Alternative Investments Flashcards
78-80 (99 cards)
1
Q
What are Alternative Investments?
A
- Alternative investments comprise various types of investments that do not fall under the heading of traditional investments, which refers to long- only investments in cash or publicly traded stocks and bonds.
- include hedge funds, private equity funds, and various types of real estate investments. Alternative investments typically are actively managed and may include investments in commodities, infrastructure, and illiquid securities.
2
Q
Benefits of including alternative investments in a portfolio
A
- Risk reduction from diversi fication (due to low correlations of alternative investments with traditional investments)
- Possible higher returns from holding illiquid securities, and from markets for some alternative investments possibly being less eff icient than those for traditional investments.
3
Q
Differentiating Features of Alt Investments
A
- More specialized knowledge required of investment managers
- Relatively low correlations with returns of traditional investments
- Less liquidity of assets held
- Longer time horizons for investors
- Larger size of investment commitments
4
Q
As a result of the features, alt inv have the following characetristics
A
- Investment structures that facilitate direct investment by managers
- Information asymmetry between fund managers and investors, which funds typically address by means of incentive-based fee structures
- Dif ficulty in appraising performance, such as more problematic and less available historical returns and volatility data
5
Q
Correlations of returns on alts & traditional inv may increase significantly during…
A
periods of economic stress
6
Q
Classification of Alternative Investments
A
- Private Capital
- Real Assets
- Hedge Funds
7
Q
Private Capital
A
- Includes private debt & private equity
8
Q
Private Debt
A
Private debt funds may make loans directly to companies, lend to early-stage f irms (venture debt), or invest in the debt of firms that are struggling to make their debt payments or have entered bankruptcy (distressed debt).
9
Q
Private Equity
A
Funds that invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the funds intend to take private.
These firms are often in the mature or decline stages of their industry life cycle.
Leveraged buyout (LBO) funds use borrowed money to purchase equity in established companies and comprise most private equity investment funds.
Venture capital funds invest in young, unproven companies at the start-up or early stages in their life cycles.
10
Q
Real Assets
A
include real estate, infrastructure, natural resources, and other assets such as digital assets:
11
Q
Real Estate
A
- Include residential or commercial properties, as well as real estate–backed debt.
These investments are held in various structures, including full or leveraged ownership of individual properties, individual real estate–backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.
12
Q
Natural resources
A
- include commodities, farmland, and timberland.
- Commodities: own physical commodities, commodity derivatives, or the equity of commodity-producing firms. Some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts (futures) that are expected to track a specif ic commodity index.
- Farmland: can produce income from leasing the land out for farming or from raising crops or livestock for harvest and sale.
- Timberland: investment involves purchasing forested land and harvesting trees to generate cash flows.
13
Q
Infrastructure
A
- refers to long-lived assets that provide public services.
- These include economic infrastructure assets (e.g., roads, airports, and utility grids) and;
- social infrastructure assets (e.g., schools and hospitals).
While often financed and constructed by government entities, infrastructure investments have more recently been undertaken by public-private partnerships, with each holding a signi ficant stake in the infrastructure assets.
Various deal structures are employed, and the asset may revert to public ownership at some future date.
14
Q
Other Real Assets
A
include collectibles such as art, intangible assets such as patents, and digital assets such as cryptocurrencies.
15
Q
Hedge Funds
A
HFs are investment companies typically open only to quali fied investors.
These funds may use leverage, hold long and short positions, use derivatives, and invest in illiquid assets.
Managers of hedge funds use many different strategies in attempting to generate investment gains.
They do not necessarily hedge risk, as the name might imply.
16
Q
Fund Investing
A
- Refers to investing in a pool of assets alongside other investors, using a fund manager who selects and manages a pool of investments using an agreed-upon strategy.
- In this case, the individual investors do not control the selection of assets for investment or their subsequent management and sale.
- The manager typically receives a percentage of the investable funds (management fee) as well as a percentage of the investment gains (incentive fee).
17
Q
Term Sheet
A
A fund’s term sheet describes its investment policy, fee structure, and requirements for investors to participate.
18
Q
Direct investing
A
Direct investing refers to an investor that purchases assets itself, rather than pooling its funds with others or using a specialized outside manager. Larger, more knowledgeable investors may purchase private companies or real estate directly.
19
Q
Co-Investing
A
- Investor contributes to a pool of investment funds (as with fund investing) but also has the right to invest, directly alongside the fund manager, in some of the assets in which the manager invests.
- Compared to fund investing, co- investing can reduce overall fees while benef iting from the manager’s expertise.
- Co-investing also can provide an investor with an opportunity to gain the skills and experience to pursue direct investing.
- For a fund manager, permitting co-investment may increase the availability of investment funds and expand the scope and diversi fication of the fund’s investments.
20
Q
Advantages & Disadvantages of Direct Investing
A
+
- no fees to outside managers
- investor has more control over investment choices
- Possibility of less diversif ication across investments
- higher minimum investment amounts
- greater investor expertise required to evaluate deals
- perform their own due diligence.
21
Q
Role of Limited Partnerships in Alts
A
- Alternative investments are often structured as limited partnerships.
- the general partner (GP) is the fund manager and makes all the investment decisions.
- The limited partners (LPs) are the investors, who own a partnership share proportional to their investment amounts.
- The LPs typically have no say in how the fund is managed and no liability beyond their investment in the partnership.
- The GP takes on the liabilities of the partnership, including the repayment of any partnership debt.
- Partnerships typically set a maximum number of LPs that may participate.
- LPs commit to an investment amount, and in some cases, they only contribute a portion of that initially, providing the remaining funds over time as required by the GP (as fund investments are made).
- General partnerships are less regulated than publicly traded companies
- Limited partnership shares are typically only available to accredited investors—those with suff icient wealth to bear signi ficant risk and enough investment sophistication to understand the risks.
22
Q
Limited Partnership Agreement
A
The rules and operational details that govern a partnership are contained in the limited partnership agreement.
23
Q
Side Letters
A
- Special terms that apply to one limited partner but not to others can be stated in side letters.
- For example, an LP might negotiate an excusal right to withhold a capital contribution that the GP would otherwise require.
- Some limited partners may require that special terms offered to other LPs also be offered to them.
- This is known as a most-favored-nation clause in a side letter.
24
Q
Master Limited Partnership (MLP
A
While most alternative investment limited partnership holdings are illiquid, a fund may be structured as a master limited partnership (MLP) that can be publicly traded. Master limited partnerships are most common in funds that specialize in natural resources or real estate.
25
Fees Structure
- Management fees (1-2% of fund's net assets), earned regardless of performance (For PE - calculated as % of committed capital)
- Performance Fee or Incentive Fee: AKA Carried Interest - % of profits on funds investments
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Committed Capital
- Committed capital is typically not all invested immediately; rather, it is “drawn down” (invested) as securities are identif ied and added to the portfolio.
- usually drawn down over three to five years, but the drawdown period is at the discretion of the fund manager.
- portion not yet been drawn down is referred to as dry powder.
- The reason for basing management fees on committed capital is that otherwise, the fund manager would have an incentive to invest capital quickly instead of selectively.
27
Performance Fees
- Portion of pro fits on fund investments.
- Most often, the partnership agreement will specify a hurdle rate (or preferred return) that must be met or exceeded before any performance fees are paid. Hurdle rates can be def ined in two ways: either “hard” or “soft.”
- If a soft hurdle rate is met, performance fees are a percentage of the total increase in the value of each partner’s investment.
- With a hard hurdle rate, performance fees are based only on gains above the hurdle rate.
- Typically, performance fees are paid at the end of each year based on the increase in the value of fund investments, after management fees and other charges, which may include consulting and monitoring fees that are charged to individual portfolio companies.
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Catch-Up Clause
A catch-up clause in a partnership agreement is based on a hurdle rate and is similar in its effect to a soft hurdle rate. Consider a fund with returns of 14%, a hurdle rate of 8%, and a 20% performance fee. A catch-up clause would result in the first 8% of gains going to the LPs and the next 2% going to the GP, allowing the GP to “catch up” to receiving 20% of the first 10% of gains. After the catchup, further gains are split 80/20 between the LPs and the GP.
29
High Watermark
- No performance fee is paid on gains that only offset prior losses.
- Thus, performance fees are only paid to the extent that the current value of an investor’s account is above the highest net-of-fees value previously recorded (at the end of a payment period).
- This feature ensures that investors will not be charged performance fees twice on the same gains in their portfolio values.
- Because investors invest in a fund at different times, they each may have a different high-water mark value.
30
Waterfall
- A partnership’s waterfall refers to the way in which payments are allocated to the GP and the LPs as pro its and losses are realized on deals.
- It can be a deal-by-deal waterfall or American Waterfall
- or a whole-of-fund waterfall or European Waterfall
31
Deal-by-Deal Waterfall or American Waterfall
- Pro its are distributed as each fund investment is sold and shared according to the partnership agreement. This favors the GP because performance fees are paid before 100% of the LPs’ original investment plus the hurdle rate is returned to them.
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Whole-of-fund waterfall or European Waterfall
The LPs receive all distributions until they have received 100% of their initial investment plus the hurdle rate (typically after all fund investments have been sold).
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clawback provision
- Stipulates that if the GP accrues or receives incentive payments on gains that are subsequently reversed as the partnership exits deals, the LPs can recover previous (excess) incentive payments.
- With a deal-by-deal waterfall, successful deals might be exited initially, while losses are realized later.
- A clawback provision would allow the LPs to recover these performance fees to the extent that the subsequent losses negate prior gains on which performance fees had been paid.
34
Where does additional risks in alts come from?
- Timing of cash lows over an investment’s life cycle
- Use of leverage by fund managers
- Valuation of investments that may or may not have observable market prices
- Complexity of fees, taxes, and accounting
35
Timing of Cash Flows
Three Phases
1. Capital Commitment Phase
2. Capital Deployment Phase
3. Capital Distribution Phase
36
Capital Commitment Phase
- A fund’s managers are identifying investments and making capital calls from the partners. (from Committed capital)
- Managers make capital calls as they identify investments for which they require cash.
- Because of these cash out flows and the long-term nature of the typical investments, returns tend to be negative during the capital commitment phase.
37
Capital Deployment Phase
- During the capital deployment phase, the managers fund, and often involve themselves directly in, the f irms or projects in which they invest. - Returns typically remain negative in this phase, especially if the investments are in start-up companies or troubled f irms that the managers are attempting to turn around.
38
Capital Distribution Phase
If the fund’s investments succeed and begin to generate income and cash f lows, the fund enters a capital distribution phase during which its returns turn positive and accelerate.
39
J-Curve Effect
- Ref lects the norm of negative returns in the capital commitment phase, followed by increasing returns in the capital deployment phase and maximum returns in the capital distribution phase. Returns may reach a plateau toward the end of a fund’s life as the managers exit any remaining investments.
- IRR on y-axis and Time on x-axis
40
Money Multiple or Multiple of Money Invested
he ratio of total capital returned plus the value of any remaining assets, to the total capital paid in over the life of the investment. Because this measure does not consider the timing of cash in lows and out lows, which can affect annual returns on invested capital signi ficantly, it can be considered somewhat naıv̈e
40
Use of Leverage
- Some alternative investments, particularly hedge funds, use borrowing to magnify their gains (at the risk of magnifying losses). Hedge funds may arrange margin financing with prime brokers or employ leverage by means of derivatives.
- Why? Some strategies attempt to exploit relatively small pricing anomalies that might not produce meaningful results without leverage.
41
Leveraged Return
= [ r(V0 + VB) - rBVB ] / V0
Where r = rate of return earned
rB = rate of interest on borrowing
V0 = unleveraged investment
VB = leveraged investment
42
Risk of Leverage
- A risk from using leverage is that a lender may issue margin calls if a fund’s equity position decreases below a certain level. These can result in a fund having to realize losses by closing positions or liquidating investments at unfavorable prices. If the fund must sell a large position in a security, doing so may depress its price further.
- Another important risk of funds that depends on leverage is that lenders may limit their access to additional borrowing.
43
Valuation of Alts
- Illiquid, require assumptions
-A fair value hierarchy groups these assumptions into the following three levels:
Level 1. The assets trade in active markets and have quoted prices readily available, such as exchange-traded securities.
Level 2. The assets do not have readily available quoted prices, but they can be valued based on directly or indirectly observable inputs, such as many derivatives that can be priced using models.
Level 3. The assets require unobservable inputs to establish a fair value, such as real estate or private equity investments, for which there have been few or no market transactions.
44
Level 3 Fair Value Hierarchy characteristic
- the absence of market activity can result in valuations that remain near their initial cost for long periods.
As a result, these values might not re flect the actual exit costs of the investments.
- Importantly, this relative lack of change in fair values can make reported returns for alternative investments appear higher, less risky, and less correlated with traditional investments than they really are.
45
Redemption
- Poses similar risk to how margin calls may require a leveraged fund to exit investments at unfavorable prices and unintended times.
- The more negative a fund’s returns, the more likely investors are to ask the manager to redeem their positions.
- For this reason, and because of the J- curve effect of negative returns in the early years, alternative investment funds (particularly hedge funds) typically take measures to restrict early redemptions.
46
Lock-Up Period
A lockup period is the time after initial investment over which limited partners either cannot request redemptions or incur signi ficant fees for redemptions.
47
Notice Period
A notice period (typically between 30 and 90 days) is the amount of time a fund has to fulf ill a redemption request. Notice periods allow time for managers to reduce positions in an orderly manner. Fund managers often incur signi ficant transactions costs when they redeem shares.
48
Redemption fees
- Redemption fees can offset redemption costs.
- Managers may also have the discretion to implement a gate that restricts redemptions for a temporary period.
49
Founders Class Shares
Early investors in a fund may also receive lower fees or better liquidity terms as an incentive to invest at the fund’s inception. The investment interests of early investors who receive such relatively better terms are called founders class shares.
50
Either-or-Fees
Annual investor fees can also be either-or fees, the maximum of the management fee or the incentive fee. Under such a structure, with a 1% management fee and a 30% incentive fee, investor fees each year would simply be the management fee unless the calculated incentive fee is higher. Such a structure may also stipulate that the 1% management fee be subtracted from the incentive fee in a subsequent year.
51
Vintage Year
Numerous alternative investment indexes exist to measure historical performance. However, they may not provide much meaningful information on the asset class because each fund’s structure is unique, and the funds that exist at any given time can be in widely different phases of their life cycles. One way around this latter issue is to compare funds that originated in the same vintage year.
52
Survivorship bias
The effect of survivorship bias is greater for a hedge fund database than for other asset classes because by some estimates, more than 25% of hedge funds fail in the first three years of their existence. An index that does not include failed funds will overstate the returns and understate the risk of hedge funds as an asset class.
53
Backfill Bias
The effects of survivorship bias may be magni fied by back ill bias, which occurs when managers only select their successful funds for inclusion in indexes.
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Total Fees Formula (Alts)
= mV1 + max[0,p(V1-V0)]
m = management fee
p = performance fee
V0 = Beginning of period Assets
V1 = End of Period Assets
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Rate of Return Formula (Alts)
= [ V1 - V0 - Total fees ] / V0
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Private Capital
Private capital is the funding provided to companies that is not raised from the public markets. Private capital includes private equity and private debt.
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Private Equity
Private equity is equity capital raised from sources other than the public markets. Private equity funds usually invest in private companies or public companies that they plan to take private (leveraged buyout funds) or in early in companies’ lives (venture capital funds). The companies in which a private equity fund invests are called its portfolio companies.
58
Leveraged Buyout (LBO)
- Acquires public companies with a large percentage of the purchase price financed by debt.
- LBOs are a way for a company to “go private” because after the transaction, the target company’s stock is no longer publicly traded.
- the private equity firm seeks to add value by improving or restructuring the portfolio company’s operations to increase its sales, pro its, and cash flows. The cash flows can then be used to service and pay down the debt taken to fund the acquisition.
- Two types: MBOs, MBIs: Management Buy-outs/Buy-ins
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Management Buy Out (MBO)
Portfolio company’s existing management team participates in the purchase
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Management Buy-ins
in which the private equity manager replaces the portfolio company’s current management team with a new team.
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Venture Capital
- VC funds provide financing to companies in the early stages of their development.
- VC funds typically receive common equity interest in the portfolio companies, but they may also get convertible debt or convertible preferred stock.
- Convertible securities help to align the interests of the VC investors and the start-up firm, in that both want to increase the value of the f irm, but give the VC investors a higher priority of claims in the event of liquidation.
- VC investment involves a high level of risk, but the returns can be substantial.
- VC investors are actively involved in developing their portfolio companies, often sitting on the boards or f illing key management roles.
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VC Stages of Development
1. Formative Stages: refers to investments made during a firm’s earliest period and comprises three different phases:
- Pre-see capital or angel investing
- Seed-Stage financing or seed capital
- Early or start-up stage financing
2. Later Stage Financing or Expansion Venture Capital
3. Mezzanine Stage Financing
63
Formative Stages
- Pre-seed capital or angel investing is the capital provided at the idea stage. The investment funds are used for business plans and assessing market potential. The amount of f inancing is usually small, coming from individuals (“angels”) rather than VC funds.
– Seed-stage financing or seed capital generally supports product development, marketing, and market research. This is the f irst stage at which VC funds usually invest.
– Early-stage financing or start-up stage financing refers to investments made to fund operations in the lead-up to production and sales.
64
Later-Stage Financing
AKA Expansion Venture Capital
- comes after production and sales have begun.
- Investment funds provided at this stage are used to support initial growth, expansion, product improvement, or marketing.
- In this stage, the owners (typically the founders and managers of the company) often sell control of the company to VC investors.
65
Mezzanine Stage Financing
- Refers to capital provided to prepare the firm for an initial public offering (IPO).
- The term mezzanine stage is used to indicate the timing of the financing rather than the method.
- A similar term, mezzanine financing, refers to hybrids of equity and debt, such as convertible securities.
- Mezzanine-stage f inancing can use these, but more often, it consists of equity or short-term debt.
66
Minority Equity Investing
- A private equity f irm that engages in minority equity investing buys a less-than-controlling interest in public companies that are looking for capital with which to expand.
- One way it can make such investments is through a private investment in public equity (PIPE), a private offering to institutional investors that allows a publicly traded f irm to raise capital more quickly and cost effectively than a public offering, with fewer disclosures and lower transaction costs.
67
Exit Strategies
Private equity firms typically add value to young companies, then sell them, with an average holding period of five years.
1. Trade Sale
2. Public Listing
3. Recapitalization
4. Secondary Sale
5. Write-off/Liquidation
68
Trade Sale
Sell a portion of the private company to a strategic buyer via direct sale or auction.
An advantage of a trade sale is that the strategic investor typically pays a premium to realize synergies with an existing business.
Advantages compared with an IPO include faster execution and lower transaction costs.
Disadvantages of a trade sale include potential resistance from the portfolio company’s management and employees, as well as a limited universe of potential buyers.
69
Public Listing
Listing on a stock exchange can take place through an IPO, a direct listing, or a special purpose acquisition company:
1. IPOs: most common, typically realize higher price, improves visibility, however, have high transaction costs and compliance costs, might not always be viewed favorably by the market
- Portfolio companies best suited for exit via IPO are large firms in growing industries that have stable finances and clear strategies.
2. Direct Listing: stock of the company is f loated on the public market directly without underwriters. This decreases the cost of the transaction, but does not raise new capital for the portfolio company.
3. Special Purpose Acquisition Company (SPAC): (sometimes referred to as a blank check company) set up solely to raise capital that it will use to acquire an unspeci fied private company within a stated time period; otherwise, it must return the capital to investors.
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Adv & Disadv of SPAC
ADV:
- more flexible than an IPO
- reduces the uncertainty about the valuation of the portfolio company
- provides access to investors who transact regularly with the sponsors.
DISADV:
- dilutive effects from SPAC shares and warrants
- a spread between the value of the SPAC and the value of the acquired company
- deal risk in the acquisition
- stockholder overhang from SPAC shareholders selling shares after the acquisition is announced
- Scrutiny from securities regulators is also increasing.
71
Recapitalisation
The company issues debt to fund a dividend distribution to equity holders. This is not an exit, in that the fund still controls the company, but a recapitalisation allows the private equity fund to extract money from the company to pay its investors.
72
Secondary Sale
Sell a portfolio company to another private equity firm or a group of investors.
73
Write-off/Liquidation
Reassess and take losses from an unsuccessful investment in a portfolio company.
74
Risk & Return from PE
- Higher Return than overall stock returns
- Higher Standard Deviation also
- Thus, higher risk, illiquidity & leverage risks
- Survivorship & Backfill Bias overstating returns
- Revalued infrequently and thus, volatility and correlation biased downward.
75
Private Debt
refers to various forms of debt provided by investors directly to private entities. Categories of private debt include the following:
1. Direct Lending
2. Venture Debt
3. Mezzanine Debt
4. Distressed Debt
5. Unitranche Debt
76
Direct Lending
refers to loans made directly to a private company without an intermediary. The debt is typically senior and secured, with covenants to protect the lender. A leveraged loan is a loan made by a private debt fund using money borrowed from other sources. That is, the fund’s portfolio of loans is leveraged to magnify returns.
77
Venture Debt
funding that provides VC backing to start-up or early-stage firms that are not yet pro fitable. Venture debt is often convertible to stock or combined with warrants. Managers of young companies may favor venture debt because it allows them to maintain ownership and control.
78
Mezzanine Debt
private debt that is subordinated to senior secured debt. Mezzanine debt may have special features, such as conversion rights or warrants, to compensate investors for additional risk.
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Distressed Debt
debt of mature companies in financial trouble, such as bankruptcy or default. In many cases, the fund becomes active in restructuring the existing debt or making other changes that increase the value of the acquired debt. Some distressed debt investors specialize in identifying otherwise good companies with temporary cash flow problems, anticipating that the value of the company and its debt will recover. Others focus on turnaround situations, acquiring a company’s debt with an intent to be active in managing and restructuring the company.
80
Unitranche Debt
combines different classes of debt (secured and unsecured) into a single loan with an interest rate that ref lects the blend of debt classes. The resulting debt typically ranks between senior and subordinated debt.
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Features of Private Debt
- Higher rate of return
- compensates for higher risk, illiquidity
- Diversification - low correl with trads
- Interest rate usually pegged to MRR (Secured Overnight Financing Rate)
- Requires expertise
- Senior private debt has less risk and steadier yields than private mezzanine debt, but mezzanine debt offers greater upside potential.
- Private equity has the highest risk and return, followed by mezzanine debt, unitranche debt, senior direct lending, senior real estate debt, and infrastructure debt.
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Which type of private capital fund is most likely to earn excess returns over its life if its vintage year took place during an economic contraction?
Distressed Companies
83
Which type of private capital fund is most likely to earn excess returns over its life if its vintage year took place during economic expansion?
Early Stage Companies
84
Hedge fund management fees are most commonly structured as a percentage of:
Assets under Management
85
Private Capital Fund management fees are most commonly structured as a percentage of:
Committed Capital
86
The formative stage of venture capital investing when capital is furnished for market
research and product development is best characterized as the:
seed stage
87
The _____ investing stage is when
investment funds are used for business plans and assessing market potential.
angel
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At what stage in its lifecycle is a company most likely to have distressed debt?
mature
Distressed debt is typically that of mature companies that have encountered financial
trouble, which may be due to a temporary situation or a structural issue.
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What type of private debt is least likely to have warrants?
Direct Lending
90
When the carrying cost exceeds the benefit of holding commodity:
backwardation
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The convenience yield of a commodity is best described as:
a benefit that reduces the forward price. non-cash
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Which is least likely to be a benefit of investing in commodities?
current income (only received by selling the asset)
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An equity hedge fund strategy that focuses primarily on exploiting overvalued securities is
best described as a(n):
Short Bias
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The performance of a hedge fund is most appropriately evaluated:
on a risk adjusted return basis
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When comparing the performance of several hedge funds, the fund with the best risk-
adjusted annual performance is the one with the:
coefficient of variation
96
Which type of cryptocurrency-related vehicle invests directly in cryptocurrencies?
Coint Trusts
97
Risks of directly investing in large, well-established cryptocurrencies least likely include:
Whales - operate in small cryptos
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