Alternative Investments Flashcards
What are common features of alternative investments?
Low liquidity Good diversification High due diligence costs Difficult to value Limited access to information
How can alternative investments be grouped by the role they typically play in a portfolio?
- Real estate & long-only commodities offer exposure to risk factors and return that stocks and bonds cannot provide.
- Hedge funds and managed futures offer exposure to special investment strategies and are heavily dependent on manager skill.
- Special strategies and unique asset classes. Private equity and distressed securities are seen as a combination of 1 and 2.
What are the major due diligence checkpoints involved in selecting active managers of alt investments?
- Market Opportunity – What is it and why is it there? Is the degree of market inefficiency necessary to support a strategy plausible?
- Investment Process – Who does this best and what is their edge?
- Organization – Are all the pieces of the organization in place?
- People – Do we trust the people?
- Terms and Structure – Are the terms fair?
- Service Providers – Who supports them?
- Documents – Read the prospectus, private placement memorandum. Also read the documents.
- Write-up – Produce a formal manager recommendation. This ensures organized thought, informs others, and formally documents the process.
What are issues that Alternative Investments raise for Private Wealth Clients?
- Taxes – Specialized tax expertise may be required.
- Suitability -
- Communication – Discussing complex strategies is not easy.
- Decision risk – Risk of emotionally abandoning a strategy right at the point of maximum loss.
- Concentrated positions – Large positions in closely held companies and private real estate should be considered as a preexisting allocation before deciding to add additional private equity or real estate exposure.
What are examples of indirect real estate?
Companies that develop and manage real estate. Real estate investment trusts (REITs) Commingled real estate funds (CREFs) Separately managed accounts. Infrastructure funds.
Discuss the benchmarks for Real Estate. List the name of the Benchmark(s), how they are constructed, and any biases.
Benchmarks: NCREIF, NAREIT
Construction: NCREIF is value weighted, NAREIT is cap weighted.
Biases: Measured volatility is downward biased. The values are obtained periodically.
Discuss the benchmarks for Private Equity. List the name of the Benchmark(s), how they are constructed, and any biases.
Benchmarks: Provided by Cambridge Associates and Thomson Venture Economics.
Construction: Constructed for buyout and venture capital. Value depnds on events. Often construct custom benchmarks.
Biases: Repricing occurs infrequently which results in dated values.
Discuss the benchmarks for commodities. List the name of the Benchmark(s), how they are constructed, and any biases.
Benchmarks: Dow Jones-UBS commodity Index, S&P Commodity Index.
Construction: Assume a futures-based strategy.
Biases: Indices vary widely with respect to purpose, composition, and method of weighting.
Discuss the benchmarks for managed futures. List the name of the Benchmark(s), how they are constructed, and any biases.
Benchmarks: MLMI, CTA Indices.
Construction: MLMI replicates the return to a trend-following strategy. CTA Indices use dollar-weighted or equal weighted returns.
Biases: Requires special weighting scheme.
Discuss the benchmarks for distressed securities. List the name of the Benchmark(s), how they are constructed, and any biases.
Benchmarks: Characteristics similar to long-only hedge fund benchmarks.
Construction: Weighting equally weighted or based upon assets under management.
What are advantages of direct equity real estate investing?
Many expenses are tax deductible.
Ability to use more leverage than most other investments.
Provides more control than stock investing.
Ability to diversify geographically.
Lower volatility of returns than stocks.
What are the disadvantages of direct equity investing?
- Lack of divisibility means a single investment may be a large part of the investor’s portfolio.
- High information cost, high commissions, high operating and maintenance costs, and hands-on management requirements.
- Special geographical risks, such as neighborhood deterioration and political risk of changing tax codes.
Who are the major issuers and suppliers of venture capital?
- Angel investors
- Venture capitalist
- Large companies (Strategic partners)
What are the stages that a private company typically goes through when dealing with venture capital?
- Seed.
- Startup.
- First stage.
- Latter stage.
- Exit stage/
In contrast to venture capital, buyout funds usually have:
- A higher level of leverage.
- Earlier and steadier cash flows.
- Less error in the measurement of returns.
- Less frequent losses.
- Less upside potential.
These differences are the natural consequences of buyout funds purchasing entities in later stages of development or established companies.
Why is convertible preferred stock a good vehicle for direct venture capital investment?
- Preferred stockholders must be paid before common stockholders. Seniority is included to entice subsequent investors and make those preferred shares more valuable than those issued earlier.
Explain the typical structure of a private equity funds
- Take the form of limited partnerships of limited liability companies (LLCs).
- The time line starts with the sponsor getting commitments from investors at the beginning of the fund and then giving “capital calls” over the first five years, which is referred to as the commitment period.
- The expected life of the fund is 7-10 years, with an option to extend 5 years.
- Compensation: The sponsor has capital invested that earns a return, to align the sponsor’s interest with investors. Management fee 2% and incentive fee of 20%.
Discuss the issues that need to be addressed in formulating a private equity investment.
Low liquidity: Allocation should be 5% or less with a plan to keep for 7 to 10 years.
Diversification through a number of positions: Only investors with over $100 million can invest in the 5 to 10 investments needed for diversification.
Diversification strategy: Know how the proposed private equity investments relates to the overall portfolio.
Plan for meeting capital calls: Committed funds are called as needed, and the investor needs to be prepared to meet the calls.
What does direct commodity investment entail?
Purchasing actual commodities or gaining exposure via derivatives.
