Increased volatility in financial markets as a result of higher interest rates has revealed fault lines in banks and lenders, sparking concerns about liquidity among a wide range of investors, including private equity fund managers. The unpredictability of financial markets should serve as another reminder for financial sponsors to anticipate new perils and actively manage a broad array of risks.
Looking for potential exposures and addressing them ought to be an ongoing effort, but this exercise has spurred a greater sense of immediacy in the wake of recent U.S. bank failures and stress within European financial institutions. Without previous dedicated diversification strategies, many institutions were caught flat-footed and experienced huge challenges in managing cash flow and analyzing information from disparate sources. Makeshift treasury management systems based on multiple spreadsheets and scattered reporting proved to be inadequate and left many scrambling.
The challenges facing private equity firms in undertaking
risk assessments and managing transparency are far and wide.
Riding out a storm in financial markets involves not only diversifying funding sources and avoiding concentration risk with key liquidity providers, but also implementing the systems and processes that empower firms to manage cash flow, risk and diversification.
The heightened need to employ robust risk management practices as part of overall liquidity management takes on greater meaning for private equity funds. These investors face market conditions which no longer assure portfolio investments can be easily monetized and fundraising efforts continue to be difficult. It’s an environment in which fund CFOs are increasingly focused on liquidity and modern treasury management systems as part of their efforts to be nimble in a rapidly changing global economy.
The challenges facing private equity firms in undertaking risk assessments and managing transparency are far and wide. Many firms may have become accustomed to relying on one bank because working with multiple institutions requires more advanced tools and processes especially when it comes to managing funds in various markets and across multiple legal entities and currencies. Gathering information from multiple banking counterparties that can be readily scrutinized is also challenging, and most home-grown solutions aren’t suited to manage this level of complexity.
A financial wellness check to ensure that liquidity remains intact and available includes the ability to conduct a broad review of a private equity firm’s counterparties, ensuring that a fund is not overly exposed to a single bank, asset class or industry. It’s an effort that involves ongoing monitoring of financial markets for any signs of stress among counterparties and employing sophisticated tools to track ratings and exposure status in real time.
Five Risk Management Strategies
Private equity firms will want to consider the following risk management strategies as they look to anticipate, and mitigate, a range of risks that have surfaced in what promises to be a protracted period of elevated interest rates:
1 – Diversify Liquidity Sources
While many private equity firms have traditionally come to rely on one financial institution because having a single banking relationship has been simpler, market participants need to be aware of concentration risk within their banking relationships.
In the first quarter of this year, investors were reminded of the pitfalls of relying on a single bank or banking group for liquidity. Funds with too much concentration in one source could face significant liquidity shortfalls when a bank, or group of lenders, encounter financial difficulties and need regulatory intervention.
Financial institutions likely will continue to be tested by the sharp runup in interest rates so diversifying the pool of lenders or banks that serve as counterparties is a key risk management technique private equity funds will want to incorporate.
2 – Mitigate Exposure to a Single Asset Class or Sector
Managing risk through diversification also applies to markets and asset classes because the rapid jump in global borrowing costs has had a powerful impact on a wide range of investments. Fund managers should track exposure to avoid concentration risk in a particular asset class, sector, and geography.
Commercial real estate, for example, illustrates the dangers of having too much concentration in one asset class during a rising rate environment. Real estate funds have been hobbled by diminished liquidity tied to higher borrowing costs that have slowed property sales and have weighed on asset prices. Today, property owners have a tougher time financing commercial property loans because of the Federal Reserve’s rate increases and wider yield premiums, or spreads, on bonds pooling commercial real estate loans.
The challenges faced by participants in commercial real estate serve as an example of why it’s important for investors to diminish their exposure to a single asset class and broaden their portfolio’s risk concentration.
3 – Watch for Telltale Signs of Increased Risk Among Counterparties
Managing counterparty risk involves closely monitoring how counterparties are viewed by financial market participants. This means watching how securities issued by various participants trade in debt markets and keeping an eye on rating actions announced by credit rating agencies including Moody’s Investors Service, Fitch Ratings, and Standard & Poor Global Ratings.
Rating actions can reveal issues about the financial health of a counterparty that pose liquidity risks. And changes to yield premiums paid for a business’ debt signal how capital markets view a counterparty’s risk profile and how readily the counterparty can access funding.
4 – Consider Money Market Funds as a Safe Haven
For private equity fund managers who want a real-time view of cash holdings and a safe haven during volatile market conditions, sweeping excess cash directly into a money market fund or money market account is another risk management technique.
Ideally, any excess cash balances are automatically transferred into a money market fund or account, which provides an additional layer of diversification and liquidity.
Money market funds invest in short-term, low-risk securities such as government bonds and commercial paper. This is a relatively safe option for cash management that mitigates the risk of having too much cash sitting idle in a bank account and provides easy access to funds when needed.
Also, companies can potentially earn a higher rate of return on excess cash with a money market fund or account than they would in a traditional bank account.
5 – Manage Currency and Rate Risks with Financial Tools
The global effort to stamp out inflation with aggressive rate hikes by central banks has fueled volatility in foreign exchange and debt markets. Private equity firms can manage these sharp moves in financial markets with hedges in currencies and interest rates. This hedging of risk can be achieved through various techniques such as forward contracts, options, and interest rate swaps.
Hedging currency and interest rate risk helps private equity firms protect their portfolios from adverse market movements, mitigating the impact of sharp currency and interest rate fluctuations on their portfolio holdings. However, it’s important to note that hedging comes with costs and may limit potential gains. It is also crucial to strike a balance between risk management and investment returns.
Conclusion
Recent stress in the banking system has created fissures in global financial markets and broadened the scope of risks for private equity funds to consider and manage. A financial wellness check, for some, may be a new mindset that will require a multi-pronged approach to anticipate risk, bolster liquidity, and manage exposure to counterparties, assets, and markets.
The latest waves of volatility and concerns about liquidity likely won’t go away soon so it’s not too late to start reviewing counterparty risk and developing relationships with a wider pool of funding sources.
About the Author
Sol Zlotchenko is chief product officer and strategy lead for the private markets group at Hazeltree, a leader in active treasury and intelligent operations technology for the alternative asset industry.
Hazeltree’s treasury and portfolio finance technology solutions serve hedge funds, asset managers, private equity funds, private debt, real estate funds, infrastructure funds, pensions and endowments, and their service providers. Hazeltree is headquartered in New York City, with offices in London and Hong Kong.
© 2023 Private Equity Professional | May 9, 2023
