Mastering Illiquidity (Hardcover)

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

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

2.4 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

PART II RISK MEASUREMENT AND MODELLING

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

PART III RISK MANAGEMENT AND ITS GOVERNANCE

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