Professional Documents
Culture Documents
FinQuiz - Curriculum Note, Study Session 17, Reading 50
FinQuiz - Curriculum Note, Study Session 17, Reading 50
FinQuiz Notes – 2 0 2 0
2. ALTERNATIVE INVESTMENTS
Alternative investments include: • The reported returns and S.D. of those returns
1) Alternative assets (i.e. real estate and commodities). represent average amount and thus may not
2) Alternative strategies (i.e. private equity funds, hedge appropriately represent risk and return of sub-periods
funds, and some exchange traded funds (ETFs). These within the reported period or future periods.
funds can • In addition, due to use of appraised values, the
volatility of returns and the correlations of returns with
traditional assets returns are underestimated.
• Use derivatives and leverage;
• Invest in illiquid assets;
• Take short positions; Assets under management in alternative investments
have increased over time; however, they still represent a
small % of total investable assets.
Such funds tend to have:
• Alpha return: Active investors assume that markets Limited Partnership is the most common structure for
are inefficient and provide opportunities to earn many alternative investments (i.e. hedge funds and
positive excess return after adjusting for beta risk. private equity funds). In partnerships,
The positive excess beta risk adjusted return is
referred to as alpha return. • Investors are referred to as limited partners (LPs). The
o For passive investors, expected alpha return = 0. LPs have fractional investment in the partnership.
o Theoretically, alpha returns are uncorrelated with • The fund is referred to as general partner (GP). The
beta returns. GP manages the business and has unlimited liability.
o Typically, alternative investments are actively Hence, to avoid unlimited liability, the GP is usually
managed with an objective to earn positive alpha set as a limited liability corporation.
return.
Features:
Basic Alpha-seeking strategies (these are not mutually
exclusive):
• Limited partnerships are not offered to general
1) Absolute return: Absolute return strategies seek to public. They are only offered to accredited investors
generate returns that are unrelated to the market and/or qualified purchasers i.e.
returns. Benchmarks used by such strategies include: o Accredited investors refer to individuals with at
least $1 million and institutions with at least $5
million in investable assets.
• Cash rate (i.e. LIBOR) o Qualified Purchasers refer to individuals with at
• Real return target (return in excess of inflation) least $5 million and institutions with at least $25
• Absolute, nominal return target (i.e. 7%) million in investable assets.
• Limited partnerships are not highly regulated.
Theoretically, beta of funds that use absolute return • Limited partnerships are located in tax-efficient
strategies should be close to 0. locations.
• Limited partnerships are generally offered to a
2) Market segmentation: Market segmentation refers to limited number of LPs i.e. accredited investors must
opportunity available to more flexible investors to be ≤ 100 or qualified purchasers must be ≤ 500.
quickly move capital from lower returns areas to
higher expected return areas when it is difficult to do Fee structure of Limited Partnerships:
so for restricted or conservative investors due to the
following reasons i.e. Management fee (or base fee) + Incentive fee (or
performance fee)
• Institutional, contractual, or regulatory restrictions on
traditional asset managers with regard to • Base fee is paid irrespective of performance of the
investments e.g. constraints regarding use of fund and is based on assets under management.
derivatives, investing in low quality or foreign • Incentive fee is based on realized profits. The
securities, managing portfolio relative to a particular incentive fee cannot be negative. So when a fund
market index etc. generates negative return, it implies a zero incentive
• Different investment objectives or liabilities. fee.
3. HEDGE FUNDS
Typical characteristics of Hedge funds: 6) They are subject to fewer regulations and thus have
the flexibility to invest in any assets.
1) They aggressively manage portfolio of investments.
2) They can take long and short positions.
3) They have the ability to use derivatives and leverage. • Side pocket: It refers to the flexibility provided to
4) They have the ability to use short selling. hedge funds that allows them to invest a specific %
5) They have absolute return objectives. of the assets under management (generally < 20%)
anywhere they feel.
Reading 50 Introduction to Alternative Investments FinQuiz.com
7) They impose restrictions on redemptions i.e. c) Diversification is a doubled-edged sword: Due to risk
diversification, both risk and expected return of FOF
• Lockup period: It refers to a minimum period before will be lowered relative to hedge funds. However, the
which investors are not allowed to withdraw their fees paid are considerably higher relative to hedge
money or redeem their shares from the hedge fund. funds.
Lock-up periods facilitate the hedge fund manager
to implement and potentially realize the expected NOTE:
outcomes of a strategy. Besides FOFs, there are some hedge funds that invest in
• Notice period: It refers to a number of days various hedge funds. Such funds are large, multi-strategy
(generally 30-90 days) before which investors are hedge funds.
required to give notice of their willingness to redeem.
Notice period facilitates the hedge fund manager to Hedge Fund Indices: The Hedge fund research indices
liquidate a position in an orderly fashion without (HRFI) include:
magnifying the losses.
a) HFRI Fund weighted composite index: It is an equally
8) Hedge funds tend to have low correlations with weighted performance index and is constructed
traditional investments. However, the correlation using self-reported data of over 2,000 individual funds
between hedge fund and stock market included in the hedge fund research (HFR) database.
performances may increase during periods of
financial crisis. • It suffers from self-reporting bias, survivorship bias and
9) Hedge funds are often referred to as “arbitrage” backfilling bias.
players as they seek to earn returns while hedging • Due to such biases, hedge fund indices may not
against risks. reflect actual average hedge fund performance but
rather reflect the performance of best performing
Fund of funds (FOFs): FOF invests in a number of hedge funds only.
underlying hedge funds (typically 10-30 hedge funds).
b) HFRI fund of funds index: It is an equally weighted
Benefits of Funds of Funds:
performance index of FOFs included in the HFR
a) Retailing: An FOF can facilitate smaller investors to get database.
exposure to a large number of hedge funds at
relatively lower costs. • It suffers from self-reporting bias.
b) Access: FOF provide individual investors an easy • It may exhibit lower reported returns due to two
access to successful hedge funds that are closed to layers of fees.
individual investors because funds have reached • Nonetheless, it reflects the actual performance of
maximum number of investors. portfolios of hedge funds.
c) Diversification: FOF facilitate diversification across
various hedge fund managers, fund strategies,
Biases in Hedge Funds Performance Data: Due to biases
investment regions and management styles.
in hedge funds historical performance data, the
d) Expertise: FOF provide investors the expertise of the
performance of the hedge fund index is biased upward
managers regarding selecting hedge funds and
(i.e. overestimated) and provides misleading results.
providing professional management.
e) Due diligence process: The due diligence process of
A. Survivorship bias: Hedge fund indexes and databases
investing in hedge funds is a highly specialized and
may include only successful funds (i.e. funds that have
time consuming process. FOF facilitate investors to
survived) whereas funds with poor performance may
shorten the due diligence process to a single
disappear and are removed from the database and
manager.
the past index values are adjusted accordingly. This
f) Better redemption terms: FOFs are able to negotiate
results in overestimated historical returns.
better redemption terms (e.g. a shorter lock-up period
B. Backfilling bias: When a new hedge fund is included
and/or notice period) relative to investors.
in a database, its past performance is (included)
back-filled in the index. Since high-performing funds
FOFs money is considered as “fast” money by hedge
are more likely to be added to an index, it results in
fund managers because managers of FOFs have the 1st
overestimation of good results.
right to redeem their money when hedge funds start to
generate poor returns and have the ability to negotiate
more favorable redemption terms. 3.1 Hedge Fund Strategies (3.1.1 – 3.1.4)
• This strategy involves “bottom-up” analysis (i.e. by buying convertible debt securities and
company level analysis followed by industry analysis simultaneously selling the same issuer’s common
followed by global macro analysis). stock. These strategies are considered as market
• This strategy takes long and short positions in neutral i.e. have zero beta.
common and preferred stocks, as well as debt b) Fixed income asset backed: These strategies involve
securities and options. exploiting mispricing in the asset-backed securities
(ABS) and mortgage-backed securities (MBS).
c) Fixed income general: It involves identifying
Categories of Equity-driven funds include:
overvalued and undervalued fixed-income securities
a) Distressed/Restructuring: These funds invest in the on the basis of expectations of changes in the term
debt or equity of companies experiencing financial or structure of interest rates or credit quality of the
operational difficulty. This strategy involves buying various related issues or market sectors. Due to
fixed income securities trading at a significant combination of long and short positions, they are
discount to par due to distressed situations and market neutral.
subsequently selling them at a higher price to d) Volatility: These strategies involve taking long or short
generate profit. positions in the market volatility either in a specific
asset class or across asset classes.
• Complicated form of such strategies may involve e) Multi-strategy: These strategies employ relative value
buying senior debt and taking short position in junior strategies within and across various asset classes or
debt or buying preferred stock and shorting instruments.
common stock to generate profits from widening of
spread between the securities. 3) Macro: This strategy focuses on “top-down” analysis
• In addition, such strategies may take short position in (i.e. global macro analysis followed by industry analysis
the companies, which are expected to followed by company analysis). It seeks to exploit
underperform in the short-term. However, if the systematic moves in major financial and non-financial
company’s prospects improve, loss occurs. markets through trading in interest rates, currencies,
futures and option contracts, commodities or may take
major positions in traditional equity and bond markets.
b) Merger arbitrage: These funds seek to generate
returns from corporate merger and takeover activity
4) Equity hedge: It involves identifying overvalued and
and attempts to exploit the price spread between
undervalued publicly traded equity securities and taking
current market prices of corporate securities and their
long and short positions in equity and equity derivative
value after successful completion of a takeover,
securities. However, portfolios are not structured as
merger, spin-off etc.
market neutral and may be concentrated i.e. may have
a net long exposure to the equity market. These
• Under these funds, the manager buys the stock of a strategies use “bottom-up” approach.
target company after a merger announcement and
takes a short position in the acquiring company’s Categories of Equity Hedge:
stock with an anticipation of overpayment by an
acquirer for acquiring the target company and the a) Market neutral: It involves taking long position in
subsequent increase in debt burden. perceived undervalued securities and short position in
• It suffers from risk that the announced merger or perceived overvalued equities and neutralizing the
acquisition does not occur and the hedge fund may portfolio’s exposure to market risk (i.e. beta = 0) by
not close its position on a timely basis. combination of long and short positions with roughly
equal $ exposure (i.e. dollar neutrality) and equal
sensitivity to the related market or sector factors (i.e.
c) Activist: It refers to an “activist shareholder”. It involves
beta neutrality).It employs quantitative (technical)
buying sufficient equity with an attempt to have
and/or fundamental analysis.
control on the company (have influence on a
b) Fundamental growth: These strategies take long
company’s policies or direction e.g. divestitures,
positions in companies that are expected to have
restructuring, capital distributions to shareholders,
high growth and capital appreciation. They use
and/or changes in management and company
fundamental analysis to identify such companies.
strategy). In contrast to private equity, activist hedge
c) Fundamental value: These strategies seek to identify
funds operate in the public equity market.
undervalued companies by using fundamental
d) Special situations: These strategies invest in the equity
analysis and take long positions in those companies.
of companies that are currently engaged in
d) Quantitative directional: These strategies use
restructuring activities other than merger/acquisitions
technical analysis to identify under and over valued
and bankruptcy e.g. security issuance/repurchase,
companies using fundamental analysis. It involves
special capital distributions and asset sales/spin-offs.
taking long positions in undervalued securities and
short positions in overvalued securities. The hedge
2) Relative value: They seek to profit from mispricing in
fund typically varies with regard to levels of net long
related securities. These strategies include:
or short exposure depending upon the anticipated
direction of the market and stage in the market cycle.
a) Fixed income convertible arbitrage: This strategy
involves exploiting mispricing in convertible securities
Reading 50 Introduction to Alternative Investments FinQuiz.com
e) Short bias: These strategies use quantitative A. Fee in the 1st year: When incentive fee is independent
(technical) and/or fundamental analysis to identify of management fee
overvalued equity securities and take short positions in
Value of fund at the end of 1st year = $100 million (1.25)
those overvalued securities. The net short exposure of
= $125 million
the fund depends on market expectations i.e., during
Management fee = $125 million (2%)
declining markets, the fund may take full short
= $2.5 million
positions.
Incentive fee = ($125 million– $100 million) (20%)
f) Sector specific: These strategies use quantitative
= $5 million
(technical) and/or fundamental analysis to identify
Total fees = $2.5 million + $5
outperforming sectors.
= $7.5 million
Investor return = ($125 – $100 – $7.5) / $100
3.3.1) Fees and Returns
= 17.50%
The return to an investor in a fund is not the same as the
return to the fund due to fees paid to the fund. Hedge B. Fee in the 1st year: When incentive fee is NOT
fund indices generally report performance net of fees. independent of management fee
Management fee = $125 million (2%)
• A common fee structure in the hedge fund market is = $2.5 million
“2 and 20” which reflects a 2% management fee Incentive fee = ($125 million– $100 million– $2.5 million)
and a 20% incentive fee. However, different classes (20%)
of investors may have different fee structures. = $4.5 million
• A common fee structure in the FOFs is “1 and 10” Total fees = $2.5 million + $4.5
which reflects a 1% management fee and a 10% = $7 million
incentive fee. Investor return = ($125– $100 – $7) / $100
• The incentive fees may be calculated net of = 18%
management fees or before management fees (i.e.
independent of management fees). C. Fee in the 1st year: When incentive fee is NOT
• Hurdle rate provision: Under this provision, incentive independent of management fee and hurdle rate is
fee is paid only when the fund generates a specified 3%
return, called hurdle rate. Hurdle rate can be
specified as an absolute, nominal, or real return Hurdle rate = 3% ($100 million)
target. = $3 million
Management fee = $125 million (2%)
= $2.5 million
Types of Hurdle Rate:
Incentive fee = ($125– $100 –$3–$2.5 million) (20%)
a) Hard hurdle rate: When incentive fees can be paid = $3.90 million
only on returns in excess of the hurdle rate, it is Total fees = $2.5 million + $3.9 million
referred to as hard hurdle rate. = $6.4 million
b) Soft hurdle rate: When incentive fees can be paid on Investor return = ($125– $100 – $6.4) / $100
entire returns, it is referred to as soft hurdle rate. = 18.60%
• High water mark provision (HWM): According to high D. Fee in the 2nd year with High-water mark provision:
water mark provision, once the first incentive fee has Management fee = $115 million (2%)
been paid, the highest month end net asset value = $2.3 million
(NAV), net of fees establishes a high water mark i.e. Incentive fee = 0 à because the fund has declined in
no incentive fee is paid until the fund’s NAV>HWM. It value.
helps to protect clients from paying twice for the Total fees = $2.3 million
same performance. Beginning capital in the 2nd year for the investor =
• Hedge fund fees depend on various factors i.e. Value of fund at the end of 1st year – Total Fees in the 1st
supply and demand, historical performance and the year (independent of management fee) = $125 – $7.5
lockup period i.e. the longer investors agree to keep million = $117.5 million
their money in the hedge fund, the lower the fees. Ending capital at the end of the 2nd year = $115 – $2.3
million
Example: = $112.7 million
Investor return = ($115 – $2.3 – $117.5) / $117.5
• Initial investment capital = $100 million = –4.085%
• Management fee = 2% è based on assets under
management at year-end. E. Fee in the 3rd year with High-water mark provision:
• Incentive fee = 20% Management fee = $130 million (2%) = $2.6 million
• The return earned in the 1st year = 25% Incentive fee = ($130 million – $117.5 million) (20%)
• Value of fund at the end of 2nd year = $115 million = $2.5 million
• Value of fund at the end of 3rd year = $130 million
• Hurdle rate = 3%
• $117.5 million represents the high-water mark
Reading 50 Introduction to Alternative Investments FinQuiz.com
Calculations:
iv. Hedge fund can sell puts on a 1000 shares of
Profit of hedge fund before fees = $100 million × (15%) Company A.
= $15 million
Management fee = $100 million × 2% • Maximum profit to the Short Put is option premium
= $2 million received.
Incentive fee = $15 million × 20% • If price fall, potential loss is extremely large for the
= $3 million
Reading 50 Introduction to Alternative Investments FinQuiz.com
• The smaller (greater) the margin requirement, the 1. Trading NAV: It represents NAV adjusted for liquidity
more (less) leverage is available to the hedge fund. discounts based on the size of the position held
• When the margin account declines below a certain relative to the total amount outstanding in the issue
level à hedge fund receives “margin call” from the and its trading volume.
broker (lender) to deposit more collateral.
• Margin calls may increase losses when the hedge 2. Reporting NAV: It represents NAV based on quoted
fund closes its losing position at unfavorable prices. market price; it does not incorporate liquidity
discounts.
Redemptions: When investors decide to exit the fund or
redeem some portion of their shares, it is referred to as
redemption. Redemptions frequently occur during poor
Practice: Example 5,
performance of hedge funds i.e. when net asset value
Volume 6, Reading 50.
starts to fall.
• Investment strategy
• Investment process
Practice: Example 4, • Competitive advantage
Volume 6, Reading 50. • Track record: Mostly, hedge funds are required to
have track record of at least 2 years. The longer the
track record period requirement, the more difficult it
is for hedge funds to raise capital.
3.4 Hedge Fund Valuation Issues • Size and longevity: The older the fund, the better it is
because it reflects that the fund has experienced
Generally, hedge funds are valued on a daily, weekly, lower losses and higher growth in assets under
monthly and/or quarterly basis using either market values management via both capital appreciation and
or estimated values of underlying positions when reliable additional investments (capital injections).
market values are not available (e.g. for illiquid or non- o The minimum hedge fund size the investor can
traded investments). consider depends on the minimum size of the
investments by investors and their investment’s
Different prices or quotes are available in the market: maximum % of a fund e.g. if an investor’s minimum
investment size is $15 million and the investor’s
maximum % of a fund is 8.5%, then
• Bid price
The minimum hedge fund size the investor can
• Ask price
consider = $15 million / 0.085 = $176.47 million
• Average quote i.e. [(bid + ask)] / 2: It is most
• Management style
commonly used.
• Markets in which the hedge fund invests
• Median quote
• Hedge fund benchmarks
• How returns are calculated and reported
• Key-person risk
• Reputation
• Investor relations
Reading 50 Introduction to Alternative Investments FinQuiz.com
4. PRIVATE EQUITY
• Form of financing used during Formative-stage: • Distressed investing involves buying the debt of a
Typically, ordinary or convertible preferred shares are financially distressed company at discounted price
issued to the VC fund while the company is (i.e. < face value of the debt).
controlled by the company’s management. • The turnaround equity investors actively manage the
company and restructure the company either
2) Early stage financing: In this stage, capital is provided operationally or financially to increase the value of
to support operations of companies before debt.
commercialization and sales of product. • Besides equity investors, debt investors (known as
“vulture investors”) may also play an active role in
the management or in the reorganization of the
• Start-up financing refers to the capital provided to
company. It must be stressed that distressed debt
commercialize the product or idea and to support
investors have a prior claim on the company assets.
product development and initial marketing.
• Some distressed investors are passive investors.
• First-stage financing is capital provided to initiate
commercial manufacturing and sales.
4.1 Private Equity Structure and Fees
B. Later-stage financing is provided to companies who
need funds to expand sales. It includes: Like hedge funds, institutional and individual investors
can invest in private equity through limited partnerships
• Second-stage financing is the capital provided for which is known as Fund.
initial expansion of a company already producing
and selling a product i.e. revenue has started but • Outside investors are known as Limited partners (LPs).
may not be yet profitable. • The private equity firm, which manages a number of
• Third-stage financing is capital provided for major funds, is known as the General partner (GP).
expansion i.e. physical plant expansion, product
improvement, or a major marketing campaign.
Fee Structure: Management fee + Incentive fee
• Mezzanine (bridge) financing is capital provided to
prepare for an IPO. It represents the bridge between
the expanding company and the IPO. • Generally, management fees range from 1-3% of
• Form of financing used during Later-stage: Typically, “Committed Capital” (not invested capital), until the
equity and debt (including convertible bonds or committed capital is fully drawn and invested.
convertible preferred shares) are issued to the VC • Committed capital: It represents the amount that the
fund while the control of the company is handed LPs have agreed to provide to the private equity
over to the VC fund. fund. The committed capital is drawdown by the
fund over 3-5 years.
• Once the committed capital is fully invested,
NOTE:
management fees are based only on the funds
remaining in the investment.
• Debt financing is used to have control over • As investors exit from the fund, capital is paid back
company’s assets and to recover them during to them and they are no more required to pay fees
bankruptcy. It is considered as a more secured on that portion of their investment.
financing for VC funds than equity financing. • Commonly, the incentive fees represent 20% of the
• Due to lack of operational and financial total profit of the private equity fund and are not
performance history and performance data, it is paid to the GP fee until the initial investment has
more difficult for VC funds (investors) to estimate been received back by the LPs. The incentive fee
value of such companies compared to LBOs, which may also be calculated on a deal-by-deal basis.
invest in mature, underperforming public companies. Amount received by the LPs = 80% of the total profit
of the equity fund +
C. Development capital: It involves minority equity Return of their initial
investments in more mature (typically private) investment
companies that need capital to expand or restructure • When distributions are made based on profits
operations, enter new markets or finance major earned over time, the GP may receive more than
acquisitions. 20% of the total profit. However, to protect the LPs
interests, the fund may set up an escrow account for
• It is often used by management of the company. a part of incentive fees and/or may impose a claw-
• Sometimes, private equity capital is also used by back provision under which the GP is obligated to
publicly quoted companies. This strategy is referred return any funds distributed as incentive fees until the
to as PIPEs (private investment in public equities). LPs have received back their initial investment and
80% of the total profit.
D. Distressed investing: It involves investing in the debt of
operationally sound BUT financially distressed Besides management and incentive fees, LBOs firms
companies (companies that are bankrupt, in default, include other fees i.e. arrangement fee for the buyout of
or likely to default).
Reading 50 Introduction to Alternative Investments FinQuiz.com
a company, fee in case a deal fails, and arrangement Disadvantages of trade sale:
fee for divestitures of assets.
• Trade sales are not preferred by portfolio company’s
4.2.1.2 Characteristics of Attractive Target Companies employees and thus may face management
for LBOs opposition.
• Number of potential buyers is very limited.
a) Undervalued/depressed stock price: Private equity • Trade sales tend to receive lower price compared to
firms seek to buy undervalued or cheaply priced an IPO.
companies that are out of favor in the public markets.
b) Willing management: Existing management is willing
B. IPOs: In an IPO, the portfolio company initially issues
to exploit long-term growth opportunities but lack
some or all of the shares to public investors through an
capital needed to finance investments in new
IPO.
processes, personnel, equipment etc.
c) Inefficient companies: Private equity firms seek to buy
Benefits of an IPO:
inefficient companies and generate attractive returns
by restructuring and improving the operations of the
companies. • In an IPO, investors may receive the highest price.
d) Strong and sustainable cash flow: Companies with • IPOs also enjoy management approval because
strong cash flows are attractive for LBOs because company’s existing management is retained.
cash flows are used to make interest payments on the • IPOs are considered a source of publicity for the
debt associated with LBOs transactions. private equity firms.
e) Low leverage: Companies with low leverage are • IPOs facilitate private equity investors to retain future
attractive for private equity firms as it facilitates them upside potential by allowing them to remain a large
to use higher leverage to finance a substantial portion shareholder.
of the purchase price.
f) Assets: Companies with a significant amount of Disadvantages of an IPO:
physical assets are preferred by private equity firms
because physical assets can serve as collateral for • It involves high transaction costs e.g. fees paid to
debt and helps to reduce cost of debt as secured investment banks and lawyers
debt is cheaper than unsecured debt. • IPOs have long lead times.
• It is subject to stock market volatility risk.
4.2.4) Exit Strategies • It has high disclosure requirements.
Exit strategies are significantly important for private • An IPO imposes a lock-up period on private investors
equity investing because the ultimate goal for private as they are prohibited to sell an equity position for a
equity investors is to exit the fund at high valuations. specific period after the IPO.
• An IPO is more appropriate for larger companies
with attractive growth profiles.
• An average buy-and-hold period for private equity
investments is 5 years.
• The time to exit can range from less than 6 months to C. Write-offs: Write-offs refer to voluntary liquidations of a
over 10 years. portfolio company that may or may not generate any
• Selection of an optimal exit strategy depends on the proceeds.
dynamics of the industry of portfolio company,
overall economic cycles, interest rates, and D. Secondary sales: Under secondary sales, securities of
company performance. a private equity firm are sold to another private equity
firm or other group of investors.
The major types of exit strategies are as follows:
E. Recapitalization: In a recapitalization, the private
A. Trade Sales: In this type of exit strategy, the private equity firm pays itself dividends by using debt. It is not
firm is sold to a strategic buyer (i.e. competitor) for considered a true exit strategy because in
stocks, cash, or a combination of both either through recapitalization, the private equity firm retains
an auction process or by private negotiation. company’s control.
Benefits of a trade sale: The above exit strategies can be employed individually,
combined together, or used for a partial exit strategy.
• Facilitates a private equity fund to have an
immediate cash exit. Private Equity: Diversification Benefits,
4.3
• May receive high valuations from “willing and able” Performance, and Risk
strategic buyers who seek to capture anticipated
synergies. • Private equity funds may generate higher returns
• It is simple and quick to execute. relative to traditional investments due to use of high
• It incurs lower transaction costs relative to an IPO. leverage and by playing an active role in the
• It is relatively a highly confidential process and management and operations of the portfolio
involves less information disclosure. companies.
Reading 50 Introduction to Alternative Investments FinQuiz.com
• Private equity investments also have higher risks 3. Asset-based: Under asset-based approach, value of
(including market, illiquidity and leverage risks) than a private company is estimated as follows:
traditional investments.
• Private equity investments also provide diversification Value of a company = Value of a company’s assets
benefits because they have less than perfect – Value of a company’s liabilities
correlation with traditional investments.
• Private equity performance index (PEPI) is an index • This value reflects the value of the company to the
used to measure performance of private equity equity holders.
investments. However, it is not a reliable • Value of company’s assets and liabilities can be
performance measure because, like hedge fund estimated either using market (fair) values or
indices, private equity indices are subject to self- liquidation values.
reporting, survivorship, backfill, and other biases, • Values estimated using fair (market) values represent
resulting in overstated returns. In addition, such an orderly transaction.
investments are not marked-to-market on a regular • Values estimated using liquidation values represent a
basis which tends to underestimate volatility and distressed transaction when a business is terminated.
correlations with other investments. During weak economy, liquidation values tend to <
fair values due to fewer potential buyers.
5. REAL ESTATE
Real estate is a form of tangible and immoveable asset. Key Benefits of investing in real estate:
It includes buildings, building land, offices, industrial
warehouses, natural resources, timber, containers, • Provide attractive long-term returns through both
&artwork etc. Real estate property ownership is rental income and capital appreciation.
represented by a title which can be purchased, leased, • Due to multiple-year leases with fixed rents, some
sold, mortgaged, or transferred together or separately, in properties generate stable cash flows.
whole or in part. • Provide diversification due to less than perfect
correlation with traditional investments.
• May provide some inflation hedge when rents can
Reading 50 Introduction to Alternative Investments FinQuiz.com
G. Government regulation and local or regional market Public, equity-based real estate investments:
factors: Real estate properties are subject to
government regulations and depend on local or • Shares in real estate corporations
regional market factors rather than country-wide or • Shares in real estate investment trusts
global price movements.
Variations within the basic forms:
The aforementioned properties imply that private real
estate investments are suitable for investors with long- 1) Free and Clear Equity or Fee simple: It is a form of
term investment horizon and greater ability to tolerate direct ownership. It refers to an unlevered 100%
relatively lower liquidity. equity-financed investment in real estate i.e. simple
purchase of some real estate property without use of
5.1 Forms of Real Estate Investment borrowed funds.
tenants and to resell the property at will. • REITs are highly liquid and provide retail investors with
access to a diversified real estate property portfolio
2) Leveraged Equity: Leveraged Equity involves use of and professional management;
both equity and borrowed funds to purchase some • REITs can be used by investors with short investment
real estate property. horizons and higher liquidity needs;
• REITs have higher correlation with stocks and bonds
than direct ownership of real estate; hence, it does
• Initial purchase costs associated with direct
not provide the same diversification benefits as that
ownership include legal expenses, survey costs,
of private real estate.
engineering/environmental studies, valuation
• REITs are required to distribute at least 90% of their
(appraisal) fees, maintenance& refurbishment
taxable income to shareholders in the form of
charges, costs associated with property
dividends.
management and mortgage arrangement fees.
• REITs and partnerships involve investment
• Investors earn return in the form of appreciation
management fees based on either committed
(depreciation) of the value of the property + net
capital or invested capital and incentive fees.
operating income in excess of the debt servicing
Investment management fees typically range from
costs.
1-2% of capital per annum.
• Any appreciation (depreciation) in the value of the
home increases (decreases) the owner’s equity in
the home. 4) Mortgage-backed securities (MBS): MBSs represent
• In case borrower defaults, the owner has the right to investment in a diversified pool of mortgages i.e.
transfer ownership of the equity. each pool is divided into various tranches (with
• Leverage financing can be provided in the form of different payment characteristics) and sold to
mortgage loans, including whole loans or pool of investors.
mortgage loans (e.g. mortgage-backed securities).
• However, leverage magnifies both gains and losses. • These include residential mortgage-backed
Leverage increases the risk to both equity and debt securities (RMBS) and commercial mortgage-
investors. As the loan-to-value ratio increases, the risk backed securities (CMBS). See exhibit 12, Reading 50
increases. in curriculum.
• MBS may be issued privately or publicly.
Mortgages: Mortgages or mortgage loans represent a
type of secured debt investment in real estate in which
5.2 Real Estate Investment Categories
the real estate property serves as collateral. In this form
of investment, lenders (investors) earn return in the form
of net interest, net of mortgage servicing fees, a Categories of Real Estate Properties:
scheduled repayment of principal and excess principal 1. Residential properties: These include only owner-
repayments (called mortgage prepayments). occupied, single residences (single-family residential
property).
The due diligence process in a Mortgage loan involves:
2. Commercial properties (income-producing
• Identifying borrower’s equity investment in the properties): These include office, retail, industrial and
purchase of property (e.g. home). warehouse, and hospitality (e.g. hotels and motels)
• Evaluating creditworthiness of the borrower e.g. properties.
borrower’s ability to make the required payments on
the mortgage and to maintain the home etc. • Commercial properties investment is preferred by
• Estimating value of the property. institutional funds or high-net-worth individuals with
• Ensuring that the property (e.g. home) is adequately long time horizons and limited liquidity needs.
and appropriately insured. • Commercial properties may have mixed uses.
• Sources of income for commercial properties include
3) Pooled real estate investment vehicles: These rental income and capital appreciation.
investments include: • Value of commercial properties is affected by
factors including development strategies, market
a) Real estate limited partnerships (RELPs): In RELPs, conditions, and property-specific features.
investors (called limited partners) can participate in
real estate projects and have limited liability (i.e. to 3. Timberland: They refer to properties that are used to
the amount of initial investment). It is managed by the produce timber (wood) for industrial use purposes. It
general partners who are real estate experts. can function both as a factory and a warehouse.
b) Real estate investment trusts (REITs): REITs represent
shares of publicly-traded companies that buy and sell • Unlike crops production, timber can be grown and
real estate. It is a form of pooled real estate stored easily. As a result, harvesting of timber is more
investment and represent an indirect investment in flexible i.e. it can be increased during rising timber
real estate property. prices and postponed during falling timber prices.
Reading 50 Introduction to Alternative Investments FinQuiz.com
• Timberland does not have high correlation with • Primary source of revenue: Interest on mortgages.
traditional asset classes. 3. Hybrid REITs: Hybrid REITs own & operate income-
• Three primary Return Drivers: producing real estate properties and make loans as
i. Biological growth well.
ii. Commodity price changes
iii. Land price changes Real Estate Performance and Diversification
5.3
Benefits
4. Farmland: They refer to properties that are used to
produce crops or as pastureland for livestock. A real estate index can generally be categorized as
follows:
Major types of Farmland:
1) An appraisal index: These indices use appraised
1) Row crops that are planted and harvested annually.
values of individual real estate properties rather than
2) Permanent crops that grow on trees or vines.
their transaction prices to construct the indices.
Farmland tends to provide inflation hedge.
• The appraised values represent subjective values
Three primary Return Drivers: determined by experts.
i. Harvest quantities • These indices suffer from appraisal lag because
ii. Commodity price changes appraisals are done infrequently. As a result, they
iii. Land price changes underestimate volatility of returns and correlation
with other asset classes.
Farmland harvesting has less flexibility than timberland. • The National Council of Real Estate Investment
Fiduciaries (NCREIF) Property Index is a type of
Return components on farmland and timberland: appraisal-based index.
i. Capital appreciation (i.e. sale of the commodities);
ii. Income streams from leasing the land to another 2) A repeat sales (transactions-based) index: This index is
entity; based on repeat sales (i.e. more than once) of the
same property. For example, if the same property sold
NOTE: twice, then the difference in value between the two
sales dates indicate changes in market conditions
Residential properties are considered as commercial over time.
property when they are maintained as rental properties.
• The greater the number of repeat sales, the more
5.2.3) REIT Investing reliable and relevant is the index.
REITs are classified into three types: • These indices are subject to sample selection bias
because different properties may sell in each period
1. Equity REITs: Equity REITs are tax-advantaged entities and thus may not truly represent the subject
(companies or trusts) that generally hold, own, properties. In addition, they may be based on non-
operate, manage and develop commercial or random sample of properties e.g. the index may be
residential properties. They use leverage and are biased towards properties that have either
similar to direct equity investments in leveraged real increased or decreased in value.
estate.
3) REIT index: REIT indices use the prices of publicly
• Primary source of revenue: Rent income from traded shares of REITs to construct the indices.
properties.
• To qualify for tax-advantaged status, they are
required to distribute at least 90% of revenue • The more frequently the REITs shares are traded, the
(including rent and realized capital gains), net of more reliable is the index.
expenses, to shareholders in the form of dividends. In • However, the index does not necessarily represent
addition, they are required to report earnings per the properties of interest to the investor.
share based on net income as defined by GAAP • The National Association of Real Estate Investment
(like other public companies). Trusts (NAREIT) is a type of REIT index.
• Objective of equity REITs: Maximize income and • REIT indexes are more strongly correlated with the
dividends by maximizing property occupancy rates stock market than bonds and they reflect more
and rents. volatile performance than appraisal-based indices.
6. COMMODITIES
Commodities are physical products. Commodities o In swaps, one party agrees to make fixed
include: payments and in exchange receives floating
payments based on future commodity or
• Precious metals: Gold, silver, platinum commodity index prices.
• Base (industrial) metals: Copper, aluminum, zinc, • The prices of commodity derivatives largely depend
lead, tin, nickel on the underlying commodity prices.
• Energy products: Oil, natural gas, electricity, coal • Commodity derivatives can be used by investors
• Agricultural products: Grains, livestock, coffee (e.g. producers and consumers) for hedging
• Other: Carbon credits, freight, forest products purposes or by speculators (e.g. retail and
institutional investors, hedge funds) to capture profits
It is important to note that returns on commodity associated with changes or expected changes in
investments depend on changes in price rather than on the price of the underlying commodities.
income i.e. interest, dividends or rent.
c) Commodity Exchange traded funds (ETFs): ETFs
Types of Commodity Investment: provide indirect exposures to commodities. ETFs may
invest in commodities or commodities futures.
1) Direct Commodity Investment: It refers to cash (spot)
Commodity index-linked ETFs also exist.
market purchase of physical commodities. It is preferred
by investors that are part of the physical supply chain i.e.
producers of commodities, users of the commodities, • ETFs are appropriate for investors who are allowed to
and participants in between. invest in equity shares only.
• ETFs are easy to trade.
2) Indirect Commodity Investment: It refers to getting • ETFs may employ leverage.
indirect exposures to changes in spot market values of • ETFs involve management fees (like mutual funds or
commodities. Indirect investment in commodities can be unit trusts); however, the expense ratios of ETFs are
made in various ways, including lower than that of mutual funds.
general public can invest or like hedge funds where • Value to users
investment is restricted to high net worth and • Global economic conditions
institutional investors.
• Managed futures funds operating like mutual funds Supply of Commodities depend on:
provide retail investors with an access to the
professional management at low investment and
• Production levels
relatively high liquidity.
• Inventory levels
• Actions of non-hedging investors
B. Individual managed accounts: These funds are o Supply of commodities is difficult to adjust quickly
managed by selected professional money managers to the changes in demand levels due to long lead
who have expertise in commodities and futures. These times associated with production. As a result,
funds are offered to high net worth individuals or during strong (weak) economy, supply is too low
institutional investors. (high) than demand. This mismatch between
supply and demand results in greater price
C. Funds exist that specialize in specific commodity volatility.
sectors(e.g. private equity partnerships): Such funds o The cost of new supply also increases over time.
can be used to gain exposure to specific sector e.g.
energy sector. Like private equity funds, they charge
Demand for commodities depend on:
management fee (range from 1-3% of committed
capital) and have lockup period of 10 years (with
extensions of 1-2 years). • Needs of end users which depend on
o Global manufacturing dynamics
Commodity Performance and Diversification o Economic growth
6.3 o Government policy
Benefits
• Actions of non-hedging investors
Benefits of Commodities:
6.4.1) Pricing of Commodity Futures Contracts
• They provide potentially attractive returns. Futures price ≈ Spot price (1 +r) + Storage costs –
• They provide inflation hedge because inflation index Convenience yield
levels are determined by commodities prices e.g.
energy and food prices impact the cost of living for where, r = period’s short-term risk-free interest rate.
consumers.
• They provide diversification benefits as they have When Futures price ≠ the spot price compounded at the
low positive correlation with traditional assets i.e. risk-free rate è arbitrage opportunities exist i.e. if Futures
stocks and bonds. price >(<) the spot price compounded at the risk-free
• Commodity futures contracts may provide higher rate è an arbitrageur can sell (buy) futures contract
liquidity and opportunities to earn a positive real
and buy (sell) the commodity at spot price.
return.
Cost of carry: The combination of storage and interest
Risks: costs is sometimes referred to as “cost of carry” or “the
carry”.
• Leverage risk: Leveraged investment in commodities
has high volatility and results in higher risk. Convenience yield: It refers to nonmonetary benefits
• Counterparty risk associated with commodity from owning the spot commodity. Therefore, futures
derivatives contracts. price is adjusted for the loss of convenience. The value
NOTE: of convenience may vary over time and across users.
When inflation index levels are determined by • When there is little or no convenience yieldà futures
commodity prices, then on average, investment in prices are higher than the spot price à commodity
commodities tend to generate zero return over time. forward curve is upward sloping à this situation is
referred to as Contango.
Investors of commodities: Institutional investors including • When the convenience yield is highà futures prices
endowments, foundations, corporate and public are lower than the spot price à commodity forward
pension funds, and sovereign wealth funds. curve is downward sloping à this situation is referred
to as Backwardation.
6.4 Commodity Prices and Investments
Sources of return for Commodity futures contract: There
Commodity spot prices depend on: are three sources of return for each commodity futures
contract:
• Supply and demand
• Costs of production and storage
Reading 50 Introduction to Alternative Investments FinQuiz.com
1) Roll Return/ yield: Roll yield refers to the return that premiums.
can be earned by rolling long futures positions
forward through time.
2) Collateral yield: It is the return (i.e. risk-free interest
rate) earned on a fully margined/collateralized
Roll yield = Spot price of a commodity – Futures
position in a long futures contract (i.e. posting 100%
contract price
margin in the form of T-bills).
Or
3) Spot Return/Price Return: It refers to the change in
Roll yield = Futures contract price with expiration date
commodity futures prices that result from changes in
‘X’– Futures contract price with expiration
the underlying spot prices. It is calculated as change
date ‘Y’
in the spot price of the underlying commodity over a
specified time period.
• When the convenience yield is significantly higher
(and thus futures price < spot price), the futures
• The spot (or current) prices primarily depend on
contract price tends to roll up to the spot price as
current supply and demand.
the maturity date approaches, generating positive
roll yield. Opposite occurs when there is little or no
convenience yield. This concept is referred to as Returns on a passive investment in commodity futures =
“Theory of Storage”. Return on the collateral + Risk premium (i.e. hedging
• Hedging Pressure Hypothesis: According to this pressure hypothesis) or the convenience yield net of
theory, the difference between the spot and futures storage costs (i.e. theory of storage)
price depends on user preferences and risk
Following are some of the challenges of alternative contracts i.e., operational risk, financial risk,
investments due diligence: counterparty risk and liquidity risk.
• Limited historical risk and return data.
• Asymmetric risk and return profiles. As a result, • Lack of manager diversification.
traditional risk and return measures (i.e. mean return,
S.D. of returns, Sharpe ratio and beta) may not be 8.1.2) Risk Issues for Implementation
appropriate to use.
• Limited portfolio transparency. Historical returns and the S.D. of those returns may not
• Illiquidity and long time horizon (i.e. long-term reliably represent the returns and volatility of alternative
commitment required). investments because:
• “Complex” structures and investment strategies.
• Difficulty in valuations i.e. valuations based on • The reported correlations of alternative investments
appraised (estimated) values due to lack of with other investments may significantly differ from
observable prices and infrequent transactions. the actual correlations.
• Minimal regulatory oversight. • Past performance can be a poor predictor of future
• Risks associated with use of alternatives derivatives performance because:
Reading 50 Introduction to Alternative Investments FinQuiz.com