An Objective Assessment of Risk in Emerging Markets PE

According to an EMPEA survey, 40 percent of limited partners this year plan to increase their emerging markets allocations, but 22 percent plan to reduce commitments, a jump in those leaving PE of 6 points from last year. These survey results show that while investors continue to see opportunity in emerging markets, an increasing number believe risk outweighs the reward. As the rapidly changing emerging markets continue to produce attractive, albeit risky, investment opportunities, how can limited partners objectively assess risk?

In a recent EMPEA webcast, Dr. Oliver Gottschalg discusses the PERACS Risk Curve Benchmark, which enables limited partners to accurately assess risk to make more informed investment decisions in emerging markets.

The PERACS Risk Coefficient quantifies and illustrates emerging markets risk

Many private equity metrics benchmark performance instead of risk, because risk is so difficult to quantify. While risk variables in emerging markets are especially complex and challenging to measure, the PERACS Risk Curve Benchmark presents a novel way to assesses risk at the deal, fund and portfolio levels. It illustrates the proportion and dispersion of the net profit contribution, or cumulative PERACS Alpha, generated by the poorest-performing percentages of funds (as measured by the percentage of deals).

The calculated risk profile, or the shape of the PERACS Risk Curve, is expressed by the PERACS Risk Coefficient, which depicts the skewedness of return values from 0 (perfectly uniform distribution) to 1 (perfectly concentrated Alpha). In the emerging markets benchmark scenario below, both Fund V and VI are less risky than the two benchmarks because they have less skewed returns and lower PERACS Risk Coefficients. Benchmark 00-05 is the riskiest of the group because only the best 20 percent of its portfolio produced positive returns.

peracs risk curve

The PERACS Risk Curve Benchmark objectively measures emerging markets risk

A benchmark must be objective to accurately assess the dynamic risk profiles of emerging markets investments. The PERACS Risk Curve Benchmark fulfils this mandate by 1) comparing funds through a peer-based approach, and 2) quantifying risk based on PERACS Alpha as its underlying metric. The Benchmark is able to produce a more accurate risk profile of funds by comparing an empirically-derived group of “relevant peer funds.” These funds are grouped together by similarities in their underlying assets, such as deal characteristics and investment focus, not superficial, arbitrary or subjective attributes including vintage year, geography or size. PERACS Alpha, the Risk Curve Benchmark’s underlying metric, quantifies risk objectively by measuring outperformance created by a manager’s underlying value creation skillset. It also corrects for the biases of IRR, the metric used in most private equity benchmarks.

As limited partners adjust their emerging markets allocations, understanding fund performance is important, but knowing the risk involved is critical.

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