It was 'back to school' for the final day of SuperInvestor 2015, with several illustrious academics invited to help the private equity industry close out the conference. Class assignment for Day 3: The private equity industry faces risk in various ways (eg, risk measurement, retention risk and reinvestment risk and even the use of risk in value creation) but are we taking the proper approach to dealing with them? Discuss.
The first lesson of the day was that there is no such thing as a single, best measure of risk in private equity. While there is obvious appeal in having a universal risk metric, it is unlikely that this would be meaningful for everyone. Risk is subjective, according to Cyril Demaria (Executive Director, Private Market Analyst, Chief Investment Office, UBS), and so we should adopt risk measures that suit the context of a particular investor. Moreover, the same measures might not even hold the same significance
for different investors. Peter Cornelius (Managing Director, AlpInvest Partners) illustrated this point using the example of Value at Risk (VaR). For a large institutional investor, private equity is typically only a small part of its investment portfolio and so the VaR of that allocation is unlikely to be significant overall. A family office, on the other hand, is likely to pay more attention to this VaR, as private equity may well be a larger, or even the largest, allocation in its portfolio. When interpreting
risk metrics, then, we must apply a subjective overlay to figures. As Mr Demaria said: it is better to be roughly correct, than precisely wrong.
LPs are also obviously concerned about GP talent and so, when it walks out the door, it can have serious consequences for a firm's ability to raise a new fund or can dramatically lower the amount raised. Taking us deeper into the world of academia, Josh Lerner (Jacob H. Schiff Professor of Investment Banking, Harvard Business School) shared some brand-new research insights on retention within private equity firms. The data, collected by a large global LP, indicates that the allocation of carried interest
has little relationship to past performance. Instead, it was more driven by status – was the person a founder or not? In fact, 'junior' partners who leave a firm have, on average, a lower allocation of carried interest, despite better past performance than those who stay. Finally, according to Mr Lerner, the data reveals that those firms with a more dramatic split of carried interest are more likely to see leavers. Even though firms tend to have limited defections, the research suggests that
firms take more notice of the dynamic consequences of such partnership economics.
LPs currently have more money than they know what to do with, according to Robert Coke (Head of Absolute Return & Buy-Out Investing, The Wellcome Trust). The traditional private equity timeframe of five-year investment / five-year realisation is producing a flood of capital back from GPs, ramping up reinvestment risk for LPs. Unsurprisingly, investors are turning to evergreen and longer-term funds to mitigate the problem. Mr Coke is looking to emerging markets, with lesser-known managers, where
the opportunities for longer-term investment are generally superior to those for short-term. Other investors, such as Allen MacDonell (Senior Director, Private Equity, Teacher Retirement System of Texas) and Jim Fasano (Managing Director, Head of Funds, Secondaries & Co-Investments, Canada Pension Plan Investment Board) are working with more established managers to extend their existing relationships into longer-term structures. Regardless of approach, GPs should take note of the common concerns
LPs share with respect to long-term funds being set up next to traditional funds, such as:
- deal allocation between the funds
- suitability of deals – investments with multiple levers (e.g., operational improvements) might warrant a shorter-term hold
- favouring LPs in one fund over the other
- marketing or 'hyping up' one product over another
- the impact of LPs exiting long-term funds on LPs who remain
- NAV-based compensation structures, where calculations are made by the GP who also receives the carried interest
It is often said that 'if there is no risk, there is no reward' – but can we turn risk itself into reward? In the final session of SuperInvestor 2015, attendees were encouraged to change the conversation when it comes to ESG – from compliance to value-add. Yvonne Bakkum (Director, FMO Investment Management) is concerned about transparency and works closely with GPs to move beyond procedural ESG reporting to focus on substance – drilling down to understand the essence of ESG and the
value creation it can bring to portfolio companies. A strong reputation for ESG performance can also act as a competitive advantage for a GP as a potential buyer of a portfolio company, according to Blaise Duault (Head of Compliance and Public Affairs, PAI Partners), as it makes them a more attractive suitor. He has gone so far as to create a 'sustainability club' which acts as an annual forum for the sustainability managers of portfolio companies, both past and present, to meet and share ESG learning.
The panel were unanimous in the view that, going forward, the industry needs further education and engagement to realise the full potential of value creation in ESG.
These discussions reveal that the risks in private equity are present in many forms but we, as an industry, perhaps have not done enough to fully understand them and appreciate their implications. What is clear, however, is that players who continue to fail to account for, or capitalise on, risk may well be passing up significant opportunities for competitive advantage.
Summary of SuperInvestor 2015 Main Conference Day 1
Summary of SuperInvestor 2015 Main Conference Day 2