Quantify Risk Reward (Private Eq)

I guess this question can be posed from the perspective of owning any security. I am hoping to learn how can one go about quantifying the risk with an investment in order to more accurately calculated the adjusted reward-risk ratio. Let me start off with a couple of examples:

  • I am looking for an investment in EM. My projected IRR is 25% and assume that the fx depreciation risk, which for simplicity purposes is the only risk, is 15%. This means my effective IRR is 10%

  • In another case, let's say projected IRR is again 25, but this time customer concentration is the only risk - top 5 customers make up 80% of revenues.

How can I quantify this risk (customer concentration) and other such type of
Risks (bad infra, Corp governance, high competition, poor industry growth forecast, lack of substantial competitive moat etc) in my investment memo analysis to better estimated the adjusted IRR Of the opportunity.

I think doing such analysis will help me better compare opportunities across markets, sectors.
I am interested in hearing how people look at this. I think there needs to be More analysis than just saying because this opportunity has many risks, I will therefore look for an irr or 30-40%

Thanks all

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Comments (10)

  • Associate 1 in PE - LBOs
Jan 20, 2020 - 9:06am

Thank you for your response Rover! Can we please go through a simple example. Say top 3 biz risks are the following with the corresponding probability of materializing:

Customer concentration (50%)
High competition (50%)
Loss of key personnel (25%)

I have constructed cases already: base, upside and downside. But to address your point, how do I factor the probability of these risks into my numbers? Do I just go extra bearish in my downside case assumptions? Would love to hear a simple example from you. Thanks agaiN

Jan 20, 2020 - 9:08pm

You would look to calculate an "expected value" for each case, like so:

For a given business, 2020 projected annual sales are $100.

Say in your base case there's a 50% probability the business loses a customer that makes up 20% of sales, a 25% probability the business loses two customers that make up 40% of sales, and a 25% probability the business loses no customers.

The probabilities multiply out: (50% * $80)+(25% * $60)+(25% * $100) = $80. This is your expected value for the various cases, and you can use it to make capital budgeting decisions, determine whether a return would be attractive enough for you to invest, etc.

Now say in your ultra-bear case there was a major quality assurance issue with your product and there is now a 90% chance the business loses 80% of sales, and 10% chance nothing happens.

You have (90% * $20)+(10% * $100) = $28 of expected revenue. You can apply this to enterprise value, all sorts of metrics, as Rover mentions, and see the effects of your probabilities in your case selections.

  • Analyst 1 in IB-M&A
Jan 20, 2020 - 9:13am

Hate to break it to you but there isn't a truly theoretically sound way to do this. MFT uses volatility to represent risk for liquid securities which you can use to calc sharpe ratios etc. but there's no way to get this data for a private company. There are certainly relative risk factors that you can use to compare among private firms, but they aren't comprehensive and usually the rest of the market knows the same basic info. Howard Marks has several excellent memos about the importance of intuitively/subjectively recognizing risk or lack thereof.

Jan 24, 2020 - 10:16am

It's perfectly fine to price in key risks like explained above. Some opportunities have client concentration, others not. It isn't science or driven by a huge nubmer of data points as you are used to when working with listed companies, but it is a very effective way to price in risks. It will however require you to do lots of interviews/read reports/talk to middle management or sales people/consultants/etc to get to a substantiated probability and impact of each of the risks if you want to do this right.

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