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JuiceNotes™
- Bv FinTree ~

eBook10

ternative nvestments

CFA®Level I JuiceNotes™ 2017

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Introduction to Alternative Investments

LOSa Comparison of alternative investments with traditional investments

Compared to traditional invesbnents, + Less liquid

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

LOSb Categories of alternative investments

G) 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 @ Realestate

Venture Leveraged Resident ial Con1mercial Real estate

capital buyout properties properties backed debt
~ .......els els

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

© Commodities @ Infrastructure

Physical Commodities Equity Economic Social

commodities derivatives infrastructure infrastructure

1 1 1 1 1
Investing in the Roads, airports, Schools,
Buying/short
equity of utility grids etc. hospitals etc.
selling
Buying commodity
futures of
gold/silver producing firms
copper,
coins or bars,
grains etc.
entering into
a forward
Problematic if ® Other
contract for the company
Includes investment in tangible collectibles
itself hedges
potato etc. such as stamps, antique furniture, art, fine
the exposure wines as well as intangibles such as patents
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LOSf Issues in valuing alternative investments
Hedge fund valuation
Accounting NAV > Trading NAV
Trading NAV tends to be lower because it considers liquidity of portfolio

Private equity company valuation

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

Transaction values of
similar companies may
be used to estimate
EBITDA, net income or
revenue to use in
estimating the portfolio
companys 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

Comparable sales Cost approach
Income approach
approach

Valuation based on
Net operating income Replacement cost of a
recent sales of similar
Capitalization rate property is estimated
properties

Commodity valuation
Contango - Future price > Spot price
Backwardation - Future price < Spot price

Change in spot
Roll yield Collateral yield
prices
Yield due to a Total price return is a
difference between the combination of the
spot price and futures change in spot prices
Interest earned on
price and the convergence of
collateral
futures prices to spot
Backwardation - +ve prices over the term of
Contango - -ve the futures contract

LOSg Risk management of alternative investments

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

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

measure - VaR or Sortino ratio

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

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LOS c Potential benefits of alternative investments
in the context of portfolio management
Alternative investments have had low correlations with traditional
investments which provides benefits of diversification

Historically alternative investments have had higher returns on average

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

The reasons for these higher returns are thought to be that

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

Adding alternative investments to a portfolio reduces portfolio rjsk

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

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

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

LOSd G) Hedge funds

+ 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
+ Typically use prime brokers who provide multiple services such
as custodial, administrative, money lending, securities lending
and trading
+ Investors are limited partners and managers are general
partners
+ Hedge fund return objectives can be absolute (20%) or relative
(Benchmark + 5%)

Lockup period Time after initial investment during which withdrawals are not allowed
Notice period The amount of time a fund has to fulfill the redemption request after
receiving the request

Fund of funds An investment company that invests in hedge funds

Advantages • Gives investors diversification among hedge

fund strategies
• Helps smaller investors to invest in hedge funds

Disadvantage • They charge an additional layer of management fees

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Hedge fund strategies

( Event-driven)

Merger Distressed/ Activist Special

arbitrage restructuring shareholder situations

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

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

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

Relative ,ralue

Convertible Asset-backed General fixed

arbitrage fixed • Volatility Multi-strategy
• fixed income mcome
mcome

Exploit pricing
discrepancies
arising from
differences Exploit pricing
Exploit pricing between returns discrepancies
discrepancies Exploit pricing volatility implied among securities
between Exploit pricing discrepancies by options prices in asset classes
convertible discrepancies between fixed and manager different from
bonds among various income expectations of those previously
common stock MBSorABS securities of listed and across
future volatility
of the issuing various types asset classes and
company markets
If
Implied volatility >
Expected volatility
= Overvalued

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 str~ttegies These are based on global economic trends and events and may involve
long or short positions in equities, fixed income, currencies or commodities
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Various stages at which venture capital investment is made

Formative stage + Investments made during firm's earliest period

+ comprised of three phases

Angel investing • Investments made very early {" idea" stage)

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

Seed stage • Investments made for product development, marketing

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

Early stage • Investments made to fund initial commercial production

and sales

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

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

financing

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 Distressed investing

• It refers to buying debt of mature

companies that are experiencing
• Known as minority equity investing
financial difficulties
• Refers to the provision of capital for
• Investors in distressed debt take
business growth or restructuring
active role in working with
management on reorganizing or
• When public companies are
determining the direction t he
financed with such funds, it is
company should take
referred to as private investment in
public equi ties {PIPEs)
• They are sometim es referred to as
vulture investors

Privat e e q uity structure a nd fees

+ They are typically structured as limited partnerships

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

+ It is typically not invested all at once but is " drawn down" { invested) as
securities are identified and added to the portfolio
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Equity hedge fund

Market Fundamental Fundamental Quantitative

Short bias
neutral growth value directional

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

@ Private equity

Leveraged Venture Distressed Developmental

•
buyoutfunds capital funds mvestment capital funds
funds

Existing
Management -+ management
buyouts team is involved
in the purchase

External
Management management
buyins team replaces
existing team

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

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

referred to as its portfolio companies

• Venture capital fund managers often sit on their boards or fill key
management roles of portfolio companies
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+ Drawdown period - Typically 3 - 5 years

+ Management fees - Typically 10/o - 3%
+ Clawback provision - It requires the manager to return any periodic incentive
fees to investors if investors receive less than 800/o of the profits generated by
portfolio investments as a whole

Private equity exit strategies

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

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

• 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

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

group of investors. Most prferred strategy

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

outcome

Potential benefits and risks of private equity

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

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

+ Choosing skilled fund managers is important

@ Real estate

Residential Commercial
Mortgages
property property

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

Other real estate assets

Timbe1·land Far ......and

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

+ Real estate performance is measured by three indices

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

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

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

+ REIT indices - are based on the actual trading prices of REIT shares

+ 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 Individual Specialized

Con1modity Managed
directly linked futures funds managed funds in
ETFs
to commodity accounts specific secto1·

Actively managed
Investment in
Suitable for shares of Some managers
investors who are commodity It is an
concentrate on
limited to buying producing firm alternative to Can be organized
specific sectors
equity shares pooled funds for under any of the
while others are
Drawback - Price HNis structures
more diversified
They invest in movement of the
commodities or stock may not be Accounts are Focus on specific
They can be
commodity perfectly tailored to the commodities
structured as
futures correlated with needs of investors
limited
price movements partnerships or
of the commodity mutual funds
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Hurdle rates
Eg. #1 Opening value = 100 Closing value = 140 Hurdle rate = 12% Incentive fee = 20%

Opening value = 100 Closing value = 140

Profit= 40

Hard hurdle rate Soft hurdle rate

Profit 40 Profit 40
Hard hurdle 12 Soft hurdle
28 40

Incentive fee Incentive fee

(20%) 5.6 {20%) 8

Eg. #2 Hedge fund opening value = $150 min Fee structure = 2/20 Hard hurdle rate = 5%
Ending value (Year 1) = $175 min Ending value (Year 2) = $180 min
Incentive fees are calculated net of management fees
Calculate total fees and investor's net return
Year1 Year 2
Management fees = $150 min x 2% = $3 min Management fees = $169.1 min x 2% = $3.382 min

Incentive fees Incentive fees

= [$175 min - $150 min - 3 - ($150 = [$180 min - $169.1 min - 3.382 -
min x 5%)] x 20% = $2,9 min {$169.1 minx 5%)] x 20% = $0

Total fees = $3 min + $2.9 min = $5.9 min Total fees = $3.382 min
Ending value net of fees Ending value net of fees
= $175 min - $5,9 min = $169.1 min = $180 min - $3.382 min = $176.618 min

Investor's net return Investor's net return

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

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

High water mark Incentive fee = 150 - 130

= 20 X 200/o = 4
~ = 150

t 1 = 130

1;, = 100

t2 = 80
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Due diligence

Hedge fund Private equity

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

Real estate Alternative investments

+ Property values fluctuate because of

global and national economic factors, local + Organization
market conditions, and interest rate levels
+ Portfolio management
+ The degree of leverage used in real
estate investment is important because + Operations and controls
leverage amplifies losses as well as gains
+ Risk management
+ Real estate development has additional
risks such as regulatory issues like zoning + Legal review
and permitting, environmental
considerations or remediation, and + Fund terms
economic changes and financing decisions
over development period
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Potential benefits and risks of commodities
+ Returns on commodities< returns on stocks/bonds
+ Sharpe ratio for commodities is low because of lower returns and
high standard deviation

+ Commodity prices tend to move with inflation rates, therefore

holding commodities can act as a hedge against inflation

Commodity prices and investments

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

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

value to user, all factor into prices

® Infrastructure

Transportation Utility assets Communications Social

assets

! ! ! !
Electiic
Broadcast assets Prisons,
Roads, airports, generation and
and cable schools,
ports and distribution,
railways etc. systems etc. healthcare
waste disposal
facilities etc.
etc.

Brownfield investments - Investments in infrastructure assets that are already constructed

Provides stable cash flows and relatively high yields, but offers
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

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

LOSe Management and incentive fees

Most common fee 2% = Management fee

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

Management fee is paid irrespective of investment performance

Incentive fee is paid as a percentage of profits