Private equity investors have several issues that complicate their analysis of private equity. Four such issues are illiquidity, parameter uncertainty, absence of an investible index, and cross-sectional differences in private equity managers.
a. Illiquidity.
Historical returns generally do not have built in any return premium required for illiquidity. Such a premium would reduce the effective return from private equity and make it less desirable. Adjusting for liquidity by reducing the expected return of PEQR by 1% per year, for instance, would reduce the recommended allocation to private equity in an efficient portfolio significantly
b. Parameter uncertainty.
Parameter uncertainty about estimates of risk and return is larger for private equity than for conventional assets, e.g., stocks and bonds. Estimates made based upon historical data may not indicate future performance.
c. Absence of an investible index.
No index is readily available for purchase, and access to some funds may be impossible.
Thus, investors in private equity are unlikely to be able to invest in assets with the properties of the indexes or the properties indicated by the private equity industry’s summary statistics.
d. Cross-sectional differences in private equity managers.
There is a large cross-sectional difference in private equity managers. One indication is the dispersion of their internal rates of return (IRR). Recent data indicates the mean IRR is 11.9%, which is much higher than the median of 5.6%. The dispersion is indicated by the three quartile boundaries: -2.6%, 5.6%, and 15.9%. (These results represent 1,747 funds for the period 1969-2005. The data was from Venture Economics.) A random draw of a private equity fund has an equal chance of being below 5.6% as above 5.6%, which would not be desirable. As mentioned earlier, only investors with the ability to recognize and have access to top managers can expect the higher returns.
References
Gorton, G. and K. G. Rouwenhorst. “Facts and Fantasies about Commodity Futures.” Financial Analysts Journal. Vol. 62, No. 2, 2006.
Marcato, G., and T. Key. “Smoothing and Implications for Asset Allocation Choices.” The Journal of Portfolio Management. Special Issue 2007.
Fung, W.K.H., and D.A. Hsieh. “Hedge Funds: An Industry in Its Adolescence.”
Federal Reserve Bank of Atlanta, Economic Review. Fourth Quarter 2006.
Conroy, R. and R. Harris. “How Good are Private Equity Returns?” Journal of Applied Corporate Finance, Vol. 19, No. 3, Summer 2007.
Please note that this Glossary is to be used exclusively in preparation for the CAIA® Exam.
The aim of this Glossary is to provide useful information, in context, that is directly related to the CAIA® Study Guide Keywords.
130/30: active extension strategies that invest 130% in long positions in one group of strategies and 30% in short positions in another group of securities. (Topic 9)
Abatement Strategies: An approach to dealing with climate change that attempts to prevent climate change. It contrasts with adjustment strategies that are reactions to the unavoidable consequences of climate change. (Topic 7)
Adjustment Strategies: An approach to dealing with climate change that is a rational reaction to the unavoidable consequences of climate change. It contrasts with abatement strategies that attempt to prevent climate change. (Topic 7)
Alignment of interests: The idea that optimal contracting between hedge fund managers and investors must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. (Topic 11) Allocation drift: The situation in which one asset class in the portfolio becomes overweighted while another becomes underweighted. Over the long run, allocation drift can change the portfolio’s risk level to a point where it might become misaligned with the investor’s objectives. (Topic 10)
Alt-A mortgage loans: Loans issued to borrowers who have better credit scores than sub- prime borrowers but fail to provide sufficient documentation with respect to all sources of income and/or assets. (Topic 9)
Alternative alphas: Alpha that is derived from the asset-based style (ABS) model of Fung and Hsieh, a risk factor model which provides investors in search of alpha with a way to assess the value of their hedge fund investment. (Topic 11)
Alternative betas: Beta that is derived from the asset-based style (ABS) model of Fung and Hsieh, a risk factor model where beta buyers can evaluate whether their investments have exposure to the right risk. (Topic 11)
Arithmetic return: The simple average of period-to-period returns. (Topic 8)
Aspirational risk: One of the three dimensions of risk, according to Kahneman and Tversky (1979), that the ideal portfolio must address; aspirational risk is associated with enhancing one’s lifestyle. (Topic 8)
Asset-backed securities (ABS): Bonds that are securitized or collateralized by the cash flows from an underlying pool of assets—such as credit cards, home loans, auto loans, equipment
leases, or other non-mortgage related assets. They are often issued by special investment vehicles with several tranches of senior and subordinate securities, with the tranches being paid in order of seniority (Topic 7)
Asset backed security (ABS) trust: The owner of securitized loans acquired from the
originators of the loans. They generate NPV from repackaging the cash flows in a way that can absorb some losses. They typically use a waterfall payment structure for the collateral’s cash flows. (Topic 9)
Asset-based style (ABS) factors: Top-down risk factors representing tradable securities and their derivatives. Fung and Hsieh use seven such risk factors to capture the risk of diversified portfolios of hedge funds. (Topic 11)
Backfill: The process in which the incubation history of a hedge fund before the entry date in an index is typically “backfilled”. (Topic 11)
Backwardation: The condition of the futures curve when near-month futures contracts trade at a premium to further-out-month futures delivery contracts, i.e., the term-structure of futures prices has a negative slope. In contrast to contango, backwardation means that the price of a commodity for future delivery is below the spot price. (Topic 9 and 11)
Bankruptcy remote: The attribute, related to the use of SPVs, that a bankruptcy of an affiliated entity (e.g., a sponsoring bank or money manager) will not affect the functioning of the structure (e.g., SPV) that is “bankruptcy remote”. (Topic 7)
Barbell strategies: The strategies that allocate a relatively high weight to the personal (low- risk cushion) and aspirational (high-risk/return) risk buckets and a smaller weight to the market (middle-risk/return) risk buckets. (Topic 8)
Basis: The cash price minus the futures price (i.e., the spread between the spot price of a commodity and the price of, usually, a short term futures contract). (Topic 11)
Black-Litterman asset allocation: A model where the investment manager begins with the equilibrium expected returns computed from the CAPM, which is called the neutral reference point. Then, the manager combines his/her own expectations about the market with the expectations from the CAPM. (Topic 8)
Bottom-up approach: An approach to identifying hedge fund risk factors based upon investment styles such as managed futures, merger arbitrage, and fixed-income arbitrage. It is in contrast to a top-down approach, which identifies factors based upon investable portfolios. (Topic 11)
Buy-and-hold: A portfolio strategy in which there is no rebalancing even when market prices move. (Topic 8)
“Buy to own” investing: Acquiring sizable stakes in companies with the goal of having control or ownership rather than trading the securities. (Topic 7)
Calendar spread strategy: A futures trading strategy that exploits the spreads between two delivery months. It is typically used by sophisticated storage operators who recognize that their storage facilities are essentially a set of complex options on calendar spreads. (Topic 9) Capital calls: When the general partner of a private equity fund recognizes a suitable investment prospect, he/she is allowed to “call” the necessary equity capital at which time each partner typically funds a pro rata share of its commitment. (Topic 10)
Capital-structure arbitrage: This is an arbitrage consisting of credit arbitrage spreads on mispricing among different securities (typically debt and equity) issued by the same company. (Topic 11)
Carbon funds: Funds that participate in the market for certified emission reductions (CERs), as created by the Kyoto Protocol. They may be government purchasing programs and private commercial funds. (Topic 7)
Catastrophe bonds: Catastrophe risk-transfer instruments, which provide a cash flow when a certain unavoidable event occurs. Coupons are usually based on LIBOR plus an appropriate risk premium, and when a predefined loss occurs, the investor forfeits the capital invested. (Topic 7)
Catastrophe risks: Unavoidable natural catastrophe and weather risks that are used in risk transfer instruments such as catastrophe bonds and weather derivatives, that provide compensation for certain events. The market for catastrophe risks offer adjustment strategies. (Topic 7)
Cat-risk CDOs: Securitized products that bundle various catastrophe risks and sell them in individual risk tranches. Typically issued by a special purpose vehicle (SPV) that purchases the underlying pool for a CDO. (Topic 7)
Centralized Clearing House (CCH): clearing house for OTC transactions recommended by the Basel-based Financial Stability Forum to the G-7. CCHs would monitor the risk exposure of participants, to make sure they have sufficient collateral, and stand ready to back defaults. (Topic 9)
Claw-back: When fees paid to the general partner by limited partners for profitable investments may be subject to reclaim if significant losses from later investments occur. (Topic 7)
Clean Development Mechanism: Part of the Kyoto Protocol that allows for investment to be made in a project that promises to yield future income in the form of certified emission reductions (CERs) in the emerging markets. (Topic 9)
Climate-related investments: Public investment funds and private equity funds that invest in assets that could profit from climate change. Examples are investing in the equity of
companies that are developing environmentally friendly products and making loans to such companies. (Topic 7)
Collateralized commodity obligation (CCO): The concept of collateralized obligations (COs) extended into commodities. The CO structure facilitates exposure to commodity price risk through the use of CTSs (commodity trigger swaps). (Topic 7)
Collateralized fund obligation (CFOs): The application of the CDO concept to investing in hedge funds and private equity. (Topic 7)
Commitment strategy: The pledge made by an investor to a private equity fund. If a private equity fund cannot find appropriate investment prospects, it will not draw on an investor's commitment. In this case, the investor may eventually invest less than was expected or committed. (Topic 10)
Commodity trigger swaps (CTS): A derivative that is similar in concept to a credit default swap and used by CCOs. In this case, the trigger event is a specified decline in commodity prices, e.g., a 35% decline. At the initiation of the CTS, the CCO would give a certain amount of money (the principal) to the counterparty and receive coupons over a specified time. If, during the life of the CTS, a trigger event occurs, then the CCO would not receive the principal back at the maturity of the CTS. (Topic 7)
Compensation contract design: The fee structure design between the hedge fund manager and the investors. Optimal compensation design must align the interests of the two and must consider the potential effects arising from those systematic risk factors that are intrinsic to each hedge fund strategy. (Topic 11)
Complex adaptive systems: Term to describe the capital markets that are made up of many interactive agents whose decisions impact each other in nonlinear and unanticipated ways, and whose behavior changes when confronted with new situations, thereby allowing the system to evolve and benefit from the changing environment. (Topic 10)
Concave payoff curves: In the context of the Perold and Sharpe study, refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises. (Topic 8)
Conditional factor models: Either rule-based approaches or econometric approaches that model the time-varying factor exposures of hedge fund returns. (Topic 7)
Constant mix: A portfolio rebalancing strategy wherein there is periodic rebalancing such that the portfolio is adjusted back to being a specified percentage mix of securities or security classes. (Topic 8)
Constant-proportion portfolio insurance: A portfolio reallocation strategy wherein the investor sets a floor value at which all risky investing terminates. Furthermore, the investor increases risky asset holdings when the market rises and decreases risky asset holdings when the market falls. (Topic 8)
Contango: The condition when near-month delivery futures contracts trade at a discount to further-out-month futures delivery contracts, i.e., the futures curve has a positive slope. In contrast to backwardation, the futures price is greater than the spot price. (Topic 8 and 9)
Contingent capital arrangements: Types of put options where option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs. One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss. Due to pricing difficulties, they are not used much today. (Topic 7)
Contrarian: trading strategies that increase the demand for losers (by buying losers) and add to the supply of winners (by selling winners), thus providing market liquidity and helping stabilize supply-demand imbalances. (Topic 9)
Convergence: The broadening of goals of hedge fund managers and private equity managers that has led to the two types of funds becoming more similar. Specifically, hedge funds have moved from just making short-term debt-type investments to some longer-term equity-type investments with the goal of having some control in companies in which they invest. Private equity funds are making more shorter-term investments without the goal of control. (Topic 7) Convergence of leveraged opinions: The event where the opinions of a large group of hedge funds (which are highly levered investment vehicles that, individually, may function
unnoticed) converge onto the same set of bets, thus potentially destabilizing markets and creating systemic risk. (Topic 11)
Convex payoff curves: In the context of the Perold and Sharpe study, refers to the tendency of a strategy to increase equity exposure (risk) as the equity market rises. (Topic 8)
Credit Enhancement: In an ABS trust, the amount of loss on the underlying collateral that can be absorbed before the tranche absorbs any loss. (Topic 9)
Credit spread: The difference in the prices or interest rates of two fixed-income securities based upon risk; it is used in fixed income strategies where the investor takes positions based upon the disparity between the prices or interest rates. (Topic 11)
Decision rule: In the context of the Perold and Sharpe study, refers to the exact determination procedure for a portfolio reallocation strategy such as the amount of dollars that will be invested in a risky asset as the prices of the risky assets change. (Topic 8)
Dimson Beta: the sum of regression coefficients on the S&P 500 and its lagged values. It attempts to correct for the smoothing that is usually observed with the stale prices associated with illiquid assets. (Topic 11)
Distributions: Cash payments investors receive as compensation for investing in private equity. (Topic 10)
Emission credits: While the EU Emission Trading System (EU-ETS) has a limit to tradable emission rights for all companies, emission credits can be won by companies from additional climate protection projects that are in other countries and that can be credited to their own reduction target (baseline and credit). (Topic 7)
Emission rights: The EU Emission Trading System (EU-ETS) makes a distinction between greenhouse gas emission rights and emission credits. There are a limited number of emission
rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7)
EU Allowances (EUAs): The limited number of greenhouse gas emission rights that are traded among companies in the EU Emission Trading System (EU-ETS). There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7)
EU Emission Trading System (EU-ETS): The biggest market for greenhouse gas emissions.
It uses targets proposed by the Kyoto Protocol, which defines a number of different emission certificates. There are a limited number of emission rights for all companies, and these rights can be traded among companies that emit the greenhouse gases. (Topic 7)
Event loss swaps: A variant of conventional industry loss warrants (ILWs). They are more tradable because they are more highly standardized. (Topic 7)
Event risk: One of the components of personal risk of an individual investor, which refers to his or her ability to adjust to events such as the loss of a job, health problems, market crashes, etc. (Topic 8)
Exposure: the degree to which an investor should be concerned about possible outcomes. It is another factor when dealing with risk and uncertainty. (Topic 10)
Exposure diagram: In the context of the article by Period and Sharpe, a graph of the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis. Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolio’s cumulative performance. (Topic 8)
Factor-replication approach: attempt to replicate hedge fund returns using hedge fund risk factors. (Topic 7)
First Order Autoregressive Reverse Filter (FOARF): An approach to generate an unsmoothed total real estate return series, with three assumptions underlying this model:
adjusted and unadjusted values of the mean for the series are equal; the model holds over time;
and random errors are left out of the index. (Topic 11)
Fixed income volatility: A bet that the implied volatility of interest rate caps will be higher than the realized (observed) volatility of the Eurodollar futures contract. (Topic 11)
Floor: In the context of the Perold and Sharpe study, refers to a total portfolio value that, if reached via a decline in portfolio value, causes a portfolio reallocation such as the termination of investment in risky assets. (Topic 8)
Full Information Value Index (FIVI): An approach to generate an unsmoothed total real estate return series, with a first-order autoregressive specification, without the need to assume that the underlying property market is informationally efficient. (Topic 11)
Geometric return: return that takes into account compounding across periods, versus arithmetic returns which is the simple average of period-to-period returns. (Topic 8)
Hazard rate: The proportion of hedge funds that drop out of a database at a given age. For example, Fung and Hsieh find that the highest dropout rate tends to happen when a hedge fund is 14 months old. (Topic 11)
Hybrid asset: An asset that shares common characteristics with two or more other assets. (Topic 7)
Hybrid funds: Funds that utilize both hedge fund and private equity strategies. (Topic 7) Illiquidity: The property where an asset cannot be sold, either rapidly, with negligible loss of value, or at anytime during market hours. Secondary markets for illiquid investments (such as private equity) are limited. (Topic 10)
Incentive fee: A performance fee charged by hedge funds on top of the management fee. Most hedge funds charge a 20% performance fee. (Topic 11)
Incubation bias: (Also known as backfill or instant history bias) refers to the bias in hedge funds returns caused when the incubation history of a fund before the entry date in an index is
“backfilled”, potentially causing that the early part of a hedge fund’s history will be upwardly biased. Incubation bias has been estimated to be around 1.5% per annum. (Topic 11)
Incubation period: A period that new hedge funds typically undergo in order to accumulate a track record. It lasts at most a few years because the opportunity costs related to a fund’s incubation period can be quite significant. (Topic 11)
Industry loss warrants: A type of capital market-financed loss (re-)insurance, which is linked to an industry loss index. It is usually in the form of private placements. (Topic 7)
Infrastructure funds: Funds that invest in companies that usually provide an essential service to the community and have some monopoly power, e.g., a bridge, utility, or road. They
typically provide relatively steady income and provide a hedge against inflation. (Topic 7)
“Lend to own” debt financing: Providing debt financing, usually to highly levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults. (Topic 7)
Lifecycle: refers to the various stages of the infrastructure asset from inception to maturity. (Topic 7) Lifecycle stage: One of the components of personal risk of an individual investor, which refers to his or her earning power and the desire to leave a legacy. (Topic 8)
Liquidation bias: The finding that fund managers discontinue reporting their returns to a database before the final liquidation value of a hedge fund, thus causing an upward bias in the observed returns of dead funds. (Topic 11)
Liquidity conundrum: The relationship between liquidity and risk where liquidity is dependent upon the risk aversion of investors and not just determined by monetary