Risk Management
What is Risk Management?
Risk management is the process of quantifying and analyzing risk profiles within an investment, and the goal is to inform investors on the potential losses and volatility of an investment. The risk analysis of an investment is critical as it acts as a filter for investment selection. Oftentimes, individuals or funds have a specific risk tolerance that will dictate their investment decisions. For example, an opportunistic fund will seek out riskier investments for the exchange of higher gains while a core fund will choose stability in exchange for lower returns. The goal of all investors is to minimize risk while maximizing expected return, so it is equally important that investors screen for any irregular risk/return relationships.
Risk Categories
Risk comes in many different forms; the two main risk categories are systematic and unsystematic risk. Systematic risk refers to the macroeconomic factors that all assets are subject to. War, for example, would be considered a systematic risk as it affects a nations entire economy. Unsystematic risks are those that are unique to the asset such as a change in management or the introduction of a new competitor in the industry. Because unsystematic risks are asset specific, they can be mitigated by either avoiding the investment altogether or by making improvements to the asset. Understanding risk in all its forms can help investors understand the opportunities, trade-offs, and costs involved with different investment approaches.
How do we Measure Risk in Finance?
In finance, standard deviation is the statistical measurement for risk. Standard deviation represents how far a value travels from the mean. In this case, our expected return would be the mean and the standard deviation would be the measurement of how far returns can deviate from that mean. To clarify, the standard deviation does not cover the range of all possible return scenarios. The extreme and low probability scenarios are covered by a measurement called value at risk (VAR). The VAR represents the potential loss on an investment given the worst possible scenario.
In the diagram above the center line represents the expected return of an investment. The dark blue section shows the standard deviation or risk of the investment, and the light blue tails represent the extreme and unlikely scenarios. Specifically, the left light blue tail is what the VAR measures. We ignore the right tail because that represents the scenario of extremely high returns which if course is not a risk to the investor.
Risk Management in Private Equity
Risk management in private equity looks very different from public equity investing. The public markets frequently release information on asset performance, risks, macroeconomic conditions, and even investment research. The private markets contain little to none of this, so it is up to the individual to figure out the key financial information and prove its relevance. Therefore, the most successful private equity funds are run by individuals with extensive backgrounds in the industry they are investing in. These individuals or teams have built up industry experience and connections that make them experts in the private market. Private equity funds charge their investors for this knowledge and in return the investors have access to investment return that would otherwise not be available to them.
Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.