Understanding the Underlying Risk in PE Portfolios

“Effective risk management ability in private equity is the backbone of success for any professional in the asset class, no matter what your role, where you are based and what your exposure may be,” according to Private Equity International. “Risk has become a hotly debated concept, borne out of the global financial crisis – managing risk is a core competence that should remain high on your professional agenda.”

PERACS has developed The “PERACS Portfolio Risk Curve,” a novel way to graphically and numerically capture risk components of private equity, drawing on a well-established methodology used by macro economists that is computationally simple and intuitively powerful.

Based on the net profit contribution, or Alpha, PERACS plots each fund investment in an institution’s private equity portfolio on a simple curve that shows the proportion of total profit assumed by a given percentage of all investments, as seen in the below chart.

The “PERACS Portfolio Risk Curve” of a Typical Portfolio


Every point on the PERACS Portfolio Risk Curve corresponds to a statement such as “the bottom 40% of this portfolio represents 30% of portfolio profits.” A perfectly equal profit distribution would be one where every investment generated the same profit and would correspond to straight line at a 45 degree angle on this chart.

Each portfolio will appear much differently, when plotted on this graph, corresponding to the way it generates returns and at what risk. A highly skewed portfolio like venture capital return distributions would have a long and deep shape with a steep upswing at the far right of the chart, such as the below chart. This means that a large percentage of the profits are generated by only a handful of funds, which the majority lose money or, at best, break even. The shape of this curve is quantified in the PERACS Portfolio Risk Coefficient which takes values from zero (= uniform performance distribution) to one (=all returns concentrated in one single investment).

Measuring and Benchmarking Capital Risk in your portfolio

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PERACS Portfolio Risk Curves are not only a powerful tool to quantify and visualize the capital risk across different parts of an LPs portfolio, they also make it possible to perform a “Capital Risk Benchmarking” by comparing the risk curve for a sub-set of the LPs portfolio to the risk curve for corresponding part of the private equity universe. Consider the example of an LP who invested in 14 buyout funds, the performance of which is distributed as per the yellow curve. This curve indicated no loss makers and a steady shape with the best 50% of all funds responsible for 80% of all returns. Comparing this to the risk curve for all Buyout funds according to any of the large data providers, we see that the yellow curve indicates a much more balanced return distribution, i.e. a lower capital risk. In fact the blue curve, which captures the capital risk across all 156 buyout funds in this data set reveals that 5% of these funds did not return capital, and that the worst 1/3 of these funds cumulatively did not generate any returns. This is also reflected in the lower risk coefficient for this LP (0.38 compared to 0.55).

Using this approach LPs can understand how good or bad their fund selection choices have been not only in terms of the returns generated but also in terms of capital risk.



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