A substantial amount of capital flowed into private equity since the aftermath of the crisis, as institutional investors (known as Limited Partners or LPs in private equity land) sought to protect their portfolios from short-term market volatility and in their search for higher investment returns. The amount of annual funds raised by private equity firms reached an all-time high in 2017 clearly showing the substantial growth of the industry. The industry now stands at over US$3 trillion in assets, more than twice the size it was a decade ago. Notwithstanding this, LPs in aggregate appear to still be increasing their allocation to private equity. Moreover, the level of dry powder as well as valuation entry multiples on recently completed deals across private equity funds are relatively high and it has very much become a seller’s market; this begs the question of whether the market could be witnessing a situation of “too much capital chasing too few deals”. Given their private nature, investors have always performed due diligence on managers (also known as General Partners or GPs) and their offerings. However, with the current market as the backdrop, LPs need to be even more disciplined in how they allocate capital assigned to private equity, in how they ascertain the risks present in those investments, and overall in their approach to manager/investment selection.
Additionally, recent well-publicised events around the liquidation proceedings of the Abraaj Group, a private equity fund which at its peak managed $14billion of AUM (in early 2018) and was the biggest private equity firm in the Middle East, have brought to the forefront operational risk concerns particularly around the adequacy of corporate governance standards and the robustness of the operational framework within some private equity funds. These events have once again emphasised that although most GPs may be well run, many well capitalised, some with blue chip investors, LPs simply must do their due diligence to be sure. Moreover, as the old adage goes “profits cover problems”, so as we head into more challenging times, high profits may be harder to achieve, and so more problems are likely to be “uncovered”.
Operational risk 1 is the risk of loss resulting from inadequate or failed internal processes, people and systems supporting the organisation. In our opinion, operational risk is a key consideration for investors regardless of the asset classes they invest into; for some asset classes, operational risk is even more important due to the illiquid nature of the investment, complexity and/or more lightly regulated nature of that particular asset class. Unlike investment risk, which provides a potential for a higher investment return the more risk one takes, operational risk provides no possible upside and needs to be minimised.
While operational risk is not easily quantifiable, operational failures can certainly affect performance. Indeed, unlike traditional investment vehicles, private equity funds/vehicles are typically only lightly regulated as in many cases they either fall outside local regulatory rules related to investment funds and hence many funds have also historically offered limited transparency to investors. All these characteristics lend themselves to the increased likelihood of operational risks.
One of the best ways for an LP to mitigate operational risk is through an independent and expert assessment of the infrastructure that supports the GP’s operations. Operational risk needs to be assessed from the point of view of an independent investor (LP) assessing the fund’s non-investment related risks, in the context of the investment risks, operational complexity and legal framework.
It is important to note that operational risk is only one of the key risk factors and there is no substitute for doing one’s homework to assess these. We believe LPs need to pay close attention to these not only prior to investing but also monitor these through the life of their allocation to private equity.
In our recent report on key risks in private equity, we detail our view of what these key risks are, in addition to operational risk, and the considerations that LP need to bear in mind to mitigate these risks.
1 Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.” Basel Committee on Banking Supervision, (June 2004), International Convergence of Capital Measurement and Capital Standards, section 644 on Operational Risk.