Can we interpret the role of PE/VC investments as a form of risk management? Investments in PE/VC are usually thought of as being high risk / high return, But, studies also show that PE investments can reduce risk in certain situations. The academic version of this paper was submitted in partial fulfilment of the requirements of the Imperial MBA degree and the Diploma of Imperial College London. The academic version of this paper was awarded a Distinction.

1. Can we view the role of
PE/VC investments as a
form of risk management?
​Izam Ryan
​Imperial FT MBA 2013/14
​izamryan@gmail.com

2. © 2014 Izam Ryan
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Investments in PE/VC are usually thought
of as being high risk / high return.
​When applying the
Markowitz Mean-Variance
framework to portfolio
construction, we analyse
investments by their
expected return (“Mean”)
and the volatility in that
return (“Variance”)
(Markowitz (1952) and
Markowitz(1970)).
​This means that we deliberately pick investments based on a conscious decision to trade
risk for return or vice versa. For example, one strategy could be to pick a target return then
construct a portfolio that has the minimum level of risk for that target return. Or we could
start with a budgeted level of risk that we are comfortable with taking on, and then construct
a portfolio that has the maximum return for our budgeted risk.
​Private equity (PE) and Venture capital (VC) funds are thought to represent high risk and
high return investment opportunities to their investors. This is because:
 they hold illiquid investments (their asset base attracts a liquidity discount and therefore
the required return must be higher to account for this higher risk) (Scarpati, F. & Ng, W.
(2013))
 Some PE funds such as Bain Capital are well known in their use of financial leverage to
amplify gains in leveraged buyout transactions (LBOs) but at the cost of increasing
bankruptcy risk (Berk, J.B. & DeMarzo, P. M. (2007).
​Leeds, R. & Sunderland, J. (2003) go on to say that it is this risk-seeking and risk-amplifying
behaviour results in an expected return to 25% or more.
statement

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In the 1997-2006 analysis below, PE funds
return >20% but have a std. dev. >30%
​Source: Idzorek (2007)
statistics support this statement
24.85%
21.46%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00%
Cash US bonds Non-US bonds
US Stocks Non-US Developed Stocks Emerging Market Stocks
US Private Equity Non-US Private Equity
Std. dev.
Average
return
These 2 data
points support
the statement
that PE/VC are
“high risk /
high return”

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But, studies also show that PE investments
can reduce risk in certain situations
Asset class Return Std.
Dev.
MSCI Europe 10.26% 18.62%
JPMorgan Euro Bond 7.84% 4.57%
PE (Equity
reinvestment)
10.56% 20.44%
PE (Bond reinvestment) 10.39% 10.62%
​An (EVCA) (2004) analysis shows that there are occasions where
investments in private equity can actually reduce risk. In this table we
can see that for the same level of return ~10%, investors could have
used a medium risk strategy (std. dev. 18%) of investing in an equity
index (MSCI Europe). Or investors could have amplified that risk (std.
dev. 20%) and invested in PE, with proceeds reinvested in an equity
index.
​Or investors could have adopted a lower risk strategy (std.dev. 11%) by
investing in PE and funnelling proceeds into the lower-correlation,
JPMorgan Euro Bonds.
​We can therefore see that in some portfolio configurations, adding a
high-risk, high-return investment can actually reduce risk in a portfolio.
complication
​Source: Table 23, European Private Equity & Venture Capital Association (EVCA) (2004)
​Source: Table 23

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Can PE/VC funds be a tool for risk
management? If so, how?
​Using the mean-variance framework to
analyse this phenomenon – we can say that
under certain conditions, PE/VC investments
lead to a mean-variance efficiency gain when
they are added to a wider portfolio.
​In order for this to happen, the existing portfolio
assets must have low correlations with the PE/VC
investment,
​But are we limiting our analysis by only using
the mean-variance framework? Could we
extend our thinking and see other ways that
PE/VC funds can be used as a tool for risk
management?
question

6. ​To understand this better, we
will now analyse the kinds of
risks (and opportunities) that
PE/VC funds are exposed to.
Could we
extend our
thinking ?

7. © 2014 Izam Ryan
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What are the value drivers, the sources of
alpha, the “special sauce” in PE/VC funds?
Expected
Return
CAPM
Rational
risks
Inefficiencies
Less: Costs
​Scarpati, F. and Ng, W.
(2013) provide a framework
we can use to analyse the
drivers of returns in PE/VC
investments.
​They analysed the main
drivers of expected return as
being:
​The traditional CAPM measures
​Rational risks
​Inefficiencies; and
​Costs.
a topology of risks
​Source: Scarpati, F. and Ng, W. (2013)

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Analysing Scarpati & Ng’s framework
against a topology of risks, there may be
scope to further develop the strategic risks
CAPM Rational Irrational Less: Costs
Systematic risk, Size,
Market premia
Market inefficiencies Opportunity costs,
internal costs, fees, etc.
Illiquidity risk
Monitoring intensity
Overconfidence
Scope to further develop strategic risks
a topology of risks
​Source: Figure 1A-1, Mark, R., Galai, D., & Crouhy, M. (2006)
Scarpati, F. and Ng, W. (2013)
Risks
Market
Credit
Liquidity
Operational
Legal and regulatory
Business
Strategic
Reputational

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We propose refining the topology of risks
by adding: Biz model, Innovation and
Financial engineering risks.
​We develop further on Mark, R., Galai, D., & Crouhy, M. (2006)
by proposing some new strategic risks which we will refer to as:
​Business model risk is the risk that a Company isn’t configured to extract
the most value out of its value proposition
​Innovation risk is the risk that a firm loses market share to a
competitor’s disruptive innovation and is eventually overtaken
​Strategic engineering risk is the risk a company isn’t actively managing
value
a topology of risks - refined
​Source: Figure 1A-1, Mark, R., Galai, D., & Crouhy, M. (2006)
Scarpati, F. and Ng, W. (2013)
Risks
Market
Credit
Liquidity
Operational
Legal and
regulatory
Business
Strategic
Reputational

10. © 2014 Izam Ryan
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Business model risk is the risk that a
Company isn’t configured to extract the
most value out of its value proposition
​Financial investors fund companies through periods of extreme
uncertainty and risk as the venture develops its value
proposition and experiments with different business models.
​We can understand this as being a situation where investors put in time
and money to extract value at a future date while their equity is being
subject to business model risk.
​For example, a PE fund may acquire a real estate asset and finance the
business model shift (e.g. X-Leisure fund) to turnaround the business.
​In another example, a VC fund may invest in a business through different
business model shifts – for example MySQL AB shifted its revenue
model from large 1-off payments to annual subscriptions, and this
business model tweak was done under the ownership of VC funds.
risks – business model risk
​Source: Ries, E. (2011). Business Model Foundry (2014). X-Leisure Ltd (2014) . LaMonica (2005). Index Ventures (2014).

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Innovation risk is the risk that a firm loses
market share to a competitor’s disruptive
innovation and is eventually overtaken
​Using the language of the mean-variance framework, if we look
at a VC’s investments in different tech startups, we could say
that building a portfolio of innovation will generate better
returns for any given level of risk when compared to investing in
only a single technology.
​Building on this concept, we may say – in a VC’s innovation portfolio
there will is a risk that one of the innovations is a disruptive innovation.
​We could therefore say that part of a VC’s function is to exploit
inefficiencies/opportunities by seeking out and financing disruptive
innovation, leveraging on its informational advantages.
risks – innovation risk
​Source: Christensen, C. M., & Raynor, M. E. (2003).
Time
Features/
performance
Disruption
Current
Today

12. © 2014 Izam Ryan
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Strategic engineering risk is the risk a
company isn’t actively managing value
​Not to be confused with model risk! Strategic engineering risk is the risk
that a company isn’t sweating its assets in the way PE owners do –
through cost cutting, capital efficiency or through constantly seeking the
best owner of its strategic assets.
​The concept of the “best owner” of strategic assets is a key cornerstone
of Value, as described by Koller, T & et al (2010), whereby the best
owner of an asset may not necessarily be the current owners.
​With this frame in mind, we can say that any portfolio investment held by
a company is a candidate for a divestment, and in fact that divestments
may be a key source of creating value for the owner (because another
company may place a higher valuation on that asset).
​This constant “pull” of forces outside the company that draw assets to
their “best owner” is partly makes private equity owners sweat their
assets – because they know that in order to achieve a profitable exit,
that they should sweat the assets under their care.
risks – strategic engineering risk
​Source: Koller, T & et al (2010)
10
17
0
2
4
6
8
10
12
14
16
18
Enterprise Value
Without engineering
With engineering

13. ​We now try to apply these
concepts to practical risk
management considerations
Conclusion

14. © 2014 Izam Ryan
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Corporates could structure holding
companies like private equity funds
MNC
Division 1 Division 2 Division 3
Intermediate
Holdco
Unit 1
Unit 2
Unit 3
​One implication for this is that multi national corporates (MNC) may want
to consider setting up intermediate holding companies as a mechanism
to hold portfolio companies (e.g. Unit 1, 2 and 3 in the diagram).
​This way, the intermediate holdco could be partly financed through
external debt, and the acquisition of the portfolio companies can be
leveraged.
​Although this increases the bankruptcy risk of Division 3 – this would
have the effect of increasing financial discipline at the portfolio company
level and enhancing returns through leverage.
​This would address what we called “strategic engineering risk” – i.e. the
risk that a company isn’t sweating its investments and assets in the
same way that a PE fund tends to do.
​Using leverage also enables the MNC to increase its total capacity for
M&A and therefore provide more capacity to experiment with “business
model risk” and “innovation risk”.
conclusion – what can corporates learn from this

15. © 2014 Izam Ryan
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Corporates could hedge innovation risk
through using corporate venturing arms
Venture
portfolio
Old Tech
New Tech #1
New Tech #2
​Corporates that are exposed to high levels of innovation risk (for
example, companies that compete in markets where the pace of
technology advancement is extremely fast) should set up corporate
venturing arms.
​In this way, the corporate would be able to build a portfolio of different
technologies, with the objective of driving excess returns from
undertaking these new risks (for example in New Tech#1 and #2 in the
diagram).
​Provided that these innovation risks are uncorrelated to the risks of the
“Old Tech” (and therefore that there is no basis risk of incorrect
hedging), this approach would increase absolute returns.
​In a way, investing through a venture portfolio creates optionality in a
corporate’s innovation portfolio. Damodaran (2010) gives an application
of real world option theory in the field of assessing investments under
extreme risk and could be a basis for corporates to value their
investments in corporate venturing.
conclusion – what can corporates learn from this

16. © 2014 Izam Ryan
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The fund is a nexus of operations that
exploits information asymmetries and
trades them with time
​Risk premium of PE/VC funds comes from more than just
financial leverage and LBO’s. Our key hypothesis is that the
funds serve as a nexus – they undertake investments that
expose the funds to biz model risk, innovation risk and strategic
engineering risk.
​In a way – the fund is exploiting information asymmetries. It is
in a unique position as investor and as fund manager to both
concentrate capital in new ventures and to earn excess returns
for investors, all the while charging a management fee.
conclusion – one way to perceive the PE/VC firm

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thank you

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Bibliography
appendix
​Berk, J. B., & DeMarzo, P. M. (2007). Corporate finance. Pearson Education.
​Business Model Foundry (2014). Business Model Canvas. Available from: http://businessmodelgeneration.com/canvas [Accessed 23 March
2014]
​Christensen, C. M., & Raynor, M. E. (2003). The innovator's solution: Creating and sustaining successful growth. Harvard Business Press.
​Damodaran, A. (2007). Strategic risk taking: a framework for risk management. Pearson Prentice Hall.
​Damodaran, A. (2010). The dark side of valuation: valuing young, distressed, and complex businesses. FT Press.
​Ries, E. (2011). The lean startup: How today's entrepreneurs use continuous innovation to create radically successful businesses. Random
House LLC.
​European Private Equity & Venture Capital Association (EVCA) (2004). Performance measurement and asset allocation for European Private
Equity Funds. Research Paper. Available from:
http://www.evca.eu/uploadedFiles/Home/Knowledge_Center/External_Research/Academics/full_study.pdf [Accessed 23 March 2014]

19. © 2014 Izam Ryan
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Bibliography
appendix
​Idzorek, T. (2007) Private Equity and Strategic Asset Allocation. Ibbotson. Available from:
https://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/IbbotsonPrivateEquity.pdf [Accessed 23 March
2014]
​Index Ventures (2014) Available from: http://www.indexventures.com/portfolio#company_id_20 [Accessed 23 March 2014]
​Koller, T., Dobbs, R., & Huyett, B. (2010). Value: The four cornerstones of corporate finance. John Wiley & Sons.
​LaMonica, M. (2005). MySQL Network shifts pricing, licensing. CNET News. Available from: http://news.cnet.com/MySQL-Network-shifts-
pricing,-licensing/2100-7344_3-5575983.html [Accessed 23 March 2014]
​Leeds, R., & Sunderland, J. (2003). Private equity investing in emerging markets. Journal of applied corporate finance, 15(4), 111-119.
​Mark, R., Galai, D., & Crouhy, M. (2006). The Essentials of Risk Management. New York.
​Markowitz, H. (1952). Portfolio selection*. The journal of finance, 7(1), 77-91.
​Markowitz, H. M. (1970). Portfolio selection: efficient diversification of investments (Vol. 16). Yale University Press.

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Bibliography
appendix
​Scarpati, F. and Ng, W. (2013) Journal of Private Equity, Vol. 16, No. 4 : 8-20
​X-Leisure Ltd (2014) About X-Leisure. Available from: http://www.x-leisure.co.uk/about-x-leisure/ [Accessed 23 March 2014]