Hitting the Curve Ball: Risk Management in Private Equity

Abstract

Recent experience has reminded us that a private equity program cannot be viewed in isolation. 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. A risk framework should distinguish benign regimes from volatile regimes, ideally ringing an alarm bell before the onset of trouble. 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 manager’s organization, and the investor’s private equity program itself. Importantly, risk assessment should not be guided by the structure and labels of a particular fund—it must focus instead on underlying components and the ways 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 them to broader risk factors, permitting dynamic insights into the behavior of the portfolio under different scenarios. This component-level analysis can 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. The authors argue that 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. <b>TOPICS:</b>Private equity, risk management, analysis of individual factors/risk premia, equity portfolio management