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).
