Click here to load reader
Click here to load reader
Mar 30, 2015
White PaperJanuary 2011
Hitting the Curve Ball: Risk Management in Private EquityAlternative Investments & Manager Selection (AIMS) (212) 855-0462
Executive Summary While private equity has been affected by the challenges of recent years, many investors are today renewing their focus on these investment strategies, mindful of the considerable dispersion of performance between top managers and average managers, and the possibility of meaningful outperformance by the strongest general partners (GPs). This renewed focus from limited partners (LPs) comes at a time when investors are taking a broader look at their entire portfolio across all asset classes, and challenging themselves to have a deeper understanding of the risks they are assuming. In private equity, such a risk assessment cannot rely on static checklists and high-level conclusions. Recent experience has reminded us that the private equity program cannot be viewed in isolation. It is a means to an end. What really matters is understanding just how the program might succeed or fail in contributing to broader, portfolio-wide investment objectives in the ways originally intended. Recent experience has also revealed that the potential challenges in a private equity portfolio tend to surface at different times and in different ways. In other words, the environment matters. A risk framework should distinguish benign regimes from volatile regimes, ideally ringing an alarm bell before the onset of trouble. Mindful of these observations, investors should first consider the places from which risks may emerge in a private equity program. Broadly speaking, these include the unrealized companies (individually and in aggregate, as a portfolio), the remaining unfunded commitments, the managers organization, and the investors private equity program itself. Importantly, the risk assessment should not be guided by the structure and labels of a particular fundit must focus instead on underlying components and the way they interact with each other, inside and outside of the private equity portfolio. Such a granular focus allows risk managers to identify the key variables, and in turn map to broader risk factors, permitting more dynamic insights into the behavior of the portfolio under different scenarios. This component-level analysis can also be complemented by a top-down approach using public-market proxies, appropriately adjusted and tailored. These approaches pierce traditional fund classifications, invite interesting hypothesis testing, and offer a mechanism for integrating with the entire investment program. One of the primary reasons for translating the private equity program into factors is to employ a common language spoken by all of the asset classes, enabling a coordinated analysis and, in turn, a coordinated response. A commit and hope strategy is not really a risk management strategy. In our view, active management should be a critical part of risk management in private equity. Simply approving or disapproving new additions to the portfolio is insufficient. Investors should consider changes that rebalance exposures and re-shape risks, working across all asset classes and availing themselves of mechanisms like the secondary market.This is the submitted version of the article: J. Christopher Kojima and Daniel J. Murphy, Hitting the Curve Ball: Risk Management in Private Equity, Journal of Private Equity, Spring 2011, Copyright (c) 2011, Institutional Investor Inc. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures. This material is provided for information purposes only and does not constitute a solicitation or offer to provide any advice or services in any jurisdiction in which such a solicitation or offer is unlawful or to any person to whom it is unlawful. Please note that Goldman Sachs Asset Management does not maintain any licenses, authorizations or registrations in Asia ex Japan, except that it conducts businesses (subject to applicable local regulations) in and from the following jurisdictions: Hong Kong, Singapore, Malaysia, Korea, and India.
Risk Management in Private Equity
Youve gotta be careful if you dont know where youre going, otherwise you might not get there.Yogi Berra
Investing in top-performing private equity managers can be similar to the challenge of consistently picking a winning baseball, football, or soccer team. Investors must choose a team based on a variety of objective and subjective factors, considering historical track records, the quality and depth of the teams bench, the effectiveness of the strategy, the competitiveness of rivals, the passion of the players, and the weather conditions on the field. And like the die-hard sports fan, the private equity limited partner (LP) often finds itself invested for the entire game before success truly can be determined. To be sure, there are interim scores and directional indications of performance. But unlike the public-market investor who enjoys regular liquidity and reliable valuation-marks, the private equity investor cannot declare victory midway through the game, and generally speaking, cannot leave the stadium prematurely. The commitment can be worth it, however. While the performance of private equity as an asset class is a question complicated by data availability, varied sample sets, and eventful time periods, what is reasonably clear is that the dispersion of performance between top managers and average managers is very wide (generally exceeding 1,200 basis points, as shown in Exhibit 1), and that the top teams outperform public equity markets, sometimes by a considerable margin.1 And perhaps even more important, there is meaningful persistence in the relative performance of private equity general partners (GPs), meaning that there is generally something special about the top teams that tends to keep them on top.2 The strongest GPs have the potential to outperform the public markets, often a result of their ability to enhance company operations, focus on longer-term strategy, inject growth and stabilizing capital, improve corporate governance, and capitalize on unique acquisition and financing dynamics with sellers. While it is no small feat to find these top managers, the promise of consistently strong investment returns has led an increasingly diverse array of investors to private equity. Indeed, as illustrated in Exhibit 2, over the past decade LPs have committed nearly three trillion dollars to private equity managers.Exhibit 1 Private equity exhibits a significant dispersion in managers investment performance335% 30% 25% 20% 15% 10% 5% 0% -5%US Fixed Income Large Cap Small Cap International Equity Asia Equity Opportunistic Private Equity Real Estate (All Venture Economics) Buyouts Venture Upper Quartile Managers Median Managers Lower Quartile Managers
Sources: Thomson Reuters VentureXpert (private data) and Morningstar Principia (public data)
Data from Thomson Reuters VentureXpert database indicates the average spread between top and bottom quartiles for leveraged buyout funds raised in each vintage year from 1996 through 2005 is 17.1%, and the average spread for venture capital funds is 19.7%. See, for example, (Kaplan and Schoar, 2005) Private equity fund returns are compared with 4-year annualized average returns of public funds, realized over a period starting three years after the private equity fund vintage year. This lag and time-averaging is done in order to take into account the private equity investment period and long time-horizon over which private returns are realized. Private equity data is for funds raised between 1989 and 2003 as of June 30, 2010. The public data for public fund returns over the years 1992 through 2008. Managers are chosen for each market segment described here based on a strategy description from Morningstar.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.
2 | Goldman Sachs Asset Management
Risk Management in Private Equity
Exhibit 2 Fundraising has increased significantly, with considerable cyclicality(US$ in Billions)
$600 $500 $400 $300 $200 $100 $0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1H10Source: Thomson Reuters VentureXpertSecondary Fund of funds Real assets Mezzanine Turnaround/Distressed Venture capital Buyout
I. The Current LandscapeIn contrast to this promising long-term picture, recent years have been hard on just about everyone. An environment in which it was relatively easy to raise, borrow, invest, and return capital turned into one where every element of the private equity business became more difficult. Some managers had the good fortune to conclude fundraising just prior to the financial crisis, providing them dry-powder for new investments at perhaps better valuations, and additional time to endure some bad weather. Others were less fortunate, running out of both money and time, failing to convince a shrinking number of LPs who could still handle a long-term illiquid commitment amidst pressures more broadly in their portfolios. Credit markets retreated, severely limiting not only acquisition financing for new deals, but also the debt capital that fueled distributions coming from secondary buyouts and special-dividend recapitalizations. And the abrupt end to a steady stream of distributions disrupted many traditional cash-flow forecasts, and revealed the extent to which some LPs had perhaps over-committed to the asset class, hoping distributions would fo