Measuring risk in private equity can be more complex than in public markets due to the lack of liquidity, transparency, and the unique nature of each investment. However, there are several methods and metrics that investors often use to assess risk in private equity:
Due Diligence: This is the first and one of the most important steps in assessing risk. It involves a comprehensive business appraisal to confirm all material facts regarding a sale. It includes reviewing financial records, legal issues, customer contracts, and all other pertinent details.
Track Record: Looking at the historical performance of a private equity firm can provide a good indication of how they manage risk and generate returns. This includes looking at the internal rate of return (IRR) and the multiple of invested capital (MOIC) for previous funds.
Portfolio Diversification: Diversification across industries, geographies, and business stages can help mitigate risk. If a private equity firm’s portfolio is heavily concentrated in one area, it may be exposed to more risk.
Deal Structure: The deal’s structure can significantly impact the investment risk. This includes the use of debt (leverage), the terms of the investment, and the exit strategy.
Management Team: The quality and experience of the management team is a critical factors in the success of a private equity investment. A strong management team can often navigate challenges and mitigate risks.
Market Risk: This involves assessing the broader market and economic conditions that could impact the investment. This can include economic cycles, regulatory changes, and industry trends.
Operational Risk: This involves assessing the risks associated with the company’s operations, including its supply chain, production processes, and human resources.
Financial Metrics: Financial metrics such as EBITDA, cash flow, and revenue growth can provide insight into the company’s financial health and its ability to generate returns.
Risk-Adjusted Returns: This involves comparing the investment’s potential returns with the associated risks. One common measure is the Sharpe ratio, which measures the performance of an investment compared to a risk-free asset after adjusting for its risk.
Private equity investments have gained popularity in Australia as a growing asset class. However, measuring risk in private equity investments is crucial, given the highly competitive environment and high asset valuations.
Private equity investments are typically made in unlisted companies with limited transparency and require a long-term investment horizon. Therefore, understanding how to measure and manage investment risk is essential for investors looking to invest in private equity.
This article explores the key practical issues in private equity law in Australia, major trends, recent activity in the private equity market, and fund structures and tax implications.
Moreover, understanding the sources of funding and investment objectives can help investors make informed decisions about private equity investments.
Fund Structures and Tax Implications
In examining fund structures and tax implications in the context of the pre-existing knowledge of the Australian private equity market, it is evident that limited partnerships are infrequently utilized due to tax implications, with unit trusts being a more common alternative structure that generally provides the tax-transparent treatment.
The fund duration in Australia is typically 10-12 years with up to two one-year extensions, and the investment period lasts for three to five years with a hold time of four to six years.
Moreover, the VCLP and ESVCLP structures have tax advantages in Australia, contributing to their popularity. Limited partnerships are taxed as corporations in Australia, while unit trusts generally provide tax-transparent treatment. However, public trading trusts may not be tax transparent.
It is important for private equity fund managers in Australia to be aware of the tax implications of different fund structures and to choose the most appropriate structure for their specific circumstances.
In addition, PE funds in Australia may exist beyond 12 years from the initial capital call to final liquidation. This is particularly relevant for funds that invest in longer-term projects.
Local investment objectives in Australia follow international norms, with PE activity focusing on mid-market opportunities. PE managers target investments with an IRR of 20% or greater and money multiple at least twice.
The low-interest rate environment affects investment targets, and PE managers seek high returns.
Investment Objectives
Investment objectives of private equity funds play a crucial role in determining the success of their investments and attracting capital from institutional and high-net-worth investors.
The primary objective of private equity funds is to generate high returns on investment by acquiring equity in companies with strong growth potential. To achieve this objective, private equity funds typically target investments with an internal rate of return (IRR) of 20% or greater and a money multiple of at least two times.
Investment objectives of private equity funds are influenced by various factors, including the current market environment, the availability of financing, and the fund’s investment strategy.
For instance, private equity funds may seek higher returns in a low-interest-rate environment by investing in riskier assets. Similarly, funds that focus on distressed assets may prioritize downside protection rather than high returns. Overall, the investment objectives of private equity funds are tailored to their investment strategy and the preferences of their investors.
Private equity funds in Australia follow international norms in terms of their investment objectives. They focus on mid-market opportunities, which are typically less risky and have higher growth potential than large-cap companies.
Additionally, most private equity funds in Australia raise capital from offshore investors, who have a higher risk appetite and seek higher returns than domestic investors.
The investment objectives of private equity funds are critical in determining their success and attracting capital from investors.
Key Practical Issues
The current practical issues facing private equity law in Australia include businesses seeking emergency capital for balance sheet repair, listed companies turning to public equity markets for record capital raising, and an increase in private debt opportunities for downside protection.
The COVID-19 pandemic has put a strain on many businesses, leading to a need for emergency capital to keep operations afloat. Private equity firms have been approached by these businesses for assistance, but careful analysis of risk is necessary to ensure that investments are sound and will generate returns for investors.
In addition to emergency capital needs, listed companies have also turned to public equity markets to raise record amounts of capital. This trend is likely to continue in the near future, as companies seek to bolster their balance sheets and take advantage of favorable market conditions.
Private equity firms will need to carefully consider the potential risks and rewards of investing in these companies, particularly in sectors that have been hardest hit by the pandemic.
Private debt opportunities have become increasingly attractive to investors seeking downside protection. As interest rates remain low, investors are turning to alternative forms of debt to generate returns.
Private equity firms are also considering these opportunities, which can provide a relatively stable income stream and a measure of protection against market volatility. However, careful analysis is necessary to ensure that these investments are sound and that risk is properly managed.
- It is concerning that businesses are in a position where they require emergency capital to keep operations afloat. Private equity firms must carefully analyze the risks associated with investing in these businesses, as they may not be able to generate returns for investors.
- The trend of listed companies turning to public equity markets for capital raising is likely to continue, as companies seek to bolster their balance sheets. However, private equity firms must carefully consider the potential risks and rewards of investing in these companies, particularly in sectors that have been hardest hit by the pandemic.
- Private debt opportunities are becoming increasingly attractive to investors seeking downside protection in a low interest rate environment. While these investments can provide a relatively stable income stream, careful analysis is necessary to ensure that risk is properly managed.
- Private equity firms must consider the potential risks and rewards of investing in these opportunities, and ensure that they are sound investments for their clients.
Major Trends and Recent Activity
Dominant sectors in consumer discretionary and healthcare have driven recent activity in the private equity market in Australia, with continued growth in offshore investment and an increase in total venture capital fundraising.
The private equity industry in Australia has remained resilient despite the impact of the COVID-19 pandemic, with a relatively limited number of proprietary opportunities and a highly competitive environment with high valuations for assets.
Public-to-private transactions accounted for a significant portion of Australian buyout deal value in 2019, while bolt-on and merger deals constituted around 30% of overall activity.
PE managers turned to trade sales as their preferred exit route in 2019 and early 2020, but the back half of 2020 saw a number of successful IPOs for PE-backed businesses.
PE and VC funding in Australia comes from a variety of sources, with industry/public pension funds and sovereign wealth funds accounting for the majority.
Local PE sponsors raise a significant proportion of new capital from offshore institutional investors, and PE funds in Australia may exist beyond 12 years from initial capital call to final liquidation.
In recent years, there has been a rapid growth of start-ups in Australia, particularly in the Fintech sector, and the majority of PE funds in Australia raise capital from offshore investors.
Low interest rates have affected investment targets, and PE managers seek high returns on investments, targeting investments with an IRR of 20% or greater and a money multiple of at least two times.
PE activity in Australia focuses on mid-market opportunities, and the local investment objectives follow international norms.
Sources of Funding
Sources of funding for private equity and venture capital in Australia are diverse. Industry/public pension funds and sovereign wealth funds are significant contributors to the private equity market.
Additionally, local PE sponsors raise a significant proportion of new capital from offshore institutional investors. The following table presents data that shows the sources of funding for private equity in Australia.
| Source of Funding | Percentage |
|---|---|
| Industry/Public Pension Funds | 40% |
| Sovereign Wealth Funds | 20% |
| Offshore Institutional Investors | 25% |
| Others | 15% |
Local PE sponsors, who have a deep understanding of the Australian market, have been successful in attracting offshore institutional investors. These investors include institutional and high net worth individuals.
The trend towards offshore investment is not unique to Australia, but it is an important factor to consider when measuring risk in private equity. A diverse funding base can mitigate some of the risks associated with private equity investment.
The majority of PE funds in Australia raise capital from offshore investors. As a result, local investment objectives follow international norms. PE managers target investments with an IRR of 20% or greater and a money multiple of at least two times.
The low interest rate environment affects investment targets, and PE managers seek high returns on investments. These factors need to be considered when measuring the risk of private equity investment.
Frequently Asked Questions
What are some common methods used to measure risk in private equity investments?
Common methods used to measure risk in private equity investments include analysis of historical performance, assessment of industry and market trends, evaluation of management team experience and track record, and stress testing of financial models.
How do private equity firms typically approach portfolio diversification?
Private equity firms typically approach portfolio diversification by investing in a range of industries, stages of development, and geographies to spread risk and maximize returns. They also employ various strategies such as co-investment and fund of funds to further diversify.
What are some key considerations for evaluating the management team of a private equity fund?
Evaluating the management team of a private equity fund involves assessing their track record, experience, expertise, and alignment with investors’ interests. It is essential to ensure that the team has a robust investment process, risk management capabilities, and a culture of transparency and accountability.
Can you provide examples of successful and unsuccessful private equity investments in recent years?
Successful private equity investments in recent years include Blackstone’s acquisition of Refinitiv and KKR’s investment in Epicor Software, while unsuccessful investments include Apollo Global Management’s investment in ADT and Bain Capital’s acquisition of Toys “R”Us.
How do economic and market conditions impact the risk profile of private equity investments?
Economic and market conditions can affect the risk profile of private equity investments. Factors such as economic growth, interest rates, and industry trends can impact the performance of portfolio companies and ultimately the returns of the investment.
Conclusion
Private equity investments in Australia are becoming increasingly popular, with strong domestic industry and growing interest from global funds. However, given the highly competitive environment and high valuations for assets, measuring risk in private equity investments is crucial for investors.
One of the most important factors in measuring risk in private equity investments is understanding the investment objectives of the fund. Investors need to consider the potential returns, level of risk, and liquidity requirements for their investment.
Fund structures and tax implications also play a crucial role in measuring risk, with different structures providing varying levels of control, transparency, and tax efficiency.
The private equity market in Australia is showing strong growth, with a range of investment opportunities available to investors. However, investors need to carefully consider the risks involved in these investments and ensure they have a thorough understanding of the key practical issues, major trends, and recent levels of activity in the market.
Chris Ekai is a Risk Management expert with over 10 years of experience in the field. He has a Master’s(MSc) degree in Risk Management from University of Portsmouth and is a CPA and Finance professional. He currently works as a Content Manager at Risk Publishing, writing about Enterprise Risk Management, Business Continuity Management and Project Management.