High-net-worth individuals have adopted the concept of investing a portion of their stock positions in alternative asset classes, such as private equity. Private equity funds are invested in new enterprises or start-ups with high growth potential. Private equity firms also attempt to turn around or enhance the company in which they invest by replacing management or simplifying corporate procedures.
Private equity investing has gained popularity due to its track record of strong returns, which are difficult to acquire through more traditional investment methods. However, due to the nature of the underlying assets, private equity entails a distinct level of risk than other asset types.
Risks in the Competitive Environment
The competition for finding suitable investment opportunities may be fierce.
Risks of noncompliance
The Securities and Exchange Commission’s (SEC) Division of Examinations is continuing to implement its previously announced top priorities for 2021, which include a greater emphasis on climate and environmental, social, and governance (ESG) risks, business continuity and disaster recovery plans, and retail investors’ fiduciary responsibilities.
This emphasis follows the SEC’s creation of a private funds unit in 2016. Compliance concerns for corporations and their assets may increase if government monitoring steps up enforcement actions surrounding private equity.
This increased scrutiny should drive private equity managers to:
a greater emphasis on due diligence and paperwork
A compliance culture with management-led training
A cost-benefit analysis of selecting and sustaining a chief compliance officer
Bottom line: private equity firms must not only do more thorough due diligence on potential partners, acquisitions, and investors, but they must also guarantee that their portfolio companies comply to regulatory obligations in continuing operations.
Agency Danger
Managers of private equity portfolio firms may not prioritise the interests of the private equity company and the investors.
Risk of Taxation
Capital gains, dividends, and limited partnerships may be taxed differently over time.
Regulatory Risk from the Government
Government regulation may have a negative impact on the portfolio enterprises’ products and services.
Capital Danger
Withdrawing capital increases the likelihood of commercial and financial dangers. Furthermore, portfolio companies may find it challenging to attract successive rounds of financing.
Cyber and technological threats
While all businesses are vulnerable to cyber attacks, private equity firms confront a broader range of cyber risks from both internal and external sources, owing to their ownership in a diversified group of portfolio companies. Among these sources are:
Employees
Third-party contractors hired by the company
Other outside actors that may share managerial duties with the company
Furthermore, because private equity investors are investing in a company’s future growth, goals are frequently centred on quickly leveraging strengths and effectively targeting returns. What is the issue? A strong emphasis on financial development and productivity might overshadow cyber-risk management and control. Inconsistencies in the firm’s use of security, such as inside infrastructure and systems, may result in unexpected exposes. To manage the risk, the company and its portfolio firms must implement a uniform set of mandatory security procedures.
Furthermore, when a private equity firm grows in size, monitoring risk across a company’s whole technological infrastructure will become increasingly difficult. That means an ever-expanding list of possible dangers associated with:
- Cloud computing software
- Access and identification
- Intellectual property protection
- Investor information security
Risk of Liquidity
Because private equity investments are not publicly traded, it may be difficult to liquidate a holding.
Third-party supervision
As private equity companies expand their outsourcing activities and employ important third-party partnerships, the breadth of possible risk expands in lockstep. Recognizing the trend, authorities have said unequivocally that outsourcing an activity or function does not absolve corporations of ultimate compliance obligation. They must actively manage these partnerships or risk being held accountable for the purposeful or unintentional unlawful activities of their third-party business partners.
An effective and standardised due diligence approach that monitors performance and evaluates the value of all partners can aid in the early discovery of potential difficulties. Take the following actions into account for continuing third-party risk management:
- Define the extent of the hazards involved.
- Establish a schedule for third-party monitoring and reporting.
- Conduct internal audits and review compliance history.
- Keep records of the due diligence process and findings.
In conclusion
Private equity investment has a greater risk profile than other asset types, but the potential profits are far larger. Private equity may be a profitable investment for a piece of a portfolio for investors with the cash and risk tolerance.
