Wed, 12/03/2014 - 13:40
Unigestion has developed a new framework within which to assess risk in private equity in a new piece of research undertaken in collaboration with EPFL.
The new approach differs from others in two major ways. First, it is 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.
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 unsatisfactory: intermediate valuations significantly understate true risk due to the self-referring nature of private equity returns, while final multiples rely on 10-12 years of history and therefore will only illustrate a fund’s performance once it has been liquidated rather than throughout its entire life.
Unigestion has designed a risk measure called Expected Cumulative Downside Absolute Deviation (ECDAD) which uses fund cash flows as an input and 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. Furthermore it can be applied to either a single fund or to groups of funds. The research is based on the cash flow data of 1,402 funds and approximately 88’000 individual cash flows spanning from 1996 to 2012. The data was sourced from Preqin.
The ECDAD risk measure enhances Unigestion’s ability to construct optimally risk adjusted top down allocations between different segments of the private equity market (e.g. large buy out, mid-market buy out, venture capital, turnaround, mezzanine). The new measure will also assist Unigestion in finding the appropriate level of diversification for tailor made portfolios depending on the client’s individual objectives.
Hanspeter Bader, managing director and head of private assets at Unigestion, says: “There is a very clear need for improved risk assessment in private equity portfolios. We have already seen significant benefits in applying the ECDAD measure to our investment analysis, enabling more effective risk management and diversification. This new methodology also illustrates the importance of the use of applied research and partnerships with leading academic bodies, such as the Swiss Finance Institute at EPF Lausanne, in creating tools that add real value to our clients’ investment activities.”
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