JuiceNotes TM

- By FinTree

eBook 10

Alternative Investments

CFA® Level 1 JuiceNotesTM 2017

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 Introduction to Alternative Investments
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LOS a Comparison of alternative investments with traditional investments

Compared to traditional investments, ª Less liquid

alternative investments are ª More specialized by managers
ª Less regulated and transparent
ª More problematic and have less available historical data
ª Different legal issues and tax treatments

LOS b Categories of alternative investments

1 Hedge funds It is a Mutual Fund like structure for High Net worth Individuals (HNIs)

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

2 Private equity funds 3 Real estate

Venture Leveraged Residential Commercial Real estate

capital buyout properties properties backed debt
funds funds

Use borrowed
e Real estate
re
money to backed loans,
Invest in securities
purchase equity Full or
companies at backed by pools
in established leveraged
their early of properties or
companies ownership
stages in life mortgages and
Most prevalent limited
partnerships
nT

4 Commodities 5 Infrastructure

Physical Commodities Equity Economic Social

commodities derivatives infrastructure infrastructure
Fi

Investing in the Roads, airports, Schools,

Buying/short
equity of utility grids etc. hospitals etc.
selling
Buying commodity
futures of
gold/silver producing firms
copper,
coins or bars, entering into 6 Other
grains etc. Problematic if
a forward
the company
contract for Includes investment in tangible collectibles
itself hedges
potato etc. such as stamps, antique furniture, art, fine
the exposure
wines as well as intangibles such as patents
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LOS c Potential benefits of alternative investments
in the context of portfolio management

Alternative investments have had low correlations with traditional

investments which provides benefits of diversification

Historically alternative investments have had higher returns on average

than traditional investments, so adding alternative investments to a
traditional portfolio may increase expected returns

The reasons for these higher returns are thought to be that

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

Adding alternative investments to a portfolio reduces portfolio risk

and increases expected return, however there are problems with
historical data and traditional risk measures

Survivorship bias refers to the upward bias of returns if data is

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

LOS d
ª
ª
1

e
Hedge funds

Pools of investor funds that are not as regulated as mutual funds

Limited in the number of investors
re
ª Often sold only to qualified investors
ª Minimum investments is quite high ($250k to $1m)
ª Use leverage, hold long and short positions, use derivatives and
invest in illiquid assets
ª Typically use prime brokers who provide multiple services such
as custodial, administrative, money lending, securities lending
and trading
nT

ª Investors are limited partners and managers are general

partners
ª Hedge fund return objectives can be absolute (20%) or relative
(Benchmark + 5%)

Lockup period Time after initial investment during which withdrawals are not allowed

Notice period The amount of time a fund has to fulfill the redemption request after
Fi

receiving the request

Fund of funds An investment company that invests in hedge funds

Advantages Ÿ Gives investors diversification among hedge

fund strategies
Ÿ Helps smaller investors to invest in hedge funds

Disadvantage Ÿ They charge an additional layer of management fees

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Hedge fund strategies

Event-driven

Merger Distressed/ Activist Special

arbitrage restructuring shareholder situations

Buy shares of the
firm being acquired
Sell short shares of
the acquirer
Invest in securities of
Buy shares of firms Buy sufficient equity firms that are
in financial distress shares to influence a issuing/repurchasing
company’s policies with securities, spinning off
Short overvalued the goal of increasing divisions, selling
securities company value assets, or distributing
capital

These strategies are based on a corporate restructuring or acquisition that creates

profit opportunities for long or short positions in securities of a specific corporation

Relative value

Convertible
arbitrage fixed
income
Asset-backed
fixed income income
e
General fixed
Volatility Multi-strategy
re
Exploit pricing
discrepancies
arising from
differences Exploit pricing
Exploit pricing between returns discrepancies
discrepancies Exploit pricing volatility implied among securities
between Exploit pricing discrepancies by options prices in asset classes
convertible discrepancies between fixed and manager different from
nT

bonds among various income expectations of those previously

common stock MBS or ABS securities of future volatility listed and across
of the issuing various types asset classes and
company If markets
Implied volatility >
Expected volatility
= Overvalued
Fi

These strategies involve buying a security and selling short a related security with
the goal of profiting when one thinks there is a pricing discrepancy between the two

Macro strategies These are based on global economic trends and events and may involve
long or short positions in equities, fixed income, currencies or commodities
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Equity hedge fund

Market Fundamental Fundamental Quantitative

Short bias
neutral growth value directional

Use technical/
fundamental Use fundamental
analysis to analysis to find Mostly use short
short overvalued high growth positions in
shares and buy companies. Buy undervalued Buy undervalued overvalued
undervalued Identify and buy shares based on shares and short shares, with
shares in shares of fundamental overvalued smaller long
approximately companies that analysis. It is shares based on positions, but
equal amounts to are expected to the hedge fund technical analysis with negative
profit from their sustain relatively structure market exposure
relative price high rates of overall
movements capital
without exposure appreciation
to market risk

2 Private equity

Leveraged
buyout funds
Venture
capital funds e Distressed
investment
funds
Developmental
capital funds
re
Existing
Management management
buyouts team is involved
in the purchase

External
Management management
nT

buyins team replaces

existing team

Venture capital funds Ÿ Investment is often in the form of equity but can be in convertible
preferred shares or convertible debt

Ÿ The companies in which a venture capital fund is invested are

referred to as its portfolio companies
Fi

Ÿ Venture capital fund managers often sit on their boards or fill key
management roles of portfolio companies
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Various stages at which venture capital investment is made

Formative stage ª Investments made during firm’s earliest period

ª comprised of three phases

Angel investing Ÿ Investments made very early (“idea” stage)

Ÿ funds are used for business plans and assessing market
potential
Ÿ funding source is usually individuals (“angels”) rather
than venture capital funds

Seed stage Ÿ Investments made for product development, marketing

and market research
Ÿ This is the stage where VC funds make initial investments,
through ordinary or convertible preferred shares

Early stage Ÿ Investments made to fund initial commercial production

and sales

Later stage ª Funds provided at this stage are typically used for
expansion of production and/or increasing sales
though an expanded marketing campaign

Mezzanine-stage ª Capital provided to prepare the firm for an IPO

financing

e
Mezzanine financing means debt or preferred stock that are subordinate to the high-yield bonds and carry
warrants or conversion features that give investors participation in equity when value increases
re
Developmental capital Distressed investing

Ÿ It refers to buying debt of mature

companies that are experiencing
Ÿ Known as minority equity investing
financial difficulties
Ÿ Refers to the provision of capital for
nT

Ÿ Investors in distressed debt take

business growth or restructuring
active role in working with
management on reorganizing or
Ÿ When public companies are
determining the direction the
financed with such funds, it is
company should take
referred to as private investment in
public equities (PIPEs)
Ÿ They are sometimes referred to as
vulture investors
Fi

Private equity structure and fees

ª They are typically structured as limited partnerships

ª Committed capital is the amount of capital provided to the fund by investors

ª It is typically not invested all at once but is “drawn down” (invested) as

securities are identified and added to the portfolio
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ª Drawdown period - Typically 3 - 5 years

ª Management fees - Typically 1% - 3%

ª Clawback provision - It requires the manager to return any periodic incentive

fees to investors if investors receive less than 80% of the profits generated by
portfolio investments as a whole

Private equity exit strategies

Ÿ Trade sale - Sell a portfolio company to a competitor or another strategic buyer

Ÿ IPO - Sell all or some shares of the company to the public

Ÿ Recapitalization - Company issues debt to fund a dividend distribution to equity

holders (the fund). This is not an exit, but is often a step toward an exit

Ÿ Secondary sale - Sell a portfolio company to another private equity firm or a

group of investors. Most prferred strategy

Ÿ Write-off/liquidation - Reassess and bear the losses from an unsuccessful

outcome

Potential benefits and risks of private equity

e
ª Private equity has less than one correlation with traditional investments. Therefore
there may be benefits of diversification from including private equity in portfolios

ª Standard deviation of private equity returns has been higher than the standard
re
deviation of equity index returns, which suggests greater risk

ª Choosing skilled fund managers is important

3 Real estate
nT

Residential Commercial
Mortgages
property property

Single-family Produces
Whole loans
homes income

Direct investment in real

Fi

estate
These properties generate
Can be cash investment
or leveraged investment
(property purchased with
a mortgage)
Lenders often sell their
mortgages. They are later
securitized and traded as
Mortgage Backed
Securities (MBS)
These are also considered
income from rents
a direct investment in real
estate
Long time horizons,
illiquidity, Large size of
Loans can be pooled into
investment and their
Commercial Mortgage
complexity make
Backed Securities (CMBS)
commercial properties
that represent an indirect
inappropriate for many
investment
investors
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Real Estate Investment Trusts (REITs) ª They issue shares that trade publicly like shares of stock
(liquid)
ª They can hold mortgages, hotel properties, malls, office
buildings, or other commercial property
ª Income is used to pay dividends (tax exempt)

Other real estate assets

Timberland
Returns come from sales of
timber
Returns also include price
changes on timberland
Farmland
Returns come from sales of
agricultural products
Returns are also based on land
price changes, changes in farm
commodity prices, and the
quality and quantity of the
crops produced

Potential benefits and risks of real estate

ª Real estate performance is measured by three indices

ª Appraisal index - It is based on periodic estimates of property values

ª
ª

e
Appraisal index returns have lowest standard deviation of other index methods

Repeat sales index - It is based on price changes for properties that have sold multiple times

ª REIT indices - are based on the actual trading prices of REIT shares
re
ª REIT index returns and global equity returns have strong correlation (business cycles affect
REITs and global equities similarly)

ª REIT index returns and global bond returns have low correlation

4 Commodities
nT

Equities Managed Individual Specialized

Commodity
directly linked futures funds managed funds in
ETFs
to commodity accounts specific sectors

Actively managed
Fi

Investment in
Suitable for shares of Some managers
investors who are commodity It is an
concentrate on
limited to buying producing firm alternative to Can be organized
specific sectors
equity shares pooled funds for under any of the
while others are
Drawback - Price HNIs structures
more diversified
They invest in movement of the
commodities or stock may not be Accounts are Focus on specific
They can be
commodity perfectly tailored to the commodities
structured as
futures correlated with needs of investors
limited
price movements partnerships or
of the commodity mutual funds
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Potential benefits and risks of commodities
ª Returns on commodities < returns on stocks/bonds

ª Sharpe ratio for commodities is low because of lower returns and

high standard deviation

ª Commodity prices tend to move with inflation rates, therefore

holding commodities can act as a hedge against inflation

Commodity prices and investments

ª Spot prices for commodities are a function of supply and demand

ª Global economics, production costs and storage costs, along with

value to user, all factor into prices

5 Infrastructure

Transportation
Utility assets Communications Social
assets

Roads, airports,
ports and
Electric
generation and
distribution,
eBroadcast assets
and cable
Prisons,
schools,
re
systems etc. health care
railways etc. waste disposal
facilities etc.
etc.

Brownfield investments - Investments in infrastructure assets that are already constructed

Provides stable cash flows and relatively high yields, but offers Old
nT

little potential for growth

Greenfield investments - Investments in infrastructure assets that are to be constructed

Involves uncertainty and may provide relatively lower yields, but New
offers greater growth potential

Other alternative investments

Fi

Various types of tangible collectibles such as rare wines, art, rare

coins and stamps, valuable jewelry and watches, and sports memorabilia
are considered investments

LOS e Management and incentive fees

Most common fee 2% = Management fee

2 and 20 (2/20)
structure for a hedge fund 20% = Incentive fee

Management fee is paid irrespective of investment performance

Incentive fee is paid as a percentage of profits
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Hurdle rates
Eg. #1 Opening value = 100 Closing value = 140 Hurdle rate = 12% Incentive fee = 20%

Opening value = 100 Closing value = 140

Profit = 40

Hard hurdle rate Soft hurdle rate

Profit 40 Profit 40
Hard hurdle 12 Soft hurdle -

28 40

Incentive fee Incentive fee

(20%) 5.6 (20%) 8

Eg. #2 Hedge fund opening value = $150 mln Fee structure = 2/20 Hard hurdle rate = 5%
Ending value (Year 1) = $175 mln Ending value (Year 2) = $180 mln
Incentive fees are calculated net of management fees

Year 1 e
Calculate total fees and investor’s net return

Year 2
re
Management fees = $150 mln × 2% = $3 mln Management fees = $169.1 mln × 2% = $3.382 mln

Incentive fees Incentive fees

= [$175 mln − $150 mln − 3 − ($150 = [$180 mln − $169.1 mln − 3.382 −
mln × 5%)] × 20% = $2.9 mln ($169.1 mln × 5%)] × 20% = $0

Total fees = $3 mln + $2.9 mln = $5.9 mln Total fees = $3.382 mln

Ending value net of fees Ending value net of fees

nT

= $175 mln − $5.9 mln = $169.1 mln = $180 mln − $3.382 mln = $176.618 mln

Investor’s net return Investor’s net return

= ($168.9 mln/$150 mln) − 1 = 12.73% = ($176.618 mln/$169.1 mln) − 1 = 4.44%

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

High water mark

Incentive fee = 150 - 130
Fi

= 20 x 20% = 4
t3 = 150

t1 = 130

t0 = 100

t2 = 80
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LOS f Issues in valuing alternative investments
Hedge fund valuation
Accounting NAV > Trading NAV
Trading NAV tends to be lower because it considers liquidity of portfolio

Private equity company valuation

Market/comparables Discounted cash Asset-based
approach flow approach approach

Transaction values of
similar companies may Dividend discount
be used to estimate model and Free Cash Liquidation values or
EBITDA, net income or Flow to the Firm (FCFF) fair market values of
revenue to use in come under this assets are used
estimating the portfolio category
company’s value

Real estate valuation

Comparable sales
Income approach Cost approach
approach

Valuation based on
recent sales of similar
properties
e
Net operating income
Capitalization rate
Replacement cost of a
property is estimated
re
Commodity valuation
Contango - Future price > Spot price
Backwardation - Future price < Spot price

Change in spot
Roll yield Collateral yield
prices
nT

Yield due to a Total price return is a

difference between the combination of the
spot price and futures change in spot prices
Interest earned on
price and the convergence of
collateral
futures prices to spot
Backwardation - +ve prices over the term of
Contango - -ve the futures contract
Fi

LOS g Risk management of alternative investments

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

ª Therefore standard deviation may not be a correct measure of risk. Recommended

measure - VaR or Sortino ratio

ª Use of derivatives introduces operational, financial, counterparty, and liquidity risk

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Due diligence

Hedge fund Private equity

ª Investment strategy
ª Investment process ª Because of the high leverage used for
ª Investment process private equity funds, investors should
ªSource of competitive advantages consider how interest rates and the
ª Historical returns availability of capital may affect any
ª Valuation and returns calculation methods required refinancing of portfolio
ª Longevity company debt
ª Amount of assets under management
ª Management style ª The choice of manager (general partner)
ª Key person risk is quite important, his operating and
ª Reputation financial experience, valuation methods
ª Growth plans used, incentive fee structures, drawdown
ª Systems for risk management procedures are also important factors
ª Appropriateness of benchmarks

Real estate Alternative investments

ª Property values fluctuate because of

global and national economic factors, local ª Organization
market conditions, and interest rate levels

ª The degree of leverage used in real

estate investment is important because e ª
ª Portfolio management

Operations and controls

re
leverage amplifies losses as well as gains
ª Risk management
ª Real estate development has additional
risks such as regulatory issues like zoning ª Legal review
and permitting, environmental
considerations or remediation, and ª Fund terms
economic changes and financing decisions
over development period
nT
Fi