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An overview
Manu Midha
11/10/2009
Abstract
The article studies various aspects of risk management, with regards to private equity investments.
Private equity investors face two basic categories of risk, one impacting their ability to raise funds from
institutional investors and the other impacting their portfolio investments and exit strategies.
The article gives an overview of the methods used commonly by private equity funds to mange each of
those risks faced by them.
Figure 2: Total size and number buyouts in years 1995 – 2009 1H.
These cycles have a very adverse impact on valuations and therefore on the returns private equity
companies are able to realize on these investments.
A good example of the impact of this is being faced by most private equity groups today.
A close study on investments of the 2006 -07 (Table 1) vintage indicates that only a fraction of
investments of this vintage have been able to return even the premium invested by the private equity
groups. The current NAV’s and the distributed capital, is lowest at 84% of invested for investments of
vintage year 2007.
Vintage Year Return Ratio Chart
Vintage Year LP Distributions
Return Ratio + Current NAV /
Chart LP Contribution
1981-1994 3.24
1995 6.06
1996 4.45
1997 2.89
1998 1.45
1999 0.88
2000 0.92
2001 0.98
2002 1.02
2003 1.09
2004 0.98
2005 0.92
2006 0.92
2007 0.84
2008 0.88
Overall 1.53
d. Risks originating from portfolio companies: A number of risks may emerge from inside of
the investee companies. These risks include:
• Technology Risk – Risk of the technology not seeing light of the day or not being
commercially viable.
• Market Risk - Will a new market develop for this technology? How would the market respond
to the product or service offered by the company?
• Company Risk - Does the company have the right capital structure? Is the management team
capable enough for executing the strategy? Are incentives of key managers aligned rightfully?
• Market risks:
Work closely with the management team, help it develop prototypes and get feedback from key
customer samples.
Help the investee develop a sustaining business model, leveraging on its industry experience.
• Company risks:
Private equity partners invest a lot of time and effort with each of their portfolio companies
managing unique risks faced by them, with respect to management and technical team, capital
structure, cost and revenue management, etc.
Incentives of management team are often re-aligned with those of the investors, usually by way
of granting equity options as part of their compensation.
Performance based milestones are often set for the management team to achieve.
References:
National Venture Capital Association. (2009). Proposed Accounting Standards Update, “Fair
Value Measurement and Disclosure (Topic 820),” issued August 28, 2009. NVCA Update , 6.