Risk Measurement Guidelines - EVCA

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In practice, the bottom-up approach is often impractical dueto: the lack of appropriate information at the limited partnerlevel; the large volume of data that has to be collected forlarge portfolios; and the complexity of specifying each cashflow position. A bottom-up approach is not necessarilysuperior to a top-down approach and in many cases it issimply not applicable (e.g. for very young funds). The choicebetween bottom-up and top-down also highly depends onthe size of the portfolio of funds to be modelled.4.2.3 Advantages, disadvantages and limitationsCash flow-volatility-based modelling is particularly usefulbecause it can incorporate information about undrawncommitments and possible re-use of distributions whenevaluating the PV of private equity partnerships. When usingthe returns of mature funds to determine the risk profile fora portfolio of funds, issues related to limited data points, suchas autocorrelation and de-smoothing, can largely be avoided.One disadvantage is the assumption that funds will performin the same way that funds have in the past. This approachprovides a general idea of the average cash requirementfor a portfolio of funds, but does not necessarily factor inthe influence of changing market environments, differentvintages, separation between different types of fund or otherdistinctive features of particular funds.While such models in their basic form have clear limitations,especially during financial market crises, the portfolio’s riskcan be approximated by applying some sort of stressmeasurement to the distribution curves.More elaborate projections draw more heavily from historicaland market data, and are therefore more reliable than thosebased on assumptions. These projections incorporate dataabout particular fund managers, various market environmentsand differentiate between different types of investmentstrategies (e.g. venture, buyout). However, the technicalcomplexity of developing and maintaining such a model canmake it too cumbersome for investors with limited allocationsto private equity.4.3 Stress testing to overcome lack of dataand data quality problemsIn the environment of high uncertainty that characterisesprivate equity, there are limits to the predictive value ofhistoric data. While it is not possible to anticipate outcomes,it is nevertheless possible and meaningful to evaluate andquantify the impact of shocks that would materially changeprojections. For cash flow-based models of private equityfunds and the associated portfolio models, a number ofshocks should be applied for stress testing, for example:> Lower IRRs or multiples than have historically beenachieved by funds> Longer lifetimes of funds> Accelerated draw-downs> Delayed repayments> Higher volatility of cash flows> Higher degree of dependency between fundsA stress testing process is important for prudent management,as it examines the “what if” scenarios necessary to detectvulnerabilities, and can help estimate shifts in the long-termeconomic environment.4.4 Use of indicesAs many investors do not have access to sufficient andreliable data sets necessary to achieve statistically significantresults, they can use indices provided by external providers(such as Thomson One and Cambridge Associates). An indexcan be a suitable proxy for the risk of the portfolio of fundsheld if the composition of the index is representative of theinstitutional investor’s portfolio composition and diversification.4.5 Look-through requirementFor deciding for which model for funds to apply, limitedpartners have to look through to the fund's portfolio companiesin order to assess whether the approach is appropriate forthe portfolio's composition and whether the underlyingassumptions still hold.24 I EVCA Risk Measurement Guidelines 2013
5AddressingFunding RiskRisks related to the liquidity required tofund capital calls can affect investors’ability to generate realisations from aprivate equity partnership or to conductorderly transactions in the secondarymarket. Therefore, monitoring fundingrisk is central to effective riskmanagement in private equity.Where investors have multiple sourcesof liquidity to meet their capital calls,they should evaluate the availability ofliquidity not only from within the privateequity portfolio, but also across businesslines, other asset classes and all legalentities of their organisation.Limited partners do not need to reserve all committed capitalin cash as distributions from existing investments and othersources of liquidity can be used to partially finance opencommitments. However, they do need to monitor funding riskto ensure they will have enough resources to honour capitalcalls and to allow them to hold their private equity investmentsto maturity. Monitoring liquidity needs also enables limitedpartners to prevent cash shortages due to over-allocationsor over-commitments.Many investors estimate and plan their short-term liquidityneeds through continuous dialogue with private equitymanagers. This approach helps smooth short-term cashmanagement. However, it has limitations when estimatingcash needs in the medium- to long-term, an estimationnecessary for preventing over-commitment. In addition, thisstrategy may be suitable for an investor with only a handfulof private equity investments in its portfolio, but it is moreburdensome for investors with hundreds of private equityinvestments in their portfolios.5.1 Preventing liquidity shortfallsLimited partners have four sources of liquidity to meet capitalcalls: (1) distributions from private equity funds, (2) liquidityprovided by other assets, (3) liquidity provided by externalsources (e.g. borrowing), and (4) proceeds from the sale ofprivate equity interests in the secondary market.EVCA Risk Measurement Guidelines 2013 I 25
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 16 and 17: The volatility is estimated by meas
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 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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