Solvency II: Doubts cast over private equity risk measures

Gail Mwamba
06 July 2010

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The scramble for cash among GPs is set to heat up as they prepare for another reduction in capital allocations т this time from European insurers - as regulators work on plans forcing them to hold additional cash as a buffer against private equity risk. But some are challenging the validity of the measures used in assessing the true risks of private equity investing. Gail Mwamba investigates

The past few months have seen private equity players debate the AIFM directive. But, while all eyes are on this, regulators have also been working on another regulation - the Solvency II - which covers the calibration of risks for European insurers. The rule falls under the European Commission's Committee of European Insurance and Occupational Pensions Supervisors (Ceiops) as part of wider measures to assess risk buffers for insurer's investments - including private equity.

However, discontent has arisen over the suitability of this method to calibrate private equity risk. With insurers estimated to have funded about €22bn of private equity allocation during 2007 in the French market alone, risk calibrations are indeed significant. Questions surround the suitability of Ceiops' use of LPX 50 - an index of publicly listed private equity companies - as a proxy for private equity investing.

Ceiops calculated the correlation of the LPX 50 and the MSCI Index to be about 75%, and therefore uses the MSCI Index as risk measure of private equity investment. But according to analysts at the EDHEC Financial Analysis and Accounting Research Centre, the index is not an appropriate proxy.

"Investing directly in listed firms involved primarily in private buyouts, such as Blackstone and Eurazeo, does not pose the same risks as investing in private equity funds or funds-of-funds," the analysts note. "Capital requirements for private equity risk could lead many European insurers to reduce appreciably their asset allocation to unlisted stocks or even to stop these investments."

The researchers found that the actual correlation between the MSCI Index and directly investing in private equity funds was in fact much lower, casting doubt on the MSCI's appropriateness as a risk proxy. Their research revealed that European buyout funds have a 54% correlation, while European venture funds only 11% - significantly lower than the 75% adopted by the regulators. The researchers analysed annualised internal rates of returns of 1,120 liquidated and closed European and US private equity funds between 1980 to 2009 - and compared these with the MSCI Index.

According to Professor Eli Talmor, chairman of the London Business School's Coller Institute of Private Equity, some of the constituents of indices such as LPX 50 and the S&P Listed Private Equity Index are not representative of true private equity fund investing.

"When you closely examine the make up of listed private equity indices, they consist of all sort of vehicles -investment companies, quoted GPs, quoted assets, and quoted fund of funds. They are all related to private equity but vary greatly in their economic model," he notes. "Some companies have a broader focus than just private equity. Many are closer to hedge funds"

Regulators are, however, ploughing on with new rules, testing the measures between August and October this year - with the directive set to come into full force by November 2011. Once the rules are fully implemented, the race for cash among GPs will indeed become even more competitive.