Part III - Applying modern financial techniques in
Private Equity
This last part is the one I describe as the «most
technical» part. Indeed, the three themes I want to introduce here are all
very important because these are the cornerstones of modern financial theory,
yet they are also very technical and sometimes they imply many mathematical
concepts that are somehow difficult to grasp or to dig in, as it is the case
for the financial risk management discipline.
My goal here is not to unveil details about these techniques,
this is nor my level of knowledge, neither my purpose. My goal for this thesis
is to understand how PE funds deal with these financial techniques when they
are confronted to such issues, and for sure they are. I also want to give to
the reader an insight about the different practices PE funds use when it comes
to face such financial issues in their daily managerial duties.
Divided in three chapters, this part starts by explaining the
stand of PE funds toward financial risk management. Then, it will move to a
more contemporary issue by giving some thoughts about where modern portfolio
theory lays out when dealing with asset management funds in the Private Equity
class. Lastly, we will touch on how PE funds structure their business and deal
with their issues when it comes to play internationally; in other terms, do
they follow and abide by the concepts of international finance or do they have
their own practices in the international marketplace?
Also, I want to add that all this part is basically stemming from
my own experience along head the PE industry in Tunisia, North Africa, where I
spent more than 8 years working besides the PE industry and also inside. So all
the analyses and conclusions in these three chapters are my own thoughts and
insights about the stands of the industry toward these financial disciplines.
Hence, my view could not be exactly the one that a US student will have, but
I'm almost sure that the differences would be quite thin since the PE practices
all over the world tend to be the same and imposed by a sort of a common body
of knowledge and practice.
Chapter 6: Risk Management in Private Equity
Since I started this graduate finance program, my view was
turned to the Private Equity as a financial theme so that I get all the finance
disciplines I learned applied to it. I was sure from an academic point of view,
that this will help me grasp the different concepts I was taught by thinking
how the PE industry will behave in such or other discipline. I finally created
my own case study on a rolling basis. And when came the latter course of
Derivatives and financial risk management, I immediately asked my self this
question: how do PE funds deal with this issue when facing different kind of
risks?
Let me first lay out immediately one concept that will be helpful
for the rest of the discussion. We already explained in part I and II that PE
funds manage portfolios of privately held companies. Hence, there is an
immediate question to ask when the financial risk management discipline: do PE
funds manage risk on a fund level, which I call «direct level» or do
they manage risk on a portfolio company level, which I call «indirect
level»; or do they manage risk either way meaning on a «direct»
and «indirect» level?
The Indirect Level:
On a portfolio company level, it is obvious for me that the
executives of the company are managing risk when they are facing it. Maybe the
level of sophistication in risk management depend on the size, the business and
the market where the company is, but we can be safe in saying that every good
management will try to minimize the risks associated with the global operations
of the company if the financial market where the company is supposed to act in
does allow the execution of risk management transactions such as derivatives
instruments.
The Direct Level:
Now on a direct level, the question is more interesting. Do PE
funds manage risk associated with their portfolios of companies on a
consolidated level? In my opinion, no, I really never heard or remarked a PE
fund managing risk on a global portfolio basis, yet this might exist, I simply
saying here that I don't believe this is a common practice.
So, my sub consequent questions are why they don't do so and
should they?
Well, I do think that PE funds executives as asset managers have
an eye on the risks associated with holding those assets for a predetermined
period of time. But I do think also that due to the fact that the portfolio
companies are not public companies, they have already avoided » the market
risk associated with the stock price, and then they narrowed down the risks to
a non market one, or as it is called to an «unsystematic» risk
compared to the «systematic» market risk.
Now that they have only «unsystematic» risks to manage,
how can we break down these risks so that we can have a more in-depth insight
into the question. I'll breakdown the unsystematic risks faced by the PE
portfolio companies into four categories of risks: Forex risk, Commodity risk,
Interest rates risk, and Credit risk.
As we said earlier, on a «direct level», a wise
management will surely undertake to manage these four risks by:
- For the Forex, Commodities and Interest Rate risks: entering
into forwards, options, futures or swaps contracts to sell, buy, take an option
or exchange currencies, commodities or cash flows.
- For the Credit risks: giving a collateral pledge to creditors
and/or setting up a «sinking fund» to ensure debt reimbursement.
Now let's change our perspective again to an «indirect
level». Do PE funds manage these four unsystematic risks on a global
portfolio basis? If the answer is yes, how do they manage those risks? And if
the answer is no, how do they monitor those risks?
Since the answer is more no than yes, I believe that the best way
to manage and monitor those risks on a global fund basis is to take benefit
from the portfolio companies' quarter reporting by asking the top management to
prepare a specific annex detailing their exposure to those four risks at the
end of each quarter. Then the PE managers can sum up those risks by category
for the entire portfolio and determine an aggregate exposure of the fund for
each category of risk. A further step would be to include the point in the
quarter board meeting with the companies top executives and discuss how the
company is measuring and hedging those risks.
I really do not think it is feasible and reasonable for a PE fund
to directly manage these risks stemming from its portfolio companies as
consolidated positions. First, it will be hard to cover a consolidated position
by one or a structured instrument, since the consolidated position is
constantly and simultaneously moving in two directions. Second, the companies
are probably already taking positions to hedge their inner risks, so a
consolidated position would be a double action, and a hedge on a hedge could
result in zero results. Third, the PE fund would be hedging quarter by quarter
because it follows the reporting schedule, and thus will not be as close as the
company to the periodically shifts in the risk exposures that only a company
could manage on a daily basis.
Finally, there is another way how PE funds behave to deal with
those unsystematic risks associated within their portfolio companies. It is not
a financial technique or methodology, but rather a «legal»
methodology or a series of «legal techniques» that are embedded in
the most important document of an acquisition deal: the «Shareholders
Agreement».
This document is crafted by highly experienced legal
professionals on behalf of the PE fund and encompasses all the legal rules and
actions that a PE fund could undertake if the portfolio company won't meet the
expectations fixed or will behave in a way that PE funds disapprove. The
shareholders agreement is also designed for other purposes such as to fix the
company executives compensation or other remunerations for the PE fund, but
certainly the most important part in this document is devoted to the circle the
structure of the «exit» from the company invested in. By including
coercive actions yet legally permitted, the PE fund can quit the company at
anytime if it has been decided so. This exit is also accompanied by a series of
financial decisions that tend to protect the PE funds for their investment in
any circumstances and in such a case I consider the «legal tool» as
an excellent technique of «hedging risks».
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