ALTERNATIVE INVESTMENTS

Transcription

1 ALTERNATIVE INVESTMENTS 1 F.I = Fixed Income PE = Private Equity RE = Real Estate VC = Venture Capital LBO = Leverage Buyout ABS = Asset Backed Securities AIs = Alternative Investments MBS = Mortgage Backed Securities 1. INTRODUCTION AIs are perceived to behave differently (provide diversification) from traditional investments. Absolute return objective to provide +ve return throughout the economic cycle. Relative return objective return relative to an equity or F.I benchmark. 2. ALTERNATIVE INVESTMENTS AIs are alternatives to long-only positions in stocks, bonds & cash. AIs are almost always actively managed. Characteristics common to many AIs: Illiquid underlying investments. Narrow manager specialization. Correlation with traditional investments. Less transparency & low level of regulation. Limited historical data. Unique tax & legal considerations. High net worth individuals & institutions are the typical investors in AI. HF indices may be inherently biased upwards due to survivorship & backfill biases. Different weightings & constituents in index construction can significantly affect the indices & their results & comparability. 2.1 Categories of Alternative Investments Hedge Funds Private Equity Funds Manage portfolio of securities & derivative positions using variety of strategies. Often highly leveraged & employ long & short positions. Generally invest in private companies or public companies with the intent to take them private. Majority of PE activity involves LBOs & VC investments. Real Estate Commodities Direct or indirect investment in buildings & / or land. Securitization structures broadened the definition of RE investing. Physical commodity investments or investments in businesses engaged in the production of physical commodities. Main vehicles commodity futures contracts & funds benchmarked to commodity indices. Others These investments may include tangible assets (e.g. wine, art, stamps etc) & intangible assets (e.g. patents).

2 2 2.2 Return: General Strategies Ways to Achieve Returns Passive Return Active Return Assume that markets are efficient & focus on β drivers of return. Expected alpha return is zero for passive managers. Efficiently take on market risk. Assumption inefficiencies exist & alpha return after adjusting for β risk is possible. Alpha returns are results of managers special skills in capturing non-systematic opportunities in the market. Alpha Seeking Strategies Absolute Return Market segmentation Return independent of market returns. No market index to beat. Formal performance objective cash rate, real return target or absolute nominal return. Capital can t migrate effortlessly from lower expected return areas to higher ones. Segmentation brought on by investment constraints that provide an opportunity for more flexible managers to move into higher returning segments quickly. Concentrated Portfolios Concentrating assets among fewer securities, strategies & / or managers (less diversification). Higher return if these concentrated positions outperform the market ( alpha potential). Risks of AIs Risks can be considered both on stand-alone basis & within the context of portfolio. Risks low liquidity, transparency & limited redemption availability. h = Sharpe ratio & downside risk measures ignore low correlation of AIs with traditional investments. 2.3 Portfolio Context: Integration of Alternative Investments with Traditional Investments Key motivation for investing in AIs diversification potential. AIs also improves portfolio s risk-return profile.

3 3 2.4 Investment Structures Most common structure partnership. Fund is the general partner (GP) investors are limited partners (LPs). Less regulation. GP runs the business & bears unlimited liability. Management fees are based on assets under management. Incentive fees are based on realized profits. Fee is only earned after the fund achieves a specified return (hurdle rate). High water marks highest cumulative return used to calculate an incentive fee. 3. HEDGE FUNDS Characteristics of HF: Aggressively managed & highly leveraged portfolio of investments across asset classes. Fewer investment restrictions & goal of generating high returns. Usually set up as a private investment partnership. Often imposes restrictions on redemptions. Funds of funds funds that hold a portfolio of HFs. Provide diversification. Available for smaller investors. Expertise in conducting due diligence on HFs. 3.1 Hedge Fund Strategies Event-Driven Strategies Seek to profit from short-term events (e.g. acquisitions or restructuring). Bottom-up strategy. Subdivisions Merger Arbitrage Distressed/Restructuring Generally involve going long on stock of Target Company & short on stock of acquiring company when merger is announced. Primary risk acquisition does not occur. Focus on the securities of companies either in bankruptcy or near to bankruptcy. Variety of ways to profit from distressed securities. Activist Special Situations Purchase of sufficient equity in order to influence a company s policies or direction. These funds operate in public equity market. Opportunities in the equity of companies that are currently engaged in restructuring activities other than M&A & bankruptcy.

4 Relative Value Strategies Seek profit from a pricing discrepancy b/w related securities. Expectations pricing discrepancy will be resolved in time. Examples Fixed Income Convertible Arbitrage Fixed Income Asset Backed Zero β investment strategies that seek to exploit a perceived mispricing b/w a convertible bond & its component parts. Typically involves buying convertible debt securities & selling the same issuer s common stock. Focus on relative value b/w a variety of ABS & MBS. Seek to take advantage of mispricing across different ABS. Fixed Income General Volatility Focus on the relative value within the FI markets. Currency dynamics & govt yield curve are important considerations. Use options to go long or short market volatility either in a specific asset class or across asset classes. Multi-Strategy Relative value within & across asset classes. Looks for investment opportunities wherever they might exist Macro Strategies Focus on top down approach to identify economic trends evolving across the world. Trade in FI, equity, currency & commodity markets. Use long &/or short positions to potentially profit from a view on overall market direction Equity Hedge Strategies They are focused on public equity markets & take long & short positions in equity & equity derivative securities. Use a bottom-up as opposed to top down approach. Examples Market Neutral Fundamental Growth Use fundamental &/or quantitative analysis to identify under/overvalued securities. Portfolio should have a β of approximately zero. Intent profit from individual securities movement while hedging against market risk. Fundamental analysis to identify companies expected to exhibit high growth & capital appreciation. Long position in identified company securities.

5 5 Examples Fundamental Value Quantitative Directional Fundamental analysis to identify undervalued securities Technical analysis to identify companies that are under/overvalued. Net long or short position depending upon anticipated direction of market. Short Bias Sector Specific Technical or fundamental analysis to identify overvalued equity securities. Net short exposure is based upon market expectations. Exploit expertise in a particular sector. Use technical & fundamental analysis to identify opportunities in the sector. 3.2 Hedge Funds and Diversification Benefits HFs lack performance persistence. Traditional view of HF arbitrage players seek to earn return while hedging against risk. HFs provides diversification benefit because of less than perfect correlation with stock market. 3.3 Hedge Fund Fees and Other Considerations Fees and Returns Common fee structure in HF market is 2&20 which reflects a 2% management fee & 20% incentive fee. Incentive fee is calculated independent of management fees. Hurdle rate is frequently set based on a RF rate proxy plus a premium. Incentive fee can be based on returns in excess of the hurdle rate or on the entire return (soft hurdle rate). High watermark provision may also included in fee structure Other Considerations Leverage has the effect of magnifying gains or losses because the HF can take a large position relative to the capital committed. HFs normally trade through prime brokers. The the margin requirement, the leverage is available to the HF. Redemptions can magnify losses for HF. When drawdown occurs, investors may decide to exit the fund or redeem at least a portion of their shares. Redemption fees discourage redemption & help to recover transaction costs. Lock up period gives the HF manager time to implement & potentially realize the expected result of a strategy. FOFs may offer more redemption flexibility than afforded by direct investment in HFs.

6 6 3.4 Hedge Fund Valuation Issues Valuations are important for calculating performance & meeting redemptions. When market prices or quotes are used for valuation, funds may differ in which price or quote they use: Common practice use avg. quote. Conservative practice use bid prices for longs & ask prices for shorts. Any model should be independently tested, benchmarked & calibrated to industry-accepted standards to ensure a consistency of approach. Liquidity discounts are necessary to reflect fair value. Trading NAV incorporates liquidity discounts based on the size of the position held. Reporting NAV based on quoted market price. 3.5 Due Diligence for Investing In Hedge Funds FOFs have an additional layer of fees. Key due diligence factors include: Investment strategy. Investment process. Competitive advantage. Track record. Size & longevity. Management style. Key person risk. Reputation & plans for growth. Systems risk management & investor relations. 4. PRIVATE EQUITY There are different stages & types of PE investing. The focus of PE firms may as business conditions & the availability of financing change. Categories of PE Leveraged Buyouts Venture Capital LBO funds that acquire public companies or established private companies mainly through debt. Assets of the target company serve as the collateral for the debt. After the buyout, the target becomes or remains a privately owned company. Invest or provide financing to private companies with high growth potential. VC can be provided at a variety of stages. Development Capital Distressed Investing Minority equity investments in more mature companies that are looking for capital to expand or restructure operations Buying the debt of mature companies in financial difficulties. Turnaround investors buy the company s debt & plan to be more active in the management & direction of the company.

7 7 4.1 Private Equity Structure and Fees PE funds are typically structured as partnerships similar to HFs (outside investors are LPs & PE firm as GP). PE firms usually charge both a management fee & an incentive fee on a fund basis. Management fees generally range from 1 to 3% of committed capital. GP does not earn an incentive fee until the LPs have received their initial investment back. Claw back provision requires the GP to return any funds distributed as incentive fees until the LPs have received back their initial investment & 80% of the total profit. 4.2 Private Equity Strategies Leveraged Buyouts Management Buyouts (MBO) current management is involved in the acquisition. Management buy-ins (MBIs) current management team is being replaced & the acquiring team will be involved in managing the company. Potential returns in this category are to a large extent due to the use of leverage LBO Financing PE firms use debt to finance a significant proportion of each deal to equity returns & no. of transactions. Typical LBO capital structure equity, bank debt & high yield bonds. Mezzanine financing (MF) debt or preferred shares with a relationship to common equity due to a feature such as attached warrants or conversion options. Being subordinate to senior & high yield debt MF pays a higher coupon rate Characteristics of Attractive Target Companies for LBOs Some characteristics of attractive target companies for LBOs include: Depressed stock price. Willing management. Inefficient companies. Strong & sustainable CF. Low leverage & significant amount of physical assets Venture Capital Portfolio Company the company that is being invested in & will become part of the portfolio of the VC fund. VC investors are actively involved in portfolio companies. VC Fund Financing Formative Financing Later-Stage Financing Company is in the process of being formed. Angel investing capital provided at idea stage. Seed-stage financing supports production development & market research. Early stage financing provide to companies moving toward operation but before commercial production & sales have occurred. This financing is provided after commercial production & sales have begun but before any IPO. Funds may be used for initial expansion or major expansion.

8 8 VC Fund Financing Provided to prepare to go public. Represents the bridge b/w the expanding company & the IPO Other Private Equity Strategies Several other specialties for PE firms include: Minority equity investing. Distressed investing purchasing the debt of a troubled company. Distressed debt investors are called vulture investors. Investing in companies in specific industries Exit Strategies Ultimate goal for PE improve underperforming businesses & exit them at high valuations. Exit strategies: Trade sale sale of a company to strategic buyer such a competitor. IPO selling of shares to public investors through an IPO (highest price). Recapitalization not a true exit strategy. PE firm maintains control but allows the PE investor to extract money from the company. Popular strategy when IR is. Secondary sale sale to another PE firm or group of investors. Liquidation occurs when transaction has not gone well. 4.3 Private Equity: Diversification Benefits, Performance, and Risk Due to less than perfect correlation with traditional investments, PE funds can add diversity to portfolio. By identifying skillful PE fund managers, investors may benefit from superior returns. 4.4 Portfolio Company Valuation Approaches to PE Valuations Market or Comparables Approach Discounted Cash Flow Approach Use multiples of different measures. Large, mature private companies EBITDA multiple. Values a company or its equity as the PV of the relevant expected future CF. = Asset-Based Approach Value of a company based on the values of its underlying assets less the value of any related liabilities. Value of the company to the equity holders. Valuations can be arrived at using fair or liquidation values. Liquidation value net amount that will be realized if the business is terminated.

9 9 4.5 Private Equity: Investment Considerations and Due Diligence IR, capital availability expectations & refinancing risk must be considered & evaluated. PE investments are long-term illiquid investments. 5. REAL ESTATE Direct or indirect equity investing in RE property such as land & buildings. Debt investing in RE includes mortgage loans or MBS investing. Reasons for investing in RE: Competitive long-term total return potential. Multiple year leases with fixed rents lessen CF impact from economic shocks. Diversification benefits. Provide inflation hedge if rents can be adjusted quickly for inflation. Unique features of RE compared with other investment asset classes: Indivisibility. Unique characteristics. Fixed location. 5.1 Forms of Real Estate Investment Debt Equity Private Mortgages Direct ownership of real estate. Ownership can be through sole ownership, joint ventures, real estate limited partnership, or other commingled funds. Public Mortgage-backed securities (residential and commercial) Collateralized mortgage obligations Shares in real estate corporations Shares of real estate investment trusts Reference: Level I Curriculum, Volume 6, Reading 66, Page 205 Leveraged ownership property title is obtained through an equity purchase combined with mortgage financing. Mortgage loans represent passive investments where the lender expects to receive a predefined stream of payments. 5.2 Real Estate Investment Categories Residential Property Direct equity investment in a residence with the intent to occupy. If purchase is partially financed, any ( ) in the value of the home ( ) the owner s equity in the home. Securitization provides indirect, debt investment opportunities in residential property Commercial Real Estate Appropriate direct investment (equity & debt) for institutional funds or high-networth individuals with long time horizons & limited liquidity needs. Direct investment requires active & experienced, professional management. Lender conducts financial analyses to establish the creditworthiness of the borrower before providing the debt financing.

10 REIT Investing Mortgage REITS risk & return characteristics similar to fixed income investments. Equity REITS invest primarily in commercial or residential properties & employ leverage. Sources of return to equity REITS= rental income debt servicing Mortgage-Backed Securities (MBS) MBS structure buying a pool of assets & assigning the income & principal returns into individual security tranches for commercial MBS. Collection of Assets Combination of Funding Assorted Securities Investment-Grade CMBS 60%-70% Last Loss Real Estate Asset Debt 70%-75% High-Yield CMBS 5%-10% BB Rated B Rated Property Owners Equity 25%-30% Unrated Property Owners Equity 25-30% Pool of Properties Pool of Loans Commercial Mortgage- Backed Securities First Loss Reference: Level I Curriculum, Volume 6, Reading 66, Page Timberland and Farmland Timberland offers an income stream based on the sale of timber products as a component of total return (low correlation with other asset classes). Flexible investment harvest more trees when timber prices are up & delaying harvests when prices are down. Farmland perceived to provide an inflation hedge. Returns related to harvest quantities & agricultural commodity prices. Two main property types: Row crops planted & harvested annually. Permanent crops grows on trees or vines. Little flexibility in harvesting as compared to timberland. 5.3 Real Estate Performance and Diversification Benefits RE index can generally be categorized as an appraisal index, transactions-based index or a REIT index. Appraisal indices use estimates of value as inputs to the indices. Rely on comparable sales & CF analysis techniques. These indices understate volatility because appraisals are done periodically. Transactions-based indices use repeat sales of properties to construct the indices. Sample selection bias. Higher the no. of sales the more reliable & relevant is the index. REIT indices use the prices of publicly traded shares of REITS to construct the index. Index may not represent the properties of interest to the investor.

11 Real Estate Valuation Comparable Sale Approach Income Approach Approximate value based on recent sales of similar properties. Adjustments are made for differences in key characteristics of property condition, age, location & size. Cost Approach Evaluates the replacement cost of the property by estimating the value of land & the costs of rebuilding using current construction costs & standards. Direct capitalization approach Estimates the value of an income producing property based upon the level & quality of NOI. NOI income to the property after deducting operating exp (property tax, insurance, maintenance utilities & repairs) but before depreciation, finance cost & income tax. h = Cap rate discount rate-growth rate Discounted CF approach discounts future projected CFs to arrive at a PV of the property REIT Valuations Income Based Valuation Asset Based Valuation Typically similar to direct cap approach. Funds from operation (FFO) & adjusted FFO are used as measure of income. FFO = NI + Dep ± gains (loss) from sale of RE property. AFFO adjusts the FFO for recurring capex. This approach calculates a REIT s NAV. REIT s NAV = Estimated MV of REIT s total assets value of its total liabilities. REIT shares are often traded at value other than NAV per share. 5.5 Real Estate Investment Risks RE investment may fail to perform in accordance with expectations. Other risks include: Change in govt regulation. Ability of fund management to select finance & manage real properties. Leverage magnifies the impact of gains & losses. 6. COMMODITIES Commodities physical products. Return based on in price rather than on an income stream. Most commodity investors trade in commodity derivatives to avoid storage & transportation costs associated with holding the underlying commodity. Commodities include precious & industrial metals, energy products & agri products. Commodity derivatives may be attractive to investors because these investments provide an inflation hedge & diversification benefits. 6.1 Commodity Derivatives and Indices Commodity derivatives include futures, forwards, options & swaps. Commodity indices typically use the price of futures contracts on the commodities included in them rather than the prices of the commodities themselves. Commodity indices vary in the commodities included in them & the weighting methods used.

12 Other Commodity Investment Vehicles Alternative means of achieving commodity exposure include: ETF suitable for investors who can only buy equity shares or seek the simplicity of trading them. Common stock of companies exposed to a particular commodity. Managed futures funds. Individual managed accounts. Funds that specialize in specific commodity sectors. 6.3 Commodity Performance and Diversification Benefits Arguments for investing in commodities include: Potential for return investors believe prices will in the short or medium term. Portfolio diversification commodities behaved differently during the business cycle from stocks & bonds. Inflation hedge commodity prices affect inflation calculations. 6.4 Commodity Prices and Investments Commodity spot prices are a function of: Supply & demand. Cost of production & storage. Value of users. Global economic conditions. The inability of suppliers to quickly respond to changes in demand levels may results in supply levels that are too low in times of eco. growth & too high in times of eco. slowing Pricing of Commodity Future Contracts The price of a commodity futures contract may be approximated by the following formula convenience where r = period s short term risk free rate. Convenience yield yield related to convenience of having physical possession of the commodity. Contango (backwardation) futures price > (<) spot price & commodity forward curve is upward (downward) sloping. Source of return for commodity futures contract: Roll yield Diff. b/w the spot price of a commodity & the price specified in the future contract. Collateral yield interest earned on the collateral posted as a good faith deposit for the futures contract. Spot prices primary determinant is relationship between current supply & demand. 7. OTHER ALTERNATIVE INVESTMENTS Collectibles: Tangible assets such as antiques & fine art, fine wine, rare stamps & coins, jewelry & watches etc. Provide no current income but potential for higher capital gains. Highly illiquid. No. of indices that provide information about returns to these investments.

13 13 8. RISK MANAGEMENT OVERVIEW 8.1 Investment and Risk Management Process The manger of an investment portfolio makes investment decisions consistent with the portfolio s established investment policies, taking risk into account. Investor due diligence should be used to ensure portfolio risk is effectively managed by the portfolio manager Risk Management Issues Risks vary across alternative investments. PE & HF may have long lockup periods. Poor manager selection can create a lingering drag on the portfolio Risk Issues for Implementation Investors should recognize that past performance is not necessarily representative of future performance. In case of illiquid investments, portfolio should be diversified sufficiently to reduce the possibility of 100% loss. 8.2 Risk Return Measures Sharpe ratio may not be the appropriate risk return measure for alternative investments because measure of return & SD may not be relevant & reliable. Returns are overstated & volatility is understated in alternative investments. Alternative investment returns tend to be leptokurtic & negatively skewed. Downside risk measure (e.g. ) focus on the left side of the return distribution curve & Sortino ratio uses downside deviation as opposed to standard deviation as a measure of risk. 8.3 Due Diligence Overview Organization: Portfolio Management: Operations and Controls: Risk Management: A Typical Due Diligence Process Experience and quality of management team, compensation, and staffing Analysis of prior and current funds Track record/alignment of interests Reputation and quality of third-party service providers, e.g., lawyers, auditors, prime brokers Investment process Target markets/asset types/strategies Sourcing of investments Role of operating partners Underwriting Environmental and engineering review process Integration of asset management /acquisitions/ dispositions Disposition process, including how initiated and executed Reporting and accounting methodology Audited financial statements and other internal controls valuation frequency and approach(es) insurance and contingency plans Fund policies and limits Risk management policy Portfolio risk and key risk factors Leverage and currency risks/constraints/hedging

14 Due Diligence Overview Legal Review: Funds Terms: A Typical Due Diligence Process Fund structure Registrations Existing/prior litigation Fees (management and performance ) and expenses Contractual terms Investment period and fund term and extensions Carried interest Distributions Conflicts Limited partners rights Reference: Level I Curriculum, Volume 6, Reading 66, Page