R60 Introduction to Alternative Investments

CFA® Level I – Alternative Investments Introduction to Alternative Investments www.irfanullah.co

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CFA® Level I – Alternative Investments Introduction to Alternative Investments www.irfanullah.co

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Contents and Introduction 1. 2. 3. 4. 5. 6. 7. 8.

Introduction Alternative Investments Hedge Funds Private Equity Real Estate Commodities Other Alternative Investments Risk Management Overview www.irfanullah.co

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2. Alternative Investments Traditional investments: long-only positions in stocks, bonds, and cash Alternative investments: all other investments

General Characteristics Of Alternative Investments

• • • • • • • • •

High fees Low diversification within alternative investments portfolio High use of leverage Illiquid; restrictions on redemptions Narrow manager specialization Low correlation with traditional investments Low level of regulation and less transparency Limited and potentially problematic risk and return data Unique legal and tax considerations

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Example As compared to traditional investments, alternative investments tend to be more?

A. Liquid B. Leveraged C. Transparent

Solution: B Alternative investments are often leveraged.

Example 1 www.irfanullah.co

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Categories of Alternative Investments • Hedge Funds

• Private Equity Funds  Leverage Buyouts  Venture Capital

• Real Estate  Residential Property  Commercial Property  Mortgage Backed Securities  Real Estate Investment Trusts (REITs)  Timberland and Farmland

• Commodities • Other

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Return: General Strategies Total return = Alpha return + Beta return

Passive managers assume that markets are efficient and rely only on beta return Active managers assume that inefficiencies exist and can be exploited  Some managers seek to generate returns that are independent of market returns (absolute return)  Managers with no limitations on investment categories try to move into higher returning segments, whereas inflexible managers stick to the restrictions (market segmentation)  Some managers concentrate investments among few securities with the hope of those securities outperforming market (concentrated portfolios)

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Portfolio Context: Integration of Alternative Investments with Traditional Investments Relatively low correlation between some categories of alternative investments and traditional investments

Relatively high returns on some alternative investment categories

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Diversification Benefit

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Investment Structures • Partnership is the most common investment structure  Fund is the general partner (GP), usually a limited liability company  Investors are limited partners (LPs)

• Funds (GP) charge a management fee based on assets under management plus an incentive fee based on realized profits

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3. Hedge Funds Alfred Winslow Jones created a ‘hedged’ fund in 1949. The purpose of this fund was to hedge long-only stock portfolio’. The fund followed three key tenets: 1. Always maintain short positions 2. Always use leverage 3. Only charge an incentive fee of 20% of profits

Characteristics of a typical contemporary hedge fund:

• Aggressively managed portfolio of investments across asset classes and regions that is leveraged, takes long and short positions, and/or uses derivatives • Goal of generating high returns, either in an absolute sense or over a specified market benchmark and has few, if any, investment restrictions • Set up as a private investment partnership open to a limited number of investors willing and able to make a large initial investment • Often imposes restrictions on redemptions

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Hedge Fund Strategies Hedge Fund Strategies Event Driven Strategies

Relative Value Strategies

Profit from short-term events Profit from a pricing that are expected to affect discrepancy between related individual companies securities • • • •

Merger Arbitrage Distressed/Restructuring Activist Special Situations

•

• • • •

Fixed Income Convertible Arbitrage Fixed Income Asset Backed Fixed Income General Volatility Multi-Strategy

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Macro Strategies

Equity Hedge Strategies

Profit from economic trends evolving across the world. Trades are made based on expected movement in economic variables.

Profit by taking long and short positions in equity and equity derivative securities • • • • • •

Market Neutral Fundamental Growth Fundamental Value Quantitative Directional Short Bias Sector Specific

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Example If Abbacus Hedge Fund identifies undervalued and overvalued firms and takes both long and positions, which strategy are they employing?

A. Relative value B. Fundamental value C. Market neutral

Solution: C

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Hedge Funds and Diversification Benefits • Theory:  Hedge funds can make money regardless of stock market direction  Low correlation with stocks provides diversification benefit

• Reality:  Lack of performance persistence  High correlation between stocks and hedge funds between 2003 and 2009

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Hedge Fund Fees and Other Considerations • Common fee structure is “2 and 20” which means 2% management fee and 20% incentive fee  “1 and 10” for Funds of Funds  Hurdle Rate  High Water Mark

• Hedge funds may use leverage to seek high returns  Generally trade through prime brokers

• Redemptions can magnify losses    

Redemptions my require hedge fund managers to liquidate positions and incur transaction costs Drawdowns (decline in NAV) might trigger redemptions Redemption fees, notice periods and lock-up periods seek to minimize impact of drawdowns See Example 4: Effect of Redemption

• Hedge funds are subject to relatively low regulation

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Example: Fee and Return Calculations Initial investment is 200 million; fee structure is 2 and 20 and is based on year-end valuation. In year 1 the return is 30%. 1. What is the total fee if management fee and incentive fee are calculated separately? What is the investor’s effective return? 2. What is the total fee if the incentive fee is calculated after deducting the management fee? Investor’s net return? 3. If there is a hurdle rate of 5% and fees are based on returns in excess of 5%, what is the total fee? What is the investor’s net return? In the second year the fund declines to 220 million. 4. Management fee and incentive fee are calculated separately. A high water mark is used in fee calculations. What is the total fee? What is the investor’s net return? In the third year the fund value increases to 256 million. 5. What is the total fee and investor’s net return? Example 2 www.irfanullah.co

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Example: Hedge Fund versus Fund of Funds Hedge Fund H (HFH) has a standard 2 and 20 fee structure. A fund of funds, FOF, has a 1 and 10 fee structure. In a given year all funds in FOF’s portfolio have the same return as HFH. Assume the management fee is charged based on asset value at the start of the year. 1. Compare the HFH and FOF returns from an investor perspective. 2. Why would an investor invest in a fund of funds?

Example 3 www.irfanullah.co

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Example The hedge fund had an initial investment of $60 million and at the end of first year, value was 70 million after fees. At the end of the second year, value was 80 million before fees. The fund has 2 and 20 fee structure and incentive fees are calculated using a high watermark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2. A. 2.5 million B. 3.6 million C. 4.8 million

Solution: B Management fee = 80 x 0.02 = 1.6 million (80-70) x 0.2 = 2 million Total fee = 1.6 + 2 = 3.6 million

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Hedge Fund Valuation Issues Hedge funds are generally valued on a daily, weekly, monthly and/or quarterly basis Value of a hedge fund depends on the value of underlying positions

Market prices

Market prices

Liquid

Illiquid

Mostly (bid+ask)/2 is used Conservative alternative: bid price for short and ask price for long positions

Consider liquidity discount or haircut Trading NAV includes haircut; reporting NAV is based on quoted prices

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Market prices NOT available

Estimate value

Example 5

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Due Diligence for Investing In Hedge Funds Key due diligence points to consider: • Investment Strategy • Investment Process • Competitive Advantage • Track Record (how are returns calculated and reported, what are the fees?) • Size and Longevity • Management style • Key Person Risk • Reputation • Investor Relations • Plans for Growth • System Risk Management Example 6

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4. Private Equity • Leveraged Buyouts • Venture Capital • Development Capital • Distressed Investing

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Private Equity Structure and Fees • Structured as partnerships  Private equity firm is the General Partner (GP)  Investors are Limited Partners (LPs)

• Committed capital

• Management fee is 1-3% of committed capital • Incentive fee is typically 20% of total profit

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Private Equity Strategies: Leveraged Buyouts Acquire companies through significant debt financing. LBO’s capital structure comprises of equity, bank debt and high yield bonds

Two types of LBOs

Target Companies for LBOs

• MBO: Current management team purchases and runs the company • MBI: Current management is replaced and acquirer team runs the company

• • • • • • www.irfanullah.co

Undervalued stock price Willing management Inefficient companies Low leverage Strong and stable cash flow Lots of physical assets 22

Private Equity Strategies: Venture Capital Invest in private companies (portfolio companies) with significant growth potential Venture capitalists are actively involved with the companies in which they invest VC investing can take place at various stages • Formative Stage: Company in the process of being formed  Angel investing: Financing provided at idea stage for sketching out business plan  Seed stage financing: Financing for product development and market research  Early stage: Financing for companies moving towards commercial production • Later Stage Financing: For expansion after commercial production and sales but before IPO • Mezzanine Stage: Preparing to go public

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Example The stage in which capital is gathered for product development and market research is called the?

A. Formative stage B. Seed Stage C. Early Stage

Solution: B

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Exit Strategies Ultimate goal of private equity is to improve new or underperforming businesses and exit them at high valuations; companies held for an average of 5 years

Common exit strategies are: • Trade sale: Selling company to a competition or any strategic buyer • IPO: Company goes public • Recapitalization: Re-leverages itself when interests are low • Secondary sale: Sell to another private equity firm • Write off/Liquidation

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Private Equity: Diversification Benefits, Performance and Risk • May provide higher return relative to traditional investments  Access to private companies  Ability to actively manage and improve portfolio companies  Leverage

• Exhibit 10: Comparison of Private Equity and U.S. Stock Returns  Private equity indices rely on self reporting; subject to survivorship, backfill and other biases

• Exhibit 11: High Risk  Investors should require higher return for accepting higher risk, including illiquidity risk and leverage risk

• Advice for investors: identify and invest in the best performing private equity funds www.irfanullah.co

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Portfolio Company Valuation Three approaches to value a portfolio company 1. Market or Comparable 2. Discounted Cash Flow (DCF) 3. Asset Based Example: A private equity firm is considering buying a firm which produces online educational content. The firm has EBITDA of 100 million. In the past year four such firms were sold at an average of 10x EBITDA. What is the estimated value of the firm?

Example 7 www.irfanullah.co

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Investment Consideration and Due Diligence • Consider current and anticipated economic conditions  Interest rates and capital availability  Refinancing risk

• Long term commitment

• Carefully select GP  Due diligence questions similar to what we saw with hedge funds  Evaluating GP’s experience and knowledge is critical

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5. Real Estate Key reasons for investing in real estate:

Investment characteristics:  Indivisibility

 Potential for competitive long term returns (income and capital appreciation)  Rent from long-term leases will lessen impact from economic shocks  Diversification

 Inflation hedge

 Unique characteristics

 Fixed location  Operational management  Local markets can be very different from national or global markets

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5.1 Forms of Real Estate Investment Private

Debt

Equity

Mortgages

Direct ownership (sole ownership, JV, real estate limited partnership, etc.)

Construction Lending

Leveraged ownership Public

MBS

Shares in REIT corporations

CMO

Shares in real estate investment trusts

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Real Estate Investment Categories • Residential Property  Investment in residence with intent to occupy  Leveraged equity

• REIT Investing  Mortgage REITs  Equity REITs

• Mortgage-Backed Securities (MBS) • Commercial Property  Requires active and experienced management  Illiquid

• Timberland and Farmland  Timberland functions as factory and store  Return drivers: growth, timber price changes, land price appreciation

 Farmland is perceived to provide a hedge against inflation  Return drivers: harvest quantities, commodity prices, land price appreciation

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Real Estate Performance and Diversification Benefits • Variety of indices to measure real estate returns  Appraisal index  Repeat sales (transaction-based)  REIT index

• Exhibit 15 shows returns of different U.S. Real Estate Indices • Exhibit 16 shows returns of global REITs

• During 1990 – 2009  Correlation of global REITs to global stocks was 0.6  Correlation of global REITs to global bonds was 0.1

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Real Estate Valuation Common techniques for appraising real estate property: • Comparable Sales Approach • Income Approach  Direct Capitalization  DCF • Cost Approach

REIT valuation: • Income Based: Similar to direct capitalization  Two income measures: Funds from Operations (FFO) and Adjusted FFO (AFFO)  FFO = Net Income + Depreciation – gains from sales of real estate + losses on sales of real estate • Asset Based: Calculates REIT’s NAV = (MV of Total Assets – Total Liabilities)/ # of Shares

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Real Estate Investment Risks • Property values are subject to variability based on national and global economic conditions

• Ability to select, finance and manage real estate properties • Expenses may increase unexpectedly • Leverage magnifies risks

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6. Commodities • Commodities are physical products; return depends on price changes only • Generally investment in commodities is through derivative instruments  Futures, forwards, options, swaps, commodity index futures  Contracts may trade on exchanges or over the counter

• Other commodity investment vehicles  Exchange traded funds (ETF)  Common stock of companies exposed to a particular commodity  Managed Future Funds:  Similar to hedge funds and are actively managed  Invest in commodity futures and forwards

 Individual managed accounts  Specific commodity sectors

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Commodity Performance and Diversification Benefits • Commodities are viewed as a good inflation hedge  Commodity prices impact inflation calculation

• Low correlation with traditional investments  diversification benefit  Exhibit 18: correlation with global stocks is 0.16  Correlation with global bonds is 0.13

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Commodity Prices and Investments • Commodity spot prices are a function of supply and demand, costs of production, value to users, and global economic conditions

• Future Price ≈ Spot Price (1+r) + Storage Costs – Convenience Yield  Convenience yield: value associated with holding the physical asset

• Futures prices may be higher or lower than spot prices based on convenience yield  Futures price > spot price  contango  Futures price < spot price  backwardation

• Three sources of return for each commodity futures contract  Roll yield  Collateral yield  Spot prices www.irfanullah.co

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7. Other Alternative Investments • • • • • • •

Fine art Fine wine Rare stamps Coins Jewelry Watches Sports memorabilia

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8. Risk Management Overview • Investment and risk management process    

Both investor and risk manager should be concerned about risk management Risks vary across alternative investments Historical returns and standard deviations might be biased Reported correlations may vary from actual correlations

• Traditional risk measures (ex: Sharpe ratio) are not adequate because  asymmetric risk and return profile  Limited transparency  Illiquidity

• Due diligence of alternative investment managers is particularly important • Hedge fund and private equity returns depend heavily on fund manager • See Exhibit 20: A Typical Due Diligence Process www.irfanullah.co

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Security Market Indices: Indices for Alternative Investments • Commodity Indices consist of futures contracts on one or more commodities  Performance of index and underlying commodities can be different  Common to have multiple indices with same commodities but in different proportions; weighting methods also different; different risk return profile • Real estate indices represent market for real estate securities and the market for real estate • Appraisal indices, repeat sales indices, REIT indices

• Hedge fund and private equity indices  Constituents determine the index  Poorly performing funds are less likely to report  Index returns overstated due to survivorship, backfill and other biases

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Summary • General characteristics of alternative investments • Hedge funds • Private equity • Real estate • Commodities • Risk management

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• • • • •

Description Strategies/sub-categories Benefits and risks Fee structures Due diligence

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Conclusion • Read summary • Review learning objectives • Examples are very good • Practice problems: good but not enough • Practice questions from other sources www.irfanullah.co

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