The levels of risk

Risk management, compliance, due diligence – they’re the unglamorous aspects of alternative investments, but increasingly important. For the burgeoning private debt fund industry, managing risk to preserve investors’ capital is paramount. But increasingly, firms like Validus are urging managers to consider risk management as a value-enhancing tool, rather than a cost.

Private Debt Investor meets Validus’ two co-chief executives, Kevin Lester and Francois Scheepers, at London Business School, where one of the firm’s senior advisors and board members, Florin Vasvari,  is a faculty. It’s an unseasonably warm September day, matching the trio’s disposition as they enthusiastically discuss changing attitudes to risk.

A tripartite approach 

Lester explains how the firm divides risk into three levels. “The first level is what we’d call investment risk. That’s the credit decision – who are you going to lend to, how you’re going to structure the deal? For a private debt fund, that’s really their core competency. So in that type of risk, there’s obviously upside and downside. The downside is that if they don’t do their job well they make bad investments and they can lose money. The upside is they make good investments, and good returns. But they’re paid to take that risk and importantly, they’re largely in control of that upside.

“The next level down is what we call market risk, which also has an upside and a downside, but it’s essentially random. For example, if you’re lending in a foreign currency, you have currency risk attached. Are you lending fixed or floating rate? If it’s fixed, rates could go up which can have a negative effect if your peers are lending with floating rates.

“The third level is risks which don’t have an upside, only downside. They are things like operational risk, counterparty risk, and liquidity risk. These are the sort of risks a fund definitely wants to mitigate,” Lester adds.

He argues that firms want  to embrace  risk at the first level because of the potential to create upside. At the second level, they want to manage it. And at the third, it’s about mitigating it. 

Validus concedes that as far as the first level is concerned, consultants have only a limited role to play. “When it comes to the investment risk area, that’s what the fund manager is an expert in, so typically the only way an outsider like us could get involved in that area is where it links to extrinsic risks. We’re more focused on the second and third levels – the origins of our firm are very much on the second level, the market risk side,” Lester explains.

As an illustration, Lester uses the example of an international bond fund as a proxy. Over the last 10 years for a dollar investor, currency issues have contributed between 50 and 80 percent of the volatility of the overall return. “All funds which are invested internationally are aware of that risk; the question is, ‘What do you do about it?’ That’s where we get involved,” he adds.

Eliminating one type of risk can increase risk elsewhere however. “A good example at the moment is the emerging market crisis. Take a private debt fund that invests in those markets. Because they’re generally perceived as being very risky, they can be very expensive to hedge, the fund will invest in dollars. That eliminates market risk, but it increases investment risk. Let’s say you’ve got an Indian company that’s borrowed from you in dollars, but the Rupee has depreciated by 30 percent; so all of a sudden that loan might not get repaid because it’s a lot bigger than it was,” Lester says. 

Core activity, cost, or differentiator? 

Different firms approach risk management in very different ways, the Validus team argues. Some view it as a core operational activity. Others roll their eyes and view it is as a requirement brought about by increased regulation and ever more demanding investors. The final way, ‘the third way’, is where funds seek to use risk management as a differentiator or source of competitive advantage.  “Currency risk is a classic example, but equally, providing a much more transparent picture of performance to their investors because they’ve got a handle on the risks involved fits into that category,” Lester says.

Scheepers picks up the baton. “In the corporate world, risk management was always a cost centre. Now, because of the volatility in currencies, commodity prices and so on, you can’t divorce risk management from the strategic direction and planning. More and more, it needs to be part of the board-level dialogue. We’re seeing it increasingly within the funds community now too, especially with investors demanding more transparency.

“Pre-AIFMD, it was a tick-the-box exercise, and I think a lot of people still hope that will remain the case. If you think about it the right way, it doesn’t have to be. You can use that energy and effort you’re putting in to your risk management programme to add value, increase performance, and aid your next fundraising cycle. If you do it right, it can be very additive.”

Traditionally, firms have tended to be reactive when it comes to risk management. “A risk issue would come up that had perhaps hurt returns, and a firm would ask, ‘How do we address this?’ That’s difficult because you’re already in a hole and trying to get out,” Lester argues.

“Now people are trying to get ahead of the curve, particularly in light of all the new regulations. During the financial crisis, things like currencies suddenly became much more volatile than they had been, and returns came under pressure. The combination of those two things woke a lot of people up to the fact that you can’t just pretend this isn’t there.”

Vasvari makes an interesting point about some additional benefits accruing from good risk management. “It doesn’t just help the GP on the investor side. It also helps the investment opportunity set. When you deal with other counterparties and you convince them you can hedge risk, you become a more reliable partner. You avoid liquidity crunches if you plan ahead. It makes a lot of investment sense,” he says.

Being proactive can also save a firm money in the long-term. “If you think about origination processes, people screen investment opportunities and conduct due diligence, and they spend a lot of money on that. During this due diligence process, a lot of issues can come up, many of which can be anticipated. The cost of hedging against those at an earlier date versus the cost at the due diligence stage can be a lot lower. In relative terms, it makes good business sense to spend a couple of basis points hedging a risk which might be a low probability tail risk, but without it hedged, you might not be able to deliver a positive return if things go wrong. Given the upside is usually limited [in PD funds] you can’t really use the upside to overcome losses. One default can kill the whole fund, whereas with private equity, one bad deal can sometimes be more easily accommodated,” he says.

Even simple currency volatility can have a severely detrimental effect on performance. Over any given year, the team argues, and based on current volatility, you could expect a detrimental impact of 8 percent or more. That’s more than half your return gone if you’re a mezzanine fund. If you’re doing senior debt, you’re staring down the barrel.

Pressure on returns is causing many firms to focus harder on yields rather than capital gains. To survive in such a market, you either need scale – the trio predict bigger fund sizes will become a key feature of the market – or you need to manage risk very carefully because the margins are so much smaller.

Counting the cost 

For managers looking to build out a fully fledged risk management programme, there are two options: go in-house, or outsource to a specialist. “If you look at the cost of building an in-house risk management team, it probably equates to about €600,000 a year – two or three full-time people, the right systems and so on,” Lester estimates. “For a fund of €500 million or below, that’s going to eat up a lot of your management fee. It’s counter-balancing how you get that risk management process whilst being as efficient as possible. You have to be clever about how and what you hedge, and not hedge things you don’t need to. Are there some risks you can offload to your investors through the structure of your fund perhaps?”

Vasvari argues that an in-house team, even a very experienced one, won’t have the same breadth of knowledge of current trends as a third party advisor however. “Even if you have an in-house team – and that’s assuming you can hire people with the requisite skillset, which is not easy – you still need that market intelligence which you get from an intermediary who sees a lot of transactions, and who can do benchmarking. An in-house team will only see a handful of deals and will work with only one or two banks so might not develop the most cost-efficient solutions.”

Scheepers sets out some of the advantages to being independent. “We deal with all the big banks. After a while, they get to know and understand how you’re seeking to risk manage your clients’ exposure to various elements of the market. When you then approach them, it’s easier to relay that message because from a benchmarking perspective they know you’re running a successful programme and you can then transpose that to a new client. It takes a long time. Despite all the technology, it’s still about personal interaction, looking the other guy in the eye and building trust. That credit risk isn’t just about asking ‘how strong is my balance sheet?’, it’s about giving the other guy a certificate of compliance that there’ll be enough liquidity in the next quarter. That’s just a trust issue. We seek to grease the wheels of the risk management process for our clients, and we strive to take as much of the strain and effort off them as possible so they can focus their energies somewhere else,” he adds.

Simplifying risk management lies at the core of Validus’ approach, Scheepers says. “Our methodology and ethos is very much about presenting risk simply. We want anybody to be able to look at a presentation and understand it immediately. We don’t want to use blind science, we want to keep it simple. At the end of the day, risk is built into us, and it’s fundamentally about judgement.”

“You can go too far the other way though,” Lester cautions. “You can argue that in conventional or theoretical risk management there’s been an over-reliance on models and they’ve developed a bad reputation. In some cases the response in the private debt and private equity space has been to go too far in the other direction though, and rely purely on gut feeling and intuition. There’s a happy medium that needs to be found.

“We do try and bring numbers and measures where we can. We do bring that rigour and structure. If we’re designing a hedging programme for currency risk, let’s say, we ask what are the key metrics? There’s the cost, there’s the potential liquidity impact that a hedging strategy could have. There’s the impact of that risk on my return. You can put numbers to that. You can say, ‘I’m willing to experience this much liquidity drag’, ‘I’m willing to pay this many basis points’, ‘I’m willing to risk up to 200bps of my return’. Then you can calibrate them and do a more rigorous cost / benefit analysis. It’s so complex, you can’t just rely on your gut. But you shouldn’t go back to the other extreme where it’s just a black box approach, crunching numbers.”

That balance lies at the heart of effective risk management – finding an equilibrium between effective modelling of risks and using good judgment and human interaction to build trust. Whether a fund manager develops those skills in-house or looks for external support, one thing is certain: in a volatile economic climate and with increasingly risk-averse investors, it’s a brave manager who doesn’t invest in a comprehensive programme.  ?