finquiz - smart summar - finapp · copyright © finquiz.com. all rights reserved. 2013, study...

Copyright © FinQuiz.com. All rights reserved.

2013, Study Session # 18, Reading # 66

“ALTERNATIVE INVESTMENTS”

1. INTRODUCTION

� AIs are perceived to behave differently (provide diversification) from traditional

investments.

� Absolute return objective ⇒to provide +ve return throughout the economic

cycle.

� Relative return objective ⇒ return relative to an equity or F.I benchmark.

F.I = Fixed Income

PE = Private Equity

RE = Real Estate

VC = Venture Capital

LBO = Leverage Buyout

ABS = Asset Backed Securities

AIs = Alternative Investments

MBS = Mortgage Backed Securities

2. ALTERNATIVE INVESTMENTS

� AIs are alternatives to long-only positions in stocks, bonds & cash.

� AIs are almost always actively managed.

� Characteristics common to many AIs:

� Illiquid underlying investments.

� Narrow manager specialization.

� � Correlation with traditional investments.

� Less transparency & low level of regulation.

� Limited historical data.

� Unique tax & legal considerations.

� High net worth individuals & institutions are the typical investors in AI.

� HF indices may be inherently biased upwards due to survivorship & backfill biases.

� Different weightings & constituents in index construction can significantly affect the indices & their

results & comparability.

2.1 Categories of Alternative Investments

Hedge Funds Private Equity Funds

� Manage portfolio of securities &

derivative positions using variety of

strategies.

� Often highly leveraged & employ

long & short positions.

� Generally invest in private

companies or public companies with

the intent to take them private.

� Majority of PE activity involves LBOs

& VC investments.

Real Estate Commodities

� Direct or indirect investment in

buildings & / or land.

� Securitization structures broadened

the definition of RE investing.

� Physical commodity investments or

investments in businesses engaged

in the production of physical

commodities.

� Main vehicles ⇒ commodity futures

contracts & funds benchmarked to

commodity indices.

Others

These investments may include tangible assets (e.g.

wine, art, stamps etc) & intangible assets (e.g. patents).

1



2.2 Return: General Strategies

Ways to Achieve Returns

Passive Return Active Return

� Assume that markets are efficient &

focus on β drivers of return.

� Expected alpha return is zero for

passive managers.

� Efficiently take on market risk.

� Assumption ⇒ inefficiencies exist &

alpha return after adjusting for β

risk is possible.

� Alpha returns are results of

managers’ special skills in capturing

non-systematic opportunities in the

market.

Absolute Return Market segmentation

� Return independent of market

returns.

� No market index to beat.

� Formal performance objective ⇒

cash rate, real return target or

absolute nominal return.

� Capital can’t migrate effortlessly from

lower expected return areas to higher

ones.

� Segmentation brought on by investment

constraints that provide an opportunity

for more flexible managers to move into

higher returning segments quickly.

Alpha Seeking Strategies

Concentrated Portfolios

� Concentrating assets among fewer securities, strategies

& / or managers (less diversification).

� Higher return if these concentrated positions

outperform the market (�alpha potential).

Risks of AIs

� Risks can be considered both on stand-alone basis & within the context of

portfolio.

� Risks ⇒ low liquidity, transparency & limited redemption availability.

� ��⇒�ℎ�� = ��

��

� Sharpe ratio & downside risk measures ignore low correlation of AIs with

traditional investments.

2.3 Portfolio Context: Integration of Alternative Investments

with Traditional Investments

� Key motivation for investing in AIs ⇒ diversification

potential.

� AIs also improves portfolio’s risk-return profile.

2



2.4 Investment Structures

� Most common structure ⇒ partnership.

� Fund is the general partner (GP) ⇒ investors are limited partners (LPs).

� Less regulation.

� GP runs the business & bears unlimited liability.

� Management fees are based on assets under management.

� Incentive fees are based on realized profits.

� Fee is only earned after the fund achieves a specified return (hurdle rate).

� High water marks ⇒ highest cumulative return used to calculate an incentive fee.

3. HEDGE FUNDS

� Characteristics of HF:

� Aggressively managed & highly leveraged portfolio of investments across asset

classes.

� Fewer investment restrictions & goal of generating high returns.

� Usually set up as a private investment partnership.

� Often imposes restrictions on redemptions.

� Funds of funds ⇒ funds that hold a portfolio of HFs.

� Provide diversification.

� Available for smaller investors.

� Expertise in conducting due diligence on HFs.

3.1 Hedge Fund Strategies

3.1.1 Event-Driven Strategies

� Seek to profit from short-term events (e.g.

acquisitions or restructuring).

� Bottom-up strategy.

Merger Arbitrage Distressed/Restructuring

� Generally involve going long on stock of

Target Company & short on stock of

acquiring company when merger is

announced.

� Primary risk ⇒ acquisition does not

occur.

� Focus on the securities of companies

either in bankruptcy or near to

bankruptcy.

� Variety of ways to profit from distressed

securities.

Subdivisions

Activist Special Situations

� Purchase of sufficient equity in order to

influence a company’s policies or

direction.

� These funds operate in public equity

market.

� Opportunities in the equity of companies

that are currently engaged in

restructuring activities other than M&A

& bankruptcy.

3



3.1.2 Relative Value Strategies

� Seek profit from a pricing discrepancy b/w related securities.

� Expectations ⇒ pricing discrepancy will be resolved in time.

Fixed Income Convertible Arbitrage Fixed Income Asset Backed

� Zero β investment strategies that seek to

exploit a perceived mispricing b/w a

convertible bond & its component parts.

� Typically involves buying convertible

debt securities & selling the same

issuer’s common stock.

� Focus on relative value b/w a variety of

ABS & MBS.

� Seek to take advantage of mispricing

across different ABS.

Examples

Fixed Income General Volatility

� Focus on the relative value within the FI

markets.

� Currency dynamics & govt yield curve are

important considerations.

Use options to go long or short market

volatility either in a specific asset class or

across asset classes.

Multi-Strategy

� Relative value within & across asset classes.

� Looks for investment opportunities wherever

they might exist.

3.1.3 Macro Strategies

� Focus on top down approach to identify economic trends evolving across

the world.

� Trade in FI, equity, currency & commodity markets.

� Use long &/or short positions to potentially profit from a view on overall

market direction.

3.1.4 Equity Hedge Strategies

� They are focused on public equity markets & take long & short positions

in equity & equity derivative securities.

� Use a “bottom-up” as opposed to “top down” approach.

Market Neutral Fundamental Growth

� Use fundamental &/or quantitative

analysis to identify under/overvalued

securities.

� Portfolio should have a β of

approximately zero.

� Intent ⇒ profit from individual securities

movement while hedging against market

risk.

� Fundamental analysis to identify

companies expected to exhibit high

growth & capital appreciation.

� Long position in identified company

securities.

Examples

4



Fundamental Value Quantitative Directional

Fundamental analysis to identify

undervalued securities

� Technical analysis to identify companies

that are under/overvalued.

� Net long or short position depending

upon anticipated direction of market.

Examples

Short Bias Sector Specific

� Technical or fundamental analysis to

identify overvalued equity securities.

� Net short exposure is based upon

market expectations.

� Exploit expertise in a particular sector.

� Use technical & fundamental analysis to

identify opportunities in the sector.

3.2 Hedge Funds and Diversification Benefits

� HFs lack performance persistence.

� Traditional view of HF ⇒ arbitrage players ⇒ seek to earn return while

hedging against risk.

� HFs provides diversification benefit because of less than perfect

correlation with stock market.

3.3 Hedge Fund Fees and Other Considerations

� Common fee structure in HF market is “2&20” which reflects a 2%

management fee & 20% incentive fee.

� Incentive fee is calculated independent of management fees.

� Hurdle rate is frequently set based on a RF rate proxy plus a premium.

� Incentive fee can be based on returns in excess of the hurdle rate or on

the entire return (soft hurdle rate).

� High watermark provision may also included in fee structure.

3.3.1 Fees and Returns

� Leverage has the effect of magnifying gains or losses because the HF can

take a large position relative to the capital committed.

� HFs normally trade through prime brokers.

� The � the margin requirement, the � leverage is available to the HF.

� Redemptions can magnify losses for HF.

� When drawdown occurs, investors may decide to exit the fund or

redeem at least a portion of their shares.

� Redemption fees ⇒ discourage redemption & help to recover

transaction costs.

� Lock up period gives the HF manager time to implement & potentially

realize the expected result of a strategy.

� FOFs may offer more redemption flexibility than afforded by direct

investment in HFs.

3.3.2 Other Considerations

5



� Valuations are important for calculating performance & meeting

redemptions.

� When market prices or quotes are used for valuation, funds may differ in

which price or quote they use:

� Common practice ⇒ use avg. quote.

� Conservative practice ⇒ use bid prices for longs & ask prices for

shorts.

� Any model should be independently tested, benchmarked & calibrated

to industry-accepted standards to ensure a consistency of approach.

� Liquidity discounts are necessary to reflect fair value.

� Trading NAV ⇒ incorporates liquidity discounts ⇒ based on the size of

the position held.

� Reporting NAV ⇒ based on quoted market price.

3.4 Hedge Fund Valuation Issues

� FOFs have an additional layer of fees.

� Key due diligence factors include:

� Investment strategy.

� Investment process.

� Competitive advantage.

� Track record.

� Size & longevity.

� Management style.

� Key person risk.

� Reputation & plans for growth.

� Systems risk management & investor relations.

3.5 Due Diligence for Investing In Hedge Funds

� There are different stages & types of PE investing.

� The focus of PE firms may ∆ as business conditions & the availability of

financing change.

4. PRIVATE EQUITY

Leveraged Buyouts Venture Capital

� LBO funds that acquire public

companies or established private

companies mainly through debt.

� Assets of the target company serve as

the collateral for the debt.

� After the buyout, the target becomes or

remains a privately owned company.

� Invest or provide financing to private

companies with high growth potential.

� VC can be provided at a variety of stages.

Categories of PE

Development Capital Distressed Investing

Minority equity investments in more

mature companies that are looking for

capital to expand or restructure operations

� Buying the debt of mature companies in

financial difficulties.

� Turnaround investors ⇒ buy the

company’s debt & plan to be more active

in the management & direction of the

company.

6



� PE funds are typically structured as partnerships similar to HFs (outside investors

are LPs & PE firm as GP).

� PE firms usually charge both a management fee & an incentive fee on a fund basis.

� Management fees generally range from 1 to 3% of committed capital.

� GP does not earn an incentive fee until the LPs have received their initial

investment back.

� Claw back provision ⇒ requires the GP to return any funds distributed as

incentive fees until the LPs have received back their initial investment & 80%

of the total profit.

4.1 Private Equity Structure and Fees

� Management Buyouts (MBO) ⇒ current management is involved in the acquisition.

� Management buy-ins (MBIs) ⇒ current management team is being replaced & the

acquiring team will be involved in managing the company.

� Potential returns in this category are to a large extent due to the use of leverage.

4.2.1 Leveraged Buyouts

4.2 Private Equity Strategies

� PE firms use debt to finance a significant proportion of each deal to � equity

returns & no. of transactions.

� Typical LBO capital structure ⇒ equity, bank debt & high yield bonds.

� Mezzanine financing (MF) ⇒ debt or preferred shares with a relationship to

common equity due to a feature such as attached warrants or conversion options.

� Being subordinate to senior & high yield debt MF pays a higher coupon rate.

4.2.1.1 LBO Financing

� Some characteristics of attractive target companies for LBOs include:

� Depressed stock price.

� Willing management.

� Inefficient companies.

� Strong & sustainable CF.

� Low leverage & significant amount of physical assets.

4.2.1.2 Characteristics of Attractive Target Companies for LBOs

� Portfolio Company ⇒ the company that is being invested in & will

become part of the portfolio of the VC fund.

� VC investors are actively involved in portfolio companies.

4.2.2 Venture Capital

Formative Financing Later-Stage Financing

� Company is in the process of being formed.

� Angel investing ⇒ capital provided at idea

stage.

� Seed-stage financing⇒ supports production

development & market research.

� Early stage financing ⇒ provide to companies

moving toward operation but before

commercial production & sales have occurred.

� This financing is provided after

commercial production & sales have

begun but before any IPO.

� Funds may be used for initial expansion

or major expansion.

VC Fund Financing

7



� Provided to prepare to go public.

� Represents the bridge b/w the

expanding company & the IPO.

VC Fund Financing

� Several other specialties for PE firms include:

� Minority equity investing.

� Distressed investing ⇒ purchasing the debt of a troubled company.

� Distressed debt investors are called vulture investors.

� Investing in companies in specific industries.

4.2.3 Other Private Equity Strategies

� Ultimate goal for PE ⇒ improve underperforming businesses & exit them at high

valuations.

� Exit strategies:

� Trade sale ⇒ sale of a company to strategic buyer such a competitor.

� IPO ⇒ selling of shares to public investors through an IPO (highest price).

� Recapitalization ⇒ not a true exit strategy.

� PE firm maintains control but allows the PE investor to extract money from

the company.

� Popular strategy when IR is�.

� Secondary sale ⇒ sale to another PE firm or group of investors.

� Liquidation ⇒ occurs when transaction has not gone well.

4.2.4 Exit Strategies

� Due to less than perfect correlation with traditional investments, PE

funds can add diversity to portfolio.

� By identifying skillful PE fund managers, investors may benefit from

superior returns.

4.3 Private Equity: Diversification Benefits, Performance, and Risk

4.4 Portfolio Company Valuation

Market or Comparables Approach Discounted Cash Flow Approach

� Use multiples of different measures.

� Large, mature private companies ⇒

EBITDA multiple.

� Values a company or its equity as the PV

of the relevant expected future CF.

� �� = ��

��

Approaches to PE Valuations

Asset-Based Approach

� Value of a company based on the values of its underlying assets

less the value of any related liabilities.

� Value of the company to the equity holders.

� Valuations can be arrived at using fair or liquidation values.

� Liquidation value ⇒ net amount that will be realized if

the business is terminated.

8



� IR, capital availability expectations & refinancing risk must be

considered & evaluated.

� PE investments are long-term illiquid investments.

4.5 Private Equity: Investment Considerations and Due Diligence

� Direct or indirect equity investing in RE property such as land & buildings.

� Debt investing in RE includes mortgage loans or MBS investing.

� Reasons for investing in RE:

� Competitive long-term total return potential.

� Multiple year leases with fixed rents lessen CF impact from economic shocks.

� Diversification benefits.

� Provide inflation hedge if rents can be adjusted quickly for inflation.

� Unique features of RE compared with other investment asset classes:

� Indivisibility.

� Unique characteristics.

� Fixed location.

5. REAL ESTATE

Debt Equity

Private � Mortgages � Direct ownership of real estate.

Ownership can be through sole

ownership, joint ventures, real estate

limited partnership, or other

commingled funds.

Public � Mortgage-backed securities (residential

and commercial)

� Collateralized mortgage obligations

� Shares in real estate corporations

� Shares of real estate investment trusts

5.1 Forms of Real Estate Investment

Reference: Level I Curriculum, Volume 6, Reading 66, Page 205

� Leveraged ownership ⇒ property title is obtained through an

equity purchase combined with mortgage financing.

� Mortgage loans represent passive investments where the

lender expects to receive a predefined stream of payments.

� Direct equity investment in a residence with the intent to occupy.

� If purchase is partially financed, any �(�) in the value of the home �(�) the owner’s equity

in the home.

� Securitization provides indirect, debt investment opportunities in residential property.

5.2 Real Estate Investment Categories

5.2.1 Residential Property

� Appropriate direct investment (equity & debt) for institutional funds or high-net-

worth individuals with long time horizons & limited liquidity needs.

� Direct investment requires active & experienced, professional management.

� Lender conducts financial analyses to establish the creditworthiness of the borrower

before providing the debt financing.

5.2.2 Commercial Real Estate

9



� Mortgage REITS ⇒ risk & return characteristics similar to fixed income investments.

� Equity REITS ⇒ invest primarily in commercial or residential properties & employ

leverage.

� Sources of return to equity REITS= rental income – debt servicing.

5.2.3 REIT Investing

� MBS structure ⇒ buying a pool of assets & assigning the income & principal returns

into individual security tranches for commercial MBS.

5.2.4 Mortgage-Backed Securities (MBS)

Combination of Funding

Debt

70%-75%

Property

Owners’ Equity

25%-30%

Pool of

Loans

Collection of Assets

Real

Estate

Asset

Pool of

Properties

Assorted Securities

Investment-Grade

CMBS 60%-70%

High-Yield

CMBS

5%-10%

BB Rated

B Rated

Unrated

Commercial Mortgage-

Backed Securities First

Loss

Last

Loss

Reference: Level I Curriculum, Volume 6, Reading 66, Page 208

� Timberland ⇒ offers an income stream based on the sale of timber products as a

component of total return (low correlation with other asset classes).

� Flexible investment ⇒ harvest more trees when timber prices are up & delaying

harvests when prices are down.

� Farmland ⇒ perceived to provide an inflation hedge.

� Returns ⇒ related to harvest quantities & agricultural commodity prices.

� Two main property types:

� Row crops⇒ planted & harvested annually.

� Permanent crops ⇒ grows on trees or vines.

� Little flexibility in harvesting as compared to timberland.

5.2.5 Timberland and Farmland

� RE index can generally be categorized as an appraisal index, transactions-based index

or a REIT index.

� Appraisal indices ⇒ use estimates of value as inputs to the indices.

� Rely on comparable sales & CF analysis techniques.

� These indices understate volatility because appraisals are done periodically.

� Transactions-based indices ⇒ use repeat sales of properties to construct the indices.

� Sample selection bias.

� Higher the no. of sales the more reliable & relevant is the index.

� REIT indices ⇒ use the prices of publicly traded shares of REITS to construct the

index.

� Index may not represent the properties of interest to the investor.

5.3 Real Estate Performance and Diversification Benefits

Property Owners’

Equity 25-30%

10



Comparable Sale Approach Income Approach

� Approximate value based on recent sales

of similar properties.

� Adjustments are made for differences in

key characteristics of property ⇒

condition, age, location & size.

� Direct capitalization approach

� Estimates the value of an income

producing property based upon the

level & quality of NOI.

� NOI ⇒ income to the property after

deducting operating exp (property tax,

insurance, maintenance utilities &

repairs) but before depreciation,

finance cost & income tax.

� ��ℎ�� = ��

��

� Cap rate ⇒ discount rate-growth rate

� Discounted CF approach ⇒ discounts

future projected CFs to arrive at a PV of

the property.

5.4 Real Estate Valuation

Cost Approach

� Evaluates the replacement cost of the

property by estimating the value of land

& the costs of rebuilding using current

construction costs & standards.

Income Based Valuation Asset Based Valuation

� Typically similar to direct cap approach.

� Funds from operation (FFO) & adjusted FFO

are used as measure of income.

� FFO = NI + Dep ± gains (loss) from sale of RE

property.

� AFFO adjusts the FFO for recurring capex.

� This approach calculates a REIT’s NAV.

� REIT’s NAV = Estimated MV of REIT’s total

assets – value of its total liabilities.

� REIT shares are often traded at value other

than NAV per share.

5.4.1 REIT Valuations

� RE investment may fail to perform in accordance with expectations.

� Other risks include:

� Change in govt regulation.

� Ability of fund management to select finance & manage real properties.

� Leverage magnifies the impact of gains & losses.

5.5 Real Estate Investment Risks

� Commodities ⇒ physical products.

� Return ⇒ based on ∆ in price rather than on an income stream.

� Most commodity investors trade in commodity derivatives to avoid storage &

transportation costs associated with holding the underlying commodity.

� Commodities include precious & industrial metals, energy products & agri products.

� Commodity derivatives may be attractive to investors because these investments

provide an inflation hedge & diversification benefits.

6. COMMODITIES

� Commodity derivatives include futures, forwards, options & swaps.

� Commodity indices typically use the price of futures contracts on the commodities

included in them rather than the prices of the commodities themselves.

� Commodity indices vary in the commodities included in them & the weighting

methods used.

6.1 Commodity Derivatives and Indices

11



� Alternative means of achieving commodity exposure include:

� ETF ⇒ suitable for investors who can only buy equity shares or seek the

simplicity of trading them.

� Common stock of companies exposed to a particular commodity.

� Managed futures funds.

� Individual managed accounts.

� Funds that specialize in specific commodity sectors.

6.2 Other Commodity Investment Vehicles

� Arguments for investing in commodities include:

� Potential for return ⇒ investors believe prices will � in the short or medium

term.

� Portfolio diversification ⇒ commodities behaved differently during the business

cycle from stocks & bonds.

� Inflation hedge ⇒ commodity prices affect inflation calculations.

6.3 Commodity Performance and Diversification Benefits

� Commodity spot prices are a function of:

� Supply & demand.

� Cost of production & storage.

� Value of users.

� Global economic conditions.

� The inability of suppliers to quickly respond to changes in demand levels may results

in supply levels that are too low in times of eco. growth & too high in times of eco.

slowing.

6.4 Commodity Prices and Investments

� The price of a commodity futures contract may be approximated by the following

formula

�� ≈ ��1 + �� + �� −convenience ��

where

r = period’s short term risk free rate.

Convenience yield ⇒ yield related to convenience of having physical possession of

the commodity.

� Contango (backwardation) ⇒ futures price > (<) spot price & commodity forward

curve is upward (downward) sloping.

� Source of return for commodity futures contract:

� Roll yield ⇒ Diff. b/w the spot price of a commodity & the price specified in the

future contract.

� Collateral yield ⇒ interest earned on the collateral posted as a good faith

deposit for the futures contract.

� Spot prices ⇒ primary determinant is relationship between current supply &

demand.

6.4.1 Pricing of Commodity Future Contracts

� Collectibles:

� Tangible assets such as antiques & fine art, fine wine, rare stamps & coins,

jewelry & watches etc.

� Provide no current income but potential for higher capital gains.

� Highly illiquid.

� No. of indices that provide information about returns to these investments.

7. OTHER ALTERNATIVE INVESTMENTS

12



� The manger of an investment portfolio makes investment decisions consistent with

the portfolio’s established investment policies, taking risk into account.

� Investor due diligence should be used to ensure portfolio risk is effectively managed

by the portfolio manager.

8. RISK MANAGEMENT OVERVIEW

8.1 Investment and Risk Management Process

� Risks vary across alternative investments.

� PE & HF may have long lockup periods.

� Poor manager selection can create a lingering drag on the portfolio.

8.1.1 Risk Management Issues

� Investors should recognize that past performance is not necessarily

representative of future performance.

� In case of illiquid investments, portfolio should be diversified

sufficiently to reduce the possibility of 100% loss.

8.1.2 Risk Issues for Implementation

� Sharpe ratio may not be the appropriate risk – return measure for

alternative investments because measure of return & SD may not be

relevant & reliable.

� Returns are overstated & volatility is understated in alternative

investments.

� Alternative investment returns tend to be leptokurtic &

negatively skewed.

� Downside risk measure (e.g. ��) focus on the left side of the return

distribution curve & Sortino ratio uses downside deviation as

opposed to standard deviation as a measure of risk.

8.2 Risk – Return Measures

A Typical Due Diligence Process

Organization: � Experience and quality of management team, compensation, and staffing

� Analysis of prior and current funds

� Track record/alignment of interests

� Reputation and quality of third-party service providers, e.g., lawyers, auditors, prime brokers

Portfolio Management: � Investment process

� Target markets/asset types/strategies

� Sourcing of investments

� Role of operating partners

� Underwriting

� Environmental and engineering review process

� Integration of asset management /acquisitions/ dispositions

� Disposition process, including how initiated and executed

Operations and

Controls:

� Reporting and accounting methodology

� Audited financial statements and other internal controls

� valuationfrequency and approach(es)

� insurance and contingency plans

Risk Management: � Fund policies and limits

� Risk management policy

� Portfolio risk and key risk factors

� Leverage and currencyrisks/constraints/hedging

8.3 Due Diligence Overview

13



A Typical Due Diligence Process

Legal Review: � Fund structure

� Registrations

� Existing/prior litigation

Funds Terms: � Fees (management and performance ) and expenses

� Contractual terms

� Investment period and fund term and extensions

� Carried interest

� Distributions

� Conflicts

� Limited partners’ rights

8.3 Due Diligence Overview

Reference: Level I Curriculum, Volume 6, Reading 66, Page 222-223

14

finquiz - smart summar - finapp · copyright © finquiz.com. all rights reserved. 2013, study...

Documents