CFA 2018 Level 2 Alternative Investments

Alternative

Investments

-- 2017

Brief Introduction

Topic weight:

Study Session 1-2 Ethics & Professional Standards 10%-15%

Study Session 3 Quantitative Analysis 5%-10%

Study Session 4 Economics 5%-10%

Study Session 5-6 Financial Reporting and Analysis 15%-20%

Study Session 7-8 Corporate Finance 5%-15%

Study Session 9-11 Equity Valuation 15%-25%

Study Session 12-13 Fixed Income 10%-20%

Study Session 14 Derivative Investment 5%-15%

Study Session 15 Alternative Investment 5%-10%

Study Session 16-17 Portfolio Management 5%-10%

Brief Introduction

Content:

Ø

Study Session 15: Alternative Investments

• Reading 43: Private Real Estate Investments

• Reading 44: Publicly Traded Real Estate Securities

• Reading 45: Private Equity Valuation

Brief Introduction

Exam-importance ranking:

• Reading 43: Private Real Estate Investments

• Reading 44: Publicly Traded Real Estate Securities • Reading 45: Private Equity Valuation

Brief Introduction

考纲对比:

Ø 与2016年相比，2017年的考纲更换了“大宗商品”这一章节。

Brief Introduction

学习建议:

Ø 本课程总体难度不高，知识点与其他课程（权益，财报，衍生品

等）有交集

Ø 重点掌握各另类资产的特征和估值方法

Ø 一定要掌握课程中重点强调的知识

Basics of Real Estate

Tasks:

Ø Classify and describe basic forms of real estate investments

Ø Describe the characteristics, the classification, and basic segments of real

estate

Ø Describe commercial property types, including their distinctive investment

Basic Forms of Real Estate Investments

Equity Debt

Private ownership, or indirectly through Direct investments such as sole partnerships and commingled

real estate funds

mortgages

Publicly

Basic Forms of Real Estate Investments

Ø Private investments involve larger investment because of the

indivisibility of real estate property and are illiquid.

Ø Publicly traded real estate investments are more liquid and

diversified

Ø Debt investors typically do not participate in any appreciation in

value of the underlying real estate

Real Estate Characteristics

Ø Heterogeneity and fixed location

• Buildings differ in use, size, location, age, type of construction, quality, and tenant and leasing arrangements

Ø High unit value

Ø Management intensive

• Including maintaining the properties, negotiating leases, etc.

Ø High transaction costs Ø Depreciation

Ø Need for debt capital Ø Illiquidity

Property Classifications

Ø Residential

• Single-family

• Multi-family

Ø Non-residential

• Commercial (including residential real estate purchased with the intent to produce income, office, industrial and warehouse, retail, hospitality properties)

Commercial Property Types

Office

Ø Demand depends heavily on employment growth Ø The average length of lease varies globally

Ø Possible lease structure:

• Net lease requires tenants to pay operating expenses

• Gross lease requires owners to pay the operating expenses

• The owner is responsible for the operating expenses in the first year, for every year after that, any increase in expenses above that amount is passed through to the tenant as an “expense reimbursement”

Commercial Property Types

Industrial and Warehouse

Ø Demand depends heavily on the overall strength of the economy and

economic growth, import and export activity

Ø Leases are often net leases

Retail

Ø Demand depends heavily on trends in consumer spending, which depends

on job and population growth, and saving rates

Ø Lease terms depend both on the quality of the property and on the size and

importance of the tenant (anchor tenants receive attractive terms)

Ø Tenants typically pay additional rent once their sales reach a certain level

Commercial Property Types

Multi-Family

Ø Demand depends on:

• Population growth, especially for the age segment most likely to rent apartments

• The propensity to rent in the culture

• How the cost of renting compares with the cost of owning (the ratio of home prices to rents)

Ø Importance: ☆

Ø Content:

• Basic forms of real estate investments

• Real estate characteristics

• Classifications of real estate

Ø Exam tips:

• 熟悉不动产投资形式

• 了解不动产特征

• 了解不动产分类

Investment Characteristics and Valuation

Approach

Tasks:

Ø Explain the role in a portfolio, economic value determinants, investment

characteristics, and principal risks of private real estate

Ø Compare the income, cost, and sale comparison approaches to valuing

Benefits of investing in Real Estate

Ø Current income (affected by taxes and financing costs) Ø Capital appreciation

Ø Bond-like and stock-like characteristics Ø Inflation hedge

• Both rents and real estate prices tend to rise in an inflationary environment

Risk Factors in Real Estate

Business conditions(GDP, employment, income, interest rates, inflation, etc.)

Long lead time for new development

Cost and availability of capital Unexpected inflation

Demographics(size and age distribution of the population, distribution of

socio-economic groups, etc.)

Lack of liquidity

Environmental issues Availability of information

Management (asset management, and

Valuation Approaches

Definitions of Values

Ø Market value: the most probable sale price

Ø Investment value: the value to a particular investor, could be higher or

lower than market value depending on how well the property fits into the investor’s portfolio, the investor’s risk tolerance, tax circumstances

Ø Value in use: the value to a particular user

Ø Mortgage lending value: the value expected to be generated in the event of

Valuation Approaches

Income approach

Ø The present value of the expected income from the property, including

proceeds from resale at the end of holding period Cost approach

Ø The concept is that you should not pay more than the cost of buying vacant

land and developing a comparable property

Ø Adjustments are made to reflect the differences between the subject

Valuation Approaches

Sales comparison approach

Ø The concept is you should not pay more than others are paying for similar

properties

Ø Transaction prices of comparable properties are used as benchmark,

Highest and best Use

Ø The highest and best use of a vacant site is the use that would result in the

highest value for the land

Ø Implied land value = value after completion – construction cost Ø The construction cost includes a profit to the developer

Ø The highest and best use is not necessarily the use with the highest total

value

Apartment Office Retail

Value after

construction 2,500,000 5,000,000 4,000,000

Ø Importance: ☆☆

Ø Content:

• Benefits of investing in real estate

• Risk factors in real estate

• Valuation approaches

Ø Exam tips:

• 熟悉不动产投资的好处和风险

• 理解不动产估值的三种方法

• 掌握土地的最高和最佳使用价值

Income Approach

Tasks:

Ø Estimate and interpret the inputs to the direct capitalization and

discounted cash flow valuation methods

Ø Calculate the value of a property using the direct capitalization and

discounted cash flow methods

Ø Compare the direct capitalization and discounted cash flow valuation

Income Approach

The direct capitalization method

Ø A capitalization rate is applied to the forecasted first-year NOI

The DCF method

Ø Apply explicit growth pattern to expect future NOI stream from which a

Income Approach

Net operating income (NOI)

Ø Income after deducting operating expenses such as property taxes,

insurance, maintenance, utilities, repairs but before deducting any costs associated with financing and before deducting income taxes

Ø NOI is a before-tax unleveraged measure of income

Ø It is necessary to consider lease terms when estimating NOI

Income Approach

NOI - Example

Income Approach

NOI – Solution

Rental income at full

occupancy 50*1,000*12 600,000

Other income 50*500 25,000

Potential gross income 625,000

Vacancy loss 5/50 or 10%*625,000 -62,500

Effective gross income 562,500

Property management 10%*562,500 -56,250

Other operating expenses 40%*562,500 -225,000

Income Approach

The direct capitalization method

Ø The method capitalizes the first-year(current) NOI at a rate known as the

capitalization rate, or cap rate for short

Value = (first-year NOI)/cap rate

Ø The cap rate is lower than the discount rate because it is calculated using the

first-year NOI whereas the discount rate is applied to first-year and future NOI

Ø When income are growing at a constant compound growth rate:

Income Approach

The direct capitalization method

Ø The cap rate can be estimated as:

Cap rate = (first-year NOI)/sales price of comparable

Ø If tenants pay all operating costs (net lease), the cap rate derived by

dividing rent by recent sales prices of comparables is called all risks yield (ARY)

Value = rent/ARY Stabilized NOI

Ø If the first-year NOI is not representative of the typical first-year NOI,

Income Approach

Valuation with a stabilized NOI – Example

A property is being purchased that requires some renovation to be

competitive with comparable properties. Renovations will be completed by the seller at the seller’s expense. If it were already renovated, it would have NOI of ¥9 million next year, which would be expected to increase by 3

percent per year thereafter. Investors would normally require a 12 percent IRR (discount rate) to purchase the property after it is renovated. Because of the renovation, the NOI will only be ¥4 million next year. But after that, the NOI is expected to be the same as it would be if it had already been

Income Approach

Valuation with a stabilized NOI – Solution

If the property was already renovated (and the NOI stabilized): Value if renovated = ¥9,000,000/(0.12 – 0.03) = ¥100,000,000 The present value of the lost income is

Loss in value = ¥5,000,000/(1.12) = ¥4,464,286

Value of the property =¥100,000,000 -¥4,464,286 = ¥95,535,714 Alternatively:

Income Approach

The discounted cash flow method

Step 1 – Forecast the terminal value at the end of the holding period (use direct capitalization method if NOI growth is constant).

Income Approach

The discounted cash flow method - Example

Net operating income (NOI) is expected to be level at $100,000 per year for the next five years because of existing leases. Starting in Year 6, the NOI is expected to increase to $120,000 because of lease rollovers and increase at 2 percent per year thereafter. The property value is also expected to

Income Approach

The discounted cash flow method – Solution Step 1 Estimate resale price after five years.

Resale (residual) or “terminal” cap rate = 12% − 2% = 10% Apply this to NOI in Year 6:

Resale = $120,000/0.10 = $1,200,000

Step 2 Discount the level NOI for the first five years and the resale price. PMT = $100,000 FV = $1,200,000 n =5 i = 12%

Solving for PV, the current value of the property is estimated to be $1,041,390.

Income Approach

Adapting to different lease structures

Ø If the appraisal date falls between the last rent review and the next rent review, Two methods are used:

• Term and reversion approach

ü The term rent is the fixed (current contract) rent, the reversion is the estimated rental value

ü The values of the two components are appraised separately using different capitalization rates

• The layer method

ü It assumes that one source of income is the current contract rent as if it would continue indefinitely

Income Approach

Term and reversion approach - Example

A property was let for a five-year term three years ago at £400,000 per year. Rent reviews occur every five years. The estimated rental value (ERV) in the current market is £450,000, and the all risks yield (cap rate) on

Income Approach

Term and reversion approach - Solution Term rent £400,000

PV 2 years at 4%

Value of term rent = £754,438 Reversion to ERV £450,000 PV perpetuity at 5%

Value at rent review £450,000 ÷ 0.05 = £9,000,000 PV 2 years at 5%

Income Approach

The layer method - Example

Consider the same property as the last example. The current contract (term) rent is to be discounted at 5 percent, and the

Income Approach

The layer method - Solution

Term rent £400,000 PV in perpetuity at 5%

Value of indefinite rent £400,000 ÷ 0.05 = £8,000,000 Incremental rent £450,000 – £400,000 = £50,000 PV perpetuity at 6% £50,000/0.06

PV 2 years at 6%

Income Approach

Advanced DCF: lease-by-lease analysis Ø Project income from existing leases

Ø Make assumptions about lease renewals

Ø Make assumptions about operating expenses

Ø Make assumptions about capital expenditures

Ø Make assumptions about absorption of any vacant space

Ø Estimate resale value (reversion)

Differences

Ø Under the direct capitalization method, a cap rate is applied to first-year NOI. Implicit in the cap rate is an expected increase in growth.

Ø Under the DCF method, the future cash flows, including the capital expenditures and terminal value, are projected over the holding period and discounted to present at the discount rate. Future growth of NOI is

explicit to the DCF method. Choosing the appropriate discount rate and terminal cap rate are crucial as small differences in the rates can

Ø Importance: ☆☆☆

Ø Content:

• Direct capitalization methods

• The DCF methods

• The comparison of direct capitalization methods and the DCF methods

Ø Exam tips:

• 必须掌握不动产估值的直接资本化法和现金流折现法

• 能区分直接资本化法和现金流折现法

Cost and Sales Comparison Approaches

Tasks:

Ø Calculate the value of a property using the cost and sales comparison

Cost Approach

Steps involved with applying the cost approach

1. Estimate the market value of the land.

2. Estimate the building’s replacement cost, assuming it was built today using current construction costs and standards

3. The replacement cost is adjusted for:

Ø physical deterioration (curable and incurable) Ø functional obsolescence

Ø locational obsolescence Ø economic obsolescence

Cost Approach

Ø Physical deterioration is generally related to the age of the property because the property wears out over time

• Curable deterioration means fixing the problem will add value that is at least as great as the cost of the cure, the cost of fixing any curable items must be deducted from the replacement cost

Cost Approach

Ø Functional obsolescence is a loss in value due to a design that is not appropriate for the intended use of the property

• Usually results in less rent income or higher operating expenses

• The amount of functional obsolescence is estimated by the present value of the income loss

Ø Locational obsolescence results when the location is not optimal for the property

Cost Approach - Example

Market value of the land (from comparables) $4,000,000

Replacement cost, including constructor’s profit $16,750,000

Reduction for curable deterioration ($1,000,000)

Reduction for incurable deterioration (total economic life and effective

age is 50 and 10 respectively, so ratio of effective to total is 20% ($3,150,000)

Reduction for functional obsolescence (poor floor plan and

substandard energy efficiency) ($1,750,000 ) Reduction for locational obsolescence (recent construction of roads in

park land thus reducing amenity) ($1,000,000 ) Reduction for economic obsolescence (recent construction of

Sales Comparison Approach

Steps involved with applying the sales comparison approach:

1. Adjust the prices of similar (comparable) properties for size, age, location, property condition, and market conditions at the time of sale, etc.

2. Calculate the per-square-price according to each adjusted price

3. Calculate the average of all the per-square-prices

• More weight may be given to comparables that are more similar to the subject property

Sales Comparison Approach - Example

variable _propertySubject comparables

1 2 3 4 5

Size(square

feet 15,000 25,000 20,000 10,000 16,000 12,500

Age (years) 10 1 5 10 15 20

Sales Comparison Approach - Example

The following indicates how the adjustments were made to the comparables to reflect the characteristics of the subject property:

1. Depreciated at 2.5 percent per annum.

2. Condition adjustment after average depreciation is taken into account: Good, none; Average, 10%; Poor, 20%.

Sales Comparison Approach - Solution

variable _propertySubject comparables

1 2 3 4 5

Age (years) 10 -22.5% -12.5% 0 12.5% 25% Condition Average -10% -10% -10% 0 10%

Location Prime 0 20% 20% 20% 0

Date of sale

(months ago) 1.5% 4.5% 3% 3.5% 6%

Adjusted

price psf $151.8 $153 $146.9 $148.24 $146.64 Average

price psf $149.3 Appraised

Ø Importance: ☆☆☆

Ø Content:

• The cost approach

• The sales comparison approach

Ø Exam tips:

• 必须掌握不动产估值的成本法和交易比较法

Real Estate Indices and Debt

Tasks:

Ø Describe due diligence in private equity real estate investment

Ø Discuss private equity real estate investment indices

Ø Calculate and interpret financial ratios used to analyze and evaluate

Due Diligence

Ø Investors perform due diligence to confirm the facts and conditions that might affect the value of the transaction.

Ø Due diligence involves: reviewing leases, confirming expenses, performing inspections, surveying the property, examining legal documents, and

Real Estate Indices

Ø Appraisal-Based Indices rely on appraisals to estimate how the value of a portfolio of properties is changing over time

Ø Transaction-Based Indices are created based on actual transactions

• Repeat sales index replies on repeat sales of the same property

• Hedonic index requires only one sale, includes variables in a regression that control for differences in size, age, quality of construction, location, etc.

Ø Appraisal-based indices tend to lag transaction-based indices and tend to

Private Market Real Estate Debt

Ø The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio

(DSCR), depending on which measure results in the lowest loan amount.

Debt service coverage ratio

DSCR = (first-year NOI) / debt service

Loan-to-value ratio

Example

A property has been appraised for $5 million and is expected to have NOI of $400,000 in the first year. The lender is willing to make an interest-only loan at an 8 percent interest rate as long as the loan-to-value ratio does not

exceed 80 percent and the DSCR is at least 1.25. The balance of the loan will be due after seven years. How much of a loan can be obtained?

Solution

Based on the loan-to-value ratio, the loan would be 80 percent of $5 million or $4 million.

With a DSCR of 1.25, the maximum debt service would be $400,000/1.25 = $320,000. If the loan is interest only, then we can obtain the loan amount by simply dividing the mortgage payment by the interest rate: $320,000/0.08 = $4,000,000.

In this case, we obtain the same loan amount based on either the LTV or DSCR requirements of the lender. If one ratio had resulted in a lower loan amount, that would normally be the maximum that could be borrowed.

Ø Importance: ☆☆

Ø Content:

• Due diligence

• Private real estate indices

• Private real estate debts

Ø Exam tips:

• 了解私人不动产投资的尽职调查

• 了解私人不动产投资指数

• 掌握私人不动产负债财务分析比值和最低贷款额计算

Characteristics of Publicly Traded Real

Estate Securities

Tasks:

Ø Describe types of publicly traded real estate securities

Ø Explain advantages and disadvantages of investing in real estate through

Basic Forms of Real Estate Investments

Ø Real Estate Investment Trusts (REITs) are tax-advantaged entities that typically own, operate, and to a limited extent develop income-producing real estate property. They include equity REITs and mortgage REITs

Ø Real Estate Operating Companies (REOCs) are ordinary taxable real estate ownership companies. They are located in countries that do not have a tax-advantaged REIT regime or when they engage to a large extent in the

development of real estate, often with the intent to sell

Advantages of Publicly Traded Real Estate Investments

Ø Superior liquidity.

Ø Lower minimum investment.

Ø Limited liability.

Ø Access to premium properties.

Ø Active professional management.

Ø Protections accorded to publicly traded securities.

Ø Greater potential for diversification.

Ø Exemption from taxation.

Ø Earnings predictability.

Disadvantages of Publicly Traded Real Estate Investments

Ø Taxes versus direct ownership.

Ø Lack of control.

Ø Costs of a publicly traded corporate structure.

Ø Price is determined by the stock market.

Ø Structural conflicts of interest.

Ø Limited potential for income growth.

Ø Forced equity issuance.

Ø Importance: ☆☆

Ø Content:

• Types of publicly traded real estate securities

• Advantages and disadvantages of publicly traded real estate securities

Ø Exam tips:

• 了解公开交易的不动产证券类型

• 了解公开交易的不动产证券的优缺点

Real Estate Investment Trust (REIT)

Tasks:

Ø Explain economic value determinant, investment characteristics, principal

risks, and due diligence considerations for real estate investment trust shares

Publicly Traded Equity REITs

REIT Structure

Ø Simple structure that hold and operate properties directly.

Ø Umbrella partnership REITs (UPREITs) under which the REIT has a

controlling interest in and serves as the general partner that owns and operates all or most of the properties.

Ø DOWNREIT is a variation of the UPREIT under which the REIT owns

Publicly Traded Equity REITs

Investment Characteristics

Ø Exemption from corporate-level income taxes.

Ø High dividend yield.

Ø Low income volatility.

Publicly Traded Equity REITs

Due Diligence

Ø Remaining lease terms. Ø Inflation protection.

Ø Occupancy rates and leasing activity. Ø In-place rents versus market rents. Ø Costs to re-lease space.

Ø Tenant concentration in the portfolio. Ø Tenants’ financial health.

Ø New supply versus demand. Ø Balance sheet analysis.

Types of REITs

Retail REITs

Ø Invest in such retail properties as regional shopping malls, community

shopping centers, or premium retail space

Ø Lease terms are typically 3-10 years

Ø Tenants pay a net rent, plus a share of the common area costs based on

their proportionate share of the space leased Office REITs

Ø Invest in and manage multi-tenanted office properties Ø Lease terms are typically long (5-25 years)

Ø With contractual base rents that are fixed and adjust upward

Ø Tenants also pay their proportionate share of operating expenses, common

Types of REITs

Residential ("multi-family") REITs

Ø Invest in and manage rental apartments, typically using one-year leases Ø Tenants typically pay gross leases

Health care REITs

Ø Invest in skilled nursing facilities, assisted living and independent residential

facilities for retired persons, hospitals, medical buildings, and rehabilitation centers

Types of REITs

Industrial REITs

Ø own properties used in manufacturing, warehousing and distribution Ø Lease terms are typically 5-25 years

Hotel REITs

Ø Own hotel properties, but usually not permitted to operate the

properties themselves

Ø Rental income typically accounts for the major portion of a hotel’s

net operating cash flow

Types of REITs

Storage REITs

Ø Own and operate self-storage lockers to individuals and small

businesses.

Ø Tenants typically pay gross leases, usually on a monthly basis

Diversified REITs

Types of REITs

Risk Factors

Ø Significant mismatches between supply and demand (particularly

health care, hotel, and office REITs

Ø Varying occupancy rates over a short period of time (especially hotels)

Ø Quality and locations of properties held by REITs

Types of REITs

Importance of Factors affecting Economic Value for Properties

National GDP

Growth Job Creation Retail Sales Growth

Population

Ø Importance: ☆

Ø Content:

• Characteristics of REITs

• Due diligence of REITs

• Types of REITs

Ø Exam tips:

• 了解不动产投资信托基金的特征，尽职调查，和类型

Net Asset Value Per Share (NAVPS)

Tasks:

Ø Justify the use of net asset value per share in REIT valuation

Valuation – Net Asset Value Approach

Ø NAVPS is the difference between a real estate company’s assets and

liabilities, all taken at current market values, divided by the number of shares outstanding

Ø Discounts in the REIT share price from NAVPS indicate potential

undervaluation

Ø Premiums in the REIT share price to NAVPS, in the absence of positive

future events such as successful property developments or expected high value creation by a management team, suggest potential

Valuation – Net Asset Value Approach

Steps in NAVPS Approach

1. Values of properties held by REITs and REOCs are estimated by capitalizing the rental streams (NOI) using a cap rate

Ø NOI removes non-cash rents due to accounting practice of “straight

lining” the rental revenue from lone-term leases

Ø NOI is also increased to reflect a full year’s rent for properties acquired

during the course of the year

Valuation – Net Asset Value Approach

2. The book values of other tangible assets including cash, account receivable, land for future development, prepaid expenses are added to obtain

estimated gross asset value

Ø Goodwill and deferred tax assets are excluded

2. Debt and other liabilities are subtracted to obtain net asset value

Ø Deferred tax liabilities are excluded

Valuation – Net Asset Value Approach

Estimated cash NOI

÷ Assumed cap rate

= Estimated value of operating real estate

+ other assets (Cash and receivable, land, etc.) excluding goodwill and deferred tax assets

－Debt and other liabilities excluding deferred tax liabilities = Net asset value

Net Asset Value Approach - Example

Net Asset Value Approach - Example

(1) 50 percent of the expected return on acquisitions was made in the middle of 2010.

(2) Growth is estimated at 1.5 percent.

Valuation – Net Asset Value Approach

Considerations in NAV approach

Ø The discount rate used by a private owner could be different from the

discount rate used by REIT investors

Ø NAV reflects the value of a REIT’s assets to a private market buyer

Ø NAV implicitly treats the REIT as a static pool of assets (sum-of-the-parts)

Ø NAV estimates can become quite subjective when property market become

Ø Importance: ☆☆☆

Ø Content:

• NAVPS valuation

• Considerations in NAVPS approach

Ø Exam tips:

• 必须掌握NAVPS计算 • 了解NAVPS的缺点

Fund From Operation (FFO)

Adjusted Fund From Operation (AFFO)

Tasks:

Ø Describe the use of funds from operations and adjusted fund from

operation in REIT valuation

Valuation – Relative Value (price multiple) Approach

Ø P/FFO and P/AFFO multiples are used in relative valuation

Ø Formula for FFO (funds from operations)

Accounting net earnings

+ Depreciation expense

+ Deferred tax expenses

Valuation – Relative Value (price multiple) Approach

Ø Formula for AFFO (adjusted funds from operations)

FFO (funds from operations)

－ Non-cash (straight-line) rent adjustment

－ Recurring maintenance-type capital expenditures and leasing commissions

Valuation – Relative Value (price multiple) Approach

Example

Patricia Ly, CFA finds the following data for a particular industrial REIT: Net operating income (NOI): $710,000

Funds from operations (FFO): $630,000 Assumed cap rate: 6%

Shares outstanding: 90,000 shares

Storage property average P/FFO multiple: 13x. Industrial property average P/FFO multiple: 10x.

Valuation – Relative Value (price multiple) Approach

Solution

FFO/share = FFO / Shares outstanding = $630,000/90,000

= $7/share.

The relevant subsector average P/FFO multiple is the value for industrial properties of 10x

Ø Importance: ☆☆☆

Ø Content:

• FFO and AFFO

Ø Exam tips:

• 必须掌握FFO和AFFO计算

• 使用P/FFO和P/AFFO估值

Fundamentals of Private Equity Investments

Tasks:

Ø Explain sources of value creation in private equity

Ø Explain how private equity firms align their interests with those of the

managers of portfolio companies

Ø Distinguish between the characteristics of buyout and venture capital

Sources of Value Creation in Private Equity

Ø Reengineer firm for more efficient operations – bring expertise

Ø Obtain lower cost debt financing via access to cheap credit and few

covenants

Alignment of Economic Interests

Ø Managers focus on long term performance over short term

Ø Mechanisms to align interests of private equity firm and managers specified

in term sheet

Ø Examples of control mechanisms specified in term sheet:

• Compensation – closely linked to performance and promote goal achievement

Valuation Characteristics of Venture Capital Investments

Ø Cash flow – unpredictable

• Product – uncertain future based on new technology

Ø Asset base is weak

Ø Management team has strong entrepreneurial record

Ø Low leverage, mostly equity

Valuation Characteristics of Venture Capital Investments

Ø Exit strategy is unpredictable (IPO or firm sale)

Ø Operations – High cash burn rate

Ø Capital required in growth phase

Ø Returns from few highly successful investments with write-offs from many

failures

Ø Not active in public capital markets

Ø Future funding – less scalable

Valuation Characteristics of Buyout Investments

Ø Cash flow – stable and predictable

Ø Established products

Ø Substantial asset base

Ø Experienced management team

Ø Highly levered with senior debt

Valuation Characteristics of Buyout Investments

Ø Exit strategy is predictable

Ø Reduction in operational inefficiencies

Ø Low working capital requirements

Ø Low variability in success, rare failures

Ø Active in public capital markets

Ø Subsequent funding easy with strong performance

Ø Importance: ☆

Ø Content:

• Sources of value creation in PE

• Alignment of interest

• Valuation characteristics of VC and Buyouts

Ø Exam tips:

• 了解PE价值创造来源

• 了解PE与组合公司管理层利益联盟

• 了解VC和Buyout估值特征

Components of Performance from LBO

Exit Routes

Tasks:

Ø Describe valuation issues in buyout and venture capital transactions

Valuation Issues in Private Equity

Valuation issue Buyout Venture capital

Use of DCF Frequently used Uncertain cash flows

Relative value Validates DCF No comparables

Use of debt High Low, more equity

Components of Performance from a Leveraged Buyout

Ø Exit Value = Investment Cost + Earnings Growth + Multiple Expansion +

Reduction in Debt

Ø Not valuation but max price determination to pay upfront and forecasted

exit value

Ø Earnings growth due to operational efficiencies

Ø Increase in price multiple due to increased growth

Components of Performance from a Leveraged Buyout

Example:

Suppose there is a €5,000 (amounts in millions) investment in a PE transaction. The transaction is financed with 50 percent debt and 50 percent equity. The €2,500 equity investment is further broken into €2,400 of preference shares owned by the PE fund, €95 of equity owned by the PE fund, and €5 of

management equity. The preference shares are promised a 12 percent annual return (paid at exit). The PE firm equity is promised 95 percent of the residual value of the firm after creditors and preference shares are paid, and

management equity holders are promised the remaining 5 percent. Assume that the exit value, five years after investment, is 1.6 times the original cost. The

Components of Performance from a Leveraged Buyout

Solution:

Ø Senior debt has been partially retired with operational cash flows, reducing

debt from €2,500 to €1,600. So debtholders get €1,600.

Ø Preference shares are paid a 12 percent return for 5 years, so they receive

€2,400(1.12)^5 = €4,230.

Ø PE Fund equity receives 95 percent of the terminal equity value, or 0.95[8000

− (4230 + 1600)] = €2,061.

Ø Management equity receives 5 percent of the terminal equity value, or

Exit Routes and PE Value

1) Initial Public Offering (IPO):

Ø Pros: highest exit value, higher liquidity, access to capital, and attract

good management

Ø Cons: Less flexible, more costly, and complex

Exit Routes and PE Value

2) Secondary Market sale: sale from one firm to another for strategic reasons

• Pros: second highest valuation

3) Management Buyout: firm sold to management with significant use of leverage

4) Liquidation: Outright sale of firm’s assets, firm no longer viable

Ø Importance: ☆☆

Ø Content:

• Valuation issues in PE

• Components of performance from LBO

• Exit routes

Ø Exam tips:

• 重点掌握LBO的投资业绩组成

• 了解PE退出策略

Risks, Costs and other details of PE investing

Tasks:

Ø Explain private equity fund structures, terms, valuation, and due diligence

in the context of an analysis of private equity fund returns

Risks in Private Equity Investing

Ø Liquidity risk – not publicly traded

Ø Competition environment risk – fewer deals with good prospects at low cost Ø Agency risk – principal agent conflict

Ø Capital risk – withdrawal of capital due increase in business and financial

risk

Ø Regulatory risk – adverse government regulation Ø Tax risk – treatment of returns changes

Ø Valuation risk – reflects subjective _judgement

Costs of Private Equity Investing

Ø Transaction costs – due diligence, bank financing, legal fees Ø Fund set up costs – usually amortized over life of fund

Ø Administrative costs – custodian, transfer agent, and accounting costs

charged yearly

Ø Audit fees

Ø Management fee = 2% (typical) Ø Performance fee = 20% (typical)

Ø Dilution costs – resulting from additional rounds of financing and stock

options

Ø Placement fees – as much as a 2% up-front fee or annual trailer paid to

Private Equity Details

Ø Structure – limited partnership (LP) provides funding, no active role, limited

liability. GP liable for all debts and unlimited liability, 10-12 year lives.

Ø Economic Terms – “qualified” investors only with > $1.0 mm in assets

• Management fees – 1.5%-2.0%

• Carried interest – GP’s share of profits

Private Equity Details

• Hurdle rate – IRR target before GP can receive carried interest (7%-10%)

• Target fund size – Signals GP’s ability to raise funds, below is negative signal

Private Equity Details

Ø Corporate Governance Terms:

• Key man clause – in case of the departure of key named executives or insufficient time spent in management of the fund, the GP may be prohibited from making any new investments until a new executive is appointed

• Disclosure and confidentiality

Private Equity Details

Ø Distribution waterfall is a mechanism providing an order of distributions to

LPs first before the GP receives carried interest

• Deal-by-deal waterfalls allow earlier distribution of carried interest to the GP

• Total return waterfalls allow earlier distributions to LPs

ü The GP receives carried interest only after the fund has returned

the entire committed capital to LPs

ü The GP receives carried interest on any distribution as long as the

Private Equity Details

Ø Tag-along, drag along rights: any potential acquirer of the company may not

acquire control without extending an acquisition offer to all shareholders, including the management

Ø No-fault divorce: a GP may be removed without cause provided that a super

majority of LPs approve

Ø Removal for “cause”: allows either a removal of the GP or an earlier

termination of the fund for cause

Ø Importance: ☆☆

Ø Content:

• Risks and costs of PE investing

• Structures, terms and governance of PE

Ø Exam tips:

• 理解PE投资的风险和成本

• 熟悉PE投资的结构，术语和治理条款

Financial Performance of PE Funds

Tasks:

Ø Interpret and Compare financial performance of PE funds from the

perspective of an investor

Ø Calculate management fees, carried interest, net asset value, distributed

Financial Performance of Private Equity Funds

Ø Recommended: GIPS Since inception IRR

• SI-IRR is a money weighted return

• Assumes intermediate cash flows reinvested at IRR but PE funds tend to be illiquid

• Gross or net of fees

Financial Performance of Private Equity Funds

Ø Multiples: Popular, simple, easy to use and differentiates between realized

and unrealized returns, specified by GIPS

• Paid in Capital (PIC) – % of capital used by GP

• Distributed to PIC (DPI) – measures LP realized return, cash on cash return

• Residual Value to PIC (RVPI) – measures LP’s unrealized return

Financial Performance of Private Equity Funds

Example:

The GP for PE Fund charges a management fee of 2% and carried interest of 20%, which is paid after portfolio value exceeds committed capital

The total committed capital for the fund was $180 million

Financial Performance of Private Equity Funds

Solution:

Management Fee = 2% × Paid in Capital

Year Paid in capital Management fee

2007 150 3

Financial Performance of Private Equity Funds

Ø Calculate Carried Interest = 20% × (NAV before distributions - committed

capital)

Ø Calculate carried interest

• Committed capital = $180

• NAV before distributions = $94.2 in 2006, $181.2 in 2007, and $227.8 in 2008

Ø In 2007, carried interest is 20% × (NAV before distribution – Committed

Capital) = 20% × ($181.2 – $180) = $0.24

Ø In 2008, carried interest is 20% × change in NAV before distribution = 20% ×

Financial Performance of Private Equity Funds

NAV before distributions = previous year NAV after distribution + capital called down – management fee + operating results

Ø Calculate 2008 NAV before distribution

• 2007 NAV after distribution = $141.0

• 2008 capital called down = $10.0

• 2008 management fee = $3.2

• Operating results = $80.0

Financial Performance of Private Equity Funds

NAV after distributions = NAV before distribution – carried interest - distribution

Ø Calculate 2008 NAV after distributions:

• 2008 NAV before distributions = $227.8

• 2008 Carried interest = $9.32

• 2008 Distributions = $60

Financial Performance of Private Equity Funds

Distributed to PIC (DPI) measures GP realized return or cash on cash return DPI = Cumulative Distributions / Paid-in-Capital

• Distributions in 2007 = $40,

• 2008 = $60

• 2009 = $100

• Assume 2009 paid-in-capital was $165

Financial Performance of Private Equity Funds

Residual Value to PIC (RVPI) – measures LP’s unrealized return

RVPI = NAV after Distributions / Paid-in-Capital Assume:

• 2009 NAV after distributions = $177.7

• 2009 paid in capital = $165

Financial Performance of Private Equity Funds

Total value to PIC (TVPI) – measures LP’s realized (DPI) and unrealized (RVPI) returns

TVPI = DPI + RVPI Assume:

• 2009 DPI = 1.21

• 2009 RVPI = 1.08

Ø Importance: ☆☆☆

Ø Content:

• Financial performance of PE funds

Ø Exam tips:

• 必须掌握PE基金投资业绩的相关计算（management fees, carried

interest, NAV, DPI, RVPI, TVPI）

VC Valuation

Tasks:

Ø Calculate pre-money valuation, post-money valuation, ownership fraction,

and price per share applying the venture capital method 1) with single and multiple financing rounds and 2) in terms of IRR

The Venture Capital Method and a Single Financing Round

Example:

Ø A firm’s entrepreneurs believe they can sell the firm for $60 mm (FV) in 5

years

Ø Initial investment $7 mm (INV)

Ø They want to hold 1 mm shares

Ø Discount rate of 40%

Ø Calculate pre- and post-money valuation, ownership fraction and price per

The Venture Capital Method and a Single Financing Round

Post-Money Valuation:

Pre-Money Valuation: PRE = POST －INV

The Venture Capital Method and a Single Financing Round

Required Fractional Ownership (ƒ):

Shares required for PE firm

7,000,000 62.75%

S_pe 1,000,000[ 0.6275

The Venture Capital Method and a Single Financing Round

Stock Price per share:

P  INV

S_pe

P  7,000,000

The Venture Capital Method and Multiple Financing Round

Example:

Ø Entrepreneurs need $4 million now and $3 million in three years

Ø IPO firm for $60 million in 5 years, want 1 million shares, and

discount rate is 40%

Ø Calculate pre- and post-money valuation, ownership fraction and

The Venture Capital Method and Multiple Financing Round

Compound Discount Rate:

Post-Money Valuation at 2nd financing round:

The Venture Capital Method and Multiple Financing Round

Pre-Money Valuation at 2nd financing round

Post-Money Valuation at 1st financing round:

PRE

₂ 

POST

₂ -

INV

₂

PRE

₂  _30,612,245-_3,000,000 _$27,612,245

The Venture Capital Method and Multiple Financing Round

Pre-Money Valuation at 1st financing round

Required ownership for 2nd round investors:

PRE

₁ 

POST

₁-

INV

₁

PRE

₁ _10,062,771-_4,000,000_$6,062,771

f₂  INV2

POST 2

f₂  3,000,000

The Venture Capital Method and Multiple Financing Round

Required ownership for 1st round investors:

Required shares for 1st round investors:

The Venture Capital Method and Multiple Financing Round

Stock price after 1st financing round:

The Venture Capital Method and Multiple Financing Round

Stock price after 2nd financing round:

P₂  INV2 S_pe2

P₂  3,000,000

The VC Method, a Single Financing Round, and the IRR

Example:

Ø In the previous example, we used a NPV approach

Ø Now we use the IRR approach with a single financing round

Ø The firm will still sell for $60 million in 5 years, need $7 million now, 1 million

shares for entrepreneurs & disc. Rate 40%

The VC Method, a Single Financing Round, and the IRR

Investor’s Future Wealth (W):

Required Fractional Ownership for the PE firm:

W INV ´₍₁r)N

W _7,000,000´₍₁_0.40)5

_$37,647,680

f  W FV

f  37,647,680

The VC Method, a Single Financing Round, and the IRR

Shares required for PE firm:

Stock Price per share:

S_pe  S_e[ f (1- f)]

S_pe 1,000,000[ 0.6275

(1-0.6275)]1,684,564

P  INV

S_pe

P  7,000,000

The VC Method, a Single Financing Round, and the IRR

Post-Money Valuation:

Pre-Money Valuation: PRE = POST －INV

PRE = 11.1 million －7.0 million = $4.1 million POST  P´₍S_peS_e)

The VC Method, a Single Financing Round, and the IRR

Example:

Ø Assume the possible terminal values are $60 million, $40 million and $0

Ø If each has an equal probability of occurring, then the expected terminal

value is: 1_{($60) ($40) ($0) $33.3}1 1

3 3 3 million

Ø Importance: ☆☆☆

Ø Content:

• VC valuations

Ø Exam tips:

• 必须掌握VC投资的估值计算（pre-money, post-money,

ownership fraction, price per share）

Fundamentals of Commodities

Tasks:

Ø Compare characteristics of commodity sectors

Ø Compare the life cycle of commodity sectors from production through

trading or consumption

Ø Contrast the valuation of commodities with the valuation of equities and

bonds

Characteristics of Commodity Sectors

Energy:

Ø Crude oil

• has limited use by itself

• drivers of demand and supply include technology, politics, and business cycle

Ø Natural gas

• can be used directly

• storage and transportation costs are relatively high

• drivers of demand and supply are similar to crude oil, but also include weather

Ø Refined products (heating oil, gasoline, jet fuel, propane, etc)

Characteristics of Commodity Sectors

Ø Grains

• generally have long storage period to last multiple seasons

• weather is extremely important

Ø Industrial metals (copper, aluminum, etc)

• demand is associated directly with GDP growth

• can be stored for years, less susceptible to weather

• politics have a sizable impact on pricing

Ø Livestock

• drivers of supply include grain prices, weather, disease, government-permitted use of drugs and growth hormones

• GDP per capita is the most important driver of demand

Characteristics of Commodity Sectors

Ø Precious metals (gold, silver, platinum, etc)

• both as stores of value (similar to currencies) and consumed inputs in electronics, auto parts, jewelry, etc)

• drivers of supply and demand include inflation expectations, fund flows, industrial production, etc.

Ø Softs/cash crops (cotton, coffee, sugar, cocoa, etc)

• sold for income as opposed to consumed for subsistence

• storability is important

• weather is an important driver of supply

Life Cycle of Commodity Sectors

Ø life cycle means the time span from production through trade and

consumption

Ø a short life cycle allows for rapid adjustment to outside events

Energy

• natrual gas can be consumed nearly after extraction

Life Cycle of Commodity Sectors

Industrial/Precious Metals

• a key consideration regarding the supply is economics of scale

• given typical economic cycle and time lag involved between deciding to expand capacity, new supply often arrives just as demand is declining Livestock

• advances in freezing technologies have increased the import/export trade

• Grains

Valuation of Commodities

Compared to equities and bonds, commodities

Ø are tangible/physical assets with an intrinsic economic value

Ø do not generate future cash flows beyond what can be realized through

purchase and sale

Ø the valuation is not based on future profitability and cash flows but on future

possible prices which are based on demand and supply

Ø incur transportation and storage costs which affect the shape of the forward

Participants in Commodity Futures Markets

Ø Hedgers trade in the markets to hedge their exposure related to the

commodity

• hedgers may speculate based on their perceived unique insight into market conditions and determine the appropriate amount of hedging

Ø Traders and investors (speculators) speculate on market direction or

volatility and provide liquidity and price discovery for the market in exchange for a profit

Ø Arbitrageurs attempt to capitalize on mispricing between commodity (along

Participants in Commodity Futures Markets

Ø Exchanges (clearing houses) set trading rules and provide the

infrastructure of transmitting prices and payments

Ø Analysts use the exchange information for non-trading purposes, such as

creating products based on commodity futures (ETF)

Ø Importance: ☆

Ø Content:

• Characteristics of commodity sectors

• Life cycles of commodities

• Valuation comparison of commodities and traditional investments

• Types of participants

Ø Exam tips:

• 了解大宗商品分类，生命周期，与传统资产估值比较，及参与者类型

Contango and Backwardation

Theories of commodity Futures Returns

Tasks:

Ø Analyze the relationship between spot prices and expected future prices in

markets in contango and markets in backwardation

Spot and Futures Pricing

Ø Basis is the difference between spot and futures prices

Ø Backwardation is the situation in which spot price exceeds the futures

price, or the near-term (closer to expiration) futures price is higher than the longer-term futures price (positive calendar spread)

Ø the opposite case of backwardation is contango

Ø the futures price difference between the near-term and longer-term

Spot and Futures Pricing

Ø commodity futures are settled by either cash or physical delivery

Ø cash settlement enable higher involvement of speculators and

arbitrageurs

Ø physical settlement ensures a convergence of the futures and spot

price, which may not occur in a cash-settlement market

Ø spot prices are highly localized and associated with physical delivery,

limiting the ability to hedge and speculate

Theories of Futures Returns

Insurance Theory (normal backwardation)

Ø a commodity producer is long the physical good and thus would

short futures contracts to hedge its sales price and make their revenues more predictable

Ø the futures curve is in backwardation normally because

producers persistently sell futures, pushing down futures prices

Ø the futures price has to be lower than the current spot price as a

form of remuneration to speculators who takes on the price risk

Theories of Futures Returns

Hedging Pressure Hypothesis

Ø hedging pressure occurs for both producers and consumers

Ø if the two forces of producers and consumers are equal in weight,

then the futures curve is flat

Ø if producers are more interested in selling futures than consumers,

the market is backwardation in order to attract speculators to complete the market

Ø if consumers are more concerned about price risk, the market is

contango

Ø the theory is still incomplete

• producers generally have greater exposure to price risk than consumer do

Theories of Futures Returns

Theory of Storage

Ø storage costs lead to a higher price in the future (contango)

Ø convenience yield lead to a lower price in the future (backwardation) Ø holding commodities inventory provides a benefit to consumers

because it acts as a buffer to a potential supply disruption

Ø convenience yield is inversely related to the inventory size and

availability of commodities

futures price = spot price + storage costs - convenience yield

Ø all theories have components that are unobservable and volatile,

Ø Importance: ☆☆☆

Ø Content:

• Contango and backwardation

• Theories of commodity futures returns

Ø Exam tips:

• 理解期货溢价和现货溢价

• 重点掌握大宗商品期货回报理论

Returns of Commodities Futures

Tasks:

Ø Describe, calculate, and interpret the components of total returns for a

fully collateralized commodity futures contract

Components of Futures Returns

The total return on commodity futures include:

Ø price return (spot yield) is the change in commodity futures prices, generally

the front month contract

price return = (current price - previous price)/previous price

Ø roll yield is the return generated by contract replacement

• investors cannot construct a portfolio including only roll returns

• roll return is a portion of total return for a fully collateralized futures contract

Ø collateral return is the yield for collateral

Example 1

consider the roll from the March contract to the April contract for WTI Crude Oil on 7 February 2014, which rolls its positions over a five-day period (so 1/5 = 20% per day):

Ø March contract closing price: $99.88/barrel

Ø April contract closing price: $99.35/barrel

Solution:

Ø ($99.88 – $99.35)/$99.88 = 0.53% gross roll return × 20% rollover portion

Example 2

An investor has a $10,000 position in long futures contracts for soybeans that he wants to roll forward. The current contracts, which are close to expiration, are

priced at $4.00 per bushel whereas the longer term contract he wants to roll into is priced at $2.50 per bushel. What are the transactions—in terms of buying and

selling new contracts—he needs to execute in order to maintain his current exposure?

A. Close out (sell) 2,500 near-term contracts and initiate (buy) 4,000 of the longer-term contracts.

B. Close out (buy) 2,500 near-term contracts and initiate (sell) 4,000 of the longer term contracts.

Solution

A is correct. To roll over the same level of total exposure ($10,000), he will need to do the following:

Sell:

$10,000/$4.00 per contract = 2,500 existing contracts And replace this position by purchasing: