CFA 2018 level 1 fintree introduction to alternative investments ebook 10

JuiceNotes

TM

- By FinTree

eBook 10

Alternative Investments

CFA® Level 1 JuiceNotesTM 2017
© 2017 FinTree Education Pvt. Ltd., All rights reserved.
FinTree Education Pvt. Ltd.
Yashwant Ghadge Nagar Road,
Yashwant Smruti,
Building 5,
2nd Floor,
Pune, India - 411007

Contact Information
Mobile - +91- 8888077722
Email - admin@fintreeindia.com
Website - https://www.fintreeindia.com/

Disclaimer: CFA Institute does not endorse, promote, review, or warrant the accuracy or quality of the products or services
offered by FinTree Education Private Limited. CFA Institute and CFA® are trademarks owned by CFA Institute


Introduction to Alternative Investments

https://www.fintreeindia.com/

LOS a

© 2017 FinTree Education Pvt. Ltd.

Comparison of alternative investments with traditional investments

Compared to traditional investments,
alternative investments are

LOS b
1

ª
ª
ª
ª
ª

Less liquid
More specialized by managers
Less regulated and transparent
More problematic and have less available historical data
Different legal issues and tax treatments

Categories of alternative investments
Hedge funds

It is a Mutual Fund like structure for High Net worth Individuals (HNIs)
These funds use leverage, hold long and short positions, use derivatives

and invest in illiquid assets

Private equity funds
Venture
capital
funds

3
Residential
properties

Invest in
companies at
their early
stages in life

Commercial
properties

e

Leveraged
buyout
funds

Real estate

Use borrowed
money to
purchase equity

in established
companies

Full or
leveraged
ownership

nT

Most prevalent

4

Commodities
derivatives

Fi

Physical
commodities

Commodities

Buying
gold/silver
coins or bars,
grains etc.

Buying/short
selling

futures of
copper,
entering into
a forward
contract for
potato etc.

5

Real estate
backed debt

Real estate
backed loans,
securities
backed by pools
of properties or
mortgages and
limited
partnerships

re

2

Infrastructure

Equity

Economic

infrastructure

Social
infrastructure

Investing in the
equity of
commodity
producing firms

Roads, airports,
utility grids etc.

Schools,
hospitals etc.

Problematic if
the company
itself hedges
the exposure

6

Other

Includes investment in tangible collectibles
such as stamps, antique furniture, art, fine
wines as well as intangibles such as patents

https://www.fintreeindia.com/

LOS c

© 2017 FinTree Education Pvt. Ltd.

Potential benefits of alternative investments
in the context of portfolio management
Alternative investments have had low correlations with traditional
investments which provides benefits of diversification
Historically alternative investments have had higher returns on average
than traditional investments, so adding alternative investments to a
traditional portfolio may increase expected returns
The reasons for these higher returns are thought to be that
ª Alternative investments are less efficiently priced than traditional
investments, providing opportunities for skilled managers
ª Alternative investments may offer extra returns for being illiquid
ª Alternative investments often use leverage
Adding alternative investments to a portfolio reduces portfolio risk
and increases expected return, however there are problems with
historical data and traditional risk measures
Survivorship bias refers to the upward bias of returns if data is
included only for currently existing (surviving) firms

LOS d

1
ª
ª
ª

ª
ª

e

Backfill bias refers to upward bias introduced by including the previous
performance data for firms recently added to a benchmark index

Hedge funds

nT

re

Pools of investor funds that are not as regulated as mutual funds
Limited in the number of investors
Often sold only to qualified investors
Minimum investments is quite high ($250k to $1m)
Use leverage, hold long and short positions, use derivatives and
invest in illiquid assets
ª Typically use prime brokers who provide multiple services such
as custodial, administrative, money lending, securities lending
and trading
ª Investors are limited partners and managers are general
partners
ª Hedge fund return objectives can be absolute (20%) or relative
(Benchmark + 5%)

Lockup period

The amount of time a fund has to fulfill the redemption request after
receiving the request

Fi

Notice period

Time after initial investment during which withdrawals are not allowed

Fund of funds

An investment company that invests in hedge funds
Advantages Ÿ Gives investors diversification among hedge
fund strategies
Ÿ Helps smaller investors to invest in hedge funds

Disadvantage Ÿ They charge an additional layer of management fees


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Hedge fund strategies
Event-driven
Merger
arbitrage

Distressed/
restructuring

Activist
shareholder

Special
situations

Buy shares of the
firm being acquired

Buy shares of firms
in financial distress

Sell short shares of
the acquirer

Short overvalued
securities

Buy sufficient equity
shares to influence a
company’s policies with
the goal of increasing
company value

Invest in securities of
firms that are
issuing/repurchasing
securities, spinning off
divisions, selling

assets, or distributing
capital

These strategies are based on a corporate restructuring or acquisition that creates
profit opportunities for long or short positions in securities of a specific corporation

Asset-backed
fixed income

Exploit pricing
discrepancies
among various
MBS or ABS

Exploit pricing
discrepancies
between fixed
income
securities of
various types

Fi

nT

Exploit pricing
discrepancies
between
convertible
bonds

common stock
of the issuing
company

General fixed
income

re

Convertible
arbitrage fixed
income

e

Relative value

Volatility

Exploit pricing
discrepancies
arising from
differences
between returns
volatility implied
by options prices
and manager
expectations of
future volatility
If

Implied volatility >
Expected volatility
= Overvalued

Multi-strategy

Exploit pricing
discrepancies
among securities
in asset classes
different from
those previously
listed and across
asset classes and
markets

These strategies involve buying a security and selling short a related security with
the goal of profiting when one thinks there is a pricing discrepancy between the two

Macro strategies

These are based on global economic trends and events and may involve
long or short positions in equities, fixed income, currencies or commodities


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Equity hedge fund

Market
neutral

Fundamental
growth

Use technical/
fundamental
analysis to
short overvalued
shares and buy
undervalued
shares in
approximately
equal amounts to
profit from their
relative price
movements
without exposure
to market risk

Use fundamental
analysis to find
high growth
companies.
Identify and buy
shares of
companies that
are expected to

sustain relatively
high rates of
capital
appreciation

Buy undervalued
shares based on
fundamental
analysis. It is
the hedge fund
structure

2

Private equity

Existing
management
team is involved
in the purchase

Management
buyins

External
management
team replaces
existing team

Short bias

Buy undervalued
shares and short
overvalued
shares based on
technical analysis

Mostly use short
positions in
overvalued
shares, with
smaller long
positions, but
with negative
market exposure
overall

Distressed
investment
funds

Developmental
capital funds

nT

Management
buyouts

Quantitative

directional

e

Venture
capital funds

re

Leveraged
buyout funds

Fundamental
value

Fi

Venture capital funds

Ÿ Investment is often in the form of equity but can be in convertible
preferred shares or convertible debt
Ÿ The companies in which a venture capital fund is invested are
referred to as its portfolio companies
Ÿ Venture capital fund managers often sit on their boards or fill key
management roles of portfolio companies


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Various stages at which venture capital investment is made
Formative stage

ª Investments made during firm’s earliest period
ª comprised of three phases

Angel investing

Ÿ Investments made very early (“idea” stage)
Ÿ funds are used for business plans and assessing market
potential
Ÿ funding source is usually individuals (“angels”) rather
than venture capital funds

Seed stage

Ÿ Investments made for product development, marketing
and market research
Ÿ This is the stage where VC funds make initial investments,
through ordinary or convertible preferred shares

Early stage

Ÿ

Later stage

ª Funds provided at this stage are typically used for
expansion of production and/or increasing sales

though an expanded marketing campaign
ª

Capital provided to prepare the firm for an IPO

e

Mezzanine-stage
financing

Investments made to fund initial commercial production
and sales

re

Mezzanine financing means debt or preferred stock that are subordinate to the high-yield bonds and carry
warrants or conversion features that give investors participation in equity when value increases

Developmental capital

Ÿ Known as minority equity investing

nT

Ÿ Refers to the provision of capital for
business growth or restructuring

Fi

Ÿ When public companies are

financed with such funds, it is
referred to as private investment in
public equities (PIPEs)

Distressed investing

Ÿ It refers to buying debt of mature
companies that are experiencing
financial difficulties

Ÿ Investors in distressed debt take
active role in working with
management on reorganizing or
determining the direction the
company should take
Ÿ They are sometimes referred to as
vulture investors

Private equity structure and fees

ª They are typically structured as limited partnerships

ª Committed capital is the amount of capital provided to the fund by investors
ª It is typically not invested all at once but is “drawn down” (invested) as
securities are identified and added to the portfolio


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

ª Drawdown period - Typically 3 - 5 years
ª Management fees - Typically 1% - 3%

ª Clawback provision - It requires the manager to return any periodic incentive
fees to investors if investors receive less than 80% of the profits generated by
portfolio investments as a whole

Private equity exit strategies
Ÿ Trade sale - Sell a portfolio company to a competitor or another strategic buyer
Ÿ IPO - Sell all or some shares of the company to the public
Ÿ Recapitalization - Company issues debt to fund a dividend distribution to equity
holders (the fund). This is not an exit, but is often a step toward an exit
Ÿ Secondary sale - Sell a portfolio company to another private equity firm or a
group of investors. Most prferred strategy
Ÿ Write-off/liquidation - Reassess and bear the losses from an unsuccessful
outcome

e

Potential benefits and risks of private equity
ª Private equity has less than one correlation with traditional investments. Therefore
there may be benefits of diversification from including private equity in portfolios

re

ª Standard deviation of private equity returns has been higher than the standard
deviation of equity index returns, which suggests greater risk
ª Choosing skilled fund managers is important

Real estate

nT

3

Residential
property

Commercial
property

Mortgages

Single-family
homes

Produces
income

Whole loans

Fi

Direct investment in real
estate

Can be cash investment
or leveraged investment
(property purchased with
a mortgage)

Lenders often sell their
mortgages. They are later
securitized and traded as
Mortgage Backed
Securities (MBS)

These properties generate
income from rents
Long time horizons,
illiquidity, Large size of
investment and their
complexity make
commercial properties
inappropriate for many
investors

These are also considered
a direct investment in real
estate
Loans can be pooled into
Commercial Mortgage
Backed Securities (CMBS)
that represent an indirect
investment


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Real Estate Investment Trusts (REITs) ª They issue shares that trade publicly like shares of stock
(liquid)
ª They can hold mortgages, hotel properties, malls, office
buildings, or other commercial property
ª Income is used to pay dividends (tax exempt)

Other real estate assets
Farmland

Timberland
Returns come from sales of
timber
Returns also include price
changes on timberland

Returns come from sales of
agricultural products
Returns are also based on land
price changes, changes in farm
commodity prices, and the
quality and quantity of the
crops produced

Potential benefits and risks of real estate
ª

Repeat sales index - It is based on price changes for properties that have sold multiple times
ª

ª

REIT indices - are based on the actual trading prices of REIT shares

re

ª

ª Appraisal index - It is based on periodic estimates of property values
Appraisal index returns have lowest standard deviation of other index methods

e

ª

Real estate performance is measured by three indices

REIT index returns and global equity returns have strong correlation (business cycles affect
REITs and global equities similarly)
REIT index returns and global bond returns have low correlation

4

Commodities

Equities
directly linked
to commodity

Managed

futures funds

nT

ª

Fi

Commodity
ETFs

Suitable for
investors who are
limited to buying
equity shares
They invest in
commodities or
commodity
futures

Investment in
shares of
commodity
producing firm

Drawback - Price
movement of the
stock may not be
perfectly
correlated with

price movements
of the commodity

Individual
managed
accounts

Specialized
funds in
specific sectors

It is an
alternative to
pooled funds for
HNIs

Can be organized
under any of the
structures

Actively managed
Some managers
concentrate on
specific sectors
while others are
more diversified
They can be
structured as
limited
partnerships or

mutual funds

Accounts are
tailored to the
needs of investors

Focus on specific
commodities


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Potential benefits and risks of commodities
ª Returns on commodities < returns on stocks/bonds
ª Sharpe ratio for commodities is low because of lower returns and
high standard deviation
ª Commodity prices tend to move with inflation rates, therefore
holding commodities can act as a hedge against inflation

Commodity prices and investments
ª Spot prices for commodities are a function of supply and demand
ª Global economics, production costs and storage costs, along with
value to user, all factor into prices

Infrastructure

Utility assets

Roads, airports,
ports and
railways etc.

Electric
generation and
distribution,
waste disposal
etc.

Brownfield investments -

Communications

Broadcast assets
and cable
systems etc.

re

Transportation
assets

e

5

Social

Prisons,

schools,
health care
facilities etc.

Investments in infrastructure assets that are already constructed

nT

Provides stable cash flows and relatively high yields, but offers
little potential for growth

Greenfield investments -

Investments in infrastructure assets that are to be constructed
Involves uncertainty and may provide relatively lower yields, but
offers greater growth potential

Fi

Other alternative investments

Various types of tangible collectibles such as rare wines, art, rare
coins and stamps, valuable jewelry and watches, and sports memorabilia
are considered investments

LOS e

Old

Management and incentive fees

Most common fee
structure for a hedge fund

2 and 20 (2/20)

2% = Management fee
20% = Incentive fee

Management fee is paid irrespective of investment performance
Incentive fee is paid as a percentage of profits

New


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Hurdle rates
Eg. #1

Opening value = 100 Closing value = 140 Hurdle rate = 12% Incentive fee = 20%

Opening value = 100

Closing value = 140
Profit = 40

Hard hurdle rate

Soft hurdle rate

Profit

40

Profit

Hard hurdle

12

Soft hurdle

28
Incentive fee
(20%)

5.6

40
40

Incentive fee
(20%)

8

Eg. #2 Hedge fund opening value = $150 mln Fee structure = 2/20 Hard hurdle rate = 5%

Ending value (Year 1) = $175 mln Ending value (Year 2) = $180 mln

e

Incentive fees are calculated net of management fees
Calculate total fees and investor’s net return

re

Year 1

Year 2

Management fees = $169.1 mln × 2% = $3.382 mln

Incentive fees
= [$175 mln − $150 mln − 3 − ($150
mln × 5%)] × 20% = $2.9 mln

Incentive fees
= [$180 mln − $169.1 mln − 3.382 −
($169.1 mln × 5%)] × 20% = $0

Total fees = $3 mln + $2.9 mln = $5.9 mln

Total fees = $3.382 mln

Ending value net of fees
= $175 mln − $5.9 mln = $169.1 mln

Ending value net of fees
= $180 mln − $3.382 mln = $176.618 mln

nT

Management fees = $150 mln × 2% = $3 mln

Investor’s net return
= ($168.9 mln/$150 mln) − 1 = 12.73%

Investor’s net return
= ($176.618 mln/$169.1 mln) − 1 = 4.44%

Fi

In year 2, incentive fee = 0 because return did not exceed hurdle rate

High water mark

Incentive fee = 150 - 130
= 20 x 20% = 4
t3 = 150

t1 = 130

t0 = 100
t2 = 80


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

LOS f

Issues in valuing alternative investments
Hedge fund valuation
Accounting NAV > Trading NAV
Trading NAV tends to be lower because it considers liquidity of portfolio

Private equity company valuation
Market/comparables
approach

Discounted cash
flow approach

Asset-based
approach

Transaction values of
similar companies may
be used to estimate
EBITDA, net income or
revenue to use in
estimating the portfolio
company’s value

Dividend discount
model and Free Cash

Flow to the Firm (FCFF)
come under this
category

Liquidation values or
fair market values of
assets are used

Real estate valuation
Income approach

Valuation based on
recent sales of similar
properties

Net operating income
Capitalization rate

re

e

Comparable sales
approach

Cost approach
Replacement cost of a
property is estimated

Commodity valuation

Contango - Future price > Spot price
Backwardation - Future price < Spot price

Collateral yield

nT

Roll yield
Yield due to a
difference between the
spot price and futures
price

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 futures contract

Fi

Backwardation - +ve
Contango - -ve

Interest earned on
collateral

Change in spot
prices

LOS g

ª

Risk management of alternative investments

Alternative investments exhibit return distribution which is left skewed and leptokurtic

ª

Therefore standard deviation may not be a correct measure of risk. Recommended
measure - VaR or Sortino ratio

ª

Use of derivatives introduces operational, financial, counterparty, and liquidity risk


https://www.fintreeindia.com/

© 2017 FinTree Education Pvt. Ltd.

Due diligence
Hedge fund

Private equity

ª Investment strategy
ª Investment process
ª Investment process

Source of competitive advantages
ª Historical returns
ª Valuation and returns calculation methods
ª Longevity
ª Amount of assets under management
ª Management style
ª Key person risk
ª Reputation
ª Growth plans
ª Systems for risk management
ª Appropriateness of benchmarks

ª

ª

ª

Because of the high leverage used for
private equity funds, investors should
consider how interest rates and the
availability of capital may affect any
required refinancing of portfolio
company debt
The choice of manager (general partner)
is quite important, his operating and

financial experience, valuation methods
used, incentive fee structures, drawdown
procedures are also important factors

Alternative investments

ª Property values fluctuate because of
global and national economic factors, local
market conditions, and interest rate levels

ª

ª

The degree of leverage used in real
estate investment is important because
leverage amplifies losses as well as gains

re

ª

Real estate development has additional
risks such as regulatory issues like zoning
and permitting, environmental
considerations or remediation, and
economic changes and financing decisions
over development period

Fi

nT

ª

Organization

e

Real estate

ª

Portfolio management

Operations and controls

ª

Risk management
ª
ª

Legal review
Fund terms