Alternative Investments

 

 

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ternative

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Introduction to Alternative Investments LOSa

C o m p a r i s o n o f alternative investments with traditional investments

Compared to tra d itio n a l invesbnents , alternative investments a r e

LOSb

+ Less liquid ore

specialized by managers

+ Less regulated and transparent + More problematic and have less available historical data + Different legal issues and tax treatments

investme nts Categories o f alternative investme

G

Hedge f u n d s

t

s a Mutual Fund like structure for High Net worth Individuals HNis)

These funds use leverage, hold long and short positions, use derivatives and invest i n illiquid assets

@

@

Private equity f u n d s

Ve n tu re capital els

Resident ial p ro p e rtie s

Leveraged buyout

els

Realestate Con mercial

p ro p e rtie s

l

Real estate backed l oans oans,,

Use borrowed

money t o purchase equity i n established companies

Invest in companies a t their early stages in life

securities

Full o r le v eraged

backed by pools o f properties o r

ownership

mortgages and limited partnershi p s

Most preval ent

© Physical commodities

1

1 Buying/short

Buying gold/silver coins o r bars, grains etc.

@

Commodities Commodi t i es derivatives

selling futures o f copper, entering into

a

forward

contract for potato etc.

Real e s ta te backed d e b t

Equity

1

Investing i n the equity o f commodity producing firms Problematic i the company itself hedges the exposure

I n f r as t r u ct u r e Social in fra s tru c tu re

Economic in fra s tru c tu re

1

1

Roa d s  a i r po r ts, utility grids et c.

®

School s, School hospital s etc.

O t h er

Includes investment i n tangible collectibles such as stamps, antique furniture, art, fine wines as well as intangibles such as patents

 

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I s s u es i n valuing alternative investments

Hedge fund valuation Accounting NAV

> Trading NAV

Trading NAV tends t o be lower because

t

considers liquidity o f portfolio

Private equity company valuation

Market/ comparables

approach

Transaction values o f similar companies may be used t o estimate net income o r E ITD revenue t o use in estimating the portfolio companys value

Comparable sales approach Valuation based on recent sales o f similar properties

Discounted cash

Asset-based

flow approach

approach

Dividend discount model and Free Cash Flow t o the Firm FCFF) come under this category

Liquidation values o r fair market values o f assets are used

Real

estate valuation

Income approach

Cost approach

Net operating income Capitalization rate

Replacement cost o f a property is estimated

Commodity valuation Contango - Future price > Spot price Backwardation - Future price < Spot price

Collateral yield

Roll yield Yield due t o a difference between the spot price and futures price Backwardation -   ve Contango - - ve

LOSg

Interest earned on collateral

Change i n spot prices Total price return is a combination o f the change in spot prices and the convergence o f futures prices t o spot prices over the term o f the futures contract

alternative ve investm ents Risk m an ag em en t o f alternati

+ Alternative investments exhibit return distribution which is left skewed and leptokurtic +

Therefore standard deviatio n may not be a correct measure o f risk. Recommended measure - VaR o r Sortino ratio

Use o f derivatives introduces operational, financial, counterparty, and liquidity risk

 

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LOS c

Potential benefits o f alternative investments i n t h e context o f portfolio m an ag em en t Alternative investments have had low correlations with traditional investments which provides benefits o f diversification Historically alternative investments have had higher returns on average than traditional investments, so adding alternative investments t o a traditional portfolio may increase expected returns

The reasons for these higher returns are thought t o be that

+ +

Alternative investments are less efficiently priced than traditional investments, providing opportunities for skilled managers Alternative investments may offer extra returns for being illiquid Alternative investments often use leverage

Adding alternative investments t o a portfolio reduces portfolio rjsk and increases expected return, however there are problems with historical data and traditional risk measures Survivorship bias refers t o the upward bias o f returns

i

data is

included only for currently existing (surviving) firms Backfill bias refers t o upward bias introduced b y including the previous performance data for firms recently added to a benchmark index

G

LOSd

Hedge funds

+ Pools o f investor funds that are not as regulated as + Limited in the number o f investors

+ + + + +

+

mutual funds

Often sold only t o qualified investor investors s Minimum investments is quite high ( 250k t o 1m) Use Us e leverage, hold long and short positions, use derivatives and invest in illiquid assets Typically use prime brokers who provide multiple services such as custodial, administrative, money lending, securities lending and tr ding Investors are limited partners and managers are general partners Hedge fund return objectives can be absolute (20%) or relative (Benchmark + 5 )

Lockup p e r i o d Notice p e r i o d

F u n d o f funds

Time after initial investment during which withdrawals are not allowed The amount o f time a fund has t o fulfill the redemption request after receiving the request

An investment company that invests i n hedge funds

Advantages • • Disadvantage •

Gives investor investors s diversificat diversification ion among hedge

fund strategies Helps smaller investors t o invest i n hedge funds They charge an additional layer o f management fees

 

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H e d g e f u n d strategies Event driven)

Merger arbitrage

Distressed/ r es t r u ct u r i n g

Buy shares o f the firm being acquired

Buy shares o f firms in financial distress

Sell short shares o f

Short overvalu overvalued ed securities

the acquirer

Activist s h ar eh o l d er

Special situations

Buy sufficient equity shares t o influence a company   s policies with the goal o f increasing company value

Invest in securities o f firms t hat are i ssuing/ repurchasing securities, spinning off divisions, selling assets,, o r distributing assets capital

These strategi es are based on a corporate restructuring o r acquisition t hat creates profit opportunities for long o r short positions in securitie securities s o f a specific corporation

Relative , ral u e

Convertible arbitrage fixed • m come

Asset backed fixed i n co m e

General fixed • m come

Volatility

Exploit pricing discrepancies arising from Exploit pricing

discrepancies

between convertible bonds common stock o f the issuing company

Exploit pric i ng

discrepancies

among various MBSor

BS

Exploit pricing

discrepanc ies discrepanc b etween fixed income

securities o f various types

differences between returns volatility implied by options prices and manager expectations o f future volatility f

Multi strategy

Exploit pricing

discrepancies

among securities in asset classe classes s different from those previously listed and across asset classes and markets

Implied volatility > Expected volatility

= Overvalued

These strategies involve buying a security and selling short a related security with the goal o f profiting when one thinks there is a pricing discrepancy between the t w o

M a c r o str~ttegies

These are based on global economic trends and events and may involve long o r short positions in equities fixed income currencies o r commodities

 

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Various stages a t which venture capital investment is made

Formative stage

+

Investments made during firm's earliest period comprised o f three phases

• •

Angel investing

• Seed stage

• •

Early stage

Investments made very early {  idea   stage) funds are used for business plans and assessing market potential funding source is usually individuals ( angels ) rather than venture capital funds Investments made for product development, marketing and market research This is the stage where V funds make initial investments, through ordinary o r convertible preferr preferred ed shares

• Investments made t o fund initial commercial production and sales

Later stage

+

Funds provided a t this stage are typically used for expansion o f production and/or increasing though an expanded marketing campaign sales

Mezzanine--stage

+

Capital provided t o prepare the firm for an IPO

financing

Mezzanine financing means debt o r preferred stock t h a t are subordinate t o the high - yield bonds and carry warrants o r conversion features that give i nvestors participation i n equity when value increases

Dev elo p men tal capital

•

Known as m inority eq u i ty i n vesti n g

•

Refers t o the provision o f ca p i ta l for business growth o r restructuring

•

W hen public co m panies are financed wi th su ch funds, i t is

referred t o s private investment in public equi ties {PIPEs

D i s t r e s s e d investing •

t o b u ying debt o f mature companies that are experiencing fi n ancial difficulties

•

Investors in distressed debt take ac ti ve role in working w ith management on reorganizing o r determ deter m i ning the directi on t he company should take

•

They are someti m es referred t o as vulture investors

t refers

P r iv at e e q uity s t r u c t u r e a n d fees

+ +

They are typically structured as li m ited partnerships

Committed capital is the amount o f capital provided to the fund by investors

+

not invested all a t once but is drawn down  { invested) as securities are identified and added to the portfolio

t s typically

 

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Equity hedge f u n d

Market neutral

F u n d am en t al growth

F u n d am en t al value

Quantitative d i r ect i o n al

Sh o r t bias

Use technical/ fundamental

analysis t o

short overvalued shares and buy undervalued shares in approximately equal amounts t o profit from their relative price movements without exposure

Use fundamental analysis to find high growth

companies.

Identify and buy shares o f companies th a t are expected to sustain relatively high rates o f capital appreciation

Buy undervalued shares based on fundamental

analysis.

s

t

the hedge fund structure

Buy undervalued shares and short overvalued

shares based on technical analysis

Mostly use short positions i n overvalued

shares, with

smaller long positions, b u t with negative market exposure overall

to market risk

@ Leveraged buyoutfunds

Management buyouts

Management buyins

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Private equity

Venture capital f u n d s

Distressed m v es t m en t funds •

Developmental capital f u n d s

Existi ng management team is involved in the purchase

External management team replaces existing team

V e n t u r e capital f u n d s

•

Investment is often in the form o f equity but can be in convertible preferred shares o r convertible debt

•

The companies in which a venture capital fund is invested are referred t o as its portfolio companies

•

Venture capital fund managers often sit on their boards or fill key management roles o f portfolio companies

 

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+

+

Drawdown period - Typically 3 - 5 years Management fees - Typically 10/o - 3

+

Clawback provision -   t requires the manager t o return any periodic incentive fees t o investors i f nvestors receive less than 800/o o f the profits generated by portfolio investments as a whole

Private e q u i t y exit strategies • •

Trade sale - Sel Selll a portfolio company t o a competitor o r another strategic buyer PO

- Sell all or some shares o f the company t o the public

•

Recapitalization - Compa Company ny issues issues debt t o fund a dividend distribution t o equity holders the fund). This is not an exit, but is often a step toward an exit

•

Secondary sale - Sell a portfolio company t o another private equity firm o r a

•

Write-off/liquidation - Re Reas asse sess ss and bear the losses from an unsuccessful outcome

group o f investors. Most prferred strategy

Potential benefits a n d r i s k s o f p r i v at e equity

+

Private equity has less than one correlation w ith traditional investments. Therefor e there may b e benefits o f diversification from including private equity in portfolios

+

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Standard deviation o f private equity returns has been higher than the standard deviation o f equity index returns, which suggests greater risk

+

Choosing skilled fund managers i s important

@ Residential property

Single-family homes Direct investment in real estate

Can be cash investment o r leveraged investment property purchased w ith a mortgage) Lenders often sell their mortgages. They are later securitized and traded as Mortgage Backed Securities MBS)

Real es t at e

Commercial property

Mortgages

Produces

Whole loans

income

These properties generate income from rents

Long time horizons, illiquidity, Large size o f investment and their complexity make commercial properties inappropriate for many investors

These are also considered a direct investment in real estate

Loans can be pooled into Commercial Mortgage Backed Securities CMBS) that represent an indirect investment

 

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Real Estate Investment Trusts REITs)

+

+ +

They issue shares t hat trade publicly like shares o f stock liquid) They can hold mortgages, hotel properties, malls, office buildings, o r other commercial property Income is used t o pay dividends tax exempt)

O t h e r r e a l e s t a t e assets Far

Timbe ·land Returns come from sales o f timber Returns also include price changes on timberland

and

Returns come from sales o f agricultural products Returns are also based on land price changes changes,, changes in farm commodity prices, and the quality and quantity o f the crops produced

Potential benefits a n d risks o f r e a l e s t a t e Real estate performance is measured by three indices

+

+

+ Appraisal index -   t s based on periodic estimates o f property values Appraisal index returns have lowest standard deviation o f other index methods

Repeat sales index -

+

 t

s based on price changes for properties that have sold multiple times

REIT indices - are based o n the actual trading prices o f REIT shares

REIT index returns and global equity returns have strong correlation (business cycles affect REITs and global equities similarly)

+

REIT index returns and global bond returns have low correlation

© Con modity ETFs

Equities directly l i n k ed to commodity

Investment i n Suitable for investors who are limited t o buying equity shares They invest i n commodities o r commodity futures

shares o f

commodity producing firm Drawback - P ric rice e movement o f the stock may not be perfectly c orrelated with price movements o f the commodity

Commodities

Managed

f u t u r es f u n d s

Individual managed accounts

S p ecialized funds in specific secto1·

s an alternative to pooled funds for

Can be organized under any o f the

Actively managed Some managers concentrate on specific sectors while others are more diversified

They can be structured as limited partnerships o r mutual funds

t

Nis

Accounts are

tailored t o the needs o f investors

structures

Focus on specific commodities

 

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Hurdle rates Eg.

1

Opening value = 100 Closing value = 140 Hurdle rate = 1 2 % Incentive fee = 20%

Opening value

=

Closing Closin g value

100

=

140

Prof i t = 4 0

Hard hurdle rate

Soft hurdle rate

Profit

40

Profit

Hard hurdle

12

Soft hurdle

28

Incentive fee ( 20% )

Eg.

2

5.6

40

40

Incentive fee {20%)

8

Hedge fund opening value = $150 min Fee structure = 2/20 Hard hurdle rate = 5 % Ending value (Year 1 ) = $175 min Ending value (Year 2 ) = $180 min Incentive fees are calculated net o f management fees Ca l culate tota l

fees and investor's net return

Year1

Year 2

Management fees = $150 min x 2 % = $3 min

Management fees = $169.1 min x 2 % = $3.382 min

Incentive fees = [$175 min - $150 min - 3 - ($150 min x 5 % ) ] x 20% = $2,9 min

Incentive fees = [$180 min - $169.1 min - 3.382 {$169.1 m i n x 5 % ) ] x 2 0 % = $0

Total fees = $3 min

+ $2.9 min

=

Ending value net o f fees = $175 min - $5,9 min = $169.1 min

=

Investor's net return = ($168.9 mln/$150 min) - 1 = 12.73% n

Total fees = $3.382 min

5.9 min

Ending value net o f fees 180 min - $3.382 min = $176.618 min

Investor's net return = ($176.618 mln/$169.1 min) - 1 = 4.44%

year 2 , incentive fee = 0 because return did not exceed hurdle rate

High w a t e r m a r k

Incentive fee = 150 - 130 = 20 X 200 o = 4

= 150 t 1 = 130

1;

= 100

t 2 = 80

 

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D u e diligence Hedge fund

Private equity

+

Investm ent strategy ss + Investment proce.ss + Investment process + Source o f competitive advantages + Historical returns + Valuation and returns calculation methods + Longevity + Amount o f assets under management + Management style + Key person risk + Reputation + Growth plans + Systems for risk management + Appropriate ness o f benchmarks

Real e s t a t e

+

Because o f the high leverage used for private equity funds, investors should consider how interest rates and the availability o f ca pi tal may affect any required refinancing o f portfolio company debt

+

The choice o f manager general partner) is quite i mportant, his operating and financial experience, valuation methods used,, incentive fee structures, drawdown used procedures are also important factors

Alternative investments

+

Property values fluctuate because o f global and national economic factors, local market conditions, and interest rate levels

+ The degree o f everage used i n real estate investment is important because leverage amplifies losses as well as gains +

Real estate devel opment has additional risks such as regulatory issues like zoning and permitting , environmental considerations o r remediation, and economic changes and financing decisions over development period

+ +

Organization

Portfolio management

+ Operations and controls

+

Risk management

+

Legal review

+ Fund terms

 

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Potential benefits a n d r i s k s o f commodities

+

Returns on commodities< returns on s to cks/bonds

Sharpe ratio for commodities is low because o f lower returns and standard d deviation high standar

+

Commodity prices tend t o move w ith inflation rates, therefore holding commodities can act as a hedge against inflation

Commodity prices a n d investments

+

Spot prices for commodities are a function o f supply and demand

+ Global economics, economics, production costs and storage costs costs,, value t o user, all factor into prices

®

along w ith

I n f r as t r u ct u r e

T r an s p o r t at i o n assets

Utility assets

Communications

Social

Roads a i r p o r t s , ports and railways e t c .

Electiic generation and distribution w a s t e disposal etc.

Broadc ast assets assets a n d cable systems e t c .

Prisons schools healthcare facilities e t c .

Brownfield investments -

Investments i n infrastructure assets that are already constructed

Provides stable cash flows and relatively high yields, but offers little potential for growth

Greenfield investments -

Investments in infrastructure assets that are t o be constructed Involves uncertainty and may provide relativel relatively y lower yields, but offers greater potential growth

O t h er alternative investments Various types o f angible collectibles such as rare wines, a rt , rare coins and stamps, valuable jewelry and watches, and sports memorabilia are considered investments

LOSe

M a n a g e m e n t a n d incentive fees Most common fee structure for a hedge fund

►

2 and 20 ( 2 / 20 )

= Management fee 2 20 = Incentive fee

Management fee is paid irrespective o f investment performance

Incentive fee is paid as a percentage o f profits