Private equity in an insurance company's strategic asset ... - PEI Media

10
Private equity in an insurance company’s
strategic asset allocation
By Paul Achleitner and Stefan Albrecht, Allianz 1
Risk aspects discussed in this chapter:
➲ How can an insurance company determine its private equity allocation
under a strategic asset allocation model?
➲ What are the effects of the J-Curve on insurance companies establishing a
new private equity programme?
➲ To what extent does a detailed understanding of asset-liability management
influence an insurance company’s private equity allocation?
➲ What impact do regulation, external ratings and internal risk-capital requirements
have on an insurance company’s private equity management?
Introduction
Strategic asset allocation (SAA) is at the core of any long-term investment programme
and largely determines its overall success. This well-known basic principle of investing is
even more important for insurance companies, which have not only to achieve satisfying
long-term investment results, but also and foremost, must meet their insurance claims.
Only when it considers both assets and liabilities at the same time can an insurance company
effectively manage the requirements of its various stakeholders.
SAA is embedded in and depends upon the larger framework of asset-liability management
(ALM), which addresses a range of topics. Among them are the analysis and optimisation
of the investment decisions, and most important, the maximisation of
shareholder profit, while managing various risks such as liquidity, interest rate, credit and
operational risks.
In this chapter, beginning with section 2, we discuss a simplified process to assist insurance
companies in determining their private equity allocation under a strategic asset allocation
model. We do so by presenting a multi-step approach where private equity
becomes part of the overall equity allocation in a more qualitative judgement. To this end,
a thorough understanding of all ALM-related characteristics is mandatory; these are
1
The authors are grateful to Thomas Ripfel, Dr. Christian Stögbauer, Henock Teklu, and Brian Welker for
helpful comments and contributions.
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Part I: Risk aspects of limited partners
addressed in some detail in section 3. In section 4 we outline the important regulatory,
ratings and risk-capital requirements relevant for insurance companies with a focus on
European regulation. Finally, section 5 offers a summary and concluding remarks.
Process to
determine an
SAA including
private equity
Determining an insurance company’s SAA is a complex and involved task. The SAA is a
long-term recommendation about how to optimally allocate available assets while considering
expected liabilities. First of all, an insurance company must fully consider the
required cash flows to meet future expected claims. In addition, in order to stay competitive
compared to its peers, an insurance company must also achieve a satisfying return
on its investments. Furthermore, these returns should not vary too much from year to
year since both policyholders and shareholders prefer stable and predictable investment
profits and returns.
All these requirements mean that insurance companies have to constantly look for ways
to improve the risk-return profile of their investment portfolios, which is particularly
important in a declining interest rate environment. Obvious approaches include exploiting
structural opportunities in the capital markets, like the normally positive slope of the
yield curve or to harvest illiquidity premiums of asset classes like real estate, private equity
or infrastructure investments, for example.
Quantitative
vs. qualitative
approaches
The scope of this chapter does not permit us to discuss all topics relevant to SAA. Rather
we present a simplified SAA process and discuss in more detail how to consider private
equity in this context. A coherent quantitative optimisation scheme considering all pertinent
aspects of private equity is often not available or reasonable. Instead, many
investors follow a multi-step SAA process, whereby the overall equity allocation is determined
first and then private equity is added later on, giving additional diversification benefits
to listed equity. Considering insurance companies’ typically ‘small’ overall equity
allocation, the split between private and listed equity may be made on a more qualitative
basis, as the same underlying macroeconomic factors, to a certain extent, drive these
equity types. Nevertheless, the decision on the private equity allocation must be done in
a well-informed and disciplined manner.
Sophisticated approaches, which attempt to coherently model alternative assets together
with traditional asset classes, such as stocks or bonds, are not discussed in this chapter.
Typically, these approaches lead to a multi-phase simulation, whereby the asset
returns and correlations have to be coherently modelled 2 . In this way specific cash-flow
characteristics, such as the J-Curve of private equity investments (see section 3), may
even be incorporated. However, there are several drawbacks to these very interesting
approaches. Evidently, they are quite involved and difficult to implement. More important,
2
See, for example, Terhaar, Staub and Singer (2003) and Staub (2005), who use common underlying factors
to derive the covariances and returns. Höcht, Ng, Wolf and Zagst (2008) employ a Markov switching
model, which also accounts for auto-correlation effects, and calibrate it against historical return series.
Escobar, Hieber, Scherer and Seco (2009) present a portfolio-optimisation scheme including default risk.
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Private equity in an insurance company’s strategic asset allocation
these methods are basically asset-only optimisations, which do not incorporate the oftencomplex
structure of insurance claims and liabilities. Particularly, for a with-profit life
insurance contract, the asset-liability interaction demands highly sophisticated ALM software
packages that simulate the full balance sheet of the insurance company over the
whole lifetime of the contract, which often do not allow for a direct optimisation of the
asset allocation. Rather, the user has to test and analyse various candidate allocations to
finally arrive at a recommendation for its SAA (by deploying a ‘what-if’ analysis approach).
Steps of an
SAA process
The first step of any SAA process requires a critical and careful analysis of the asset
structure and the expected liability patterns. This ALM analysis is a vast subject in itself
and too detailed to list here. It may suffice to mention that the long-term return requirements
of the portfolio in general and the return expectations for equity in particular
should be understood. Additional factors to consider include the risk-bearing capacity and
risk appetite as well as the operating profit and liquidity needs that have to be identified.
Another important point is a thorough investigation of the term structure of the expected
liabilities to find the required key-rate durations of the asset portfolio. A simple duration-matching
is usually not adequate.
The next point in the SAA process is the definition of the main asset classes being considered.
We propose for ease and practicability four main asset classes: government
bonds (in various maturity buckets); corporate bonds; equity; and real estate.
Government bonds are assumed to be almost risk-free and very liquid; they allow for keyrate
duration-matching of the liabilities. Corporate bonds, which may also include covered
bonds, provide higher returns and current income from coupons. Equities allow reserves
(unrealised capital gains and losses (UCGL)) to be built up and are linked to inflation and
the overall growth of the economy. Real estate delivers current income through rent and
a protection against inflation surprises. Depending on the investment structure, real
estate also allows reserves to build up both from planned book-value depreciation and
potential market-value appreciation. The reader should note that for ease we consider
only one economy with a single currency regime.
Since the private equity allocation will be determined later as part of the total equity
quota, a prospective private equity investor should, at the latest, now start to acquire a
comprehensive understanding of the asset class as far as it is necessary from a portfolio-construction
point of view. The various peculiarities of private equity investments are
discussed in section 3.
Next, it is necessary to evaluate what we call ‘room for manoeuvre’ for SAA. Various
external constraints and regulations – which are further discussed in section 4 – like solvency,
accounting principles, tax laws and ratings as well as internal risk-capital requirements
can severely limit the possibility to change the current asset allocation and set
constraints for the subsequent portfolio optimisation. As an aside, we note that we also
collect necessary information to be able at a later stage to set some leeway for tactical
asset allocation (TAA) bets around the still-to-be-determined SAA. Liquidity and operating
profit needs should also to be taken into account at this point. In particular, the specific
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Part I: Risk aspects of limited partners
characteristics of the various existing or prospective illiquid allocations (eg real estate, private
equity, mezzanine, infrastructure, renewable energy and loans) are to be accounted
for and planned for.
Having determined the room for manoeuvre, we can endeavour to find an optimal portfolio
allocation for our four main asset classes: government and corporate bonds, equity
and real estate. In the property and casualty (P&C) business segment, this may be
achieved with a Markowitz-inspired optimisation approach, possibly also considering the
expected distribution and term structure of future claims through a portfolio of zerocoupon
bonds yielding negative returns, which matches the key-rate durations of the liabilities.
Thus, a proxy of the total net asset value is optimised under appropriate
constraints. As already mentioned above, the situation is much more complicated for a
with-profit life insurance contract due to the typically complex asset-liability interaction.
However, by making a range of educated what-if analyses using ALM software, a suitable
SAA can be determined, which takes the various constraints into account.
Defining the
private equity
exposure
The private equity exposure in relation to the overall equity allocation has to be defined
considering various aspects like cash-flow planning or duration-matching. Negative cash
flows during the first years of a fund, referred to as the J-Curve effect, generally limit the
ability to initially commit large portions of the portfolio and must be planned for in the
context of a longer-term commitment strategy.
Since the actual investments in portfolio companies made by a private equity fund can
be spread over a period of up to six years (the investment period), the target exposure
should be defined at an early stage. It is important to clearly distinguish between the
commitment (contingent exposure to future draw-downs) and the net asset value (NAV)
(value of current investments). The latter should be taken as exposure.
Building up a meaningful private equity exposure from scratch takes at least five years
and requires special cash-flow planning tools (these topics will be discussed in the next
section in more detail). Careful planning and a long-term, multi-year commitment strategy
that largely avoid market timing are key criteria for success.
Characteristics of
private equity
relevant for ALM
Illiquidity, moderate
reserve-building
potential and midterm
investment
duration
Private equity is a complex asset class with many differences from common listed
stocks 3 . One of the most prominent characteristics is the organisation of the investment
vehicles (funds) as limited partnerships 4 . An investor makes a commitment to a fund,
which leads to a long-term engagement (at least ten years) without the option of an easy
3
4
5
For an introduction and overview on investing in private equity, see, for example, Bance (2004) or
Gilligan and Wright (2010)
This is the prominent legal structure in the US or UK. Similar structures are used in other jurisdictions.
Here we do not consider listed private equity, as it “does not reflect the risk & return characteristics of
a private equity portfolio of a typical institutional investor”, see CEIOPS (2010b), Comment No. 167 by
Capital Dynamics.
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Private equity in an insurance company’s strategic asset allocation
early exit 5 ; hence the descriptor that private equity is a very illiquid asset class. This is not
unlike other asset classes, such as real estate or private debt, where securities are not
traded on an organised and regulated market.
Another difference to listed equity is the limited duration of a single private equity
investment. Listed stocks can be held over very long time periods, thus allowing
considerable reserves to be built up (UCGL calculated as the difference between market
and book value). This is an important feature particularly for the management of
with-profit life insurance companies. By realising UCGL, management can smooth
the insurance company’s returns and help to achieve the highly stable investment
results expected by both shareholders and customers. This is generally not possible in
private equity 6 since the cash flows from both investments and exits are inherently
non-discretionary.
Private equity investments also require special accounting expertise: Under IFRS the distributions
are either treated as return of capital or operating profit, the latter being the
case for divestments declared by the fund as dividends. In local GAAP, an insurance company
may have some flexibility to steer the distributions 7 .
Another key point in ALM is the key-rate duration-matching of assets with liabilities.
Although the life of a private equity fund (limited partnership) is generally ten years, the
duration of cash flows is on average between four and five years 8 . Private equity investments
may not adequately cover very long-term liabilities, and will entail some reinvestment
risk. Another important consequence of the mid-term average investment duration
is an only moderate potential for inflation protection.
Random, but
predictable
cash flows with
J-Curve pattern
As mentioned above, the stochastic and non-discretionary nature of private equity cash
flows poses a considerable challenge for investors. Unless an allocation to private equity
is so small that cash calls and distributions can be served out of an insurance company’s
cash account, a careful monitoring of the past and sophisticated planning for future cash
flows is essential for a responsible investor 9 . However, investors should not overestimate
the possibility to actually manage, that is, swiftly adjust by buying or selling, their private
equity exposure. The NAV exposure is basically illiquid and it can be properly planned
within certain ranges of confidence in advance, but not substantially altered in a short
period of time.
6
7
8
9
Here we disregard captive direct funds, which allow some discretion in the timing of the cash flows
(investment and exit decisions), as usually insurance companies only invest directly in external funds
or indirectly in a fund of funds.
For example, under German HGB it is possible to reinvest the distributions into the special holding company
usually established for a fund of funds structure. This allows control and timing of the final distribution
pay-outs, which are then recognised as dividends.
See, for example, Rouvinez (2003) or Lopez-de-Silanes Phalippou and Gottschalg (2009), who note that
“returns are concentrated in short-held investments averaging 79 percent for investments held less
than two years and 10 percent for those held over four years”.
See, for example, Meyer and Mathonet (2005) or the chapters 1, 3 and 6 of this book.
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Part I: Risk aspects of limited partners
In particular, when building up a new private equity portfolio, an investor is exposed to the
famous J-Curve. During the initial phase, the fund’s internal rate of return (IRR), total value
to paid-in (TVPI) and net cash flows are all negative 10 . Diller and Kaserer (2005) report that
the payback period – the time until the net cumulative cash flows become positive – is
around 7.5 to 7.8 years. On average, in the first four years, private equity funds do not provide
significant current income as investments in bonds or real estate would provide.
A private equity programme should follow a multi-year plan. In fact, if we assume for simplicity
to commit the same amount each year, it takes around ten years to reach a steady
state, in which the overall portfolio is not changing significantly from year to year. In
essence, patience is a virtue for a private equity investor.
Stale pricing
requires adjustment
of volatilities and
correlations
An important aspect of private equity returns is the phenomenon of stale pricing. This
characteristic was first described and investigated for real estate and hedge funds and
later adapted to private equity 11 . Due to infrequent and appraised estimates of a fund’s
NAV, private equity return times series, which are provided, for example, by Thomson
Venture Economics, suffer from smoothed and delayed adjustments to developments in
the equity markets. Volatilities directly calculated from these time series are underestimated
by a factor of around two as shown in Table 10.1 12 . Using the Sharpe Ratio
approach, we find that both EU LBOs and US LBOs, as well as US Mezzanine, produce
superior risk-adjusted returns compared to public equity.
Correlations also need to be adjusted. However, the approach by Getmansky, Lo and
Makarov (2004) is statistically less reliable for this purpose and may not lead to valid
Table 10.1: Mean return, naive and unsmoothed volatility, and Sharpe Ratio
of quarterly private and public equity return time series for the period
Q1-1985 to Q4-2008
All funds EU LBOs EU VC US LBOs US Mezz. US VC S&P 500
Mean return 14% 6% 15% 10% 14% 9%
Naive volatility 11% 10% 11% 9% 17% 17%
Unsmoothed volatility 20% 17% 20% 13% 34% 17%
Sharpe ratio 50% 12% 55% 46% 29% 29%
Note: The private equity returns consider all active funds of all maturities during each time step and are net of fund fees and carry.
The naive volatility is directly calculated from the time series, while the unsmoothed volatility is adjusted following Getmansky, Lo and
Makarov (2004). The risk-free rate is set to 4% for the Sharpe Ratio, which uses the unsmoothed volatility.
Source: Thomson Reuters Venture Economics, Thomson Reuters Datastream, own calculations.
10
See, for example, Meyer and Mathonet (2005).
11
See, for example, Geltner (1990), Getmansky, Lo and Makarov (2004), Conroy and Harris (2007) or chapter
1 of this book.
12
This is also confirmed by CEIOPS (2010b), Comment No. 168 by Partners Group AG.
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Private equity in an insurance company’s strategic asset allocation
results. Indeed, due to an average investment duration of over four years for private equity
deals, it is more appropriate to deduce the correlation of private equity with listed
stocks from structural longer-term economic reasoning, which leads to fairly high figures.
Terhaar, Staub and Singer (2003), for example, give a value of 0.9 for the correlation
between US LBOs and US equities.
There are several implications of stale pricing for ALM. First, taking naive volatilities and
correlations in a portfolio optimisation overstates the risk-return profile and diversification
benefits of private equity. Second, although the naive volatility does not reflect the underlying
economic risk of private equity investments, it is the volatility directly inferred from
the fund NAVs and cash flows reported by the fund managers. Consequently, the naive
volatility is accounted for on the insurance balance sheet. Private equity investors benefit
from delayed and smoothed reactions to market crashes, giving shorter-term diversification
advantages when particularly needed and enjoy a more stable balance sheet.
These benefits will, however, gradually disappear with the adoption of more stringent
mark-to-market valuations guidelines as stated in the new FAS 157 regulations.
Returns need
to be adjusted
for leverage
and illiquidity
Perhaps the most discussed topics in private equity are the reported historical fund
returns (IRRs and TVPIs). Generally, funds do not publicly publish their returns. Therefore,
investors can either use proprietary in-house databases, which can be built up from data
received during fund due diligence and from their own commitments, or resort to data
collected by commercial data providers such as Thomson Venture Economics. In this
chapter, we concentrate on some aspects of private equity returns which are of particular
interest in the context of ALM and portfolio optimisation, namely how to compare private
equity with public equity returns on a risk-adjusted basis and how reliably an investor
can expect to avoid badly performing funds.
As the letter ‘L’ clearly stands for leverage in LBO 13 , leverage is an important part of the business
model for buyout funds. In fact, Achleitner et al (2010) find that one-third of the overall
value creation (defined as ‘TVPI-1’) is due to leverage 14 , while operational improvement
accounts for 46 percent. The rest is multiple expansion (18 percent) and a mixture of operational
improvement and multiple expansion (4 percent). Thus, broadly speaking, around onethird
of private equity IRR is also due to simple leverage. This fact should be accounted for
when comparing private with public returns. Using an elaborate approach, Phalippou and
Gottschalg (2009) find that the risk adjustment for leverage amounts to 3 percent annually 15 .
They also report that “the market beta is 1.3 and buyouts resemble small-value stocks”.
The next important distinctive return-driver is the illiquidity premium, which amounts to
around 3 percent annually 16 . Obviously, this is earned without any achievement by the
13
We focus on buyout and disregard venture capital as it is less relevant for many institutional investors.
14
Note that this implies that one-third of the performance fee, also known as carry, is due to simple leverage
effects.
15
This value has to be understood as negative alpha on the fund IRR. Note that illiquidity is not accounted
for yet.
16
See Staub (2003) or Franzoni, Nowak and Phalippou (2010).
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Part I: Risk aspects of limited partners
Table 10.2: Mean return, naive and unsmoothed volatility, and Sharpe Ratio
of quarterly private and public equity return time series for the period Q1-
1985 to Q4-2008
Top 75% of funds EU LBOs EU VC US LBOs US Mezz. US VC S&P 500
Mean return 17% 8% 18% 13% 17% 9%
Naive volatility 13% 11% 11% 10% 18% 17%
Unsmoothed volatility 23% 19% 21% 15% 36% 17%
Sharpe ratio 57% 21% 67% 60% 36% 29%
Note: Bottom quartile funds are excluded. See Table 10.1 for further comments.
Source: Thomson Reuters Venture Economics, Thomson Reuters Datastream, own calculations.
fund manager and must also be deducted in order to have a fair comparison between private
and public returns.
However, there is some good news for private equity fund investors. Various studies have
found remarkable performance persistence among private equity funds 17 . Aigner et al
(2008) determine the probability that a top-quartile fund manager will again be top quartile
with his successor fund ranging somewhere between 33 percent and 42 percent,
depending on the applied performance measure. Phalippou and Gottschalg (2009) note
“that prior fund performance actually subsumes all other fund characteristics in explaining
fund performance”. Strongly underperforming funds may be largely avoided by a fundselection
scheme excluding the fund managers with the worst return history.
Consequently, it may be justifiable to exclude the bottom-quartile funds from historical
performance analyses. In doing so, the mean return of US buyout funds increases, for
example, from 15 percent to 18 percent, as can be seen in Table 10.2. Furthermore, only
EU VC has now a lower Sharpe Ratio than public equity, which underlines the capability
of private equity to generate superior risk-adjusted returns.
External fund of funds managers are often mandated since the aforementioned selection
process is quite labour-intensive. Furthermore, a successful private equity programme
does not only require avoidance of bad funds, but also having access to
top-performing funds, which external fund of funds managers promise to provide. The
additional fund of funds structure adds another fee layer of around 1 percent per
annum (plus typically 5 percent carry) 18 . However, a good fund of funds manager can
pay for itself by earning higher net returns (after payment of all costs and fees) than an
internal team might generate 19 .
17
See, for example, Rouvinez (2006), Brigl et al (2008), Aigner et al (2008) or Phalippou and Gottschalg
(2009).
18
In comparison, Phalippou and Gottschalg (2009) find that the fees of a typical private equity direct fund
amount to 6% per annum.
19
See PiperJaffray (2003).
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Private equity in an insurance company’s strategic asset allocation
Regulatory, rating
and risk-capital
requirements for
private equity
Insurance companies’ investment decisions are strongly influenced by a range of external
constraints and regulations, notably solvency, external ratings and internal risk-capital
requirements. In this section we focus on European regulation. Important aspects like
the implications of different tax regimes for private equity in the European Union or of
local accounting principles on the management of UCGL, which have already been partly
discussed in section 3.1, are not addressed since they are rather country-specific.
Investments by financial institutions in private equity are governed by different regulatory
regimes: Insurance and reinsurance companies are covered by Solvency II 20 and banks
by the Capital Adequacy Directive (CAD III) 21 .
Following a request by the European Commission to specify the implementation of
Solvency II, the Committee of European Insurance and Occupational Pensions Supervisors
(CEIOPS) has proposed risk-capital charges both for listed (EEA or OECD countries) and for
private equity investments (as part of the so called ‘other’ equity class) within the standard
formula 22 . CEIOPS has calculated a 99.5 percent empirical Value at Risk (VaR) for certain
indices used to reflect the performance of the according equity segment. This results in a
capital charge of 55 percent for private equity on a standalone basis. The risks related to private
equity are mapped to the market-risk module. As a reaction to the industry’s reasoning
regarding this suggestion, the European Commission has reduced this value to 49 percent
during the consultation period of the Quantitative Impact Study 5. 23 Employing internal models,
which have to be signed off by the supervisor, can lead to lower charges than the standard
Solvency II formula. In addition, diversification effects and risk mitigation through
sharing of potential losses with policyholders will further reduce the effective risk charge.
Similar to Solvency II, capital charges are also differentiated according to the approach
chosen in the CAD III regulation. For the most advanced approach (PD/LGD approach 24 )
the capital charges range from 12.6 percent to 17.4 percent. In chapter 20 of this book,
Thomas Meyer discusses and comments in some length on CAD III. Accordingly, we will
simply summarise the differences between Solvency II and CAD III in Table 10.3.
Comparing Solvency II to CAD III regulation for private and listed equity, it becomes clear
that equity investments are treated quite differently in the two regulatory approaches.
This is true for both the relationship between private equity and listed equity and also at
the absolute level.
Apparently, banking and insurance industry regulators have quite diverging opinions on
the riskiness of private equity investments 25 . This fact does not only stem from the spe-
20
See European Parliament, Council (2009). Currently the Solvency II regulations are in discussion; for the
time being Solvency I is the effective regulation.
21
See European Parliament, Council (2006). The according international standard is codified in Basel II
(Basel II (2006)).
22
See CEIOPS (2010a).
23
European Commission (2010).
24
PD/LGD stands for ‘probability of default / loss-given default’.
25
There are even differences regarding capital charges within the banking specific regulations CAD III and
Basel II.
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Part I: Risk aspects of limited partners
Table 10.3: Regulatory capital requirements: Solvency II vs. CAD III.
The Solvency II charge is before diversification as proposed by the
standard formula
Private equity
Listed equity
Solvency II
CAD III
(floors)
49% 39%
Internal ratings-based – Simple 15.2%–29.6% 23.2%
Internal ratings-based – PD/LGD 12.6%–17.4% 6.1%
Note: This standard value is subject to an additional correction factor representing the difference between the current value of the equity
index and an average of historical values, which dampens the effect of short-term fluctuations. The CAD III-values for the PD/LGD
approach are based on the risk-weight formula and the defined equity floor values for PD, LGD and maturity in the CAD-directive.
Additionally, a correlation adjustment factor for small caps is considered (European Parliament, Council (2006), pages 96f and 105f).
Generally, the ranges depend on the degree of diversification and the granularity of the private equity portfolio or the regularity of the
annual cash flows.
cial characteristics of private equity being a distinctive hybrid asset with both market- and
credit-risk features, but also from the varied success of private equity industry lobby
groups for lower risk-capital charges 26 .
Ratings agencies have also included private equity in their frameworks and developed
specific risk-capital charges. Standard & Poor’s, for example, sets the European Capital
Adequacy Factors for private equity at 75 percent and for European equity at 32 percent,
both for a single-A target rating 27 . Clearly, Standard & Poor’s views private equity as much
riskier than listed equity.
As an example of how the internal economic risk-capital assignment on a standalone
basis can be deferred, we use the un-smoothed volatilities for EU and US LBOs from
Table 10.1. Taking a standard VaR approach under the assumption of normally distributed
returns, the risk-capital factor amounts to 55 percent for the 99.93 percent quantile over
a one-year horizon, which is commensurate with a single-A rating. Thus, the investor
should allocate a risk capital of 55 percent of the NAV for a well-diversified private equity
portfolio. This is similar or even higher than for listed equity indices and compares well
with the Solvency II requirements.
For a more refined internal risk-capital modelling, it is advisable to define additional private
equity sub-asset classes with comparatively low-risk profiles – like infrastructure investments
– for which risk-capital charges lower than the proposed regulatory capital charges
can be applied, based on a thorough analysis of the essential risk drivers of each investment.
Of course such a procedure has to be accompanied by clear investment guidelines,
strong corporate governance and a thorough risk-controlling and management process.
Recent evidence from the latest recession starting in 2008 shows relatively few default
events from private equity-backed companies 28 , indicating the ability of private equity
26
See chapter 20 for further comments and details.
27
See Standard & Poor’s (2008).
28
See Thomas (2010).
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Private equity in an insurance company’s strategic asset allocation
funds to mitigate credit risk through deal selection (preferring cash flow-strong companies),
operational improvements and good refinancing capabilities.
In the context of portfolio optimisation, a proposed new strategic asset allocation should
fulfil all relevant constraints and capital requirements under the market conditions and
the risk capital available at the time of the recommendation. Of course, it is possible to
make contingent proposals (eg suggesting a new asset allocation under the condition of
a severe equity markets drop). However, this relates more to a tactical view than a longterm
unconditional SAA.
Additionally, an insurance company may require various internal stress-tests, like interest
up-shifts or down-shifts and/or equity market drops. These stress-tests are applied on the
solvency and rating models. Ideally, a current and a proposed asset allocation should survive
these stress-tests. In this way, the insurance company can ensure that its rating is
not at risk either under the current or the proposed new asset allocation.
Summary and
concluding
remarks
The inclusion of private equity in an insurance company’s SAA is a multi-step process,
which demands separate approaches for the P&C and life business segments.
Particularly, the intricate asset-liability interaction of a with-profit life insurance contract
requires sophisticated ALM tools to determine an optimal asset allocation, while in the
P&C case, a Markowitz-inspired optimisation approach is sufficient for our purposes.
In view of the typically low total-equity allocation, we suggest a simplified SAA process
with only four strategic asset classes: government bonds, corporate bonds, equity, and
real estate. At the first stage, we determine an optimal asset allocation taking the room
for manoeuvre – determined by regulatory, rating and risk-capital constraints – into
account. Liquidity and operating profit requirements also have to be considered. In the
second step, we assign a part of the overall equity quota to private equity.
Investors must have a good understanding of the characteristics of private equity. For
example, cash calls and distributions are at the discretion of the private equity fund manager.
This fact impedes the ability to manage the investment results by deliberately realising
UCGL. Private equity investments may not be suitable for hedging very long-dated
liabilities, since the average duration is less than five years.
The stale-pricing phenomenon leads to underestimated volatilities and correlations, when
directly calculated from typical industry-standard return time series. Adjusted volatilities
increase by a factor of around two, thus reducing the diversification potential in portfolio
optimisations. On the other hand, an insurance company profits from reduced balancesheet
volatility due to stale pricing.
Private equity returns need to be adjusted for leverage and illiquidity, which both require
a risk adjustment (negative alpha) of around 3 percent annually. Interestingly, private equity
fund managers show a remarkably high performance persistence, which can be
employed in a fund selection scheme.
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Part I: Risk aspects of limited partners
Various external constraints and regulations influence the investment decisions of
insurance companies and define the available room for manoeuvre. In this context, the
new proposed Solvency II requirements for insurance companies and the European
CAD III directive banking regulation show remarkable discrepancies. Solvency II is
more restrictive and judges private equity as riskier than listed private investments.
This is in clear contrast to CAD III, but follows the assessment of the ratings agency
Standard & Poor’s.
Private equity investing is a long-term engagement, which promises strong returns with
a favourable risk-return relationship. However, good preparation is essential and key to a
successful investment programme. To this end, the industry should improve the availability
of performance data and further strive to standardise their interpretation. On the regulatory
side, there is obviously some need for better alignment and more refinement of
the current approaches.
■
Summary findings:
➲ Private equity in an insurance company’s strategic asset allocation is a
multi-step process which demands separate approaches for property &
casualty and life business segments
➲ A private equity programme should follow a multi-year plan considering
that it takes around ten years to establish such a steady programme
➲ Private equity investments may not be suitable for hedging very long-dated
liabilities since the average cash-flow duration is less than five years
➲ Solvency II regulation for insurance companies introduces restrictions on
private equity which can be mitigated by several approaches
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Paul Achleitner was born in 1956 in Linz, Austria and was educated at the University of St. Gallen
in Switzerland and the Harvard Business School. In 1984, he started his professional career at the
management consultancy Bain & Co. in Boston, moving to Goldman Sachs & Co. in the field of
investment banking by 1988. After various positions in New York and London he was Goldman
Sachs resident partner in Frankfurt from 1994–1999. In 2000, he joined the management board of
Allianz SE, the international financial Group where he is responsible for Group Finance. Paul
Achleitner serves on various boards (such as Bayer, Daimler and RWE) as well as several government
commissions of the Federal Republic of Germany (such as the Takeover Board and Chair of
the Capital Markets Commission). He is a professor for finance at the WHU Koblenz where he also
serves on the board of trustees.
Stefan Albrecht was born in 1968 in Deggendorf, Germany and works in the Global ALM/SAA team
of Allianz Investment Management SE. Previously, he was responsible at Allianz Private Equity
Partners GmbH for risk-modeling, portfolio construction and optimisation, cash-flow forecasting
and performance analysis. Prior to joining APEP, he worked at Allianz PIMCO Asset Management
GmbH as portfolio manager fixed income and financial engineer and at AFIN GmbH, a specialised
financial solutions subsidiary of Allianz. He holds an MSc from the Georgia Institute ofTechnology
and a diploma in physics from the Technical University of Munich. He received his doctorate from
the École Polytechnique in France and is also a CFA charterholder.
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