Private equity derivatives: Hedging your bets

This month sees the newly created private exchange, London Private Equity Futures and Options Exchange (PEFOX), launch derivatives tracking private equity funds - understood to be the first in this space. The products have been structured as non-deliverable standardised contracts, where no delivery of the underlying asset takes place. As such, investors in a specific private equity fund would be able to take short positions on their exposures, hedging the downside risks, with the counterparty to the transaction being another investor speculating on the rise in the value of the fund.

"After the financial crisis, investors in private equity really began to question the wisdom of being locked into a blind pool for eight years plus, with little or no chance of liquidity," says Kishore Kansal, PEFOX's managing partner in London. "Like the Emperor, they found themselves both naked and over exposed. Like it or not, we now live in a time of significantly higher volatility and this is something which investors can no longer ignore."

The derivatives will track what PEFOX describes as the "elite" funds - usually the most heavily subscribed funds. Although not able to provide full details of the names and number of funds to be tracked, the company said the move was driven by market demand from institutional investors - to improve liquidity and hedge risks. However, questions have been raised on how they will be priced, and whether it makes economic sense to use derivatives to hedge private equity exposure. Pricing concerns are targeted at options, whose models require a measure of volatility for valuation.

"This is another development - maybe not a surprising one - as the asset class develops further. What I would be most interested to find out is how the options are going to be priced," says a head of fund investments at a London-based private equity investment company. "For the public markets - volatility is the standard deviation of daily returns. How do you work out volatility on a private equity investment? I would be fascinated to find out."

Paul Ward, partner at Pantheon Ventures, a London-based funds-of-funds investment company also raises concerns on pricing and volatility - questioning whether there is even sufficient volatility in private equity funds. He notes that, at most, investors would see a quarterly movement in fund values - and additionally questions the economic rational of hedging private equity exposure in the first place.

"Most investors go into private equity to get alpha - to have part of their portfolio exposed to higher risk and gain the high returns associated with it," says Ward. "I am not sure why they would neutralise their returns by hedging."

Only time will tell whether private equity derivatives will be sought after by investors but, for now, the private equity landscape has become a lot more complicated.

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