Risk and Leverage in Private Equity
Risk measures like volatility, correlation, Beta for Private Equities are greatly underestimated. Most PE funds do not properly adjust for this underestimation. Most funds have improper portfolio construction methods with improper risk controls.
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Risk and Leverage in Private Equity
Underestimation of Risk Measures
It is well known that illiquid assets have traditional risk measures like volatility, covariance, correlation and Beta underestimated. This underestimation of risk may, in some case, be a property which is sought after by some investors as it allows them to show artificially lower measured risk at the portfolio level. As long as the portfolio does not experience a large 3-standard-deviation event based on the true underlying risk, the managers show an artificially inflated/improved return-to-risk profile.
Companies, whether private or public, are exposed to the same “common factors”, including macro-economic, fundamental and industry factors. If we take two companies from the same industry, a public and a private one, any such two companies will have a lot of things in common which can be measured by their respective exposure to a set of common factors. In particular, we know that there will be a difference in the risk premium attached to the lack of liquidity of these companies. Private companies are generally exposed to more leverage which would show up in the leverage common factor exposure. Besides differing exposure to these common factors, these companies differentiate themselves by risks specific to each of them. It is generally understood that the stock specific risk, when adjusted for the illiquidity effect, is larger for the private company vs. the public one.
Investors interested in investing in Private Equity have long-term horizons and are interested in obtaining the risk premium attached to illiquidity. They are also interested in the stock-specific component (alpha) to the extent that they can identify winners/losers with a significant predictive ability or Information Content.
Because public companies are exposed to many of the same common factors, and because of the increased leverage inherent in private equity investments, we expect:
- the volatility (true underlying risk) to be higher for Private Equity companies vs public ones;
- the correlation of Private Equity companies to be high with their public companies counterpart (in the same industries);
- the market exposure or Beta of Private Equity companies to be significantly higher than their public company counterparts. For a diversified Private Equity portfolio, we expect the Beta to be significantly higher than 1.
While the underestimation of risk is a well-known property of illiquid assets, it is surprising to observe that some large investors still think that Private Equities are less risky! There are various ways to adjust this underestimation.
In a study, MSCI-BARRA has calculated the effect of the underestimation on some typical portfolio. Such effect looked like this on that particular portfolio:
The risk measure underestimation is strong. In this example, the adjusted risk measures show volatility and Beta to be close to twice larger than the unadjusted estimates.
Impact on Strategic Asset Allocation Studies
While most investors and consultants won’t make the error of using such underestimated risk parameters in their SAA studies, some do. The artificially lowered risk and correlation measures make such assets much more attractive and the resulting recommended optimal asset mix will evidently overly overweight such artificially low-risk asset. Just the lowered correlation from say 80% to 60% may increase the desired allocation to Private Equity by as much as 20%! This underestimation explains the increased popularity of Private Equity...
Before performing such SAA studies, all risk measures need to be adjusted for the underestimation effect.
Improper Risk Controls in Private Equity and Lack of Diversification
The techniques used for risk controls in many Private Equity funds are similar to the techniques used by the Public Equity industry in the 1970s – i.e. ad-hoc methods. Some funds achieve good diversification by brute force – i.e. investing in many industries and in a large number of companies.
Why not use the advances in risk control techniques observed in the Public Equity world? In fact, what is the difference between a public company and a private one in the same industry? They are exposed to the same “common factors” with greater leverage, more illiquid and different stock specifics.
Therefore, the same advanced risk control methodology and optimal portfolio construction techniques could be used in managing Private Equity portfolios. Why is it that so few firms use those techniques?
Lack of Diversification – Increased Concentration
Over the last 5-10 years, we have seen many large government-linked funds invest a larger percentage of their assets in single Private Equity deals. Some funds are transitioning into more highly concentrated portfolios. They explain that in order to have the scale and influence on the management of the firms they invest in, they need to invest larger amounts. This goes against any diversification logic.
We know that stock specific risk decreases approximately with √N (N being the number of stocks in a portfolio). Since stock specific risk from Private Equity investments is much larger (as much as twice larger), managing risk requires buying more stocks (vs a Public Equity portfolio).
The following chart illustrates this concept. Assuming an average stock specific risk of 32% for public equities, it takes around 41 stocks to get the stock specific component of a diversified portfolio down to 5%. With Private Equities’ higher stock specific risk of say 41.6%, it takes 69 stocks to achieve the same diversification benefit.
Thus, the higher risk in Public Equities requires more stocks in a properly diversified portfolio. This makes it difficult to invest in large Private Equity deals even for the largest funds.
For more information on Private Equity risk management and how to build a better risk-diversified portfolio of Private Equity investments, please contact us.
Dominic Clermont, ASA, MBA, CFA
State of the Art Investment Management