Introduction to Alternative Investment
1) Investments
Traditional Invt Alternative Invt
- Long position in Stocks and cash - Hedge funds (Use leverage, Long and short positions, derivatives, illiquid assets) - Long position in Bonds - Private Equity funds (invts in pvt companies)
- Real estate (Direct or indirect investments) - Commodities (Via derivatives)
- Others (Stamps, Antique)
2) Compared to traditional investment alternative investments are - Less liquididity of assets held
- More specialization by investment managers - Less regulations and transparency
- Less historical returns and volatility data available - Different legal and tax treatment
3) Potential benefits and issues of Alt.Inv
- Low correlation with traditional investment over long periods hence can reduce investor risk - Historical returns are higher den traditional investment since some Alt.inv are illiquid like pvt equity Hence including Alt inv will improve return and risk
- Use of Standard deviation is not enough for Alt. Investment
- Survivorship bias - only existing firms data is used (failed firm data is excluded) and hence upward bias of returns
- Backfill bias - Firms previous performance is also included even if it was not part of earlier years data (Constructing an index)
4) Hedge funds (HF)
- Uses number of strategies
- Less regulated den traditional investments
- Uses leverage, Long and short positions, derivatives, illiquid assets
- Via prime brokers who helps in custodian services, finanicing, stock loan, trading and adminstrative services - Charges management fees (Value of assets held) and performance fees (fund returns)
- Can have lockup period for redemptions and notice period required - Fund of funds is an invt company which invests in HF but charge addn fees
4 Type of Strategies:
- Event driven [Take position based on corporate events - Merger arbitrage, distressed situations, Activist shareholders (control), special situation (buy back,spin off)] - Relative value strategy (buying a security and selling short a related security)
- Marco strategies (based on global economic trends, currencies and commodities) - Top down analysis
- Equity hedge fund strategies (Use of technical or fundamental strategy, short selling over valued securities) - Bottom up analysis
Potential benefits and risks:
- Returns are higher den global equities in down mkts and vice versa
- Less den perfect correlation with global equity returns may offer diversification but correlation tends to increase during financial crisis
HF valuation:
- For traded securities - mkt price and non-traded security - estimates
HF due diligence:
- Lack of complete information
- Examination can include strategy used, histrical performance; benchmark used; valn and return calculation method used - Other qualitative factors to consider are key person risk, reputation, growth plans,etc
5) Private Equity
- Invests in Pvt companies or public companies they intend to make it pvt, Leverage buy out (LBO), venture capital (VC)
LBO (take debt and invest)
Bank debt, high-yield bonds and mezzaine fianancing (conversion options,warrannts to equity)
MBOs MBIs
Existing mngt team is involved in buy outs External management team will replace exisiting management team
Formative stage Mezzanine stage
a) Angel investing - Production and sales - Capital provided to prepare the firm for an IPO
- Idea stage - Expansion thru increased sales and marketing - Time between pvt co becomes public company - funding by individual
b) Seed stage
- Product development, Mkt R&D - Venture capitalist invests
c) Early stage
- Investment made to initial comm production
Other type of pvt equities strategies
a) Development capital or minority equity investing - provision of capital for business growth and reconstruction b) Distressed investing (vulture investing) - buying debt of distressed company for turnaround
Pvt equity structure and fees
- Committed capital is the capital to be provided and not invested capital, it is brought over a period of time - Management fees are typically on committed capital rather den invested capital
- Incentive fees are typically 20% of profits and clawback provision can be added
- Clawback provision requires manager to return any periodic incentive fees if certain profit is not generated
Pvt equity exit strategies
- Trade sale - Sell to competitor or strategic buyer - IPO - Sell some shares to public
- Recapitalization - Company issues debt and fund a divd distribution to the equities; step towards exit - Secondary sell - Sell to another pvt equity company
- Write off/Liquidation - Reassess and adjust to take losses from unsuccessful outcomes
Potential benefits and risks: - Higher returns den equity stock - Less den perfect correlation
- Standard deviation is higher sugesting higher risk - May suffer from survivorship bias and backfill bias
- Companies are not frequently valued; hence risk and correlation is biased downward
Pvt company valuation
a) Mkt/comparables approach - Value of similar company may be used to estimate EBITDA, net income or sales and which in turn will help to compute company's value b) Discounted C.F - Dividend discount model - Present value of C.F or FCFE
c) Asset based approach - Value at fair price where company is in distressed or termination condn (Asset - outside liabilities)
Pvt equity Due diligence
- Financial experience of manager - Valuation methods
- Drawdown (redemption) procedures
6) Real Estate
- Income in the form of rent
- Helps in diversification since its an hedge against inflation
Forms of Real estate a) Residential properties
- Direct investment (can be leverage invt) - Value = Property value - Loan taken - MBS
b) Commercial properties
- Direct investment (generates rental income) - CMBS
c) Real estate inv trusts (REITs)
- Issues shares and they deal in real estate - Indirect investment
- 90% of income must be distributed to SH's
d) Timberland
- Sale of agricultural products or timber
e) Farmland
- Price depends on land, farm commodity products, quality of crops produced
Potential benefits and risks:
Performance is measured by 3 types of indices
a) Appraisal index - Period estimate of property values - National council of Real estate inv fiduciaries (NCREIF) Index return is smoother den actual sales and have lowest std deviation
b) Repeat sales index - Based on price of properties that have sold multiple times Sample sold may not be representative of board properties available
c) REIT indices - Actual trading prices of shares; similar to equity indices
Correlation of REIT and equity shares is 0.6 have same business cycle Correlation of REIT and bond has been very low
Methods used for perfomance valn can be one reason for lower reported correlation
Valuation of Real Estate
a) Comparable sales approach - Valuation based on sale of similar property adjusted for location, condition, age and size
b) Income approach i) PV of C.F
ii) Net operating income/Capitalization rate
c) Cost approach - Replacement cost i.e if similar property is bought/constructed today
d) REIT valuation
i) Income approach - Adjusted FFO/Capitalization rate
Adjusted FFO = Net income + Dep + Loss on sale of property - Gain on sale of property (since non recurring to be excluded) ii) q
Due diligence for Real estate
- Distressed investing and real estate development (zones) have addn risk to consider
7) Commodities
- Physical goods will have storage and transportation cost and hence derivatives are used to gain exposure
Types of commodities
a) Exchange traded funds (ETFs) - invests in commodities future and index
b) Equities that are directly linked to commodity - Purchase share of a company producing it ; Drawback commodity price and share price are not perfectly correlated c) Managed funds - Actively managed; specific sectors with min investment and better liquidity
d) Individual manaed accounts - For high net worth; tailored made accounts e) Specialized funds in specific sectors - Oil and gas, metals, etc
Potential benefits and risks:
- Return on commodities have low correlation as compared to equity and bonds (0.20) - Sharpe ratio have been low due to lower returns and high volatility of commodity prices
- Acts as hedging against inflation (commodity real return will be zero; futures can have +ve real returns)
Commodity pricing
- Spot price is based on demand and supply for the product
- If supply is inelastic in the short term and demand rises; price will be volatile
- Future price = spot price (1+risk free int rate) + storage cost - convenience yield - where Convenience yield = value of having physical commodity used over time
- If there is little or no convenience yield den future price will be higher den spot price called as "contango" and vice versa is called as "backwardation"
3 sources of commodity future returns:
a) Roll yield - Difference between 2 future contracts (+ve in backwardation and -ve in contango) b) Collateral yield - Interest earned on collateral reqd into a futures contract
c) Change in spot price - Convergence of future price into spot price
8) Management fees and Incentive fees calculation (2 and 20 or 1 and 10) a) Profits can be
- Any gain in value in excess of management fees - Any gain in excess of hurdle rate
b) Hard hurdle rate - Incentive only if profit is in Excess of benchmark provided Soft hurdle rate - Incentive will be provided on all whole profit if hurdle rate is met
c) Highwater mark - Incentive is not paid on gains that just offset prior losses Investor will not be charged twice on the same gains
Management fees can be charged on beginning asset value or ending asset value
Incentive can be based on net of management fee or independent of management fee (if nothing provided in qs - net of management fees)
Incentive fees = [Ending value - beg value - Management fee - hurdle rate] * Incentive %
9) Risk Management of Alternative Investments
a) Standard deviation may be misleading due to 2 reasons: - Return distribtion is not normal for alt investments
- Uses appraisal or estimate values and hence might understate S.D
This leads to higher Sharpe ratio and therefore Downside risk measure such as VAR or Sortino ratio should be used
b) REITs and ETFs - Mkt returns and std deviation can be used as they are traded on exchange
