EVCA examines the risk profile of investment in relation to Basel II

10 March 2004

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EVCA has announced the findings of a new independent study, conducted on behalf of EVCA by Tom Weidig and Pierre-Yves Mathonet, on the risk profiles of venture capital and private equity investment in relation to the Basel II proposals. The study shows that the risk levels involved in private equity investment vary considerably depending on the investment vehicle used. It indicates that diversifying investments through a fund structure (whether a managed fund or a fund-of-funds) reduces risk compared to direct investment into an individual company.Based on this evidence, EVCA's view is that the current Basel II proposals on risk weighting for private equity investment, intended to match the amount of capital that banks are required to hold more closely to the risk levels of their investments, require greater deliberation. The study looked at the risk profiles of three possible routes to investment in private equity and venture capital: direct investment into a company; investment through a managed fund; investment through a fund-of-funds. The findings show that the probability of a complete loss of the initial capital invested or any loss at all varies significantly between the three types of investment.The study's findings report that an investment through a fund-of-funds, where capital is collected from investors for investment in some 20 private equity and venture capital funds, has a 0% probability of total loss and only about 1% probability of some loss. The probability of a complete loss of capital invested via investment through a managed fund, where capital is raised from investors for investment in 10 to 20 portfolio companies, is only about 1%, although the probability of some loss is around 30%. Direct investment, whereby an investor provides capital directly to a company, is the most risky with a 30% probability of total loss and a 42% probability of some loss.EVCA has already expressed concerns to the Basel Committee that the risk weighting aspects of the proposed Basel II Accord appear excessive, and if applied as currently proposed to the private equity and venture capital industry, these risk weightings could rise as much as three-fold from current levels (from 8% in the Basel I Accord to 24% or even 32% in the Basel II proposal). This could lead to a significant retreat by banks from investment in private equity and venture capital funds. In 2002, E6.8bn - one quarter of all capital raised for the European private equity and venture capital industry - came from banks. Over a five-year period (1998/2002) that figure rose to over E38bn. Consequently, many small- and medium-sized enterprises could be deprived of this annual flow of equity finance, especially if banks limit their investment at the same time due to a change in risk weightings in their allocation of loan capital to SMEs.