EVCA

Exposure Draft for Consultation: EVCA Private Equity Fund Risk Measurement Guidelines

EVCA's Professional Standards Committee and EVCA's Private Equity Fund Risk Measurement Guidelines Working Group has launched a consultation on a proposed set of Private Equity Fund Risk Measurement Guidelines.

You are invited to submit your views through this consultation document. The deadline for submissions is 30 June 2011. You may submit comments to RMGconsultation@evca.eu.

As the necessity to measure and quantify private equity related risks increases, particularly with the advent of new risk-based capital adequacy regimes, EVCA members would benefit from extra guidance.

Please ensure you include: your name, job title, company, and your type of activity (eg: GP, LP, placement agent, financial adviser etc). Also please specify the exact part of the document to which your comments relate.

Please click here to comment.

Yours faithfully,

Peter Cornelius
Chief Economist
AlpInvest

Background Information

The Private Equity Fund Risk Measurement Guidelines deal with two important topics for the industry:

1. Solvency II. The regulator is currently asking insurance companies to set aside regulatory capital at a level that could discourage them to invest in the asset class. However, the possibility of having lower regulatory capital is offered to insurance companies if they can prove that they understand the risk they are taking and consequently have developed internal models to measure their risk. These internal models need to be approved by regulators. The Guidelines are here to facilitate the dialogue between insurance companies and their regulators when the former seek authorization to use these internal models.
2. There are conceptual issues and misunderstanding in regulatory treatment beyond Solvency II. We can expect that if we do not address these issues at a time when institutional investors have to cope with re-regulation, we will be faced with a shrinking investor basis. The Guidelines aim at conveying a different message on these points. High level indications on these issues and how the Guidelines deal with them are provided below.

Main concerns on Regulatory Treatment

Regulators don’t seem to differentiate between private equity fund commitments by LPs and investments in underlying companies by GPs. What’s the industry’s position on this?

• The Guidelines aim to introduce the principle that the structure of the limited partnership needs to be taken into account because it changes the risk/return profile significantly compared to direct investments.
• Regulators do not specifically address differences between GPs and LPs and neglect the role of undrawn commitments. It is not taken into account that fund managers manage a diversified portfolio where failure/underperformance of individual companies is not necessarily indicative of the fund’s risks.
• A look-through approach (i.e. only looking at the underlying companies) across the board is neither feasible nor meaningful in many situations and can be conceptually problematic. Practical experience suggests that in many situations (young funds, highly diversified funds, VC) top-down approaches (i.e. looking at the fund itself) can be superior.

Regulation is based on the concept of market risk – how can you deal with market risk for illiquid assets for which no efficient market exists?

• Regulators point to publicly quoted private equity funds and to secondary transactions as indication for market prices.
• The Guidelines aim to introduce the principle that the starting point of risk measurement is the model rather than these alleged “market prices”.

Regulators implicitly force a “fire sale” perspective: they ask “what would I get if I sold the asset today?”

• Under such assumptions it is anybody’s guess what one would get for a private equity asset. This does not make sense for an investor who has the intention and ability to hold the fund over its full lifetime.
• However, regulators do not allow a specific treatment that depends on the investor’s intentions.
• Instead, the Guidelines aim to introduce the principle of an “orderly transaction” (comparable to the IPEV Guidelines) on the fund level, that assume that for an investor who does not have to act under compulsion the price he would achieve for selling a fund is the net present value of the cash flows of the fund.
• The Guidelines introduce a funding liquidity test which is an impartial measure of whether the investor has sufficient liquidity to meet his obligations.

Based on the discussions around Basel II, regulators could take a credit risk view on funds, i.e. to require that for each fund a Probability of Default/Loss Given Default is to be calculated and the expected losses are then aggregated without reflecting the upside of the portfolio of funds.

• The Guidelines aim to reinforce the principle that in a Value-at-Risk approach unrealised net gains from some funds can compensate for (un)realised net losses from others. This is consistent with the way investors manage their overall portfolio of assets and liabilities, i.e. on a fair value basis.
• The Guidelines aim to stress that diversification (particularly over vintage years) have a major impact on the risk profile of the portfolio of funds held by an investor.

Regulators put up stringent requirements regarding validation and verification of models:

• For private equity a complete data history and depth on the entire population of funds like that for other asset classes is not available. However, investors will have access to fairly detailed historic cash-flow and other data from both funds they are invested in as well as from funds they are considering through due diligence with a view of investing in.
• The Guidelines aim to introduce the principle that qualitative assessment can be used to fill gaps in data and that where pure back-testing is not feasible alternative methods for verification can be the way.