Please enable JavaScript.

Coggle requires JavaScript to display documents.

Reading 50: Introduction to Alternative Investments - Coggle Diagram

- - - - Limited to qualified investors
      - Lockup period: Minimum time before investor can withdraw funds
      - Notice period: Days within which a fund must fulfill a redemption request
      - Investment companies structured as limited partnerships, use leverage, derivatives, short selling
      - Loss is magnified by margin call: Have to liquidate losing position to meet margin call, thus exacerbate the loss
    - - Event-driven strategies
        
        Merger arbitrage: buy shares of firm being acquired, short shares of acquirer
        
        Distressed/ restructuring: buy if restructuring will increase value
        
        Activist shareholder: Gain board seats to influence company decisions
        
        Special situations: Spinoffs, asset sales, security issuance or repurchase
        
        use bottom-up approach and seek to profit from short-term event
      - Relative value strategies
        
        Convertible arbitrage: Convertible bonds vs. underlying common stock
        
        Asset-backed: ABS, MBS
        
        General fixed income
        
        Volatility: Trade options based on implied versus expected volatility
        
        Multi-strategy: Across asset classes
      - Macro strategies
        
        Trade securities, currencies, commodities based on global economic trends
      - Equity hedge fund strategies:
        
        Market neutral: Equal values in long and short positions
        
        Fundamental growth: Identify high-growth companies
        
        Fundamental value: Identify undervalued companies
        
        Quantitative directional: may have net long or short exposure
        
        Short bias: Net short exposure
      - Fund of funds:
        
        invest in multiple hedge funds.
    - - Should use bid prices for long positions, ask prices for short positions
      - Values of non-traded securities estimated with pricing models
      - Illiquid securities
        
        Reduce market price to account for illiquidity based on size of position held
        
        Trading NAV is adjusted for illiquidity
    - - 2 and 20%: 2% management fee AND 20% incentive fee
        
        Incentive fee is charged by a fund manager based on fund's performance over a given period. The fee is usually compared to a benchmark
      - Management fee may be calculated on beginning or ending assets
      - Incentive fee may be
        
        Net of management fees: Incentive fee = (Ending Capital - Beginning Capital - Management Fee) x Incentive Fee
        
        independent of management fees: Incentive Fee = [Ending capital - Beginning capital ] x Incentive Fee
      - Fund of funds typically charges 1 and 10 in addition to fees paid on underlying hedge fund investments
      - Hurdle
        
        Hard hurdle rate: Incentive fees only on gains above hurdle rate
        
        Soft hurdle rate: Incentive fees on all gains, but only if return exceeds hurdle rate.
      - High water mark:
        
        Incentive fees only on gains that increase assets above the high watermark value (net of or independent of management fee)
        
        If so, incentive fee is calculate based on high water mark level, not the beginning capital level
      - Example:
        
        Management fee: 5%, incentive fee 20% over the 8% hurdle amount. Original fund: 250 mil, appreciated 16% at the end of year.
        
        End of year capital: 250 x 1.16 = 290 (mil)
        
        Management fee: 290 x 0.02 = 5.8 (mil)
        
        Hurdle amount: 250 x 0.08 = 20 (mil)
        
        Incentive fee: (290 - 250 - 20 - 5.8) x 0.2 = 2.84 (mil)
        
        Investor net return: (290 - 250 - 5.8 - 2.84)/250 = 12.54%
  - - - Leveraged buyout (LBO):
        
        Most common private equity strategy
        
        Funded by debt
        
        Bank debt, high yield bonds
        
        Mezzanine financing: subordinated debt, includes warrants or conversion to equity
        
        Types
        
        Management buyout (MBO): Current managers involved in purchase, remain with company
        
        Management buy-in: Replace managers of acquired company
      - Venture capital:
        
        Invest in a company at the early stage
        
        Stages
        
        Formative stage:
        
        A. Angel investing: Business plans, market potential
        
        B. Seed stage: Product development, market research. Most common to receive venture capital fund
        
        C. Early stage: Begin production and sales
        
        Later stage:
        
        Company expansion
        
        Mezzanine stage:
        
        Prepare for IPO
        
        Structure and Fees
        
        Typically structured as limited partnership
        
        Investors provide committed capital which fund managers draw down to invest in portfolio companies.
        
        management fee is based on committed capital
        
        Management fees typically 1% to 3% of committed capital
        
        Inventive fees typically 20% of profits
        
        Fees paid periodically may exceed 20% over time.
        
        Clawback provision requires managers to return any funds distributed as incentive fees, until the investor has received back initial investment plus a contracted portion of total profit.
        
        Exit strategies
        
        Trade sale: Sell portfolio company to competitor
        
        Secondary sale: Sell portfolio company to other private equity investors
        
        IPO: Sell portfolio company shares to public
        
        Recapitalization: Issue portfolio company debt to fund dividend payment (to private equity owner)
        
        Write-off / liquidation: Take loss
      - Developmental capital / minority equity / private investment in public equity (PIPE)
      - Distressed investing
    - - Same techniques used to value publicly traded companies are used to value private equity portfolio companies
        
        Market / comparables approach
        
        Discount cash flow approach
        
        Asset-based approach
      - Private companies may require different discount rates or price multiples than publicly traded companies
  - - - Residential property
      - Commercial property
      - Mortgages, mortgage-backed securities
      - Real-estate investment trusts (REITs)
      - Farmland, timberland
      - Infrastructure security (Exchange-traded MLP)
    - - Comparable sales approach:
        
        recent sales of similar properties
      - Income approach:
        
        Present value of future cash flows from property
        
        =\(\frac{Net.Operating.Income}{Capitalization.rate}\)
      - cost approach:
        
        Replacement cost, including land and current costs to rebuild
      - Real Estate Investment Trust (REITs) valuation
        
        Income based: Similar to direct capitalization
        
        Funds from operations (FFO)
        
        Adjusted funds from operation (AFFO)
        
        Capitalization rates
        
        Asset-based approach:
        
        calculate a REIT's NAV = \( \frac{Total.Asset - Total.Liabilities}{No.Share.Outstanding}\)
      - Repeat sale index
        
        Repeat-sales method assesses how house valuations change over time by focusing on the different sale prices of the same piece of real estate.
        
        susceptible to sample selection bias
  - - - Return comes from price changes (no income)
      - Hedge against inflation risk
    - - Commodity ETFs: available to investors who are restricted to equity shares
      - Shares of commodity producers: less-than-perfect correlation with commodity prices.
      - Managed futures funds: active management of commodity investments
      - Individual managed accounts
      - Commodity sector funds
    - - cost-of-carry model
        
        Futures price = Spot price x (1 +Rf) + storage costs - convenience yield
        
        Convenience yield: value of having physical commodity available for use
        
        Low convenience yield → Contango, F > S; roll yield = F - S
        
        High convenience yield → backwardation, S >F
  - - - transportation (road, bridge, airports)
      - utility assets (pipelines, waste treatment, communications)
    - - (schools, hospitals, prisons)
    - - Direct vs. Indirect
        
        Direct investment:
        
        Large size, low liquidity, must operate and maintain physical assets
        
        Indirect Investment:
        
        Publicly traded infrastructure securities
        
        Master limited partnership
        
        Shares of firms
        
        Exchange-traded funds
        
        Listed mutual funds
        
        Private equity funds
        
        Unlisted mutual funds
      - Brownfield vs. Greenfield
        
        Brownfield investment
        
        Invest on existing projects
        
        have less risk and lower expected return
        
        Greenfield investment
        
        Invest on yet-to-be-built infrastructure
        
        higher risk but higher return
- - - - less reliable than traditional asset classes
      - reflect risk specific to alternative investments
        
        lack of liquidity & transparency
        
        restrictions on redemptions
        
        choice of managers

Create your own diagrams like this for free with Coggle

made for free at coggle.it

Reading 50: Introduction to Alternative Investments

Reading 50: Introduction to Alternative Investments

Difference from Traditional Investments

Different types of assets held, structure of investment vehicles

Higher fees (management, incentive)

Less liquid

Less regulated, less transparent

Different tax treatments

More concentrated portfolios

Redemption restrictions

Categories of alternative investments

Hedge funds

Private equity

Real estate

Commodities

Infrastructure

Others
(e.g., collectibles, patents)

Invest in private companies or take public companies private

Private equity strategies

Leveraged buyout (LBO):

Venture capital:

Developmental capital / minority equity / private investment in public equity (PIPE)

Distressed investing

Most common private equity strategy

Funded by debt

Bank debt, high yield bonds

Mezzanine financing: subordinated debt, includes warrants or conversion to equity

Types

Management buyout (MBO): Current managers involved in purchase, remain with company

Management buy-in: Replace managers of acquired company

Invest in a company at the early stage

Stages

Formative stage:

A. Angel investing: Business plans, market potential

B. Seed stage: Product development, market research. Most common to receive venture capital fund

C. Early stage: Begin production and sales

Later stage:

Mezzanine stage:

Company expansion

Prepare for IPO

Structure and Fees

Typically structured as limited partnership

Investors provide committed capital which fund managers draw down to invest in portfolio companies.

Management fees typically 1% to 3% of committed capital

Inventive fees typically 20% of profits

Fees paid periodically may exceed 20% over time.

Clawback provision requires managers to return any funds distributed as incentive fees, until the investor has received back initial investment plus a contracted portion of total profit.

Exit strategies

Trade sale: Sell portfolio company to competitor

Secondary sale: Sell portfolio company to other private equity investors

IPO: Sell portfolio company shares to public

Recapitalization: Issue portfolio company debt to fund dividend payment (to private equity owner)

Write-off / liquidation: Take loss

Valuation

Same techniques used to value publicly traded companies are used to value private equity portfolio companies

Market / comparables approach

Discount cash flow approach

Asset-based approach

Private companies may require different discount rates or price multiples than publicly traded companies

Categories

Residential property

Commercial property

Mortgages, mortgage-backed securities

Real-estate investment trusts (REITs)

Farmland, timberland

Valuation

Comparable sales approach:

Income approach:

Present value of future cash flows from property

= $\frac{Net.Operating.Income}{Capitalization.rate}$

cost approach:

Real Estate Investment Trust (REITs) valuation

Income based: Similar to direct capitalization

Funds from operations (FFO)

Adjusted funds from operation (AFFO)

Capitalization rates

Asset-based approach:

Charateristics

Limited to qualified investors

Lockup period: Minimum time before investor can withdraw funds

Notice period: Days within which a fund must fulfill a redemption request

Investment companies structured as limited partnerships, use leverage, derivatives, short selling

Strategies

Event-driven strategies

Merger arbitrage: buy shares of firm being acquired, short shares of acquirer

Distressed/ restructuring: buy if restructuring will increase value

Activist shareholder: Gain board seats to influence company decisions

Special situations: Spinoffs, asset sales, security issuance or repurchase

Relative value strategies

Convertible arbitrage: Convertible bonds vs. underlying common stock

Asset-backed: ABS, MBS

General fixed income

Volatility: Trade options based on implied versus expected volatility

Multi-strategy: Across asset classes

Macro strategies

Trade securities, currencies, commodities based on global economic trends

Equity hedge fund strategies:

Market neutral: Equal values in long and short positions

Fundamental growth: Identify high-growth companies

Fundamental value: Identify undervalued companies

Quantitative directional: may have net long or short exposure

Short bias: Net short exposure

Fund of funds:

invest in multiple hedge funds.

Valuation

Should use bid prices for long positions, ask prices for short positions

Values of non-traded securities estimated with pricing models

Illiquid securities

Reduce market price to account for illiquidity based on size of position held

Trading NAV is adjusted for illiquidity

Hedge Fund Fees:

2 and 20%: 2% management fee AND 20% incentive fee

Incentive fee is charged by a fund manager based on fund's performance over a given period. The fee is usually compared to a benchmark

Management fee may be calculated on beginning or ending assets

Incentive fee may be

Fund of funds typically charges 1 and 10 in addition to fees paid on underlying hedge fund investments

Hurdle

Hard hurdle rate: Incentive fees only on gains above hurdle rate

Soft hurdle rate: Incentive fees on all gains, but only if return exceeds hurdle rate.

High water mark:

Commodities exposure most commonly gained through derivatives rather than outright ownership

Return comes from price changes (no income)

Hedge against inflation risk

Categories

Commodity ETFs: available to investors who are restricted to equity shares

Shares of commodity producers: less-than-perfect correlation with commodity prices.

Managed futures funds: active management of commodity investments

Individual managed accounts

Commodity sector funds

Valuation

cost-of-carry model

Futures price = Spot price x (1 +Rf) + storage costs - convenience yield

Convenience yield: value of having physical commodity available for use

Low convenience yield → Contango, F > S; roll yield = F - S

High convenience yield → backwardation, S >F

Long-lived assets that provide essential public services.

Economic infrastructure

transportation (road, bridge, airports)

utility assets (pipelines, waste treatment, communications)

Social infrastructure

(schools, hospitals, prisons)

categories

Direct vs. Indirect

Direct investment:

Indirect Investment:

Publicly traded infrastructure securities

Master limited partnership

Shares of firms

Exchange-traded funds

Listed mutual funds

Private equity funds

Unlisted mutual funds

Large size, low liquidity, must operate and maintain physical assets

Brownfield vs. Greenfield

Brownfield investment

Invest on existing projects

have less risk and lower expected return

Greenfield investment

Invest on yet-to-be-built infrastructure

higher risk but higher return

Regulatory risk is inherent to infrastructure investment

Benefits of Alternative Investments

To improve the risk/return profile of the overall portfolio

Hedge funds and private equity have had higher Sharpe ratios than global equities

HOWEVER

Return measures for alternatives are

less reliable than traditional asset classes

reflect risk specific to alternative investments

lack of liquidity & transparency

restrictions on redemptions

choice of managers

Risk management

Standard deviation is not the most appropriate measure for derivatives

WORSE PAIRING: Fat tails (leptokurtosis) , negative skewness

Return smoothed by model or appraisal asset valuations

Measure of DOWNSIZE RISK

Maximum losses over various periods

Sortino ratios: use standard deviation only of returns below the target ratio

Sharpe ratios, Sortino ratios, and measures of downsize risk do not consider diversification benefits or provide estimates of optimal allocation

Diversification benefits are not always realized

Correlations increase during financial stress and can approach one during financial crises

Problems

Risks from use of derivatives (counterparty, illiquidity, operational, financial risk)

Performance depends on manager's skill (manager selection risk)

Lack of transparency

Illiquidity

Correlations with traditional investment returns vary over time

recent sales of similar properties

Replacement cost, including land and current costs to rebuild

calculate a REIT's NAV = \( \frac{Total.Asset - Total.Liabilities}{No.Share.Outstanding}\)

use bottom-up approach and seek to profit from short-term event

Loss is magnified by margin call: Have to liquidate losing position to meet margin call, thus exacerbate the loss

Repeat sale index

Repeat-sales method assesses how house valuations change over time by focusing on the different sale prices of the same piece of real estate.

susceptible to sample selection bias

Infrastructure security (Exchange-traded MLP)

Example:

Management fee: 5%, incentive fee 20% over the 8% hurdle amount. Original fund: 250 mil, appreciated 16% at the end of year.

End of year capital: 250 x 1.16 = 290 (mil)

Management fee: 290 x 0.02 = 5.8 (mil)

Hurdle amount: 250 x 0.08 = 20 (mil)

Incentive fee: (290 - 250 - 20 - 5.8) x 0.2 = 2.84 (mil)

Investor net return: (290 - 250 - 5.8 - 2.84)/250 = 12.54%

Net of management fees: Incentive fee = (Ending Capital - Beginning Capital - Management Fee) x Incentive Fee

independent of management fees: Incentive Fee = [Ending capital - Beginning capital ] x Incentive Fee

Incentive fees only on gains that increase assets above the high watermark value (net of or independent of management fee)

If so, incentive fee is calculate based on high water mark level, not the beginning capital level

management fee is based on committed capital