Mastering Illiquidity. Risk management for portfolios of limited partnership funds. The Wiley Finance Series

  • ID: 2330791
  • Book
  • 304 Pages
  • John Wiley and Sons Ltd
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Allocations to illiquid investments have grown substantially in recent years as investments in asset classes such as private equity, real estate, infrastructure or timber, are expected to generate superior returns and help investors diversify their portfolios.  Their unique characteristics however, require specific tools to measure and manage the risk associated with such investments.

This book focuses primarily on the illiquidity risk premium that structurally illiquid asset classes may offer. In contrast to asset classes that may become illiquid thanks to financial turmoil and heightened risk aversion, investors in structurally illiquid asset classes are aware ex–ante of the risk they take. It is precisely this risk, and more specifically the associated risk premium, that attracts investors to these asset classes. Not all investors are able to harvest this risk premium, however. As a matter of principle, only long term investors can, whose liability profile allows them to lock capital in for a prolonged period of time. Harvesting the illiquidity risk premium requires specific risk management techniques, and these are the subject of this book.

Mastering Illiquidity: Risk Management for Portfolios of Limited Partnership Funds provides a clear and accessible overview of the particularities of illiquid fund investments, what the main risks of these asset classes are and how risks are measured in the new regulatory environment. It provides solutions for institutional investors who are searching for guidance in the new era of regulation and offers detailed descriptions of risk measurement in illiquid asset classes which are illustrated with real life case studies. This book helps readers to develop appropriate risk management tools while complying with new regulations which have been put in place to contain individual as well as systemic risks arising from illiquid investments.

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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


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

2.4 Conclusions 32

3 Prudent Investing and Alternative Assets 33

3.1 Historical background 34

3.2 Prudent investor rule 36

3.3 The OECD guidelines on pension fund asset management 38

3.4 Prudence and uncertainty 38

3.5 Conclusion 41

4 Investing in Illiquid Assets through Limited Partnership Funds 43

4.1 Limited partnership funds 43

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

4.3 The limited partnership fund s illiquidity 49

4.4 Criticisms of the limited partnership structure 52

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

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

5.2 Conclusions 73

6 The Secondary Market 75

6.1 The structure of the secondary market 76

6.2 Market size 83

6.3 Price formation and returns 87

6.4 Conclusions 93


7 Illiquid Assets and Risk 97

7.1 Risk, uncertainty and their relationship with returns 98

7.2 Risk management, due diligence and monitoring 102

7.3 Conclusions 105

8 Limited Partnership Fund Exposure to Financial Risks 107

8.1 Exposure and risk components 108

8.2 Funding test 113

8.3 Cross–border transactions and foreign exchange risk 117

8.4 Conclusions 121

9 Value–at–Risk 123

9.1 Definition 123

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

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

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

10.4 Conclusions 159

11 Cash Flow Modelling 161

11.1 Projections and forecasts 162

11.2 What is a model? 163

11.3 Non–probabilistic models 167

11.4 Probabilistic models 171

11.5 Scenarios 178

11.6 Blending of projections generated by various models 179

11.7 Stress testing 180

11.8 Back–testing 184

11.9 Conclusions 187

12 DistributionWaterfall 189

12.1 Importance as incentive 190

12.2 Fund hurdles 191

12.3 Basic waterfall structure 193

12.4 Examples for carried interest calculation 195

12.5 Conclusions 202

13 Modelling Qualitative Data 207

13.1 Quantitative vs. qualitative approaches 207

13.2 Fund rating/grading 208

13.3 Approaches to fund ratings 211

13.4 Use of rating/grading as input for models 216

13.5 Assessing the degree of similarity with comparable funds 218

13.6 Conclusions 220

14 Translating Fund Grades into Quantification 221

14.1 Expected performance grades 221

14.2 Linking grades with quantifications 225

14.3 Operational status grades 228

14.4 Conclusions 229


15 Securitization 233

15.1 Definition of securitization 233

15.2 Financial structure 237

15.3 Risk modelling and rating of senior notes 239

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

15.5 Conclusions 248

16 Role of the Risk Manager 249

16.1 Setting the risk management agenda 249

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

16.3 Built–in tensions 253

16.4 Conclusions 255

17 Risk Management Policy 257

17.1 Rules or principles? 258

17.2 Risk management policy context 258

17.3 Developing a risk management policy 262

17.4 Conclusions 264

References 267

Abbreviations 277

Index 279

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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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