Risk Measurement Guidelines - EVCA

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The volatility is estimated by measuring the returns reported at different time intervals based on quoted indices or otherprivate equity benchmarks available in the market. The measured volatility over the relevant period is then applied to the NAVof the fund or the portfolio. Currently, the investment industry’s standard approach for measuring returns is to apply a chainedModified Dietz formula. Under this formula, the investor has an NAV at the start of every period. Over that period, investmentsdraw down and distribute capital, then report another NAV at the end of the period. The return of this period (typically perquarter) is described through the following formula:The market value of a portfolio is defined as:4.1.1 Advantages of using an NAV-time series-basedmodelNAV-time series-based methodologies are likely to beappropriate for funds whose value derives mainly from thevalue of their existing underlying portfolio companies and forinvestors with a limited allocation to private equity that arenot exposed to significant liquidity risk. Such methods appearattractive, as quarterly or annual returns are thought to beeasily comparable to public indices, for example for thepurposes of testing correlations. In particular, using indicesmakes it possible to integrate the private equity portfolio in abroader market risk measurement framework together withreal estate, public equity, etc. as indices for the other assetclasses are researched elaborately. NAV-time series-basedmethodologies can often give a good approximation of therisks of mature funds and diversified portfolios of fundsspread over several vintage years.The return of the first data point in the historyis set to 0. This time series allows investors toestimate the volatility of a portfolio by takingthe standard deviation of log return of themarket values.The yearly standard deviation can be derived fromthe standard deviation of the quarterly log-returns,Because of the so-called appraisal value effect, NAVtime series tend to understate volatility. For measuring risks,in many cases it is necessary to apply statistical un-smoothing techniques to achieve more realistic results 12 .12 See Geltner et al., 200316 I EVCA Risk Measurement Guidelines 2013
4.1.2 Limitations and disadvantages of using an NAV-timeseries-based modelThe NAV-time series-based models may look reasonablysimple and are thought to be easy to implement. They can beappropriate for funds whose values derive mainly from thevalue of their existing underlying portfolio companies andwhere undrawn commitments can be ignored. However, suchmodels have a number of limitations and disadvantages.In particular, they often violate the criteria for proper riskmeasurement:> NAV-based models can be incomplete as they do not takeinto consideration a fund’s future use of the undrawncommitments, the future management fees and the fundmanager’s value added (or value destroyed). This mattersin particular for portfolios of young funds.> Rather than being random movements, changes in theNAV often reflect the lifecycle characteristics of privateequity funds, such as the J-curve. Whether the degree ofNAV change exposes a limited partner to risk depends onwhether this change is atypical for the fund’s stage andatypical relative to its peer group. A model should filterout such systematic biases.> The NAV often does not move in the same way as the valueof the limited partner’s interest in the fund. The conceptof market risk at the portfolio company level can beproblematic from the perspective of a fund’s limitedpartners: a limited partner cannot initiate the sell-offa portfolio company; this is entirely within the controlof the fund managers.Consequently, the fund’s value is derived from valuechanges in portfolio companies but does not necessarilymove in the same proportion. In fact, it could be arguedthat the entire purpose of the fund is shielding fledglingportfolio companies or companies that are beingrestructured from disruptive market influences.Disadvantages mainly relate to a number of technicalcomplications that need to be addressed:> The NAV-time series approach tries to project the fund’sfuture development based on a relatively short history.For private equity funds the frequency at which the NAV isdetermined is limited and it is not possible for informationto be more granular than quarterly. This gives limited datapoints with which to perform analysis, which createsa dilemma as trying to use the richest possible set ofrelevant data also leads to the possibility of distortionresulting from autocorrelation.> In cases where significant commitments to new funds– with no portfolio companies and therefore no NAV –are added to a portfolio, the return calculation can givemisleading signals, e.g. when there are far more capitalcalls than distributions, the value change will underestimatevolatility. Comparable issues can occur for small NAVscompared to the size of the cash flows.4.2 Cash flow-volatility-based modellingapproachCash flow-based modelling methodologies can be used tomeasure various risks of investing in private equity funds.The method is based on cash flow projections, which areused to derive the net present value (NPV) of investmentsunder different scenarios. Cash flows are discounted usingappropriate risk-adjusted rates that quantify the riskinherent in the future cash flows.Investors use a variety of models based on cash flow forecaststo assess the risks of their private equity investments.The simplest cash flow projections make assumptions aboutthe levels of draw-downs and distributions over the lifetimeof an average fund as observed historically, and apply thisto the funds invested in to come up with an aggregate forthe portfolio.4.2.1 Basic approachTo calculate the VaR we need to determine the probabilitydistribution for the valuation for a portfolio of funds at t1>t0(typically quarterly or annually). This is done by simulatinga large number of samples for scenarios of fund cash flowsover their full lifetime as opposed a time series analysis andthen to annualise “backward” (see Figure 2).EVCA Risk Measurement Guidelines 2013 I 17
Page 4 and 5: IntroductionInvestors in private eq
Page 6 and 7: 1Key Objectives ofPrivate Equity Ri
Page 8 and 9: Exhibit 1Prior to the financial cri
Page 10 and 11: For this purpose, a risk model for
Page 12 and 13: 3Overview ofMain Risks to beConside
Page 14 and 15: Interest rates and refinancing term
Page 18 and 19: Figure 2: Backward annualisation (V
Page 20 and 21: Exhibit 4How can we calculate a por
Page 22 and 23: Exhibit 4(2) For each scenario i an
Page 24 and 25: In practice, the bottom-up approach
Page 26 and 27: In a buoyant economy, proceeds from
Page 28 and 29: The use of correlation as a measure
Page 30 and 31: II. Top-down approachThis approach
Page 32 and 33: 9ApplicationGuidanceThis section pr
Page 34 and 35: Discount rates can also be used to
Page 36 and 37: 10GlossaryEntries in the glossary m
Page 38 and 39: Net asset value (NAV)The NAV of a f
Page 40: The ‘Private Equity Fund Risk Mea

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