)WILEY A John Wiley &. Sons, Ltd., Publication

Transcription

1 Mastering Illiquidity Risk Management for Portfolios of Limited Partnership Funds Peter Cornelius Christian Diller Didier Guennoc Thomas Meyer )WILEY A John Wiley &. Sons, Ltd., Publication

2 Foreword Acknowledgements xi xiv 1 Introduction Alternative investing and the need to upgrade risk management systems Scope of the book Organization of the book Illiquid investments as an asset class ', Risk measurement and modelling Risk management and its governance 12 PART I ILLIQUID INVESTMENTS AS AN ASSET CLASS 2 Illiquid Assets, Market Size and the Investor Base Defining illiquid assets Market size The investor base i Current investors in illiquid assets and their exposure Recent trends Conclusions * 32 3 Prudent Investing and Alternative Assets Historical background The importance of asset protection The prudent man rule The impact of modern portfolio theory Prudent investor rule Main differences, Importance of investment process The OECD guidelines on pension fund asset management Prudence and uncertainty May prudence lead to herding? May prudence lead to a bias against uncertainty? 39

3 3.4.3 Process as a benchmark for prudence? Size matters Conclusion 41 Investing in Illiquid Assets through Limited Partnership Funds Limited partnership funds Basic setup The limited partnership structure Is "defaulting" an option for limited partners? Limited partnerships as structures to address uncertainty and ensure control Addressing uncertainty Control from the limited partner perspective The limited partnership fund's illiquidity Illiquidity as the source of the expected upside The market for lemons Contractual illiquidity Inability to value properly Endowment effect Criticisms of the limited partnership structure Competing approaches to investing in private equity and real assets Listed vehicles \ Direct investments Deal-by-deal Co-investments A time-proven structure Conclusion 57 Returns, Risk Premiums and Risk Factor Allocation Returns and risk in private equity Comparing private equity with public equity returns Market risk and the CAPM '' Stale pricing and the optimal allocation to private equity Informed judgments and ad hoc adjustments to the mean-variance framework Extensions of the CAPM and liquidity risk Liability-driven investing and risk factor allocation Conclusions, 73 The Secondary Market ~ The structure of the secondary market Sellers and their motivations to sell Buyers and their motivations to buy Intermediation in the secondary market Market size Transaction volume Fundraising 86

4 6.3 Price formation and returns Pricing secondary transactions Returns from secondary investments Conclusions 93 PART II RISK MEASUREMENT AND MODELLING 7 Illiquid Assets and Risk Risk, uncertainty and their relationship with returns Risk and uncertainty '" How objective are probabilities anyway? How useful are benchmark approximations? Subjective probabilities and emerging assets Risk management, due diligence and monitoring Hedging and financial vs. non-financial risks Distinguishing risk management and due diligence Conclusions Limited Partnership Fund Exposure to Financial Risks Exposure and risk components Defining exposure and identifying financial risks _ Capital risk Liquidity risk Market risk and illiquidity Funding test Cross-border transactions and foreign exchange risk Limited partner exposure to foreign exchange risk Dimensions of foreign exchange risk Impact on fund returns Hedging against foreign exchange risk? Foreign exchange exposure as a potential portfolio diversifier Conclusions Value-at-Risk Definition Value-at-risk based on NAV time series Calculation Problems and limitations Cash flow volatility-based value-at-risk ~ Time series calculation Fund growth calculation Underlying data Diversification Factoring in opportunity costs Cash-flow-at-risk Conclusions 144

5 viii Contents 10 The Impact of Undrawn Commitments Do overcommitments represent leverage? How should undrawn commitments be valued? A possible way forward Reconciling fund valuations with accounting view " Modelling undrawn commitments as debt The "virtual fund" as a basis for valuations Conclusions 159 v 11 Cash Flow Modelling - ' Projections and forecasts What is a model? Model requirements Model classification Non-probabilistic models Characteristics of the Yale model Extensions of the Yale model Limitations of the Yale model Probabilistic models Cash flow libraries Projecting a fund's lifetime Scaling operations ' Scenarios Blending of projections generated by various models Stress testing Accelerated contributions Decelerated distributions Increasing volatility Back-testing Conclusions Distribution Waterfall Importance as incentive Waterfall components Profit and loss Distribution provisions Deal-by-deal vs. aggregated returns Fundhurdles Hurdle definitions Option character and screening of fund managers Basic waterfall structure Soft hurdle Examples for carried interest calculation Soft hurdle for compounded interest-based carried interest allocation Hard hurdle for compounded interest-based carried interest allocation 198

6 Soft hurdle for multiple-based carried interest allocation Hard hurdle for multiple-based carried interest allocation Conclusions Modelling Qualitative Data Quantitative vs. qualitative approaches Relevance of qualitative approaches Determining classifications Fund rating/grading, Academic work on fund rating - " Techniques Practical considerations Approaches to fund ratings Rating by external agencies Internal fund assessment approaches ^4 Use of rating/grading as input for models Assessing downside risk Assessing upside potential Is success repeatable? Assessing the degree of similarity with comparable funds The AMH framework, Strategic groups in alternative assets s Linking grading to quantification ^Conclusions Translating Fund Grades into Quantification Expected performance grades Determine quantitative score Determine qualitative score Combine the two scores, review and adjust Linking grades with quantifications Estimate likely TVPIs Practical considerations Operational status grades Conclusions 229 PART m RISK MANAGEMENT AND ITS GOVERNANCE 15 Securitization Definition of securitization Size, quality and maturity Treatment of other types of assets Financial structure Senior notes of a securitization Junior notes/mezzanine tranche of a securitization Equity of a securitization 238

7 x Contents 15.3 Risk modelling and rating of senior notes Payment waterfall Modelling of default risk and rating on notes Transformation of non-tradable risk factors into tradable financial securities CFOs as good example for risk and liquidity management practices Risk of coupon bonds as one part of the risk of illiquid asset classes Market risk as second part of-the risk of illiquid asset classes Conclusions Role of the Risk Manager Setting the risk management agenda What risk taking is rewarded? Risk management: financial risk, operational risk or compliance? A gap of perceptions? Risk management as part of a firm's corporate governance "Democratic" approach "Hierarchic" approach Built-in tensions Risk managers as "goal keepers" \ Different perspectives - internal vs. external Analysing and modelling risks Remuneration Conclusions Risk Management Policy Rules or principles? "Trust me-i know what I'm doing" "Trust but verify" ' Risk management policy context Investment strategy Business plan Organizational setting System environment Developing a risk management policy Design considerations < Risk limits Conclusions v 264 References 267 Abbreviations 277 Index 279