1 Asset allocation and exposure management
By Christian Diller and Christoph Jäckel, Capital Dynamics
Risks discussed in this chapter:
➲ What is the optimal private equity share in an overall asset allocation?
➲ Which model can be used to assess a future commitment programme?
➲ How can a private equity exposure and various probabilities be derived?
➲ What is the risk of overshooting a target allocation and how can it
Introduction Private equity’s specific characteristics make it challenging to integrate the asset class
into an overall asset allocation, not least because of the partnership model that private
equity funds are based on. Essentially, investors commit capital to a private equity fund,
which then draws most or all of the capital during the investment period of the fund.
Given the very nature of this structure and because the secondary market for private
equity is still relatively small, it is difficult for investors to allocate a set target percentage
of their portfolio to private equity. Investors have to plan commitment programmes for
medium- and long-term horizons in order to reach and maintain their investment target.
This raises a number of questions about what the optimal target allocation to private
equity is and how much an investor needs to commit to private equity over time to reach
its investment target.
This chapter highlights some of the difficulties of integrating private equity into an over-
all asset allocation and presents a method based on historical simulations for integrating
private equity into the traditional Markowitz asset allocation framework; based on this
method, the chapter addresses the question of the optimal allocation.
The second part of this chapter analyses the concept of commitment pacing to reach and
maintain an allocation target. This is particularly important for investors with narrowly
defined allocation targets, either due to their own investing philosophy or because of reg-
ulation; for instance, pension funds often have maximum allocation targets to private
Examples include Norwegian pension funds, which are only allowed to invest up to 7 percent into alter-
native asset classes. The Swiss government is also discussing the introduction of a 15 percent cap on
private equity investments for pension funds. US pension funds set their own maximum limit in their
own constitutions or investment guidelines.
Part I: Risk aspects of limited partners
equity1. Private equity investors are at risk of overshooting or undershooting their alloca-
tions not just because of changes in the value of their investments, but also because of
the so-called denominator effect. As a percentage allocation to private equity depends on
the value of an overall portfolio, large swings in overall portfolio valuation (like those
observed in the second half of 2008) can alter the private equity share significantly. This
chapter also discusses a commitment-pacing model that helps investors reach and main-
tain their allocation targets.
Difficulties in The traditional mean-variance analysis requires three basic input parameters for each
integrating private asset class in the portfolio: expected returns, standard deviation of returns, and correla-
equity into a tion to other asset classes. For liquid asset classes, estimating such parameters is not so
traditional difficult2, as market prices are available for any point in time. However, this is not the case
Markowitz asset for private equity, which is an illiquid asset class not traded in an active and transparent
allocation secondary market.
It is possible to estimate a private equity investment’s market price using the principal
fund manager valuation – the fund’s net asset value (NAV). However, these are only
approximations that have traditionally been left to the fund manager’s discretion.
Furthermore, managers have not updated these valuations frequently and therefore
prices show little volatility, which in turn underestimates the true risk of a private equity
investment. In the future, the new FAS 157 also known as FASB ASC 820, regulations
requiring mark-to-market valuation and the International Private Equity Valuation (IPEV)
Guidelines should ensure less subjectivity and should reflect more realistic price volatili-
ty. If the valuations will be used to estimate expected returns or volatility, it is important
to at least correct for the smoothing effect of the NAV time-series.3
One additional issue complicates the incorporation of private equity into a Markowitz
framework: cash positions dilute the returns of private equity. A private equity portfolio
consists of private equity fund investments and a liquid position such as cash or other liq-
uid investments, which are used to meet capital calls. While private equity investments
might yield a high return, the cash position yields low interest rates, which dilute the
overall return. This effect is further compounded by fund managers not always calling all
of the committed capital. To minimise the erosion of returns, private equity investors
need to overcommit – compensating for the fact that not all the commitments will be
called – and to reinvest some of the distributions to minimise the cash position.
Empirical analysis: To estimate an optimal allocation to private equity in a mean-variance framework, realis-
the optimal tic private equity portfolios, based on a data set from Thomson Venture Economics, are
allocation to private
equity in a mean- 2
See Markowitz (1952) for the description of the approach. However, financial literature also shows that
it is difficult to have the correct estimation parameters even for public markets that are transparent and
more efficient than private markets.
For a detailed description of how to calculate private equity returns, see Chapter xy of this book and
8 Manager-related risks
By Réal Desrochers
Risks discussed in this chapter:
➲ Selecting the right private equity fund manager is the most critical decision a
limited partner can make and needs to be based on very detailed due diligence
➲ Understanding how a fund manager’s operations are structured, how the
partners are incentivised and how to choose a pure private equity house as
opposed to an asset manager
➲ Being in touch with how a fund manager operates, how it sources investments
and financing and how it communicates effectively with its limited partners
➲ Knowing that good corporate governance is a positive sign of a reputable
fund manager that acutely aware of its various stakeholders
Introduction Fiduciary responsibility is one of the vital qualities that private equity fund managers
must be able to demonstrate clearly to investors in their funds. Without a relationship
based on complete trust and total confidence in the investment manager’s abilities and
motivations, an investor will not entrust tens or hundreds of millions of dollars of long-
term investment into a private equity fund. Pension funds, in particular, are the guardians
of their scheme members’ hard-earned savings. They have immense responsibility to
invest wisely and efficiently for the future security of thousands of hard-working people
who put their trust in asset managers to provide them with pension benefits earned with
their services provided to society.
In this context, therefore, it is paramount that every allocation to a private equity fund is
made following the strictest application of portfolio management and due diligence best
practice for the sole benefits of the beneficiaries. With such a heavy onus on a pension
fund, private equity portfolio design and construction have to be done with all the ingre-
dients of discipline, diligence and prudence, taking into consideration the riskiness of the
asset class. Private equity portfolio design is really the first step for any pension fund to
mitigate risk at the total fund level. Recent experience is demonstrating that overly
aggressive allocation to managers over the last three to four years proves to be really
costly and embarrassing for many pension plans.
It is well understood that pension funds typically invest in this risky asset class to
enhance the total fund return over a long term as there is no liquidity per se unless one
Part I: Risk aspects of limited partners
has to exit via the secondary market, which is not desirable under any circumstances.
Thus, risk management is applied during the asset allocation process at the total fund
level. Then a very critical element for the portfolio managers is to do a further asset allo-
cation for the private equity portfolio, which has a window of five to eight years. It is cus-
tomary for the private equity portfolio manager to have a portfolio simulation model that
will typically forecast the behaviour of the portfolio over a long period. Assumptions have
to be made on the expected rate of return, take down for cash investment and realisa-
tions. This model, once stress-tested, should provide some comfort for the investment
committee or boards of directors.
Foundations This first step is the foundation of a robust pension fund private equity programme,
of a robust which is critically important to be successful in this risky asset class. A robust pension
private equity fund private equity fund features the following characteristics:
1. Before a pension fund embarks on private equity programme it is important that the
investment committee and/or the board of trustees clearly understand the nature of
an allocation to private equity as it is relates to expected returns, illiquidity and the J-
2. The investment committee and/or the board of trustees should understand that private
equity is a cyclical business, but potentially with high expected returns and carries a
larger standard deviation of return in the range of 30-35 percent compared to 14-16 per-
cent for a public equities portfolio.
3. It is essential to have a benchmark that is clear, easy to measure and that the invest-
ment committee and/or the board of trustees can clearly understand.
4. It is important to have a well-diversified asset allocation diversified by sector, geogra-
phy and vintage year.
5. It is essential to employ an experienced and time-tested in-house private equity invest-
6. Make sure the investment team has ample resources to measure or assess risk, per-
formance, track the portfolio performance down to the individual company level and
undertake detailed governance for the partnership agreement, which is typically a com-
bination of legal and private equity experience.
The second step consists of defining the investment strategy and tactical plan – and it
should be assumed here that the portfolio will be built using an indirect investment
approach – that is, investing with private equity fund managers whose expertise is to
make direct investments whether they focus on venture capital, buyouts, growth equity,
debt-related opportunities or special situations.
Lastly and obviously, portfolio benchmarking is important in every aspect of the invest-
ment management process. Private equity portfolio benchmarking remains a subject of
controversy given its long-term investment horizon, variety of strategy being pursued and
the lack of liquidity. In my opinion, the benchmark for a private equity portfolio has to be
equity-like given that this portfolio is competing with other asset classes at the total pen-
sion plan level. However, there is a wide variety of benchmarks used in the industry and
13 Firm-level risk considerations
By John Barber, Bridgepoint
Risks discussed in this chapter:
➲ A private equity firm’s success is built on the continued quality of its
➲ General partners rely on the flow of capital from limited partners to be able
run their businesses
➲ Making the wrong investment decision in a company can prove to be poten-
tially disastrous for a buyout fund
Introduction Private equity investing involves consciously taking risks. It is expected that, over time,
the investments scrutinised by its investment managers and those that attract their cap-
ital will produce compelling performance that exceeds traditional asset classes’ returns.
In the buyouts context, greater rewards are often generated because private equity-
backed businesses typically set more ambitious goals for growth and profitability than
their public corporate peers. These businesses often make longer-term, sometimes bold-
er decisions to commit capital expenditures or to restructure operations (as they stand
outside the sphere of listed companies required to report short-term results each quar-
ter) or are more leveraged financially than comparable quoted companies. On occasion,
private equity investment managers can also generate exceptional returns when they
defy conventional wisdom by acquiring fundamentally sound businesses at knock-down
prices when they are out-of-favour or overlooked.
Therefore, the factors contributing to extra rewards for private equity investing general-
ly comprise assuming incremental risks, whether they are strategic, managerial, finan-
cial or operational in nature. The key challenge for private equity investment managers
(usually general partners of private equity funds) is therefore to measure and take such
risks in a disciplined and thoughtful way, judging when the assumed risks are appropri-
ate or excessive versus the potential extra rewards on offer. The market offers material
evidence that some general partners succeed quite consistently in meeting this chal-
lenge, while others – particularly in the recent private equity cycle up to late 2009 – have
failed in judging the appropriate risk-reward tolerances of the assets to which they have
Given the high-profile public scrutiny of and critical reaction to a number of failed invest-
ments of late, the buyouts industry has garnered considerable adverse ‘external’ atten-
Part II: Risk aspects of direct funds
tion from market participants (such as institutional investors in funds), stakeholder groups
(particularly employees and corporate pension fund trustees) and interested observers
(including politicians, regulators and journalists).
Much less attention has been paid to the ‘internal’ risks of private equity investing. These
play out in a general partner’s day-to-day operations involving a firm’s dealings with its
core constituencies (such as its team and its investors), its assessment and containment
of risks to portfolio companies and, over the longer run, its nurturing and development of
a corporate culture that expresses its character and gives form to its ambitions. This chap-
ter seeks to address those internal risks, commenting on their sources as well as poten-
tial ways they can be managed or mitigated.
Team risks It may be a platitude to state that a private equity firm’s most valuable asset is its skilled
personnel, but it is a statement that will always be true. Without a talented, motivated,
creative, well-rounded and diligent team, a private equity firm could not accomplish its
mission at the best of times, not to mention at the worst. To succeed in the buyout world,
a firm must be accomplished in finding, understanding, winning, pricing, financing, man-
aging, and at times rescuing and eventually exiting its investments; each stage is
undoubtedly a complex assignment. Collectively, they are usually conducted against
pressure from competition, timing (in the sense of deal deadlines as well as compound-
ing IRR thresholds) and market cycles.
Although not guaranteed, private equity professionals’ rewards for successfully meeting
all of the required demands can be exceptional. With respect to carried interest, howev-
er, much more has to go right than wrong over several years in managing financially lever-
aged assets with ambitious business plans in order for serious capital gains to be
generated for a general partner’s team.
The principal team risk – ensuring sufficient team quality to handle the many daily chal-
lenges – is largely mitigated by the potential for very compelling rewards. Highly capable,
ambitious, hard-working and skilled professionals are attracted to the private equity arena
not just because of the quantity of rewards on offer but also because it is a multi-faceted,
fast-moving business. Newcomers to the industry are also self-select to hold out for
longer-term, larger financial rewards. In so doing they opt out of the more predictable,
shorter-term remuneration available through annual bonus pools in other professions
where their investment execution, research or strategic talents could be applied, such as
in investment banking, consulting or quoted asset management.
The flip-side of private equity’s capacity to attract outstanding personnel is that manag-
ing such first class professionals in a fluid yet relentless business is highly challenging in
itself. Sometimes with very little notice a deal can fail or succeed despite months of
intensive effort; completed investments can produce binary outcomes over time, with
sometimes a seemingly unfair 5x gain on a middling asset benefitting from an improving
market, or just a 0.5x gain on a thoroughly decent company trading in tough market con-
ditions, despite years of hard effort to resuscitate it. Star private equity players can fall
15 Venture capital – SV Life Sciences
By Kate Bingham, SV Life Sciences
Risks discussed in this chapter:
➲ How can risk be mitigated when investing at all stages of the life sciences
➲ How can a venture capitalist ensure it establishes a team structure to secure
the best investments?
➲ As company loss management becomes increasingly riskier, how can ven-
ture capitalists avoid risks associated with loss of capital, loss of reputation,
litigation and loss of expended time?
➲ Have venture capital syndicates bridged the lack of fundraising the asset
class has suffered since the world recession took hold?
Every successful investment is powered by a strategy that incorporates effective risk
management. As each investment class carries its own set of risks, the strategies and
management tools employed to mitigate those risks vary as well. To provide a practical,
hands-on understanding of the main risks and management tools in venture capital, ven-
ture capital adviser and manager SV Life Sciences (SVLS) will share some of the expert-
ise it has been cultivating since 1993. The following chapter will discuss the most
common risks associated with venture capital, and SV Life Science’s methods of coun-
tering them in the life sciences industry. In particular, the points to be examined are:
• Multi-pronged asset allocation and diversification
• Investment timing and portfolio size
• Fund construction and deal structuring
• Technology and industry-specific exposure
• Company loss management
• Team-building and succession
• Limited partner, company and litigation risks
• Syndication risk
• Foreign exchange fluctuations
For every aspect of risk that a venture capital fund will face, there should be investment
discipline and mitigation strategies that will reduce the impact of procedural flaws.
However, fundamental to success in venture capital – and success is to make money –
Part II: Risk aspects of direct funds
is investment in knowledge. Knowledge drives intelligent investment practices and deci-
sions; thus, the advantages gained through knowledge developed with high-quality
research and industry expertise cannot be understated.
Asset Employing a high level of diversification with respect to asset allocation is a primary meas-
allocation and ure in lowering risk, specifically allocating across different sectors, various company stages
diversification and geography. With the broad allocation policy in place, further refinements can be made
to a venture capital’s diversification strategy to respond to market opportunities and cycles.
At SVLS we focus on three life sciences sectors – an approach akin to three mini funds
within a fund – comprising biotechnology, medical devices and healthcare services – with
respective approximate weightings of 50 percent, 25 percent and 25 percent.
Allocating across different company stages further spreads the risk, and even if the
emphasis is on investment with early-stage companies as is the case with SVLS, it is still
advisable to invest in companies at a range of different stages in order to generate con-
sistent returns. SVLS also spreads investment capital over an investee company’s life
cycle thereby providing risk-adjusted stage exposure even within individual investments.
Geographically, venture capitalists can also mitigate risks by not limiting their focus to
one particular region or country; SVLS approaches this by investing predominately in the
US, but across Western Europe as well. Investing on an international scale serves to
increase the firm’s exposure to a broader range of international buyers which is impor-
tant for generating exits.
Employing milestones to limit risk is particularly effective when investing in early-stage
companies, which biotechnology and medtech companies tend to be. The riskier the
investment, the more milestones can be used as a tool to gain better visibility on the out-
look of a company before actually putting significant sums of money to work.
An effective example of using milestones to limit risk is SVLS’s investment is the biotech
company Alantos, initially based in Germany and then headquartered in the US. SV Life
Sciences led a three-tranche Series-C financing round of the company in 2003 in order to
prove the viability of TACE as a robust drug discovery platform. TACE failed to be an
acceptable discovery tool in terms of cost and speed, however, the company had suc-
cess in developing two potential blockbuster drug candidates. Therefore, with the primary
milestone being missed, SVLS re-capitalised the company on new terms in order to redi-
rect the company towards developing its osteoarthritis/inflammation and diabetes drug
candidates. In July 2007 partnering discussions with Amgen on the mmp13 inhibitor for
osteoarthritis accelerated into a full acquisition offer of $300 million in cash. As part of
the risk-assessment processes associated with early-stage biotechnology companies,
SVLS believes that milestones are very important risk-minimising tools.
In terms of portfolio composition, limiting any one company – regardless of sector, stage
or location – from becoming too large within a portfolio is an effective strategy to limit
18 Public-perception issues and regulatory risk
By Simon Walker,The British Private Equity and Venture Capital Association
Risk discussed in this chapter:
➲ Private equity has had to learn to cope with being under the political, media
and stakeholder spotlights in Europe in a relatively short amount of time
➲ Public-perception risk can be managed and mitigated but never complete-
➲ Good-quality research, including attribution analyses, equips the industry
with the facts that it needs to communicate its position within the economy
➲ Private equity is faced with regulatory risk as European regulators seek to
impose further controls on alternative investment managers
Private equity The private equity industry has grown significantly over the last ten years and this growth
and public has brought with it increased attention from politicians, public officials, the media and a
perception wider group of stakeholders. This chapter will explore the implications of this growth
from a public relations and regulatory perspective and suggest ways in which these risks
can be identified and effectively managed or mitigated.
Risk management For a long time, risk management meant understanding diversification benefits and accu-
in private equity rately assessing the reward of an investment opportunity relative to its risk. Beyond the
– growth of purely financial sphere the concept of risk management was not considered relevant by
an industry most private equity firms. As the rapid growth of private equity took place away from the
public eye, private equity firms had little cause to interact with stakeholders other than
investee companies and investors in their funds. Yet with the industry consistently gen-
erating excellent returns, its popularity with investors grew and it came to be seen,
increasingly, as an essential element of any diversified investment portfolio. As fund sizes
grew, private equity funds began acquiring companies which previously were out of
reach; what ensued was that household names came under private equity ownership
amid a wave of de-listings in the US and throughout Europe.
By managing multi-billion-pound funds and buying well-known brands, private equity had
as an industry assumed a level of economic importance beyond its meagre public profile.
It was only a matter of time, especially in a world of 24/7 news, before large size and lim-
Part III: Systemic risks
ited public profile conflicted to ensure that private equity was thrust into the spotlight
and, for a while, became the story.
This chapter will examine the growth of private equity’s public profile, the risks associated
with inadequately communicating to a broad audience and the steps the private equity
industry has taken, which other industries might consider taking, to improve public percep-
tion and mitigate negative public exposure which can lead to damaging policy responses.
Private equity Unlike in Germany, where comments by Franz Münterfering, the vice-chancellor of
under the Germany from 2005 to 2007 that private equity firms acted like locusts sparked a debate
spotlight about the role of private equity, there was no similar catalytic event in the UK.
Münterfering’s made his infamous comment in April 2005 but in the UK the first real sign
that private equity was going to enter the broader consciousness and move beyond the
financial pages and into the mainstream press came in June 2006, when unions protested
Permira’s takeover of The Automobile Association (AA), the motoring and financial services
company, by parading a camel outside of the church attended by Permira chief executive
Damon Buffini.1 This was followed in November 2006 by a Financial Services Authority dis-
cussion paper on private equity; in early 2007 reports that a consortium of buyout houses
were preparing a bid for the supermarket chain J Sainsbury generated significant press
interest, which intensified when the Qatari Investment Authority also announced that it was
considering a possible bid. In response to the increasing scrutiny and criticism of the indus-
try’s opacity, the BVCA announced that David Walker would conduct a review into trans-
parency and disclosure. This was followed just two weeks later by the decision from the
UK Treasury Select Committee to hold an inquiry into private equity.
Many of the criticisms levelled at private equity by the some media commentators and
politicians in the UK and elsewhere are based largely on misleading information. The pri-
mary charge that private equity firms asset-strip companies has been disproven by
research from London Business School and McKinsey & Co. which said that the “outper-
formance of private equity deals correlates with the active ownership and governance
approach of private equity funds and GPs involved with these deals. Overall our results are
consistent with PE deals generating productive growth. 2 Arguably, productive growth is
hard to generate if you have stripped out the most profitable parts of the business.
What the private equity industry failed to do was to put in place a strategy which com-
municated effectively the benefits of private equity for companies and the wider econo-
my. Allowing the creation of a vacuum provides critics with the necessary space to make
London-based buyout firm Permira was criticised by the GMB (formerly known as National Union of
General and Municipal Workers), a trade union representing a minority of workers at the AA, which the
private equity firm acquired alongside CVC Capital Partners in July 2004 for £1.75 billion. The GMB
placed an advert in the business section of the Evening Standard, a London newspaper, in early August
2007 showing a photograph of Permira’s managing partner Damon Buffini and accusing the firm of
unfair dismissal of AA workers.
London Business School and McKinsey & Co., ‘Corporate Governance and Value Creation: Evidence
from Private Equity’, by Viral V. Acharya, Moritz Hahn and Conor Kehoe, November 2008.