JuiceNotes TM - By FinTree eBook 10 Alternative Investments CFA® Level JuiceNotesTM 2017 © 2017 FinTree Education Pvt Ltd., All rights reserved FinTree Education Pvt Ltd Yashwant Ghadge Nagar Road, Yashwant Smruti, Building 5, 2nd Floor, Pune, India - 411007 Contact Information Mobile - +91- 8888077722 Email - admin@fintreeindia.com Website - https://www.fintreeindia.com/ Disclaimer: CFA Institute does not endorse, promote, review, or warrant the accuracy or quality of the products or services offered by FinTree Education Private Limited CFA Institute and CFA® are trademarks owned by CFA Institute Introduction to Alternative Investments https://www.fintreeindia.com/ LOS a © 2017 FinTree Education Pvt Ltd Comparison of alternative investments with traditional investments Compared to traditional investments, alternative investments are LOS b ª ª ª ª ª Less liquid More specialized by managers Less regulated and transparent More problematic and have less available historical data Different legal issues and tax treatments Categories of alternative investments 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 Private equity funds Venture capital funds Residential properties Invest in companies at their early stages in life Commercial properties e Leveraged buyout funds Real estate Use borrowed money to purchase equity in established companies Full or leveraged ownership nT Most prevalent Commodities derivatives Fi Physical commodities Commodities Buying gold/silver coins or bars, grains etc Buying/short selling futures of copper, entering into a forward contract for potato etc Real estate backed debt Real estate backed loans, securities backed by pools of properties or mortgages and limited partnerships re Infrastructure Equity Economic infrastructure Social infrastructure Investing in the equity of commodity producing firms Roads, airports, utility grids etc Schools, hospitals etc Problematic if the company itself hedges the exposure Other Includes investment in tangible collectibles such as stamps, antique furniture, art, fine wines as well as intangibles such as patents https://www.fintreeindia.com/ LOS c © 2017 FinTree Education Pvt Ltd 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 LOS d ª ª ª ª ª e Backfill bias refers to upward bias introduced by including the previous performance data for firms recently added to a benchmark index Hedge funds nT re Pools of investor funds that are not as regulated as mutual funds Limited in the number of investors Often sold only to qualified investors Minimum investments is quite high ($250k to $1m) 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 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 The amount of time a fund has to fulfill the redemption request after receiving the request Fi Notice period Time after initial investment during which withdrawals are not allowed 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 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Hedge fund strategies Event-driven Merger arbitrage Distressed/ restructuring Activist shareholder Special situations Buy shares of the firm being acquired Buy shares of firms in financial distress Sell short shares of the acquirer Short overvalued securities Buy sufficient equity shares to influence a company’s policies with the goal of increasing company value Invest in securities of firms that are issuing/repurchasing securities, spinning off divisions, selling 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 Asset-backed fixed income Exploit pricing discrepancies among various MBS or ABS Exploit pricing discrepancies between fixed income securities of various types Fi nT Exploit pricing discrepancies between convertible bonds common stock of the issuing company General fixed income re Convertible arbitrage fixed income e Relative value Volatility Exploit pricing discrepancies arising from differences between returns volatility implied by options prices and manager expectations of future volatility If Implied volatility > Expected volatility = Overvalued Multi-strategy Exploit pricing discrepancies among securities in asset classes different from those previously listed and across asset classes and markets 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 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Equity hedge fund Market neutral Fundamental growth Use technical/ fundamental analysis to short overvalued shares and buy undervalued shares in approximately equal amounts to profit from their relative price movements without exposure to market risk Use fundamental analysis to find high growth companies Identify and buy shares of companies that are expected to sustain relatively high rates of capital appreciation Buy undervalued shares based on fundamental analysis It is the hedge fund structure Private equity Existing management team is involved in the purchase Management buyins External management team replaces existing team Short bias Buy undervalued shares and short overvalued shares based on technical analysis Mostly use short positions in overvalued shares, with smaller long positions, but with negative market exposure overall Distressed investment funds Developmental capital funds nT Management buyouts Quantitative directional e Venture capital funds re Leveraged buyout funds Fundamental value Fi 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 Ÿ Venture capital fund managers often sit on their boards or fill key management roles of portfolio companies https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd 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 Later stage ª Funds provided at this stage are typically used for expansion of production and/or increasing sales though an expanded marketing campaign ª Capital provided to prepare the firm for an IPO e Mezzanine-stage financing Investments made to fund initial commercial production and sales re 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 Developmental capital Ÿ Known as minority equity investing nT Ÿ Refers to the provision of capital for business growth or restructuring Fi Ÿ When public companies are financed with such funds, it is referred to as private investment in public equities (PIPEs) Distressed investing Ÿ It refers to buying debt of mature companies that are experiencing financial difficulties Ÿ Investors in distressed debt take active role in working with management on reorganizing or determining the direction the company should take Ÿ They are sometimes referred to as vulture investors 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 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd ª Drawdown period - Typically - 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 e Potential benefits and risks of private equity ª Private equity has less than one correlation with traditional investments Therefore there may be benefits of diversification from including private equity in portfolios re ª Standard deviation of private equity returns has been higher than the standard deviation of equity index returns, which suggests greater risk ª Choosing skilled fund managers is important Real estate nT Residential property Commercial property Mortgages Single-family homes Produces income Whole loans Fi Direct investment in real estate 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 properties generate income from rents Long time horizons, illiquidity, Large size of 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 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd 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 Farmland Timberland Returns come from sales of timber Returns also include price changes on timberland 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 Repeat sales index - It is based on price changes for properties that have sold multiple times ª ª REIT indices - are based on the actual trading prices of REIT shares re ª ª Appraisal index - It is based on periodic estimates of property values Appraisal index returns have lowest standard deviation of other index methods e ª Real estate performance is measured by three indices 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 Commodities Equities directly linked to commodity Managed futures funds nT ª Fi Commodity ETFs Suitable for investors who are limited to buying equity shares They invest in commodities or commodity futures Investment in shares of commodity producing firm Drawback - Price movement of the stock may not be perfectly correlated with price movements of the commodity Individual managed accounts Specialized funds in specific sectors It is an alternative to pooled funds for HNIs Can be organized under any of the structures Actively managed Some managers concentrate on specific sectors while others are more diversified They can be structured as limited partnerships or mutual funds Accounts are tailored to the needs of investors Focus on specific commodities https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd 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 Infrastructure Utility assets Roads, airports, ports and railways etc Electric generation and distribution, waste disposal etc Brownfield investments - Communications Broadcast assets and cable systems etc re Transportation assets e Social Prisons, schools, health care facilities etc Investments in infrastructure assets that are already constructed nT Provides stable cash flows and relatively high yields, but offers little potential for growth Greenfield investments - Investments in infrastructure assets that are to be constructed Involves uncertainty and may provide relatively lower yields, but offers greater growth potential Fi Other alternative investments 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 Old Management and incentive fees Most common fee structure for a hedge fund and 20 (2/20) 2% = Management fee 20% = Incentive fee Management fee is paid irrespective of investment performance Incentive fee is paid as a percentage of profits New https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd 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 Hard hurdle 12 Soft hurdle 28 Incentive fee (20%) 5.6 40 40 Incentive fee (20%) 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 e Incentive fees are calculated net of management fees Calculate total fees and investor’s net return re Year Year Management fees = $169.1 mln × 2% = $3.382 mln Incentive fees = [$175 mln − $150 mln − − ($150 mln × 5%)] × 20% = $2.9 mln Incentive fees = [$180 mln − $169.1 mln − 3.382 − ($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 = $175 mln − $5.9 mln = $169.1 mln Ending value net of fees = $180 mln − $3.382 mln = $176.618 mln nT Management fees = $150 mln × 2% = $3 mln Investor’s net return = ($168.9 mln/$150 mln) − = 12.73% Investor’s net return = ($176.618 mln/$169.1 mln) − = 4.44% Fi In year 2, incentive fee = because return did not exceed hurdle rate High water mark Incentive fee = 150 - 130 = 20 x 20% = t3 = 150 t1 = 130 t0 = 100 t2 = 80 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd 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 approach Discounted cash flow approach Asset-based approach Transaction values of similar companies may be used to estimate EBITDA, net income or revenue to use in estimating the portfolio company’s value Dividend discount model and Free Cash Flow to the Firm (FCFF) come under this category Liquidation values or fair market values of assets are used Real estate valuation Income approach Valuation based on recent sales of similar properties Net operating income Capitalization rate re e Comparable sales approach Cost approach Replacement cost of a property is estimated Commodity valuation Contango - Future price > Spot price Backwardation - Future price < Spot price Collateral yield nT Roll yield Yield due to a difference between the spot price and futures price Total price return is a combination of the change in spot prices and the convergence of futures prices to spot prices over the term of the futures contract Fi Backwardation - +ve Contango - -ve Interest earned on collateral Change in spot prices LOS g ª Risk management of alternative investments 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 https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Due diligence Hedge fund Private equity ª Investment strategy ª Investment process ª Investment process Source of competitive advantages ª Historical returns ª Valuation and returns calculation methods ª Longevity ª Amount of assets under management ª Management style ª Key person risk ª Reputation ª Growth plans ª Systems for risk management ª Appropriateness of benchmarks ª ª ª Because of the high leverage used for private equity funds, investors should consider how interest rates and the availability of capital may affect any required refinancing of portfolio company debt The choice of manager (general partner) is quite important, his operating and financial experience, valuation methods used, incentive fee structures, drawdown procedures are also important factors Alternative investments ª Property values fluctuate because of global and national economic factors, local market conditions, and interest rate levels ª ª The degree of leverage used in real estate investment is important because leverage amplifies losses as well as gains re ª Real estate development has additional risks such as regulatory issues like zoning and permitting, environmental considerations or remediation, and economic changes and financing decisions over development period Fi nT ª Organization e Real estate ª Portfolio management Operations and controls ª Risk management ª ª Legal review Fund terms ... $17 5 mln − $5.9 mln = $16 9 .1 mln Ending value net of fees = $18 0 mln − $3.382 mln = $17 6. 618 mln nT Management fees = $15 0 mln × 2% = $3 mln Investor’s net return = ( $16 8.9 mln/ $15 0 mln) − = 12 .73%... https://www.fintreeindia.com/ © 2 017 FinTree Education Pvt Ltd Hurdle rates Eg #1 Opening value = 10 0 Closing value = 14 0 Hurdle rate = 12 % Incentive fee = 20% Opening value = 10 0 Closing value = 14 0 Profit = 40.. .Introduction to Alternative Investments https://www.fintreeindia.com/ LOS a © 2 017 FinTree Education Pvt Ltd Comparison of alternative investments with traditional investments Compared to traditional