Risk-Taking in Private Equity. Evaluation of the main value drivers in PE and Comparison of risk measures

Bachelor Thesis, 2017

36 Pages, Grade: 1,3


Table of contents

List of figures

List of abbreviations

1 Introduction

2 Cash flow, return and risk characteristics
2.1 Value added by General Partners
2.1.1 Financial engineering
2.1.2 Operational engineering
2.1.3 Governance engineering
2.1.4 Fees and compensation charged by General Partners
2.2 How General Partners impact risk-taking

3 Evaluating risk on fund level
3.1 Risk factors
3.1.1 Shortfall risk
3.1.2 Funding risk
3.1.3 Liquidity risk
3.2 Research on historical risk frameworks
3.3 Relevance of traditional finance approaches
3.4 Measuring risk in return

4 Risk perceived by investors
4.1 Significance of track records in Private Equity
4.2 Relevance of recent advances in behavioral finance
4.3 Identifying proxies for perceived risk
4.3.1 The Anzoni/Zeisberger methodology
4.3.2 Application on Private Equity

5 Conclusion


List of figures

Figure 1: Example of a return distribution as presented in Experiment 2.

Figure 2: Exemplary return distributions for an application in Private Equity.

List of abbreviations

illustration not visible in this excerpt

1 Introduction

Private equity (PE) firms like Blackstone, Carlyle or KKR became publicly known through huge acquisitions, such as the takeover of RJR Nabisco.[1] Following these highly leveraged deals, some investors were able to generate stunning profits in the field of PE.[2] In absolute numbers, the rather new asset class of PE has seen a strongly increasing capital inflow by investors, reaching an estimated USD 3 trillion capital under management in 2012.[3] Yet, in the same way as in other types of investments, returns in PE are coupled with risk-taking. Additionally, PE funds are highly illiquid and withdrawing invested capital is difficult, a key issue for investors. Previous research is consistent in reporting substantial risk that has to be faced by investors in PE. This thesis will focus on risk-taking in private equity from an investor’s perspective.

PE funds are run by specialized investment firms and are structured as partnerships of general partners (GP) and limited partners (LP). LPs allocate capital to investment opportunities in the field of non-publicly traded securities provided by GPs. LPs are composed of institutional investors, often pension funds, but also life insurance companies, endowment funds, sovereign wealth funds, funds of funds, or wealthy individuals.[4] As retirement savings plans mostly come with a built-in capital protection, the risk of losing capital is a grave danger for pension funds, which might not be able to fulfil their payment obligations in that case.[5] With consumer finance asset managers investing a tremendous amount of capital in PE, downside risk and upside potential of PE affect not only the academic research, but also a wider audience.

In the asset class of PE two distinct segments exist, buy-out and venture capital.[6] Both segments are much alike when it comes to fund raising, but differ vastly in their investment behavior. Buy-out-type funds buy out current owners, or heirs of previous owners, to acquire a controlling stake in mature companies. Target companies usually have high and stable cash flows, to allow for equity-light investments with high ratios of leverage through debt financing. Such transactions are specified as leveraged buy-outs (LBO). Venture capitalists on the contrary, specialize in funding promising ventures in their start-up phase, from seed-phase business angel activity to early stage and growth funding through to later stage investments. Being disqualified for debt financing due to their empirically significant failure rate, start-ups seek outside equity financing. In exchange for stakes in equity, a venture capitalist provides the required risk capital, usually alongside several other investors, funding is thus syndicated. Moreover, the initial funding round is frequently expanded by follow-on rounds. Aside from the investment objective, the segments also differ in the number of deals closed. A median fund with buy-out objective makes twelve investments, whereas a median venture capitalist funds twenty companies and the ratio deals per partner is significantly lower in buy-out.[7] This could indicate that partners in buy-out funds expend more effort in improving in their individual portfolio companies, probably because it is financially less rewarding for venture capitalists holding minority stakes to put labor force into a company.

Keeping these distinction in mind, this thesis will differentiate venture capital and buy-out, whenever apposite. This is particulary the case in chapter 2, which examines the characteristics of PE in terms of value creation, performance and risk-taking. Chapter 3 evaluates risk on fund level and compares measures of risk with measures established in public markets. Based on empirical findings, section 4.1 explains why track records are highly relevant in practice. Thereafter, risk is considered from a behavioral finance perspective. Advances in public markets are detailed and their appropriateness in the field of PE is assessed. Section 4.3.1 describes a recent experimental setting, which aims at identifying proxies for perceived risk and could be especially relevant in PE. Finally, section 4.3.2 delivers a basic approach to transfer the experiment into the context of PE.

Which factors for risk do exist? How do today’s PE investors measure risk? Can public market measurements be applied? This thesis aims at addressing these questions. The thesis puts emphasis on measures of risk and performance, on differences in frameworks compared to public markets, and on risk as eventually perceived by investors during their investment process.

2 Cash flow, return and risk characteristics

Before proceeding to objective risk measures and to risk as perceived by investors, this chapter depicts the framework for investments in PE funds. The Cash Flows in a PE fund are defined by the value created, the risk taken and the compensation charged. These characteristics are often distinct from other asset classes and are specified hereafter.

2.1 Value added by General Partners

While there is an ongoing discussion about whether PE creates economic value for society, there is strong empirical evidence of value creation for investors, both in terms of gross and net fees.[8] On deal level, firm values show strong increases with regards to absolute numbers as well as when benchmarked to industry.[9] The main levers for achieving high profits in investments are financial engineering, governance engineering, and operational engineering.[10] Governance and operational improvement signify that GPs actively engineer portfolio companies, which distinctly differentiates PE from other types of managed investment funds. Yet, financial engineering tools well-known from financial markets, arbitrage and leverage effects in particular, are accounted for here as well.

2.1.1 Financial engineering

Buying low and selling high is one way for fund managers to realize high returns. Sophisticated industry knowledge and outstanding negotiation skills allow for multiple arbitrage at acquisition and exit. Whilst buyers still pay the usual premium on traded equity value, purchase price premiums are significantly lower for PE buyers than for other types of buyers.[11] Additionally, discounts on equity price might possibly also appear when succession solutions become indispensable (frequently the case of buy-out transactions), or when start-ups with no or little prove of market success and few experience seek risk financing (the case of venture capital). Yet, with growing purchase price multiples,[12] high multiple arbitrage effects might be less likely realizable.

A heavily used and exclusively used factor in buy-out is leveraging investments by increasing debt ratio in a portfolio company’s capital structure. Contrarily to venture capital, target companies have stable and high cash flows, making them eligible for debt financing. In the clear majority of cases, buy-out-type investments are LBOs, where purchase costs are financed through a considerable amount of target company indebting apart from equity financing. When approaching banks and debt markets, PE funds receive better financing conditions than average corporate borrowers.[13] PE firms can possibly leverage their repeated contact with banks and their reputation of being able to generate rising Cash Flows for debt amortization here to negotiate lower-than-usual interest rates.[14] One crucial effect of high leverage ratios is tax optimization.[15] Previous research has been inconsistent though when it comes to the specific financial impact of tax deductibility on equity values. Moreover, high amortization burdens of leverage should result in a more efficient handling of means on management level, hence reducing the effects of what has been described as Free Cash Flow problems and signifies the frequent dissipation of means in mature industries.[16]

Leverage effects are yet highly driven by debt market conditions. There are indicators that favorable market conditions “fuel” buy-out transactions. With the extent of debt leverage available largely driven by changing macro-economic circumstances, the amount and size of deals are highly volatile, as transaction volumes depend on more invariant capital commitments. This partly explains why boom and bust phases do appear in PE.[17]

2.1.2 Operational engineering

With the extent of arbitrage and leverage declining, operational engineering is the emergent lever in today’s PE landscape. In a recent survey, 82% of PE executives mentioned potential for operational improvement as the cornerstone of their investment decision. A majority of executives taking part in the survey also expect a continuing increase in the importance of operational engineering during the next five years.[18]

Operational engineering aims at enhancing of operating performance, productivity and long-term competitiveness in assets. Potentials for improvement are often traced in cost reduction, sales effectiveness, working capital optimization and strategic objectives. In addition, increased investments in Research and Development (R&D) and entry into new markets are common approaches.[19] These efforts taken by the PE firm’s managers effect increases in Operating Income before Depreciation and Amortization (OIBDA) and Net Cash Flow (NCF), as well as decreases in Capital Expenditures (CapEx).[20] However, assumptions of cost cuttings and other gains in efficiency causing job cuts, as often voiced by labor unions, have been found to not hold true. On average, there is evidence of employment change, yet it can be observed more slowly increasing wages, benchmarked to the respective industry peer-group.[21] Previous research has suggested that in companies with PE ownership overall factor productivity enhances significantly, and that R&D intensity increases after acquisition.[22] This can be regarded contradictory to the expected short-term focus of PE investors that is occasionally assumed given the investment horizon is of generally only five years.[23]

2.1.3 Governance engineering

Lastly, governance engineering is applied to be actively involved and take board control in portfolio companies. To ensure management decision-making in line with their expectations and a low influence of principal-agent problems, GPs often set financial incentives for top-management. On the other hand, GPs do not at all hesitate to replace top-management in case of underperformance. Personel turnover in the Chief Executive Officer (CEO) position happens in more than two-thirds of investigated asset companies during the time of a PE fund’s investment, while most of these replacements, take place already in the first 100 days after the acquisition.[24] The latter could imply that fund managers already bear in mind how to reshape the mangement team at the time of their investment, it is thus a lever for governance that goes beyond setting management incentives. Moreover, one could possibly interpret that PE investors purposely target assets with high potential but underperforming top-management and apply active ownership to multiply firm value, similar to arbitrage winnings through investor activism in public markets.

2.1.4 Fees and compensation charged by General Partners

After gross value creation, management compensation charged on portfolio and company level must be taken into consideration for net performance. Portfolio managers are compensated in up to three ways.[25] Management fees are charged as a percentage of capital committed, respectively capital employed as investments are realized. From a GP’s perspective, management fees resemble fixed income. GPs additionally receive pay for performance through carried interest. Moreover, monitoring and transaction fees are charged to portfolio companies in buy-out, yet rarely in venture capital.[26] Empirical research found ratios of total management compensation to committed capital of 18% for venture capital funds 12% for buy-out funds.[27] Other research in venture capital discounts management fees and calculates a ratio to committed capital ranging between 16% and 19%.[28]

2.2 How General Partners impact risk-taking

Risk on deal level is specific with regards to the fund’s investment objective and could be assumed to correlate to some extent with the upside potential of an investment, thus value creation. For early-stage investments, uncertainty with regards to market success and venture development can be key downsides, on the other hand risky investments in highly disruptive innovations might also promise higher upsides. When the target company is more mature and leverage can be applied, the ratio of leverage chosen does not only enable excess returns, high leverage also requires strong Cash Flows and results in an increased impact of credit risk.

How GPs deal with risk inherent in investments and leverage can be assumed to be affected by financial incentives. Fund managers act in an incentive framework that includes direct as well as indirect pay for performance. Besides fixed compensation, fund managers can earn high amounts of performance-based carried interest. This variable component has an estimated weight of one-third of total income on average.[29] It could be assumed that management compensation is designed in line with LPs’ risk-taking preferences. Carried interest is charged as a rate, called carry level, of nearly always 20% on profits. An annual internal rate of return (IRR), called carry hurdle or retainer, must be jumped over before GPs receive profit-sharing. In this case, catch-up clauses guarantee GPs the full carry level and interest retained between zero-profit and carry is re-added. The concept of carry hurdles, commonly set at around 8%, is built to protect LPs from GPs getting disproportionally compensated at their expense in case of net losses. It could thus be argued that carried interest is constructed in a way that incentivizes GPs to take relatively low risk. Moreover, assuming a direct link between upside potential and downside risk, one could argue that catch-up clauses, which let GPs participate on profits even when they are relatively low, encourage fund managers to take moderate risk.[30]

When a fund shows profitable success at final capital distribution, GPs nonetheless earn reputation and build track records of gainful investments for their professional future. Building track records is specifically important in PE, where high personnel-linked persistence in performance exists (see section 4.1). Incentives for fund managers do thereby not only include direct financial pay, but also indirect pay for performance with regards to better marketing chances for subsequent funds. With fund terms being very similar all over PE, managers preferably increase their income through rising fund sizes in subsequently issued funds. Research has found performance to significantly correlate with both, probability and size of a follow-on fund, and, correspondingly, indirect pay to weight more than direct pay for performance.[31] This should particularly be the case for GPs without long industry experience who need positive track records for issuing more lucrative follow-on funds. Distinguishing in fund objective, follow-on fund sizes seem to increase faster in buy-out than in venture capital.[32] This could result from a higher scalability of buy-out-type investments that lets GPs leverage their experience at higher rates.[33] These findings imply that in PE, and particularly in buy-out, fund managers should consider indirect pay. GPs acquainted with this fact might thus adjust their risk-taking behavior towards maximizing future earnings. One alternative for GPs could be the avoidance of above-average risk that would have less upside than downside implications for indirect pay for performance as capital loss severely impairs chances for future fundraising.

Cash Flow curves from an investor’s perspective, thus capital calls and distributions, have distinct characteristics in PE. When plotted over time, they resemble a J-Curve. In the early years of a partnership, acquisition prices and management compensation are payable, yet no exits happen. Cash Flows are capital-call-induced in this period and a cumulated curve would be strongly negative here. When investments are more mature, first exits are realized and cumulated Cash Flows start rising and eventually reach break-even-point. In a third period, extending over the fund’s final years, exit revenue should continue rising, exceeding investment costs and invested capital. Plotted curve thus show the J-Curve distinctive for PE, which has notable effects for characterizing and evaluating risk, as to be examined later.[34]

These effects complicate the tracking of risk for investors, as GPs have possibilities to alter Cash Flows in amount and time. Fund managers can quite deliberately invest and exit portfolio companies in a way that is in line with their preferences about the message the J-Curve should give at this point in time regarding return and risk. Because of this, evaluating risk is especially difficult when observations are preliminary or when benchmarking non-distributed funds against each other.

The nature of risk for LPs differs over fund duration. In the investment period, LPs face all types of risk (see section 3.1) at their full extent. In the following, second phase, downside considerations are made with regards to whether and when break-even is reached. PE also gets somewhat more liquid in this period, LPs can potentially exit from funds. In the final period of the partnership, return and liquidity risk is declining until exits are successfully completed.[35]

3 Evaluating risk on fund level

PE funds generally use called capital to invest in a number of companies. Empirical research has proven that risk taken in individual transactions can thereby effectively be diversified.[36] The structure of PE funds implicates that fund-level return and risk are the aggregation of portfolio companies’ performances and the inherent risk. Only aggregated measures can accurately evaluate fund performance, considering that GPs have limited resources and might concentrate their efforts on the most promising assets rather than equally divide their labor force.[37]

For analyzing the performance of a fund or a sequence of funds issued by the same firm, risk taken is an impactful parameter aside from return. Sophisticated measurements such as the Capital Asset Pricing Model (CAPM) or Value at Risk (VaR) incorporate risk in a return framework. These modern advances as well as traditional methods, including beta-factors and volatilities, can be applied for stocks and traded funds. For LPs seeking to invest in PE, on the other hand, no standardized measures of risk exist to evaluate and benchmark GP’s track records. In this chapter, a comparison of frameworks and risk measures for public markets and PE will be given and lead to an analysis of risk-in-return measurements applicable in PE.

3.1 Risk factors

In PE, risk can be broken down to the factors shortfall risk, funding risk and liquidity risk. As funding and liquidity risk are specific for each LP, only shortfall-type risk, referred to as capital or return risk, is quantifiable on fund level, the focus of this paper. Additionally, literature argues for shortfall risk as the most relevant for fund investors.[38] Shortfall risk allows for a profound analysis of risk measurement and perception. It will therefore be the focus of analysis in the following sections.

The closed, less-regulated nature of funds in PE entails a remaining risk of frauds, such as pyramid schemes. However, fraud risk can be minimized through in-depth due diligence under consideration of track records. Thus, fraud risk is generally not considered as a main factor in PE and will not be further considered in this paper.

3.1.1 Shortfall risk

Shortfall risk is considered the key risk in PE and describes the probability that a fund’s capital distributions fail to achieve a certain return on called capital. Shortfall risk can be measured as capital risk or return risk. Capital risk is the probability of an IRR below zero, whereas return risk assesses the risk that a set target IRR is not met. The threshold value of return risk adjusts for return expectations including opportunity costs investors face when they put capital into the asset class of PE instead of investing in common alternatives, such as other funds, stocks, bonds or other types of investment.[39] This thesis treats capital risk as a proxy for overall shortfall risk, for the simple reason that it is the more severe one by loss proportion. This is also corresponding to current research identifying loss probability as key driver for risk perception.[40]

Shortfall risk also covers market risk, mainly accounting for short- and mid-term downsides resulting from exogenous factors[41], similarly to public markets. Resulting from lacking market prices in PE, market risk can neither be examined separately nor split up into systematic and specific risk as known from public markets. Market risk also refers the illiquidity of PE, implying that interim net asset value observations might not be realized.

3.1.2 Funding risk

The span of several years between a fund’s closing and actual capital calls requires LPs to restrain liquidity for a considerable time. The danger of an investor defaulting on payment obligations established in the partnership is captured by capital risk, or, more obvious, default risk. To ensure a viable fund structure for both, GPs and other LPs, defaulting on a capital call can carry severe contractual penalties. In addition to intuitive approaches, funding risk can be assessed with scenario models for investor’s net cash requirements.[42]

3.1.3 Liquidity risk

Risk taken when investing in closed, non-publicly traded funds, includes considerable liquidity risk. Over a fund’s lifetime of usually ten to twelve years, a LP might have to meet unexpected liabilities to pay or might want to reallocate capital to more promising investment opportunities. Albeit, there are only small and not efficient secondary markets for buying and selling stakes in PE funds. A LP inclined to sell will either not be able to find a buyer, or must accept significant losses.[43] In addition, LPs also face unsecure Cash Flows. The resulting downsides are referred to as liquidity risk. It is assumed that the high excess returns observed in PE can be explained by investors expecting a premium for the illiquidity caused by the long holding periods in PE.[44]

As an integrated model for both, liquidity risk and funding risk, the British Private Equity & Venture Capital Association (BVCA) recently presented the Funding and Liquidity Test as practicable method which provides investors with insights about how much capital they can put into illiquid assets without facing liquidity and funding issues.[45]


[1] See Kaplan/Strömberg (2009), p. 3.

[2] See Weidig/Mathonet (2004), p. 21.

[3] See Demaria (2013), pp. 6f.

[4] See Kaplan/Strömberg (2009), p. 3.

[5] See Zeisberger (2014), p. 2.

[6] This thesis explicitly follows the standard approach, covering Private Equity in a broader sense, whereas in parts of the literature, including popular publications, Private Equity only refers to buy-out investments.

[7] See Metrick/Yasuda (2010), p. 2309.

[8] See Gompers/Kaplan/Mukharlyamov (2015), p. 1.

[9] See Kaplan (1989b), pp. 236f.

[10] See Kaplan/Strömberg (2009), pp. 11f.

[11] See Bargeron et al. (2007), p. 23.

[12] See PricewaterhouseCoopers (2015), p. 31.

[13] See Kaplan/Strömberg (2009), pp. 17f.

[14] See Ivashina/Kovner (2011), p. 2462.

[15] See Kaplan (1989a), pp. 628-630.

[16] See Kaplan/Strömberg (2009), pp. 11f.

[17] See Kaplan/Strömberg (2009), p. 19.

[18] See PricewaterhouseCoopers (2015), p. 11.

[19] See PricewaterhouseCoopers (2015), p. 9.

[20] See Kaplan (1989b), pp. 250f.

[21] See Kaplan/Strömberg (2009), pp. 14f.

[22] See Lichtenberg/Siegel (1990), pp. 32-34.

[23] See Demaria (2013), p. 103.

[24] See Acharya et al. (2013), p. 32.

[25] See Kaplan/Strömberg (2009), p. 4.

[26] See Metrick/Yasuda (2010), p. 2314.

[27] See Metrick/Yasuda (2010), p. 2310.

[28] See Gompers/Lerner (1999), p. 21.

[29] See Metrick/Yasuda (2010) p. 2328.

[30] See Metrick/Yasuda (2010), pp. 2310-2312.

[31] See Chung et al. (2012), p. 3263.

[32] See Metrick/Yasuda (2010), p. 2303.

[33] See Metrick/Yasuda (2010), p. 2303.

[34] See Demaria (2013), pp. 103f., pp. 294f.

[35] See Demaria (2013), pp. 295f.

[36] See Weidig/Mathonet (2004), p. 59; The paper additionally examines funds of funds and proves that investing in a great number of PE funds efficiently diversifies return risk.

[37] See Demaria (2013), p. 104.

[38] See Meyer/Mathonet (2005), p. 320.

[39] See Meyer/Mathonet (2005), pp. 320f.

[40] See Anzoni/Zeisberger (2016), pp. 1f.

[41] See BVCA Research (2015), pp. 9f.

[42] See Capital Dynamics (2009b), pp. 23-26.

[43] See Weidig/Mathonet (2004), pp. 94f.

[44] See Ljungqvist/Richardson (2003), p. 28.

[45] See BVCA Research (2015), p. 12.

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Risk-Taking in Private Equity. Evaluation of the main value drivers in PE and Comparison of risk measures
Technical University of Munich  (TUM School of Management - Chairs of Entrepreneurial Finance)
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private equity, venture capital, buy-out, buyout, lbo, risk, finance, asset management, portfolio
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Philipp Handel (Author), 2017, Risk-Taking in Private Equity. Evaluation of the main value drivers in PE and Comparison of risk measures, Munich, GRIN Verlag, https://www.grin.com/document/383578


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