Mastering Illiquidity: Risk Management for Portfolios of Limited Partnership Funds -- Contents -- Foreword -- Acknowledgements -- 1 Introduction -- 1.1 Alternative investing and the need to upgrade risk management systems -- 1.2 Scope of the book -- 1.3 Organization of the book -- 1.3.1 Illiquid investments as an asset class -- 1.3.2 Risk measurement and modelling -- 1.3.3 Risk management and its governance -- 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 -- 2.3.1 Current investors in illiquid assets and their exposure -- 2.3.2 Recent trends -- 2.4 Conclusions -- 3 Prudent Investing and Alternative Assets -- 3.1 Historical background -- 3.1.1 The importance of asset protection -- 3.1.2 The prudent man rule -- 3.1.3 The impact of modern portfolio theory -- 3.2 Prudent investor rule -- 3.2.1 Main differences -- 3.2.2 Importance of investment process -- 3.3 The OECD guidelines on pension fund asset management -- 3.4 Prudence and uncertainty -- 3.4.1 May prudence lead to herding? -- 3.4.2 May prudence lead to a bias against uncertainty? -- 3.4.3 Process as a benchmark for prudence? -- 3.4.4 Size matters -- 3.5 Conclusion -- 4 Investing in Illiquid Assets through Limited Partnership Funds -- 4.1 Limited partnership funds -- 4.1.1 Basic setup -- 4.1.2 The limited partnership structure -- 4.1.3 Is "defaulting" an option for limited partners? -- 4.2 Limited partnerships as structures to address uncertainty and ensure control -- 4.2.1 Addressing uncertainty -- 4.2.2 Control from the limited partner perspective -- 4.3 The limited partnership fund's illiquidity -- 4.3.1 Illiquidity as the source of the expected upside -- 4.3.2 The market for lemons -- 4.3.3 Contractual illiquidity -- 4.3.4 Inability to value properly.

4.3.5 Endowment effect -- 4.4 Criticisms of the limited partnership structure -- 4.5 Competing approaches to investing in private equity and real assets -- 4.5.1 Listed vehicles -- 4.5.2 Direct investments -- 4.5.3 Deal-by-deal -- 4.5.4 Co-investments -- 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 -- 5.1.1 Comparing private equity with public equity returns -- 5.1.2 Market risk and the CAPM -- 5.1.3 Stale pricing and the optimal allocation to private equity -- 5.1.4 Informed judgments and ad hoc adjustments to the mean-variance framework -- 5.1.5 Extensions of the CAPM and liquidity risk -- 5.1.6 Liability-driven investing and risk factor allocation -- 5.2 Conclusions -- 6 The Secondary Market -- 6.1 The structure of the secondary market -- 6.1.1 Sellers and their motivations to sell -- 6.1.2 Buyers and their motivations to buy -- 6.1.3 Intermediation in the secondary market -- 6.2 Market size -- 6.2.1 Transaction volume -- 6.2.2 Fundraising -- 6.3 Price formation and returns -- 6.3.1 Pricing secondary transactions -- 6.3.2 Returns from secondary investments -- 6.4 Conclusions -- PART II RISK MEASUREMENT AND MODELLING -- 7 Illiquid Assets and Risk -- 7.1 Risk, uncertainty and their relationship with returns -- 7.1.1 Risk and uncertainty -- 7.1.2 How objective are probabilities anyway? -- 7.1.3 How useful are benchmark approximations? -- 7.1.4 Subjective probabilities and emerging assets -- 7.2 Risk management, due diligence and monitoring -- 7.2.1 Hedging and financial vs. non-financial risks -- 7.2.2 Distinguishing risk management and due diligence -- 7.3 Conclusions -- 8 Limited Partnership Fund Exposure to Financial Risks -- 8.1 Exposure and risk components -- 8.1.1 Defining exposure and identifying financial risks -- 8.1.2 Capital risk.

8.1.3 Liquidity risk -- 8.1.4 Market risk and illiquidity -- 8.2 Funding test -- 8.3 Cross-border transactions and foreign exchange risk -- 8.3.1 Limited partner exposure to foreign exchange risk -- 8.3.2 Dimensions of foreign exchange risk -- 8.3.3 Impact on fund returns -- 8.3.4 Hedging against foreign exchange risk? -- 8.3.5 Foreign exchange exposure as a potential portfolio diversifier -- 8.4 Conclusions -- 9 Value-at-Risk -- 9.1 Definition -- 9.2 Value-at-risk based on NAV time series -- 9.2.1 Calculation -- 9.2.2 Problems and limitations -- 9.3 Cash flow volatility-based value-at-risk -- 9.3.1 Time series calculation -- 9.3.2 Fund growth calculation -- 9.3.3 Underlying data -- 9.4 Diversification -- 9.5 Factoring in opportunity costs -- 9.6 Cash-flow-at-risk -- 9.7 Conclusions -- 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 -- 10.3.1 Reconciling fund valuations with accounting view -- 10.3.2 Modelling undrawn commitments as debt -- 10.3.3 The "virtual fund" as a basis for valuations -- 10.4 Conclusions -- 11 Cash Flow Modelling -- 11.1 Projections and forecasts -- 11.2 What is a model? -- 11.2.1 Model requirements -- 11.2.2 Model classification -- 11.3 Non-probabilistic models -- 11.3.1 Characteristics of the Yale model -- 11.3.2 Extensions of the Yale model -- 11.3.3 Limitations of the Yale model -- 11.4 Probabilistic models -- 11.4.1 Cash flow libraries -- 11.4.2 Projecting a fund's lifetime -- 11.4.3 Scaling operations -- 11.5 Scenarios -- 11.6 Blending of projections generated by various models -- 11.7 Stress testing -- 11.7.1 Accelerated contributions -- 11.7.2 Decelerated distributions -- 11.7.3 Increasing volatility -- 11.8 Back-testing -- 11.9 Conclusions -- 12 Distribution Waterfall -- 12.1 Importance as incentive.

12.1.1 Waterfall components -- 12.1.2 Profit and loss -- 12.1.3 Distribution provisions -- 12.1.4 Deal-by-deal vs. aggregated returns -- 12.2 Fund hurdles -- 12.2.1 Hurdle definitions -- 12.2.2 Option character and screening of fund managers -- 12.3 Basic waterfall structure -- 12.3.1 Soft hurdle -- 12.4 Examples for carried interest calculation -- 12.4.1 Soft hurdle for compounded interest-based carried interest allocation -- 12.4.2 Hard hurdle for compounded interest-based carried interest allocation -- 12.4.3 Soft hurdle for multiple-based carried interest allocation -- 12.4.4 Hard hurdle for multiple-based carried interest allocation -- 12.5 Conclusions -- 13 Modelling Qualitative Data -- 13.1 Quantitative vs. qualitative approaches -- 13.1.1 Relevance of qualitative approaches -- 13.1.2 Determining classifications -- 13.2 Fund rating/grading -- 13.2.1 Academic work on fund rating -- 13.2.2 Techniques -- 13.2.3 Practical considerations -- 13.3 Approaches to fund ratings -- 13.3.1 Rating by external agencies -- 13.3.2 Internal fund assessment approaches -- 13.4 Use of rating/grading as input for models -- 13.4.1 Assessing downside risk -- 13.4.2 Assessing upside potential -- 13.4.3 Is success repeatable? -- 13.5 Assessing the degree of similarity with comparable funds -- 13.5.1 The AMH framework -- 13.5.2 Strategic groups in alternative assets -- 13.5.3 Linking grading to quantification -- 13.6 Conclusions -- 14 Translating Fund Grades into Quantification -- 14.1 Expected performance grades -- 14.1.1 Determine quantitative score -- 14.1.2 Determine qualitative score -- 14.1.3 Combine the two scores, review and adjust -- 14.2 Linking grades with quantifications -- 14.2.1 Estimate likely TVPIs -- 14.2.2 Practical considerations -- 14.3 Operational status grades -- 14.4 Conclusions -- PART III RISK MANAGEMENT AND ITS GOVERNANCE -- 15 Securitization.

15.1 Definition of securitization -- 15.1.1 Size, quality and maturity -- 15.1.2 Treatment of other types of assets -- 15.2 Financial structure -- 15.2.1 Senior notes of a securitization -- 15.2.2 Junior notes/mezzanine tranche of a securitization -- 15.2.3 Equity of a securitization -- 15.3 Risk modelling and rating of senior notes -- 15.3.1 Payment waterfall -- 15.3.2 Modelling of default risk and rating on notes -- 15.4 Transformation of non-tradable risk factors into tradable financial securities -- 15.4.1 CFOs as good example for risk and liquidity management practices -- 15.4.2 Risk of coupon bonds as one part of the risk of illiquid asset classes -- 15.4.3 Market risk as second part of the risk of illiquid asset classes -- 15.5 Conclusions -- 16 Role of the Risk Manager -- 16.1 Setting the risk management agenda -- 16.1.1 What risk taking is rewarded? -- 16.1.2 Risk management: financial risk, operational risk or compliance? -- 16.1.3 A gap of perceptions? -- 16.2 Risk management as part of a firm's corporate governance -- 16.2.1 "Democratic" approach -- 16.2.2 "Hierarchic" approach -- 16.3 Built-in tensions -- 16.3.1 Risk managers as "goal keepers" -- 16.3.2 Different perspectives - internal vs. external -- 16.3.3 Analysing and modelling risks -- 16.3.4 Remuneration -- 16.4 Conclusions -- 17 Risk Management Policy -- 17.1 Rules or principles? -- 17.1.1 "Trust me - I know what I'm doing" -- 17.1.2 "Trust but verify" -- 17.2 Risk management policy context -- 17.2.1 Investment strategy -- 17.2.2 Business plan -- 17.2.3 Organizational setting -- 17.2.4 System environment -- 17.3 Developing a risk management policy -- 17.3.1 Design considerations -- 17.3.2 Risk limits -- 17.4 Conclusions -- References -- Abbreviations -- Index.