Archive for October 5th, 2010

Mission Impossible? Managing Risk in Private Equity Portfolios

October 5, 2020

Josh Lerner, Harvard Business School, will speak at SuperReturn Middle East, 18 - 20 October 2020


Josh Lerner, Jacob H Schiff Professor of Investment Banking, Harvard Business School, will be presenting new research at the SuperReturn Middle East conference in Abu Dhabi (18 - 20 October 2020) on risk management.

This talk will grapple with what is in many respects the most challenging questions in private equity today.  There are no firmly established answers as to how risk and reward should be assessed in this industry.  This arena is a rapidly changing one, with new ideas and approaches emerging every year.

Why should the decision to allocate money to private equity pose more difficulties than other asset classes, such as government bonds or European equities?  The crucial problem lies in the nature of the investments that general partners make.  What makes private equity particularly tricky to evaluate is the fact that private firms affected by three essential problems:

  • First, the firms receiving capital from private equity funds very often remain privately held for a number of years after the initial investment.  These firms have no observable market price. In addition, the private equity funds themselves, which are typically structured as private partnerships, do not typically trade on an organized public market.  Hence, investors cannot observe their valuations.
  • Second, valuations assigned by private equity firms to their own portfolio of investments are often based not on quantitative metrics (such as price-to-earnings, market-to-book, or discounted cash flow), but rather on complex, frequently subjective assessments of a venture’s technology, the market opportunity it can expect and its management team.
  • Finally, private equity valuation levels, as a whole, appear to rise and fall dramatically over time in response to the fundraising environment.  For example, when considerable capital is flowing into private equity funds, valuation levels rise significantly, and vice versa.  Work exploring the U.S. venture capital industry makes this point explicitly, showing that each doubling in the level of fundraising was associated with between a 7% and 21% increase in valuation.  These results suggest that more than the forty-fold increase in venture fundraising between 1991 and 2000 in the United States alone led to a six-fold increase in valuation levels.


But despite these difficulties, practices in this arena seem far from ideal. A recent example is from the buyout industry following the September 2008 financial crisis. During the fourth quarter of 2008, private equity funds reported returns of -16%, according to Cambridge Associates. This might seem bad enough, but many observers were skeptical about these reported returns. In particular, they pointed out that over the same period, the S&P 500 declined by nearly 22% and many other benchmarks did even worse. Moreover, in most cases the equity of the buyout funds was highly leveraged, and thus the effect of any losses should have been magnified.

Based on these vignettes, many readers might end up agreeing with Bob Boldt, the head of University of Texas’ endowment, who when discussing the private equity performance numbers that the University had disclosed, noted “I hope when people write about these numbers, they include some sort of warning like on cigarette packages.  They can be harmful to your health if you pay attention to them.  To be sure, the calculation of private equity returns is not an easy challenge. But as we will discuss in the session, there are ways to look systematically at these issues.

In general, it is hard to be convinced that there is a definitive answer about thinking about the risk and returns of private equity. In general, it is fair to say that most studies conclude venture firms match or slightly exceed the benchmark, while most suggest that buyout funds lag returns. But few studies have included the boom period for buyout funds in the mid-2000s and the subsequent bust, and thus, subsequent funds may differ.  Moreover, the results seem incredibly sensitive to assumptions made while modeling the evolution of the value of private equity portfolios.

Nonetheless, the importance of the topic cannot be understated.  As the recent financial crisis has underscored an understanding of the risks one is assuming is absolutely essential.  Thus, investing in understanding the key issues in this arena will pay substantial dividends.

About Josh Lerner

Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School.  His focus is on the world of alternative investments, with a particular emphasis on venture capital, private equity, and sovereign wealth funds.  He also examines how public policies can boost entrepreneurship, most recently in the book Boulevard of Broken Dreams. In the 1993-94 academic year, he introduced “Venture Capital and Private Equity” has consistently been one of the largest elective courses at Harvard Business School.  He is leading an international team of scholars in a multi-year study of the future of alternative investments for the World Economic Forum.

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