Private equity is generally considered to be a very risky asset class, implying a low weight in most portfolios, but is this really the case? Private equity’s outperformance potential stems directly from its ability to venture into the unknown. It is the nature of this risk that therefore merits the greatest consideration. But how does one measure ‘the unknown.’ There is, by definition, no relevant data on it.
There appears to be a vicious circle: the perception that private equity is highly risky results in small allocations. The immaterial exposure to private equity means less effort is spent building specific methodologies that are appropriate to private equity. The result is that the investment industry tends to work with overly-pessimistic assumptions and over-simplifications regarding private equity related risk. This remains the case despite the advent of the AIFM Directive and Solvency II.
My journey into private equity started around 2000 after the dot-com bubble, when a large institutional investor in European venture capital funds wanted to know how serious his situation was. Clearly valuation is the starting point for risk measurement. And yet how we value private equity is very odd, as the existence of the ‘J-curve’ suggests. To assess the venture capital portfolio’s risk we took what was at the time, an unusual perspective, looking at the ranges of the outcomes (under the assumption that the investor remained committed until the end of the funds’ lifetime).
Alongside my colleague at the time Pierre-Yves Mathonet, we detailed our experiences in ‘Beyond the J-Curve’ , wherein we concluded that even the ‘highly risky’ portfolio of venture capital funds in 2000 would not ‘default’, meaning that they would almost certainly repay at least their nominal capital. We did not anticipate a high return but the risk of loss was remote – a result that surprised many at the time but that was subsequently confirmed.
And yet more than a decade on, sophisticated investors continue to radically overstate private equity risk. One of the problems is that investors tend to assess private equity risk through the prism of operational risk. Operational risk is not a private equity specific risk, and can be relatively easily dealt with: through diversification, given its lack of correlation between managers and between funds. Analysis shows there are surprisingly strong positive diversification effects for portfolios of funds. On the other hand, even when operational aspects are well accounted for, financial risks can remain and can account for extreme outcomes.
When talking about risk we are quickly faced with a lack of data, for its measurement. Most institutions will not invest unless the fund manager has a track record backed up by in-depth data. But if we accept the concept of private equity as an arbitrage between the ‘real economy’ and the financial markets, the absence of data is also consistent with increased potential. We confuse absence of data with risk, but in reality the precise opposite may be the case. The rush into private equity has been likened to an Easter egg hunt where industry statistics is relating to all the eggs that have already been found. In fact, the more high quality data becomes available, the less performance potential may remain going forward. Reliable statistics requires many contributors and thus reflects a consensus, whereas successful investors are going against the grain.
This is where the limited partnership structure comes in. Throughout human history, structures similar to the limited partnership have been employed to deal with a similar combination of problems: investments under high uncertainty, where opportunities only exist for a relatively short time and the payoff potentially is enormous, but unquantifiable. From Italy’s medieval Commenda exploring the high seas to early 20th century oil prospectors, the limited partnership (or variations thereof) has been the model of choice. The popular criticisms about the ‘inefficiency’ of the structure often miss this vital point.
The fact that industry average returns tend to unimpressive is no longer a secret. Investors justify their continued commitment to the industry by the assumption that they are able to identify and invest in the top-quartile funds.
When modelling portfolios of private equity funds in the way described and in adherence with EVCA’s recent Private Equity Risk Measurement Guidelines, their risk is much lower than commonly perceived. So much lower, in fact, that the relationship between risk and return becomes attractive for many institutional investors, even if they assume only average selection skills. In many ways this view is inverse to conventional wisdom regarding private equity investing. By over-stating private equity risk, smaller institutions are forced out of this area of investment.
Private equity will never be for the novice. It requires institutions to build up the teams and processes in order to make significant allocations to private equity and to be long-term oriented in order to harvest this asset classes’ illiquidity premium. For now, private equity is still ‘chained’ to old ideas – it is too small to fail seriously but its potential is unrealised or misapplied. It needs to be ‘unchained’.