Risk management for private equity funds

Although risk management has been explored thoroughly in financial modeling for over three decades, there is still a limited understanding of how to correctly quantify and manage the risks of investing in private equity, which continues to hinder our understanding of the risks associated with other traditional asset classes. This paper develops a comprehensive risk management framework for private equity fund investments, which captures the three main sources of risks that private equity investors face when investing in the asset class: market risk, liquidity risk and cashflow risk. Underlying the framework is a stochastic model for the value and cashflow dynamics of private equity funds, which allows us to derive three dynamic risk measures for private equity fund investments: value-at-risk, liquidity-adjusted value-at-risk and cashflow-at-risk. The model is calibrated with historical data of buyout funds, and the dynamics of the developed risk measures are illustrated for a single fund investment using Monte Carlo simulations. A model extension also studies the dynamics of the risk measures for portfolios of funds and develops a novel dynamic commitment strategy. Finally, sensitivity analyses show the impact of changes in the main model parameters on risk measures.