Revisiting Risk Management in Private Equity
Private equity has always been characterized as a long-term, patient form of capital, and most investors – those resolute enough to stick with the asset class during periods of unrest – have, by and large, been well rewarded for their perseverance. In many respects, risk management is a fundamental component to running a successful private equity investment program. However, the consistency of private equity and relative lack of short-term volatility has limited the institutionalization of risk management among private equity investors – effectively making it more of an afterthought for many in the space. Now that private equity is increasingly front and center in the mindset of institutional investors and regulators, risk management will become a priority.
To be sure, there have been periods when investors have had to reconsider their approach. Consider, for instance, the fates of some of the most well known general partners (GPs) from the 1990s, such as Forstmann Little, which got burned by going big in telecom just prior to the tech bust. Yet even during the worst years for the economy, private equity has managed to outperform. One need look no further than the 2006- and 2007-vintage buyout funds – which invested directly into the run-up of the credit bubble – that are today showing median IRRs of 7.5% and 9.4%, respectively. This is certainly below historical IRRs, but given the anxiety amid the crisis and in the years that followed, the performance supports the idea that PE remains one of the most robust alternatives for risk-adjusted returns.
Still, overconfidence begets complacency, which is a catalyst for the kinds of surprises that will sink any portfolio. Even as risk management among private equity investors remains in its infancy, the practice will soon evolve beyond merely complying with heightened regulatory requirements. In fact, we believe a comprehensive enterprise risk management platform will quickly become a defining characteristic and competitive advantage for those that can leverage extensive private equity investment experience, deeper transparency, data analytics and increased standardization to create a framework that engenders far more investment control and insight.
For obvious reasons, attention to risk is far more pronounced among public market investors. Modern Portfolio Theory, for instance, has become so imbued in the mindset of all investors that even those who get their financial advice from Jim Cramer know the benefits of diversification. But the evolution of liability-driven investing and other absolute-return strategies is reflective of the emphasis that institutional investors place on managing risk among their public holdings.
In private equity, however, risk management until now has largely focused on identifying top-quartile GPs and diversifying across vintage years, investment stages, deal sizes, and, increasingly, across regions and manager specializations. There have always been caps in place, too, as part of fund mandates that seek to limit how much one fund can invest in one company or how much an investor can commit to one fund or GP.
It was also around this time that U.S. regulators sought to rein in the amount of leverage banks could provide to fund LBOs, with guidance for a 6x debt-to-Ebitda ceiling. In Europe, The Alternative Investment Fund Managers Directive (AIFMD) introduced a number of other compliance hurdles, such as disclosure requirements detailing valuations, exposures and investment types.
Despite all of this, however, it could be argued that these efforts have done little to ensure that risk management is actually focused on the greatest threats to an investor’s portfolio and its enterprise. For instance, the emphasis on post-investment activities may aid attribution but does little to prevent losses. And while it’s a step in the right direction -- from an organizational perspective -- to add resources that can dimensionalize risk, if these roles merely report into the investment team, the structural challenges will severely limit their influence on the larger organization. Moreover, if the risk analysis itself is confined to simply quantitative assessments, the role of risk management will become marginalized to the point of serving as simply another research function.
At Adveq, though, we see risk management as an opportunity to deliver incremental value for our clients and our firm. As such, we’ve taken an enterprise-wide approach to risk management and structured our operations to ensure that this function is independent of the investment team and management and reports directly to the board of directors. We’ve also sought to promote a risk-oriented culture across the firm, with independent and systematic oversight of all of the firm’s key activities. We count on our risk management function to identify, quantify and manage all of the key risks that influence our overall business performance – from operational to reputational risks, with direct involvement in the investment decision-making process as well as post-investment monitoring and strategy. It’s both a qualitative and quantitative approach that seeks to protect our investments at the portfolio and direct-investment levels and ensure the firm is mindful of its key enterprise risks.
We’ve found that beyond organizational considerations, successful risk management requires independence and empowerment. As Chief Risk Officer, for example, I attend all investment committee meetings and have a veto right on all investment projects.
Of course, adopting a culture of risk-awareness doesn’t happen overnight. At many partnerships it will entail re-imagining investment processes and longstanding philosophies. It will also require potentially years of execution before a risk-oriented approach becomes part of the muscle-memory that guides day-to-day activities. But there should be no confusion that this is where the world is going, particularly in a low-return environment that forces institutions to push the limits in terms of how much risk they can take on in their pursuit of alpha.