Mastering Illiquidity

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 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