Alternative Investments

Question 1

Compare the characteristics, classifications, principal risks, and basic forms of public and private real estate investments.

Answer 1

There are four basic forms of real estate investment: private equity (direct ownership), publicly traded equity (indirect ownership), private debt (direct mortgage lending), and publicly traded debt (mortgage-backed securities).

Real estate investments are heterogeneous, have high unit values, have high transaction costs, depreciate over time, are influenced by the cost and availability of debt capital, are illiquid, and are difficult to value.

Risks include changing business conditions, long lead times to develop property, cost and availability of capital, unexpected inflation, demographic factors, illiquidity, environmental issues, property management expertise, and the effects of leverage.

Question 2

Compare the direct capitalization and discounted cash flow valuation methods.

Estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods.

Answer 2

NOI is equal to potential gross income (rental income fully leased plus other income) less vacancy and collection losses and operating expenses.

The cap rate, discount rate, and growth rate are linked.

cap rate = discount rate (r) − growth rate (g)

If the cap rate is unknown, it can be derived from recent comparable transactions as follows:

cap rate = NOI1 ÷ comparable sales price

The discount rate is the required rate of return of the investor.

discount rate = cap rate + growth rate

Question 3

Explain advantages and disadvantages of investing in real estate through publicly traded securities compared to private vehicles.

Answer 3

Relative to publicly traded securities, private investment provides direct exposure to the real estate class, returns dictated by property performance, tax benefits, inflation hedge, illiquidity premium, control, and lower correlation with other asset classes. However, private investments suffer from illiquidity, high fees and expenses, high minimum investment, low transparency, fewer regulatory protections for investors, and higher risk due to leverage.

Publicly traded securities are attractive because they provide high liquidity, professional management, tax efficiency (REITs), diversification, low minimum investment, low entry/exit costs, regulatory protection for investors, and high transparency. However, they suffer from higher volatility, higher correlation with stocks, and agency conflict.

Question 4

Calculate the value of a property using the direct capitalization and discounted cash flow valuation methods.

Answer 4

Direct capitalization method:

Discounted cash flow method:

Step 1:Forecast the terminal value at the end of the holding period (use direct capitalization method if NOI growth is constant).

Step 2:Discount the NOI over the holding period and the terminal value to present.

Using the gross income multiplier:

value = gross income × gross income multiplier

Question 5

Discuss real estate investment indexes, including their construction and potential biases.

Answer 5

Appraisal-based indices calculate return as current yield (from NOI) plus price appreciation (adjusted for capital expenditures). Transaction-based indices are based on (1) repeat sales, (2) ahedonic model, or (3) public securities. Appraisal-based indices tend to lag transaction-based indices and appear to have lower volatility and lower correlation with other asset classes.

Question 6

Describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation.

Answer 6

Accounting net earnings

+ Depreciation, amortization, impairments, and writedowns

− Gains (losses) from sales of property

= Funds from operations

FFO (funds from operations)

− Non-cash (straight-line) rent adjustment

>− Recurring maintenance-type capital expenditures and leasing commissions

= AFFO (adjusted funds from operations)

Question 7

Calculate and interpret the value of a REIT share using the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches.

Answer 7

Price-to-FFO approach:
Funds from operations (FFO)
÷ Shares outstanding
= FFO / share
× Sector average P / FFO multiple
= NAV / share

Price-to-AFFO approach:
Funds from operations (FFO)
− Non-cash rents
− Recurring maintenance-type capital expenditures
= AFFO
÷ Shares outstanding
= AFFO / share
× Property subsector average P / AFFO multiple
= NAV / share

Discounted cash flow approach:
value of a REIT share
= PV(dividends for years 1 through n) + PV(terminal value at the end of year n)

Question 8

Discuss commercial property types, including their distinctive investment characteristics.

Answer 8

Commercial property types, and the demand for each, are driven by the following:

Office—Job growth.
Industrial—The overall economy.
Retail—Consumer spending.
Multifamily—Population growth.

Question 9

Explain portfolio roles and economic value determinants of real estate investments.

Answer 9

Reasons to invest in real estate include current income, capital appreciation, inflation hedge, diversification, and tax benefits. Real estate is less-than-perfectly correlated with the returns of stocks and bonds; thus, adding real estate to a portfolio can reduce risk relative to the expected return.

While factors such as GDP growth, population growth, wage growth, taxes, and regulations affect all property types, factors such as changing supply routes, advances in logistics, trade, and transportation are unique to industrial properties.

Question 10

Discuss the income, cost, and sales comparison approaches to valuing real estate properties.

Answer 10

Cost approach. Value is derived by adding the value of the land to the replacement cost of a new building less adjustments for estimated depreciation and obsolescence.

Sales comparison approach. The sales prices of similar (comparable) properties are adjusted for differences with the subject property.

Income approach. Value is equal to the present value of the subject’s future cash flows over the holding period.

Question 11

Justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income.

Answer 11

Net asset value per share (NAVPS) is the (per-share) amount by which a REIT’s assets exceed its liabilities, using current market value of REIT real estate investments rather than accounting or book values. The REIT or REOC portfolio of operating real estate investments can be valued by capitalizing net operating income (after removing any non-cash rents). Adding other assets and subtracting other liabilities yields net asset value.

Question 12

Explain the due diligence process for both private and public equity real estate investments.

Answer 12

Investors perform due diligence to confirm the facts and conditions that might affect the value of the transaction. Due diligence can be costly, but it lowers risk of unexpected legal and physical problems. Due diligence involves reviewing leases, confirming expenses, performing inspections, surveying the property, examining legal documents, and verifying compliance.

Question 13

Calculate and interpret financial ratios used to analyze and evaluate private real estate investments.

Answer 13

Lenders often use the debt service coverage ratio (DSCR) and the loan-to-value (LTV) ratio to determine the maximum loan amount on a specific property. Investors use ratios such as the equity dividend rate (cash-on-cash return), leveraged IRR, and unleveraged IRR to evaluate performance.

Question 14

Discuss types of REITs.

Answer 14

The main types of REITs are:
Equity REITs, which take ownership stakes in income-producing property.
Mortgage REITs, which invest primarily in mortgages, mortgage securities, or loans that use real estate as collateral.

Advantages of REITs include:
Superior liquidity.
Transparency.
Access to premium properties.
Active professional management.
Greater potential for diversification.
Exemption from taxation.
Earnings predictability and high yield.

Disadvantages of REITs include:
Limited potential for income growth.
Forced equity issuance.

Question 15

Calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund.

Answer 15

The following statistics are important for evaluating the performance of a PE fund:

Management fees are calculated as the percentage fee multiplied by the total paid-in capital.

The carried interest is calculated as the percentage carried interest multiplied by the increase in the NAV before distributions.

The NAV before distributions is calculated as = NAV after distributions in prior year + capital called down – management fees + operating results

The NAV after distributions is calculated as = NAV before distributions – carried interest – distributions

The DPI multiple is the cumulative distributions divided by the paid-in capital.

The RVPI multiple is the NAV after distributions divided by the paid-in capital.

The TVPI multiple is the sum of the DPI and RVPI.

Question 16

Explain how private equity firms align their interests with those of the managers of portfolio companies.

Answer 16

Private equity firms use the following mechanisms to align their interests with those of the managers of portfolio companies:
 Manager’s compensation tied to the company’s performance.
 Tag-along, drag-along clauses ensure that anytime an acquirer acquires control of the company, they must extend the acquisition offer to all shareholders, including firm management.
 Board representation by private equity firm.
 Noncompete clauses required for company founders.
 Priority in claims. PE firms have priority if the portfolio company is liquidated.
 Required approval by PE firm for changes of strategic importance.
 Earn-outs. Acquisition price paid is tied to portfolio company’s future performance.

Question 17

Explain private equity fund structures, terms, due diligence, and valuation in the context of an analysis of private equity fund returns.

Answer 17

The most common form of ownership structure for private equity funds is the limited partnership where limited partners (LPs) provide funding and have limited liability. The general partner (GP) manages the investment fund.

The economic terms in a private equity prospectus address the following issues: management fees; transaction fees; carried interest (the GP’s share of the fund profits); ratchet (the allocation of equity between stockholders and management of the portfolio company); hurdle rate (the IRR that the GP must meet before receiving carried interest); target fund size; vintage year; and term of the fund.

The corporate governance terms in the prospectus address the following issues: key man clause (the provisions for the absence of a key named executive); performance disclosure and confidentiality (specifies the fund performance information that can be disclosed); clawback (the provision for when the GP must return profits); distribution waterfall (the method in which profits will flow to the LPs before the GP receives carried interest); tag-along, drag-along clauses (give management the right to sell their equity stake if the private equity firm sells its stake); no-fault divorce (specify when a GP can be fired); removal for cause (provisions for the firing of the GP or the termination of a fund); investment restrictions; and co-investment (allows the LPs to invest in other funds of the GP at low or no management fees).

Valuations are difficult for private equity funds because there is no ready secondary market for their investments. Additional issues with NAV calculations include the following: (1) the NAV will be stale if it is only adjusted when there are subsequent rounds of financing; (2) there is no definitive method for calculating NAV; (3) undrawn LP capital commitments are not included in the NAV calculation but are essentially liabilities for the LP; (4) different strategies and maturities may use different valuation methodologies; and (5) it is the GP who usually values the fund.

Investors should conduct due diligence before investing in a private equity fund due to the persistence in returns in private equity fund returns, the return discrepancies between outperformers and underperformers, and their illiquidity.

Question 18

Explain sources of value creation in private equity.

Answer 18

The sources of value creation in private equity are: (1) the ability to reengineer the company, (2) the ability to obtain debt financing on more favorable terms, and (3) superior alignment of interests between management and private equity ownership.

Question 19

Explain alternative exit routes in private equity and their impact on value.

Answer 19

The means and timing of the exit strongly influence the exit value.

The four typical exit routes:

1. Initial public offerings usually result in the highest exit value due to increased liquidity, greater access to capital, and the potential to hire better quality managers.
2. Secondary market sales to other investors or firms result in the second highest company valuations after IPOs.
3. In an MBO, the company is sold to management, who utilize a large amount of leverage.
4. A liquidation is pursued when the company is deemed no longer viable and usually results in a low exit value.

Question 20

Interpret LBO model and VC method output.

Answer 20

Under the VC method, the proportion of the company (f     ) received for an investment in the company is calculated as the investment amount (INV) divided by the post-money (post-investment) value of the company. The post-money value of the company is calculated by dividing the estimated exit value for the company by the investor’s required return on investment (ROI) multiple.

Once we have calculated this ownership share, we can calculate the number of shares issued to the venture capital investor for the investment (sharesVC) and the price per share as:

shares VC = shares founders x (ƒ ÷ (1 − ƒ))

price = INV ÷ sharesVC

Subsequent rounds of financing dilute the ownership fractions of early-round investors. After a second round, the first-round fractional ownership will be diluted as follows:

f∗1 (after dilution) = f1 × (1 - f2)

Question 21

Compare and contrast characteristics of buyout and venture capital investments.

Answer 21

Relative to buyouts, venture capital portfolio companies are characterized by: unpredictable cash flows and product demand; weak asset base and newer management teams; less debt; unclear risk and exit; high demand for cash and working capital; less opportunity to perform due diligence; higher returns from a few highly successful companies; limited capital market presence; company sales that take place due to relationships; smaller subsequent funding; and general partner revenue primarily in the form of carried interest.

Question 22

Valuation Issue - Applicability of DCF Method

Answer 22

Buyout: Frequently used to estimate value of equity

Venture Capital: Less frequently used as cash flows are uncertain

Question 23

Valuation Issue - Applicability of Relative Value Approach

Answer 23

Buyout: Used to check the value from DCF analysis

Venture Capital: Difficult to use because there may be no true comparable companies

Question 24

Valuation Issue - Use of Debt

Answer 24

Buyout: High

Venture Capital: Low as equity is dominant form of financing

Question 25

Valuation Issue - Key Drivers of Equity Return

Answer 25

Buyout: Earnings growth, increase in multiple upon exit, and reduction in the debt

Venture Capital: Pre-money valuation, investment, and subsequent equity dilution

Question 26

Interpret and compare financial performance of private equity funds from the perspective of an investor.

Answer 26

The Gross IRR reflects the fund’s ability to generate a return from portfolio companies. The Net IRR is the relevant return metric for the LPs and is net of management fees, carried interest, and other compensation to the GP. The Net IRR should be benchmarked against a peer group of comparable private equity funds of the same vintage and strategy.

Question 27

Explain risks and costs of investing in private equity.

Answer 27

The general private equity risk factors are liquidity risk, unquoted investments risk, competitive environment risk, agency risk, capital risk, regulatory risk, tax risk, valuation risk, diversification risk, and market risk.

The costs of investing in private equity are significantly higher than those associated with publicly traded securities and include transactions costs, investment vehicle fund setup costs, administrative costs, audit costs, management and performance fee costs, dilution costs, and placement fees.

Question 28

Contrast roll return in markets in contango and markets in backwardation.

Answer 28

Roll return is positive when a futures market is in backwardation because a long position holder will be buying longer-dated contracts that are priced lower than the expiring contracts. Roll return is negative when a futures market is in contango because the longer-dated contracts are priced higher than the expiring contracts.

Question 29

Compare characteristics of commodity sectors.

Answer 29

Commodity sectors include energy (crude oil, natural gas, and refined petroleum products); industrial metals (aluminum, nickel, zinc, lead, tin, iron, and copper); grains (wheat, corn, soybeans, and rice); livestock (hogs, sheep, cattle, and poultry); precious metals (gold , silver, and platinum); and softs or cash crops (coffee, sugar, cocoa, and cotton).

Crude oil must be refined into usable products but may be shipped and stored in its natural form. Natural gas may be used in its natural form but must be liquefied to be shipped overseas.

Industrial and precious metals have demand that is sensitive to business cycles and typically can be stored for long periods.

Production of grains and softs is sensitive to weather. Livestock supply is sensitive to the price of feed grains.

Question 30

Compare theories of commodity futures returns.

Answer 30

Insurance Theory states that futures returns compensate contract buyers for providing protection against price risk to futures contract sellers (i.e., the producers). This theory implies that backwardation is a normal condition.

The Hedging Pressure Hypothesis expands on Insurance Theory by including long hedgers as well as short hedgers. This theory suggests futures markets will be in backwardation when short hedgers dominate and in contango when long hedgers dominate.

The Theory of Storage states that spot and futures prices are related through storage costs and convenience yield.

Question 31

Describe how the construction of commodity indexes affects index returns.

Answer 31

Returns on a commodity index are affected by how the index is constructed. The index components and weighting method affect which commodities have the greatest influence on the index return. The methodology for rolling over expiring contracts may be passive or active. Frequent rebalancing of portfolio weights may decrease index returns in trending markets or increase index returns in choppy or mean-reverting markets.

Question 32

Compare the life cycle of commodity sectors from production through trading or consumption.

Answer 32

The life cycle of commodity sectors includes the time it takes to produce, transport, store, and process the commodities.

Crude oil production involves drilling a well and extracting and transporting the oil. Oil is typically stored for only a short period before being refined into products that will be transported to consumers.

Natural gas requires little processing and may be transported to consumers by pipeline.

Metals are produced by mining and smelting ore, which requires producers to construct large-scale fixed plants and purchase equipment. Most metals can be stored long term.

Livestock production cycles vary with the size of the animal. Meat can be frozen for shipment and storage.
Grain production is seasonal, but grains can be stored after harvest. Growing seasons are opposite in the northern and southern hemispheres.

Softs are produced in warm climates and have production cycles and storage needs that vary by product.

Question 33

Contrast the valuation of commodities with the valuation of equities and bonds.

Answer 33

In contrast to equities and bonds, which are valued by estimating the present value of their future cash flows, commodities do not produce periodic cash inflows. While the spot price of a commodity may be viewed as the estimated present value of its future selling price, storage costs (i.e., cash outflows) may result in forward prices that are higher than spot prices.

Question 34

Describe types of participants in commodity futures markets.

Answer 34

Participants in commodity futures markets include hedgers, speculators, arbitrageurs, exchanges, analysts, and regulators.

Informed investors are those who have information about the commodity they trade. Hedgers are informed investors because they produce or use the commodity. Some speculators act as informed investors and attempt to profit from having better information or a better ability to process information. Other speculators profit from providing liquidity to the futures markets.

Question 35

Describe how commodity swaps are used to obtain or modify exposure to commodities.

Answer 35

Investors can use swaps to increase or decrease exposure to commodities. In a total return swap, the variable payments are based on the change in price of a commodity. In an excess return swap, the variable payments are based on the difference between a commodity price and a benchmark value. In a basis swap, the variable payments are based on the difference in prices of two commodities. In a commodity volatility swap, the variable payments are based on the volatility of a commodity price.

Question 36

Analyze the relationship between spot prices and futures prices in markets in contango and markets in backwardation.

Answer 36

Basis is the difference between the spot price and a futures price for a commodity. Calendar spread is the difference between futures prices for contracts with different expiration dates.

A market is in contango if futures prices are greater than spot prices, or in backwardation if futures prices are less than spot prices. Calendar spreads and basis are negative in contango and positive in backwardation.

Question 37

Describe, calculate, and interpret the components of total return for a fully collateralized commodity futures contract.

Answer 37

The total return on a fully collateralized long futures position consists of collateral return, price return, and roll return. Collateral return is the yield on securities the investor deposits as collateral for the futures position. Price return or spot yield is produced by a change in spot prices. Roll return results from closing out expiring contracts and reestablishing the position in longer-dated contracts.