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Mastering Illiquidity

Mastering Illiquidity Risk management for portfolios of limited partnership funds

  • Author:
  • Publisher: John Wiley & Sons
  • ISBN: 9781119952428
  • Published In: June 2013
  • Format: Hardback , 304 pages
  • Jurisdiction: International ? Disclaimer:
    Countri(es) stated herein are used as reference only
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    Arms investors with powerful new tools for measuring and managing the risks associated with the various illiquid asset classes

    With risk-free interest rates and risk premiums at record lows, many investors are turning to illiquid assets, such as real estate, private equity, infrastructure and timber, in search of superior returns and greater portfolio diversity. But as many analysts, investors and wealth managers are discovering, such investments bring with them a unique set of risks that cannot be measured by standard asset allocation models. Written by a dream team of globally renowned experts in the field, this book provides a clear, accessible overview of illiquid fund investments, focusing on what the main risks of these asset classes are and how to measure those risks in today's regulatory environment.

    • Provides solutions for institutional investors in need of guidance in today's regulatory environment
    • Offers detailed descriptions of risk measurement in illiquid asset classes, illustrated with real life case studies
    • Helps you to develop reliable risk management tools while complying with the regulations designed to contain the individual and systemic risks arising from illiquid investments
    • Features real-life case studies that capture an array of risk management scenarios you are likely to encounter
  • Foreword xi

    Acknowledgements xiv

    1 Introduction 1

    1.1 Alternative investing and the need to upgrade risk management systems 1

    1.2 Scope of the book 4

    1.3 Organization of the book 6

    1.3.1 Illiquid investments as an asset class 6

    1.3.2 Risk measurement and modelling 8

    1.3.3 Risk management and its governance 12

    PART I ILLIQUID INVESTMENTS AS AN ASSET CLASS

    2 Illiquid Assets, Market Size and the Investor Base 17

    2.1 Defining illiquid assets 17

    2.2 Market size 20

    2.3 The investor base 23

    2.3.1 Current investors in illiquid assets and their exposure 23

    2.3.2 Recent trends 26

    2.4 Conclusions 32

    3 Prudent Investing and Alternative Assets 33

    3.1 Historical background 34

    3.1.1 The importance of asset protection 34

    3.1.2 The prudent man rule 34

    3.1.3 The impact of modern portfolio theory 35

    3.2 Prudent investor rule 36

    3.2.1 Main differences 36

    3.2.2 Importance of investment process 37

    3.3 The OECD guidelines on pension fund asset management 38

    3.4 Prudence and uncertainty 38

    3.4.1 May prudence lead to herding? 39

    3.4.2 May prudence lead to a bias against uncertainty? 39

    3.4.3 Process as a benchmark for prudence? 40

    3.4.4 Size matters 40

    3.5 Conclusion 41

    4 Investing in Illiquid Assets through Limited Partnership Funds 43

    4.1 Limited partnership funds 43

    4.1.1 Basic setup 43

    4.1.2 The limited partnership structure 45

    4.1.3 Is “defaulting” an option for limited partners? 47

    4.2 Limited partnerships as structures to address uncertainty and ensure control 47

    4.2.1 Addressing uncertainty 48

    4.2.2 Control from the limited partner perspective 48

    4.3 The limited partnership fund’s illiquidity 49

    4.3.1 Illiquidity as the source of the expected upside 49

    4.3.2 The market for lemons 50

    4.3.3 Contractual illiquidity 51

    4.3.4 Inability to value properly 51

    4.3.5 Endowment effect 51

    4.4 Criticisms of the limited partnership structure 52

    4.5 Competing approaches to investing in private equity and real assets 52

    4.5.1 Listed vehicles 53

    4.5.2 Direct investments 53

    4.5.3 Deal-by-deal 54

    4.5.4 Co-investments 54

    4.6 A time-proven structure 55

    4.7 Conclusion 57

    5 Returns, Risk Premiums and Risk Factor Allocation 59

    5.1 Returns and risk in private equity 59

    5.1.1 Comparing private equity with public equity returns 60

    5.1.2 Market risk and the CAPM 64

    5.1.3 Stale pricing and the optimal allocation to private equity 67

    5.1.4 Informed judgments and ad hoc adjustments to the mean–variance framework 68

    5.1.5 Extensions of the CAPM and liquidity risk 69

    5.1.6 Liability-driven investing and risk factor allocation 70

    5.2 Conclusions 73

    6 The Secondary Market 75

    6.1 The structure of the secondary market 76

    6.1.1 Sellers and their motivations to sell 76

    6.1.2 Buyers and their motivations to buy 79

    6.1.3 Intermediation in the secondary market 82

    6.2 Market size 83

    6.2.1 Transaction volume 83

    6.2.2 Fundraising 86

    6.3 Price formation and returns 87

    6.3.1 Pricing secondary transactions 87

    6.3.2 Returns from secondary investments 90

    6.4 Conclusions 93

    PART II RISK MEASUREMENT AND MODELLING

    7 Illiquid Assets and Risk 97

    7.1 Risk, uncertainty and their relationship with returns 98

    7.1.1 Risk and uncertainty 98

    7.1.2 How objective are probabilities anyway? 99

    7.1.3 How useful are benchmark approximations? 100

    7.1.4 Subjective probabilities and emerging assets 101

    7.2 Risk management, due diligence and monitoring 102

    7.2.1 Hedging and financial vs. non-financial risks 102

    7.2.2 Distinguishing risk management and due diligence 103

    7.3 Conclusions 105

    8 Limited Partnership Fund Exposure to Financial Risks 107

    8.1 Exposure and risk components 108

    8.1.1 Defining exposure and identifying financial risks 108

    8.1.2 Capital risk 110

    8.1.3 Liquidity risk 111

    8.1.4 Market risk and illiquidity 112

    8.2 Funding test 113

    8.3 Cross-border transactions and foreign exchange risk 117

    8.3.1 Limited partner exposure to foreign exchange risk 117

    8.3.2 Dimensions of foreign exchange risk 118

    8.3.3 Impact on fund returns 119

    8.3.4 Hedging against foreign exchange risk? 120

    8.3.5 Foreign exchange exposure as a potential portfolio diversifier 120

    8.4 Conclusions 121

    9 Value-at-Risk 123

    9.1 Definition 123

    9.2 Value-at-risk based on NAV time series 124

    9.2.1 Calculation 125

    9.2.2 Problems and limitations 127

    9.3 Cash flow volatility-based value-at-risk 129

    9.3.1 Time series calculation 131

    9.3.2 Fund growth calculation 133

    9.3.3 Underlying data 135

    9.4 Diversification 136

    9.5 Factoring in opportunity costs 141

    9.6 Cash-flow-at-risk 143

    9.7 Conclusions 144

    10 The Impact of Undrawn Commitments 149

    10.1 Do overcommitments represent leverage? 150

    10.2 How should undrawn commitments be valued? 151

    10.3 A possible way forward 153

    10.3.1 Reconciling fund valuations with accounting view 153

    10.3.2 Modelling undrawn commitments as debt 154

    10.3.3 The “virtual fund” as a basis for valuations 155

    10.4 Conclusions 159

    11 Cash Flow Modelling 161

    11.1 Projections and forecasts 162

    11.2 What is a model? 163

    11.2.1 Model requirements 164

    11.2.2 Model classification 164

    11.3 Non-probabilistic models 167

    11.3.1 Characteristics of the Yale model 168

    11.3.2 Extensions of the Yale model 169

    11.3.3 Limitations of the Yale model 171

    11.4 Probabilistic models 171

    11.4.1 Cash flow libraries 172

    11.4.2 Projecting a fund’s lifetime 173

    11.4.3 Scaling operations 176

    11.5 Scenarios 178

    11.6 Blending of projections generated by various models 179

    11.7 Stress testing 180

    11.7.1 Accelerated contributions 181

    11.7.2 Decelerated distributions 182

    11.7.3 Increasing volatility 183

    11.8 Back-testing 184

    11.9 Conclusions 187

    12 DistributionWaterfall 189

    12.1 Importance as incentive 190

    12.1.1 Waterfall components 190

    12.1.2 Profit and loss 191

    12.1.3 Distribution provisions 191

    12.1.4 Deal-by-deal vs. aggregated returns 191

    12.2 Fund hurdles 191

    12.2.1 Hurdle definitions 192

    12.2.2 Option character and screening of fund managers 192

    12.3 Basic waterfall structure 193

    12.3.1 Soft hurdle 193

    12.4 Examples for carried interest calculation 195

    12.4.1 Soft hurdle for compounded interest-based carried interest allocation 196

    12.4.2 Hard hurdle for compounded interest-based carried interest allocation 198

    12.4.3 Soft hurdle for multiple-based carried interest allocation 200

    12.4.4 Hard hurdle for multiple-based carried interest allocation 200

    12.5 Conclusions 202

    13 Modelling Qualitative Data 207

    13.1 Quantitative vs. qualitative approaches 207

    13.1.1 Relevance of qualitative approaches 207

    13.1.2 Determining classifications 208

    13.2 Fund rating/grading 208

    13.2.1 Academic work on fund rating 209

    13.2.2 Techniques 209

    13.2.3 Practical considerations 210

    13.3 Approaches to fund ratings 211

    13.3.1 Rating by external agencies 211

    13.3.2 Internal fund assessment approaches 215

    13.4 Use of rating/grading as input for models 216

    13.4.1 Assessing downside risk 216

    13.4.2 Assessing upside potential 217

    13.4.3 Is success repeatable? 217

    13.5 Assessing the degree of similarity with comparable funds 218

    13.5.1 The AMH framework 219

    13.5.2 Strategic groups in alternative assets 219

    13.5.3 Linking grading to quantification 220

    13.6 Conclusions 220

    14 Translating Fund Grades into Quantification 221

    14.1 Expected performance grades 221

    14.1.1 Determine quantitative score 222

    14.1.2 Determine qualitative score 223

    14.1.3 Combine the two scores, review and adjust 224

    14.2 Linking grades with quantifications 225

    14.2.1 Estimate likely TVPIs 225

    14.2.2 Practical considerations 228

    14.3 Operational status grades 228

    14.4 Conclusions 229

    PART III RISK MANAGEMENT AND ITS GOVERNANCE

    15 Securitization 233

    15.1 Definition of securitization 233

    15.1.1 Size, quality and maturity 236

    15.1.2 Treatment of other types of assets 237

    15.2 Financial structure 237

    15.2.1 Senior notes of a securitization 237

    15.2.2 Junior notes/mezzanine tranche of a securitization 238

    15.2.3 Equity of a securitization 238

    15.3 Risk modelling and rating of senior notes 239

    15.3.1 Payment waterfall 239

    15.3.2 Modelling of default risk and rating on notes 240

    15.4 Transformation of non-tradable risk factors into tradable financial securities 244

    15.4.1 CFOs as good example for risk and liquidity management practices 245

    15.4.2 Risk of coupon bonds as one part of the risk of illiquid asset classes 246

    15.4.3 Market risk as second part of the risk of illiquid asset classes 247

    15.5 Conclusions 248

    16 Role of the Risk Manager 249

    16.1 Setting the risk management agenda 249

    16.1.1 What risk taking is rewarded? 250

    16.1.2 Risk management: financial risk, operational risk or compliance? 250

    16.1.3 A gap of perceptions? 251

    16.2 Risk management as part of a firm’s corporate governance 251

    16.2.1 “Democratic” approach 251

    16.2.2 “Hierarchic” approach 252

    16.3 Built-in tensions 253

    16.3.1 Risk managers as “goal keepers” 253

    16.3.2 Different perspectives – internal vs. external 253

    16.3.3 Analysing and modelling risks 253

    16.3.4 Remuneration 254

    16.4 Conclusions 255

    17 Risk Management Policy 257

    17.1 Rules or principles? 258

    17.1.1 “Trust me – I know what I’m doing” 258

    17.1.2 “Trust but verify” 258

    17.2 Risk management policy context 258

    17.2.1 Investment strategy 259

    17.2.2 Business plan 260

    17.2.3 Organizational setting 261

    17.2.4 System environment 261

    17.3 Developing a risk management policy 262

    17.3.1 Design considerations 262

    17.3.2 Risk limits 264

    17.4 Conclusions 264

    References 267

    Abbreviations 277

    Index 279

  • Dr PETER CORNELIUS is heading AlpInvest Partners’ economic and strategic research. Prior to his current position, he was the Group Chief Economist of Royal Dutch Shell, chief economist and Director of the World Economic Forum’s Global Competitiveness Program, Head of International Economic Research of Deutsche Bank, a senior economist with the International Monetary Fund, and a staff economist of the German Council of Economic Advisors. He is the chairman of EVCA’s ‘Risk Measurement Guidelines’ working group. He has been an adjunct professor at Brandeis University and a Visiting Scholar at Harvard University and has published widely in leading academic and trade journals and (co)authored several books, including International Investments in Private Equity (Elsevier/Academic Press).

    Dr CHRISTIAN DILLER is co-founder of Montana Capital Partners, focused on secondary liquidity in private equity through its own innovative investment product, sophisticated securitizations and risk management services for institutional investors. Previously, he was Head of Solutions at Capital Dynamics leading the structuring and portfolio and risk management activities. Christian advised some of the world’s largest investors on portfolio rebalancing and structuring, cash flow planning and risk management in private equity. Prior to that, he worked for Allianz Group and Pioneer Investments. Christian is a member of the EVCA’s ‘Risk Measurement Guidelines’ working group, co-chairman of the ‘Technical Working Group on Solvency II & IORP’ and lecturer at the CIPEI course held by the Oxford Said Business School. He is author of several articles for practitioners and academics and holds a Dr. rer. pol. in finance specializing on risk-/return characteristics of private equity funds.

    Dr DIDIER GUENNOC is co-founder of LDS Partners, specialised in decision systems, program structuring, corporate governance and risk management solutions for institutional investors in private equity. He also acts as the secretary of the International Private Equity and Venture Capital Valuation Board (IPEV Board). Previously he worked for Origo Management and advised EVCA, the European Private Equity and Venture Capital Association on public affairs, statistics and professional standards. He started his career at Xerfi, the leading French market research company. Didier was a member of the advisory board of the Centre for Entrepreneurial and Financial Studies (Technische Universität München – Germany) and of the private equity subcommittee of the Chartered Alternative Investment Analyst Program. Didier holds a PhD in Business Administration from the University Robert Schuman, Strasbourg (France).

    Dr THOMAS MEYER is co-founder of LDS Partners, specialised in decision systems, program structuring, corporate governance and risk management solutions for institutional investors in private equity. Previously he was with EVCA, the European Investment Fund and Allianz Asia Pacific. He is a member of the EVCA’s ‘Risk Measurement Guidelines’ working group and of the Chartered Alternative Investment Analyst Association's (CAIA) private equity sub-committee and a Shimomura Fellow of the Development Bank of Japan’s Research Institute of Capital Formation. Thomas is co-directing the Certificate in Institutional Private Equity Investing (CIPEI) course held by the Oxford Said Business School’s Private Equity Institute and co-authored several books including Beyond the J-Curve and J-Curve Exposure.

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