Excerpt from ‘The Young Professionals Guide to Conquering Private Equity Transactions’ available on Amazon
Investor Risk In Private Equity (Chapter 6)
What are the main risks that face the investors, limited partners, in PE funds:
The Main Types Of Risks In Private Equity for Investors
Liquidity Risk – Market Risk – Interim net asset value (NAV) risk (short and mid-term)
Funding Risk – Capital Risk (mid and long-term)
- Liquidity risk: The illiquidity of private equity partnership interests exposes investors to asset liquidity risk.
- Funding risk: The unpredictable timing of cash flows poses funding risks to investors. PE investment commitments are contractually binding and defaulting on payments results in the loss of private equity partnership interests.
- Market risk: The fluctuation of the market has an impact on the value of the investments held in the portfolio.
- Capital risk: The realisation value of private equity investments can be affected by numerous factors: the quality of the fund manager, equity market prices, interest rates and foreign exchange.
Investor risk in private equity investments is different to public markets for several reasons:
- Private equity is an equity investment into non-quoted companies. As the companies are not traded on a secondary market, there is no market price.
- Typically, limited partner (“LP”) investors in PE do not invest directly into a company. In most cases, a fund is used as the investment vehicle. LP structures tend to be set-up for 10 years with no redemption rights for investors.
- An investor does not pay in all their capital on the first day; the money is drawn over time. This represents a specific risk for investors i.e. funding risk. If the investor is not able to pay the capital call, they might lose all their capital. This requirement, however, gives the PE fund manager greater certainty that investments will be funded.
The first possible reason for running into liquidity issues is an over-commitment strategy of some investors. Secondly, investors who have been running a private equity portfolio for some years typically use the distributions of mature private equity funds to finance the capital calls of young funds (self-funding strategy).
Investors can reduce the funding risk by assessing their future commitment plan with cash flow simulations and cautious planning.
Funding risk is important, particularly during market instability with a mismatch of capital calls and distributions. In an equity market downturn as in 2009, M&A activity dries out as none of the funds are willing to sell their investments at low market prices. As soon as signs of recovery appear, fund managers start to invest again at relatively low prices, which results in more capital calls compared to distributions.
A random selection of one fund is much riskier than a diversified portfolio. The diversification effect is even more important for distributions than for capital calls; diversification substantially decreases the funding risk for an investor.
While more than 5% of PE funds are unable to return any money to their investors after five years, the best funds returned more than the invested capital within this time period. This variability underpins the advantage of investing in a portfolio of PE funds to reduce funding risk.
Liquidity risk is the risk that an investor is unable to redeem their investment at the time of their choosing. Private equity fund structures are designed so that the investor remains in the fund for its full term.
There is a secondary market in PE fund holdings, but it not a liquid efficient market. Secondary market volumes only represent 3% to 5% of the primary volume.
If an investor is solely focused on private equity assets and they need to sell in difficult market times, they cannot circumvent the liquidity risk. If private equity is only a small part of a well-diversified asset allocation, other assets are more liquid and can be traded.
Market Risk, Capital Risk & Conclusion can be found in Chapter 6 ‘The Young Professionals Guide to Conquering Private Equity Transactions’ available on Amazon