Risk Management Focus by LDS Partners
Active Portfolio Management with LDS Partners
Alternative investment risk management is experiencing significant development. In this article, Thomas Meyer, Director at LDS Partners and co-author of ‘Beyond the J-Curve’ (John Wiley & Sons, 2005), explores some of the current challenges of risk management and the approaches that can be taken to meet those challenges.
The ability to determine and report on the risk profile of a portfolio leads to tangible indicators of a portfolio’s behavior – future cash flows, expected performance indicators like net final IRR’s and multiples, expected final TVPI’s, value at risk, tail value at risk – permit investors to take appropriate actions before damage may occur. As such, risk management represents the umbrella under which all other financial analyses and modeling takes place.
Methodologies, Old and New
Financial projections were – and still are – largely deterministic. They mainly consisted of Excel-based spreadsheet models that were generally inflexible, slow and produced predictions of limited accuracy.
The LDS Partners approach to risk management is different: we start at the fund level, taking into account events taking place at the company level and at the wrapper level. This produces more reliable projections and more accurate predictions. Instead of the good-neutral-bad ratings traditionally used, we generate a probability curve, which allows an investor to predict with a specific level of confidence how one fund or many may perform. This is less deterministic and more probabilistic.
LDS Partners specializes in strategic decision systems, program structuring, corporate governance and risk management for limited partners investing in closed-ended funds, such as private equity, venture capital, infrastructure and real estate. By determining the likelihood of liquidity events to calculate cash flows, investors can realize an accessible view of the future with the goal of predicting events that will affect liquidity.
Our venture with eFront resulted in the FrontAnalytics Risk Management module, a dashboard of management tools, of which risk management is a central capability. It incorporates LDS Partners’ stochastic approach and, together with the FrontAnalytics dashboard and cash flow modules, introduces fund managers to a new level of predictive ability.
It should come as no surprise that risk management is very high on regulators’ agendas. As in every other area of financial services, regulators are now imposing tough requirements for risk policies, which place greater burdens on risk management operations.
For example, the Dutch National Bank almost imposes that pension funds have a risk management function in place from inception to full execution and monitoring of an investment program. Many private equity industry players – limited and general partners alike – are having difficulty accepting these new requirements, but they do realize the necessity.
A New Governing Body Association
Our industry, which operates in a private market without quoted prices, needed an independent governing body to establish standards and guidelines for valuations and reporting. That need culminated in the establishment of the IPEV Association, funding arm of the International Private Equity and Venture Capital Valuation Board. As a founding member of the IPEV Association, we support the creation of guidelines that impact how LPs and GPs around the world generate valuations and report on this and other performance information.
There are three key actions LPs can take to optimize their risk management operations.
- Implement an easy-to-use yet comprehensive tool to actively manage a portfolio of funds
- Have a clear understanding of risk and establish an opportunity profile
- Maintain regulatory compliance across the investment program
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