EDHEC: Market risk in private equities
By Frederic Blanc-Brude, Director at Scientific Infra & Private Assets (SIPA), Evan Clark, Senior Private Market Analyst at EDHEC Infra & Private Assets (EIPA), and Srinivasan Selvam, Senior Researcher at EDHEC Infra & Private Assets (EIPA)
In a recent report entitled ‘Market Risk in Private Equities,’ we conclude that the prices of most private equities can be explained by systematic risk factors and bid-ask spreads.
In a world in which the valuations of private equities are seen to be opaque, our publication shows that private equities valuations are largely systematic, and most transaction prices can be explained by risk factor exposures and a valuation band.
The prominent role of systematic risk factors
The fact that that private equities valuations are largely systematic is crucially important for asset-level valuation and for benchmarking private asset funds at the portfolio level, which in turn has considerable implications for private assets in pensions and retail products: if market dynamics are tracked, then private assets can be repriced to reflect their fair market value. Moreover, implied discount rates (expected returns) for private equities transactions are estimated as 14% on average, which is roughly 6% points over expected public equity returns over time.
Sources of risk
In our paper, we propose an empirical analysis of the market risk of private equities, which is the risk of investing in private equity at the asset level. To avoid confusion with the term ‘private equity,’ which has become synonymous with investing in private equity funds, we talk of private equities to refer to the market for investing in the underlying equity stakes of private companies.
Market risk is not the only source of risk for an investor or limited partner (LP) into a private market fund managed, and often co-invested, by a general partner (GP). LPs also face liquidity risk since their capital is locked up for multiple years, and cash flow risk because the inflows and outflows from private funds are uncertain and not easily predicted.
We show in our paper that market risk is the least well understood or documented by existing academic research on private equity investment, which solely focuses on fund-level data and thus conflates market risk with liquidity and cash flow risk.
Unlike liquidity and cash flow risks, which are created by the fund structure itself, market risk should be understood first and in isolation before investing private asset funds. Indeed, the rationale to invest in such funds is to seek exposure to private market risk. GPs and LPs also share market risk directly as frequent co-investors in private assets. Identifying and documenting market risk in private equities is pivotal to understand the private equities asset class and compare it with others, especially public equities. It is also the starting point to assess GP performance and their ability to add value when compared to the private market itself.
Private market risk is simply the potential for financial loss or gain due to fluctuations in private equities market prices. Such losses or gains can be expected to have a significant impact on the performance of investments made by private equity fund managers.
Market risk
Simply put, there is a market for the equity stakes of private companies in which various investors are both buyers and sellers. As in any other market, the price of these stakes fluctuates with supply and demand. Changes in supply may be driven by economic or technological trends in the economy. For instance, there are more data centre companies today than there were ten years ago. Likewise, the level of demand for investing in private companies is the reflection of the number of buyers and their risk appetite at one point in time. The past decades have seen an increase in the number of private equity investors (both GPs and LPs) and significant variance of their risk appetite or the level of expected returns from private equities, as we document in our paper.
This is why understanding market risk is crucial for investors as it helps them assess the volatility and potential returns of their investments in private equity funds.
