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The rewards of risk

The rewards of risk 2008-08-01 Staff Writer For most, risk is something to be avoided. For good private equity investors, risk is something to be evaluated, controlled and ultimately embraced as a condition for outsized returns.<br /><br />The August issue of <italic>PEI Manager</italic&

For most, risk is something to be avoided. For good private equity investors, risk is something to be evaluated, controlled and ultimately embraced as a condition for outsized returns.

The August issue of PEI Manager examines the many forms of risk facing today's private equity firm, as well as presents several approaches that firms now use to perform due diligence on, and hedge against, that risk.

The risks facing private equity firms today are many and multiplying. A glance at the table of contents of our risk management and due diligence issue below reveals our coverage of the following risks: change to the tax policy on carried interest in the US; added regulatory burden in the UK; a portfolio company breaching a debt covenant; the manager of a company in an emerging market (or any market) has not told the truth about his/her background; contact with a corrupt businessperson abroad result in jail time at home; the GP will miss something important in the financial statement of a target company; and pension liability at a target company.

Private equity firms face a conundrum in addressing risk, the resolution of which speaks volumes about individual firm cultures. Those GPs that spend lavishly on due diligence and background investigations show themselves to be willing to cut into potential profits in an attempt to limit downside. Those firms that eschew many potential risk hedges ? insurance, currency products, consulting services, in-house operating resources ? benefit more when deals work out. But these firms also tend to blow up more frequently.

In today's market, LPs are more likely to prefer the first risk profile; they want to see a portion of their capital spent wisely on downside protection so that the balance of the money stands a better chance at not being lost.

This month's focus on risk makes our profile of Brazil's GP Investimentos all the more appropriate. For 15 years, the firm has thrived in a market known more for political and macroeconomic instability than for private equity success. Now that LPs perceive better days ahead in Brazil, GP Investimentos is reaping major benefits, most evidently by now controlling the largest fund in Latin America. LPs are not sure when the good times will end in Brazil, but they like the fact that good isn't the only environment in which this firm has performed well.

Enjoy the issue,

By David SnowDavid.s@peimedia.com