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November 27, 2023

How AI Can Help Manage Private Equity Risk

There’s no reward without risk – but you still want to keep your risks to a minimum. When it comes to managing private equity risk, thorough research and careful decision-making are key. Artificial intelligence could help on both counts. 

The Ups and Downs of Private Equity 

Private equity has provided good returns, but investors might be facing harder times ahead. According to Bain & Company, 2022 was the second-best year ever for private equity. However, the tide appears to be turning due to interest rate hikes that have led to a sharp drop in deals, exits, and fundraising in the second half of the year. 

Private equity has also received increased scrutiny from regulators, according to Bloomberg Law, with the SEC working on new rules and the Biden Administration announcing plans to crack down on private equity investors in nursing homes. Combined with economic turmoil, this is creating an uncertain situation for private equity investors. 

Understanding AI and What It Means for Private Equity 

Private equity investors want a good return on their investments. AI might be able to help them reach their goals. However, before we dive into the possibilities, here are some key definitions: 

  • McKinsey defines Artificial Intelligence (AI) as a machine’s ability to perform cognitive functions we usually associate with humans. Artificial intelligence has many different applications – from sifting through data to creating new content.  

  • Machine learning occurs when AI can detect patterns and make predictions and recommendations based on data and experience as opposed to needing direct programming instruction. AI analytics leverages machine learning to process data and glean insights. 

  • Generative AI is another application of AI that’s recently attracted a lot of attention, thanks to programs like ChatGPT and DALL-E. McKinsey explains that generative AI uses algorithms to create content, such as code, images, text, or audio. 

  • Programs like ChatGPT are a specific type of generative AI called a large language model. For businesses, this particular application of AI is exciting due to its ability to analyze large amounts of data. For example, the Financial Times says that Zurich is planning to use ChatGPT to extract data from claims descriptions to improve underwriting.  

The Possibility of AI in Private Equity 

AI is advancing rapidly, which is creating new opportunities. There are many ways private equity investors could leverage AI to control risks already or in the near future. 

  • AI analytics can support better decision-making. For private equity investments to be successful, firms need to make smart decisions when deciding which companies to invest in and how to direct those companies to increase value. AI-powered analytics can provide insights to make good decisions. Predictive analytics (which predicts likely outcomes based on patterns in data) and prescriptive analytics (which makes recommendations based data) are particularly useful.  

  • Large language models can extract and analyze data. Data exists everywhere, but collecting it and cleaning it to make it usable can be a major undertaking. AI-based large language models can help. We’ve seen that the insurance industry is already looking to leverage large language models to extract data from claims documents. Similar risk management applications should be possible in private equity investments. 

  • AI can supercharge due diligence. Before choosing an investment, it’s important to conduct due diligence by verifying information. This can be time consuming, but it’s important for accuracy – overlooking something could result in a poor investment or even lead to allegations of negligence. AI excels at the fact-checking and verification that goes into due diligence.  

The Future of Private Equity 

By leveraging emerging AI technologies, private equity firms may be able to gain data-backed insights that support decision-making and minimize the risk of poor investments, all while reducing the amount of work involved in due diligence. Since technology is improving rapidly, things that weren’t possible just a year or two ago are suddenly within reach. Plus, even more tools may be available in the near future.  

AI is promising – and certainly something private equity firms should explore – but they also need the right insurance to manage private equity risk.  

Heffernan’s Private Equity and M&A Practice provides the risk management solutions you need to manage your deals. Contact Rob Jevens. 

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