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Risks and Insurance for Private Equity Firms

To buy, renew, reword midterm, or trigger Insurance for Private Equity firms: contact us. We are Google's # 1 Liability Risk Manager and a Top Operational Risk Advisor worldwide. We can contractually guarantee results including payout ratios and net cost for tailored coverage that we structure and trigger independently of any insurance broker, company, or lobbyist, for best value to business and investors with a direct impact on IRR.

Insurance for Private Equity Firms

Insurance for private equity firms consists of various commercial insurance products protecting a private equity firm directly or indirectly from physical, cyber, and financial losses. There is a direct correlation between the benefits of insurance for private equity firms and IRR. Such correlation becomes much stronger if the insurance is reworded and triggered independently of any insurance broker, company, lobbyist, so that it covers core operational risks of a portfolio company while producing high insurance payout ratios, which translates into measurable cash flow protection. Upon measuring the extent to which cash flow is protected, the dollar amount of protected cash flow can be incorporated within the valuation models of a portfolio company impacting both liquidity and valuation of such portfolio company and ultimately IRR.

Disclaimer

This content is independent of any content coming from insurance brokers, insurers, law firms, or insurance lobbyists. Commercial insurance is rarely taught in schools, and when it is, it’s mostly done through the lens of brokers or insurers. There are many misconceptions around Insurance for Private Equity firms, like many other topics in commercial insurance, due to bad habits acquired through over reliance on insurance brokers or insurers or information providers who are lobbied by them. It is also important to note that insurance has both an operational aspect and a legal aspect, on which we put weights of 95% and 5% respectively in terms of importance to protecting a business and its investors (the point is that going to court to enforce coverage defeats the purpose of buying insurance, so you want to make sure that whatever insurance you buy protects your organization right and pays out fast on large losses).

construct of insurance for private equity firms
Most Business and Investors miscalculate the construct of insurance for private equity firms.

Private Equity Risk Management Framework

When a private equity firm centralizes its risk management including the procurement of commercial insurance on its portfolio companies, it derives substantial monetary benefits from protecting cash flow across a group of companies making up its fund, which will in turn yield a noticeable positive impact on fund IRR. This is in addition to net savings derived from lower premiums and commissions paid to insurers and brokers. Moreover, it is recommended that a private equity firm conduct an insurance broker RFP every few years in order to maintain cost effectiveness. Ultimately, the private equity risk management framework will have to be tailored to the operations of the private equity firm alongside its investment mandate. A good way to start is to identify the Operational Risk of a private equity firm and build a framework around that.

Private Equity Risk Metrics and Impact on DCF Valuation

Private Equity metrics entail measuring the probability of occurrence along with the severity of specific risks, which will yield an expected value of risk (EVR*) for each risk measured. The total expected value of risk (TEVR), which is the sum of all EVRs across measured risks, can then be deducted from unlevered free cash flow (FCF), either on an average or weighted basis across periods, which then impacts the present value of unlevered FCF. In addition, TEVR can impact Terminal Value and corresponding PV of Terminal Value. Together, TEVR will therefore impact Implied Enterprise Value.

Following the same rationale and for publicly traded companies or those going through an IPO, if TEVR is large enough relative to EV it will noticeably impact the implied equity value of the company and therefore impacting the implied share price from DCF.

*EVR is analogous to Expected Shortfall (ES), which is also known as Conditional Value at Risk (CVaR), Average Value at Risk (AVaR), Expected Tail Loss (ETL), etc. We used a different terminology to highlight the distinction of measuring operational risk to financial risk with various standard deviation outcomes from the mean, not just long tail events. Nevertheless, the mathematical concept is similar in nature.

Impact of Insurance for Private Equity Firms

The insurance bought by private equity firms will essentially have an impact on TEVR. Specifically, the amount and payout ratio (or inversely the basis risk) of the insurance relative to a specific risk will influence the severity of such risk, which will then impact EVR. For example, a credit risk that has a maximum severity of $1 million (without insurance) will have a net maximum severity of $500,000 with credit insurance of $600,000 entailing a deductible of $100,000 and a payout ratio of 100%. In this example, severity was reduced by 50%, which would translate into EVR being reduced by 50% assuming the probability of occurrence of such risk has not changed. That is a significant reduction in the magnitude of a single risk. If multiple measured risks can yield similar levels of reduction in EVR, then TEVR will be substantially reduced and will have a noticeable impact on Enterprise Value.

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'What Private Equity'

Private Equity is an investment asset class, which entails investing in private companies (those whose shares are not publicly traded).

Risks of Private Equity

Risks of private equity vary and they would fall under 3 main categories: physical, cyber, and financial. Each one of those categories includes various sub-categories. In order for investors or LPs to accurately assess risks of private equity, it is important for them to measure the Operational Risk of the private equity structure they are investing in, including the underlying investments. Our team can assist with performing risk due diligence on private equity investments for institutional investors.

Private Equity Risk Factors

Please see the section right above, which broadly describes the categories of risks of private equity. Individual private equity risk factors require a formal approach to risk assessment and measurement.

Private Equity Risk Assessment

Private Equity Risk Assessment can entail either the LPs assessing the risk of the private equity structure they are investing in, or the assessment of investment risks and insurance for private equity firms by the GP. Risk Assessment is a part of an overall private equity risk management framework, which we discuss in a section above.

Risk Strategies Private Equity

There are a variety of risk strategies that can be utilized by a private equity firm to boost and/or protect IRR. The first step in the process is to build a private equity risk management framework, which we discuss in a section above.

Private Equity Risk Premium

The risk premium attached to private equity investments depends on private equity risk metrics including insurance for private equity firms. A thorough understanding and analysis of the drivers of risks impacting IRR and how they are hedged is essential to determining the private equity risk premium. Please refer to the above sections.

Private Equity Performance and Liquidity Risk

The measurement and premium attached to private equity performance and liquidity risk follows the same rationale as outlined in the section above.

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