Concordia University Nebraska

April 26, 2010

Alternative Investments

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Alternative Investments

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Many Types• Long/Short• Merger Arbitrage• Venture Capital• Leverage Buyout• Timber• Real Estate• Other

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Low Correlation (sometimes)•

Hard to Model

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Proper Use in a Diversified Portfolio

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Role within a portfolio–

Alpha

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Diversification–

Esoteric risk premiums (or betas)

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Alternative Manager Selection Thesis and Process

• “Default” opinion: the manager does not add value• They must convince us otherwise

• Team Driven Methodology• Historical performance numbers tell you little (by themselves)• Emphasis is on qualitative issues (People, Process, Philosophy)• Quantitative analysis should confirm qualitative factors/ considerations• Building a relationship with managers overtime is essential to success• Majority of hedge fund failures and/or blow-ups result from organizational or

infrastructure problems• Not the highly publicized investment problems

• Task force approach: done in conjunction with the investor's legal, tax, accounting and financial advisers.

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Hedge Fund Strategies • Basic thesis: In the hedge fund world, there are bold pilots and old pilots, but there are very

few bold and old pilots• Hedge funds: Actively managed private investment vehicles geared to institutional and high-

net-worth investors that implement non-traditional strategies and techniques• “Hedge Fund” is not a legal term, but only an industry phrase describing a structure• Esoteric/ Variable Beta’s• Exempt from traditional rules and regulations• High dispersion of returns• Opaque industry• Attempt to make money in a variety of market types

• Funds of Hedge Funds: are investment vehicles that allocate investor capital among several underlying Hedge Funds

• Opportunities for increased diversification (managers, strategies, horizons, and regions)• Full-time resources dedicated to diligence and portfolio management.• Access to highly desirable and often closed funds• Fund analysis, selection, and monitoring expertise• Double layer of fees

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Hedge Fund Implementation

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Inappropriate–

Tactical

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Everybody else is doing it–

Hedge fund panacea - High returns with low risk

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Replacement for traditional asset classes (stocks and bonds)

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Appropriate–

Strategic

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Reduce portfolio risk at same expected return–

Increase expected return at same expected risk

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Complement traditional asset classes (stocks and bonds)

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Hedge Fund Considerations

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Potential Advantages:–

Skilled managers

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Absolute return/Capital preservation focus–

Access to alternative beta’s

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Utilization of expanded toolset–

Low historical correlation

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Expands Efficient Frontier–

Alignment of incentives

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Hedge Fund Considerations

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Potential Disadvantages:–

Leverage

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Lack of liquidity–

Lack of transparency

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Imperfect information–

Commingling of assets/ Co-investor risk

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High fees–

Capacity constraints

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Fraud

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Special Situations

More company specific rather than market related

Merger Arbitrage

Opportunities more plentiful and attractive in stable to rising equity markets where business activity is more predictable

Distressed Securities

Tend to proliferate during periods of protracted economic weakness

Eco

nom

ic A

ctiv

ity

GDP Growth Chart

Long/Short EquityLong/Short Equity favored in early stages of an improving market cycle

MacroCurrency, Debt, Equity

Capital Structure Arbitrage

Relative mispricing can occur throughout the business cycle

Fundamentally

Undervalued Securities

Opportunities available due to market inefficiencies

Relative ValueConvertible Arb, Statistical Arb,Fixed Income Arb and Market Neutral opportunities can exist throughout economic cycle.

Opportunities through Business Cycles

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No Single Strategy Optimizes Returns

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How to position Hedge Funds

• Inappropriate positioning:• Tactical • Everybody else is doing it• Hedge fund panacea: High returns with low risk!• Replacement for traditional asset classes (Stocks and Bonds)• Absolute Return

• Appropriate positioning:• Strategic • Reduce overall portfolio volatility at same expected return• Increase expected return at same expected volatility• Compliment traditional asset classes (Stocks & Bonds)• Capital Preservation

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Private Equity Characteristics

• Median private equity returns tend to underperform broad public equity market

• Much wider dispersion between top quartile & bottom quartile returns than in public equities.• Manager selection is crucial

• Access to good managers is critical (and difficult to achieve)• Firms whose prior funds have been in the top quartile bear a 72%

probability that their successor fund will be a first or second quartile fund

• Diversification is key:• Vintage year, Strategy, Sub-strategy, and manager

• Long term commitment (10+ years)

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Venture capital–

Seed or start-up investment–

Companies that may not yet be generating revenue or profits

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Growth capital–

Maturing companies–

Funding for growth and expansion•

Leveraged buyouts–

Investments to acquire a controlling interest in mature companies

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Debt finance•

Mezzanine–

Loan finance with an equity kicker–

Unsecured or with junior access to security•

Special situations–

Nontraditional strategies that do not fit established categories or subsectors

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Distressed

Sample Private Equity Portfolio

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Private Equity Investment Lifecycle

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Private Real Estate Characteristics

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Represents a large portion of the investable universe•

Improves portfolio efficiency/ risk-adjusted performance

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Portfolio diversification/ Low correlation to stocks and bonds•

Historically strong and stable returns

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High historical relative income plus appreciation potential•

Historically lower volatile than most asset classes

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Significant market inefficiency (pricing and information)•

Inflation hedging potential

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Global opportunities but Need local market knowledge

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Wide variety of offerings–

Buy property directly or invest indirectly

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REITS: Public and Private–

Open/Closed end commingled funds

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Separate Managed Accounts–

Hybrid/ Multi-strategy–

Fund of funds•

Not just a decision to allocate to RE

Gaining Real Estate Exposure

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18Multi-Strategy: Combinations across the entire spectrum

Private Real Estate Strategies

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Private Real Estate Strategies•

Core–

Stable / predictable income–

“Trophy” markets and sub- markets

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Passive mgmt / beta–

Efficient market, capital flooded–

REIT substitute?

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Core Plus–

Income with small price appreciation potential

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Smaller-scale “Trophy” markets and sub-markets

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Slight oversight / enhance•

Some correction need•

Still stable tenants

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Value-Added–

Income / Appreciation–

Lower quality assets / areas–

Acquisition / management expertise required

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Forward purchase - new•

Joint venture–

Lease-up / turnover–

Minor upgrades / rehab–

Shorter time horizon

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Opportunistic–

Return source: price–

Distressed assets–

Skillful active management•

Turnarounds / development•

High leasing uncertainty–

More exotic / inefficient market–

Underlying entity risk–

Shortest holding period

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Public vs. Private Real EstateCategory REITs Private Real Estate

Market Size (US and 

Global RE)

Small Large

Liquidity High Low

Valuation Daily Primarily when sold with 

periodic appraisals

Business Model Income‐Oriented/ Cash 

flow maximization

Income and asset 

appreciation

Access to Capital Public debt, equity 

markets, and bank loans

Bank financing and private 

arrangements

Transparency Price = High, Holdings = 

Low

Low

Complexity Medium High

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• Returns are driven primarily by biological tree growth and secondarily by land and timber price appreciation

• Consists of softwoods (trees with needles such as pine and spruce) or hardwoods (trees with leaves such as oak and maple)

• Natural forests or plantations

• Return and volatility vary substantially by country, region, and species

• Inefficient marketplace

• Relatively new investment class for institutional investors

Timberland Characteristics

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Timberland Characteristics

• Modestly affected by market forces (sun shines & rain falls regardless of capital market performance)

• Strategic diversifier

• Inflation hedge

• Volatility close to long-term corporate bonds

• Expected long-term risk-premium on par with stocks

• Primary Risks: Illiquidity risk (10 year commitment), Market risk (overbidding), and environmental risk (wildfire and disease)

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Alternative Investment Terms and Structure

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Fees: complex and varied–

Management fee, carried interest, preferred return, catch-up, etc.–

Ex.•

Annual cumulative compounded Preferred Return of 9% to LP investors after 100% Return of Capital

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Carried Interest of 95% to investors after a 50% GP/ 50% LP investor catch-up

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Management Fee of 1% on committed capital through the Investment Period and on invested capital contributions, thereafter

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Investment life: varied, up to 15+–

Potential J-curve•

Minimums: $500,000 to $10 million+

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Limited transparency•

Lagged, complicated reporting

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Tax complexity based on structure

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Asset Allocation with Alternative Investments

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Asset Allocation (Beta Mixing)

• Correlation & asset class risk premiums

• Efficiently mixing betas should not lose priority

• Beta may be a commodity, but has value!

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Asset Allocation (Beta Mixing)

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Esoteric betas versus expensive alpha–

Foreign Bonds (developed & emerging)–

High Yield Bonds–

TIPS–

Commodity Futures Indices–

Timberland–

Real Estate–

Energy Infrastructure MLPs–

Etc.

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Asset Allocation (Beta Mixing)

Efficient Frontier (with esoteric betas &

hedge funds)

Risk (σ)

Retu

rn

Efficient Frontier (with esoteric betas)

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Asset Allocation (Beta Mixing)

Version: 08.1

Fixed Equity Alter- native Cash TIPS US Bonds Int'l

BondHY

BondLarge

Cap USSmall

Cap US REITs Int'l Equity

Em. Mkts. Equity

Commod- ity Futures

Hedge Fund MLPs Expected 10-

Year Return

Expected Annual Risk

(σ)

Annual Normal VaR

(99%)1

Annual Non- Normal VaR

(99%)2

Annual Return (88-

07)

Annual Risk (σ) (88-07)

Best 12-months

Worst 12-months

Worst Month

Worst draw- down

S&P 500 0% 100% 0% 0% 0% 0% 0% 0% 100% 0% 0% 0% 0% 0% 0% 0% 0% 8.0% 14.7% -26% -32% 11.8% 13.5% 52% -27% -14% -45%Portfolio 1 56% 24% 20% 0% 8% 37% 7% 3% 7% 2% 6% 6% 3% 5% 10% 5% 0% 6.8% 6.2% -8% -12% 10.1% 4.7% 21% -3% -5% -6%Portfolio 2 31% 44% 25% 0% 10% 10% 6% 5% 14% 5% 8% 11% 5% 10% 10% 5% 0% 7.6% 8.3% -12% -15% 11.3% 6.8% 33% -5% -9% -11%Portfolio 3 19% 54% 27% 0% 6% 3% 6% 5% 18% 6% 9% 13% 7% 12% 10% 5% 0% 8.1% 9.5% -14% -18% 11.9% 7.9% 39% -9% -10% -14%Portfolio 4 11% 63% 26% 0% 3% 1% 4% 4% 21% 7% 10% 15% 11% 11% 10% 5% 0% 8.4% 10.8% -17% -22% 12.3% 9.1% 43% -12% -12% -17%

Portfolio of Emphasis 11% 63% 26% 0% 3% 1% 4% 4% 21% 7% 10% 15% 11% 11% 10% 5% 0% 8.4% 10.8%

1 VaR stands for "Value at Risk". VaR (99%) defines a one in a hundred worst case annual return assuming normally distributed returns . Greater losses are possible (1% likelihood).2 VaR stands for "Value at Risk". VaR (99%) defines a one in a hundred worst case annual return assuming historical asset class skewness & kurtosis (1997-2007) . Greater losses are possible (1% likelihood).Past performance is no guarantee of future returns.

Frontier Engineer™ AnalysisEfficiently Mixed Betas Plus 10% Hedge Funds

Broad Allocation Asset Class Allocation Historical Return & Risk Metrics (1988-2007)Expected Return & Risk Characteristics

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Private Equity

Small CapMid CapLarge Cap

Int'l EquityEmerging Markets

Commodity Futures

REIT

MLPs

Fund of Hedge Funds

HY Bonds

Int'l Bonds

US Bonds

TIPS

Cash2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% 22.5% 25.0% 27.5% 30.0%Expected Risk (Standard Deviation)

Exp

ecte

d R

etu

rn

S&P 500

Asset Classes Return-Risk (Geometric)

Asset Class Return - Risk (Arithmetic)

Efficiently Mixed Betas Plus 10% Hedge Funds

Efficiently Mixed Betas (No Hedge Funds)

US Equity, US Bonds & Foreign Developed Only

US Equity & US Bonds Only

Illustrative purposes only

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Asset Allocation (Beta Mixing)

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Efficiently mixing betas and alpha–

Increased Sharpe Ratio

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Betas cheaper than alphas

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Key Risks•

General/Loss of capital. An investment in alternative investment funds involves a high degree of risk. There can be no assurance that the alternative investment fund’s return objectives will be realized and investors in the alternative investment fund could lose up to the full amount of their invested capital. The alternative investment fund’s fees and expenses may offset the alternative investment fund’s trading profits.

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Lack of information. The industry is largely unregistered and loosely regulated with little or no public market coverage. Investors are reliant on the manager for the availability, quality and quantity of information. Information regarding investment strategies and performance may not be readily available to investors.

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Limited liquidity. Interests are not publicly listed or traded on an exchange or automated quotation system. There is not a secondary market for interests, and as a result, invested capital is less accessible than that of traditional asset classes. Also, withdrawals and transfers are generally restricted

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Dependence on Trading Manager. Performance is more dependent on manager-specific skills, rather than broad exposure to a particular market

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Event risk. Given their niche specialization, market dislocations can affect some strategies more adversely than others•

Speculation. Alternative investments often employ leverage, sometimes at significant levels, to enhance potential returns. Investment techniques may include the use of derivative instruments such as futures, options and short sales, which amplify the possibilities for both profits and losses and may add volatility to the alternative investment fund’s performance

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Potential conflicts of interest. The payment of a performance based fee to the Trading Manager may create an incentive for the Trading Manager to cause the alternative investment fund to make riskier or more speculative investments than it would in the absence of such incentive.

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Valuation. Because of overall size or concentration in particular markets of positions held by the alternative investment fund or other reasons, the value at which its investments can be liquidated may differ, sometimes significantly, from the interim valuations arrived at by the alternative investment fund.

The information herein is confidential and may not be reproduced, quoted or distributed without the prior written consent of DiMeo Schneider & Associates, L.L.C. Past performance is not necessarily indicative of future results. This material is intended for informational purposes only, does not constitute investment advice, or a recommendation, or an offer and solicitation, and is not the basis for any contract to purchase or sell any security, or any other instrument as a consequence of any information contained herein. The information contained in this correspondence was taken from sources which we deem reliable. We do not represent that it is accurate nor complete and it should not be relied upon as such. Any opinions expressed herein reflect our judgment at this date and are subject to change.