finquiz - curriculum note, study session 18, reading 60_alternative investments

8/17/2019 FinQuiz - Curriculum Note, Study Session 18, Reading 60_Alternative Investments

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Reading 60 Introduction to Alternative Investments

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2. ALTERNATIVE INVESTMENTS

Alternative investments include:

1) Alternative assets (i.e. real estate and commodities).2) Alternative strategies (i.e. private equity funds, hedge

funds, and some exchange traded funds (ETFs). Thesefunds can

• Use derivatives and leverage;• Invest in illiquid assets;• Take short positions;

Such funds tend to have:

• High fees• Low diversification of managers and investments• High leverage• Restrictions on redemptions.

Characteristics of Alternative Investments:

1. Illiquidity of underlying investments2. Narrow manager specialization3. Low correlation with traditional investments4. Low level of regulation and less transparency5. Difficulty in determining current market values6. Limited and potentially problematic historical risk and

return data7. Longer time horizon8. Higher fees9. Unique legal and tax considerations10. Involves active management and extensive

investment analysis11. Trade in less efficient markets and tend to be less

efficiently priced than traditional marketablesecurities

12. Use high leverage compared to traditionalinvestments

Investors of Alternative Investments:

• Institutional investors including endowments, pensionfunds, foundations, sovereign wealth funds

• High net worth individuals

Arguments for investing in Alternative Investments:

a) Provide diversification benefits as they tend to have

low correlation with traditional assets.b) Enhance risk-return profiles as they tend to provide

positive absolute return.c) Provide hedge against inflation

Alternative investments generally have an absolute return objective i.e. provide positive returns throughoutthe economic cycle. However, alternative investmentsare not risk-free and may tend to have high correlationwith traditional investments (stocks and bonds)particularly during periods of financial crisis.

• The reported returns and S.D. of those returnsrepresent average amount and thus may notappropriately represent risk and return of sub-periodswithin the reported period or future periods.

• In addition, due to use of appraised values, the

volatility of returns and the correlations of returns withtraditional assets returns are underestimated.

Assets under management in alternative investmentshave increased over time; however, they still represent asmall % of total investable assets.

2.1 Categories of Alternative Investments

1)

Hedge funds: Hedge funds represent privateinvestment vehicles. They manage portfolios ofsecurities and derivative positions employing variousstrategies.

2)

Private Equity Funds: Private equity funds invest inequity investments that are not publicly traded onexchanges or in public companies with an objectiveto take them private

3) Real Estate: Real estate is a form of tangible andimmoveable asset. It includes buildings, building land,offices, industrial warehouses, natural resources,timber, containers, and artwork etc.

4) Commodities: Commodities investments refer toinvesting in physical commodity products i.e. grains,metals, and crude oil, through various ways e.g.

• Investing in cash instruments • Using derivative products (e.g. futures contracts) •

Investing in companies engaged in the productionof physical commodities

• Investing in commodity funds which are linked tocommodity indices

5) Other: Other alternative investments include tangibleassets (i.e. fine wine, art, antique furniture andautomobiles, stamps, coins, and other collectibles)and intangible assets i.e. patents.

2.2 Return: General Strategies

Total return = Alpha return + Beta return

Beta return: Beta represents the sensitivity of an asset tochanges in particular market index. It reflects thesystematic risk of an asset. Passive investors assume thatmarkets are efficient and seek to generate beta-drivenreturns.

• E.g. A portfolio that closely tracks the performanceof S&P 500 index will represent passive investmentand will have +1 correlation with the market(represented by S&P 500 index).


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NOTE:

Systemic risk is different from systematic risk. It is used inthe credit markets to indicate highly correlated defaultrisk.

• Alpha return: Active investors assume that marketsare inefficient and provide opportunities to earnpositive excess return after adjusting for beta risk.The positive excess beta risk adjusted return is

referred to as alpha return.o For passive investors, expected alpha return = 0.o Theoretically, alpha returns are uncorrelated with

beta returns.o Typically, alternative investments are actively

managed with an objective to earn positive alphareturn.

Basic Alpha-seeking strategies (these are not mutually

exclusive):

1)

Absolute return: Absolute return strategies seek togenerate returns that are unrelated to the market

returns. Benchmarks used by such strategies include:

• Cash rate (i.e. LIBOR)• Real return target (return in excess of inflation)• Absolute, nominal return target (i.e. 7%)

Theoretically, beta of funds that use absolute returnstrategies should be close to 0.

2) Market segmentation: Market segmentation refers toopportunity available to more flexible investors toquickly move capital from lower returns areas tohigher expected return areas when it is difficult to doso for restricted or conservative investors due to

following reasons i.e.

• Institutional, contractual, or regulatory restrictions ontraditional asset managers with regard toinvestments e.g. constraints regarding use ofderivatives, investing in low quality or foreignsecurities, managing portfolio relative to a particularmarket index etc.

• Different investment objectives or liabilities.

3) Concentrated portfolios: Concentrated portfoliostrategy refers to investing in assets among fewersecurities and/or managers to enhance returns (i.e.

higher alpha returns). However, as the name implies,this strategy results in lower diversification.

2.4 Investment Structures

Limited Partnership is the most common structure formany alternative investments (i.e. hedge funds andprivate equity funds). In partnerships,

•

Investors are referred to as limited partners (LPs). TheLPs have fractional investment in the partnership.

• The fund is referred to as general partner (GP). TheGP manages the business and has unlimited liability.Hence, to avoid unlimited liability, the GP is usuallyset as a limited liability corporation.

Features:

• Limited partnerships are not offered to generalpublic. They are only offered to accredited investorsand/or qualified purchasers i.e.o Accredited investors refer to individuals with at

least $1 million and institutions with at least $5million in investable assets.

o Qualified Purchasers refer to individuals with atleast $5 million and institutions with at least $25million in investable assets.

• Limited partnerships are not highly regulated.• Limited partnerships are located in tax-efficientlocations.

• Limited partnerships are generally offered to alimited number of LPs i.e. accredited investors mustbe ≤ 100 or qualified purchasers must be ≤ 500.

Fee structure of Limited Partnerships:

Management fee (or base fee) + Incentive fee (orperformance fee)

• Base fee is paid irrespective of performance of thefund and is based on assets under management.

•

Incentive fee is based on realized profits. Theincentive fee cannot be negative. So when a fundgenerates negative return, it implies a zero incentivefee.

3. HEDGE FUNDS

Typical characteristics of Hedge funds:

1) They aggressively manages portfolio of investments.2)

They can take long and short positions.3) They have the ability to use derivatives and leverage.4) They have the ability to use short selling.5)

They have absolute return objectives.

6) They are subject to fewer regulations and thus havethe flexibility to invest in any assets.

•

Side pocket: It refers to the flexibility provided tohedge funds that allows them to invest a specific %of the assets under management (generally < 20%)anywhere they feel.


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7) They impose restrictions on redemptions i.e.

• Lockup period: It refers to a minimum period beforewhich investors are not allowed to withdraw theirmoney or redeem their shares from the hedge fund.Lock-up periods facilitate the hedge fund managerto implement and potentially realize the expectedoutcomes of a strategy.

• Notice period: It refers to a number of days

(generally 30-90 days) before which investors arerequired to give notice of their willingness to redeem.Notice period facilitates the hedge fund manager toliquidate a position in an orderly fashion withoutmagnifying the losses.

8) Hedge funds tend to have low correlations withtraditional investments. However, the correlationbetween hedge fund and stock marketperformances may increase during periods offinancial crisis.

9) Hedge funds are often referred to as “arbitrage”players as they seek to earn returns while hedgingagainst risks.

Funds of funds (FOFs): FOF invests in a number ofunderlying hedge funds (typically 10-30 hedge funds).

Benefits of Funds of Funds:

a) Retailing: An FOF can facilitate smaller investors to getexposure to a large number of hedge funds atrelatively lower costs.

b)

Access: FOF provide individual investors an easyaccess to successful hedge funds that are closed toindividual investors because funds have reachedmaximum number of investors.

c) Diversification: FOF facilitate diversification across

various hedge fund managers, fund strategies,investment regions and management styles.d) Expertise: FOF provide investors the expertise of the

managers regarding selecting hedge funds andproviding professional management.

e) Due diligence process: The due diligence process ofinvesting in hedge funds is a highly specialized andtime consuming process. FOF facilitate investors toshorten the due diligence process to a singlemanager.

f) Better redemption terms: FOFs are able to negotiatebetter redemption terms (e.g. a shorter lock-up periodand/or notice period) relative to investors.

FOFs money is considered as “ fast” money by hedgefund managers because managers of FOFs have the 1st right to redeem their money when hedge funds start togenerate poor returns and have the ability to negotiatemore favorable redemption terms.

Drawbacks with an FOF:

a) Fee: FOFs involve two layers of fees i.e. one to thehedge fund manager and other to the manager ofFOF.

b) Performance: An FOF does not necessarily providebetter and/or persistent returns.

c) Diversification is a doubled-edged sword: Due to riskdiversification, both risk and expected return of FOFwill be lowered relative to hedge funds. However, thefees paid are considerably higher relative to hedgefunds.

NOTE:

Besides FOFs, there are some hedge funds that invest invarious hedge funds. Such funds are large, multi-strategy

hedge funds.

Hedge Fund Indices: The Hedge fund research indices(HRFI) include:

a) HFRI Fund weighted composite index: It is an equallyweighted performance index and is constructedusing self-reported data of over 2,000 individual fundsincluded in the hedge fund research (HFR) database.

• It suffers from self-reporting bias, survivorship bias andbackfilling bias.

• Due to such biases, hedge fund indices may notreflect actual average hedge fund performance but

rather reflect the performance of best performinghedge funds only.

b)

HFRI fund of funds index: It is an equally weightedperformance index of FOFs included in the HFRdatabase.

• It suffers from self-reporting bias.• It may exhibit lower reported returns due to twolayers of fees.

• Nonetheless, it reflects the actual performance ofportfolios of hedge funds.

Biases in Hedge Funds Performance Data: Due to biasesin hedge funds historical performance data, theperformance of the hedge fund index is biased upward (i.e. overestimated) and provides misleading results.

A.

Survivorship bias: Hedge fund indexes and databasesmay include only successful funds (i.e. funds that havesurvived) whereas funds with poor performance maydisappear and are removed from the database andthe past index values are adjusted accordingly. Thisresults in overestimated historical returns.

B. Backfilling bias: When a new hedge fund is includedin a database, its past performance is (included)back-filled in the index. Since high-performing fundsare more likely to be added to an index, it results inoverestimation of good results.

3.1 Hedge Fund Strategies (3.1.1 – 3.1.4)

Four broad categories of Hedge Fund Strategies:

1) Event-driven: These funds seek to generate positivereturn by exploiting opportunities created by corporateevents (i.e. merger, bankruptcies, liquidation, buy-back,etc.)


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• This strategy involves “bottom-up” analysis (i.e.company level analysis followed by industry analysisfollowed by global macro analysis).

• This strategy takes long and short positions incommon and preferred stocks, as well as debtsecurities and options.

Categories of Equity-driven funds include:

a) Distressed/Restructuring: These funds invest in thedebt or equity of companies experiencing financial oroperational difficulty. This strategy involves buyingfixed income securities trading at a significantdiscount to par due to distressed situations andsubsequently selling them at a higher price togenerate profit.

• Complicated form of such strategies may involvebuying senior debt and taking short position in juniordebt or buying preferred stock and shortingcommon stock to generate profits from widening ofspread between the securities.

• In addition, such strategies may take short position in

the companies, which are expected tounderperform in the short-term. However, if thecompany’s prospects improve, loss occurs.

b) Merger arbitrage: These funds seek to generatereturns from corporate merger and takeover activityand attempts to exploit the price spread betweencurrent market prices of corporate securities and theirvalue after successful completion of a takeover,merger, spin-off etc.

• Under these funds, the manager buys the stock of atarget company after a merger announcement andtakes a short position in the acquiring company’sstock with an anticipation of overpayment by anacquirer for acquiring the target company and thesubsequent increase in debt burden.

• It suffers from risk that the announced merger oracquisition does not occur and the hedge fund maynot close its position on a timely basis.

c) Activist: It refers to an “activist shareholder ”. It involvesbuying sufficient equity with an attempt to havecontrol on the company (have influence on acompany’s policies or direction e.g. divestitures,restructuring, capital distributions to shareholders,and/or changes in management and company

strategy). In contrast to private equity, activist hedgefunds operate in the public equity market.

d) Special situations: These strategies invest in the equityof companies that are currently engaged inrestructuring activities other than merger/acquisitionsand bankruptcy e.g. security issuance/repurchase,special capital distributions and asset sales/spin-offs.

2) Relative value: They seek to profit from mispricing inrelated securities. These strategies include:

a) Fixed income convertible arbitrage: This strategyinvolves exploiting mispricing in convertible securities

by buying convertible debt securities andsimultaneously selling the same issuer’s commonstock. These strategies are considered as marketneutral i.e. have zero beta.

b)

Fixed income asset backed: These strategies involveexploiting mispricing in the asset-backed securities(ABS) and mortgage-backed securities (MBS).

c)

Fixed income general: It involves identifyingovervalued and undervalued fixed-income securitieson the basis of expectations of changes in the term

structure of interest rates or credit quality of thevarious related issues or market sectors. Due tocombination of long and short positions, they aremarket neutral.

d) Volatility: These strategies involve taking long or shortpositions in the market volatility either in a specificasset class or across asset classes.

e) Multi-strategy: These strategies employ relative valuestrategies within and across various asset classes orinstruments.

3)

Macro: This strategy focuses on “top-down” analysis(i.e. global macro analysis followed by industry analysis

followed by company analysis). It seeks to exploitsystematic moves in major financial and non-financialmarkets through trading in interest rates, currencies,futures and option contracts, commodities or may takemajor positions in traditional equity and bond markets.

4)

Equity hedge: It involves identifying overvalued andundervalued publicly traded equity securities and takinglong and short positions in equity and equity derivativesecurities. However, portfolios are not structured asmarket neutral and may be concentrated i.e. may havea net long exposure to the equity market. Thesestrategies use “bottom-up” approach.

Categories of Equity Hedge:a)

Market neutral: It involves taking long position inperceived undervalued securities and short position inperceived overvalued equities and neutralizing theportfolio’s exposure to market risk (i.e. beta = 0) bycombination of long and short positions with roughlyequal $ exposure (i.e. dollar neutrality ) and equalsensitivity to the related market or sector factors (i.e.beta neutrality ).It employs quantitative (technical)and/or fundamental analysis.

b) Fundamental growth: These strategies take longpositions in companies that are expected to havehigh growth and capital appreciation. They usefundamental analysis to identify such companies.

c)

Fundamental value: These strategies seek to identifyundervalued companies by using fundamentalanalysis and take long positions in those companies.

d) Quantitative directional: These strategies usetechnical analysis to identify under and over valuedcompanies using fundamental analysis. It involvestaking long positions in undervalued securities andshort positions in overvalued securities. The hedgefund typically varies with regard to levels of net longor short exposure depending upon the anticipateddirection of the market and stage in the market cycle.


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e) Short bias: These strategies use quantitative(technical) and/or fundamental analysis to identifyovervalued equity securities and take short positions inthose overvalued securities. The net short exposure ofthe fund depends on market expectations i.e., duringdeclining markets, the fund may take full shortpositions.

f)

Sector specific: These strategies use quantitative(technical) and/or fundamental analysis to identifyoutperforming sectors.

3.3.1) Fees and Returns

The return to an investor in a fund is not the same as thereturn to the fund due to fees paid to the fund. Hedgefund indices generally report performance net of fees.

• A common fee structure in the hedge fund market is“2 and 20” which reflects a 2% management feeand a 20% incentive fee. However, different classesof investors may have different fee structures.

• A common fee structure in the FOFs is “1 and 10”which reflects a 1% management fee and a 10%incentive fee.

•

The incentive fees may be calculated net ofmanagement fees or before management fees (i.e.independent of management fees).

•

Hurdle rate provision: Under this provision, incentivefee is paid only when the fund generates a specifiedreturn, called hurdle rate. Hurdle rate can bespecified as an absolute, nominal, or real returntarget.

Types of Hurdle Rate:

a) Hard hurdle rate: When incentive fees can be paidonly on returns in excess of the hurdle rate, it isreferred to as hard hurdle rate.

b)

Soft hurdle rate: When incentive fees can be paid onentire returns, it is referred to as soft hurdle rate.

• High water mark provision (HWM): According to highwater mark provision, once the first incentive fee hasbeen paid, the highest month end net asset value(NAV), net of fees establishes a high water mark i.e.no incentive fee is paid until the fund’s NAV>HWM. Ithelps to protect clients from paying twice for thesame performance.

• Hedge fund fees depend on various factors i.e.supply and demand, historical performance and thelockup period i.e. the longer investors agree to keep

their money in the hedge fund, the lower the fees.

Example:

• Initial investment capital = $100 million• Management fee = 2% based on assets under

management at year-end.• Incentive fee = 20%• The return earned in the 1st year = 25%• Value of fund at the end of 2nd year = $115 million• Value of fund at the end of 3rd year = $130 million• Hurdle rate = 3%

A. Fee in the 1 st year: When incentive fee is independent

of management fee

Value of fund at the end of 1st year = $100 million (1.25)= $125 million

Management fee = $125 million (2%)= $2.5 million

Incentive fee = ($125 million– $100 million) (20%)= $5 million

Total fees = $2.5 million + $5

= $7.5 millionInvestor return = ($125 – $100 – $7.5) / $100

= 17.50%

B.

Fee in the 1 st year: When incentive fee is NOT

independent of management fee


Incentive fee = ($125 million– $100 million– $2.5 million)(20%)

= $4.5 millionTotal fees = $2.5 million + $4.5

= $7 million

Investor return = ($125– $100 – $7) / $100= 18%

C.

Fee in the 1 st year: When incentive fee is NOT

independent of management fee and hurdle rate is

3%

Hurdle rate = 3% ($100 million)= $3 million


Incentive fee = ($125– $100 –$3–$2.5 million) (20%)= $3.90 million

Total fees = $2.5 million + $3.9 million= $6.4 million

Investor return = ($125– $100 – $6.4) / $100= 18.60%

D. Fee in the 2nd year with High-water mark provision:


Incentive fee = 0 because the fund has declined invalue.

Total fees = $2.3 millionBeginning capital in the 2nd year for the investor =Value of fund at the end of 1st year – Total Fees in the 1st year (independent of management fee) = $125 – $7.5million = $117.5 million

Ending capital at the end of the 2nd

year = $115 – $2.3million

= $112.7 millionInvestor return = ($115 – $2.3 – $117.5) / $117.5

= –4.085%

E. Fee in the 3rd year with High-water mark provision:

Management fee = $130 million (2%) = $2.6 millionIncentive fee = ($130 million – $117.5 million) (20%)

= $2.5 million

• $117.5 million represents the high-water mark


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established at the end of Year 1.

Total fees = $2.6 million + $2.5 million= $5.1 million

Investor return = ($130 – $5.1– $112.7) / $112.7= 10.825%

• $112.7 million is the ending capital at the end of 2nd year.

•

The ending capital position at the end of Year 3 =$130 million – $5.1 = $124.9 million this is the newhigh-water mark.

Arithmetic mean annual return = (17.50% – 4.085% +10.825) / 3 = 8.08%

From part A, D and E.

Geometric mean annual return = (New HWM at the end

of 3rd year / Initial

investment) 1/3 – 1 = (124.9 / 100) 1/3 – 1

= 7.69%

Capital gain to the investor = (New HWM at the end of 3 rd

year – Initial investment)

= ($124.9 - $100) million= $24.9 million

Total fees = ($7.5 + $2.3 + $5.1) million= $14.9 million

From part A, D and E.

Example:

• Initial investment = $100 million• Hedge fund has “2 and 20” fee structure with nohurdle rate.

• Funds of funds has “1 and 10” fee structure.• Management fees are calculated on an annualbasis on assets under management at the beginningof the year.

• Management fees and incentive fees arecalculated independently.

•

Hedge fund has a 15% return for the year beforemanagement and incentive fees.

• FOF has a 10% return for the year after fees of hedgefunds.

Calculations:

Profit of hedge fund before fees = $100 million × (15%)= $15 million

Management fee = $100 million × 2%= $2 million

Incentive fee = $15 million × 20%= $3 million

Investor Return = (15 – 2 – 3) / 100= 10%

Profit of FOF = $100 million × (10%)= $10 million

Management fee of FOF = $100 million × 1%= $1 million

Incentive fee = $10 million ×10%= $1 million

Investor return = (10 – 1 – 1) / 100= 8%

3.3.2) Other Considerations

Most hedge funds (but not all) , use leverage in theirtrading strategies to seek higher returns. However,leverage magnifies both profit and losses. Thus, use ofhigh leverage is viewed as a source of risk for hedgefunds.

Hedge Funds can create leverage in many forms i.e. by

a) Borrowing capital.b) Buying securities on margin.c) Using financial instruments and derivatives.

For example, a hedge fund can realize profit fromexpected increase in the value of a company, (sayCompany A) in either of the following ways:

i. Hedge fund can buy 1000 shares of Company A.ii. Hedge fund can buy 10 futures contracts on

Company A.

• The profit or loss from holding the futures will besimilar to the profit or loss from holding the shares.

• However, futures contracts involve less capital toinvest than that of buying shares.

• In futures contracts, investors are subject to collateralrequirement to protect against default risk. Theamount of collateral depends on the riskiness of theinvestment and the creditworthiness of the hedgefund or other investor.

iii. Hedge fund can buy calls on a 1000 shares ofCompany A.

• It involves less capital to invest i.e. buyer is onlyrequired to pay option premium.

• Maximum loss to the long Call is option premiumpaid.

iv. Hedge fund can sell puts on a 1000 shares ofCompany A.

• Maximum profit to the Short Put is option premiumreceived.

• If price fall, potential loss is extremely large for the

Practice: Example 2,

Volume 6, Reading 60.




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Short Put.

Prime Brokers: Normally, hedge funds trade throughprime brokers. Besides trading on behalf of clients, primebrokers provide following services:

• Custody• Administration• Lending•

Short borrowing

Margin account: The margin account represents thehedge fund’s equity in the position.

• The smaller (greater) the margin requirement, themore (less) leverage is available to the hedge fund.

• When the margin account declines below a certainlevel hedge fund receives “margin call” from thebroker (lender) to deposit more collateral.

• Margin calls may increase losses when the hedgefund closes its losing position at unfavorable prices.

Redemptions: When investors decide to exit the fund orredeem some portion of their shares, it is referred to asredemption. Redemptions frequently occur during poorperformance of hedge funds i.e. when net asset valuestarts to fall.

• Redemptions involve transaction costs. Thus, toavoid such costs and to avoid losses associated withliquidating positions, hedge funds may chargeredemption fees.

• Decline in net asset value (NAV) is referred to asDrawdown.

3.4 Hedge Fund Valuation Issues

Generally, hedge funds are valued on a daily, weekly,monthly and/or quarterly basis using either market valuesor estimated values of underlying positions when reliablemarket values are not available (e.g. for illiquid or non-traded investments).

Different prices or quotes are available in the market:

• Bid price• Ask price• Average quote i.e. [(bid + ask)] / 2: It is mostcommonly used.

• Median quote

A more conservative and theoretically accurateapproach is to use:

• Bid prices for longs• Ask prices for shorts

It is recommended that hedge funds should set upprocedures and guidelines for in-house valuations.

For illiquid investments (i.e. convertible bonds,collateralized debt obligations, distressed debt andemerging markets fixed income securities), liquiditydiscounts or “haircuts” are used to reflect fair value.Hedge funds generally use two NAVs i.e.

1. Trading NAV: It represents NAV adjusted for liquiditydiscounts based on the size of the position heldrelative to the total amount outstanding in the issueand its trading volume.

2. Reporting NAV: It represents NAV based on quotedmarket price; it does not incorporate liquiditydiscounts.

3.5 Due Diligence for Investing in Hedge Funds

Due Diligence Process for Hedge Funds includes

following factors:

• Investment strategy•

Investment process• Competitive advantage• Track record: Mostly, hedge funds are required tohave track record of at least 2 years. The longer thetrack record period requirement, the more difficult itis for hedge funds to raise capital.

• Size and longevity: The older the fund, the better it isbecause it reflects that the fund has experiencedlower losses and higher growth in assets undermanagement via both capital appreciation andadditional investments (capital injections).o The minimum hedge fund size the investor can

consider depends on the minimum size of theinvestments by investors and their investment’smaximum % of a fund e.g. if an investor’s minimuminvestment size is $15 million and the investor’smaximum % of a fund is 8.5%, then

The minimum hedge fund size the investor canconsider = $15 million / 0.085 = $176.47 million

• Management style• Markets in which the hedge fund invests• Hedge fund benchmarks• How returns are calculated and reported• Key-person risk• Reputation• Investor relations






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• Plans for growth• Systems risk management• Management procedures (i.e. leverage, brokerage,and diversification policies)

• Fee structures and their affect on the returns toinvestors

• Additional things to consider include fund’s primebroker and custody arrangements for securities;auditor of the hedge fund.

Due to lack of transparency and fewer regulations,conducting due diligence for hedge funds can be verychallenging. The investor should also conduct duediligence when choosing a fund of funds (FOFs).

4. PRIVATE EQUITY

Private equity investments are equity investments thatare not publicly traded on exchanges or investments inpublic companies with the intent to take them private.Private equity investments are sensitive to businesscycles.

Categories of Private equity strategies (Section 4.2):

A. Leveraged buyouts (LBOs): LBOs involve buying all the

shares of a public company or established privatecompany partially through equity (i.e. 20-40%) andpartially issuing debt and converting it into a privatecompany.

• The private equity firm restructures and improves theoperations of the company to increase revenuesand ultimately increase company’s value to resellthe acquired company or part of it at a higher pricelater on and/or to improve company’s cash flowswhich can be used to pay down the debt.

• LBOs financing: LBOs use a greater amount ofleverage to finance a significant proportion of eachdeal and thus are also known as “highly leveraged

transactions”.• Capital structure: It includes equity, bank debt

(leveraged loans), and high yield bonds (with lowquality ratings and high coupons).o Leveraged loans represent the largest % of total

capital. They also have covenants to protect theinvestors. Leveraged loans are generally seniorsecured debt whereas the bonds are unsecuredwith respect to bankruptcy.

o The assets of the target company typically serve asthe collateral for the debt, and the debtobligations are met using company’s cash flows.

o Mezzanine financing: Mezzanine financing is ahybrid of debt and equity financing. It is a debt

capital, with current repayment requirements andhas warrants or conversion options i.e. can beconverted into common equity interest in acompany. It is generally subordinated to bothsenior and high yield debt and offers highercoupon rate. Besides interest or dividends,mezzanine financing also provides return whenvalue of common equity increases.

o It is important to note that different deals havedifferent optimal capital structure.

• Sources of growth in EBITDA include organic revenuegrowth; cost reduction/restructuring, acquisition etc.

Types of LBOs:

Management buyouts: MBO is similar to LBOs, however,in MBOs, internal management acts as (co-) buyer of thecompany and eventually become large investors in thecompany after its privatization.

Management buy-ins (MBIs): In MBIs, the acquiringcompany management replaces the current

management team.

B. Venture capital (VC): VC investments are privateequity investments used to finance a start-up (new)business or growing private companies. Eachcompany in which the VC fund invests is referred to as“portfolio company ”. It involves various financingstages i.e. formative-stage, expansion stage, pre-IPOstage, and exit stage.

• VC firms are active investors and actively managetheir portfolio companies. Typically, they have equityinterests in the portfolio companies.

• VC investments require a long time horizon and are

subject to high risk of failures.• Due to higher risk of failure during early stage, early-

stage investors demand higher expected returnsrelative to later stage investors.

• It represents a small portion of the private equitymarket relative to LBOs.

Stages of Venture Capital Investing

A. Formative-stage financing includes seed stage andearly stage financing.

1) Seed-stage financing: In seed stage, small amount ofmoney is provided to form a company or to transform

the idea into a business plan and to assess marketpotential.

• In the initial seed-stage when business idea is beingtransformed into a business plan, amount of capitalis typically small and is primarily provided byfounders, founder’s friends and family (called angelinvestors) rather than by VC funds. This stage is alsoknown as “Angel investing stage”.

• Later on, the seed capital is also provided by VCfunds to finance the product development andmarket research.




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• Form of financing used during Formative-stage:

Typically, ordinary or convertible preferred shares areissued to the VC fund while the company iscontrolled by the company’s management.

2) Early stage financing: In this stage, capital is providedto support operations of companies beforecommercialization and sales of product.

•

Start-up financing refers to the capital provided tocommercialize the product or idea and to supportproduct development and initial marketing.

• First-stage financing is capital provided to initiatecommercial manufacturing and sales.

B.

Later-stage financing is provided to companies whoneed funds to expand sales. It includes:

• Second-stage financing is the capital provided forinitial expansion of a company already producingand selling a product i.e. revenue has started butmay not be yet profitable.

•

Third-stage financing is capital provided for majorexpansion i.e. physical plant expansion, productimprovement, or a major marketing campaign.

•

Mezzanine (bridge) financing is capital provided toprepare for an IPO. It represents the bridge betweenthe expanding company and the IPO.

•

Form of financing used during Later-stage: Typically,equity and debt (including convertible bonds orconvertible preferred shares) are issued to the VCfund while the control of the company is handedover to the VC fund.

NOTE:

•

Debt financing is used to have control overcompany’s assets and to recover them duringbankruptcy. It is considered as a more securedfinancing for VC funds than equity financing.

• Due to lack of operational and financialperformance history and performance data, it ismore difficult for VC funds (investors) to estimatevalue of such companies compared to LBOs, whichinvest in mature, underperforming public companies.

C. Development capital: It involves minority equityinvestments in more mature (typically private)companies that need capital to expand or restructure

operations, enter new markets or finance majoracquisitions.

• It is often used by management of the company.• Sometimes, private equity capital is also used bypublicly quoted companies. This strategy is referredto as PIPEs (private investment in public equities).

D. Distressed investing: It involves investing in the debt ofoperationally sound BUT financially distressedcompanies (companies that are bankrupt, in default,or likely to default).

• Distressed investing involves buying the debt of afinancially distressed company at discounted price(i.e. < face value of the debt).

• The turnaround equity investors actively manage thecompany and restructure the company eitheroperationally or financially to increase the value ofdebt.

• Besides equity investors, debt investors (known as“vulture investors”) may also play an active role in

the management or in the reorganization of thecompany. It must be stressed that distressed debtinvestors have a prior claim on the company assets.

• Some distressed investors are passive investors.

4.1 Private Equity Structure and Fees

Like hedge funds, institutional and individual investorscan invest in private equity through limited partnershipswhich is known as Fund.

• Outside investors are known as Limited partners (LPs).• The private equity firm, which manages a number of

funds, is known as the General partner (GP).

Fee Structure: Management fee + Incentive fee

• Generally, management fees range from 1-3% of“Committed Capital” (not invested capital), until thecommitted capital is fully drawn and invested.

• Committed capital: It represents the amount that theLPs have agreed to provide to the private equityfund. The committed capital is drawdown by thefund over 3-5 years.

• Once the committed capital is fully invested,management fees are based only on the funds

remaining in the investment.• As investors exit from the fund, capital is paid back

to them and they are no more required to pay feeson that portion of their investment.

• Commonly, the incentive fees represent 20% of thetotal profit of the private equity fund and are notpaid to the GP fee until the initial investment hasbeen received back by the LPs. The incentive feemay also be calculated on a deal-by-deal basis.Amount received by the LPs = 80% of the total profit

of the equity fund +Return of their initialinvestment

• When distributions are made based on profits

earned over time, the GP may receive more than20% of the total profit. However, to protect the LPsinterests, the fund may set up an escrow account fora part of incentive fees and/or may impose a claw-back provision under which the GP is obligated toreturn any funds distributed as incentive fees until theLPs have received back their initial investment and80% of the total profit.

Besides management and incentive fees, LBOs firmsinclude other fees i.e. arrangement fee for the buyout of


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a company, fee in case a deal fails, and arrangementfee for divestitures of assets.

4.2.1.2 Characteristics of Attractive Target Companies

for LBOs

a) Undervalued/depressed stock price: Private equityfirms seek to buy undervalued or cheaply pricedcompanies that are out of favor in the public markets.

b) Willing management: Existing management is willingto exploit long-term growth opportunities but lackcapital needed to finance investments in newprocesses, personnel, equipment etc.

c) Inefficient companies: Private equity firms seek to buyinefficient companies and generate attractive returnsby restructuring and improving the operations of thecompanies.

d) Strong and sustainable cash flow: Companies withstrong cash flows are attractive for LBOs becausecash flows are used to make interest payments on thedebt associated with LBOs transactions.

e)

Low leverage: Companies with low leverage areattractive for private equity firms as it facilitates them

to use higher leverage to finance a substantial portionof the purchase price.f) Assets: Companies with a significant amount of

physical assets are preferred by private equity firmsbecause physical assets can serve as collateral fordebt and helps to reduce cost of debt as secureddebt is cheaper than unsecured debt.

4.2.4) Exit Strategies

Exit strategies are significantly important for privateequity investing because the ultimate goal for privateequity investors is to exit the fund at high valuations.

• An average buy-and-hold period for private equityinvestments is 5 years.

• The time to exit can range from less than 6 months toover 10 years.

• Selection of an optimal exit strategy depends on thedynamics of the industry of portfolio company,overall economic cycles, interest rates, andcompany performance.

The major types of exit strategies are as follows:

A.

Trade Sales: In this type of exit strategy, the privatefirm is sold to a strategic buyer (i.e. competitor) forstocks, cash, or a combination of both either throughan auction process or by private negotiation.

Benefits of a trade sale:

• Facilitates a private equity fund to have animmediate cash exit.

• May receive high valuations from “willing and able”strategic buyers who seek to capture anticipatedsynergies.

• It is simple and quick to execute.• It incurs lower transaction costs relative to an IPO.• It is relatively a highly confidential process andinvolves less information disclosure.

Disadvantages of trade sale:

• Trade sales are not preferred by portfolio company’semployees and thus may face managementopposition.

• Number of potential buyers is very limited.• Trade sales tend to receive lower price compared toan IPO.

B.

IPOs: In an IPO, the portfolio company initially issuessome or all of the shares to public investors through anIPO.

Benefits of an IPO:

• In an IPO, investors may receive the highest price.• IPOs also enjoy management approval becausecompany’s existing management is retained.

• IPOs are considered a source of publicity for theprivate equity firms.

• IPOs facilitate private equity investors to retain futureupside potential by allowing them to remain a largeshareholder.

Disadvantages of an IPO:

• It involves high transaction costs e.g. fees paid toinvestment banks and lawyers

• IPOs have long lead times.• It is subject to stock market volatility risk.• It has high disclosure requirements.• An IPO imposes a lock-up period on private investorsas they are prohibited to sell an equity position for aspecific period after the IPO.

• An IPO is more appropriate for larger companieswith attractive growth profiles.

C. Write-offs: Write-offs refer to voluntary liquidations of aportfolio company that may or may not generate anyproceeds.

D.

Secondary sales: Under secondary sales, securities ofa private equity firm are sold to another private equityfirm or other group of investors.

E. Recapitalization: In a recapitalization, the privateequity firm pays itself dividends by using debt. It is notconsidered a true exit strategy because inrecapitalization, the private equity firm retainscompany’s control.

The above exit strategies can be employed individually,combined together, or used for a partial exit strategy.

4.3Private Equity: Diversification Benefits,

Performance, and Risk

• Private equity funds may generate higher returns relative to traditional investments due to use of highleverage and by playing an active role in themanagement and operations of the portfoliocompanies.


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• Private equity investments also have higher risks(including market, illiquidity and leverage risks) thantraditional investments.

• Private equity investments also provide diversificationbenefits because they have less than perfectcorrelation with traditional investments.

•

Private equity performance index (PEPI) is an indexused to measure performance of private equityinvestments. However, it is not a reliable

performance measure because, like hedge fundindices, private equity indices are subject to self-reporting, survivorship, backfill, and other biases,resulting in overstated returns. In addition, suchinvestments are not marked-to-market on a regularbasis which tends to underestimate volatility andcorrelations with other investments.

4.4 Portfolio Company Valuation

The following three common approaches are used tovalue a company in the private equity investments:

1.

Market or comparable: Under the comparableapproach, company is valued using various multiples.These multiples are determined using market value orrecent transaction price of a similar publicly tradedcompany. Multiples include:

• EBITDA multiple: It is used for valuing large andmature private companies.

•

Net income or revenue multiples: They are preferredto use for small and less mature private companies.

2. Discounted cash flow (DCF): The DCF approachinvolves valuing a company by discounting relevant

expected future cash flows at the required rate ofreturn e.g.

• Discounting free cash flow to the firm at theweighted average cost of capital; or

• Discounting free cash flow to equity at the cost ofequity; or simply

• Discounting Net income or cash flow by using acapitalization rate.

• When the estimated value (using DCF approach) >(


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be adjusted quickly for inflation.

Features of Real Estate:

A. Heterogeneity and fixed location: Unlike stocks andbonds, real estate properties are not homogeneous i.e. they differ in use, size, location, age, type ofconstruction, quality, and tenant and leasingarrangements. In addition, they are immobile due totheir fixed location.

B. High unit value: Due to large sizes and indivisibility, realestate investments have greater unit value comparedto stocks and bonds and thus require greater amountof investment.

C. Management intensive: Unlike stocks or bonds, aprivate real estate equity investment or directownership of real estate requires active management by investors or by hired property managers.

D.

High transaction costs: Buying and selling real estateproperties involve higher transactions costs and is

more time-consuming.

E. Illiquidity: Real estate properties are relatively illiquiddue to

• Large transaction sizes• Lack of availability and timeliness of informationwhich requires extensive valuation and duediligence.

F. Difficulty in Price determination and valuations: Heterogeneity of real estate properties, low volume oftransactions and less informationally efficient marketsrelative to equity and bonds markets, changes in real

estate value or expected selling price over time aredetermined based on estimates of value or appraisalsrather than transaction prices.

G. Government regulation and local or regional market

factors: Real estate properties are subject togovernment regulations and depend on local orregional market factors rather than country-wide orglobal price movements.

The aforementioned properties imply that private realestate investments are suitable for investors with long-term investment horizon and greater ability to toleraterelatively lower liquidity.

5.1 Forms of Real Estate Investment

• Private equity investment in real estate properties. Itrefers to a direct ownership of real estate properties.

• Publicly traded debt investment. It refers to anindirect ownership of real estate properties i.e. viainvesting in mortgage-backed securities; real estateinvestment trusts (REITs) etc.

Forms of real estate investment:

1) Equity investment: Equity investment refers to a directownership interest in a real estate or investment insecurities of a company or a REIT that owns the realestate property.

• Direct, equity investing requires active andexperienced professional management.

• Equity investment performance depends on general

economic and specific real estate marketconditions, the way property is managed, terms ofdebt financing and the amount of borrower’s equityin the property (the higher the borrower’s equity, thegreater the cushion available for lender and thus thelower the risk).

2) Debt investment: Debt investment refers to lendingfunds to the buyer of real estate where the real estateproperty serve as collateral for a mortgage loan orinvestment in securities based on real estate lendinge.g. mortgage-backed securities (MBSs).

Private, debt-based real estate investments include:

• Mortgages• Construction lending

Private, equity-based real estate investments:

• Direct ownership of real estate i.e. through soleownership, joint ventures, real estate limitedpartnerships, or other commingled funds.

Public, debt-based real estate investments:

•

Mortgage-backed securities (residential andcommercial)

• Collateralized mortgage obligations

Public, equity-based real estate investments:

• Shares in real estate corporations• Shares in real estate investment trusts

Variations within the basic forms:

1) Free and Clear Equity or Fee simple: It is a form ofdirect ownership. It refers to an unlevered 100%equity-financed investment in real estate i.e. simplepurchase of some real estate property without use ofborrowed funds.

• Initial purchase costs associated with directownership include legal expenses, survey costs,engineering/environmental studies, valuation(appraisal) fees, maintenance & refurbishmentcharges, and costs associated with propertymanagement.

• The property can be managed either by the owneritself or by a hired managing agent.

• The owner has the right to lease the property to


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tenants and to resell the property at wil l.

2) Leveraged Equity: Leveraged Equity involves use ofboth equity and borrowed funds to purchase somereal estate property.

• Initial purchase costs associated with directownership include legal expenses, survey costs,engineering/environmental studies, valuation

(appraisal) fees, maintenance& refurbishmentcharges, costs associated with propertymanagement and mortgage arrangement fees.

• Investors earn return in the form of appreciation(depreciation) of the value of the property + netoperating income in excess of the debt servicingcosts.

• Any appreciation (depreciation) in the value of thehome increases (decreases) the owner’s equity inthe home.

• In case borrower defaults, the owner has the right totransfer ownership of the equity.

• Leverage financing can be provided in the form ofmortgage loans, including whole loans or pool of

mortgage loans (e.g. mortgage-backed securities).• However, leverage magnifies both gains and losses.Leverage increases the risk to both equity and debtinvestors. As the loan-to-value ratio increases, the riskincreases.

Mortgages: Mortgages or mortgage loans represent atype of secured debt investment in real estate in whichthe real estate property serves as collateral. In this formof investment, lenders (investors) earn return in the formof net interest, net of mortgage servicing fees, ascheduled repayment of principal and excess principalrepayments (called mortgage prepayments).

The due diligence process in a Mortgage loan involves:

• Identifying borrower’s equity investment in thepurchase of property (e.g. home).

• Evaluating creditworthiness of the borrower e.g.borrower’s ability to make the required payments onthe mortgage and to maintain the home etc.

• Estimating value of the property.• Ensuring that the property (e.g. home) is adequatelyand appropriately insured.

3) Pooled real estate investment vehicles: Theseinvestments include:

a) Real estate limited partnerships (RELPs): In RELPs,investors (called limited partners) can participate inreal estate projects and have limited liability (i.e. tothe amount of initial investment). It is managed by thegeneral partners who are real estate experts.

b) Real estate investment trusts (REITs): REITs representshares of publicly-traded companies that buy and sellreal estate. It is a form of pooled real estateinvestment and represent an indirect investment inreal estate property.

• REITs are highly liquid and provide retail investors withaccess to a diversified real estate property portfolioand professional management;

• REITs can be used by investors with short investmenthorizons and higher liquidity needs;

• REITs have higher correlation with stocks and bondsthan direct ownership of real estate; hence, it doesnot provide the same diversification benefits as thatof private real estate.

•

REITs are required to distribute at least 90% of theirtaxable income to shareholders in the form ofdividends.

• REITs and partnerships involve investmentmanagement fees based on either committedcapital or invested capital and incentive fees.Investment management fees typically range from1-2% of capital per annum.

4) Mortgage-backed securities (MBS): MBSs representinvestment in a diversified pool of mortgages i.e.each pool is divided into various tranches (withdifferent payment characteristics) and sold toinvestors.

• These include residential mortgage-backedsecurities (RMBS) and commercial mortgage-backed securities (CMBS). See exhibit 14, pg 208.

• MBS may be issued privately or publicly.

5.2 Real Estate Investment Categories

Categories of Real Estate Properties:

1. Residential properties: These include only owner-occupied, single residences (single-family residentialproperty).

2. Commercial properties (income-producing

properties): These include office, retail, industrial andwarehouse, and hospitality (e.g. hotels and motels)properties.

• Commercial properties investment is preferred byinstitutional funds or high-net-worth individuals withlong time horizons and limited l iquidity needs.

• Commercial properties may have mixed uses.• Sources of income for commercial properties include

rental income and capital appreciation.• Value of commercial properties is affected byfactors including development strategies, marketconditions, and property-specific features.

3. Timberland: They refer to properties that are used toproduce timber (wood) for industrial use purposes. Itcan function both as a factory and a warehouse.

• Unlike crops production, timber can be grown andstored easily. As a result, harvesting of timber is moreflexible i.e. it can be increased during rising timberprices and postponed during falling timber prices.

• Timberland does not have high correlation with


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traditional asset classes.• Three primary Return Drivers:

i. Biological growthii. Commodity price changesiii. Land price changes

4. Farmland: They refer to properties that are used toproduce crops or as pastureland for livestock.

Major types of Farmland:

1) Row crops that are planted and harvested annually.2) Permanent crops that grow on trees or vines.

Farmland tends to provide inflation hedge.

Three primary Return Drivers:

i. Harvest quantitiesii. Commodity price changesiii. Land price changes

Farmland harvesting has less flexibility than timberland.

Return components on farmland and timberland:i. Capital appreciation (i.e. sale of the commodities);ii. Income streams from leasing the land to another

entity;

NOTE:

Residential properties are considered as commercialproperty when they are maintained as rental properties.

5.2.3) REIT Investing

REITs are classified into three types:

1. Equity REITs: Equity REITs are tax-advantaged entities

(companies or trusts) that generally hold, own,operate, manage and develop commercial orresidential properties. They use leverage and aresimilar to direct equity investments in leveraged realestate.

• Primary source of revenue: Rent income fromproperties.

• To qualify for tax-advantaged status, they arerequired to distribute at least 90% of revenue(including rent and realized capital gains), net ofexpenses, to shareholders in the form of dividends. Inaddition, they are required to report earnings pershare based on net income as defined by GAAP

(like other public companies).• Objective of equity REITs: Maximize income anddividends by maximizing property occupancy ratesand rents.

2. Mortgage REITs: Mortgage REITs finance real estateinvestments by making mortgage loans to real estateowners or invest in existing mortgages or mortgagebacked securities. They are similar to fixed incomeinvestments.

• Primary source of revenue: Interest on mortgages.

3. Hybrid REITs: Hybrid REITs own & operate income-producing real estate properties and make loans aswell.

5.3Real Estate Performance and Diversification

Benefits

A real estate index can generally be categorized asfollows:

1)

An appraisal index: These indices use appraisedvalues of individual real estate properties rather thantheir transaction prices to construct the indices.

• The appraised values represent subjective valuesdetermined by experts.

• These indices suffer from appraisal lag becauseappraisals are done infrequently. As a result, theyunderestimate volatility of returns and correlationwith other asset classes.

• The National Council of Real Estate InvestmentFiduciaries (NCREIF) Property Index is a type ofappraisal-based index.

2) A repeat sales (transactions-based) index: This index isbased on repeat sales (i.e. more than once) of the

same property. For example, if the same property soldtwice, then the difference in value between the twosales dates indicate changes in market conditionsover time.

• The greater the number of repeat sales, the morereliable and relevant is the index.

• These indices are subject to sample selection biasbecause different properties may sell in each periodand thus may not truly represent the subject

properties. In addition, they may be based on non-random sample of properties e.g. the index may bebiased towards properties that have eitherincreased or decreased in value.

3) REIT index: REIT indices use the prices of publiclytraded shares of REITs to construct the indices.

• The more frequently the REITs shares are traded, themore reliable is the index.

• However, the index does not necessarily representthe properties of interest to the investor.

• The National Association of Real Estate InvestmentTrusts (NAREIT) is a type of REIT index.

•

REIT indexes are more strongly correlated with thestock market than bonds and they reflect morevolatile performance than appraisal-based indices.

NOTE:

It is important to note that real estate investment returnsvary across countries and regions.


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5.4 Real Estate Valuation

Real estate values need to be estimated and theprocess of estimating values is known as appraising theproperty. Common techniques for appraising real estateproperty include:

1)

Comparable sales approach: In this approach, recentsales (transaction) prices of similar (comparable)

properties are compared to a subject property. Salesprices are adjusted for each of the comparables forthe differences in size, age, location, quality ofconstruction, amenities, view, condition of theproperty, market conditions at the times of sale andthe price changes in the relevant real estate marketbetween dates of sales.

2) Income approach: Two major types of incomeapproach are:

i. Direct capitalization approach: In this approach, thenet operating income (NOI) of a property iscapitalized using a growth implicit capitalizationrate.

Value of a property = NOI / Capitalization rate

where,

NOI = Gross potential income – Estimated vacancylosses – Estimated collective losses – Insurance –Property Taxes – Utilities - Repairs andmaintenance expenses

• Financing costs, federal income taxes anddepreciation are not subtracted to determine theNOI.

Capitalization rate = Discount rate – Growth rate• The cap rate depends on strength of tenants, levelof landlord involvement, the extent and adequacyof repairs and improvements, vacancy rate,management and operating costs, and expectedinflation costs and rent.

ii. Discounted cash flow approach: In this approach,after-tax future projected cash flows (i.e. annualoperating cash flows for a finite number of periodsand a resale or reversion value at the end of thattotal period) are discounted at the investor’srequired rate of return (i.e. discount rate) on equityto estimate the Present Value of the property.

3) Cost approach: In the cost approach, value of theproperty (i.e. building) is estimated based on adjusted

replacement cost. The cost approach involvesestimating the value of the land and the costs ofrebuilding using current construction costs andstandards.

• Costs of rebuilding (replacement costs) includebuilding materials, labor to build, tenantimprovements, and various “soft” costs i.e.architectural and engineering costs, legal, insurance

and brokerage fees, and environmental assessmentcosts.

• The replacement cost is adjusted for the differencesin location and condition of the existing building (s).

Three valuation approaches do not necessarily providethe same value. Hence, it is recommended that finalestimate of value for the subject property should bedetermined after reconciliation of the differences in the

estimates of value from each approach.

5.4.1) REIT Valuations

There are two basic approaches to estimating theintrinsic value of a REIT:

1) Income-based approach: It is similar to the directcapitalization approach. Two commonly usedincome measures are:

Funds from operations (FFO): FFO = Net earnings +Depreciation expense on real estate + Deferred taxcharges – gains from sales of real estate property + losses

on sales of real estate property.

• Depreciation is added back because it represents anon-cash expense and is generally consideredunrelated to changes in the value of the property.

• Gains and losses from sales are excluded becausethey represent non-recurring items.

Adjusted funds from operations (AFFO): AFFO = FFO –Recurring capital expenditures.

• AFFO is similar to free cash flow measure.

2)

Asset-based approach: Asset-based approachinvolves estimating the net asset value (NAV) of REITs.Generally,

REIT’s NAV = Estimated market value of a REIT’s totalassets – Value of REIT’s total liabilities

• REITs shares may trade at discount or premium toNAV per share.

5.5 Real Estate Investment Risks

• Real estate property values are highly sensitive tochanges in national and global economicconditions, local real estate conditions, and interestrate levels.

• Real estate investment performance highly dependson the ability of a fund management to select,finance, and manage real properties, and changesin government regulations.

• Real estate investment in distressed properties andproperty development are more risky thaninvestment in financially sound and operationallystable properties.


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6. COMMODITIES

Commodities are physical products. Commoditiesinclude:

• Precious metals: Gold, silver, platinum•

Base (industrial) metals: Copper, aluminum, zinc,

lead, tin, nickel• Energy products: Oil, natural gas, electricity, coal• Agricultural products: Grains, livestock, coffee• Other: Carbon credits, freight, forest products

It is important to note that returns on commodityinvestments depend on changes in price rather than onincome i.e. interest, dividends or rent.

Types of Commodity Investment:

1)

Direct Commodity Investment: It refers to cash (spot)market purchase of physical commodities. It is preferredby investors that are part of the physical supply chain i.e.

producers of commodities, users of the commodities,and participants in between.

2)

Indirect Commodity Investment: It refers to gettingindirect exposures to changes in spot market values ofcommodities. Indirect investment in commodities can bemade in various ways, including

a)

Stocks/Equity of companies producing the

commodity or exposed to a particular commodity:

However, such companies do not provide effectiveexposure to commodity price changes becausethese companies themselves hedge commodity risk.

b)

Commodity derivative contracts: Commodityderivatives include futures, forwards, options andswaps. These contracts may trade on exchanges orover the counter. To avoid incurring transportationand storage costs, investors prefer to invest incommodity derivatives instead of investing in physicalcommodities.

• The underlying for a commodity derivative may be asingle commodity or an index of commodities.Commodities derivative contracts specify terms withrespect to quantity, quality, maturity date, anddelivery location.o Futures and forward contracts represent

obligations to buy or sell a specific amount of agiven commodity at a fixed price, location anddate in the future.

o Futures contracts are exchange-traded products(ETPs).

o Forward contracts trade OTC. They have highercounterparty risk.

o Options contracts represent the right (notobligation) to buy or sell specific amount of agiven commodity at a specified price and deliverylocation on or before a specified date in thefuture. Options can be ETPs or OTC traded.

o In swaps, one party agrees to make fixedpayments and in exchange receives floatingpayments based on future commodity orcommodity index prices.

• The prices of commodity derivatives largely depend

on the underlying commodity prices.• Commodity derivatives can be used by investors

(e.g. producers and consumers) for hedgingpurposes or by speculators (e.g. retail andinstitutional investors, hedge funds) to capture profitsassociated with changes or expected changes inthe price of the underlying commodities.

c) Commodity Exchange traded funds (ETFs): ETFsprovide indirect exposures to commodities. ETFs mayinvest in commodities or commodities futures.Commodity index-linked ETFs also exist.

• ETFs are appropriate for investors who are allowed toinvest in equity shares only.

• ETFs are easy to trade.• ETFs may employ leverage.• ETFs involve management fees (like mutual funds orunit trusts); however, the expense ratios of ETFs arelower than that of mutual funds.

d) Commodity-linked Bonds

6.1 Commodity Derivatives and Indices

• Typically, commodity indices are constructed using

the price of futures contracts on the commoditiesrather than the prices of underlying commodities.Therefore, the performance of a commodity indexmay significantly differ from the performance of theunderlying commodities.

• In addition, commodity indices vary with respect toweighting systems and constituent commodities.E.g., the S&P GSCI commodity index is over-weighted in energy sector. As a result, differentindices have different commodity exposures, makingcomparison difficult across indices.

6.2 Other Commodity Investment Vehicles

Alternative means of commodity investments include:

A.

Managed futures funds: These are actively managedinvestment funds, which invest in exchange-tradedderivatives on commodities and focus on eitherspecific commodity sectors or on a broadly diversifiedportfolio of commodities.

• Like hedge funds, they are managed by professionalmoney managers (called the general partner) andhas fee structure of 2-20%.

• They may operate like mutual funds where the


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general public can invest or like hedge funds whereinvestment is restricted to high net worth andinstitutional investors.

• Managed futures funds operating like mutual fundsprovide retail investors with an access to theprofessional management at low investment andrelatively high liquidity.

B.

Individual managed accounts: These funds are

managed by selected professional money managerswho have expertise in commodities and futures. Thesefunds are offered to high net worth individuals orinstitutional investors.

C. Funds exist that specialize in specific commodity

sectors(e.g. private equity partnerships): Such fundscan be used to gain exposure to specific sector e.g.energy sector. Like private equity funds, they chargemanagement fee (range from 1-3% of committedcapital) and have lockup period of 10 years (withextensions of 1-2 years).

6.3

Commodity Performance and Diversification

Benefits

Benefits of Commodities:

• They provide potentially attractive returns.• They provide inflation hedge because inflation indexlevels are determined by commodities prices e.g.energy and food prices impact the cost of living forconsumers.

• They provide diversification benefits as they havelow positive correlation with traditional assets i.e.stocks and bonds.

• Commodity futures contracts may provide higher

liquidity and opportunities to earn a positive realreturn.

Risks:

• Leverage risk: Leveraged investment in commoditieshas high volatility and results in higher risk.

• Counterparty risk associated with commodityderivatives contracts.

NOTE:

When inflation index levels are determined bycommodity prices, then on average, investment incommodities tend to generate zero return over time.

Investors of commodities: Institutional investors includingendowments, foundations, corporate and publicpension funds, and sovereign wealth funds.

6.4 Commodity Prices and Investments

Commodity spot prices depend on:

• Supply and demand• Costs of production and storage

• Value to users• Global economic conditions

Supply of Commodities depend on:

• Production levels• Inventory levels• Actions of non-hedging investorso Supply of commodities is difficult to adjust quickly

to the changes in demand levels due to long leadtimes associated with production. As a result,during strong (weak) economy, supply is too low(high) than demand. This mismatch betweensupply and demand results in greater pricevolatility.

o The cost of new supply also increases over time.

Demand for commodities depend on:

• Needs of end users which depend ono Global manufacturing dynamicso Economic growth

o

Government policy• Actions of non-hedging investors

6.4.1) Pricing of Commodity Futures Contracts

Futures price ≈ Spot price (1 +r) + Storage costs –Convenience yield

where, r = period’s short-term risk-free interest rate.

When Futures price ≠ the spot price compounded at the

risk-free rate arbitrage opportunities exist i.e. if Futuresprice >(


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1) Roll Return/ yield: Roll yield refers to the return thatcan be earned by rolling long futures positionsforward through time.

Roll yield = Spot price of a commodity – Futurescontract price

Or

Roll yield = Futures contract price with expiration date‘X’– Futures contract price with expirationdate ‘Y’

• When the convenience yield is significantly higher(and thus futures price < spot price), the futurescontract price tends to roll up to the spot price asthe maturity date approaches, generating positive

roll yield. Opposite occurs when there is little or noconvenience yield. This concept is referred to as“Theory of Storage”.

• Hedging Pressure Hypothesis: According to thistheory, the difference between the spot and futuresprice depends on user preferences and risk

premiums.

2) Collateral yield: It is the return (i.e. risk-free interestrate) earned on a fully margined/collateralizedposition in a long futures contract (i.e. posting 100%margin in the form of T-bills).

3) Spot Return/Price Return: It refers to the change incommodity futures prices that result from changes inthe underlying spot prices. It is calculated as change

in the spot price of the underlying commodity over aspecified time period.

• The spot (or current) prices primarily depend oncurrent supply and demand.

Returns on a passive investment in commodity futures =

Return on the collateral + Risk premium (i.e. hedgingpressure hypothesis) or the convenience yield net ofstorage costs (i.e. theory of storage)

7. OTHER ALTERNATIVE INVESTMENTS

Collectibles: Collectibles are tangible assets e.g.antiques and fine art, fine wine, rare stamps and coins,

jewelry and watches, and sports memorabilia.

• Sources of return for Collectibles: They provide long-term capital appreciation and do not provide anycurrent income.

• They can also be used for diversification purposes.• Risks associated with collectibles:o Their value is subject to substantial fluctuations.o They are highly illiquid.o To earn superior returns, investors need to have

high expertise.o To preserve their conditions and value, some

collectibles must be stored in appropriate

conditions.• Collectibles can be traded in various ways includingthrough professional auctioneers, in local fleamarkets, online auctions, garage sales, and antiquestores or directly with personal collectors.

• Different collectibles indices exist in the marketwhich provide information about their performance.However, they may not reliably representperformance of such asset class.

8. RISK MANAGEMENT OVERVIEW

Following are some of the challenges of alternativeinvestments due diligence:

• Asymmetric risk and return profiles. As a result,

traditional risk and return measures (i.e. mean return,S.D. of returns, Sharpe ratio and beta) may not beappropriate to use.

• Limited portfolio transparency.• Illiquidity and long time horizon (i.e. long-termcommitment required).

• “Complex” structures and investment strategies.• Difficulty in valuations i.e. valuations based onappraised (estimated) values due to lack ofobservable prices and infrequent transactions.

• Minimal regulatory oversight.• Risks associated with use of alternatives derivatives

contracts i.e., operational risk, financial risk,counterparty risk and liquidity risk.

• Limited historical risk and return data.• Lack of manager diversification.

8.1.2) Risk Issues for Implementation

Historical returns and the S.D. of those returns may notreliably represent the returns and volatility of alternativeinvestments because:

• The reported correlations of alternative investmentswith other investments may significantly differ fromthe actual correlations.

• Past performance can be a poor predictor of futureperformance because:


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o It may be highly sensitive to business cycle (e.g.commodities and real estate investments).

o It may suffer from price bubbles.

8.1.3) Due Diligence Issues Regarding Risk

Due to lack of transparency in alternative investment, itis difficult for investors to effectively managediversification across funds and to conduct adequatedue diligence.

• To deal with aforementioned risks, it is criticallyimportant for investors to select good managers withverifiable track record, a high level of expertise andexperience with the asset type.

• To avoid risk of 100% loss of equity on individualinvestments, investors should diversify portfoliosacross various investments and managers.

• Investors should ensure that risk associated with useof leverage is effectively managed by portfoliomanagers.

• Fee structure (compensation package) should becritically analyzed to ensure alignment of interest

because managers may seek to attract largeamounts of capital to increase their managementfess which are based on assets under managementor committed capital. In addition, due to option likefeature of incentive fees, portfolio managers maytake unduly high risk to generate higher returns.

• Investors should ensure that investment is incompliance with its stated policies in the prospectus.

• Due diligence also requires to assess organizationalstructural and terms of the fund including thepolicies and procedures for managing operationsand risks.

• Due to use of appraised values for valuations,independent valuation of illiquid underlying assets

should be performed on a periodic basis.• Rationale, analysis, and suitability of everyinvestment, exit strategies of investments, (includingtiming and realization price) should be adequatelyassessed.

• Investment policy should be clearly defined whichproperly define limits on security type, leverage,sector, geography and individual positions.

• Investors should ensure that all positions and riskexposures are carefully & effectively monitored andmanaged by the manager. Generally, hedge fundsare monitored by a chief risk officer, who is notinvolved in the investment process.

• To reduce risks, unusually good and overly consistent

reported performance should be scrutinized.• Investment performance results should be reportedto investors on a regular basis.

NOTE:

For investors (particularly small investors) with highliquidity needs, publicly traded securities (i.e. REITs shares,ETFs shares and publicly traded private equity firms) aremore suitable.

8.2 Risk-Return Measures

A. Sharpe ratio can be used to measure theperformance of alternative investments.

Sharpe ratio = (Investment return – Risk-free rate ofreturn) / S.D. of return

The Sharpe ratio may not be the appropriate risk-return

measure for alternative investments because

• Due to illiquidity and use of appraised values ratherthan transaction prices for valuation purposes,returns may be smoothed and/or overstated andthe volatility (represented by S.Ds) of returnsunderstated.

• The standard deviation (S.D.) measure fails toconsider the impact of diversification in a broadlydiversified portfolio.

• Alternative investment returns are not normallydistributed; rather, they tend to be leptokurtic (fattails i.e. positive average returns), negatively skewed

(long-tails i.e. potential extreme losses). Hence, it notappropriate to use S.D. as a measure of risk.

B.

Downside Risk: It refers to the probability of losing acertain amount of money in a given time period. Forexample,

1. Value at risk (VAR) measures the “minimum amountof loss expected over a given time period at a givenlevel of probability”. It uses S.D. as a measure of risk.

2.

Shortfall or safety-first risk measures the “probabilitythat the portfolio value will fall below some minimumacceptable level over a given time period”. It uses

S.D. as a measure of risk.

3. Sortino Ratio = (Annualized rate of return – Annualizedrisk-free rate*) / Downside Deviation

*Minimum acceptable return or risk free rate is typically used.

Limitations:

• Downside risk measures provide incompleteinformation because they focus only on losses i.e. leftside of the return distribution curve.

• For a negatively skewed distribution, estimating VARand shortfall risk using S.D. lead to anunderestimation of downside risk.

• In addition, both Sharpe ratio and downside risk donot consider the low correlation of alternativeinvestments with traditional investments.

C. Stress testing/scenario analysis: It involves estimatinglosses under extremely unfavorable conditions. Due tolimitations of VAR, stress testing/scenario analysisshould be used as a complement to VAR. Stresstesting/scenario analysis is useful under both normaland stressed market conditions.


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8.3 Due Diligence Overview

Read Exhibit 20, Volume 6, Reading 60.

Practice: End of Chapter Practice

Problems for Reading 60.

finquiz - curriculum note, study session 18, reading 60_alternative investments

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