Stress Testing Private Equity

FRG, partnered with Preqin, has developed a system for simulating cash flows for private capital investments (PCF).  PCF allows the analyst to change assumptions about future economic scenarios and investigate the changes in the output cash flows.  This post will pick a Venture fund, shock the economy for a mild recession in the following quarters, and view the change in cash flow projections.

FRG develops scenarios for our clients.  Our most often used scenarios are the “Growth” or “Base” scenario, and the “Recession” scenario.  Both scenarios are based on the Federal Reserve’s CCAR scenarios “Base” and “Adverse”, published yearly and used for banking stress tests.

The “Growth” scenario (using the FED “Base” scenario) assumes economic growth more or less in line with recent experience.

The “Recession” scenario (FED “Adverse”) contains a mild recession starting late 2019, bottoming in Q2 2020.  GDP recovers back to its starting value in Q2 2021.  The recovery back to trend line (potential) GDP goes through Q2 2023.

Real GPD Growth chart


The economic drawdown is mild, the economy only loses 1.4% from the high.

Start DateTrough DateRecovery DateFull PotentialDepth
Q4 2019Q2 2020Q2 2021Q2 2023-1.4%

Equity market returns are a strong driver of performance in private capital.  The total equity market returns in the scenarios include a 34% drawdown in the index.  The market fully bottoms in Q1 2022, and has recovered to new highs by Q1 2023.

This draw down is shallow compared to previous history and the recovery period shorter:

Begin DateTrough DateRecovery DateDepthTotal LengthTrough Recovery

The .COM and Global Financial Crisis (GFC) recessions took off nearly 50% of the market value.  This recession only draws down 34%.  The time from the peak to the trough is 10 and 6 quarters for the .COM and GCF respectively.  Here we are inline with the .COM crash with a 10-quarter peak to trough period.  This recovery is faster by nearly double than either of the recent large drawdowns at 8 quarters versus 17 and 16.

We start by picking a 2016 vintage venture capital fund.  This fund has called around 89% of its committed capital, has an RVPI of 0.85 and currently sports about an 18% IRR.  For this exercise, we assume a $10,000,000 commitment.

Feeding the two scenarios, this fund, and a few other estimates into the PCF engine, we can see a dramatic shift in expected J-curve.

Under the “Growth” scenario, the fund’s payback date (date where total cash flow is positive) is Q1 2023.  The recession prolongs the payback period, with the expected payback date being Q3 2025, an additional 2.5 years.  Further, the total cash returned to investors is much lower.

This lower cash returned as well as the lengthening of the payback period have a dramatic effect on the fund IRR.

That small recession drops the expected IRR of the fund a full 7% annualized.  The distribution shown in the box and whisker plot above illustrates the dramatic shift in possible outcomes.  Whereas before, there were only a few scenarios where the fund returned a negative IRR, in the recession nearly a quarter of all scenarios produced a negative return.  There are more than a few cases where the fund’s IRR is well below -10% annually!

This type of analysis should provide investors in private capital food for thought.  How well do your return expectations hold up during an economic slowdown?  What does the distribution of expected cash flows and returns tell you about the risk in your portfolio?

At FRG, we specialize in helping people answer these questions.  If you would like to learn more, please visit  or contact us.

Dominic Pazzula is a Director with FRG, specializing in asset allocation and risk management. He has more than 15 years of experience evaluating risk at a portfolio level and managing asset allocation funds. He is responsible for product design of FRG’s asset allocation software offerings and consults with clients helping to apply the latest technologies to solve their risk, reporting, and allocation challenges.



How Embracing SR 11-7 Guidelines Can Support the CECL Process

The Board of Governors of the Federal Reserve System’s SR 11-7 supervisory guidance (2011) provides an effective model risk management framework for financial institutions (FI’s). SR 11-7 covers everything from the definition of a model to the robust policies/procedures that should exist within a model risk management framework. To reduce model risk, any FI should consider following the guidance throughout internal and regulatory processes as its guidelines are comprehensive and reflect a banking industry standard.

The following items and quotations represent an overview of the SR 11-7 guidelines (Board of Governors of the Federal Reserve System, 2011):

  1. The definition of a model – “the term model refers to a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates.”
  2. A focus on the purpose/use of a model – “even a fundamentally sound model producing accurate outputs consistent with the design objective of the model may exhibit high model risk if it is misapplied or misused.”
  3. The three elements of model risk management:
    • Robust model development, implementation, and use – “the design, theory, logic underlying the model should be well documented and generally supported by published research and sound industry practice.”
    • Sound model validation process – “an effective validation framework should include three core elements: evaluation of conceptual soundness, …, ongoing monitoring, …, and benchmarking, outcomes analysis, …”
    • Governance – “a strong governance framework provides explicit support and structure to risk management functions through policies defining relevant risk management activities, procedures that implement those policies, allocation of resources, and mechanisms for evaluating whether policies and procedures are being carried out as specified.”

The majority of what the SR 11-7 guidelines discuss applies to some of the new aspects from the accounting standard CECL (FASB, 2016). Any FI under CECL regulation must provide explanations, justifications, and rationales for the entirety of the CECL process including (but not limited to) model development, validation, and governance. The SR 11-7 guidelines will help FI’s develop effective CECL processes in order to limit model risk.

Some considerations from the SR 11-7 guidelines in regards to the components of CECL include (but are not limited to):

  • Determining appropriateness of data and models for CECL purposes. Existing processes may need to be modified due to some differing CECL requirements (e.g., life of loan loss estimation).
  • Completing comprehensive documentation and testing of model development processes. Existing documentation may need to be updated to comply with CECL (e.g., new models or implementation processes).
  • Accounting for model uncertainty and inaccuracy through the understanding of potential limitations/assumptions. Existing model documentation may need to be re-evaluated to determine if new limitations/assumptions exist under CECL.
  • Ensuring validation independence from model development. Existing validation groups may need to be further separated from model development (e.g., external validators).
  • Developing a strong governance framework specifically for CECL purposes. Existing policies/procedures may need to be modified to ensure CECL processes are being covered.

The SR 11-7 guidelines can provide FI’s with the information they need to start their CECL process. Although not mandated, following these guidelines overall is important in reducing model risk and in establishing standards that all teams within and across FI’s can follow and can regard as a true industry standard.


  1. Board of Governors of the Federal Reserve System. “SR 11-7 Guidance on Model Risk Management”. April 4, 2011.
  2. Daniel Brown and Dr. Craig Peters. “New Impairment Model: Governance Considerations”. Moody’s Analytics Risk Perspectives. The Convergence of Risk, Finance, and Accounting: CECL. Volume VIII. November 2016.
  3. Financial Accounting Standards Board (FASB). Financial Instruments – Credit Losses (Topic 326). No. 2016-13. June 2016.

Samantha Zerger, business analytics consultant with FRG, is skilled in technical writing. Since graduating from the North Carolina State University’s Financial Mathematics Master’s program in 2017 and joining FRG, she has taken on leadership roles in developing project documentation as well as improving internal documentation processes.


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