Risk management in a global asset class
Private equity – encompassing venture capital, leveraged buyouts, defaulted debt and mezzanine securities – has generated extraordinary returns and become a darling asset class for institutional and individual investors globally. High absolute and relative returns, especially in recent years, not only attracted new investors to the asset class but also caused established investors to ratchet up their commitments. Indeed, total commitments to private equity grew by approximately 16 times between 1991 and 1999.
Despite recent record fund-raising, uncertainties loom over the future returns of, and allocations to, private equity. Firstly, the bubble deflation of ‘new economy’ and specific technology stocks has dampened investor enthusiasm for venture capital. Secondly, leveraged buyout strategies also face risks as the global economy slows and credit spreads widen on bank financing and high yield instruments. Thirdly, the assertion that private equity has ‘low correlation’ with other asset classes becomes more uncertain in a down market, when cross-correlation factors tend to rise across the board.
Given current market conditions, it is more important than ever for investors to approach private equity with great caution. By definition, risks in private equity tend to be non-systematic, and most or all of one’s risk management must be done up-front through superior due diligence and proper portfolio construction. The most common risks and ways to mitigate them, are discussed below.
Manager selection risk: create a best-of-breed, multi-manager programme
The merits of private equity are premised on the notion that general partners (managers) with a focused and proven approach are most likely to deliver positive alpha returns. Thus, access to ‘best-of-breed’ managers in particular niches, and a dedicated team of investment professionals, are critical. We believe that access to the best managers and proper diversification require a commitment of at least $100m to a minimum of eight discrete private equity funds. Anything less will subject the capital to inadequate diversification and adverse manager selection. Most investors wanting to commit less than $100m can achieve adequate diversification and access through an institutionally-oriented fund-of-funds or through a listed fund-of-funds.
If one is prepared to commit sufficient capital to build a diversified fund-of-funds programme internally, one should seek diversification by strategy, manager, geography and vintage year, and remember the following:
q Up-front general partner due diligence Inconsistencies abound in the reporting of general Partner performance history; thus, investors must undertake thorough track record and manager due diligence. Limited facts and potentially misleading representations are common. Furthermore, one must verify the abilities of individual general partners to determine if the track record was a function of one or several members of the team who may or may not remain active. Strong knowledge of the manager’s peer group is also helpful. In this regard, a dedicated fund-picking team can really earn its value by having in-depth knowledge of the leading players in certain markets segments.
q Legal due diligence Private equity fund terms require active review of partnership and deal documentation, and a ‘buyer beware’ approach should apply. Numerous term-specific items are typically heavily negotiated and can, in fact, significantly shift the risks of an investment between the investor and general partner. An active and experienced team of legal and accounting professionals can add tremendous value toward negotiating better terms for investors.
q ‘First time’ fund risk The easiest type of private equity fund to avoid is the ‘first time’ fund. At the extreme, this could mean a ‘first time’ team and strategy. These funds often involve new principals who have not worked together before and have no demonstrable track record in executing a new strategy. The uncertainties are so numerous as to preclude an investor from logically exercising his fiduciary duty. On the other hand, we believe that ‘first time’ funds should not be categorically dismissed. They require more up-front due diligence and should receive lower capital allocations because of their higher operating and execution risks. In reality, many of the best all-time performing private equity funds were ‘first time’ funds that had highly motivated and hungry teams pursuing sound strategies in under-served market segments.
q ‘Last time’ fund/mega-fund median return risk This refers to the risk of investing in a fund that has no successor because it fails to deliver superior returns. A fund may get too large for its segment of the market, and sheer size could change the motivation of the general partners, who become more concerned with capital preservation and management fee accumulation than capital appreciation. A very large capital base can also cause ‘style drift’ or a foray into unfamiliar investment areas. A large fund might also pursue larger transactions in competition with other mega-funds, resulting in deal concentration risk. Additionally, a fund with high growth in its capital base may stumble in its transition from small to large. Senior personnel may fail to provide for redistribution of carried interest incentives to the next level of junior partners, leading to staff turnover and paralysis in fund decision-making and execution.
Large private equity funds do have advantages, however. Their capital base and brand name make them significant players in their niches, and they can often afford to pay for the best talent. Small funds are not necessarily better than large ones, but mega-funds have unique risks. As a result, it would be prudent to have a variety of funds in one’s portfolio.
Fund strategy risk: conduct thorough homework
q Up-front strategy due diligence Many investors mistakenly commit to a strategy that worked in the past but may not work going forward due to capital market or macroeconomic changes. This is particularly the case with industry-specific funds, whose management teams may have superior microscopic analytical capabilities but fail to recognize potentially fatal environmental changes. The general partner of a sector-focused fund can be severely prejudiced to see opportunity in his or her narrow field of expertise. To admit the absence of opportunity would imply a need to retool his or her skill set. Investors must study the capital markets and economic conditions comprehensively to determine whether or not a specialised strategy is likely to continue delivering attractive returns.
q Portfolio construction Successful private equity investing usually involves adequate diversification by geography, manager, strategy and vintage year. Commitments should be made consistently over time to avoid high vintage year concentration. Commitments should also be made in recognition of the sizes of the markets available. For example, developed markets encompass most of the global private capital market, while emerging markets are narrower but could provide unique and profitable opportunities. In pursuing an emerging markets strategy, one must recognize the implicitly higher risks and the need for specialised local knowledge. We suggest a policy that delineates manager concentration limits (5–10% per manager) and vigilance to ensure that underlying deal exposure is not unintentionally duplicated.
q Monitoring and systematic oversight Effective portfolio monitoring requires a potentially significant investment in a customised portfolio management system to evaluate absolute and relative performance and to capture high volumes of incoming and outgoing cash flows. Even though it is difficult to assess interim performance in the first couple of years of a programme, the more quantitative depth one has on a portfolio, the stronger the foundation for subsequent predictive and comprehensive analysis. Third-party vendors can provide excellent ‘back office’ support for private equity investors, adding sufficient value to justify the required expense.
Private equity has emerged as a legitimate, permanent, and globally recognised industry with years of growth ahead. As in other asset classes, returns in private equity follow normal cycles of excess and retrenchment. Investors must recognise this pattern, be prepared to commit for the long-term, and follow sound risk management principles in order to gain the benefits of the asset class.
David B Pinkerton is managing director and Astrid S Tuminez is director of research, alternative investments, at AIG Global Investment Corp in New York
This article contains the current opinions of the authors of the article and does not represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes and should not be considered investment advice.