Risk management for private equity funds

Abstract

Although risk management has been a well-ploughed field in financial modeling for over three decades, the understanding how to correctly quantify and manage the risks of investing in private equity remains limited and continues to considerably lag that of other traditional asset classes. The objective of this paper is to fill this gap by developing the first comprehensive risk management framework for private equity fund investments. The framework captures the three main sources of risks that private equity investors face when investing in the asset class: market risk, liquidity risk, and cash flow risk. Underlying the framework is a stochastic model for the value and cash flow dynamics of private equity funds, which allows deriving three dynamic risk measures for private equity fund investments: Value-at-Risk (VaR), Liquidity-Adjusted Value-at-Risk (LVaR), and Cash-Flow-at-Risk (CFaR). The model is calibrated to historical data of buyout funds and the dynamics of the developed risk measures are illustrated using Monte-Carlo simulations. A sensitivity analysis shows the impact of changes in the main model parameters on risk measures.