Private equity and venture capital investor Prabhav Sharma illuminates the path of risk management and mitigation planning

Sharma's insights reiterate the fact that risk management is a dynamic, evolving discipline that requires adaptability, continuous learning, and an acute awareness of both the financial and non-financial risks inherent in private equity and venture capital investing

In a recent exclusive interview, Prabhav Sharma, a renowned private equity and venture capital investor, shared his unique perspective on risk management and mitigation planning for private equity investments. Sharma explained that investing in private equity and venture capital is not quite the same as investing in public markets due to distinct features like illiquidity, long-term commitments, and uncertain cashflows. These characteristics necessitate a specific approach to risk management, finely tuned to the private equity and venture capital realm.

"Essentially, we are contending with three key risks: market risk, liquidity risk, and funding or cashflow risk," Sharma elucidated. These risks require specific risk measures for effective management. He emphasised that these include value-at-risk (VaR) for market risk, liquidity-adjusted VaR (LVaR) to account for illiquidity and cashflow-at-risk (CFaR) for funding risk. By using these metrics, investors can dynamically model the fund's lifecycle, which helps in understanding and managing the risk exposure that evolves over time.

The science of constructing risk-mitigation portfolios: A blend of art and mathematics

Shifting the focus from risk identification to risk mitigation, Sharma delved into the intricacies of portfolio construction. "Creating a portfolio that mitigates equity risk isn't about throwing in some bonds and calling it a day. It's an intricate process that requires the right mix of strategies," he highlighted.

Sharma identified four common risk-mitigation strategies: US treasuries, trend-following, tail-risk hedging, and alternative risk premiums. Each of these strategies, he explained, plays a specific role in a comprehensive risk-mitigation portfolio. They need to be carefully weighed against the return-seeking components based on an investor's risk tolerance.

Insurance and coverage: The shields against unforeseen events

Sharma then brought up the topic of insurance. He shed light on how general partnership liability insurance policies can provide coverage against regulatory scrutiny, while directors' and officers' liability insurance can safeguard against employment practices claims.

"Insurance is like a safety net. But to make sure the net is strong and wide enough, you need to conduct regular internal audits, coordinate coverage between policies, and verify the financial status of portfolio companies regularly."

Diversification and resilience

Taking the risk conversation forward, Sharma shared his thoughts on the power of diversification in mitigating risk. He highlighted that a well-diversified portfolio is the key to managing market volatility. "Diversification does not necessarily mean adding more assets to the portfolio. Instead, it involves selecting a mix of assets that are less likely to move in the same direction simultaneously. This strategy can help reduce portfolio risk and increase potential returns," explained Sharma.

Sharma also touched on the concept of 'resilience' in the context of private equity and venture capital investments. According to him, resilience is the ability of an investment portfolio to withstand shocks and maintain its value. He further explained that resilience involves two crucial aspects - 'robustness', the capacity to absorb shocks without significant changes, and 'adaptability', the ability to modify strategies in response to external shocks.

By integrating resilience into risk management strategies, firms can enhance their ability to navigate uncertainty, he suggested. "Resilient portfolios might not always perform exceptionally in booming markets, but they have a higher probability of withstanding market downturns," he added.

The future of risk management: Leveraging technology and machine learning

Sharma stressed the transformative potential of technology in managing risk more effectively. "Today, machine learning algorithms can analyse large volumes of complex data, which can significantly aid in identifying and quantifying risks. These algorithms can also help in predictive modelling, providing investors with a future outlook based on current trends and data," he said.

The renowned investor also pointed out that leveraging these advanced technologies could also help private equity and venture capital firms keep up with regulatory changes and standards. "Regulatory technology, or RegTech, uses information technology to enhance regulatory processes. This can be of significant aid in risk management, regulatory reporting, identity management, and compliance," Sharma elaborated.

Creating a culture of risk awareness

Sharma underlined the importance of a risk-conscious culture within private equity and venture capital firms. He believes that risk management shouldn't be a task confined to a specific department or team, but rather a shared responsibility that permeates every level of the organisation.

"A culture of risk awareness is about embedding the understanding of risk into every decision, from strategy formation to daily operations. This is crucial to ensure that risks are identified, assessed, and mitigated effectively," he asserted. To cultivate such a culture, Sharma advocated for regular risk training sessions, open dialogue about risks, and setting risk management objectives aligned with the overall business strategy.

Sharma's enlightening discourse on private equity and venture capital risk management paints a comprehensive picture, revealing not just the challenges, but also the strategies that can guide investors towards success in this complex landscape. His insights reiterate the fact that risk management is a dynamic, evolving discipline that requires adaptability, continuous learning, and an acute awareness of both the financial and non-financial risks inherent in private equity and venture capital investing.