Alternative Investments - Cfa Level Ii

Front 1

Vacant or Raw Land

Back 1

Main value determinants: expansion of demand, convenient location, travel patterns, planning/zoning/highest-best-use

Investment characteristics: passive, illiquid, rate of return by value appreciation, no tax depreciation, capital gains taxation, expenses capitalized

Principal risks: “alligator” – needs to be fed, carrying costs, value appreciation uncertain

Most likely investors: speculator, developer, estate as store of value

Front 2

Apartments

Back 2

Main value determinants: expanding population, rising incomes, location: convenience, favorable exposure; prestige?

Investment characteristics: moderately liquid, high leverage, rate of return by periodic income and value appreciation, tax depreciation, ordinary and capital gains taxation

Principal risks: start up when new, management: probably necessary to hire professional

Most likely investors: high income benefiting from tax shelter, suitable for anyone but must be able to put up equity investment

Front 3

Office Buildings

Back 3

Main value determinants: expanding local economy, location linkages, presitage?, tenant mix compatibility

Investment characteristics: active (unless leased to one firm), moderately liquid, rate of return by periodic income and value appreciation, tax depreciation, ordinary and capital gains taxation

Principal risks: start up when new, mgmt: high level of service provided, competitive facilities, obsolescence, shift in location of business activity

Most likely investors: high income, needing tax shelter, suitable for anyone if professional mgmt hired and able to put up initial equity investment

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Warehouses

Back 4

Main value determinants: commercial/industrial activity, location for ease of movement, structural design to endure change

Investment characteristics: most passive, often a long-term lease, moderately liquid, moderate leverage, rate of return mainly by periodic income, tax depreciation, ordinary and capital gains taxation

Principal risks: obsolescence due to changes in material handling equipment and technology

Most likely investors: retired: desiring both cash flow and limited mgmt; or anyone desiring tax shelter who has adequate initial equity capital

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Neighborhood shopping centers

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Main value determinants: community growth, effective demand: population and income, convenient location relative to competition; adequate parking, tenant mix relative to local spending patterns, effective lease negotiation

Investment characteristics: moderately active, liquidity limited, moderate leverage, rate of return by periodic income and value appreciation, tax depreciation, ordinary and capital gains taxation

Principal risks: start up: getting proper tenant mix, mgmt: need to provide adequate level of service, vacancies, competitive facilities, obsolescence

Most likely investors: reasonably wealthy: need to make large equity investment; anyone able to use tax shelter plus other benefits

Front 6

Hotels/motels

Back 6

Main value determinants: location: linkages and convenience, demand: conference, tourist, resort, business; mix of facilities and services

Investment characteristics: active, moderately liquid, moderate to poor leverage, rate of return periodic income and value appreciation, tax depreciation, ordinary capital gains taxation

Principal risks: mgmt: high tenant turnover (professional mgmt almost a necessity), competing facilities

Most likely investors: anyone able to use tax shelter and with adequate initial equity capital, smaller properties suitable for investors also willing to manage and maintain

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NPV in Real Estate valuation

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present worth of cash flows – equity investment

PV of expected after-tax cash flow (generated by the property) through period n, and the after-tax equity reversion due on sale – initial equity investment

If NPV > 0, buy –means that the present worth of the property is greater than the equity cost of the investment; even if NPV = 0, buyer’s wealth is unaffected, and still a “buy”

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IRR in Real Estate valuation

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the rate of return that discounts future cash flows to the exact amount of the investment, or when NPV is = 0

If IRR is greater than or equal to the required rate of return, the investment should be made

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Multiple root problem - IRR problems

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Multiple root problem with irregular cash flows – when IRR crosses the NPV = 0 horizontal plain multiple times, therefore there are multiple IRR solutions

This occurs when annual CFs vary from positive to negative through the life of the investment

Front 10

Different scales of investment - IRR problems

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NPV and IRR will rank mutually exclusive projects differently when the scale of investment is different; IRR doesn’t factor in size as NPV does, so always side with the NPV outcome to make a final decision

Can also determine between projects by taking the differential cash flows and computing NPV, i.e. outlay A- outlay B; CFA-CFB, and calculate incremental NPV – so if a project cost $50M more, if incremental NPV is + should go with the bigger project

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Timing of CFs - IRR problem

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causes different IRR, NPV outcomes – always consider incremental NPV, and most often side with NPV

Front 12

The relation between a real estate capitalization rate and a discount rate

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MVo = NOI/(r – g) = NOI/Ro, where Ro = capitalization rate from comparables

Discount rates represent the required rate of return, or yield, on real estate

Capitalization rate are the net of value appreciation or depreciation – in times of rapid inflation, a very low capitalization rate is likely. Cap rates also vary with fluctuations in interest rates

“g” is essentially the difference between the rate of depreciation of an asset (-) + the appreciation of the asset

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Market-extraction method - finding cap rate

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when the capitalization rate is derived from the market, via comparables; NOI/MVo, and then apply Ro to the NOI of the property being valued for MVo

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Band-of-investment method - finding cap rate

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Given the required return for the lender and their investment period, determine the sinking fund factor = the amount that must be put aside for each period to be whole at the end of the lender's investment period

sinking fund factor = lender R / ((1 + lender R)^n - 1); per month; than X 12 for annual

Mortgage constant = required return + sinking fund factor

Using weights from debt and equity, and given a required return on equity, find the weighted rate required, or the overcapitalization rate

cash on cash return required by the equity investor = the equity dividend rate
a. rate per period/((1 + rate per period)^# of periods – 1)
b. reflects the fraction needed to “put aside” each period for the lender, to have $1 at time n

total required payment to the lender = return on funds (or the annual debt rate) + sinking fund factor (annual)

then weight the total required payment rate to the lender + weighted equity required return = capitalization rate under the band of investment method

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Built-up method - finding cap rate

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capitalization rate is a composition of pure interest (gov’t, RFR bond-alternative source of return) + rate for non-liquidity + recapture premium (an adjustment for appreciation less depreciation) + rate of risk

The higher the rate, the lower the MVo

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Direct Income capitalization valuation approach for Real Estate

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find NOI and derive a cap rate from the marketplace

NOI/cap rate = MVo

Front 17

Gross income multiplier technique for valuing real estate

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related total annual income to market value – 1) ascertain the gross annual income of the subject property; 2) derive GIM from the marketplace; 3) apply GIM to the subject property

GIM for a property = Sale Price / Gross annual income

Front 18

Limitations of the direct capitalization approach compared to those of the gross income multiplier technique

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Direct capitalization is limited by the challenge in selecting a cap rate, as it is market-derived, but also must reflect attributes of the building

Direct capitalization is also dependent on income generating buildings

GIM is limited by the infrequency of sales and the fact that it uses gross rents instead of NOI (this may distort results due to the building’s ratio of land to building, as well as, the age/quality

Sale price may reflect zoning, maintenance, of heavy property taxes that will pressure the GIM

GIM is also not useful for unique properties, or ones that generate income from amenities

Front 19

Sources of value creation in Private Equity

Back 19

The ability to re-engineer the private firm to generate superior returns

The ability to access credit markets on favorable terms – have paid back successfully large amounts of debt, so reputation supports high leverage, and less FCF for management’s discretion is not necessarily a bad thing, it demands focus

A better alignment of interests between private equity firm owners and the managers of the firms they control; PE is often more long-term, big picture focused – less looking for short-term answers to appease sell-side analysts and the market on a quarterly basis

Front 20

How private equity firms align their interests with those of the managers of portfolio companies

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looking for a balance of rights and obligations between PE and management

Corporate board seats – ensures PE control over major events like a company sale, takeover, restructuring, IPO, bankruptcy, or liquidation

Non-compete clause: mostly imposed on founders, to prevent them from leaving and starting up a competing company, within a given time period

Preferred dividends and liquidation preference: PE firms often come first with regard to distributions, and may require a minimum multiple of their original investment before other shareholders see returns

Reserved matters: certain issues are subject to approval or veto by the PE firm – changes in the business plan, acquisitions, or divestitures

Earn-outs (mostly with venture capital) – a mechanism linking the acquisition price paid by PE to the company’s future financial performance over a predetermined time horizon (2-3 years)

Front 21

Characteristics of Buyouts

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Buyout – looking for predictable cash flow patterns and therefore PE is more focused on EBIT and EBITDA growth (typically larger, more established firms)

Steady predictable CFs, excellent market position, significant asset base, strong and experienced management team, extensive use of leverage, risk is measurable (mature, established operating history), predictable exit (secondary buyout, sale to a strategic buyer, IPO), established products, potential for restructuring and cost reduction, low WC requirements

Buyout firm typically conducts full blown due diligence before investing, buyout firm monitors CF management, strategic and business planning, returns are generally characterized by lower variance across returns from underlying investments (bankruptcies rare), large buyout firms are well known and followed, transactions are often in auctions with multiple bidders, strong buyout firms have no issue raising money, variable revenue to the general partner (GP) is often comprised of: carried interest, transaction fees and monitoring fees

Front 22

Characteristics of Venture Capital investments

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Venture Capital –often a specialized industry focus – the next big thing – PE is seeking revenue growth (typically new firms and new technologies)

Low CF predictability (CF projections may not be realistic), lack of market history (or might be a new market), weak asset base, primarily equity funded, assessment of risk is difficult, exit is difficult to anticipate (IPO, trade sale, secondary venture sale), technological breakthrough but route to market has yet to be proven, significant cash burn rate, expanding capex requirement in growth phase

venture capital firms tend to conduct a technology or commercial due diligence before investing, as a financial due diligence would have little basis, venture capital firm will monitor achievement of planned milestones, returns are generally very high returns from a limited number of highly successful investments and a significant number of write-offs, VC firms are less active in the market, transactions are often “proprietary” and completed by connections, VC firms tend to be less scalable, and carried interest (participation in profits)is often the main source of variable revenue to the GP at VC firms – transaction and monitoring fees are rare

Front 23

Valuation issues in a Buyout

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LBO model is a way of determining the impact of the capital structure, purchase price, and various other parameters on the returns expected by the PE firm from the deal

LBO has three main input parameters: cash flow forecasts of the target company, the expected return form the providers of financing (equity, senior debt, high yield bonds, mezzanine) – exit value often determined by market multiples, and the amount of financing available for the transaction

Valuation creation chart: cost + earnings growth + multiple expansion + debt reduction = exit

Stakeholder payoffs often come in the form of debt pay down, preference shares receiving a promised annual return, and management equity program: PE fund’s equity + management equity getting the remaining upside of the exit value – basically everyone else is fixed, so if exit value is well above the fixed payout, major returns flow to the management equity program

Front 24

Valuation issues venture capital transactions

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pre-money and post-money valuation

Pre-money refers to the agreed value of a company prior to a round of financing or investment

Post-money is the value of the company after the financing or investing round

POST = PRE + Investment

Proportionate ownership of VC investor is determined by Investment/POST

Dilution of ownership is always a fundamental point of conversation and concern

Front 25

Alternative exit routes in private equity and their impact on value

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the exit is the most critical mechanism to unlock value in PE

IPO – good: higher valuation multiples with enhanced liquidity, access to large amounts of capital, and potential to attract higher management talent; bad: cumbersome, inflexible, expensive process – better for companies with an established operating history, great growth prospects, and of sufficient size; IPO timing is also critical

Secondary – selling on financial investor’s stake to another financial investor or strategic investor; often occur within their own respective industries; good: the possibility to achieve the highest valuation multiples second to an IPO, often brings specialization to the firm if a strategic buyer; bad: rare for VC in terms of buyout – often buyouts buy other buyouts and VCs buy other VCs

Management buyout – management takeover with the use of significant leverage; alignment of interests is optimal, but at the expense of hefty leverage, reducing the company’s flexibility

Liquidation – controlling shareholders decide the company is no longer viable and liquidate, often results in a floor value for the portfolio company, but may have negative publicity consequences

Front 26

J curve effect in PE

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investors in PE structures commit a certain amount initially and then the PE fund subsequently draws down to reach total commitment; results in negative returns in early years followed by increased returns as the PE firm manages the portfolio companies toward the exit

Front 27

Limited partnership in PE

Back 27

fund manager of general partner (GP), and fund’s investors or limited partners (LPs); the GP has control of the fund and is jointly liable for all debts, LPs have limited liability (not risking more than what they have invested in the fund); alternative is limited partnership or corporate structure, which protects the GP legally to some extent

Front 28

Closed end - in PE

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means investors cannot redeem shares over the lifetime of the fund, and limits new investors to entering the fund outside of predetermined time periods and at GP discretion

Front 29

The "two" businesses of PR firms

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management funds and raising money – premarketing phase may take 1-2 years, draw down is deployed , and more PE funds have a 10-12 year duration – extendable by 2-3 years

Front 30

PE fund investor specifications

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wealth criteria or minimum subscription threshold, often a balance of powers between GP and LPs – essentially the fund’s prospectus

Front 31

PE management fees

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paid annually to the GP, 1.5-2.5% typically (or % of NAV/invested capital)

Front 32

PE transaction fees

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paid to GPs who provide investment banking services for M&A, LPs may also benefit through fee-sharing

Front 33

PE Carried Interest

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the GP’s share of profits generated by a PE fund (typically 20% of the fund’s profits after management fees)

hurdle rate must be satisfied first

Front 34

PE Ratchet

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determines the allocation of equity between shareholders and the management team of the PE controlled company – enables the management team to increase its equity allocation depending on actual performance and the return achieved by the PE firm

Front 35

PE Hurdle rate

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the PE IRR that must be achieved before the GP receives any carried interest (typically 7-10%) – looking to align GP interests with LPs

Front 36

PE target fund size

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the absolute amount in the fund prospectus, provides GP capacity, and sets the fund raising target (if closed below, questionable execution is likely)

Front 37

PE Vintage year

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the year the PE fund was launched; helps for comparison proposes with other funds at the same stage and industry focus

Front 38

PE term of fund

Back 38

typically 10 years with built in extensions, can be unlimited – but rare

Front 39

Key man clause - PF corporate governance

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appoints a certain number of key named executives who are expected to play an active role in the management of the fund; a specific clause may prohibit a GP from making any new investments under a new key executive is appointed

Front 40

Clawback provision

Back 40

requires a GP to return capital to LPs in excess of the agreed profit split between GPs and LPs, occurs when some investments are wildly successful and others are not – GPs give back their earnings to even out the predefined profit split between GPs and LPs

Front 41

Distribution waterfall

Back 41

an orderly distribution to LPs before GP sees carried interest – can be deal-by-deal allowing for carried interest to GPs after each deal, or total return method where the GP either receives carried interest only after the fund has returned the entire committed capital to LPs or the GP receives carried interest on any distribution as long as the value of the investment portfolio exceeds a certain threshold (typically 20%) about invested capital

Front 42

Tag-along, drag-along rights

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contractual provisions in share purchase agreements that ensure any future acquirer may not acquire control without extending an acquisition offer to all shareholders, including company management

Front 43

No-fault divorce

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GP can be removed with cause, if supermajority of LPs (above 75%) prevails

Front 44

Removal for “cause”

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removal of a GP or an early termination of the fund for “cause” – include GP gross negligence, a “key person” event, felony, bankruptcy of the GP, a material breach in fund prospects

Front 45

PE Investment restrictions

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imposing a minimum level of diversification of the fund’s investments, geo mix, sector focus, or borrowing limits

Front 46

Co-investment in PE

Back 46

LPs often have first right of co-investing along with the GP – fees and profit share is then often lower, but may be more restricted in investments due to crossover co-investment rules: the same GP cannot invest in a portfolio co that has received funding from a previous fund of the same GP

Front 47

PE risk factors

Back 47

i. Illiquidity of investments
ii. Unquoted investments
iii. Competition for attractive investment opportunities
iv. Reliance on the management of the investee companies (agency risk)
v. Loss of capital
vi. Government regulations
vii. Taxation risk
viii. Valuation of investments
ix. Lack of diversification
x. Market risk

Front 48

PE costs

Back 48

i. Transaction fees
ii. Investment vehicle fund setup
iii. Administrative costs
iv. Audit costs
v. Management and performance fees
vi. Dilution
vii. Placement fees – fundraising fees up front, or by means of a trailer fee (charged annually)

Front 49

Investor perspective of PR as an investment; its investment characteristics

Back 49

Strong persistence of returns over time – top performing funds tend to continue to outperform

Performance range between funds is large

Liquidity in PE is typically limited, and thus LPs are locked for the long term – but when PE funds exit an investment, they return the cash to the investor’s immediately – therefore the general duration of the investment in PE is typically shorter than the maximum life of the fund

Front 50

Gross IRR & Net IRR - in PE valuation

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IRR (despite its "issues") is the most common valuation tool for PE

Gross IRR is the CFs between the PE firm and its portfolio companies (good measure of the investment management team’s track record)

Net IRR is the CFs between the PE firm and LPs – captures the returns enjoyed by investors

Multiples are also used due to simplicity and how they ignore time value of money – appealing to LPs

Front 51

PIC (paid in capital)

Back 51

ratio of paid in capital to date, divided by committed capital (proportion of capital called by a GP) – management fees are calculated off this value

Front 52

DPI (distributed to paid in)

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cumulative distributions paid out to LPs as a proportion of the cumulative invested capital

“cash-on-cash-returns” – indication of the PE fund’s realized ROI (presented net of mgmt fees and carried interest) – percent of capital distributed

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RVPI (residual value to paid in)

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value of LPs shareholding held with the PE fund as a proportion of the cumulative invested capital (numerator = the remaining portfolio companies as valued by GP) – is a measure of the PE fund’s unrealized ROI (net of mgmt fees and carried interest)

the percent of capital that remains to see returns and be distributed

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TVPI (total value to paid in)

Back 54

the portfolio companies’ distributed and undistributed value as a proportion of the cumulative invested capital; or the sum of DPI + RVPI (net of fees + CI) – percent of ratio of capital in terms of returns

“$1.29 TVPI for every $1 invested”

Front 55

Carried Interest

Back 55

the first year that NAV is higher than committed capital, 20% is applied to the excess, and thereafter assuming NAV remains above committed capital

Front 56

Alternative methods to account for risk in venture capital

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VCs usually apply a very high discount rate to compensate for the risk – this is both a compensation requirement, but also a failure to remain a going concern

First method is for the discount rate to incorporate a risk of failure component:
a. First define the required return with certainty of success, i.e. 20% r for a 4 year time period = terminal value/<(1 + r)^t>
b. Then apply a probability factor – the annual probability that the investment will remain a going concern: (1 – % probability of failure)^t = probability of success
c. Combine the two to find new discount rate = (required return + probability of failure)/(1 – probability of failure)

Second method – apply different scenarios to terminal value, probability weighted to determine a new terminal value with no adjustment to the original discount rate or required rate of return

Front 57

Hedge Funds vs. Mutual Funds

Back 57

Hedge funds are not required to report returns, and are therefore less regulated and more opaque than long-only mutual funds

Hedge funds often employ the use of leverage, derivative products, multiple assets classes, and short selling, rather than a long-only single asset class approach

Mutual funds must report to the SEC, file a prospectus with full disclosure of portfolio holdings semi-annually, and daily disclosure of NAV, are limited on leverage, but can market their products broadly with low minimum investments required

Hedge fund regulatory requirements consist of a monthly or quarterly NAV, often there are withdrawal restrictions (1-3 year lock up periods), and limited # of investors per fund

Hedge fund management fees are typically 1-2% based on assets under management, while incentive fees as a set of % of profits on the underlying pool of assets (15-25%)

Most mutual funds are restricted on incentive fees, as investment managers must share equally in both gains and losses

Hedge fund fees are paid quarterly or annually, and often have a high-water market provision: ensures that incentive fees are earned only once for a given dollar of investment return

Hedge funds essentially only share gains, not losses

High water marks can also be structured on hurdle rates vs. absolute performance

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Example of high water marks

Back 58

if hedge fund is up 10% in YR1, down 9% in YR2 and up 15% in YR3

This results in incentive paid in YR1 on the 10%, nothing in YR2, and only the incremental difference (above YR1’s return – dollar basis) in YR3

ensures that incentive fees are earned only once for a given dollar of investment return

Front 59

Arbitrage-based hedge funds

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the risk and size of the long positions are highly correlated with the risk and size of the short positions – often see gains in quiet markets and losses in turbulent markets

Front 60

Convertible bond arbitrage hedge fund

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portfolio of convertible bonds + short positions in related equity security – considered to be market neutral; performs well in periods of declining credit spreads and high stock price volatility

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Equity market neutral hedge fund

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zero beta exposure to equity markets, long position betas and matched with short position betas

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Event driven hedge fund

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focused on a single strategy: distressed investments of risk arbitrage (these are often debt securities of issuers in default; can take an either passive or active approach if the investments are in bankruptcy)

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Risk arbitrage or merger arbitrage hedge funds

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seek to predict the outcome of announced corporate merger transactions; typically buy long the target company and sell short the acquiring company – big risk is if the merger fails to go through

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Fixed-income arbitrage hedge fund

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typically purchase higher yielding bonds, which can be investment or speculative-grade bonds, via higher quality debt (lower rate) issuance – producing a positive income; ideal when credit spreads are stable or tightening and markets are relatively liquid

Front 65

Medium volatility hedge fund

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take long and short positions, but not necessarily designed as hedges

Front 66

Global macro hedge fund

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focused on long and short investments in broad markets: indices, currencies, commodities and interest rate markets – focused on the macro picture, specific asset classes and countries (often tied to governmental actions)

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Long-short equity hedge fund

Back 67

the largest type of hedge fund strategy (40% of the hedge fund market); similar to market neutral, but do NOT target zero beta

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Managed futures hedge fund

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commodity trading advisers (mostly quantitative models), will invest in any asset type looking to seek long positions during times of rising prices and short positions in declining prices

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Multi-strategy hedge fund

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similar to fund of funds, diversifying broadly among a variety of hedge fund strategies, often only one set of fees (vs. fund of funds with two layers of fees), as its “in-house” – the diversified basket of hedge funds are all managed by one firm

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Directional hedge funds

Back 70

most volatile, because little to no hedging is used

Front 71

Dedicated short bias hedge funds

Back 71

typically invests exclusively in the short sale of equity securities; often a beta of -1, can drive significant alpha if the stock selection is strong

Front 72

Emerging market hedge funds

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often long only because the ability to short in emerging markets is less developed or prohibitively expensive – may be a mix, or exclusive of one particular class or asset

Front 73

Possible biases in reported hedge fund performance

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Self-reporting bias – since reporting is not required, often only the good ones report results

Selection (also backfill) bias – when the history of a hedge fund is back-filled with often better results, as it is based on the returns achieved in the present, not the actual returns achieved

Survivor bias – reporting is often not inclusive of those funds that fail; often more prevalent in equally weighted indices and those without a listing of deceased or graveyard funds

Front 74

Hedge fund return metric

Back 74

the portion of risk derived from the market and the value added by the hedge fund manager

Alpha + RFR + Sum of Beta * Factor

Traditional market risk factors explain 50-80% of the variation in hedge fund returns

Front 75

Sources of non-normality in hedge fund returns and implications for performance appraisal

Back 75

Many hedge funds have return profiles with skewness and kurtosis of returns that do not closely match the assumption of normal distribution, making the Sharpe ratio and efficient frontier less relevant

In calm markets hedge funds tend to outperform, and underperform in volatility as rapid movements in prices or credit spreads often work against their hedged positioning

Front 76

Motivations for hedge fund replication "copy cat" strategies

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When hedge fund managers are not earning a positive alpha

When investors are worried about the size of fees paid to hedge fund managers

Or lack of historical liquidity and transparency of hedge fund investments

Front 77

Difficulties in applying traditional portfolio analysis to hedge funds

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Ideally adding hedge funds to a traditional investment portfolio would reduce portfolio risk without reducing portfolio return

Caveats:
i. it’s difficult to develop expected return assumptions for hedge funds given the survivor, selection, stale pricing, and backfill biases inherent in hedge fund databases
ii. correlation and volatility of historical hedge fund returns are be used to judge estimates of future risks, to determine beta of a fund, which is then applied to estimated alpha to determine expected returns
iii. information ratio: alpha / the standard deviation of alpha
iv. manager selection is key, as “losers” tend to exhibit great persistence than “winners”

Front 78

Funds of Funds vs. single manger hedge funds

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Fund of funds diversify among hedge fund styles, which diversifies the risks of relying on returns from a specific market factor

Often a lower minimum invested needed – and a one stop shop for all investor needs – but at higher/dual fees (often 1% mgmt fee + 10% performance fee + 2% underlying hedge fund fee and 20% hedge fund incentive fees) – average is 1.3% mgmt fee + 8.1% incentive

Redemptions are often looser – by month as opposed of multi-year lock up periods

Fund of funds often have low: mortality, survivor bias, and backfill bias than single manager HFs