text

Eli Talmor and Florin VasvariMay 2014

www.collerinstitute.com

ADVEQResearchSeries onPrivateEquityRisk Management Practices at Private Equity Firms

Coller Institute of Private Equity at London Business School02

Title

The global financial crisis has led to dramatic and ongoing changes in risk management among private equity firms around the world. Major regulatory reforms have been enacted with the goal of creating a more stable and transparent financial system. Among the most important developments were the passage of the European Directive for Alternative Investment Fund Managers (AIFMD) in Europe and the Dodd-Frank Act in the United States. These regulations introduce significant requirements for private equity fund managers in areas such as reporting and transparency as well as in risk management activities. In particular, the more stringent regulatory environment requires the disclosure of risk management practices across the private equity industry and could affect how private equity funds are managed in the future.

We gratefully acknowledge the generous financial support for this research provided by Adveq Management. We have greatly benefited from the comments and suggestions of

Edward Gera (FPI), Ann Iveson (CIPE) and Kevin Lester (Validus Risk Management) as well as several anonymous professionals from various private equity firms who have graciously shared their time with us.

02 Coller Institute of Private Equity at London Business School

Executive Summary

Email Contacts: etalmor@london.edufvasvari@london.edu

Coller Institute of Private Equity at London Business School ADVEQ Research Series on Private Equity 03

We performed a risk management survey to assess the state of risk management practices in the private equity industry as general partners (GPs) adapt to this new regulatory landscape. The survey was conducted during April and May 2014 and we received responses from 36 GPs, representing various geographies around the world and a range of private equity investment strategies: buyouts, venture capital, distressed, special situations, private debt, growth equity, secondaries and real estate. The majority of these private equity fund managers are based in Europe (67%) and run multiple funds with assets under management of at least $1 billion. Our survey was mostly completed by senior professionals in the private equity firms, such as managing or other senior partners, CEOs, CIOs and COOs.

The survey captures GPs views on three major risk areas that are often beyond their control: (1) Regulatory and liability risks; (2) Operational risks; and (3) Market risks. We collect information on how important GPs perceive these risks to be, the extent to which they measure and assess these risks, the strategies they employ to mitigate their impact and the extent to which they report their risk evaluations to LPs. Our main findings are:

Approach to risk management.

AsignificantmajorityoftheGPssurveyed(73%)specifythattheyhaveaformalwrittenriskmanagementpolicyinplace,while23%haveaninformalriskpolicy.Wefindstrongevidencethatriskmanagementactivitiesareimportantinprivateequityfirms:mostGPsassignresponsibilityforimplementingriskmanagementpoliciestoseniorprofessionalsand83%rankriskmanagementasbeinghighorveryhighontheirlistofconcernswheninvesting.

Thepurposeofariskmanagementpolicyisto: -Alleviateconcernsaboutcapitallossesintheportfolioinworstcaseoutcomes(96%ofGPs); -improverisk-adjustedperformance(97%ofGPs); -satisfyLPdemandsforriskmanagementpoliciesduringandafterfundraising(93%ofGPs). 41%ofGPsuseexternaladvisorstohelpinmanaging

theperceivedrisks.

Regulatory risks

AlargepercentageofGPs(89%)areconcernedaboutregulatoryrisks.With80%and60%ofGPsexpressingconcernsaboutAIFMDandFATCA,respectively,thesearetopofthelist.TheDodd-FrankActcomesinthird,with52%ofGPsconcerned.

MostGPs(58%)havemanagedtoovercomeregulatoryimplementationhurdlesdespitefeelingthattheregulationsdonotprovideclearguidelines.However,23%struggletounderstandtheguidelinesprovidedandarestillwaitingforclarifications.

Thecostofadheringtoregulationsseemstobesignificant.Asmanyas60%oftheGPshaveestablishedadditionalcompliancegroupstodealeffectivelywiththenewregulations.WhiletheGPsassessthedirectcompliancecostsasrelativelyhigh,98%oftheparticipantsinthesurveyseenooronlymarginalbenefitstothenewregulations.

Fundraisingeffortsaremostaffectedbynewregulations,with72%ofGPsclaimingthis.Thisisfollowedbyoperationalandinvestmentactivities,citedby68%and64%ofGPs,respectively.

GPsmitigateregulatoryrisksbyusinglegaladvisors(89%),settingupinhouselegalteams(43%)orpurchasingliabilityinsurance(50%).

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Operational risks ThemainsixoperationalrisksidentifiedbyGPs,

intheorderoftheirfrequencyofmentionsinthesurvey,are:(1)Failuresininternalduediligenceprocedures(2)Fundraisinguncertainty(3)Abilityofmanagementteamstodeliver(4)Potentialweaknessinportfoliocompanyaccountingorreportingsystems(5)Managementturnoveratthefirmorportfoliocompanylevel(6)Weaknessinportfolioriskevaluation,eitherformalorinformal.

MostGPsindicatethattheyareregularlymeasuringandmitigatingtheseoperationalrisks.Asignificantnumberofrespondents(80%)mentionthatoperationalriskmitigationoccursattheprivateequityfirmlevel.

Nevertheless,wefindthatreportingtoLPsthemagnitudeofoperationalrisksandwaysofmitigatingthemisrelativelylimited.About73%oftheGPsdonotreportinformationontheserisksexternallytoLPs.

Market risks GPsrankedinterestratefluctuationsasthemost

criticalmarketrisk,followedbyforeigncurrencyexchangeandcommoditypricefluctuations.Themostcommonwayofmeasuringtheserisksistolookatthenotionalsizeoftheexposureand/ortoperformstresstesting.However,quantitativemethodscommonlyusedbyhedgefunds,suchasValueatRiskorCashFlowatRisk,arenotused.

MarketrisksseemtohaveasignificantimpactonGPsperceptionofprivateequityfundperformance:about61%ofGPsbelievethatmarketrisksaffecttheNetIRRofthefundbyupto25%,whileafurther8%believetheycanshifttheNetIRRoftheirfundsbymorethan25%.

Incontrasttooperationalrisks,marketrisksaremitigatedtypicallyattheportfoliocompanylevel.Thus,thereisabiggapbetweenthesignificanceofmarketriskonreturnsidentifiedaboveandtheextentofhedgingatthefundlevel.Foreignexchangerisksarethemostcommonlyhedged(61%ofGPs)while40%(20%)oftheGPshedgeinterestrate(commodityprice)risks.

Anotherdifferencerelativetooperationalrisksismarketriskreporting.Approximately62%ofGPsreportinformationaboutmarketriskstotheirLPs.

Overall,oursurveydocumentsthatprivateequityfirmsareenhancingtheirriskmanagementprogramsinresponsetobothmarketandregulatorydemandsbystrengtheninggovernance,riskassessmentcapabilitiesandmitigationstrategies.

ThemainfindingsfromthisresearchsuggestanumberofcriticalaspectsthatGPsandLPsshouldconsider.WebelievethatGPswouldgaingreatercontroliftheyweretoadoptamoreanalyticalapproachtomeasuringcertainriskexposures.Simultaneously,regulatorsshouldnotetheconcernsraisedbyGPsandengageinatransparentdiscussionwithindustryrepresentativestoimproveregulatoryguidelinesfurther.Afewpointsdeserveparticularattention:

First,stricterregulatoryrequirementsforriskmanagementdemandmoreresourcesandarelikelytohaveasignificantimpactonprivateequityfirmoperationalandinvestmentactivities..

Second,aforensicapproachtoevaluatingandmitigatingidentifiableoperationalandmarketrisksislikelytoprovidethosefirmswillingtoinvesttoimproveriskmanagementwithlong-term,meaningfuladvantageswithfundraisingandreturnperformance.

Third,whilepre-screeninginvestmentsandmonitoringrisksinexistingportfolioinvestmentsremaincriticaltothesuccessofprivateequityfunds,theuseofmorestandardizedriskmanagementtoolsandtechniques,suchasderivatives,duringthepost-investmentperiodislikelytoincrease.

Furtherworkshouldbeundertakentoexamineandcorroborateourfindings,withananalysisofriskmanagementdisclosuresonGPswebsites.ManyGPsmayalreadyhaveimplementedmostofthemeasuresstipulatedbythenewregulationasbestpractice,butwesenseareluctancetodisclosetheirexactactivitiesperhapsgiventherelativelyshortpassageoftimesinceenactment.Also,oursurveycoversunlistedGPsandsoitwouldbeinterestingtocomparetherelevantactivitiesanddisclosurestothosemadebyquotedfirms.

Executive SummaryContinued

Coller Institute of Private Equity at London Business School ADVEQ Research Series on Private Equity 05

Introduction

This report aims to provide new insights into the attitudes and practices of private equity fund managers or general partners (GPs) around risk management. GPs risk management policies should aim to address the uncertainty about fund returns and liquidity events. Such policies also support LPs in evaluating their own risk exposure to the private equity asset class by helping them measure liquidity, market and capital risks. More evidence on the risk management activities of GPs is necessary: there has been relatively little industry or academic research on this topic. Also, there is little consensus among private equity practitioners about what constitutes best practice for risk management.

Bydefault,managersofprivateequityfundsareengagedinsignificantriskmitigationactivities.First,GPscarryoutextensivefinancial,legalandcommercialduediligenceoncompaniesandthesustainabilityoftheirprojectionsbeforeinvesting.Theduediligenceprocessperformsacriticalriskmanagementfunction.Second,GPsdrawdowncapitalfrominvestorsonlywhenneededtoinvestorcovermanagementfeesanddonotholdinvestorscashforanysignificantperiodoftime;thisuniversalpracticebyprivateequityfundsactstolimitliquidityrisk.Third,GPsthatusedebtwhenmakinginvestmentsdonotborrowfrombankstoleveragetheprivateequityfund(exceptforshort-termbridgefinancinginsomecircumstances).Theytypicallyholdtheleverageattheportfoliocompanylevel,thusinsulatingtheprivateequityfundfromdefaultrisk.Fourth,GPsoftenmitigaterisksthroughdiversification.Withinasingleprivateequityfund,thisisusuallyachievedthroughlimitsonafundsmaximumexposuretoanysingleinvestment.Investmentsarealsomadeacrossindustriesandbydeployingthecapitaloveraninvestmentperiodofthreetofiveyears.

Whilethesefeaturesofprivateequityinvestingfulfilariskmanagementrole,theydonotfullyeliminateinvestmentrisks.Inaddition,therearemanyothertypesofrisk,rangingfrommarketandoperationaltoregulatory,legal,accounting,andtax.

Togainabetterunderstandingofriskperceptionandmanagementintheprivateequityindustry,weconductedasurveyofGPs.OursurveycapturesGPsviewsonthreemajorriskareasthatareoftenbeyondtheircontrol:(1)Regulatoryandliabilityrisks,(2)Operationalrisks;and(3)Marketrisks.Wecollectinformationonseveralaspects,suchashowimportantGPsperceivethesetypesofrisktobe,theextenttowhichGPsmeasureandassessthem,thestrategiestheyemploytomitigatetheirimpact,aswellastheextenttowhichtheyreporttheirriskevaluationstoLPs.

TheimpactofthefinancialcrisishascontributedtoanincreasedawarenessamongLPsaboutriskmanagementpracticesemployedbyGPs.Ithasbecomemoredifficulttoraise,borrow,invest,andreturncapital,whilelegalandregulatoryriskshaveincreasedasaconsequenceofnewregulations,suchastheDodd-FrankAct,BaselIII,SolvencyII,AIFMDirectiveandFATCA.AstatementthatillustratesthestiffeningregulatoryenvironmentoftheprivateequityindustrywasmadebyJose-ManuelBarroso,theEuropeanCommissionPresident,in2009:Nofinancialplayershouldbeexemptfromregulationandoversight.Thatisaclearcommitmentonourpart.Itmeansthathedgefundsandprivateequitymustbecovered.

FX is the highest perceived risk, followed by political/reg and macro risks.

Coller Institute of Private Equity at London Business SchoolColler Institute of Private Equity at London Business School06

Riskmanagementinaprivateequityfirmcanbeseenasacoreactivity,acostcenter,oracriticaldifferentiatorinthemarket.WhilesomeGPsviewitasacoreoperationalactivity,othersrolltheireyesandviewitasjustarequirementbroughtaboutbyincreasedregulationandLPsthatdemandmoretransparencyonGPactivities.However,riskmanagementstrategiescouldprovidedifferentiationinthefundraisingmarketandbecomeasourceofcompetitiveadvantage.Ariskmanagementprogramcouldpotentiallyaddvaluebyloweringthevolatilityofprivateequityfundsperformance.GettingmarketriskmanagementrightispotentiallyanimportantareaforGPstoaddressinthelightofthecurrency,commoditypriceandinterestratefluctuationstriggeredbythefinancialcrisis.Operationalrisk-theriskoflossesstemmingfrominadequateorfailedinternalprocesses,peopleandsystemsorfromexternalevents-shouldbeonthetopofGPsagendasastheyseektomeettheraftofnewregulatoryrequirementsmentionedabove.Finally,illiquidityandthelackofprecisevaluationofassetundermanagementareviewedasmajorconsiderationinprivateequity.ThismeasurementriskispartiallyoffsetbyGPsapplyingconservativevaluationsfortheirportfolios,inpartbecausereputationiscriticalforraisingthenextfund.

Investors,aswellasmanagers,arebecomingmuchmoreproactiveintermsofriskmanagement.AnecdotalevidencesuggeststhatmanyLPsnowconductriskanalysesnotjustofthefundforwhichtheGPissolicitingcommitments,buttheprivateequityfirmasawhole.Thisisaparticularlysensitivematterforthelargermulti-assetGPswhicharelistedonanexchange.

Likemanyotherassetclasses,privateequityinvolvessignificantrisk.Infact,lackingacontinuousmarking-to-marketmakesitmoredifficulttomeasureandmanagetherisks.However,inthepost-crisisworld,riskmanagementcouldbecomeanimportantbarriertoentry.FromaGPsstandpoint,investmentinriskmanagementtoolsand,indeed,personnelcanbeexpensive.Privateequitycharacteristicscreateuniqueperceptionsofriskandrequirelessconventionalriskmanagementprocedures.DifferentGPsmayhavedifferentriskmanagementneedsdependingonthetypeofprivateequityassetstheyinvestinandthelengthoftimeforwhichtheyareholdingthem.Forexample,anidealriskmanagementsystemshouldbeabletorunfuturescenarios,ratherthansimplyfocusingonthestateofthemarketatthetimeaninvestmentismade.Themorethoroughafirmsapproachtoriskmanagement,thehighertheprobabilityofitdeliveringbetterreturnstoLPs.

IntroductionContinued

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Coller Institute of Private Equity at London Business School ADVEQ Research Series on Private Equity 07Coller Institute of Private Equity at London Business School

Negligible or minor portion of fund return is attributable to market risk

Coller Institute of Private Equity at London Business School08 Coller Institute of Private Equity at London Business School08

Methodology and data

We use a survey instrument to collect data on the risk management practices of GPs. The survey questionnaire consists of over 50 questions to gather information about the funds managed and the GP characteristics, GPs internal policies on risk management and the evaluation of specific risks (regulatory, litigation, operational and market risks). The questionnaire has several different types of questions but mostly requires the respondents to select their answers from a list of options.

Theriskmanagementsurveycollectedtheviewsofarandomsampleof36GPsbasedinEurope(67%),theUSandCanada(22%)andAsia(8%).TheremaininggroupofGPsislocatedinAfricaortheMiddleEast.ItisdifficulttoassesswhetherthesampleofsurveyparticipantsformsarepresentativesampleofGPs,butweseemtocapturethetrendsintheindustrybyinvestmentstrategyatleast.ThemajorityoffundsmanagedbytheseGPsarededicatedtobuyouts(61%oftheGPsmanageatleastonebuyoutfund).Almostafifth(19%)ofoursamplemanageatleastonespecialsituationsfundand14%atleastoneventurefund.Otherfundstrategiesincludedinthesamplearedistressed,privatedebt,secondaries,realestate,growthequityandinfrastructure.

ThenumberoffundsmanagedperGPisreportedinFigure1:only17%oftheGPsinoursamplemanageasinglefund,withtherestmanagingatleasttwofunds.TheGPrespondentscontrolsignificantpoolsofcapital:58%manageatleast$1billion,while31%managebetween$250millionand$1billion(seeFigure2).AscanbeseeninFigure3,fundsinoursamplecoverabroadgeographicarea,with54%investinginEurope,23%followingaglobalfundstrategyand17%investinginNorthAmerica;Asia,AfricaandtheMiddleEastandOtherstrategiesaccountfortherest.Consistentwiththesizeofthefundsundermanagement,28%oftheGPshaveatleast25investmentprofessionalsinvolved.However,themajority(67%)havebetween5and25investmentprofessionals(seeFigure4).

Coller Institute of Private Equity at London Business School08

Coller Institute of Private Equity at London Business School ADVEQ Research Series on Private Equity 09Coller Institute of Private Equity at London Business SchoolColler Institute of Private Equity at London Business School ADVEQ Research Series on Private Equity 09

Figure 1: How many funds do you currently manage?

Figure 2: What are your total assets under management?

19% 17%

64%

58%

11%

31%

More than 5

Between 2 and 5

1 Fund

Greater than $1 billion

Between $250 million and $1 billion

Less than $250 million

Coller Institute of Private Equity at London Business School10

Methodology and dataContinued

Figure 3: What is the geographical focus of your fund(s)? Please choose one or more of the below:

Figure 4: How many investment professionals work in your firm?

6%

67%

6%

22%

0%

10%

20%

30%

40%

50%

60%

OtherAfrica and/or the Middle East

AsiaUS and/or Canada

EuropeGlobal

Greater than 50

Between 25 and 50

Between 5 and 25

Less than 5

ADVEQ Research Series on Private Equity 11Coller Institute of Private Equity at London Business School

General RiskManagement Questions

We start the assessment with several general questions to assess the importance of risk management strategies to GPs. A significant majority (73%) specify that they have in place a formal written risk management policy. In contrast, 23% have an informal risk policy, while 3% do not have any risk management policy.

GPsthathaveeitheraformaloraninformalriskmanagementpolicyassignresponsibilityforimplementingthispolicytoseniorprofessionalsinthefirm.Thishighlightstheimportanceofriskmanagementinthefundgovernance.InmostGPs,achiefriskofficer,amanagingpartner,theboardoranexecutiveriskmanagementcommitteeareresponsibleforimplementingtheriskmanagementstrategy.Theseresponsibilitiesarefurtherallocatedtootherlowerlevelcommitteeswhichmightincludeinvestmentandportfolioreviewcommittees,agroupofriskmanagementpartnersorregionalcommittees.Thesegroupsoftenreporttotheboardofthefirmand/ortheseniorpartners/CEOofthefirm.Theinvolvementofseniorprofessionalsinriskmanagementisconsistentwiththeirviewontheimportanceofriskmanagementwhenmakinginvestments.AccordingtoFigure5,83%oftheGPsrankriskmanagementashighorveryhighonthelistofconcernswhenengagingininvestments.

ThereisvariationinthesizeofgroupsprimarilyresponsibleforriskmanagementattheGPlevel.AsignificantpercentageofGPshasfewerthanthreepeopleassigned(41%),31%assignbetweenthreeandfiveprofessionals,while24%assignmorethanfiveindividuals(seeFigure6).

Themostimportantjustificationsforhavingariskmanagementpolicyare:concernsaboutcapitallossesintheportfolioinworstcaseoutcomes(96%ofGPs);improvementsinrisk-adjustedperformance(97%ofGPs);andLPrequestsforriskmanagementpoliciesduringandafterfundraising(93%ofGPs).Asmanyas16%ofGPsviewedregulatorychangesandrequirementsasnotbeingrelevanttotheirriskmanagementpolicies.

WealsoaskedtheGPstoidentifytheirhighestperceivedrisks.Thereisconsiderablevariationinresponsesbuttherisksmostfrequentlymentionedarethoserelatedto:foreignexchange,interestrates,political/regulatorychangesandthemacro-economyorbusinesscycle.Otherrisksmentionedaretheriskoffraudandcorruptpractices,reputationriskandliquidityrisks.

Whenaskedwhethertheseperceivedrisksaremanagedwiththehelpofexternaladvisorsonly41%oftheGPssaidyes.Basedontheresponseswereceived,externaladvisorsaregenerallyemployedtohelpwithmarketriskmanagement,suchasforeignexchangeandinterestrates,butalsopoliticalandregulatory(includingtax)risks.

Coller Institute of Private Equity at London Business School12

General RiskManagement QuestionsContinued

Figure 5: How high do you rank risk management concerns when you make investments at your firm?

Figure 6: How many persons are engaged primarily in risk management activities at the firm level?

10%

30%

53%

7%

0

10%

20%

30%

40%

50%

NoneMore than 5Between 3 and 5Less than 3

Low

Medium

High

Very high

Coller Institute of Private Equity at London Business School

Impact of regulatory and litigation risks

The Alternative Investment Fund Managers Directive (AIFMD) came into force on 1 July 2011 and the ultimate deadline for national law was July 2013. As a result it is being implemented across Europe during this year (2014). AIFMD affects most private equity firms who manage funds or have investors in the European Union. GPs must meet requirements (including disclosure) on remuneration practices, use third party custodian services, be transparent and report to regulators and engage in risk management. The Directive states that risk management duties must be assigned to a member of senior management who is not involved in making or managing the firms investments and that due diligence procedures should be formalized.

Similarly,theDodd-FrankWallStreetReformandConsumerProtectionAct(Dodd-Frank),whichwassignedintolawon21July2010,fundamentallyaffectedprivatefunds.Itintroducedanewrestrictiononbankingentitiesabilitytosponsororinvestinprivatefunds(theVolckerRule),andincludednewreportingrequirementsforfundmanagers.OneofthemostfundamentalDodd-FrankchangesaffectingprivateequityfundsistheeliminationoftheexemptionforprivateadvisorsfromregisteringwiththeSECasinvestmentadvisors.MostUSfundmanagerswith$150millionormoreinassetsundermanagementnowneedtoregisterwiththeSEC.

Finally,anothercriticalpieceofregulationistheForeignAccountTaxComplianceAct(FATCA),publishedbytheUSTreasuryDepartmentandtheInlandRevenueService,whichhaswide-rangingconsequencesfortheprivateequityindustry.FATCAhasa1January2014effectivedateandrequiresthatoffshorenon-USfundsbealreadyregisteredbythenwiththeIRSasParticipatingForeignFinancialInstitutions.Firmsareexpectedtohaveprocessesinplacetoaccuratelyclassifynewinvestorsandtomonitorthemforcircumstantialchanges.Compliancewiththisactextendsbeyondtherealmsoftaxtoincludeoperations,legal,investorrelations,riskmanagementandinformationtechnologyfunctions.Unsurprisingly,89%ofGPsareconcernedaboutregulatoryrisk.WithalargeproportionofoursampleconsistingofEuropeanGPsitisalsonotasurprisethat80%ofGPsareconcernedaboutAIFMDand60%aboutFATCA(seeFigure7).ConcernsabouttheDodd-FrankAct(andtheVolckerrule)comeinthird,with52%oftheGPsaffected.GPsoperationsarealsoaffectedbycountry-specificrules,suchasFINMA(Switzerland),theChinesegovernmentsregulations,orrulesissuedbytheSECintheUS.

The Volcker Rule prohibitions came into effect on 21 July 2012. Banking entities have a further period of two years from the effective date to

comply. Regulators may, upon application by any banking entity, extend the transition period for the requesting banking entity (i) for up to five

years (which is in addition to the two-year transition period), and (ii) to the extent necessary to fulfil a contractual obligation that was in effect on 1 May 2010.

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WhilemostGPs(58%)believethattheregulationsdonotprovideclearguidelines,theyhaveneverthelessmanagedtoovercomeimplementationhurdles(seeFigure8).OneGParguesthatregulationstodayarefarfromstaticandseemtoevolvetocopewiththeexternalenvironmentandindustrysophistication/complexity.Only8%oftheGPsthinkthattheregulationsareclearandinvolvestraightforwardimplementation,whiletheremaining23%arestillwaitingforclarifications.So,whilemostfirmsmanagedtokeepupwithregulation,manystillstruggletounderstandtheguidelinesprovided.

WefindclearevidencethatregulatorycomplianceisexpensiveforGPs.Welloverhalf(60%)ofGPshadtosetupadditionalcompliancegroupstodealeffectivelywithnewregulations(Figure9).Also,onaverage,GPsassessthedirectcostsofcomplianceasbeingrelativelyhigh(48onascalefrom0to100,with100forveryhighcosts).Nearlyall(98%)ofGPsseeeithernoormarginalbenefitsfromtheseregulations(Figure10).

GPfundraisingeffortsseemtobemostaffectedbythenewregulations(72%oftheGPsareaffected).Inaddition,operational(68%),investment(64%)andtaxactivities(28%)aresignificantlyaffected.Only12%(6%)ofGPshaveadjustedtheircompensationarrangements(duediligenceprocedures)asaresultoftheseregulations,whiletheresthavenot.Altogether

abouthalf(44%)ofGPsviewthenewriskmanagementregulationsofsignificanceconsequencetotheirmanagementpractices.ApartialexplanationforthisresultisthatGPsexpectgreaterliabilityriskasaresultoftheregulations.

Figures12and13captureGPsconcernsaboutliabilityriskassociatedwiththeirinvestmentprocesses.Asignificantproportionofthesurveyparticipantsareeitherconcernedorveryconcernedaboutthisrisk(67%).MostGPs(89%)mitigatethisriskbyusinglegaladvisors,somehaveanin-houselegalteam(43%)orpurchaseliabilityinsurance(50%).Theyalsocreatetransactionstructuresthateliminatelegacyrisksandprovideprotectionorrelyonmorethoroughduediligenceprocedures,coupledwithtransparentandrigorousapprovalprocesses.

Impact of regularatoryand litigation risksContinued

GPs find new regulation unclear and increasing compliance cost withno or marginal benefit.

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Figure 7: Which regulations affect your firm? Please choose one or more answers below.

Figure 8: Do the regulations provide comprehensive guidance regarding the implications for your firm?

0% 10% 20% 30% 40% 50% 60% 70% 80%

AIFMD (Alternative InvestmentFund Manager Directive)

EMIR (European MarketInfrastructure Regulation)

Dodd Frank Act/Volker Rule

FATCA (Foreign AccountTax Compliance Act)

Other country specific regulation(Please specify)

Project/ transaction-specificregulatory risks and uncertainties

0% 10% 20% 30% 40% 50% 60%

12%

23%

8%

58%

Yes, regulation(s) are clear andstraight forward to implement

Yes, regulations(s) are not clear and straight forward to implement but the firm managed

to overcome these hurdles

No, the regulations are not clear and straight forward to implement but the firm managed

to overcome these hurdles

Other(Please elaborate)

Coller Institute of Private Equity at London Business School

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Impact of regularatoryand litigation risksContinued

Figure 9: Did you have to set up an additional compliance group within the firm to deal with the impact of the regulation(s)?

Figure 10: Are there any perceived benefits from the regulation(s) for your firm?

60%

40%

48%

48%

4%

No

Yes

No

Yes, but only marginally

Yes, significantly

Fundraising

Investment process

Operational process

Tax liability

Other (please specify)

The Adveq Applied Research Series 017

text

ADVEQ Research Series on Private Equity 17Coller Institute of Private Equity at London Business School

Figure 11: Which areas of the firm are impacted by the Regulation?(Please choose one or more answers)

Figure 12: How concerned is your firm about legal/litigation risks associated with the investment process?

0% 10% 20% 30% 40% 50% 60% 70% 80%

46%

21%

32%

8%

28%

68%

64%

72%Fundraising

Investment process

Operational process

Tax liability

Other (please specify)

Not concerned

Somewhat concerned

Very concerned

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Impact of regularatoryand litigation risksContinued

Figure 13: How do you mitigate legal/litigation risks? Please choose one or more answers below:

0% 20% 40% 60% 80% 100%

43%

89%

50%

11%

0%

Installing legal team in-house

Obtaining advice from law firm(s)

Purchasing liability insurance

Other solutions (Please specify)

Do not mitigate

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Managing operational risks

Our survey also seeks to evaluate GPs perception of operational risks. Operational risks are those that are not purely investment-related in nature but that arise from the private equity funds daily management and business operations. These operational risks can cover anything from unexpected irregularities in back office operations to counterparty and compliance-related risks.

ThetopsixoperationalrisksidentifiedbyGPsare,inorderofimportance(percentageofGPsmentioningtheseasimportantorveryimportantisinbrackets):(1)Failuresininternalduediligenceprocedures(84%);(2)Fundraisinguncertainty(80%);(3)Abilityofmanagementteamstodeliver(80%);(4)Potentialweaknessinportfoliocompaniesaccountingorreportingsystems(72%);(5)Managementturnoveratthefirmorportfoliocompanylevel(68%);(6)Weaknessinportfolioriskevaluation,eitherformalorinformal(68%).OtherimportantoperationalriskshighlightedbyGPsarepotentialweaknessesintheaccountingorreportingsystemsatthefundlevel,fraud,ITdisruptionsorcompliancewithhealthandsafetyregulations.

MostGPsindicatethattheyareregularlymeasuringortrackingtheriskassociatedwithfundraisinguncertainty,managementturnoverandrecruitingavailabilityforportfoliocompanies,potentialweaknessesinportfoliocompanyaccountingandpotentialfailuresintheirinvestmentduediligenceprocesses.OnlyafewoftheGPstracktheavailabilityofdebtcapitalorportfoliocompanyconcentrationrisk.

Thetoolsusedtomeasureandmitigatetheserisksvaryconsiderably.Thisisdrivenbythemanyidiosyncraticcharacteristicsandprivateequityfirmsfollowdifferentinvestmentstrategiesandhavevariedresources.Approximately65%ofGPsmanagetheirtopthreeoperationalrisksregularly(seeFigure14).Themonitoringoftheserisksoccursatalllevels(portfoliocompany,fundandfirm):morethan50%oftheGPsmeasuretherisksatalllevels(Figure15).

Forinstance,fundraisinguncertaintyismitigatedbymaintainingregulardiscussionswithexistingandprospectiveLPs,evaluatingthesuccessofpriorfundraisingefforts,bysurveyingLPsorbyminimizingexposuretoanysingleLP.Failuresininternaldue

diligenceprocessesareassessedandmitigatedbyperformingquarterly(andsometimesmonthlyorweekly)reviewsofportfoliocompaniesperformancerelativetokeyperformanceindicators,byrunningpostmortem-typeanalysesorbyinvolvinginvestmentcommitteemembersintheduediligenceprocess.Managementavailabilityandturnoverismitigatedbyhavingawrittenpolicyonrecruitment,byclosecollaborationwithexecutivesearchfirmstomaintainanactiverosterofbackablebuy-inexecutives,bykeepingacertainratioofseniorprofessionalsonthepayrollversusthenumberofprofessionalstheGPthinksitshouldhave,byensuringafairworkloadspreadamongmembersofthemanagementteamsandbyexaminingcloselytheperformanceandworkofthemanagers.Potentialweaknessesinportfoliocompanyreportingaremitigatedbyimplementingfund-wide,standardizedreportingframeworksorbyappointinganaccountanttotheboardofthecompanywithsoleresponsibilityforcheckingandbalancingtheoperatingpartnerinchargeofthatportfoliocompany.SomeGPsimplementquantitativemetricstotrackoperationalrisksbutthemeasurementoftheserisksremainsinherentlysubjective.WealsocollectedinformationonthetechnologytoolsthatGPsusetotracktheserisksandfoundthattheytypicallyusebasictools,suchasExcelsoftwareorbasicreportingtemplates,ifany.

Interestingly,80%ofGPsperformmitigationactivitiesattheprivateequityfirmlevel,whileonly40%dosoalsoatthefundlevel(Figure16).Riskmitigationactivitiesareoftenbenchmarked,withthemostcommonbenchmarkbeingafirmspreviousexperienceintimesofstress(SeeFigure17).AnotherbenchmarkoftenusedbyGPsisabestpracticebenchmarkoftenproposedbyacademiaorconsultants.About14%oftheGPsperformnobenchmarking(Figure17),while54%useatleasttwobenchmarks.

WefindthatreportingtoLPsofoperationalriskmagnitudeandthemeansbywhichitismitigatedisrelativelylimited.Most(73%)GPsdonotreportinformationontheserisksexternallytoLPs.Iftheydoreport,thefrequencyismostlythesameasthefrequencyofreportedportfolioperformance,ifnotlower.Onlyasmallminorityofrespondentssaytheyreporttheserisksmorefrequentlythantheyreportfundportfolioperformance.

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Coller Institute of Private Equity at London Business School20

Univariate Evidence onPrivate Equity AllocationsContinued

Figure 14: Do you manage your top three operational risks?

Figure 15: At what level are these top three operational risks measured? Please choose one or more answers below:

65%

35%

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Firm (or GP) level?Fund level?Investment (i.e. portfolio company)

level?

61%

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No

Yes

Managingoperational risksContinued

Coller Institute of Private Equity at London Business School

Figure 16: At what level(s)do the mitigating activities take place?Please choose one or more options below:

Figure 17: How do you benchmark your operational risk mitigation activities? Please choose one or more answers below:

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Firm (GP) level?Fund level?Investment (i.e portfolio company

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Compared to your firms past experience/observed results in times of stress

Comparing to best practices as they areproposed by academia/consultant

Comparing to peer firms29%

43%

64%

7%

14%

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22

Managing market risks

The relationship between GPs and LPs is governed primarily by the Limited Partnership and the Investment Management agreements. This documentation is often quite flexible about market risk management activities. For instance, the manager may, but is not obliged to, enter into currency or interest rate hedging transactions on behalf of the partnership. The manager may also have the authority to enter into hedging arrangements to mitigate interest rate or currency risk for an investments realization proceeds once a sale decision has been made. Very often though, GPs may be pushed to look at hedging these risks at the portfolio company level by lenders who need better protection for their interest.

Withvolatilityacrossassetclassesrising,hedgingvariousmarketrisks,suchascurrency,interestrateorcommodityrisks,couldhelpprivateequityfirmsimprovetheirreturnonequity.Obtainingconsistentlygoodreturnsisbecomingmuchmoredifficultand,asmarketvolatilityincreases,managingtheseriskspoorlycandrasticallyreducethereturnonequity.

Inoursurvey,GPsrankedtheinterestrateriskasthemostimportantrisk,followedbyforeignexchangeandcommodityrisks.TherelianceofsomeGPsonleveragecertainlyincreasestheirvulnerabilitytorisinginterestratesandeconomicshocks.Othermarketrisksmentionedwerestockmarketandeconomiccyclerisks.InflationriskwasconsideredtobeunimportantbymostGPs.Thetopthreemarketrisks-interestrate,foreignexchangeandcommoditypricefluctuations-aretypicallymeasuredattheportfoliocompanylevel.Themostcommonwaytomeasuretheserisksistolookatthenotionalsizeoftheexposureand/ortoperformstress-testing.MorequantitativemethodsofmarketriskassessmentsuchasValueatRiskorCashFlowatRiskareneverused(SeeFigure18),althoughthesecouldimproveGPsmeasurement.

TheimportanceofmarketrisksforprivateequityfundperformanceishighlightedinFigure19.Nearlytwo-thirds(61%)ofGPsbelievethatmarketrisksaffectfundNetIRRsbyupto25%,whichisquitesignificant.Infact,another8%ofGPsbelievethattheimpactoftheseriskscanshifttheNetIRRoftheirfundsbymorethan25%.

So,giventhepotentiallylargeimpactonfundperformance,doGPshedgetheserisks?AswereportinFigure20,foreignexchangerisksarethemostcommonlyhedged(61%ofGPs),while40%ofGPshedgeinterestraterisksand20%hedgecommoditypricerisks.Althoughinterestrateriskisrankedasthemostimportant,itisnottheonehedgedmostfrequently.Potentialexplanationsarethatinterestraterisksmightbemoreexpensivetohedgeortheyaremitigatedbyborrowingatfixedrates.AmongGPsthathedgetheserisks,73%hedgeattheportfoliocompanylevel.Only27%ofthemmighthedgesomeoftheserisksatthefundlevel.Thisoutcomeissomewhatsurprising,giventhesignificantpotentialimpactofforeignexchangevolatilityonfundreturns.Forinstance,adollar-denominatedfundinvestinginasterling-basedcompanymaysignificantlyreduceitsreturnifsterlingweakensbetweenpurchaseandexitdates.Takenonestepfurtheristhereanycross-portfoliocompanyriskmanagementtonetoutthepotentialeffectsofallportfoliocompanyforeigncurrencyriskexposures?

Consistentwiththeinterpretationthatprivateequityfirmsarebeginningtodevelopmarketriskmanagementfunctionsandaremakinggreateruseofderivatives,wedocumentinFigure21that64%ofGPsthatengageinmarketriskhedgingactivitiesusefinancialderivatives.TheremainingGPseitherhedgewithdebtinstruments(14%)orrelyonnaturalhedgingarrangements(21%),suchasborrowingincurrenciesinwhichportfoliocompaniesproducesurpluscash.Themostimportantconcernsassociatedwithhedgingmarketrisksaretheadditionalcostsincurredfromadjustingthehedgingandliquidityrisks,respectively(seeFigure22).

Incontrasttooperatingrisks,62%ofGPsreportinformationaboutmarketriskstotheirinvestors.Also,amongtheGPsthatreporttoinvestors,92%reportmarketriskinformationwiththesamefrequencyasthatofreportingforperformance.

Coller Institute of Private Equity at London Business School

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Figure 18: How do you measure the top 3 market risks? Please choose one or more answers below:

Figure 19: What proportion of your firms most recent fund return (e.g. Net IRR) do you think is attributable to market risks?

0% 10% 20% 30% 40% 50%

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More than 50%

Up to 50%

Up to 25%

Neglible

Notional exposure size

Stress testing (scenario analysis)

At-risk analysis (Var, CFaR, ...)

Other (Please specify)

Do not measure them

Coller Institute of Private Equity at London Business School

Coller Institute of Private Equity at London Business School24

Figure 21: Were the market risks hedged using:

0% 10% 20% 30% 40% 50% 60% 70% 80%

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64%Financial derivatives

Debt

Natural hedging

Diversification

Figure 20: Which market risks did you hedge?

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OtherInflationFOREXCommodity pricesInterest rates

61% 80% 39% 100% 100%

39%

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Hedged

Managingmarket risksContinued

Coller Institute of Private Equity at London Business School The Adveq Applied Research Series 25

Not hedged

Hedged

Figure 22: Please rank your concerns about potential consequences of hedging market risks.

0

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Third ConcernSecond ConcernFirst Concern

69% 19% 13%

6%

19%75%

25%

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13%

Additional cost incurred from adjusting the hedging

Counterparty risks

Liquidity risk

Coller Institute of Private Equity at London Business School

Authors Biographies

Eli Talmor

EliTalmorisProfessoratLondonBusinessSchoolandFounderofitsCollerInstituteofPrivateEquity.HewaspreviouslyaprofessoroffinanceattheUniversityofCalifornia(UCLAandIrvine),TelAvivUniversityandtheWhartonSchool(UniversityofPennsylvania).

ProfessorTalmoristheco-authorofInternationalPrivateEquity,broadlyconsideredasthereferencebookoftheprivateequityindustry.Heisfrequentlyinvitedtodeliverkeynotespeechestobusinessexecutivesworldwideandinterviewstointernationaltelevisionnetworksandnewspapers.InrecentyearshehasbeenaskedbytheUKParliamenttoprovidealeadingtestimonyatitshigh-profilehearingsonprivateequityandtoadvisetheUKPrimeMinisterialoffice.

HeservedontheboardofGovernorsofLondonBusinessSchoolandtheadvisoryboardoftheAfricanVentureCapitalAssociation.Business-wise,hepracticesventurecapitalwithmultiplesuccessfulexits;notablyheco-foundedSunRayRenewableEnergy,whichwasacquiredin2010inatransactionconsideredasoneEuropeslargestventureexitsofthatyear.

ProfessorTalmorholdsaPh.D.fromtheUniversityofNorthCarolinaatChapelHillandB.Sc.(CumLaude)fromtheTechnionIsraelInstituteofTechnology.

Florin Vasvari

FlorinVasvariisLBSTermAssociateProfessoratLondonBusinessSchoolandFellowattheCollerInstituteofPrivateEquity.Heco-teachesthePrivateEquityandVentureCapitalaswellasDistressedInvestingandFinancialRestructuringcoursestoMBAandExecutiveMBAstudentsinLondonandDubai.

ProfessorVasvariistheco-authorofInternationalPrivateEquity,broadlyconsideredasthereferencebookoftheprivateequityindustry.HeisservingontheeditorialboardofthreetopacademicaccountingjournalsandisregularlyinvitedtopresenthisresearchattopbusinessschoolsintheU.S.ProfessorVasvariisactivelypursuingresearchonprivateequitytopicsanddebtmarketsandhaspublishedextensivelyintoptierbusinessacademicjournals.

Hehasalsobeenadvisingonprivateequityrelatedissuesseveralorganizations,includingafundof-fundsandasovereignwealthfundandsitsontheadvisoryboardofseveralprivateequityorganizationsinLondon,DubaiandBerlin.

ProfessorVasvariholdsaPh.D.inManagementfromtheUniversityofToronto,RotmanSchoolofManagementandanM.A.inEconomicsfromUniversityofToronto,DepartmentofEconomics.

02626 Coller Institute of Private Equity at London Business School

Coller Institute of Private Equity at London Business School The Adveq Applied Research Series 27

Coller Instituteof Private Equity

HousedwithinLondonBusinessSchool,theCollerInstituteofPrivateEquityhasasitsprimaryfocustheestablishmentofaworldrenownedresearchcentreanddebatingforumonprivateequity.

Castingabridgebetweentheacademicandpractitionerworlds,theInstitutehasnopredeterminedagendaorposition.Wearededicatedtotherigorousanalysisandsynthesisofdatatoestablishandpromotenewinsightsandsofacilitateabetterunderstandingoftheindustry.

Weareinterdisciplinaryinourapproachtoresearchtoencompassstrategy,economics,organisationandmanagementaswellasfinance.

Integraltoourvision,istheprovisionofworldclasseducationbothtoourstudentsandexecutivesviatheprivateequityelectiveandCollerInstituteMasterClass.

TheInstitutehostsseveraleventsintheUKandabroadandpublishesabi-annualresearchjournal,PrivateEquityFindings.

DirectorProfessor Francesca Cornelli

Executive DirectorNicole Hergarten-Tucker

Contactcollerpe@london.eduwww.collerinstitue.com

Coller Institute of Private Equity at London Business School

of Private EquityColler Institute

London Business School, Regents Park, London NW1 4SA, United KingdomTel: +44 (0)20 7000 8126 Fax: +44 (0)20 7000 7000www.london.eduA Graduate School of the University of London