Mastering Illiquidity Risk management for portfolios of limited partnership funds

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.

1 Introduction

1.1 Alternative investing and the need for upgrading risk management systems

1.2 The scope of the book

1.3 Organization of the book

PART I ILLIQUID INVESTMENTS AS AN ASSET CLASS

2 Illiquid Assets, Market Size and the Investor Base

2.1 Defining illiquid assets

2.2 Market size

2.3 The investor base

2.4 Conclusions

3 Prudent Investing and Alternative Assets

3.1 Historical background

3.2 Prudent investor rule

3.3 The OECD guidelines on pension fund asset management

3.4 Prudence and uncertainty

3.5 Conclusion

4 Investing in Illiquid Assets through Limited Partnership Funds

4.1 Limited partnership funds

4.2 Limited partnerships as structures to address uncertainty and to assure control

4.3 The limited partnership fund’s illiquidity

4.4 Criticisms of the limited partnership structure

4.5 Competing approaches to investing in private equity and real assets

4.6 A time-proven structure

4.7 Conclusion

5 Returns, Risk Premiums and Risk Factor Allocation

5.1 Returns and risk in private equity

5.2 Conclusions

6 The Secondary Market

6.1 The structure of the secondary market

6.2 Market size

6.3 Price formation and returns     

6.4 Conclusions

PART II RISK MEASUREMENT AND MODELLING

7 Illiquid Assets and Risk

7.1 Risk, uncertainty and their relationship with returns

7.2 Risk management, due diligence and monitoring

7.3 Conclusions

8 Limited Partnership Fund Exposure to Financial Risks

8.1 Exposure and risk components

8.2 Funding test

8.3 Cross-border transactions and foreign exchange risk

8.4 Conclusions

9 Value-at-Risk

9.1 Definition

9.2 Value-at-risk based on nav-time series

9.3 Cash flow-volatility based value-at-risk

9.4 Diversification

9.5 Factoring in opportunity costs

9.6 Cash-flow-at-risk

9.7 Conclusions

9.8 Appendix – Examples

10 The Impact of Undrawn Commitments

10.1 Do overcommitments represent leverage?

10.2 How should undrawn commitments be valued?

10.3 A possible way forward

10.4 Conclusions

10.5 Appendix – Examples

11 Cash Flow Modelling

11.1 Projections and forecasts

11.2 What is a model?

11.3 Non-probabilistic models

11.4 Probabilistic models

11.5 Scenarios

11.6 Blending of projections generated by various models

11.7 Stress testing

11.8 Back-testing

12 Distribution Waterfall

12.1 Importance as incentive

12.2 Fund hurdles

12.3 Basic waterfall structure

12.4 Examples for carried interest calculation

12.5 Conclusion

12.6 Appendix – examples

13 Modelling Qualitative Data

13.1 Quantitative versus qualitative approaches

13.2 Fund rating/grading

13.3 Approaches to fund ratings

13.4 Use of ratings/grades [SH1] as input for models

13.5 Assessing the degree of similarity with comparable funds

13.6 Conclusions

14 Translating Fund Grades into Quantification

14.1 Expected performance grades

14.2 Linking grades with quantifications

14.3 Operational status grades

14.4 Conclusions

PART III RISK MANAGEMENT AND ITS GOVERNANCE

15 Securitization

15.1 Definition of securitization

15.2 Financial structure

15.3 Risk modelling and rating of senior notes

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

15.5 Conclusions

16 Risk Management Policy

16.1 Setting the risk management agenda

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

16.3 Built-in tensions

16.4 Conclusions

17 Risk Management Policy

17.1 Rules or principles?

17.2 Risk management policy context

17.3 Developing a risk management policy

17.4 Conclusion

Bibliography

Abbreviations

Index

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