The last challenge to achieving transparency is the completeness and comparability of manager data. The extent and format of the information can vary by manager, which challenges the investor’s ability to create a comprehensive analysis across a portfolio with more than one manager. This is why most program managers and investors agree that the most accurate measure of risk requires complete access to the holdings—a feat rarely achieved even by well-established and sophisticated investors.
When holdings or exposure data are not available, many investors resort to returns-based analysis. Although this is not a substitute for the transparency offered by a rigorous holdings analysis, some of these techniques promise the ability to identify market sensitivity and even to detect embedded leverage. Usually, these analyses are regression-based, requiring a time-weighted return stream on the investment and an appropriate index. In the hands of experienced analysts, these techniques can be useful. However, they can yield extremely misleading signals in the hands of the inexperienced.
An unfortunate by-product of the lack of transparency is the inability to create true benchmarks for private market assets. There are plenty of composites and universes; however, they do not meet the well-known criteria of true benchmarks such as investability, known constituency and appropriateness. Even if you have complete transparency within your program, you will have no idea of the composition of the myriad hedge, real asset and private equity composites, as this information is not available.
Not knowing the composition of these so-called indexes is problematic, as you cannot determine appropriateness in asset classes with great performance dispersion. This often leads to investors using fixed bogeys or marketable indexes plus a premium, which leads to another set of problems. These composites and indexes may help the investor make generalizations about certain asset classes and sub-styles, but they are not true benchmarks.
Liquidity – Liquidity problems include getting money out of an investment and raising money to fund an investment, such as paying capital calls for private equity.
Private equity partnerships and real asset partnerships are illiquid asset classes by nature. Investors know they are making a long-term commitment to a relationship that is expected to last 10 years or more, with no control over the contributions and distributions. There is the expected illiquidity of not being able to easily sell the investment, but liquidity has also taken on a new meaning in a market environment that has impaired managers’ abilities to sell investments and return capital in the way of distributions.
At the same time, the money flowing into partnerships and capital calls continues. Investors and managers are now negotiating terms to defer calls until a later date so that the investor does not have to further reduce the marketable side of the portfolio and lock in public portfolio losses via a sale to fund a capital call. On the flip side, many private equity managers believe the risk of this call-deferral practice creates the opportunity cost of missing the acquisition bargains that this very mess has created.
The current cash flow environment presents a unique risk for limited partners in vehicles such as private equity, in which the manager “calls” money from the investor when investment opportunities have been identified. Until recently, investors have counted on distributions to help pay capital calls. Requiring money for capital calls can create liquidity issues when partnership distributions are low, as they are in the current environment.
To help understand the impact of market environmental forces, investors can benefit from a structured partnership investment process that includes a partnership liquidity and allocation model. A good model can help the investor to anticipate cash needs under various scenarios, understand the likely valuation levels of the program and even plan for the replacement of retiring partnerships.
Even in good times, it is prudent to understand the likely range of behaviour of a private market program. In bad times, it’s good to have at least an educated guess at the downside.
There are also liquidity risks for hedge funds. Many hedge funds include lock-up provisions limiting the investor’s rights to sell. Managers argue that these provisions are there to ensure that the remaining investors are not harmed by the exit. Investors should know these lock-up periods prior to investment and perform ongoing monitoring to determine how many investors have redeemed in good times and in bad.
Need to Know
Investing in alternatives is administratively challenging as well as potentially rewarding, and the private, opaque and often long-term nature of these assets that drives performance brings unique issues that must be anticipated, understood and managed. Successful investors would agree that it is important to take the following steps.
1. Be aware of your evaluation and risk management approach before starting an alternatives investment program.
2. Understand your ability and willingness to manage the analysis and the disproportionate administrative challenges that an illiquid portfolio entails.
3. Know your manager’s ability to provide timely and transparent valuations.
4. Understand how your service providers, including your custodian and your consultant, can help.
Beyond performance and risk measurement, investors in alternatives must manage a mountain of paperwork, attend manager meetings and be prepared to answer tough questions posed by auditors and regulators. Successful investors either anticipate and plan for these needs or opt to take a simpler approach, such as fund-of-funds investment. Either way, it’s important to enter this asset class with your eyes wide open.
Paul Finlayson is multinational product manager, risk and performance services, with Northern Trust in Chicago.
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the March 2009 edition of BENEFITS CANADA magazine.