Alternative Investments

Other Private Equity Strategies

*Developmental Capital / Minority Equity Investing -- provision of capital for business growth or restructuring. The firms financed may be public or private. If they are public, such financing is referred to as PRIVATE INVESTMENT IN PUBLIC EQUITIES (PIPEs). *Distressed Investing -- buying debt of mature companies that are experiencing financial difficulties (potentially/currently in default, or in bankruptcy proceedings). Investors in distressed debt often take an active role in the turnaround by working w/ management on reorganization or to determine the direction the company should take. *distressed debt investors are sometimes called "VULTURE INVESTORS".

Sources of Commodities Futures Returns

1. ROLL YIELD -- the yield due to a difference between spot and futures price. Futures prices converge toward spot prices as contracts near expiration. *Positive for a market in backwardation, and negative for a market in contango. 2. COLLATERAL YIELD -- the interest earned on collateral required to enter into a futures contract. 3. CHANGE IN SPOT PRICSE -- the total price return is a combination of the change in spot prices and the convergence of futures prices to spot prices over the term of the contract.

Hedge Fund Strategies

4 main classifications: 1. EVENT DRIVEN STRATEGIES -- typically based on corporate restructuring or acquisition that creates profit opportunities for long or short positions in common equity, preferred equity, or debt of a specific corporation. *Subcategories: merger arbitrage, distressed/restructuring, activist investing, special situations. 2. RELATIVE VALUE STRATEGIES -- buying a security and selling short a related security with the goal of profiting when a perceived pricing discrepancy between the two is resolved. *Convertible Arbitrage Fixed Income, Asset-Backed Fixed Income (w/ MBS or ABS), General Fixed Income, Volatility, and Multi-Strategy (across asset classes) 3. MACRO STRATEGIES -- based on global economic trends and events and may involve long or short positions in equities, fixed income, currencies, or commodities. 4. EQUITY HEDGE FUND STRATEGIES -- seek to profit from long or short positions in publicly traded equities and derivatives. Types include: *MARKET NEUTRAL -- ~equal amount of longs/shorts, gain exposure to relative price movements while aiming to eliminate exposure to market risk. *FUNDAMENTAL GROWTH -- find high-growth companies through use of fundamental analysis. *FUNDAMENTAL VALUE -- buy shares that are believed to be undervalued based on fundamental analysis. Here, it is the the hedge fund structure, rather than the type of assets purchased, that results in classification as an alternative investment. *QUANTITATIVE DIRECTIONAL -- buy equity securities believed to be undervalued and short securities believed to be overvalued based on TECHNICAL ANALYSIS. *SHORT BIAS -- employing predominantly short positions in overvalued equities, possibly with smaller long positions. Hedge funds may start w/ a specific strategy at first and then become multi strategy over time.

Alt Investments & Returns

As a group, alt investments have had low returns correlations with traditional investors. Therefore, the primary motivation for holding alternative investments is diversifying a portfolio's risk. Be careful -- the risk measures used for traditional assets may not be adequate to capture the risk characteristics of alt investments -- mgmt may use other measures of risk like "worst month" or "historical frequency of downside returns". Historical returns for alt investments have been higher on average than for traditional investments, so adding alternative investments to a portfolio may increase expected returns. Alt investments may not be as efficiently priced, may offer extra returns for being illiquid, and are often levered. Biases for alt investment returns: survivorship bias, backfill bias (including the previous performance data for firms recently added to a benchmark index).

Private Equity Exit Strategies

Average holding period for companies in a private equity portfolio is five years. Several primary methods of exiting an investment in a portfolio company: 1. TRADE SALE -- sell a portfolio company to a competitor or another strategic buyer. 2. IPO -- sell all or some shares of a portfolio company to the public. 3. RECAPITALIZATION -- the company issues debt to fund a dividend distribution to equity holders (the fund). This is not an exit, but is often a step towards an exit. 4. SECONDARY SALE -- sell a portfolio company to another private equity firm or a group of investors. 5. WRITE-OFF/LIQUIDATION -- reassess and adjust to take losses from an unsuccessful outcome

Categorization/Stages of VC Investments

Based on the company's stage of development. The stages include: 1. FORMATIVE STAGE -- investments made during a firm's earliest period and comprises three distinct phases: *ANGEL INVESTING -- very early in a firm's life; investment at the "idea" stage; funds are used for business plans and assessing market potential. Funding source is often individuals. *SEED STAGE -- investments made for product development, marketing, and market research. Typically the stage during which VC funds make initial investments, through ordinary or convertible preferred shares. *EARLY STAGE -- investments made to fund initial commercial production and sales. 2. LATER STAGE -- stage of development where a company already has production and sales and is operating as a commercial entity. Funds provided are typically used for expansion of production &/or increasing sales through an expanded marketing campaign. 3. MEZZANINE-STAGE FINANCING -- capital provided to prepare the firm for an IPO. Term refers to the TIMING of the financing (btwn private company and public company) rather than the TYPE of financing (not mezz debt).

Commodity Prices and Investments

Commodities prices are a function of supply and demand. *Demand is affected by the value of the commodity to end-users and by global economic conditions and cycles. *Supply is affected by production and storage costs and existing inventories. For many commodities, supply is inelastic in the short run because of long lead times to alter production levels. Therefore, commodity prices can be volatile when demand changes significantly over the economic cycle. Production of some commodities (esp. ag) can be significantly affected by weather.

Alternative Investments

Differ from traditional investments (publicly traded stocks, bonds, cash) both in the types of assets and securities included in this asset class and in the structure of the investment vehicles in which these assets are held. Managers of alternative investment portfolios may use derivative and leverage, invest in illiquid assets, and short securities. Types of alt invest structures include: hedge funds, PE funds, various types of real estate investments, ETFS. Fee structures differ - alt investments have higher mgmt fees on average and often w/ additional incentive fees based on performance. As a group, alt investments have had low returns correlations with traditional investors. Therefore, the primary motivation for holding alternative investments is diversifying a portfolio's risk. Be careful -- the risk measures used for traditional assets may not be adequate to capture the risk characteristics of alt investments -- mgmt may use other measures of risk like "worst month" or "historical frequency of downside returns". Historical returns for alt investments have been higher on average than for traditional investments, so adding alternative investments to a portfolio may increase expected returns. Alt investments may not be as efficiently priced, may offer extra returns for being illiquid, and are often levered. Biases for alt investment returns: survivorship bias, backfill bias (including the previous performance data for firms recently added to a benchmark index). Compared to traditional investments, alt investments exhibit: *less liquidity *more specialization by investment managers *less regulation and transparency *more problematic and less available historical return and volatility data *different legal issues and tax treatments

Private Equity Due Dilligence

Due to the high leverage typically used for PE funds, investors should consider how interest rates and the availability of capital may affect any required refinancing of portfolio company debt. Choice of manager (general partner) of the fund is quite important -- specifically, his operating and financial experience, valuation methods used, incentive fee structures, and drawdown procedures

Hedge Fund Valuation

For traded securities ---- use the most conservative prices at which a position could be closed (bid for long positions, ask for short positions) -- or the average of bid and ask. For illiquid securities --- quoted prices may be reduced due for the degree illiquidity ("trading NAV", which is different from calculated NAV required by accounting standards)

Hedge Fund Potential Benefits and Risks

HF returns have tended to be better than those of global equities in down markets and to lag the returns of global equities in up markets. Different hedge fund strategies have the best returns during different time periods. Statements about the performance and diversification benefits of hedge funds are problematic because of the greater variety of strategies used. Less-than-perfect correlation with global equity returns may offer some diversification benefits, but correlations tend to increase during periods of financial crisis.

Backwardation

High convenience yield Futures prices are higher than spot prices

Contango

If there is little or no convenience yield, futures prices will be higher than spot prices.

"Other" Alternative Investments

Includes: *tangible collectible assets (e.g. fine wines, stamps, antiques) *intangbile assets (i.e. patents)

PE Funds

Invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the fund intends to take private. LBO funds use borrowed money to purchase equity in established companies and comprise the majority of PE funds. Debt may be bank debt (leveraged debt), high-yield bonds, or MEZZANINE FINANCING --- subordinate to high-yield bonds issued and carry warrants or conversion features that give investors participation in equity value increases. A much smaller portion of these funds, VENTURE CAPITAL funds, invest in or finance young unproven companies at various stages early in their existence. Investment is often in the form of equity, but it can be in convertible preferred shares or convertible debt. Risk and returns are high. PORTFOLIO COMPANIES -- the companies in which a VC fund is invested. VC fund managers are closley involved in the development of portfolio companies, often sitting on their boards or filling key management roles. For our purposes -- consider investing in the securities of FINANCIALLY DISTRESSED COMPANIES to be private equity, although hedge funds may invest in these too. Two additional, but smaller, categories of private equity funds are (1) distressed investment funds and (2) developmental capital funds.

Hedge Fund Fees

MANAGEMENT FEE -- earned regardless of investment performance. 2% of "2 and 20" INCENTIVE FEE -- HURDLE RATE -- can be set as a percentage or a rate plus a premium. *HARD HURDLE RATE -- incentive fees are earned only on returns in excess of the benchmark. *SOFT HURDLE RATE -- incentive fees are paid on all profits, but only if the hurdle rate is met. HIGH WATER MARK -- this means that the incentive fee is not paid on gains that just offset prior losses. Therefore, incentive fees are only paid to the extent that the current value of the investors' account is above the highest previously recorded value. This ensures that investors will not be charged incentive fees twice on the same gains in their portfolio values. FUND OF FUNDS -- subject investors to additional fees; common fee structure of "1 and 10". Fee structures vary. Price breaks to investors, competitive conditions, and historical performance can influence negotiated rates.

LBO's: Management Buy Outs (MBO's) vs. Management Buy Ins (MBIs)

MBO -- existing management team is involved in the purchase. MBI -- external mgmt team will replace the existing team.

Mezzanine Financing (in context of PE funds)

MEZZANINE FINANCING --- subordinate to high-yield bonds issued and carry warrants or conversion features that give investors participation in equity value increases. **DIFFERENT THAN VC MEZZ STAGE FINANCING!**

Hedge Funds

May use leverage, hold long and short positions, use derivatives, and invest in illiquid assets. HF managers have more flexibility than mangers of traditional investments. The complex nature of hedge funds leads managers to trade through their PRIME BROKER, who provide many services, including custodial services, administrative services, money lending, securities lending for short sales, and trading. HF managers use a great many different strategies in attempting to generate investment gains. They do not necessarily hedge risk as the name may imply. Return objectives can be on an ABSOLUTE BASIS (e.g., 10%), a relative basis (e.g., 5% above SPX). HF's are LESS REGULATED than traditional investments. They are traditionally structured as limited partnerships, with investors as the limited (liability) partners. Mgmt firm is the general partner. HF investments are LESS LIQUID than traditional, publicly traded investments. Restrictions on redemptions may include a LOCKUP PERIOD and/or a NOTICE PERIOD, which discourage redemptions. *LOCKUP PERIOD -- time after initial investment during which withdrawals are not allowed. *NOTICE PERIOD -- typically 30-90 days -- amount of time a fund has after receiving a redemption request to fulfill the request. *Redemption fees can help offset the significant transaction costs HF managers incur when they redeem shares. FUND OF FUNDS -- an investment company that invests in hedge funds, giving investors diversification among hedge fund strategies and allowing smaller investors to access hedge funds in which they may not be able to invest directly. *FoF mangers charge an additional layer of fees beyond the fees charged by the individual HF's in the portfolio.

Private Equity Potential Benefits and Risks

Over the last 20 years, returns on PE funds have been higher on average than overall stock returns. There may be portfolio diversification benefits. SD of PE returns has been higher than the SD of equity index returns, suggesting greater risk. As with hedge fund returns data, PE returns data may suffer from survivorship bias and backfill bias (both lead to overstated returns).

Private Equity Structure and Fees

Private Equity Funds are typically structured as limited partnerships (similar to hedge funds). COMMITTED CAPITAL -- the amount of capital provided to the fund by investors. This is typically not all invested immediately, but is "drawn down" (invested) as securities are identified and added to the portfolio. *usually drawn down over 3-5 yrs, though the "drawdown period" is at the discretion of the fund manager. Management fees are typically 1% TO 3% OF COMMITTED CAPITAL, rather than invested capital. Incentive fees for PE funds are typically 20% of profits, but these fees are not earned until after the fund has returned investors' initial capital. CLAWBACK PROVISION -- requires the manager to return any periodic incentive fees to investors that would result in investors receiving less than 80% of the profits generated by portfolio investment as a whole.

Real Estate Investment Due Diligence

Property values fluctuate because of global/national economic factors, local market conditions, and interest rate levels. Other risks: variation in the abilities of managers to select and manage properties, and changes in regulations. Degree of leverage must be considered.

Forms of Real Estate Investment

RESIDENTIAL PROPERTY -- direct investment in real estate. The issuer (lender) of the mortgage has a direct investment in a whole loan and is said to "hold the mortgage". Properties purchased with a mortgage is referred to as a "leveraged investment" and the owner's equity is the property value minus the outstanding loan amount. COMMERCIAL REAL ESTATE -- generate income from rent payments. Homes purchased for rental income are considered investment in commercial property. Long time horizons, illiquidity, the large size of investment needed, and the complexity of the investments make commercial real estate inappropriate for many investors. As with residential mortages, whole loans (commercial property mortgages) are considered a direct investment, but loans can be pooled into CMBS that represent an indirect investment. REITS -- issue shares that trade publicly like shares of stock. REITS are often identified by the type of real estate assets they hold: mortgages, hotel properties, malls, office buildings, or other commercial property. Income is used to pay dividends, and typically, 90% of income must be distributed to shareholders to avoid taxes on this income.

Potential Benefits and Risks of Real Estate

Real estate performance is measured by three different types of indices. APPRAISAL INDEX -- based on periodic investments of property values; returns are smoother than those based on actual sales; have the lowest standard deviation of returns. REPEAT SALES INDEX -- based on price changes for properties that have sold multiple times. Example of sample selection bias -- may not be representative of the broad spectrum of available properties. REIT INDICES -- based on the actual trading prices of REIT shares; similar to equity indices. Historically, REIT index returns and global equity returns have had a relatively strong correlation (~0.6) because business cycles affect REITS and global equities similarly. Correlation between global bond returns and REIT returns has been very low historically.

Real Estate

Residential or commercial properties, and real estate-backed debt. Can provide income in the form of rent or the potential for capital gains. Can be a potential inflation hedge, since rents and real estate values tend to rise with inflation. These investments are held in a variety of structures, including full or leveraged ownership of individual properties, individual real estate backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.

Potential Benefits and Risks of Commodities

Returns on commodities over time have been LOWER than returns on global stocks or bonds. Sharpe ratios for commodities as an asset class have been low due to these lower returns and the high volatility of commodities prices. Historical correlations between commodities and global equities and global bonds is low (<0.2), so adding commodities to a traditional portfolio can provide diversification benefits. Commodity prices tend to move with inflation, so holding commodities can act as a hedge of inflation risk.

Hedge Fund Due DIlligence

Selecting a hedge fund is an intensive research process, which may be somewhat hampered by a lack of transparency of information by funds. Partial list of factors to consider: *investment strategy *investment process *source of competitive advantages *historical returns *valuation and returns calculation methods *longevity *AUM *mgmt style *key person risk *reputation *growth plans *systems for risk management *appropriateness of benchmarks

Real Estate Valuation

Three methods to value real estate: 1. COMPARABLE SALES APPROACH -- bases valuation on recent sales of similar properties. 2. INCOME APPROACH -- estimates property values by calculating the PV of expected future cash flows from property ownership, or by dividing the NOI for a proprety by a capitalization rate. ***CAP RATE -- discount rate minus a growth rate and is estimated based on factors such as general biz conditions, property qualities, management effectiveness, and sales of comparable companies. ***NOTE THAT DIVIDING BY A CAP RATE of 12.5% is the same as using a multiple of 8 times NOI (1/0.125) = 8. 3. COST APPROACH -- estimates the replacement cost of a property. The cost of land and the cost of rebuilding at current construction costs are added to estimate replacement costs. Value estimates for REITS can be income-based or asset-based. *FFO -- REITS use FFO as a measure of cash flow -- calculated from net income w/ depreciation added back (non-cash charge) and with gains from property losses subtracted and losses on property sales added. *AFFO -- FFO with recurring capex subtracted; similar to FCF. *Asset-based approach provides an estimate of NAV by subtracting total liabilites from the total value of the real estate assets and dividing by the # of shares outstanding.

Other Real Estate Assets

Timberland and farmland.

Commodities

To gain exposure to changes in commodities prices, investors can own PHYSICAL COMMODITIES, COMMODITY DERIVATIVES, or the EQUITY OF COMMODITY PRODUCING FIRMS. Most commonly used instruments to gain exposure to commodities prices are derivatives. Futures, forwards, options, and swaps are all available forms of commodity derivatives. Other methods of gaining exposure to commodities include: *ETFs *Equities that are directly linked to a commodity (ex. oil producing firm, gold mining firm); though correlation may not be perfect *Managed futures funds -- actively managed funds; can be constructed as limited partnerships with hedge fund-esque fees; can also be structured like mutual funds. *Individual managed accounts -- alternative to pooled funds for high net worth individuals and institutions; accounts tailored to the need of specific investor *Specialized funds in specific commodity sectors can be organized under any of the structures we have discussed and focus on certain commodities - O&G, grains, precious metals, or industrial metals. Some funds seek exposure via commodity indices.

Private Equity Company Valuation

Valuation for PE portfolio companies is essentially the same as valuing a publicly traded company, though the discount rate or multiples used may be different for private companies. Approaches: *MARKET/COMPARABLES APPROACH -- use multiples of EBITDA, net income, or revenue to estimate a portfolio co's value. *DCF APPROACH -- DCF, DDM. *ASSET-BASED APPROACH -- liquidtion values, fair market values. Liquidition values will be lower than fair market values. Liabilites are subtracted so that only the equity portion of the firm's value is being estimated.

Commodity Futures Pricing

Wheat today and wheat six months from today are different products. Purchasing the commodity today will give the buyer the use of it if needed, while contracting for wheat to be delivered six months from today avoids storage costs and having cash tied up. Equation: futures price ~ spot price (1 + RFR) + storage costs - convenience yield *if this equation does not hold, an arbitrage transaction is possible