The European Investment Fund, a subsidiary of the European Investment Bank, has set up a risk management team which could make the fund's first use of over-the-counter derivatives to hedge the performance of its EUR2 billion (USD1.75 billion) venture capital portfolio. That would mark the first time an institution has used derivatives to hedge the performance of its private equity portfolio, according to equity derivatives professionals. The OTC derivatives would form part of a broader risk assessment and management initiative the EIF is undertaking and would not occur until after the risk management office has quantified its risks, which is expected to take until year-end.
The EIF is now creating models to evaluate performance risk in the 155 venture capital funds, mostly early-stage technology funds, in which it invests. "The first step is to measure and quantify the risks and once this is done I believe it makes sense to protect these investments with derivatives," said Thomas Meyer, head of risk management in Luxembourg.
Meyer said it is too early to specify what kind of derivatives the EIF would use. However, he said it could use some sort of total-return swap or risk transfer whereby it would receive the performance of fixed-income instruments in return for the performance of its high-risk equity investments. The EIF's investments have an average expected return of 15-30%, said Marc Schublin, spokesman in Luxembourg.
An equity derivatives banker in London said he is unaware of any one product that would fit the EIF's needs, given there is no real proxy for VC investments. He speculated the EIF could enter equity collars referenced to high-risk reference entities such as the Nasdaq Stock Market, although that would entail basis risk for the fund. Or, he said, the EIF could completely split its risks once it fully quantifies them. "They could try to separate the risks into separate hedgeable components," he said.
Schublin added that there is a particular impetus to manage the risk now as the EIF's portfolio has grown dramatically in the last two years, first in 2000 when it assumed management of the EIB's venture capital portfolio and then last year when it made EUR800 million in new investments. He added the EIF is the largest early-stage investor in the European Union, where all of its investments are made. He and Meyer both stressed the initiative is not driven by performance. "It is not linked with losses, it is part of an overall reform within the bank," Schublin said. Meyer declined comment on potential counterparties.