Key risks in private equity investment

The following is an extract from an interesting paper that I read recently, issued by MJ Hudson Allenbridge.

The Private Equity industry is an ever-growing element of the financial services sector and, having had some personal experience within the sector, I thought the following extracts provide a good summary of the key risks that investors should be aware of when considering making Private Equity investments.

Introduction

Following the 2007/08 financial crisis, the global economy has benefited from a long period of quantitative easing, low-interest rates, and, as a result, a period of relatively sustained growth. This relatively benign environment has helped global asset prices across the board, albeit with some assets performing better than others. Private Equity (‘PE’) has been one of the better performing asset classes, driven, in part, by the fact that fiscal and monetary stimuli helped stock market valuations rebound quickly from the financial crisis.

There are several specific risks in private equity investing, given the inherently illiquid nature of the investments and the need to lock-up capital for several years.

What are the key risks?

There are, broadly, five key risks to private equity investing:

1. Operational Risk

Operational risk is the risk of loss resulting from inadequate processes and systems supporting the organisation. It is a key consideration for investors regardless of the asset classes that PE funds invest into.

2. Funding Risk

This is the risk that investors are not able to provide their capital commitments and is effectively the ‘investor default risk’. PE funds typically do not call upon all the committed investor capital and only draw capital once they have identified investments. Funding risk is closely related to liquidity risk, as when investors are faced with a funding shortfall they may be forced to sell illiquid assets to meet their commitments.

3. Liquidity Risk

This refers to an investor’s inability to redeem their investment at any given time. PE investors are ‘locked-in’ for between five and ten years, or more, and are unable to redeem their committed capital on request during that period. Additionally, given the lack of an active market for the underlying investments, it is difficult to estimate when the investment can be realised and at what valuation.

4. Market Risk

There are many forms of market risk affecting PE investments, such as broad equity market exposure, geographical/sector exposure, foreign exchange, commodity prices, and interest rates. Unlike in public markets where prices fluctuate constantly and are marked-to-market, PE investments are subject to infrequent valuations and are typically valued quarterly and with some element of subjectivity inherent in the assessment. However, the market prices of publicly listed equities at the time of sale of a portfolio company will ultimately impact realisation value.

5. Capital risk

The capital at risk is equal to the net asset value of the unrealised portfolio plus the future undrawn commitments. In theory, there is a risk that all portfolio companies could experience a decline in their current value, and in the worst-case drop to a valuation of zero. Capital risk is closely related to market risk. Whilst market risk is the uncertainty associated with unrealised gains or losses, capital risk is the possibility of having a realised loss of the original capital at the end of a fund’s life.

There are two main ways that capital risk brings itself to bear – through the failure of underlying companies within the PE portfolio and suppressed equity prices which make exits less attractive. The former is impacted by the quality of the fund manager, i.e. their ability to select portfolio companies with good growth prospects and to create value, hence why fund manager selection is key for investors. The condition, method, and timing of the exit are all factors that can affect how value can be created for investors.

Conclusion

Given the illiquid and long-term nature of PE investments, investors can sometimes forget that operational and investment-related risks are still very much present in PE. Furthermore, as investors continue to increase their allocation to PE, and fund managers manage increasingly large pools of capital, investors need to understand the increased vulnerability of their portfolios to PE-specific risks, particularly under different market conditions.