Arms investors with powerful new tools for measuring and managing the risks associated with the various illiquid asset classes. With risk-free interest rates and risk premiums at record lows, many investors are turning to illiquid assets, such as real estate, private equity, infrastructure and timber, in search of superior returns and greater portfolio diversity. But as many analysts, investors and wealth managers are discovering, such investments bring with them a unique set of risks that cannot be measured by standard asset allocation models. Written by a dream team of globally renowned experts in the field, this book provides a clear, accessible overview of illiquid fund investments, focusing on what the main risks of these asset classes are and how to measure those risks in today's regulatory environment. It provides solutions for institutional investors in need of guidance in today's regulatory environment. It offers detailed descriptions of risk measurement in illiquid asset classes, illustrated with real life case studies. It helps you to develop reliable risk management tools while complying with the regulations designed to contain the individual and systemic risks arising from illiquid investments. It features real-life case studies that capture an array of risk management scenarios you are likely to encounter.
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 1.3.1 Illiquid investments as an asset class 6 1.3.2 Risk measurement and modelling 8 1.3.3 Risk management and its governance 12 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 2.3.1 Current investors in illiquid assets and their exposure 23 2.3.2 Recent trends 26 2.4 Conclusions 32 3 Prudent Investing and Alternative Assets 33 3.1 Historical background 34 3.1.1 The importance of asset protection 34 3.1.2 The prudent man rule 34 3.1.3 The impact of modern portfolio theory 35 3.2 Prudent investor rule 36 3.2.1 Main differences 36 3.2.2 Importance of investment process 37 3.3 The OECD guidelines on pension fund asset management 38 3.4 Prudence and uncertainty 38 3.4.1 May prudence lead to herding? 39 3.4.2 May prudence lead to a bias against uncertainty? 39 3.4.3 Process as a benchmark for prudence? 40 3.4.4 Size matters 40 3.5 Conclusion 41 4 Investing in Illiquid Assets through Limited Partnership Funds 43 4.1 Limited partnership funds 43 4.1.1 Basic setup 43 4.1.2 The limited partnership structure 45 4.1.3 Is "defaulting" an option for limited partners? 47 4.2 Limited partnerships as structures to address uncertainty and ensure control 47 4.2.1 Addressing uncertainty 48 4.2.2 Control from the limited partner perspective 48 4.3 The limited partnership fund's illiquidity 49 4.3.1 Illiquidity as the source of the expected upside 49 4.3.2 The market for lemons 50 4.3.3 Contractual illiquidity 51 4.3.4 Inability to value properly 51 4.3.5 Endowment effect 51 4.4 Criticisms of the limited partnership structure 52 4.5 Competing approaches to investing in private equity and real assets 52 4.5.1 Listed vehicles 53 4.5.2 Direct investments 53 4.5.3 Deal-by-deal 54 4.5.4 Co-investments 54 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 5.1.1 Comparing private equity with public equity returns 60 5.1.2 Market risk and the CAPM 64 5.1.3 Stale pricing and the optimal allocation to private equity 67 5.1.4 Informed judgments and ad hoc adjustments to the mean--variance framework 68 5.1.5 Extensions of the CAPM and liquidity risk 69 5.1.6 Liability-driven investing and risk factor allocation 70 5.2 Conclusions 73 6 The Secondary Market 75 6.1 The structure of the secondary market 76 6.1.1 Sellers and their motivations to sell 76 6.1.2 Buyers and their motivations to buy 79 6.1.3 Intermediation in the secondary market 82 6.2 Market size 83 6.2.1 Transaction volume 83 6.2.2 Fundraising 86 6.3 Price formation and returns 87 6.3.1 Pricing secondary transactions 87 6.3.2 Returns from secondary investments 90 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 7.1.1 Risk and uncertainty 98 7.1.2 How objective are probabilities anyway? 99 7.1.3 How useful are benchmark approximations? 100 7.1.4 Subjective probabilities and emerging assets 101 7.2 Risk management, due diligence and monitoring 102 7.2.1 Hedging and financial vs. non-financial risks 102 7.2.2 Distinguishing risk management and due diligence 103 7.3 Conclusions 105 8 Limited Partnership Fund Exposure to Financial Risks 107 8.1 Exposure and risk components 108 8.1.1 Defining exposure and identifying financial risks 108 8.1.2 Capital risk 110 8.1.3 Liquidity risk 111 8.1.4 Market risk and illiquidity 112 8.2 Funding test 113 8.3 Cross-border transactions and foreign exchange risk 117 8.3.1 Limited partner exposure to foreign exchange risk 117 8.3.2 Dimensions of foreign exchange risk 1
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