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

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 Distribution Waterfall 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 inves