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
