the fundamentals of alternative investments laney sanders, cfa assistant chief investment officer...

The Fundamentals of Alternative InvestmentsLaney Sanders, CFAAssistant Chief Investment Officer LASERS

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1. Alternative vs Traditional Investments2. Types of Alternative Investments3. More On: Alternative Investments4. Fund of Funds vs Direct Funds5. Alternative Manager Selection6. Goals of Alternative Investing

Topics

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Include long positions in cash, bonds, and stocks. These are the most well known and widely used by investors.

A “non-traditional” asset. Encompass many different categories including:1. Real Assets2. Hedge Funds3. Commodities4. Private Equity

Alternative Assets vs Traditional Assets

What is a traditional asset?

What is an alternative asset?

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• A typical “financial asset” such as a bond, is a claim on a set of cash flows of a firm

• Whereas a real asset is the investment in an actual physical asset such as:• Real Estate: land and permanent improvements to the land• Timberland: trees (underlying land is not always part of the

investment)• Infrastructure: toll roads, utility companies, etc. Claim on the cash

flow generated by these assets. • Intellectual Property: copyrights, patents, trademarks, royalties, etc.

Types of Alternative Assets: Real Assets

Real assets are investments that directly control nonfinancial assets and represent actual rights to consumption rather than indirect financial claims on cash flows generated by the tangible assets of a firm

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• Classifications of hedge funds include: • Futures Funds: Macro and managed• Event Driven: Activist, Merger Arbitrage, Distressed, Event Driven

Multi Strategy• Relative Value Hedge Funds: Convertible, Volatility, Fixed Income,

Event Driven• Equity Hedge Funds: Long-Short, Market Neutral, Short Selling,

130/30• Fund of Funds: Hedge fund manager chooses and invests in

underlying hedge funds

Types of Alternative Assets: Hedge Funds

Hedge Funds are private investment vehicles that capitalize on various investment opportunities. Funds often use derivatives, leverage, short positions, and other strategies.

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• Commodity investments can take the form of:• Ownership of the physical commodity• Forward or futures contracts• Securities of commodity producing firms• Exchange traded funds (ETFs) – these provide passive commodity

price exposure

Types of Alternative Assets: Commodities

Commodities are standardized goods (metals, agriculture products, energy products, and building materials) delivered to markets by many producers in large quantities

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• Greater risk than public counterparts – more likely to achieve greater returns

• Willing to accept long term investment horizons and conduct extensive due diligence

• 5 types:• Venture capital• Leveraged buyouts (LBOs)• Mezzanine financing• Distressed debt investing• Special situations/opportunistic

Types of Alternative Assets: Private Equity

Private Equity includes debt and equity securities that are not publically traded

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Diversification• Many alternative products have low correlation to traditional assets• Allow reduced risk without significantly lowering return expectations

Illiquidity• Illiquidity refers to securities with infrequent trading and/or low volume

trading• Difficult to observe price and returns through trades• “Lumpy assets” are difficult to divide and can only be traded in certain

quantities• Illiquidity premium

Return Characteristics of Alternatives

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• Efficiency in markets means all available information is incorporated into asset prices

• Efficient market prices reflect highly competitive bidding process• Inefficiency indicates that prices are different than those expected from an

efficient market• Fewer participants, lower competition• Excess returns can be generated due to market inefficiency

Return Characteristics of Alternatives

Market Inefficiency

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Regulatory Structure• Privately organized and generally unlisted• Not heavily regulated – exempt from Investment Company Act of 1940 –

do not adhere to same filing and disclosure requirements and record keeping as mutual funds

• Must meet certain standards to invest such as “qualified purchaser” – net worth greater than $5 million for individuals or $25 million for institutions

Trading Structure• Private securities, real assets, derivatives, structured products, leverage,

long/shortIndustry Growth• $500 billion in 2000 to $1.8 trillion in 2010

More on: Hedge Funds

Primary Elements of Hedge Funds

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• Performance-based incentive fees that attract elite managers• Management fee – collected on a quarterly, semi-annual, or annual basis

• Collected regardless of performance (1% - 3%)• Performance fee – collected annually but only if fund is profitable (usually

20%)• High water mark provision – incentive fee only paid if NAV is above previous

NAV• Hurdle rate – incentive fee only paid after fund exceeds a set threshold

return


Compensation Structure

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Benefits of Hedge Funds

100% T-Bonds

50% S&P 500 50% T-Bonds

100% S&P 500

5%

7%

9%

11%

13%

15%

17%

19%

7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17%

Annualized Standard Deviation

Annualiz

ed R

ate

of

Retu

rn

Traditional Stock and Bond Portfolio

10% Allocation to AR Portfolio

20% Allocation to AR Portfolio

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• Long Position – owning a security• Short Position – selling a borrowed security (sell high, buy low)• Derivative – instruments which derive their value from an underlying asset• Alpha – value added or subtracted by a fund manager (above or below a

benchmark)• Beta – market driven performance• Leverage – increasing exposure to markets by borrowing and/or using derivatives• Absolute Return Fund – euphemism for a hedge fund/ these funds were supposed

to deliver “absolute returns” no matter what state the markets were in• Fund of Fund – a fund that aggregates investor money and invests in hedge funds

as opposed to stocks, bonds, and other assets


Definitions

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Traditional Funds vs Hedge Funds

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• Most managers do not want to share their positions• Provides the ability to evaluate and understand the manager’s

process/strategy• Institutions have asked for more transparency over recent years• Information usefulness• Many HFs now report to 3rd party risk aggregators (Measurisk and

RiskMetrics)


Transparency

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• Usually a 6 month to 1 year initial lock up unless some event occurs (key man provision)

• Redemptions can usually occur every quarter with a 60 – 90 day notice• Gates/Suspensions• Side pocket investments


Liquidity

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• Employed by HFs to magnify gains, but magnifies losses as well• Funds can employ different types of leverage

• Financial (borrowing)• Use of derivatives• Can these exposures be quantified and monitored?


Leverage

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StrategiesHedge Funds

Market Directional

Equity Long/Short

Emerging Markets

Short Selling

Activist Investing

Corporate Restructuring

Distressed Securities

Merger Arbitrage

Event Driven

Regulation D

Convergence Trading

Fixed Income Arbitrage

Convertible Bond Arbitrage

Equity Market Neutral

Fixed Income Yield Alternative

Relative Value Arbitrage

Opportunistic

Global Macro

Fund of Funds

Multi-Strategy

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• Like long-only traditional equity managers, these HFs will go long on the stocks they like

• Also go short• Stocks they do not like or• An ETF (S&P 500) or• An index future

• These managers tend to maintain a net long position • Shortcut: buy the good, sell the bad


Equity Long/Short

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• Loose use of the word “arbitrage” by hedge fund managers• “The exploitation of security mispricing in such a way that risk-free economic

profits may be earned” • 1 security, 2 exchanges example

• In HF world, this usually means the purchase and sale of similar investments (not a risk free exercise)

• Empirical evidence suggests that corporations tend to overpay for acquisitions• The stock of the company being acquired will trade at a discount to the offering

price (reflects the risk of the deal not taking place)• Merger Arbitrage managers will short the stock of the acquirer and buy the stock of

the company being targeted• Spread must be sufficient to compensate for the possibility of deal failing • Shortcut: Short the acquirer, buy the target


Arbitrage and Merger Arbitrage

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• Macro-economic approach/Global reach• These managers invest opportunistically across currencies, commodities,

equities, fixed income, derivatives, etc. in any country or market• Use other strategies under their umbrella (fixed income arbitrage, equity

long/short, etc.)


Global Macro

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• Ability to invest in different strategies• Ability to shift capital across strategies to reflect their views on markets• Sometimes these funds will grow based on their “bread and butter” and

then branch into other strategies• Use other strategies under their umbrella


Multi-Strategy

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• Hedge fund managers that invest their capital into other hedge fund managers

• Tactically allocate capital• Pros:

• Immediate hedge fund diversification• Fund of Funds (FoF) have infrastructure and expertise to conduct due diligence and

monitor underlying managers• Knowledge transfer to staff

• Cons: • Double layer of fees (investors pay underlying hedge fund fee and FoF manager fee) could

be substantial• Asset allocation in the hands of the FoF manager• Over-diversification is possible


Fund of Funds

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The Good• Potential for non-correlated returns to traditional assets• Potential to reduce overall portfolio volatility• Access to the best• Rapidly evolving • Incentive structure

The Bad• Complicated • Lack of transparency• Difficult to evaluate• Infrequent liquidity• Expensive


The Good and the Bad

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• Limited Partnership Agreement (LPA) – legal framework for partnership and terms and conditions of fund investments in companies that are not listed on a publicly-traded exchange.

• Private markets are usually less efficient. • Exposure to carefully selected and efficiently structured companies with

strong corporate governance and growth potential.• A fund is managed by a General Partner (GP) who invests on behalf of the

Limited Partners (LPs)• Ten to twelve-year limited partnership• Commitment called over four to five years• Distributions typically begin by year three or four• Partnerships are terminated once all investments have been liquidated

More on: Private Equity

What is Private Equity

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Three levels1. Private Equity Firms (Zeus Global Management)2. Private Equity Funds (Zeus Buyout Fund IV)3. Private Equity Portfolio Companies (Sanders Bake Shop)Partnership Structure• General Partner – money management firm• Limited Partners – institutions and wealthy individuals• Limited Partnership Agreement (LPA) – legal framework for partnership

and terms and conditions of fund


Private Equity Structure

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PE Investor (Pension)

PE Firm Fund

(Zeus IV)

Portfolio Company (Bakery)

Investment (capital calls)

Partnership Interests

(distributions)

Equity Position

Investment

Limited Partner

General Partner

Limited Partnership Agreement

Portfolio Company

(Shoe Store)

PE Firm(Zeus Global

Management)

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– Years 1-3 returns are negative, little income is generated, management fees are collected on committed (not invested) base, additionally there are some early investments which fail;

– Years 3-5 returns flatten out and gradually turn positive as values are written up to reflect transactions and some income is received;

– Years 5-10 returns spike as assets are sold and accumulated increases in value are reflected, and income is received as businesses become profitable;

– All years combined leads to what has been termed the “J-Curve.”


Cash flow pattern of investing in private equity

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The “J Curve”

Projected Cash Flows for a $10 Million Commitment

-$10,000,000

-$5,000,000

$0

$5,000,000

$10,000,000

$15,000,000

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year10

Drawdown Distribution Cumulative Net Cash Flow J Curve

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Venture Capital, Growth Equity, Buyouts

Investment Style

Description of Investment Strategy

Main Sector Types

Time Horizon

to Liquidity

IRR Range

-DPI

Multiple

Primary Return Drivers

Venture Capital Investments in early stage of companies with an innovative and or a disruptive business idea for a proprietary product or service. Investments are made in the early life of the company, seed stage, early stage and pre-revenue.

TechnologyCommunications

SoftwareBio-tech

HealthcareClean Tech

8 – 12 years 10% - 15%2.00x

Capital Appreciation

Growth Equity Provides expansion capital for small, growing businesses, that are generating cash flow and profits. Generally, these types of investments have minimal exposure to technology risk

Diversified

Business ServicesIndustrialConsumer

5 – 7 years 15% - 20%2.00x


Buyouts Investments in established companies that require capital to expand and or restructure

Diversified

Business ServicesIndustrialConsumer

5 – 7 years 15% - 20%2.00x

Current Income and Capital

Appreciation

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Mezzanine

Investment Style


Main Sector Types

Time Horizon

to Liquidity

IRR Range

-DPI

Multiple


Mezzanine Investment strategy involving subordinated debt, (the level of financing senior to equity and below senior debt). Investments are generally shorter in duration, loans are 3 – 5 years, returns, generated are primarily current income with a lesser emphasis on capital appreciation

Capital supplied by mezzanine financing is used for various situations such as facilitating changes in ownership through leveraged buyouts or recapitalizations, financing acquisitions, or enabling growth

Revenue and Royalty interests are a subset of mezzanine financing that targets intellectual property, license agreements and other similar property that has the ability to restrict the rights to commercialization.

Companies in a variety of industries that are backed by

Private Equity Managers (Sponsored)

Or Not backed by a Private Equity

Manager(Sponsor-less)

Venture backed technology and healthcare companies

Royalty and Revenue Interests generally targets intellectual

property and pharmaceuticals

Corporate Finance

1 – 4 years

Venture Lending

1 – 3 years

Royalty & Revenue Interests

1 – 4 years

11% - 14%1.50x

11% - 16%1.60x

12% - 16%1.60x

Current Income and


Current Incomeand


Current Income

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Distressed, Secondaries

Investment Style


Main Sector Types

Time Horizon

to Liquidity

IRR Range

-DPI

Multiple


Distressed Investments in companies that have poorly organized capital structures or failing operations.

Distressed strategies includes trading strategies, significant influence and control positions. Long and short positions are commonly used as a technique to lock in profit or reduce risk.

Trading strategies, Investment instruments include publicly traded debt securities, private debt, trade

claims, mortgage debt, common and preferred stock and commercial

paper.

Significant influence and Control strategies involve companies with

poorly organized capital structures, turnaround situations and bankrupt

companies.

3 – 4 years 13% - 17%1.65x


Secondaries Private equity interests are generally purchased at a discount from valuation from motivated owners of private equity interests. The interests purchased are generally venture and buyout interests with limited exposure to unfunded capital commitments.

The strategy also includes the purchase of direct interests in companies through the secondary market

Diversified

Venture and Buyout investors’ interests with limited exposure to unfunded capital commitments.

Direct interests in companies through the secondary market

2 – 3 years 14% - 22%1.50x


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Energy, Infrastructure, Timber, Agriculture

Investment Style


Main Sector TypesTime

Horizon to Liquidity

IRR Range

-DPI

Multiple


Energy Investments will include exploration & production, generation, storage, transmission, distribution, renewable energy sources, clean technologies, energy technologies and other like-kind investments

Up-StreamMid-Stream

Down-StreamPower

CleantechRenewables

Energy efficiency

5 – 7 years 15% - 20%2.00x

Capital Appreciation, some income

from production

Infrastructure Investments in physical assets or companies that operate assets that provides essential services to society and typically exhibit one or more of the following qualities: monopolistic or quasi-monopolistic, high barriers to entry, long term assets, regulatory or permitting constraints

Infrastructure strategies may be classified into four broad

categories: Transportation, Energy and Utilities, Communications, and

Social Infrastructure

5-15 years 6% - 15%1.75x

Current Incomeand


Timber Investment in producing timber properties for forest products

HardwoodsSoftwood Plantations

Growth only

10-15 years 6%-12%1.50x


Appreciation

Agriculture Ownership of properties leased to farm operators

Row & Field CropsPermanent Crops

6-10 years 6%-12%1.75x


Appreciation

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The Good• Precedent of 20% + annual returns over long horizon• Diversification resulting in improved risk and volatility

characteristics• Imperfect correlation with other asset classes• Market inefficiency; transactions are negotiated

The Bad• High risk, particularly on an individual transaction basis• Illiquidity• Lack of transparency• Valuations somewhat judgmental


The Good and the Bad

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Fundraising (0 to 1.5 years)• Private Equity Manager raises sufficient funds for the strategy• Investors make capital commitments to the fund

Investing (1-6 years)• Private Equity manager calls capital from investors to source investment

opportunities and create value

Harvesting (7-10 years)• Private Equity Manager exits investments through IPOs and Mergers and

Acquisitions• Proceeds of the exits are distributed to the fund’s investors according to provisions

in LPA

Liquidating (10-12 years)• Private Equity Manager exits the few remaining investments in fund


Lifecycle


Projected Cash Flows for a $10 million Commitment

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Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10-$10,000,000

-$5,000,000

$0

$5,000,000

$10,000,000

$15,000,000

Drawdown Distribution Cumulative Net Cash Flow J Curve

• General Partner is compensated through fees and shares of profits• Annual fee based on committed capital

– Venture Funds: 2 - 2.5%– Buyout Funds: 1.5 - 2%

• Profit participation– Most often set at 20% of gains– Usually above a preferred return of 5 - 10%


Management Fees

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• Tangible assets that have their own intrinsic worth based on utility• Assets whose intrinsic value is less eroded by inflation compared to paper

assets – provide real returns over inflation• Examples

More on: Real Assets

General Definition

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Real Estate Energy

Commodities Timber

Infrastructure TIPS/Inflation Linked Bonds

Natural Resource Equities REITS

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Purchase the commodity outright• Shipping and Storage costs/logistics

Commodity Linked Notes/ Exchange Traded Funds• CLNs: Debt instrument whose value at maturity will be a function

of the value of an underlying commodity index• ETFs: Simple, but higher fees for commodity index exposure and

added layer of complexityNatural resource companies

• Stocks and bonds of the companies• Do you get pure exposure to the commodity?• Equity Market Risk


Commodities


The Business Cycle and Stock, Bond and Commodity Prices

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Source: CAIA Level I Text (Anson)

Commodities Bottom

Bonds Rising

Equities Rising

Commodities Rising

Bonds Falling

Equities Falling

Commodities Falling

Time

GDP

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• Many alternative investments are in a fund structure (hedge fund, private equity fund, etc.)

• There are two general ways to implement an investment:• Direct Fund• Fund of Funds

Fund of Funds vs Direct Investing

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• A direct fund is when a pension system invests directly in an individual fund

• Louisiana Retirement System invests in the Zeus IV Fund• Zeus IV Fund invests in individual companies

• A fund of funds is when a pension system invests in a fund that in turn invests the capital in a group of different underlying funds

• Louisiana Retirement invests in the Cronus I Fund• Cronus I fund invests in the following funds:

• Zeus IV Fund• Poseidon III Fund• Hades II Fund• Hestia IV Fund

Fund of Funds vs Direct Investing

• Strong reputation• Established firm• Stable investment team• Relevant experience• Demonstrated track record• Thorough due diligence process• Ability to accommodate client needs

Alternative Manager Selection

Key drivers

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1. Structure of the fund2. Investment strategy review3. Performance review4. Risk assessment5. Administrative review6. Legal review7. Checking references

3 fundamental questions in order to understand a fund’s investment program:

8. What is the fund manager’s investment objectives?9. What is the fund manager’s investment process?10. What is the fund manager’s competitive advantage?

Alternative Manager Selection

Due Diligence Process

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• Higher returns• Higher risk• Illiquidity premium

• Diversification• Structure program so that returns of alternatives are uncorrelated

to traditional portfolio returns• Unique Opportunities

• Alternative investments allow strategies that are often not available in traditional long only investments

Goals of Alternative Investing

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Questions?

the fundamentals of alternative investments laney sanders, cfa assistant chief investment officer...

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