Alternative Investments Flashcards
Categories of alternative investments:
- Hedge funds
- Private capital (private equity, private debt)
- Real estate
- Natural resources (commodities, farmland, timberland)
- Infrastructure
Differences between alternative and traditional investments
- Different types of assets held, structure of investment vehicles
- Higher fees (management incentives)
- Less liquid
- Less regulated, less transparent
- Different tax treatments
- More concentrated portfolios
- Redemption restrictions
Direct investing:
investor purchases assets:
* Advantages: no fees to outside managers, and full control over investment choices
* Disadvantages: possible lack of diversification, high minimum investment amounts, and requires expertise
Fund investing:
invest in a pool of assets alongside other investors
* Advantages: uses fund manager’s expertise, requires less direct involvement in investment choices, greater diversification, and lower minimum investment amounts compared to direct investing
* Disadvantages: management and incentive fees, and possibility of poor manager performance
Co-investing:
fund investing with the right to invest directly in fund assets alongside the manager
* Advantages: may reduce fees and gives investor more control over investment choices while still benefiting from fund manager’s expertise
* Disadvantages: requires greater expertise, involvement, and due diligence than fund investing
Compensation structures
- General partner (GP) is the fund manager
- Investors are limited partners (LPs)
- Limited partnership agreement states fund rules and operational details
- Side letters may state special terms negotiated by individual LPs
Management fees
- Typically, 1%-2%
- Paid to GP regardless of fund performance
- Based on assets under management for hedge funds
- Based on committed capital for private capital funds (dry powder = not invested yet)
Catch-up clause
similar to soft hurdle rate (first x% goes to LP, then x% to GP, and then a 80/20 split)
Clawback provision
if the GP receives incentive payments on gains that are later offset by losses, LPs can recover excess incentive payments
Deal-by-deal (or American) Waterfall
distributed as fund exists each investment, shared between GP and LPs according to partnership agreement, better for GP
Whole-of-fund (or European) waterfall
LPs receive all distributions until they recover initial investment plus hurdle rate, then GP participates in distributions = better for LP (delay incentive payments)
Sharpe ratio:
(return – Rf)/ std. deve of returns (normal dist risk) (high is better)
Sortino ratio
(return – Rf)/downside deviation (better risk adj) (high is better)
Treynor ratio
(return – Rf)/beta (systematic risk of a diversified portfolio) (high is better)
Calmar ratio
average annual compound return/maximum drawdown (high is better)
Management buyout:
current managers involved in purchase, remain with company
Management buy-in
replace managers of acquired company
Venture Capital
- Formative stage
a. Angel investing/pre-seed capital – business plans, market potential
b. Seed stage/seed capital: product development, market research
c. Early/start-up stage: begin production and sales - Later stage: company expansion
- Mezzanine-stage financing: prepare for IPO
Private Equity Exit Strategies
- Trade sale: sell portfolio company to competitor
- Secondary sale: sell portfolio company to other private equity investors
- IPO: sell portfolio company shares to public
- Recapitalisation: issues portfolio company debt to fund dividend payment (to private equity owner)
- Write-off/liquidation: take loss
Private debt:
- Direct lending: includes leveraged loans using money borrowed from other sources
- Venture debt: lending to start-up companies, often convertible or with warrants
- Mezzanine loans: subordinated to company’s existing debt
- Distressed debt: buying debt near or in default, may be active in restructuring company
Explain investment characteristics of real estate
- Residential property – single family homes
o Homeowners have a direct investment in real estate
o Mortgage lenders have a direct investment in the loans
o Mortgage-backed security holders have a n indirect investment in the loan - Commercial property – income from rents - Homes purchased for rental income -Commercial (business) properties
o Direct investment: long time horizon, illiquid, typically large size
o Indirect investment: limited partnership, REITs, commercial mortgage-backed securities - Mortgages, mortgage-backed securities
- Real estate investment trusts (REITs) – liquid
Real Estate Performance Measures:
- Appraisal indices – based on estimated property values; low variance compared to other measures
- Repeat sales indices – based on properties that have sold multiple times; not necessarily a representative sample (sample selection bias)
- REIT indices – based on trading prices of REIT shares; relatively high correlation with equity market
Explain investment characteristics of infrastructure
Infrastructure investments – long-lived assets that provide essential public services:
* Transportation (e.g. roads, bridges, airports)
* Utility assets (e.g. pipelines, waste treatment)
* Communications (e.g. cable, fibre optic)
* Social infrastructure (e.g. hospitals, prisons)
Brownfield vs Greenfield
- Brownfield investments (existing infrastructure) are less risk and lower expected returns than greenfield investments (infrastructure to be built).
Regulatory risk (infra)
inherent to infrastructure investments
Indirect infrastructure investment vehicles
o ETFs
o Listed mutual funds
o Master limited partnerships
o Publicly traded infrastructure securities
Commodities
Commodities
Commodities exposure most commonly gained through derivatives rather than outright ownership
* Return comes from price change (no income)
* Low correlation with traditional investments
* Hedge against inflation risk
Ways to gain exposure to commodities:
- Commodity ETFs – available to investors who are restricted to equity shares
- Managed futures funds – active management of commodity investments; may be structured like hedge funds or mutual funds
- Commodity sector fund
Commodity valuation
Futures price = spot price x (1 + Rf) + storage costs – convenience yield
Low convenience yield -> contango, futures > spot
High convenience yield -> backwardation, spot > futures
Farmland and Timberland – attractive ESG
Sources of return:
* Sales of timber or agricultural products
* Price changes on the land
Risks:
* Low liquidity
* High fixed costs of production
* Subject to adverse weather, natural disasters
Lockup period
minimum time before investor can withdraw funds
Notice period
days within which a fund must fulfil a redemption request
Event driven strategies
- Merger arbitrage
- Distressed/restructuring
- Activist shareholder
- Special situations
Relative value strategies
- Convertible arbitrage fixed income
- Asset-backed fixed income
- General fixed income
- Volatility
- Multistrategy.
Macro strategies
based on global economic trends and events and may involve long or short positions in equities, fixed income, currencies, or commodities. Managed futures funds may focus on trading commodity future
Equity hedge fund strategies
- Market neutral
- Fundamental long/short growth.
- Fundamental value
- Sector specific
- Short bias
Fund of funds – hedge funds that invests in other hedge funds
Advantages – lower minimum investments than underlying hedge funds, diversification across hedge fund managers and strategies
Disadvantages – charge management and incentive fees in addition to fees paid to individual hedge funds
Hedge funds benefits and risks
Potential diversification benefits because hedge fund returns are not perfectly correlated with traditional investments – however:
* Correlations increase during financial crises
* Hedge fund index returns and standard deviations reflect survivorship bias and backfill bias
* Valuations based on models and appraisals bias standard deviations and correlations downward
