managers and Institutional Investors and has advised numerous strategicand private equity acquirers in all areas of mergers, acquisitions, joint ventures, divestitures and valuationrelated maters. He provides valuation policy and process assistance to a number of the world’s largestinstitutional limited partner investors and some of the world’s largest alternative Investment managers. David is amember of the International Valuation Standards Council Standards Review Board, an advisor to and hasserved as Vice Chair of the International Private Equity and Venture Capital Valuations Board (IPEV), which in2018 released updated International Private Equity Valuation Guidelines and serves as a member of theAmerican Institute of Certified Public Accountants (AICPA) PE/VC Practice Guide Task Force. David has servedas a special advisor to the Institutional Limited Partners Association; board member, project manager andtechnical advisor to the Private Equity Industry Guidelines Group and was instrumental in developing anddrafting the Private Equity Industry Guidelines Group’s Valuation and Reporting Guidelines; member of theFinancial Accounting Standards Board’s Valuation Resource Group responsible for providing the Board withinput on potential clarifying guidance on issues relating to the application of the principles of FASB ASC Topic820 (formerly SFAS No. 157), Fair Value Measurements and a member of the AICPA Net Asset Value TaskForce.Prior to joining Duff & Phelps, David was a Partner in KPMG LLP’s Transaction Services practice, where he wasthe segment leader of KPMG’s U.S. Institutional Investor practice. He served 13 years in KPMG’s Seattle,Düsseldorf and Prague audit practices prior to moving full time to advisory work.David received his M.S. in accounting from Brigham Young University’s Marriott School, his B.S. in accountingfrom Brigham Young University. He is a certified public accountant licensed in California and Washington. Davidis also a member of the AICPA and the California and Washington Society of Certified Public Accountants and isa FINRA Series 7, 24 and 63 registered representative.3
Ryan McNelleyManaging Director, Alternative Asset AdvisoryRyan McNelley is a managing director in the London office of Duff & Phelps, and part of the Portfolio Valuation service line withinthe Alternative Asset Advisory business unit. Ryan’s clients primarily include alternative investment fund managers, includingprivate equity and private debt fund managers, hedge fund managers, infrastructure fund managers, real estate debt fundmanagers, etc., in both Europe and in the U.S. Ryan assists such clients in all matters related to valuation: Assisting alternative fund managers in establishing valuation policies and procedures that meet investor and regulatorstandards of top tier governance and independence Providing independent and objective third-party valuations of the underlying assets of such funds in order to validate whetherthe fund manager’s valuations are fair and reasonable Assisting with the valuation of the carried interest of the fund for tax or management incentive purposes Performing fairness opinions when assets are transacted between related parties Benchmarking the returns of the fund, with the aim of identifying and quantifying the manager’s unique contribution to valuecreationDuff & Phelps, LtdLondon 44 (0)20 7089 4822Ryan.McNelley@duffandphelps.comRyan is a regular speaker at conferences across Europe and is part of several industry working groups and trade organisations.Most notably, Ryan was a contributing author to the Alternative Investment Management Association’s (AIMA) Guide to SoundPractices for Hedge Fund Valuation, and is a member of Invest Europe’s Working Group on Accounting Standards, Valuation andReporting. In addition, Ryan has been regularly quoted in the financial press, including in publications such as the Wall StreetJournal, the Financial Times, Private Equity News, Private Debt Investor, and others. Ryan specializes in the valuation of illiquid(“hard-to-value”, or Level 3) investments, typically under the IFRS 13, ASC§820 or other local GAAP Fair Value standards usedby alternative investment managers. Ryan’s experience includes the valuation of the following asset types: Senior, subordinated and mezzanine debt; revolving lines of credit, delayed draw facilities, asset backed loans Common equity, preferred equity, convertible preferred equity and hybrid instruments Non-performing loans and loan portfolios Litigation claims Fund management companies and limited partner interestRyan’s past experience includes seven years in various finance and business management roles at Maxim Integrated Products, aSilicon Valley semiconductor company. Ryan received his B.S. in Business and Economics from Saint Mary’s College of Californiain 1997, and his M.B.A. with a specialization in Corporate Finance from Cornell University in 2006.4
Dexter B. Blake, IIIManaging Director, Secondary Market AdvisoryDexter B. Blake, III is a managing director and leads the Duff & Phelps’ Secondary Market Advisory Group.Dexter specializes in providing liquidity solutions for various alternative investments including limited partnershipinterests in private equity funds, hedge funds, and real estate funds and shares in private companies. Dexterhas more than 19 years of experience advising general partners, limited partners and shareholders onsecondary market alternatives. During that time, Dexter has advised on and executed transactions ranging fromcomplex portfolio divestitures and fund restructurings to secondary direct sales of shares in private companies.Prior to joining Duff & Phelps, Dexter was a managing director at NYPPEX Private Markets.Dexter received his BS in Business Management from the University of Vermont and holds the FINRA Series 7,24, 63 and 79 licenses.Duff & Phelps, LLCMorristown 1 973 775 0069Dexter.Blake@duffandphelps.com5
Duff & PhelpsDuff & Phelps is the global advisor that protects, restores and maximizes value for clientsin the areas of valuation, corporate finance, disputes and investigations, cyber security,claims administration and regulatory issues. We work with clients across diverse sectorson matters of good governance and transparency. 4,000TOTALPROFESSIONALSGLOBALLYMORE THAN19,00013,500CLIENTS INCLUDING NEARLYENGAGEMENTSPERFORMED IN 201947% OF THES&P 500THEAMERICASEUROPE ANDMIDDLE EASTASIAPACIFIC 2,0001100 700 PROFESSIONALSPROFESSIONALSPROFESSIONALS6
Enhancing Value Across a Range of ExpertiseVALUATIONADVISORYValuation and consulting for financialreporting, tax, investment and riskmanagement purposesCORPORATEFINANCEGOVERNANCE, RISK,INVESTIGATIONSAND DISPUTESBUSINESSSERVICESObjective guidance to management teamsand stakeholders throughout restructuring,financing and M&A transactions, includingindependent fairness and solvencyopinionsCombined Duff & Phelps and Kroll riskLeading global provider of complexmanagement and mitigation, disputesclaims administration and businessand other advisory servicesservices through its proprietarysoftware and industry leading Valuation Services Alternative Asset Advisory M&A Advisory Real Estate Advisory Fairness and Solvency Opinions Global Disputes Consulting RestructuringTax Services Transaction Advisory Services Global Restructuring AdvisoryGlobal Corporate Actions Transfer Pricing ESOP and ERISA Advisory Cyber RiskSettlement AdministrationFixed Asset Management and Private Equity - Financial SponsorsGroup Legal Management Consulting Security Risk Management Notice Media Solutions Distressed M&A and Special Situations Compliance Risk and Diligence Contract Review and Contract Private Capital Markets and DebtAdvisory Compliance and Regulatory Insurance Solutions Business Intelligence andmanagement team.InvestigationsManagementConsulting Financial Restructuring7
Duff & Phelps Alternative Asset AdvisoryDuff & Phelps assists clients with design and implementation of best-in-class valuation policies andprocesses, including on-going review of valuation procedures and conclusions to ensure best practices.Market Leader» Our client base consists of 400 alternative asset fundmanagers and investors in the U.S. and globally» We perform in-depth valuation analyses of all asset types forclients across the spectrum of banks, hedge funds and privateequity firms globally:- 70% of the top 25 largest Hedge Funds- 70% of the top 25 largest Private Equity Funds- 50% of the top 25 largest publicly traded Hedge Fundplatforms (business development companies or “BDCs”)- Our client base includes 20 BDCs- Private debt funds and mid-market private equityfunds are the fastest growing segment of our client base» We review or value over 10,000 investment positions on aquarterly basis, including derivatives and structured productsThought Leader» We are at the forefront of the industry’s leading committees onvaluation processes, guidelines, and regulations:–––––IPEV – Board MemberILPA – Special AdvisorAICPA PE/VC Valuation Guide Task Force – MemberFASB Valuation Resource Group – MemberManaged Funds Association – Sustaining Member» Leadership on drafting IPEV and PEIGG private equityvaluation guidelines» Development of Duff & Phelps Created Value AttributionFramework.» We have 12 full-time Managing Directors and draw fromD&P’s pool of over 1,000 valuation professionals with wideranging sector and asset class expertise across the spectrumDuff & Phelps’ Portfolio Valuation practice enables alternative investment managers to enhance theirvaluation process with the independence and objectivity that investors require.8
Why We Need a Risk Framework for Private Equity Private equity is acomplex asset from a riskstandpoint. There are multiple risksprivate equity fundinvestors face, such asfunding, liquidity, marketand capital risk. Complexity makes riskdifficult to measure,manage and mitigate.Capital risk is thepossibility of having arealized loss of the originalcapital at the end of afund's life.Market risk is the risk ofunrealized losses in thevalue of the portfoliocompanies held by a fund,due to market factors.Funding risk is the risk thatinvestors are not able toprovide their capitalcommitments; failure frominvestors to pay may resultin the loss of theirinvestment, including all ofthe paid-up capital.Liquidity risk is thepotential loss associatedwith selling a fund in thesecondary markets at adiscount on the fund’s netasset value, or below cost.9
Why We Need a Risk Framework for Private EquityConsider funding riskNext, consider liquidity risk If a market distortion such as 2008or COVID-19 occurs, the exit activityon the underlying companies andthe subsequent distributions maydry up, while the GPssimultaneously increase capital callsto facilitate attractive investments inthe down market. While there is a secondary marketfor LP stakes in private equity, thereis still the risk that an investor wantsto sell a fund interest, but the marketdoes not offer enough volume, orshows large discounts to NAV. This mismatch of distributions andcapital calls can have a significantimpact on funding risk for investorswith large PE allocations and limitedaccess to external financing. Mitigating this risk requires havingexternal funding sources, or adiversified vintage portfolio. This may happen while at the sametime, public markets are distressedsuch as in the financial crisis in2008 or in the first quarter of 2020because of COVID-19. Liquidity risk can be difficult tomanage for investors that do nothave a large enough cushion ofliquid assets that can be sold indifficult market times.10
Why We Need a Risk Framework for Private EquityNow, consider market riskAnd finally, capital risk The value of a private company isaffected by market factors, inaddition to idiosyncratic ones. While market risk is associatedwith unrealized losses, capital riskis the potential of having arealized loss on the capitalinvested with a fund over its entirelifetime. There are many public marketfactors affecting the value ofprivate equity investments, suchas broad equity market exposure,geographic and sector exposure,foreign exchange, commodityprices and interest rates. Changes in market factors havean effect in the value of a fund’sinvestments and will be reflectedin the quarterly unrealized gainsor losses of the fund. Such realized loss may come frommarket factors, such as marketprices of public stocks at the timeof sale of a portfolio company,impacting realization value. Or the loss may come as wellfrom factors specific to the fund,such as the quality of the GPmanaging it.11
Why We Need a Risk Framework for Private EquityTo sum up The scale and complexity of risks private equity fund investors facerequire them to complement their asset allocation skills with arobust and holistic risk management framework. LPs have become increasingly sophisticated since the end of thelast financial crisis. However, until now, there has been no widely adopted solution tomeasure the different dimensions of private equity risk and integrateit with the risk of other assets such as public stocks and bonds. The risk framework we have implemented at Duff & Phelps enablesfund investors to appraise the risks of their private equity assets in arobust and holistic way. This will empower them also to enhancetheir long-term investment, reallocation and recycling decisions.12
A Holistic Risk Solution We offer a private equity risk model * that This is complemented with a factormeasures liquidity, market and cashflowmodel that makes it possible to integraterisk for PE funds and portfolios:the risk of private equity with the risk ofother asset classes:– Liquidity and market risk have beendefined in the previous section.– Cashflow risk is the potential of lossdue to the uncertain timing andmagnitude of the funding paymentsrequired from investors, anddistributions paid to them.– Cashflow risk includes funding anddistributions risk, including capital riskas FixedIncome No such comprehensive risk solution isfully implemented elsewhere.* Based on “Risk Management for Private Equity Funds”, Buchner,Axel. Journal of Risk, Vol. 19, No. 6, 2017.13
Key FeaturesOur private equity riskmodelOur factor model The model incorporates theunique features of private equityfunds: The model assesses the relationshipbetween historical fund performanceand market factors influencing it: Capital drawdowns are initiallyhigh and decrease over thecommitment period. Capital distributions increase asthe fund ages and investmentsare sold. The secondary marketdiscount/premium and the speedof capital distributions maydepend on the state of theeconomy. As fund returns are estimates ofassets that don’t trade in themarkets, the method depends on therigor of fair value calculation. To adjust for stale prices and makeprivate returns better resemblepublic ones, fund volatility isadjusted using de-smoothingtechniques. Principal component analysis isused to address excessivecorrelation between market factorswhich could lead to unstable results.14
Risk Measures UsedMarket VaR, Liquidity-adjusted VaR and Cashflow-at-risk Value-at-Risk or VaR is a measure of the potential loss in the value of an asset.For instance, 1-year, 99% VaR is the loss that is likely to be exceeded only 1%of the time over the next year. Our model uses three VaR measures to measure the risk of private equity fundinvestments: market VaR, liquidity-adjusted VaR and cashflow-at-risk. Market VaR is a measure of potential unrealized losses in the value of a fund,due to changes in public markets. Liquidity-adjusted VaR (LVaR) includes the cost of liquidity in the VaRcalculation, in order to account for the fact that stakes in private equity funds areilliquid and may typically be sold at a discount to NAV on the secondary markets. Cashflow-at-risk (CFaR) is defined as the potential loss in the investor’s cashposition, that decreases with capital drawdowns and increases with distributions.15
Benefits Of Our SolutionDetailed Risk Measures Tailored to The Investor’s Needs We provide investors with useful measures to describe liquidity, market and cash flowrisk. The time horizon and the statistical confidence level used to calculate the risk areflexible, so that they coincide with the investor's horizon and objectives.Ability To Perform Stress Test and Sensitivity Analysis How would the portfolio perform in the event of a financial crisis? How sensitive is the portfolio to a 20% drop in public stocks? etc.Holistic Risk Integration With Other Assets How much a fund contributes to portfolio risk? How much does private equity contribute to the risk of a multi-asset portfolio?Key Input To Asset Allocation What is the risk that private equity funds add to a portfolio in exchange for theircontribution to performance?16
Who Benefits Limited partner investorsin private equity funds. For LP investors,accepting the illiquidityand other risksassociated with privateequity funds in exchangefor the promise of higherreturns requires knowinghow much the funds willadd to portfolio risk inexchange for theirincremental ntsAssetManagers Our framework allowsthem to assess this risk.17
Case StudiesPortfolio RiskDissecting a Fund’sMarket RiskPortfolioReallocation18
Portfolio Risk Example portfolio consists of five funds for simplicity of illustration. VaR was computed as of March 31, 2008 with a horizon of 1 year and 99%confidence. Model outputs are as follows:– Market VaR: potential losses of up to 40% to 80% of fund’s NAV due to marketshocks.– Liquidity-adjusted VaR: potential loses of up to 46% to 98% of fund’s NAV if fundswere to be forcedly liquidated in the secondary market.– Cashflow-at-risk: potential loses of up to 1% to 32% of fund’s NAV.19
Portfolio Risk – Model Outputs20
Dissecting a Fund’s Market Risk Our factor model generates a portfolio of liquid indicesthat replicate the market risk of a private equity fund(or portfolio). Allocations translate the market risk of a private equityasset in terms of liquid indices. This provides a detailed overview of the factors drivingmarket risk.Note: positive allocation to cash is usedto de-lever the portfolio (and negativeallocation to lever it) in order to align thevolatility of the replicating portfolio tothe target fund’s volatility. This is also a useful step to integrate the risk of theprivate equity asset with the risk of a larger portfoliomade up of other asset classes.21
Portfolio Reallocation Portfolio “A” commits the same dollaramount to ten different funds.FundNameVintage TypeGeographicalFocusIndustryFocusPortfolio PortfolioAB Portfolio “B” reallocates exposures inportfolio “A” by increasing commitment tofunds that show relatively high expectedreturn per unit of risk, while decreasingcommitment to funds showingcomparatively low expected return per unitof lDiversified1,0001,052 Risk was measured as 1-year, 99%market WesternEuropeDiversified1,0001,17410,00010,000 Historic fund returns were used as proxyfor expected return in this simple example. Both historic returns and VaR werecomputed as of the reallocation date ofMarch 31, 2008.Portfolio22
Portfolio Reallocation - Results Portfolio “B”outperformed portfolio“A” for most of the 10year period following the2008 financial crisis.Cumulated Return Since Mar-08100%80%60%40%20%Portfolio -11Sep-10Mar-10-20%Sep-090%Mar-09 This happened eventhough no furtherreallocation was doneafter March 2008.Portfolio B23
Duff & Phelps Secondary Market AdvisoryPotential Limited Partner Issues and Secondary Market SolutionsThe COVID-19 pandemic is having a devastating impact on financial markets globally. As aresult, limited partners may need to address issues in their alternative investment portfoliosthrough the secondary market.Limited Partner ChallengesSecondary Market Solutions1. Need to make capital calls1. Conduct a single asset or portfolio saleto raise capital to meet current capitalcalls2. Obtain relief from future capital callsand unfunded liabilities2. Divest highly unfunded partnershipinterests to reduce future capital callliabilities3. Requirement to fund obligations3. Sell more mature assets to raise capitalto meet funding obligations4. Rebalance the portfolio4. Divest assets in one strategy andreallocate to another strategy5. Manage the “denominator effect” inthe portfolio5. Divest alternative assets to align withportfolio asset allocations24
Questions?
Our Team Duff & Phelps’ Financial Instruments andTechnology (FIT) Team is a leadingvaluation and risk management solutionsprovider to financial institutions andcorporates. We are 45 employees globally,comprising of ex-wall street front officequants, structurers, risk and portfoliomanagers, with financial engineering,quantitative modeling, risk, regulatoryand capital management expertise. For more details about this solutionplease contact:albert.maass@duffandphelps.comPrivate EquityRisk ive Risk mValuationsRegulatoryFinancialSolutionsEnterprise &Capital RiskManagementServicesTreasury,Finance & FXAdvisoryservicesWhole LoanValuation &AdvisoryValuation ofStructured FixedIncome ProductsCLO Structuring& Advisory26
For more information about our globallocations and services, please visit:www.duffandphelps.comAbout Duff & PhelpsDuff & Phelps is the global advisor that protects, restores and maximizes value for clients in the areas of valuation, corporate finance, disputes and investigations, cyber security, claimsadministration and regulatory issues. We work with clients across diverse sectors on matters of good governance and transparency. With Kroll, the leading global provider of risk solutions, andPrime Clerk, the leader in complex business services and claims administration, our firm has nearly 4,000 professionals in 25 countries around the world. For more information, visitwww.duffandphelps.com.M&A advisory, capital raising and secondary market advisory services in the United States are provided by Duff & Phelps Securities, LLC. Member FINRA/SIPC. Pagemill Partners is aDivision of Duff & Phelps Securities, LLC. M&A advisory, capital raising and secondary market advisory services in the United Kingdom are provided by Duff & Phelps Securities Ltd. (DPSL),which is authorized and regulated by the Financial Conduct Authority. M&A advisory and capital raising services in Germany are provided by Duff & Phelps GmbH, which is a Tied Agent ofDPSL. Valuation Advisory Services in India are provided by Duff & Phelps India Private Limited under a category 1 merchant ba nker license issued by the Securities and Exchange Board ofIndia.
private equity and private debt fund managers, hedge fund managers, infrastructure fund managers, real estate debt fund managers, etc., in both Europe and in the U.S. Ryan assists such clients in all matters related to valuation: Assisting alternative fund managers in establishing valuation policies and procedures that meet investor and .
All contiguous periods from 1996 to 2015 show a private equity PME 1 except for 2006 to 2015 Kaplan: " Phalippou's definition of private equity is too broad" Phalippou's private equity universe includes real assets, real estate, infrastructure and energy. When private equity is defined just as buyout, growth equity and venture capital
2. Private equity in South Africa Private equity is an asset class which differs in nature from most other assets, including listed equity. Typically, private equity fund investments show low correlation to quoted equity markets and are relatively illiquid, particularly in the early years. Private equity will normally show a drop in net asset value
The Private Equity Conundrum: Reconciling Private and Public Equity Risk/Return Profiles Private equity (PE) seems to contradict the investment maxim that greater reward only comes with increased risk. On an observed basis, private equity has higher returns and lower volatility than public equities, as shown in the chart below: Benchmark Annualized Return Annualized Volatility State Street .
9.2.1. Real estate private equity definition 33 9.2.2. Electricity generation private equity definition 33 9.2.3. Relevant criteria 33 9.2.4. SDA for real estate private equity investments 34 9.2.5. SDA for electricity generation private equity investments 34 9.3. Asset classes: private equity direct investments including buyout, growth capital and
Employment Levels at Private Equity and Private Debt Firms There are currently over 7,400 firms actively managing private equity and private debt funds worldwide (i.e. currently raising funds or that have raised a fund in the past 10 years). In the case of private equity, when private equity firms that do not raise or
U.S. Private Equity Index and Selected Benchmark Statistics The Cambridge Associates LLC U.S. Private Equity Index is an end-to-end calculation based on data compiled from 1,199 U.S. private equity funds (buyout, growth equity, private equity energy and mezzanine funds), including fully liquidated partnerships, formed between 1986 and 2014.
Sentinel Capital, etc.)and overall U.S. private equity dry powder of approximately 500 Billion 1 Tracking 250 -300 private equity firms that have invested in franchisors or multi -unit franchisees Segmentation happening with private equity firms interested in franchising 1. PItchBook 2013 Annual Private Equity Breakdown
future, supporting growth-based private equity. 3) Significant growth-oriented private equity opportunities are available beyond the small number of countries in which most Emerging Market Private Equity investment is currently concentrated. 4) Many of the Risks of Emerging Market Private Equity are over-stated and we provide data which
