ALTERNATIVE INVESTMENT
What are the basic characteristics of alternative investments ?
Alternative investments differ from traditional investments by both the type of assets and
securities they include and in the different structures in which those securities are held.
Basic characteristics of alternatives:
• Low liquidity – therefore they have a liquidity premium and > E(r)
• Offer diversification benefits –low correlation with equities/fixed income
• Less regulation & information disclosure
• High due diligence costs
• Hard to get or evaluate/benchmark performance or compare across benchmarks
• Unique legal issues and tax treatment
• May have higher use of leverage and derivatives
Bottom line: Alternatives require more due diligence and are less suitable for some investors (i.e.
those who are less sophisticated or have higher liquidity needs).
What are the 5 major asset classes within alternative investments?
• Real estate – Includes direct property ownership and indirect via vehicles
• Commodities – Owning physical commodities, derivatives, or equity of commodity producing
firms
• Private Equity – Includes LBO funds and venture capital
• Hedge Funds– Many strategies, usually leveraged and use derivatives
• Other – Tangible assets like art or collectibles, as well as patents and intangibles
•
What benefits do alternatives offer from a portfolio context?
The primary benefit is to increase a portfolio’s diversification. Most alternatives have very low
correlation with stocks and bonds due to either different risk factors or different strategies.
Alternatives have also historically outperformed traditional investments from a return
perspective. Note that these higher expected returns mainly stem from due to lower liquidity and
possibly higher risk.
That risk is also difficult to measure using traditional risk measurements.
What are survivorship bias and backfill bias and how do they impact benchmark results?
Survivorship bias is an upward bias in investment results that occurs when only surviving firms
report their results (i.e. all the ones that failed because of poor results aren’t included). This is
most common with hedge funds.
Backfill bias also biases results upwards. It occurs when successful managers decide to add
their investment results to a benchmark.
What are the basic characteristics of a private equity fund?
Private equity (PE) involves ownership in a non-publically traded private company and for the
purposes of the CFA exam includes both venture capital and buyout funds.
PE investments have low liquidity and are often subject to lock up periods. They tend to be
higher risk, higher reward than public equity investments, with earlier stage investing being riskier
than buying more established companies.
How are PE and Hedge Fund fees commonly structured?
(Clawback, High Water Marks, AUM vs. Performance)
Most GPs are paid an annual fee for committed capital of 1-2%. The vast majority of their fees,
however, are performance based and comes in the form of carried interest. Carried interest is
taken as a percentage cut, traditionally 20%, of a fund’s profit. This is the common term 2 & 20
(2% management fee, 20% performance).
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As you might imagine LPs are concerned about the nature of this profit, and will often structure
provisions to try to protect themselves. One provision is setting a hurdle rate, or minimum level of
return, the fund must clear before any profits are distributed to the GP. Another common
provision is a high-water mark which sets clawback provisions that force a GP to repay profits if
the fund’s value subsequently falls below a certain threshold.
Compare and contrast leveraged buyouts (LBOs) to Venture Capital investments…
Leveraged buyouts (LBOs) use debt-financing to acquire/take a company private. These can
be management buyouts which involve the existing management team or management-buy
ins which will replace the management team. The goal is to restructure the company to increase
cash flows, pay down debt, pay dividends, and then resell the company.
Venture capital involves identifying and investing in younger emerging private companies. VCs
include angel investors (wealthy individuals), VC firms, or other large firms (strategics). Their
investments are usually for a minority stake in the business. VCs are differentiated by the stage
at which they invest (formative & later stage)
What are the different stages of VC investment based on company lifecycle?
What factors make a company an attractive target for PE?
• Willing management
• A depressed/low stock price
• Inefficient companies where significant restructuring is possible
• Strong and sustainable cash flows
• Low leverage
• High amount of physical assets
How do we value a PE company?
• Market/Comparables – Compare using EBITDA, net income, revenue multiples from public or
private comps to estimate value
• DCF Approach – Use discounted cash flow analysis like DDM model
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ALTERNATIVE INVESTMENT
• Asset-based approach – Use the liquidation value or fair market value of assets to estimate the
firm’s intrinsic value. Realized value would likely be lower than this in event of a rushed asset
sale
What are the different PE exit strategies?
• IPO – Sell Shares to the public
• Sale to strategic buyer or competitor
• Recapitalization – Issue debt to pay dividends (not a true exit)
• Secondary Sale – Sale to another PE firm or group of investors
• Write-off/Liquidation – Take losses from an unsuccessful company
What are the special considerations for evaluating a PE opportunity or a PE manager?
1. The operating and financial skill and experience of the team
2. The interest rate environment – Because PE tends to use a lot of debt lower interest rates
benefit their actions and higher ones = higher opportunity costs
3. Availability of capital
4. The fee structure – Incentives, claw backs, benchmarks
5. Drawdown procedures for calling in committed capital
6. The illiquidity of the asset class in general
What are the basic characteristics of a hedge fund?
Hedge funds are less regulated, skill-based strategies that can offer both higher absolute and
risk-adjusted returns depending on the choice of strategy. They usually use derivatives, leverage,
and often take both long and short positions. Generally long-only strategies have fewer
diversification benefits than long-short strategies.
Their fee structure is similar to what we talked about for PE. It usually has a base AUM
component and a performance fee (e.g. 2 & 20) that is subject to high water marks. LPs
investing in hedge funds typically will be subject to a lock-up period where they cannot retrieve
their capital.
A fund of funds will invest in a basket of hedge funds, giving investors more diversification but
adding an additional layer of fees.
What types of investors are hedge funds suitable for?
Because of their risk, lack of liquidity, and longer holding periods hedge funds are only
considered suitable for institutional investors and individual investors who:
• Have sufficient wealth (Ultra-high networth individuals)
• Do not have any immediate liquidity needs they cannot meet
• Are sophisticated
What are the main classes or buckets of hedge fund strategies?
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What are the 9 specific hedge fund trading strategies and how do they work?
What are some of the key factors in performing due diligence when selecting a HF manager?
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Hedge funds are traditionally opaque and operate with minimal regulatory oversight.
Comprehensive due diligence is essential when selecting a manger.
Factors to consider:
What are some difficulties with evaluating hedge fund returns?
Hedge funds are often characterized as absolute return vehicles. Since they are not
directly investable there is no single easy benchmark to evaluate their performance. This is part
of the reason their performance is sometimes compared to the risk free rate of return. The other
reason being that many hedge funds seek to hedge systematic risk.
What are the basic characteristics of real estate as an asset class?
Real estate offers:
• Diversification benefits
• Income potential
• Inflation hedge- rents and real estate values are positively correlated with inflation).
Real estate investments can include residential property, commercial property, or loans with real
estate as collateral.
Compare direct and indirect real estate
Real estate investments can be either direct or indirect. Direct investments include owning a
home, owning commercial property, or owning (agricultural) land.
Indirect exposure to real estate is more diverse and more liquid. It can consist of owning
development companies, REITs, a commingled real estate fund (CREF), or infrastructure funds
What are the characteristics and differences in residential real estate, commercial real estate,
and REITS?
• Residential real estate – Direct investment; Defined as ownership with intent to reside in the
house. Usually done w/ mortgages which levers the investment where the owner’s equity =
property value − outstanding loan amount. Any ↑↓ in property value will ↑↓ the owner’s equity
• Commercial real estate –Direct investment; Generates rental income (owning homes to rent is
considered commercial). Commercial real estate has a long time horizon, is illiquid, needs a
large investment, and is complex often requiring professional management.
• REITs – Indirect; Real estate investment trusts issue shares that are publically traded. They are
distinguished by the underlying real estate they hold—whether mortgages, hotels, malls etc.
Legally 90% of REIT income must be distributed to shareholders as dividends. REITs more
correlated to equities than other forms of real estate.
What are the characteristics of farmland and timberland?
• Farmland - Inflation hedge. Returns correlated with crop yields and agricultural prices.
Harvesting is less flexible than with timberland.
• Timberland – Return from land appreciation and the sale of timber and timber products. Offers
great diversification from other assets. Flexibility as to timing of harvesting timber—can wait out
periods of low prices (as the asset grows)
What are the pros and cons of real estate investing?
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What are the 3 approaches to valuingdirect real estate?
• Comparable sales approach – Values real estate based on sales of recent properties, adjusted
for specific characteristics like square footage, age, location etc
• Income approach – Estimates the real estate value as
Net Operating Income (NOI) = income from the property minus operating expenses (taxes,
utilities, & repairs) but before depreciation, finance cost, & income tax and Capitalization rate =
discount rate minus growth rate
• Cost approach – Estimates the replacement cost of a property as the cost of the land and
today’s cost of rebuilding the home
How do we use income-based and asset-based valuation with REITs?
Income-based valuation
• Similar to direct cap approach in that we use a measure of income divided by the cap rate
• We use Funds from operations (FFO) or Adjusted FFO as measure of net income
• FFO = NI + Dep ± G/L sales of property
• AFFO = FFO − recurring capex (its basically free cash flow)
Asset based valuation
• Calculates a REIT’s NAV
• NAV = MV Assets − MV liabilities
• REIT shares may fluctuate above or below NAV in trading
What are characteristics of a commodity?
Commodities are physical products like oil, metals, agricultural products etc. Investment can
be direct—via ownership of the physical commodity or more commonly using derivatives/futures
priced on those assets—or it can be indirect which involves investing in companies whose main
business is tied to commodities.
With the indirect approach you need to be careful that the firm does not fully hedge its exposure
to the underlying asset; if it does that would not give you your desired exposure to the asset.
With the direct approach you need to be aware of actual storage costs.
Commodity returns come from price changes not income streams.
What are the perceived benefits of investing in commodities?
In general commodities have:
• High liquidity Offer diversification from stocks/bonds (low correlation)
• Inflation hedge – Some commodities correlated tend to be positively correlated with inflation IF
they are storable or IF they have a correlation with economic activity, e.g. copper and energy
commodities.
Even if including commodities lowers portfolio returns it can still lead to a higher Sharpe ratio due
to the diversification benefits.
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ALTERNATIVE INVESTMENT
What are the common methods of gaining exposure to commodities?
• Futures, forwards, options, swaps on commodities
• Commodity ETFs
• Equities linked to commodities – Like a gold producer, may not be perfectly correlated
• Managed futures funds – Actively managed commodity funds, can be concentrated in an asset
or diversified across commodities. Can be private or public
• Individual managed accounts
• Specialized sector funds
What are commodity spot prices a function of?
• Supply & demand for the commodity (Scarcity)
• Cost of producing and storing the commodity
• The value of the commodity
• Macroeconomic factors
Commodities often undergo boom and bust cycles as producers are not able to rapidly adjust
their production in response to fluctuations in demand
How do we calculate the value of a commodity futures price?
Futures price≈Spot price convenience yield
The higher the storage cost the greater the benefit of not holding the asset and being able to buy
it. The convenience yield is any non-monetary benefit that comes from holding a commodity.
For example, if I am an airline company, I may get some convenience and de-risking of my
business by holding actual oil.
What is contango and backwardation?
• Contango is where Spot price < Futures price
o Occurs when storage costs are high or convenience yield is low
• Backwardation is where Spot Price > Futures price
o Occurs when there is a high convenience yield
What are the 3 sources of return on a commodity futures contract?
Total Return=spot return+collateral return+roll return
The spot return is the price return on the underlying commodity over the life of the contract. In
other words it is the change in the spot price of the commodity between the time you purchased
the contract and its expiration. So if you buy a 1 year futures contract giving you the right to buy
oil for $45/barrel and its spot price in 1 year is $65/barrel, the spot return is $20/barrel.
Collateral return is the risk free rate of return you earn because a futures contract does not
require payment until the expiration of the contract (this is true of all futures contracts). It’s the
periodic risk free return, or the equivalent return you’d make earning cash. So just like with cash,
higher interest rates increase the collateral yield and lower interest rates decrease it.
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Roll return is the return that comes from rolling a futures contract forward at expiration. It is
equal to:
roll return=ΔFutures price−ΔSpot price
Roll return can be either negative or positive depending on the term structure of
commodity prices. It will be negative when markets are in contango, which means the futures
price is greater than the spot price (think crap, contango!). Roll return will be positive when
markets are in backwardation, which is where the FP is lower than the spot price.
What are some of the key factors/ complications associated with managing risk within
alternatives?
• Alternatives are illiquid (and thus require a return premium)
• Standard deviation may not be a good measure of risk since returns are not likely to be
normally distributed (tend to be fat tailed, negatively skewed) and the infrequent appraisal of
value tends to smooth out returns thereby underestimating risk. Alternatives include value at risk
(VAR)and use of the Sortino ratio
• Past benchmarks and returns may not be indicative of the future
• Derivatives involve hard to model risks such as counterparty risk, financial risk, & liquidity risk
• Performance within assets such as hedge funds and PE depends more on management’s ability
to execute than other asset classes
• HF and PE are much less transparentso investors will have less information
What are the 6 major categories of due diligence in alternatives?
1. Organization – Experience, quality, & compensation of staff as well as past results
2. Portfolio management – Investment process, asset allocation, target market, role of operating
partners, underwriting, dispositions
3. Operations and controls – Reporting/accounting methods, audited financials, insurance,
contingency plans
4. Risk management – Policies and controls, constraints on leverage, key risk factors
5. Legal – Fund legal structure, registrations, any litigation history
6. Fund terms – Fees, expenses, investment period, process of calling in commitments, rights of
LPs, etc
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