Introduction to Alternative Investments

High-Yield

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 Alternative Investments versus Traditional Investments
Traditional Investments: long positions in stocks, bonds and cash
Alternative Investments: all other investments including hedge funds, private equity, real estate,
commodities and infrastructure

Compared to traditional investments, alternative investments typically have:

• Less regulation
• Lower transparency
• Higher fees
• Limited and potentially problematic historical risk and return data
• Unique legal and tax considerations

One of the primary drivers for investing in alternative investments is the low correlation of alternative
investment with traditional investments

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 Hedge Funds
• Aim for absolute returns.
• Partnership structure with a general partner (the fund) that manages the business
and bears unlimited liability and limited partners (investors) who own fractional
interests in the partnership.
• General partner typically receives a management fee based on assets under
management and an incentive fee based on realized profits.
• Hedge funds are typically classified by strategy into four broad categories
• Event-driven: Includes merger arbitrage, distressed/restructuring, activist
shareholder and special situation.
• Relative value: Strategies that seek to profit from pricing discrepancies.
• Macro: Strategies based on top-down analysis of global economic trends.
• Equity hedge: Strategies based on bottom-up analysis. Includes market
neutral, fundamental growth, fundamental value, quantitative directional, and
short bias.
• During financial crisis the correlation of returns between global equities and hedge
funds tends to increase.

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 Private Equity (1/2)
 Partnership structure with a general partner (the fund) that manages the business and
bears unlimited liability and limited partners (investors) who own fractional interests in the
partnership
 General partner typically receives a management fee based on committed capital and an
incentive fee based on realized profits
 Two broad sub-categories are: leveraged buyout (LBO) and venture capital (VC)
 Types of LBOs include
o Management buyouts: The existing management team is involved in the purchase
o Management buy-ins: External management team replaces the current management
 Stages in venture capital include
o Formative stage: Angel investing, seed and early stages
o Later stage: Companies in expansion phase
o Mezzanine stage: Companies preparing for an IPO

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 Private Equity (2/2)
 Exit strategies for investments in portfolio companies include
o Trade sale: Company is sold to a competitor or another strategic buyer
o IPO: Company is sold to the public
o Recapitalization: Leverage is increased in the Company
o Secondary sale: Company is sold to another private equity firm or another
investor
o Write off/ liquidation: Company is sold at a loss
 Historically, private equity has provided potential diversification benefits
 An investor must identify top performing private equity managers to benefit from
private equity

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 Real Estate
• Primary reasons to invest in real estate include
• Potential for competitive long term returns
• Rental income
• Diversification benefits
• Inflation hedge
• Investment characteristic of real estate include
• Indivisibility
• Unique characteristics (no two properties are identical)
• Fixed location
• Operational management
• Local markets can be very different from national or global markets

Debt Equity
Private Mortgages Direct ownership of real estate
Construction lending Sole ownership, joint ventures, real estate limited partnerships etc.
Public Mortgage-backed securities Indirect ownership via shares in real estate development corporations
Collateralized mortgage obligations or shares of real estate investment trusts (REITs).

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 Commodities

• Commodity investments may involve investing in actual physical

commodities or in producers of commodities, but more typically,
commodity investing is done using commodity derivatives.
• Commodities do not offer an income stream.
• The components of return on a commodity investment are
• Collateral yield: Return on collateral posted to satisfy margin
requirements.
• Price return: The gain or loss due to changes in the spot price.
• Roll yield: Gain or loss resulting from re-establishing future
positions. Roll yield is positive if futures market is in
backwardation and negative if the market is in contango.
• Good inflation hedge.
• Low correlation with traditional investments.

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 Infrastructure

• Infrastructure assets are capital intensive, long-lived, real assets that

are intended for public use and provide essential services

• Investors expect these assets to generate stable cash flows, which

adjust for economic growth and inflation

• Investors may also expect capital appreciation

• Category, stage of development, and geographical location of

underlying assets and the form of infrastructure investment affect risks
and expected returns of infrastructure investments

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 Hedge Fund Fees

• The total fee for a hedge fund consists of a

management fee and an incentive fee.
Common fee structure is 2 and 20 which
means 2% management fee and 20%
incentive fee.

• Incentive fee is usually calculated on profits

net of management fees or on profits before
management fees.

• Generally, the incentive fee is paid only if the

returns exceed a hurdle rate.

• In some cases the incentive fee is paid only if

the fund has crossed the high watermark.

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 Issues in Valuing and Calculating Returns
Hedge funds often invest in securities that are not actively traded. The values of such securities must therefore be
estimated. They also invest in securities that are illiquid. The values of such securities must be adjusted for illiquidity.

Private equity portfolio companies must be valued using one of the following approaches
• Market/comparables approach: Values a company based on multiples.
• Discounted cash flow approach: Present value of expected future cash flows
• Asset based approach: Value is based on underlying assets minus liabilities

Real estate properties must be valued using one of the following approaches
• Comparable sales approach: Value is based on recent sales of similar properties
• Income approach: Present value of expected future cash flows from the property
• Cost approach: Replacement cost of a property

Real estate investment trusts (REITs) can be valued using

• Income based approach
• Asset based approach

A commodity futures price is equal to spot price compounded at the risk free rate + storage costs – convenience yield
Convenience yield is the value of having the physical commodity for use over the period of the futures contract.

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 Risk Management of Alternative Investments

• Asymmetric risk and return profiles, illiquidity

• Traditional risk and return measures may not provide an adequate
picture of characteristics of alternative investments
• Operational, financial, counterparty, and liquidity risks may be key
considerations for those investing in alternative investments
• Due diligence must be performed to assess whether
• a potential investment is in compliance with its prospectus
• the appropriate organizational structure and policies for
managing investments, operations, risk, and compliance are
in place
• the fund terms appear reasonable
• The inclusion of alternative investments in a portfolio, including the
amounts to allocate, should be considered in the context of an
investor’s risk–return objectives, constraints, and preferences

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