What Private Equity Can Learn From Hedge Funds About Investing in a Downturn

Hedge fund investors think about their work a lit­tle dif­fer­ent­ly by design. In that indus­try, it’s all about risk man­age­ment and down­side pro­tec­tion when con­struct­ing a port­fo­lio. You don’t make wild bets with­out cov­er­ing your­self in case of a loss.

I should know. Before join­ing Pow­er­Plant Part­ners, I worked at a hedge fund for near­ly 15 years help­ing to man­age a $3B port­fo­lio.

What I learned over that time is that, com­pared to pri­vate equi­ty or ven­ture cap­i­tal, at the hedge fund lev­el there is much more time spent on look­ing at your port­fo­lio as a whole and real­ly try­ing to under­stand the risk pro­file of it all togeth­er. What would adding one or two invest­ments mean to the expo­sure lev­el of your over­all port­fo­lio? Are your invest­ments clus­tered in too few indus­tries or ver­ti­cals? How well is your entire process posi­tioned for growth over time?

Hedge fund investors are ask­ing those kinds of ques­tions every day, and I don’t see that very often in pri­vate equi­ty and ven­ture cap­i­tal. More often than not, investors in our space are focused on invest­ments on an iso­lat­ed basis – how much poten­tial does this com­pa­ny, or indus­try, or team have? – with­out think­ing about the over­all impact and risk that you would be tak­ing on by adding them to the port­fo­lio.

That’s a mis­take, in my opin­ion, and one rea­son why we do things dif­fer­ent­ly at Pow­er­Plant.

As a firm we’ve spent a lot of time think­ing about and research­ing what our ide­al port­fo­lio needs to look like for what we’re build­ing. That includes siz­ing posi­tions with respect to allo­ca­tion to cer­tain sec­tors and cat­e­gories, and just being more delib­er­ate and thought­ful with our port­fo­lio con­struc­tion and ulti­mate­ly our risk adjust­ed returns. Just as in the hedge fund world – where you have a base case, a bull case and a bear case for every invest­ment you con­sid­er – we weigh our deci­sions based on each expect­ed out­come and by our con­fi­dence lev­el in them, leav­ing us with a risk adjust­ed, weight­ed return expec­ta­tion for each indi­vid­ual invest­ment. Repeat that over and over again across the port­fo­lio and you have a bet­ter sense of what the expect­ed return will look like for your port­fo­lio as a whole.

In a growth mar­ket, this type of port­fo­lio con­struc­tion process ensures that we’re able to deliv­er expect­ed returns with­out expos­ing our­selves to excess risk.

But where this approach tru­ly shines is in a down­turn like we’re start­ing to see right now, as val­u­a­tions start to dip, heav­i­ly lever­aged star­tups go under, and investors start to pull back and go defen­sive. When the mar­ket gets chop­py, hav­ing a risk adjust­ed port­fo­lio offers a lev­el of cer­tain­ty around what’s com­ing and what the poten­tial impact on our hold­ings might be. We know what the worst case could look like, and we’re OK with that because we pre­pared for this from the very begin­ning.

That not only helps pro­tect the port­fo­lio in the short term but also sets us up to take advan­tage of the oppor­tu­ni­ties that are sure to pop up as this down­turn drags on. Low­er val­u­a­tions mean a chance to buy for val­ue lat­er on, rid­ing the mar­ket back up as things recov­er. After all, that’s what a hedge fund would do.