Analysing private equity and venture capital funds through the lens of risk management

659 views
539 views

Published on

Can we interpret the role of PE/VC investments as a form of risk management?

Investments in PE/VC are usually thought of as being high risk / high return, But, studies also show that PE investments can reduce risk in certain situations.

The academic version of this paper was submitted in partial fulfilment of the requirements of the Imperial MBA degree and the Diploma of Imperial College London. The academic version of this paper was awarded a Distinction.

Published in: Business
0 Comments
1 Like
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total views
659
On SlideShare
0
From Embeds
0
Number of Embeds
14
Actions
Shares
0
Downloads
11
Comments
0
Likes
1
Embeds 0
No embeds

No notes for slide

Analysing private equity and venture capital funds through the lens of risk management

  1. 1. Can we view the role of PE/VC investments as a form of risk management? ​Izam Ryan ​Imperial FT MBA 2013/14 ​izamryan@gmail.com
  2. 2. © 2014 Izam Ryan 2 Investments in PE/VC are usually thought of as being high risk / high return. ​When applying the Markowitz Mean-Variance framework to portfolio construction, we analyse investments by their expected return (“Mean”) and the volatility in that return (“Variance”) (Markowitz (1952) and Markowitz(1970)). ​This means that we deliberately pick investments based on a conscious decision to trade risk for return or vice versa. For example, one strategy could be to pick a target return then construct a portfolio that has the minimum level of risk for that target return. Or we could start with a budgeted level of risk that we are comfortable with taking on, and then construct a portfolio that has the maximum return for our budgeted risk. ​Private equity (PE) and Venture capital (VC) funds are thought to represent high risk and high return investment opportunities to their investors. This is because:  they hold illiquid investments (their asset base attracts a liquidity discount and therefore the required return must be higher to account for this higher risk) (Scarpati, F. & Ng, W. (2013))  Some PE funds such as Bain Capital are well known in their use of financial leverage to amplify gains in leveraged buyout transactions (LBOs) but at the cost of increasing bankruptcy risk (Berk, J.B. & DeMarzo, P. M. (2007). ​Leeds, R. & Sunderland, J. (2003) go on to say that it is this risk-seeking and risk-amplifying behaviour results in an expected return to 25% or more. statement
  3. 3. © 2014 Izam Ryan 3 In the 1997-2006 analysis below, PE funds return >20% but have a std. dev. >30% ​Source: Idzorek (2007) statistics support this statement 24.85% 21.46% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% Cash US bonds Non-US bonds US Stocks Non-US Developed Stocks Emerging Market Stocks US Private Equity Non-US Private Equity Std. dev. Average return These 2 data points support the statement that PE/VC are “high risk / high return”
  4. 4. © 2014 Izam Ryan 4 But, studies also show that PE investments can reduce risk in certain situations Asset class Return Std. Dev. MSCI Europe 10.26% 18.62% JPMorgan Euro Bond 7.84% 4.57% PE (Equity reinvestment) 10.56% 20.44% PE (Bond reinvestment) 10.39% 10.62% ​An (EVCA) (2004) analysis shows that there are occasions where investments in private equity can actually reduce risk. In this table we can see that for the same level of return ~10%, investors could have used a medium risk strategy (std. dev. 18%) of investing in an equity index (MSCI Europe). Or investors could have amplified that risk (std. dev. 20%) and invested in PE, with proceeds reinvested in an equity index. ​Or investors could have adopted a lower risk strategy (std.dev. 11%) by investing in PE and funnelling proceeds into the lower-correlation, JPMorgan Euro Bonds. ​We can therefore see that in some portfolio configurations, adding a high-risk, high-return investment can actually reduce risk in a portfolio. complication ​Source: Table 23, European Private Equity & Venture Capital Association (EVCA) (2004) ​Source: Table 23
  5. 5. © 2014 Izam Ryan 5 Can PE/VC funds be a tool for risk management? If so, how? ​Using the mean-variance framework to analyse this phenomenon – we can say that under certain conditions, PE/VC investments lead to a mean-variance efficiency gain when they are added to a wider portfolio. ​In order for this to happen, the existing portfolio assets must have low correlations with the PE/VC investment, ​But are we limiting our analysis by only using the mean-variance framework? Could we extend our thinking and see other ways that PE/VC funds can be used as a tool for risk management? question
  6. 6. ​To understand this better, we will now analyse the kinds of risks (and opportunities) that PE/VC funds are exposed to. Could we extend our thinking ?
  7. 7. © 2014 Izam Ryan 7 What are the value drivers, the sources of alpha, the “special sauce” in PE/VC funds? Expected Return CAPM Rational risks Inefficiencies Less: Costs ​Scarpati, F. and Ng, W. (2013) provide a framework we can use to analyse the drivers of returns in PE/VC investments. ​They analysed the main drivers of expected return as being: ​The traditional CAPM measures ​Rational risks ​Inefficiencies; and ​Costs. a topology of risks ​Source: Scarpati, F. and Ng, W. (2013)
  8. 8. © 2014 Izam Ryan 8 Analysing Scarpati & Ng’s framework against a topology of risks, there may be scope to further develop the strategic risks CAPM Rational Irrational Less: Costs Systematic risk, Size, Market premia Market inefficiencies Opportunity costs, internal costs, fees, etc. Illiquidity risk Monitoring intensity Overconfidence Scope to further develop strategic risks a topology of risks ​Source: Figure 1A-1, Mark, R., Galai, D., & Crouhy, M. (2006) Scarpati, F. and Ng, W. (2013) Risks Market Credit Liquidity Operational Legal and regulatory Business Strategic Reputational
  9. 9. © 2014 Izam Ryan 9 We propose refining the topology of risks by adding: Biz model, Innovation and Financial engineering risks. ​We develop further on Mark, R., Galai, D., & Crouhy, M. (2006) by proposing some new strategic risks which we will refer to as: ​Business model risk is the risk that a Company isn’t configured to extract the most value out of its value proposition ​Innovation risk is the risk that a firm loses market share to a competitor’s disruptive innovation and is eventually overtaken ​Strategic engineering risk is the risk a company isn’t actively managing value a topology of risks - refined ​Source: Figure 1A-1, Mark, R., Galai, D., & Crouhy, M. (2006) Scarpati, F. and Ng, W. (2013) Risks Market Credit Liquidity Operational Legal and regulatory Business Strategic Reputational
  10. 10. © 2014 Izam Ryan 10 Business model risk is the risk that a Company isn’t configured to extract the most value out of its value proposition ​Financial investors fund companies through periods of extreme uncertainty and risk as the venture develops its value proposition and experiments with different business models. ​We can understand this as being a situation where investors put in time and money to extract value at a future date while their equity is being subject to business model risk. ​For example, a PE fund may acquire a real estate asset and finance the business model shift (e.g. X-Leisure fund) to turnaround the business. ​In another example, a VC fund may invest in a business through different business model shifts – for example MySQL AB shifted its revenue model from large 1-off payments to annual subscriptions, and this business model tweak was done under the ownership of VC funds. risks – business model risk ​Source: Ries, E. (2011). Business Model Foundry (2014). X-Leisure Ltd (2014) . LaMonica (2005). Index Ventures (2014).
  11. 11. © 2014 Izam Ryan 11 Innovation risk is the risk that a firm loses market share to a competitor’s disruptive innovation and is eventually overtaken ​Using the language of the mean-variance framework, if we look at a VC’s investments in different tech startups, we could say that building a portfolio of innovation will generate better returns for any given level of risk when compared to investing in only a single technology. ​Building on this concept, we may say – in a VC’s innovation portfolio there will is a risk that one of the innovations is a disruptive innovation. ​We could therefore say that part of a VC’s function is to exploit inefficiencies/opportunities by seeking out and financing disruptive innovation, leveraging on its informational advantages. risks – innovation risk ​Source: Christensen, C. M., & Raynor, M. E. (2003). Time Features/ performance Disruption Current Today
  12. 12. © 2014 Izam Ryan 12 Strategic engineering risk is the risk a company isn’t actively managing value ​Not to be confused with model risk! Strategic engineering risk is the risk that a company isn’t sweating its assets in the way PE owners do – through cost cutting, capital efficiency or through constantly seeking the best owner of its strategic assets. ​The concept of the “best owner” of strategic assets is a key cornerstone of Value, as described by Koller, T & et al (2010), whereby the best owner of an asset may not necessarily be the current owners. ​With this frame in mind, we can say that any portfolio investment held by a company is a candidate for a divestment, and in fact that divestments may be a key source of creating value for the owner (because another company may place a higher valuation on that asset). ​This constant “pull” of forces outside the company that draw assets to their “best owner” is partly makes private equity owners sweat their assets – because they know that in order to achieve a profitable exit, that they should sweat the assets under their care. risks – strategic engineering risk ​Source: Koller, T & et al (2010) 10 17 0 2 4 6 8 10 12 14 16 18 Enterprise Value Without engineering With engineering
  13. 13. ​We now try to apply these concepts to practical risk management considerations Conclusion
  14. 14. © 2014 Izam Ryan 14 Corporates could structure holding companies like private equity funds MNC Division 1 Division 2 Division 3 Intermediate Holdco Unit 1 Unit 2 Unit 3 ​One implication for this is that multi national corporates (MNC) may want to consider setting up intermediate holding companies as a mechanism to hold portfolio companies (e.g. Unit 1, 2 and 3 in the diagram). ​This way, the intermediate holdco could be partly financed through external debt, and the acquisition of the portfolio companies can be leveraged. ​Although this increases the bankruptcy risk of Division 3 – this would have the effect of increasing financial discipline at the portfolio company level and enhancing returns through leverage. ​This would address what we called “strategic engineering risk” – i.e. the risk that a company isn’t sweating its investments and assets in the same way that a PE fund tends to do. ​Using leverage also enables the MNC to increase its total capacity for M&A and therefore provide more capacity to experiment with “business model risk” and “innovation risk”. conclusion – what can corporates learn from this
  15. 15. © 2014 Izam Ryan 15 Corporates could hedge innovation risk through using corporate venturing arms Venture portfolio Old Tech New Tech #1 New Tech #2 ​Corporates that are exposed to high levels of innovation risk (for example, companies that compete in markets where the pace of technology advancement is extremely fast) should set up corporate venturing arms. ​In this way, the corporate would be able to build a portfolio of different technologies, with the objective of driving excess returns from undertaking these new risks (for example in New Tech#1 and #2 in the diagram). ​Provided that these innovation risks are uncorrelated to the risks of the “Old Tech” (and therefore that there is no basis risk of incorrect hedging), this approach would increase absolute returns. ​In a way, investing through a venture portfolio creates optionality in a corporate’s innovation portfolio. Damodaran (2010) gives an application of real world option theory in the field of assessing investments under extreme risk and could be a basis for corporates to value their investments in corporate venturing. conclusion – what can corporates learn from this
  16. 16. © 2014 Izam Ryan 16 The fund is a nexus of operations that exploits information asymmetries and trades them with time ​Risk premium of PE/VC funds comes from more than just financial leverage and LBO’s. Our key hypothesis is that the funds serve as a nexus – they undertake investments that expose the funds to biz model risk, innovation risk and strategic engineering risk. ​In a way – the fund is exploiting information asymmetries. It is in a unique position as investor and as fund manager to both concentrate capital in new ventures and to earn excess returns for investors, all the while charging a management fee. conclusion – one way to perceive the PE/VC firm
  17. 17. ​This work is licensed under the Creative Commons Attribution- ShareAlike 4.0 International License. To view a copy of this license, visit http://creativecommons.org/li censes/by-sa/4.0/ or send a letter to Creative Commons, 444 Castro Street, Suite 900, Mountain View, California, 94041, USA. thank you
  18. 18. © 2014 Izam Ryan 18 Bibliography appendix ​Berk, J. B., & DeMarzo, P. M. (2007). Corporate finance. Pearson Education. ​Business Model Foundry (2014). Business Model Canvas. Available from: http://businessmodelgeneration.com/canvas [Accessed 23 March 2014] ​Christensen, C. M., & Raynor, M. E. (2003). The innovator's solution: Creating and sustaining successful growth. Harvard Business Press. ​Damodaran, A. (2007). Strategic risk taking: a framework for risk management. Pearson Prentice Hall. ​Damodaran, A. (2010). The dark side of valuation: valuing young, distressed, and complex businesses. FT Press. ​Ries, E. (2011). The lean startup: How today's entrepreneurs use continuous innovation to create radically successful businesses. Random House LLC. ​European Private Equity & Venture Capital Association (EVCA) (2004). Performance measurement and asset allocation for European Private Equity Funds. Research Paper. Available from: http://www.evca.eu/uploadedFiles/Home/Knowledge_Center/External_Research/Academics/full_study.pdf [Accessed 23 March 2014]
  19. 19. © 2014 Izam Ryan 19 Bibliography appendix ​Idzorek, T. (2007) Private Equity and Strategic Asset Allocation. Ibbotson. Available from: https://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/IbbotsonPrivateEquity.pdf [Accessed 23 March 2014] ​Index Ventures (2014) Available from: http://www.indexventures.com/portfolio#company_id_20 [Accessed 23 March 2014] ​Koller, T., Dobbs, R., & Huyett, B. (2010). Value: The four cornerstones of corporate finance. John Wiley & Sons. ​LaMonica, M. (2005). MySQL Network shifts pricing, licensing. CNET News. Available from: http://news.cnet.com/MySQL-Network-shifts- pricing,-licensing/2100-7344_3-5575983.html [Accessed 23 March 2014] ​Leeds, R., & Sunderland, J. (2003). Private equity investing in emerging markets. Journal of applied corporate finance, 15(4), 111-119. ​Mark, R., Galai, D., & Crouhy, M. (2006). The Essentials of Risk Management. New York. ​Markowitz, H. (1952). Portfolio selection*. The journal of finance, 7(1), 77-91. ​Markowitz, H. M. (1970). Portfolio selection: efficient diversification of investments (Vol. 16). Yale University Press.
  20. 20. © 2014 Izam Ryan 20 Bibliography appendix ​Scarpati, F. and Ng, W. (2013) Journal of Private Equity, Vol. 16, No. 4 : 8-20 ​X-Leisure Ltd (2014) About X-Leisure. Available from: http://www.x-leisure.co.uk/about-x-leisure/ [Accessed 23 March 2014]

×