Quantifying risk where precise quantification matters
By Paul Mackintosh - 24/03/14
Swiss boutique asset manager Unigestion has just introduced what it describes as “a new framework within which to assess risk in private equity” for limited partners (LPs) already in private equity funds, or looking to access the asset class. “Analysis of fund cash flows is vital to understanding risks and enabling accurate comparisons between private equity funds”, it claims.
Based on research conducted in partnership with the Ecole Polytechnique Fédérale de Lausanne (EPFL), the new approach claims to be “based on actual cash flows of private equity funds, rather than their interim valuations that are more commonly used. Second, it defines risk as the deviation of actual cash flows from expected cash flows by timing and amount”. In other words, it quantifies the risk that a private equity fund will distribute less or later than expected to investors.
Analysis of cash flows from private equity funds has in fact been instanced in the past as a useful way to track the actual performance of private equity investments. Cambridge Associates for one has used this as a means to compare the performance of cash flows held within private equity vehicles to that of similar commitments to the public markets. But Unigestion goes further. “Existing risk measures in private equity are typically founded on the input of either self-reported interim valuations or final multiples. Whilst this data allows risk calculations to be performed easily, Unigestion believes such analysis is ultimately unsatisfactory”, it claims. “Intermediate valuations significantly understate true risk due to the self-referring nature of private equity returns, while final multiples rely on ten-12 years of history and therefore will only illustrate a fund’s performance once it has been liquidated rather than throughout its entire life”.
Unigestion's new methodology, called Expected Cumulative Downside Absolute Deviation (ECDAD), “measures the difference between the actual cash flow curve and the expected cash flow curve, retaining as risk the amounts where actual cash flows are lower than expected cash flows. This measure presents significant advantages as it results in a single number, allowing an easy comparison between funds, while nevertheless taking both the magnitude and timing of distribution into account”.
How useful will such a risk measure be, though? Yes, it will aid in quantifying risk where precise quantification matters. Apparently, it “enhances Unigestion’s ability to construct optimally risk adjusted top down allocations between different segments of the private equity market (e.g. large buyout, mid-market buyout, venture capital, turnaround, mezzanine)”. That may be so. But in the broader, less quantifiable but very important qualitative approach to private equity, most investors persist in believing that the best way to reduce risk is to get into top quartile or even top decile funds. Crises have not changed that. Anyone who applies a stricter numbers-driven approach to fund selection is liable to end up, eventually, with indigestion.