Why Don't Private Equity Investors Hedge Against Bear Markets?

A lot of the endowments are struggling with the recent market meltdown. Unfortunately, my alma mater happens to be one of the worst performers.

As an aside, I have always wondered why investors in private equity don't hedge their portfolios against long bear markets? The biggest risk factors to a P/E portfolio are a bad economy coupled with a long stock market decline - the exits disappear, there is no liquidity, funding is scarce, multiples contract, and the underlying businesses face tougher conditions. Why in the world wouldn't you hedge that, or even run the allocation with a constant percent hedge?

Using something as simple as a long term moving average would work to take out some of the volatility and drawdowns. If you used the U.S. private equity ETF (PSP) (yes, I know that is not a good proxy for private equity, but this is just an example), and used a long term moving average and assuming you sold (or hedged) the position at 20, which is very conservative, you would have avoided (or hedged out) a 60%+ decline. Isn't that the main risk you face as a private equity investor?

Comments

[HKI:]

Guess you have not been or doesn't know much about the PE business. LPs do not expect PE firms to hedge since it is a long-only product. Some fund documents do not allow for that.

2008 Nov 13 10:20 PM

[Old Trader:]

HKI,

Farber's position strikes me as pretty much a "no-brainer"....maybe somebody OUGHTTA start a PE fund that DOES such hedging, eh?

I'd be willing to bet there's no shortage of PE firms that did a proper job of evaluating investments (i.e. didn't over-pay), have/had the management expertise to wring increased profits from those investments, but had their exit strategy blow up through no fault of their own (crappy market = no IPO, crappy economy with tight credit = no "strategic buyers"). A hedge would be nice under those circumstances.

2008 Nov 13 10:52 PM