private equity risk
TRANSCRIPT
Private Equity Risk
How It Can Be Measured and Used to Maximize Returns
June 2, 2020
Albert Maass, FRM
Albert is a managing director in the London office and part of the Financial Instruments and Technology service
line within the Alternative Asset Advisory business unit.
Albert’s client focus includes institutional investors and asset managers with illiquid portfolios worldwide. Albert
assists such clients by providing transparent valuations of illiquid assets including private debt, structured
products and derivatives; providing independent model validation; and advising on building a risk framework for
illiquid 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 and
Asia.
Albert was the head of alternative investments and risk capital allocation at Shinsei Bank in Japan. He was also
Risk 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, risk
management specialists and research firms. Prior to that, Albert was with HVB in New York, Tokyo and Hong
Kong. He previously worked for Central Bank of Chile (Santiago), European Bank for Reconstruction and
Development (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 from
Universidad Católica de Chile.
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Duff & Phelps, Ltd.
Managing Director, Financial Instruments and Technology
London
+44 (0)207 089 4828
David L. Larsen, CPA/ABV/CEIV
David Larsen is a managing director in the Seattle office of Duff & Phelps and part of the Alternative Asset
Advisory service line. He has more than 35 years of transaction and accounting experience. He specializes in
fair value accounting issues, and specifically in valuation, accounting, and regulatory issues faced by Alternative
Asset managers and investors.
David advises leading Private Equity Managers and Institutional Investors and has advised numerous strategic
and private equity acquirers in all areas of mergers, acquisitions, joint ventures, divestitures and valuation
related maters. He provides valuation policy and process assistance to a number of the world’s largest
institutional limited partner investors and some of the world’s largest alternative Investment managers. David is a
member of the International Valuation Standards Council Standards Review Board, an advisor to and has
served as Vice Chair of the International Private Equity and Venture Capital Valuations Board (IPEV), which in
2018 released updated International Private Equity Valuation Guidelines and serves as a member of the
American Institute of Certified Public Accountants (AICPA) PE/VC Practice Guide Task Force. David has served
as a special advisor to the Institutional Limited Partners Association; board member, project manager and
technical advisor to the Private Equity Industry Guidelines Group and was instrumental in developing and
drafting the Private Equity Industry Guidelines Group’s Valuation and Reporting Guidelines; member of the
Financial Accounting Standards Board’s Valuation Resource Group responsible for providing the Board with
input on potential clarifying guidance on issues relating to the application of the principles of FASB ASC Topic
820 (formerly SFAS No. 157), Fair Value Measurements and a member of the AICPA Net Asset Value Task
Force.
Prior to joining Duff & Phelps, David was a Partner in KPMG LLP’s Transaction Services practice, where he was
the 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 accounting
from Brigham Young University. He is a certified public accountant licensed in California and Washington. David
is also a member of the AICPA and the California and Washington Society of Certified Public Accountants and is
a FINRA Series 7, 24 and 63 registered representative.
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Duff & Phelps, LLC
Managing Director, Alternative Asset Advisory
Seattle
+1 415 693 5330
Ryan McNelley
Ryan McNelley is a managing director in the London office of Duff & Phelps, and part of the Portfolio Valuation service line within
the Alternative Asset Advisory business unit. Ryan’s clients primarily include alternative investment fund managers, including
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 regulator
standards of top tier governance and independence
• Providing independent and objective third-party valuations of the underlying assets of such funds in order to validate whether
the 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 value
creation
Ryan 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 Sound
Practices for Hedge Fund Valuation, and is a member of Invest Europe’s Working Group on Accounting Standards, Valuation and
Reporting. In addition, Ryan has been regularly quoted in the financial press, including in publications such as the Wall Street
Journal, 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 used
by 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 interest
Ryan’s past experience includes seven years in various finance and business management roles at Maxim Integrated Products, a
Silicon Valley semiconductor company. Ryan received his B.S. in Business and Economics from Saint Mary’s College of California
in 1997, and his M.B.A. with a specialization in Corporate Finance from Cornell University in 2006.
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Duff & Phelps, Ltd
Managing Director, Alternative Asset Advisory
London
+44 (0)20 7089 4822
Dexter B. Blake, III
Dexter 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 partnership
interests in private equity funds, hedge funds, and real estate funds and shares in private companies. Dexter
has more than 19 years of experience advising general partners, limited partners and shareholders on
secondary market alternatives. During that time, Dexter has advised on and executed transactions ranging from
complex 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.
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Managing Director, Secondary Market Advisory
Duff & Phelps, LLC
Morristown
+1 973 775 0069
Duff & Phelps
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Duff & 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,
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Management
» Our client base consists of 400 alternative asset fund
managers and investors in the U.S. and globally
» We perform in-depth valuation analyses of all asset types for
clients across the spectrum of banks, hedge funds and private
equity 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 Fund
platforms (business development companies or “BDCs”)
- Our client base includes 20 BDCs
- Private debt funds and mid-market private equity
funds are the fastest growing segment of our client base
» We review or value over 10,000 investment positions on a
quarterly basis, including derivatives and structured products
» We have 12 full-time Managing Directors and draw from
D&P’s pool of over 1,000 valuation professionals with wide
ranging sector and asset class expertise across the spectrum
» We are at the forefront of the industry’s leading committees on
valuation processes, guidelines, and regulations:
– IPEV – Board Member
– ILPA – Special Advisor
– AICPA PE/VC Valuation Guide Task Force – Member
– FASB Valuation Resource Group – Member
– Managed Funds Association – Sustaining Member
» Leadership on drafting IPEV and PEIGG private equity
valuation guidelines
» Development of Duff & Phelps Created Value Attribution
Framework.
Duff & Phelps assists clients with design and implementation of best-in-class valuation policies and
processes, including on-going review of valuation procedures and conclusions to ensure best practices.
Market Leader Thought Leader
Duff & Phelps’ Portfolio Valuation practice enables alternative investment managers to enhance their
valuation process with the independence and objectivity that investors require.
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Duff & Phelps Alternative Asset Advisory
Why We Need a Risk Framework for Private Equity
• Private equity is a
complex asset from a risk
standpoint.
• There are multiple risks
private equity fund
investors face, such as
funding, liquidity, market
and capital risk.
• Complexity makes risk
difficult to measure,
manage and mitigate.
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Funding risk is the risk that investors are not able to
provide their capital commitments; failure from investors to pay may result
in the loss of their investment, including all of
the paid-up capital.
Liquidity risk is the potential loss associated with selling a fund in the secondary markets at a
discount on the fund’s net asset value, or below cost.
Market risk is the risk of unrealized losses in the
value of the portfolio companies held by a fund,
due to market factors.
Capital risk is the possibility of having a
realized loss of the original capital at the end of a
fund's life.
Why We Need a Risk Framework for Private Equity
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• If a market distortion such as 2008 or COVID-19 occurs, the exit activity on the underlying companies and the subsequent distributions may dry up, while the GPs simultaneously increase capital calls to facilitate attractive investments in the down market.
• This mismatch of distributions and capital calls can have a significant impact on funding risk for investors with large PE allocations and limited access to external financing.
• Mitigating this risk requires having external funding sources, or a diversified vintage portfolio.
Consider funding risk
• While there is a secondary market for LP stakes in private equity, there is still the risk that an investor wants to sell a fund interest, but the market does not offer enough volume, or shows large discounts to NAV.
• This may happen while at the same time, public markets are distressed such as in the financial crisis in 2008 or in the first quarter of 2020 because of COVID-19.
• Liquidity risk can be difficult to manage for investors that do not have a large enough cushion of liquid assets that can be sold in difficult market times.
Next, consider liquidity risk
Why We Need a Risk Framework for Private Equity
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• The value of a private company is affected by market factors, in addition to idiosyncratic ones.
• There are many public market factors affecting the value of private equity investments, such as broad equity market exposure, geographic and sector exposure, foreign exchange, commodity prices and interest rates.
• Changes in market factors have an effect in the value of a fund’s investments and will be reflected in the quarterly unrealized gains or losses of the fund.
Now, consider market risk
• While market risk is associated with unrealized losses, capital risk is the potential of having a realized loss on the capital invested with a fund over its entire lifetime.
• Such realized loss may come from market factors, such as market prices of public stocks at the time of sale of a portfolio company, impacting realization value.
• Or the loss may come as well from factors specific to the fund, such as the quality of the GP managing it.
And finally, capital risk
Why We Need a Risk Framework for Private Equity
12
• The scale and complexity of risks private equity fund investors face require them to complement their asset allocation skills with a robust and holistic risk management framework.
• LPs have become increasingly sophisticated since the end of the last financial crisis.
• However, until now, there has been no widely adopted solution to measure the different dimensions of private equity risk and integrate it with the risk of other assets such as public stocks and bonds.
• The risk framework we have implemented at Duff & Phelps enables fund investors to appraise the risks of their private equity assets in a robust and holistic way. This will empower them also to enhance their long-term investment, reallocation and recycling decisions.
To sum up
* Based on “Risk Management for Private Equity Funds”, Buchner,
Axel. Journal of Risk, Vol. 19, No. 6, 2017.
A Holistic Risk Solution
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• We offer a private equity risk model * that
measures liquidity, market and cashflow
risk for PE funds and portfolios:
– Liquidity and market risk have been
defined in the previous section.
– Cashflow risk is the potential of loss
due to the uncertain timing and
magnitude of the funding payments
required from investors, and
distributions paid to them.
– Cashflow risk includes funding and
distributions risk, including capital risk
as well.
• This is complemented with a factor
model that makes it possible to integrate
the risk of private equity with the risk of
other asset classes:
• No such comprehensive risk solution is
fully implemented elsewhere.
Public stocks
Real Estate
Private equity
Fixed Income
Hedge Funds
Key Features
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• The model incorporates the unique features of private equity funds:
• Capital drawdowns are initially high and decrease over the commitment period.
• Capital distributions increase as the fund ages and investments are sold.
• The secondary market discount/premium and the speed of capital distributions may depend on the state of the economy.
Our private equity risk model
• The model assesses the relationship between historical fund performance and market factors influencing it:
• As fund returns are estimates of assets that don’t trade in the markets, the method depends on the rigor of fair value calculation.
• To adjust for stale prices and make private returns better resemble public ones, fund volatility is adjusted using de-smoothing techniques.
• Principal component analysis is used to address excessive correlation between market factors which could lead to unstable results.
Our factor model
Risk Measures Used
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• 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 fund investments: 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 are illiquid 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 cash position, that decreases with capital drawdowns and increases with distributions.
Market VaR, Liquidity-adjusted VaR and Cashflow-at-risk
Benefits Of Our Solution
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• We provide investors with useful measures to describe liquidity, market and cash flow risk.
• The time horizon and the statistical confidence level used to calculate the risk are flexible, so that they coincide with the investor's horizon and objectives.
Detailed Risk Measures Tailored to The Investor’s Needs
• 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.
Ability To Perform Stress Test and Sensitivity Analysis
• How much a fund contributes to portfolio risk?
• How much does private equity contribute to the risk of a multi-asset portfolio?
Holistic Risk Integration With Other Assets
• What is the risk that private equity funds add to a portfolio in exchange for their contribution to performance?
Key Input To Asset Allocation
Who Benefits
• Limited partner investors
in private equity funds.
• For LP investors,
accepting the illiquidity
and other risks
associated with private
equity funds in exchange
for the promise of higher
returns requires knowing
how much the funds will
add to portfolio risk in
exchange for their
incremental return.
• Our framework allows
them to assess this risk.
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Endowments FoundationsInsurance
Companies
BanksSovereign
Wealth Funds
Family Offices
Pensions ConsultantsAsset
Managers
Case Studies
18
Portfolio Risk Dissecting a Fund’s Market Risk
Portfolio Reallocation
Portfolio Risk
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• 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 market
shocks.
– Liquidity-adjusted VaR: potential loses of up to 46% to 98% of fund’s NAV if funds
were to be forcedly liquidated in the secondary market.
– Cashflow-at-risk: potential loses of up to 1% to 32% of fund’s NAV.
Portfolio Risk – Model Outputs
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Dissecting a Fund’s Market Risk
• Our factor model generates a portfolio of liquid indices
that replicate the market risk of a private equity fund
(or portfolio).
• Allocations translate the market risk of a private equity
asset in terms of liquid indices.
• This provides a detailed overview of the factors driving
market risk.
• This is also a useful step to integrate the risk of the
private equity asset with the risk of a larger portfolio
made up of other asset classes.
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Note: positive allocation to cash is used
to de-lever the portfolio (and negative
allocation to lever it) in order to align the
volatility of the replicating portfolio to
the target fund’s volatility.
Portfolio Reallocation
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• Portfolio “A” commits the same dollar amount to ten different funds.
• Portfolio “B” reallocates exposures in portfolio “A” by increasing commitment to funds that show relatively high expected return per unit of risk, while decreasing commitment to funds showing comparatively low expected return per unit of risk.
• Risk was measured as 1-year, 99% market VaR.
• Historic fund returns were used as proxy for expected return in this simple example.
• Both historic returns and VaR were computed as of the reallocation date of March 31, 2008.
Fund
Name Vintage Type
Geographical
Focus
Industry
Focus
Portfolio
A
Portfolio
B
1 2005
Buy
Out US
Communication
Services 1,000 1,428
2 2007
Buy
Out US
Information
Technology 1,000 1,059
3 2006
Buy
Out Developed Diversified 1,000 1,970
4 2006
Buy
Out Global Diversified 1,000 1,052
5 2006
Buy
Out Japan Diversified 1,000 1,232
6 2007
Buy
Out Turkey Diversified 1,000 882
7 2007
Buy
Out US Industrials 1,000 -
8 2007
Buy
Out Global
Information
Technology 1,000 571
9 2007
Buy
Out Global Financials 1,000 632
10 2007
Buy
Out
Western
Europe Diversified 1,000 1,174
Portfolio 10,000 10,000
Portfolio Reallocation - Results
• Portfolio “B”
outperformed portfolio
“A” for most of the 10
year period following the
2008 financial crisis.
• This happened even
though no further
reallocation was done
after March 2008.
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-20%
0%
20%
40%
60%
80%
100%
Ma
r-09
Sep
-09
Ma
r-10
Sep
-10
Ma
r-11
Sep
-11
Ma
r-12
Sep
-12
Ma
r-13
Sep
-13
Ma
r-14
Sep
-14
Ma
r-15
Sep
-15
Ma
r-16
Sep
-16
Ma
r-17
Sep
-17
Ma
r-18
Sep
-18
Ma
r-19
Cumulated Return Since Mar-08
Portfolio A Portfolio B
Duff & Phelps Secondary Market Advisory
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1. Need to make capital calls
2. Obtain relief from future capital calls and unfunded liabilities
3. Requirement to fund obligations
4. Rebalance the portfolio
5. Manage the “denominator effect” in the portfolio
Limited Partner Challenges
1. Conduct a single asset or portfolio sale to raise capital to meet current capital calls
2. Divest highly unfunded partnership interests to reduce future capital call liabilities
3. Sell more mature assets to raise capital to meet funding obligations
4. Divest assets in one strategy and reallocate to another strategy
5. Divest alternative assets to align with portfolio asset allocations
Secondary Market Solutions
Potential Limited Partner Issues and Secondary Market Solutions
The COVID-19 pandemic is having a devastating impact on financial markets globally. As a
result, limited partners may need to address issues in their alternative investment portfolios
through the secondary market.
Questions?
Our Team
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• Duff & Phelps’ Financial Instruments and
Technology (FIT) Team is a leading
valuation and risk management solutions
provider to financial institutions and
corporates.
• We are 45 employees globally,
comprising of ex-wall street front office
quants, structurers, risk and portfolio
managers, with financial engineering,
quantitative modeling, risk, regulatory
and capital management expertise.
• For more details about this solution
please contact:
Private Equity Risk Solutions
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Valuations
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Services
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Advisory
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About Duff & Phelps
Duff & 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, claims
administration 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, and
Prime 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, visit
www.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 a
Division 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 of
DPSL. Valuation Advisory Services in India are provided by Duff & Phelps India Private Limited under a category 1 merchant banker license issued by the Securities and Exchange Board of
India.