Luxembourg-based Head of Risk Management AIFM, Adela Baho, spoke to AGEFI about the importance of risk management and the ideal risk framework for alternative assets.
The funds managed by our AIFM cover a wide range of investment strategies including private equity, real estate, private debt, infrastructure, fund of funds and hedge funds.
Investors are turning to alternative assets in search of higher yield, better diversification and lower risk than the ones offered by traditional asset classes. As recently announced by the FED and the ECB, yields are going to remain lower for longer, with negative yielding debt hitting new records. One of the outcomes of this situation is the increasing share of investments in private debt, private equity and infrastructure assets. The inclusion of the alternative assets, from the investors’ perspective, has been beneficial to the risk-adjusted performance of the overall portfolio, and this in both pre- and post- global financial crisis macro-regimes. This broadly diversified portfolio has shown a lower volatility and therefore higher risk-adjusted returns when measured by the well-known measure of the “Sharpe Ratio”.
Well, it depends on the strategy. We apply a customised risk assessment for each asset class, at initial investment and on an ongoing basis following the valuation cycle. In any case, it is widely accepted that the aim of risk management is to use a forward-looking approach when assessing the risks. In my opinion, the approach to follow should include both top-down and bottom-up.
The former consists of estimating returns and understanding the behavior of the fund, that is the main determinants of the investment decision including leverage, over-performance versus the risk-free rate and the decomposition in systematic and idiosyncratic risk elements. It’s worth noting that most of academic research and market practice also focuses on the aggregated fund level. We aim at improving that by using a bottom-up approach looking at the target investment. As an example, if we take the private debt case, though it remains challenging to obtain the data, the bottom-up risk assessment shall focus on the performance of the target company. We need to know the financial health of the company, that is if the firm has the ability to generate enough cash flows in order to pay back its debt and eventually decrease leverage risk, or what is the chance that the company may go out of business before the loan maturity is reached or before the exit of the investment. Without going into details, the family of credit default models such as Merton structural model can be used.
Read the full interview here.