By Chase Nerison
High risk, high reward. Private Equity Firms face different risks than other financial institutions like investment and commercial banks, insurance companies, and brokerage firms. These other companies deal with credit risk, foreign exchange risk, and more. PE firms are dealing with accredited investors with high net worth, so credit risk is not a factor, and foreign exchange risk is only prevalent for investors who purchase foreign assets, which increases the volatility of your expected return. Rather, the 8 biggest risks facing a private equity firm are liquidity, compliance, consumer privacy, fraud, crisis management, third party/market, interest rate, and cyber and technology.
Though PE firms consider liquidity risk like these other financial institutions, most PE investors understand it is a longer-term (2-5 years) illiquid investment; this is why we see endowments, pension funds, and wealthy individuals not needing readily available cash invest in this area. Clearly, the investor is unable to redeem their investment at their possibly desired time; it is in the hands of the firm. In fact, many firms structure a design in which the investor remains in the fund for its full term. However, unlike other illiquid assets, private equity is a cash flow-based asset class that generates liquidity when investments are sold. It is a very unique asset class.
Private Equity firms are subject to heavy regulation and oversight from the SEC. They established a private funds unit in 2016 to emphasize this area. Business models are no longer driven by sole performance; they must balance costs to make certain robust compliance infrastructure. This increased oversight will likely cause a deeper focus on due diligence and documentation, a culture of compliance beginning in training, and assessing the possible need of a chief compliance officer. Not only for their potential partners, acquisitions, and investors, PE firms will need to stress the importance of their portfolio companies following regulation.
As a current resident of California and with many PE firms based in this state, I have to mention the California Consumer Privacy Act (CCPA). This regulation calls for:
- disclosing the collection of personal information and how it is used
- giving consumers the choice to opt-out of purchasing and sharing their information
- informing consumers the ability to request their data to be deleted
Based on the requirements to comply, most California PE firms will have to abide by these regulations. Experts anticipate the CCPA continuing to affect data protection practices. Consequently, PE firms should review the types of consumer information they collect, update privacy policies, and create a fundamental process for consumer data requests.
Since firms are highly motivated to improve and sell a portfolio company, fraud and misconduct is a potential risk. Thankfully, firms and funds value transparency with their limited partners and regulators. To mitigate this risk, firms should value prevention, detection and monitoring, and response when a defense is needed. According to PwC’s latest global economic crime and fraud survey, 47% of U.S. companies experienced fraud in the last two years. The costs of these crimes totaled $42 billion. KPMG identified why PE firms are susceptible to risks of misconduct and fraud:
1. Involvement in complex transactions
2. Lean operating structures
3. Intense competition for portfolio company investments
4. Extensive involvement with third-party intermediaries
5. Lack of transparency
6. Rising trend of investor activism
Fraud and Corporate misconduct provide a nice transition to the risk of crisis management. It is very important to respond quickly to a crisis like allegations of fraud, misconduct, or bribery. This can significantly devalue the firm. In 2021, information travels through our phones and social media in an instance. The ability to respond via a crisis management team can save the firm in the long run. To prevent such occurrences, take the time to analyze the potential impacts of potential events, develop a comprehensive response plan, and apply the plan at the portfolio company level as well as the firm itself.
Dealing with securities, public or private, there are third-party and market risks. PE firms are increasingly outsourcing to third parties. Despite this outsourcing, firms are still liable for any compliance regulation. To manage third-party risk, follow these four steps:
1. Define the scope of risks involved
2. Determine a timeline for third-party monitoring and reporting
3. Review compliance history and conduct internal audits
4. Keep documentation of the due diligence process and results
Along with factors out of a firm’s control, they have the potential to face greater market risk than traditional investments as the return is very volatile and not guaranteed. It can be very hard to succeed in difficult market times, especially for a smaller company. Many of these small companies fail, which is why the default risk is higher in this risky asset class. Third parties, the market, and the entirety of its environmental surroundings have the potential to affect any company.
The seventh risk is interest rate risk. If unaware, the Federal Reserve changes interest rates to keep the economy and inflation stable. When the economy is growing, we might see interest rates rise to reduce inflation, while the opposite is also true that the Federal Reserve may reduce interest rates to stimulate the economy. These interest rates are very important to Private Equity firms because they use a great deal of leverage and are sensitive to interest rate changes. Leverage is the strategy of borrowing money to increase the potential return of an investment. For example, many PE firms perform leveraged buyout transactions (LBOs). Through this transaction and strategy, the firm funds the purchase using little capital and heavy amounts of debt. With this heavy debt as shown below, the cost to borrow significantly impacts a firm’s bottom line. This is why Private Equity activity might slow down during high-interest rates, and firms attempt to hedge their interest rate risk.
The eighth and final big risk identified is cyber and technology risk. With employees, third parties, and other external figures, cyber risks stem both internally and externally. Since private equity firms are typically focused on a business’s future growth and returns, there is the possibility of a lack of cyber-risk management and control. Additionally, as the company expands, its technological footprint will impose more risks related to cloud-based software, email, intellectual property safeguards, and investor information protection, which was recently discussed. As technology continues to grow quickly, cyber and technology risk management practices must constantly grow and evolve accordingly.
In conclusion, Private Equity firms face significant risks. Most of their risks are very different than other financial institutions like investment and commercial banks, insurance companies, and brokerage firms. PE is high risk, high reward. In order to succeed in this space, a firm must manage liquidity, compliance, consumer privacy, fraud, crisis management, third party/market, interest rate, cyber and technology risks, and more. It is no wonder why it is hard to make it in private equity.
Works Cited
6 risks in private equity. Liberty Mutual Business Insurance. (2021, July 16). Retrieved October 18, 2021, from https://business.libertymutual.com/insights/top-6-risks-in-private-equity/.
Agarwal, K. (2021, May 19). How interest rates affect private equity. Investopedia. Retrieved October 18, 2021, from https://www.investopedia.com/articles/investing/070715/how-interest-rates-affect-private-equity.asp.
Horton, M. (2021, May 19). How does the risk profile of private equity investments compare to those of other types of investments? Investopedia. Retrieved October 18, 2021, from https://www.investopedia.com/ask/answers/040615/how-does-risk-profile-private-equity-investments-compare-those-other-types-investments.asp.
Shah, S. (2018, June 21). KPMG Brandvoice: Top six risks for private equity firms. Forbes. Retrieved October 18, 2021, from https://www.forbes.com/sites/kpmg/2017/07/05/top-six-risks-for-private-equity-firms/?sh=53559b1627d0.
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