AssetMetrix’ Liquidity Stress Testing

How bulletproof is your private equity fund?

As evidenced by recent EU regulations, Liquidity Stress Testing (LST) is a vital topic for Alternative Investment Fund Managers (AIFMs) in sectors like private equity, private debt, real estate, infrastructure, and similar. Generally, a stress testing exercise assesses the impact of (various potential) adverse shocks on the future performance of a given financial asset. From the regulatory perspective, stress testing is viewed as an important risk management tool that supports the fund manager’s decision-making process and crisis management planning.

“AIFMs shall regularly conduct stress tests, under normal and exceptional liquidity conditions, which enable them to assess the liquidity risk of the AIFs and monitor the liquidity risk of the AIFs accordingly.” (AIFMD, Article 16(1) )

„A manager should have a strong understanding of the liquidity risks arising from the assets and liabilities of the fund’s balance sheet, and its overall liquidity profile, in order to employ LST that is appropriate for the fund it manages.” (ESMA guidelines on liquidity stress testing in UCITS and AIFs, Point 18 )

From our experience, many fund managers (and investors) are desperately looking forward to replacing their internal Excel-based stress testing prototypes by something more efficient. To keep the manual effort minimal, the PE industry craves for a powerful and highly automated LST solution that is aligned with current regulatory requirements. In this article, we describe the new AssetMetrix LST tool, which is designed to fill this gap. Our solution is based on our well-established and market-validated private capital fund forecasting engine, which has been in use by various clients for over five years now.

Liquidity Stress Testing Requirements and Features

The Alternative Investment Fund Managers Directive (AIFMD) obliges GPs to “regularly conduct stress tests, under normal and exceptional liquidity conditions.” Concretely, this EU regulation act refers to Article 16(1) of the AIFMD (2011/61/EU) and to Articles 47 and 48 of the supplementary Level II Regulation (No 231/2013). The “ESMA Guidelines – On liquidity stress testing in UCITS and AIFs” further specify the details of the required stress test exercises and apply from 30 September 2020.

In the spirit of these recent AIFMD and ESMA guidelines, AssetMetrix developed a highly sophisticated Liquidity Stress Testing module tailored for private capital funds (and fund-of-funds). In the following table, we compare the requirements defined by the “ESMA Guidelines” and the capabilities of our new LST module.

ESMA Guidelines Regulatory requirements Module capabilities
Point 27: Frequency Recommended frequency of LST: Quarterly, unless a higher or lower frequency is justified by the characteristics of the fund. Our model runs on a quarterly basis, or whenever a new NAV is available.
Point 31: Scenarios LST should employ hypothetical and historical scenarios […]. LST should not overly rely on historical data, particularly as future stresses may differ from previous ones. Our model helps you to calculate hypothetical and historical scenarios, but also user-defined input.
Point 41: Risk factors LST can also be used at fund launch to help identify factors material to the future risk management of the fund. For example: quantifying the sensitivity of the fund’s liquidity risk; identifying factors impacting liquidity risk; … Our model employs a dynamic macro-factor model for the fund performance and cash flows.
Point 60: Illiquidity Risks arising from less liquid assets and liabilities risks should be reflected in the LST. Our model is tailored for the illiquid nature of private capital funds, e.g. shocks materialize with larger time lags compared to the public market.
Point 66: Fund of Funds FoFs which gain indirect exposure to less liquid assets via their target funds should pay due regard to considerations relating to less liquid assets. Our model can be easily used to stress the underlying portfolio of a Fund of Fund (FoF).
Point 67: Asset and liabilities After separately stress testing the assets and the liabilities of the fund balance sheet, the manager should combine the results of the LST appropriately to determine the overall effect on fund liquidity. Our model can help you to separately stress fund contributions, distributions, net cash flow, and NAV.
Point 72: Portfolio aggregation A manager should aggregate LST across funds under its management where it assesses such an activity to be appropriate for those funds. Our model facilitates the calculation of results on a fund-by-fund basis but easily aggregates results to portfolio level (hereby considering diversification effects).

Table 1 – ESMA Guidelines

Due to these distinctive features, we strongly believe that our LST module is the most comprehensive fund-level Liquidity Stress Testing solution for AIFs in the market.

Liquidity Stress Testing Scenarios

As a starting point, we calculate the following five stress scenarios by default:

  • Historical: Dot-Com bubble (starting 2000)
  • Historical: Financial crisis (starting 2007)
  • Regulatory: Federal Reserve – Dodd-Frank Act stress test (2022)
  • Regulatory: European Banking Authority – EU-wide stress test (2021)
  • Regulatory: Bank of England – UK banking system stress test (2019)

Additionally, our tool can easily provide user-defined scenarios on demand.

The highly dynamic and complex nature of the stress scenarios that can serve as model input is exemplified by the Financial Crisis scenario depicted below in Figure 1. Here we see nontrivial paths for the variables (1) GDP, (2) stock market return, (3) dividend yield, (4) term spread, (5) corporate spread, and (6) inflation spread.

Figure 1: Dynamic stress scenario example

Liquidity Stress Testing Results

The AssetMetrix LST model estimates stressed versions of all private-capital-relevant metrics and KPIs like contributions, distributions, net cash flow, NAV, and the corresponding performance ratios. All results can be consumed and/or downloaded in a visual and/or table format. The stressed NAV projections in the chart and the short-term liquidty table below serve as possible example output.

Figure 2 shows that our LST model generates distinct but very plausible stressed NAV paths for our five default scenarios. For the Federal Reserve scenario (in light blue) we, for example, see a powerfull recovery in the years 2023-25 after a sharp initial slump in portfolio NAV.

Figure 2: Stressed Net Asset Value paths

Table 2 provides a very detailed view on the short-term liquidity of our example portfolio since it – in addition to the expected net cash flow – also provides the 10% and 90% percentiles. Depending on the specific liquidity planning needs, this table can be configured to also include mid-term and long-term liquidity results (split to contributions and distributions).

Table 2 – Detailed view on the short-term liquidity (example portfolio)

Need to find a solution for liquidity stress testing?

If you are in the private capital industry and under pressure to (quickly) provide meaningful LST results, our brand-new LST solution offers the

  • benefits of a cutting-edge, out-of-the-box Liquidity Stress Testing module,
  • possibility to create own user-defined stress scenarios,
  • convenience to consume LST results via a state-of-the-art web portal,
  • confidence to plan your liquidity even in difficult macroeconomic environments,
  • access to a comprehensive suite of supplementary analytical models (like forecasting, risk, benchmarking, program planning, and more),

Arrange a meeting with our team!

If you want to learn more, also read our two previous articles

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