Mastering illiquidity : risk management for portfolios of limited partnership funds

306 Pages·2013·12.389 MB·English

by  Cornelius, Peter, Guennoc, Didier, Diller, Christian, Meyer, Thomas

Mastering Illiquidity
Risk Management for Portfolios of Limited
Partnership Funds
Peter Cornelius
Christian Diller
Didier Guennoc
Thomas Meyer
A John Wiley & Sons, Ltd., Publication
(cid:2)C 2013JohnWiley&Sons,Ltd
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LibraryofCongressCataloging-in-PublicationData
Cornelius,Peter,1960-
Masteringilliquidity:riskmanagementforportfoliosoflimitedpartnershipfunds/PeterCornelius,Christian
Diller,DidierGuennocandThomasMeyer.
pagescm
Includesbibliographicalreferencesandindex.
ISBN978-1-119-95242-8(cloth)
1.Privateequityfunds. 2.Portfoliomanagement. 3.Riskmanagement. I.Diller,Christian,1976-
II.Guennoc,Didier,1967- III.Meyer,Thomas,1959- IV.Title.
HG4751.C7542013
332.63(cid:3)27–dc23
2013004405
AcataloguerecordforthisbookisavailablefromtheBritishLibrary.
ISBN978-1-119-95242-8(hardback) ISBN978-1-119-95280-0(ebk)
ISBN978-1-119-95281-7(ebk) ISBN978-1-119-95282-4(ebk)
Coverimage:Shutterstock.com
Setin10/12ptTimesbyAptara,Inc.,NewDelhi,India
PrintedinGreatBritainbyCPIGroup(UK)Ltd,Croydon,CR04YY
Toourfamilies:
PeterCornelius:Susanne;andHeikeandPaul
ChristianDiller:Susanne,MoritzandMara
DidierGuennoc:Brigitte,Lorenz-GabrielandNinon-Marie
ThomasMeyer:MikaKaneyuki

Contents
Foreword xi
Acknowledgements xiv
1 Introduction 1
1.1 Alternativeinvestingandtheneedtoupgraderiskmanagementsystems 1
1.2 Scopeofthebook 4
1.3 Organizationofthebook 6
1.3.1 Illiquidinvestmentsasanassetclass 6
1.3.2 Riskmeasurementandmodelling 8
1.3.3 Riskmanagementanditsgovernance 12
PARTI ILLIQUIDINVESTMENTSASANASSETCLASS
2 IlliquidAssets,MarketSizeandtheInvestorBase 17
2.1 Definingilliquidassets 17
2.2 Marketsize 20
2.3 Theinvestorbase 23
2.3.1 Currentinvestorsinilliquidassetsandtheirexposure 23
2.3.2 Recenttrends 26
2.4 Conclusions 32
3 PrudentInvestingandAlternativeAssets 33
3.1 Historicalbackground 34
3.1.1 Theimportanceofassetprotection 34
3.1.2 Theprudentmanrule 34
3.1.3 Theimpactofmodernportfoliotheory 35
3.2 Prudentinvestorrule 36
3.2.1 Maindifferences 36
3.2.2 Importanceofinvestmentprocess 37
3.3 TheOECDguidelinesonpensionfundassetmanagement 38
3.4 Prudenceanduncertainty 38
3.4.1 Mayprudenceleadtoherding? 39
3.4.2 Mayprudenceleadtoabiasagainstuncertainty? 39
vi Contents
3.4.3 Processasabenchmarkforprudence? 40
3.4.4 Sizematters 40
3.5 Conclusion 41
4 InvestinginIlliquidAssetsthroughLimitedPartnershipFunds 43
4.1 Limitedpartnershipfunds 43
4.1.1 Basicsetup 43
4.1.2 Thelimitedpartnershipstructure 45
4.1.3 Is“defaulting”anoptionforlimitedpartners? 47
4.2 Limitedpartnershipsasstructurestoaddressuncertaintyand
ensurecontrol 47
4.2.1 Addressinguncertainty 48
4.2.2 Controlfromthelimitedpartnerperspective 48
4.3 Thelimitedpartnershipfund’silliquidity 49
4.3.1 Illiquidityasthesourceoftheexpectedupside 49
4.3.2 Themarketforlemons 50
4.3.3 Contractualilliquidity 51
4.3.4 Inabilitytovalueproperly 51
4.3.5 Endowmenteffect 51
4.4 Criticismsofthelimitedpartnershipstructure 52
4.5 Competingapproachestoinvestinginprivateequityandrealassets 52
4.5.1 Listedvehicles 53
4.5.2 Directinvestments 53
4.5.3 Deal-by-deal 54
4.5.4 Co-investments 54
4.6 Atime-provenstructure 55
4.7 Conclusion 57
5 Returns,RiskPremiumsandRiskFactorAllocation 59
5.1 Returnsandriskinprivateequity 59
5.1.1 Comparingprivateequitywithpublicequityreturns 60
5.1.2 MarketriskandtheCAPM 64
5.1.3 Stalepricingandtheoptimalallocationtoprivateequity 67
5.1.4 Informedjudgmentsandadhocadjustmentstothe
mean–varianceframework 68
5.1.5 ExtensionsoftheCAPMandliquidityrisk 69
5.1.6 Liability-driveninvestingandriskfactorallocation 70
5.2 Conclusions 73
6 TheSecondaryMarket 75
6.1 Thestructureofthesecondarymarket 76
6.1.1 Sellersandtheirmotivationstosell 76
6.1.2 Buyersandtheirmotivationstobuy 79
6.1.3 Intermediationinthesecondarymarket 82
6.2 Marketsize 83
6.2.1 Transactionvolume 83
6.2.2 Fundraising 86
Contents vii
6.3 Priceformationandreturns 87
6.3.1 Pricingsecondarytransactions 87
6.3.2 Returnsfromsecondaryinvestments 90
6.4 Conclusions 93
PARTII RISKMEASUREMENTANDMODELLING
7 IlliquidAssetsandRisk 97
7.1 Risk,uncertaintyandtheirrelationshipwithreturns 98
7.1.1 Riskanduncertainty 98
7.1.2 Howobjectiveareprobabilitiesanyway? 99
7.1.3 Howusefularebenchmarkapproximations? 100
7.1.4 Subjectiveprobabilitiesandemergingassets 101
7.2 Riskmanagement,duediligenceandmonitoring 102
7.2.1 Hedgingandfinancialvs.non-financialrisks 102
7.2.2 Distinguishingriskmanagementandduediligence 103
7.3 Conclusions 105
8 LimitedPartnershipFundExposuretoFinancialRisks 107
8.1 Exposureandriskcomponents 108
8.1.1 Definingexposureandidentifyingfinancialrisks 108
8.1.2 Capitalrisk 110
8.1.3 Liquidityrisk 111
8.1.4 Marketriskandilliquidity 112
8.2 Fundingtest 113
8.3 Cross-bordertransactionsandforeignexchangerisk 117
8.3.1 Limitedpartnerexposuretoforeignexchangerisk 117
8.3.2 Dimensionsofforeignexchangerisk 118
8.3.3 Impactonfundreturns 119
8.3.4 Hedgingagainstforeignexchangerisk? 120
8.3.5 Foreignexchangeexposureasapotentialportfoliodiversifier 120
8.4 Conclusions 121
9 Value-at-Risk 123
9.1 Definition 123
9.2 Value-at-riskbasedonNAVtimeseries 124
9.2.1 Calculation 125
9.2.2 Problemsandlimitations 127
9.3 Cashflowvolatility-basedvalue-at-risk 129
9.3.1 Timeseriescalculation 131
9.3.2 Fundgrowthcalculation 133
9.3.3 Underlyingdata 135
9.4 Diversification 136
9.5 Factoringinopportunitycosts 141
9.6 Cash-flow-at-risk 143
9.7 Conclusions 144
viii Contents
10 TheImpactofUndrawnCommitments 149
10.1 Doovercommitmentsrepresentleverage? 150
10.2 Howshouldundrawncommitmentsbevalued? 151
10.3 Apossiblewayforward 153
10.3.1 Reconcilingfundvaluationswithaccountingview 153
10.3.2 Modellingundrawncommitmentsasdebt 154
10.3.3 The“virtualfund”asabasisforvaluations 155
10.4 Conclusions 159
11 CashFlowModelling 161
11.1 Projectionsandforecasts 162
11.2 Whatisamodel? 163
11.2.1 Modelrequirements 164
11.2.2 Modelclassification 164
11.3 Non-probabilisticmodels 167
11.3.1 CharacteristicsoftheYalemodel 168
11.3.2 ExtensionsoftheYalemodel 169
11.3.3 LimitationsoftheYalemodel 171
11.4 Probabilisticmodels 171
11.4.1 Cashflowlibraries 172
11.4.2 Projectingafund’slifetime 173
11.4.3 Scalingoperations 176
11.5 Scenarios 178
11.6 Blendingofprojectionsgeneratedbyvariousmodels 179
11.7 Stresstesting 180
11.7.1 Acceleratedcontributions 181
11.7.2 Decelerateddistributions 182
11.7.3 Increasingvolatility 183
11.8 Back-testing 184
11.9 Conclusions 187
12 DistributionWaterfall 189
12.1 Importanceasincentive 190
12.1.1 Waterfallcomponents 190
12.1.2 Profitandloss 191
12.1.3 Distributionprovisions 191
12.1.4 Deal-by-dealvs.aggregatedreturns 191
12.2 Fundhurdles 191
12.2.1 Hurdledefinitions 192
12.2.2 Optioncharacterandscreeningoffundmanagers 192
12.3 Basicwaterfallstructure 193
12.3.1 Softhurdle 193
12.4 Examplesforcarriedinterestcalculation 195
12.4.1 Softhurdleforcompoundedinterest-basedcarriedinterest
allocation 196
12.4.2 Hardhurdleforcompoundedinterest-basedcarriedinterest
allocation 198