Alternative Investments Flashcards
alternative vs traditional investments
higher return, greater diversification, low correlation with stock, less liquid, longer time horizon, lager investment size, higher fee, more specialized knowledge;
managers have direct investments;
information asymmetry between managers and investors;
difficult to evalute performance;
no cash flows; fund managers use leverage; valuation may not have market prices; complex fees, tax
investment methods
fund investing, co investing, direct investing
fund investing
fund investing=investor contributes to a pool of investment funds with other investors;
adv: less direct involvement rely on fund manager’s expertise, greater diversification (pool);
dis adv: large capital investment, long horizon, limited transparency, management fees (2-20%);
term sheet=includes investment policy, fee structure and requirements;
co-investing
investor contributes to a pool of investment funds (as with fund investing, indirect) but also has the right to invest (direct), directly alongside the fund manager, in some of the assets in which the manager invests.
adv to investor: reduce fees, investor has more control over investment choices still benefit from manager expertise;
adv to fund manager: increase scope and diversification
Direct investing
investor that purchases assets itself, rather than pooling its funds with others or using a specialized outside manager;
adv: no fees to mangers, full control;
dis-adv: less diversification, high min investment amount, requries expertise, have all the risk
compensation structures
limited partnerships:
general partner (GP)=fund manager;
limited partner (LP)=accredited investors but not involved in mangement, limited liability;
limited partnership agreement=rules and operations details;
side letters=state special terms (regulatory requirements) negotiated by LPs e.g. excusal rights, most-favored-nation clause;
master limited partnership (MLP)=specialize in natrual resources and real estate, publicaly traded;
1-2% AUM if hedge funds, commited capital if private capital funds (100m committed but 50m is invested, 50m dry power) ;
paid to GP regardless of performance;
performance fee: soft hurdle rate vs hard hurdle rate
Paid to GP depending on fund performance, no perf fee if below hurdle rate;
soft hurdle rate=performance fees are percentrage of the increase in LP’s investment value if over a stated minimum (get the 0-8% if exceed 8%); benefits GP;
hard hurdle rate=performance fees paid only to the increase on LP’s investment value exceed the stated minimum (get the 1% (total 9%) if exceed 8%); benefit LP;
catch-up clause=similar to soft hurdle rate; first 8% goes to LP, next 2% goes to GP, rest 20/80 split; total amount same as soft
performance fee: high-water mark vs clawback provision
high-water mark=paid only on gains above LP’s previous highest investment value (90m->100m investment value yes IC, 100m->95m->100m no IC), wont get paid twice for the same performance, no double dipping;
clawback provision=if GP receives incentive payments on gains that are later offset by losses, LP can clawback the fees paid
waterfall: deal-by-deal waterfall (American) vs whole-of-fund waterfall (or European waterfall)
waterfall refers to the way in which payments are allocated to the GP and the LPs as profits and losses are realized on deals;
deal-by-deal waterfall=profits are distributed as EACH fund exits each investment, and shared between GP and LP according to partnership agreement; benefit GP because performance fees are paid before LPs’ original investment+hurdle rate is returned to them; potential clawback; benefit GP
whole-of-fund waterfall=profits distributed until after LP received 100% of initial investment plus the hurdle rate, after ALL fund investments have been sold; delay performance fee and no clawback; benefit LP
private capital
provide finance to firms without issuing shares, PRIVATE; improve new and underperforming firms to have high evalutations;
modest correlation of private capital index returns with public market index returns (diversification); Infrequent valuation results in downward bias in both standard deviations and correlations;
vintage year=year made first investment
private equity=owner, invest in private or take public private
1. invest in private firms, maybe will IPO
2. public firms going private:
- leverage buyout (LBO)=finance by 90% debt 10% equity, use equity to payoff debt once go private;
-management buyout (MBO)=current managers involved in purchase and stayed;
-management buy-in (MBI)=replace managers;
- venture capital=start up, high risk high return;
-PIPE (Private investment in public equities)=providing equity financing to publicly traded companies;
1. Formative stage
pre-seed capital (angel investing)=idea
seed stage/seed capital=research, developement, marketing (PE vintage year)
early stage/start-up stage=begin production and sales
2. Later stage=expansion, improvements
3. mezzanine-stage financing=prepare for IPO
PE exit strategy (where money is made) [5-10 years]:
trade sale=sell firm to strategic buyer (competitor, pay more)
secondary sale=sell firm to any other PE investors
IPO or SPAC, best scenario
recapitalization=issue debt to fund div payment to PE owner (not an exit but provide returns)
write-off/liquidation=take loss
private debt=lender (bond, venture debt, distressed debt)
1. direct lending=leveraged loans using money borrowed from other sources
2. venture debt=lend to start ups for convertible bond or warrants
3. mezzanine debt=subordinated to firm’s exisiting debt
4. distressed debt=buy debt that are near in default, may be active in restructuring company
5. unitranche debt=combine different classes of debt into one loan with different interest rates
establishment spectrum:
VC (start-up) -> growth capital (more established, growing, primary capital) -> LBO (matured, high leverage, secondary capital)
risk spectrum lowest to highest:
infrastructure debt->senior real estate debt->senior direct lending->unitranche debt->mezzanine debt->PE
hedge fund
qualified private investors whose money is pooled and managed by fund managers using leverage and derivatives in traditional assets; limited partnership, LLCs, GP, private placement, indefinite life;
less regulated, flexible mandates, high fees, lack transparency, low liquidity (lock up period, notice period, liquidity gate=paritial redeemed); remove market beta, leverage for sector beta and manager alpha
return drivers: arbitrage and price volatility;
evaluted by total return or risk-adjusted return;
- equity hedge fund strategies= fundamental analysis, long and short positions (market neutral strategies=long undervalued and short overvalued, offset positions to minimize market risk, emphasize on growth and high earnings), growth stock, short bias (net short exposures);
- event-driven strategies:
merger arbitrage=long shares of acquired, short acquirer;
distressed/restructuring=long if restructuring;
activist shareholder=gain board seats to influence company decisionsl
special situations=spinoff (break out subsidary), asset sale, repurchase; - relatve value strategies=finding arbitrage from mispricings rather than predicting market:
convertible arbitrage fixed income=long convertible bond short stock to hedge;
specific fixed income=ABS, MBS, high yield;
general fixed income=arbitrgage between interest rate, spot rate and fwd rate;
multistrategy=across assets&markets; - opportunistic strategies:
macro strategies=trade on economic trends;
managed futures=trade commodity futures based on fundamental analysis;
forms of HF investment:
-commingled funds (master-feeder structure)=tax efficient, economies of scale, pool investments globally in feeder funds, which investment into master fund;
-seperately managed account=HF provide management service to investment held by investors (investor ownership), customized, for institutional investors;
fund of fund (additional layer of fees):
lower min investments, diversification, expertise but layers of fees;
HF returns (beta):
market beta=return from broad market index;
strategy beta=return specific to sectors;
alpha=return specific to manager expertise;
performance indicies have upward biased on returns, downward bias on risks on performed well and survived due to: survivorship bias, selection bias, backfill bias (inconsistent reporting inflate performance cuz mgmt choose when to report)
Real assets include real estate, infrastructure, natural resources, and other assets such as digital assets
Real estate Investments include residential or commercial properties, as well as real estate–backed debt.
Natural resources:commodities, investors can own physical commodities, commodity derivatives, or the equity of commodity-producing firms;
Farmland can produce income from leasing the land out for farming or from raising crop
Timberland investment involves purchasing forested land and harvesting trees to generate cash flows.
timing of cash flow
capital commitment phase (capital calls)=managers select properties to include;negative returns, fees, no cash flows, outflow>inflow
capital deployment phase=building out phase, outflow>inflow;
capital distribution phase=start generating revenue, inflow>outflow
J-curve
multiple of invested capital (money multiple)
multiple of invested capital (money multiple)=
(total capital returned+value of remaining assets)/total capital paid in
[similar to value+distribution/initial investment]
because this does not consider timing of cash flows, IRR is used aka ytm
performance appraisal
levered and unlevered return
unlevered portfolio return=rV0
levered portfolio return=r(V0+VB)-(rBVB) [VB is borrowed amount]
leveraged return=[r(V0+VB)-(rB*VB)]/V0=r+(Vb/V)(r-rb); breakeven when asset return=borrowing cost
leverage magnifies gain and loss
valution of investments
fair value hierarchy:
level 1=asset trade in active markets and quoted prices are readily available;
level 2=assets do not have readily available quoted prices but can be valued based on direct or indirectly observe inputs;
level 3=asset need unobserved inputs to establish fair value
redemptions
lockup period=LP cannot redeem or will pay redemption fees
notice period=amount of time fund has to fulfill redemption request
biases
survivorship bias (overstate return)
backfill bias=include the good ones to include in index (selection bias)
before-fee returns vs after-fee returns
after-fee returns=adjust cash flow for performance fee paid;
total fees=management feeend of period V1+max[0, performance fee(V1-V0)]
rate of return after fees=(V1-V0-total fees)/V0=HPR
calc performance fee after deducted management fee
fund of funds
Investors invest in the fund of funds, and the fund manager then allocates that capital to a variety of other funds (which could include mutual funds, hedge funds, private equity funds;
investing in funds of funds have additionally layer of fees, return less than direct invest in the fund
forms of real estate investments
debt
private: mortgage, loans, mezzanine debt;
public: MBS, CMBS, CMO, covered bonds, mortgage REITs, mortage ETFs
equity
public: publicaly traded shares, mutual funds, public REITs, ETFs
private: direct ownership (join venture, limited partnership), indirect ownership (real estate funds, private REITs)
direct real estate investment
adv: control, diversification from stock, tax benefits (depreciation expense)
dis adv: illiquidity and price opacity, need to manage property, specialized knowledge, high investment, concentration risk
indirect real estate investment
REITs (equity REIT generate rental income, mortgage REIT generate intersets CMBS RMBS or hybrid REITs)
exempt from double taxation (90% earnings paid out to avoid taxed at REIT level), exchange traded liquid, specialized knowledge, low investment
Core real estate strategies — Generally lowest risk and target returns=high quality comm or resi properties delivering stable returns; open end structure, indefinite lives; senior debt less risky than this
Core Plus — Generally low-to-moderate risk and target returns=closed end structure, definite lives; light renovation
Value-Add — Generally moderate-to-higher risk and target returns=closed end structure, definite lives; larger scale redevelopment renovation
opportunistic real estate strategies - major redevelopment renovation, speculation, riskiest
Equity REITs vs Mortgage REITs
Equity REITs own and operate real estate properties, generating income from rental income and property appreciation, while Mortgage REITs invest in mortgages and mortgage-backed securities, earning income from interest payments, purchasing or originating mortgages and mortgage-backed securities
infrastructure investments
long-lived assets providing essential public services;
economic (transportation, utility, communications) vs social (hospital, prisons, school);
for long term institutional investors (diversification);
regulatory risk;
other risks e.g. financial leverage, construction risk, operational risk
cash flows:
availability payments=making infrastructure available;
usage-based payments=tolls, when used;
take-or-pay arrangements=buyer pay minimum purchase price for agreed upon value;
direct investment is large size, low liquidity;
indirect investment=ETF, mutual funds, master limited parternship (energy sector), publicly traded infrastructure securities;
MLP=company that combines the tax benefits (pass-through) of a limited partnership with the liquidity of a stock;
brownfield investments (old)=existing infrastructure, less risk and lower expected returns; e.g. Secondary-stage investment (stable firms, no need investment), sales and leaseback arrangements (less mature than secondary, have cash flow but uncertain)
greenfield investments (new)=to be built, more risk more return;
natural resources
raw land (direct investment, partnership), commodities (indirect investments derivatives), land used for growing crops or timber (direct and indirect);
can be direct investments, ETF, REITs, limited partnerships, LLCs;
farmland and timberland:
value driver: location, transportation and markets, access to natural resources;
sources of return: lease income, price appreciation, produce sold;
commodities:
metals, argricultural produce, energy products;
no cash flow (div nor coupon);
price change drives returns (derivatives, ETFs=high liquidity low fees, managed future funds (active management of com investments similar to hedge funds), commodity sector funds);
low liquidity (physically), high cost, natural disasters;
higher return than stocks or bonds cuz high risk;
hedge against inflation, low correlation with stocks;
timberland and farmland have higher average returns with lower volatility than stocks
futures price
contango=futures price>spot due to low convinience yield;
backwardation=future prices<spot due to high yield;
futures price=spot(1+rf+cost-convinience yield)^T
lower the coefficient of variation, the greater the return for the same level of risk (ratio of the standard deviation to the expected return); Standard deviation is a measure of risk, and alpha is a measure of return.
coefficient of variation is best risk-adjusted measure for HF
commodities can act as a hedge of inflation risk; positive correlation
Timberland and farmland are relatively illiquid. While timberland mostly caters to institutional investors due to the large investment required, most farms are family owned. Only timberland enjoys the flexibility option, whereby the trees can be cut when the market price of timber is high. Farm products need to be harvested when ready so no flexibility option to increase output when market prices are high.
Farmland provides the steadiest cash flows compared to timberland and raw land. Farmland can generate cash flows from leasing the land or selling the crop each year. Timberland provides cash flows, but owners have more discretion over the timing; they can choose to let the timber grow or harvest it for sale. Raw land does not generate any current cash flow.
Specialized funds focus on specific commodities such as oil and gas, grains, precious metals, or industrial metals. Some managed futures funds may concentrate on specific sectors (e.g., agricultural commodities), while others may be more diversified. Balanced funds invest in both stocks and bonds.
digital assets
assets electronically created and transferred; high price volatility and noconsensue on valutions; e.g. cypto (private issue, no backing from central bank), tokens (trading digital artwork; tokenization has the potential to streamline transfers of physical assets such as real estate); low correlation with stock; supply of several cryptocurrencies is limited;
distributed ledger technology (DLT)=where digital assets is secured, shared and validated; various systems where a digital ledger is replicated and shared across a network;
distributed ledger=a record of transactions, often electronic;
adv: accuracy, transparency, P2P;
dis adv: cyber security concern, privacy violation, large computational power;
DLT network=made of digital ledger, consensus mechanism (common state of ledger), participants, use cyptography to encrypt data; (specific implementation or network that utilizes DLT principles);
permissionless networks=transactions visible to all users within network; any user can execute a transaction (bitcoin); consensue mechanism rather than process transaction through central authority; decentralized; unlimited membership;
permissioned networks=users restricted from some network activities; less costly than permissionless networks; faster; limited membership; centralized
smart contracts=automatic executed based on predetermined conditions; extending the value of a blockchain beyond a store of value.
blockchain=decentralized, distributed and public digital ledger that is used to record transactions across many computers so that the record cannot be altered retroactively without the alteration of all subsequent blocks and the consensus of the network; cryptographic techniques;
consensue protocols=determine how blocks are chained together and protect from malicious manipulations;
proof of work (PoW) protocol=when a transaction takes place, MINERS use computers to solve a cryptographic problem, which then verifies the transaction;
proof of stake (PoS) protocol=v”VALIDATORS” vouching for validity of block;
initial coin offering (ICO) is a security token; an unregulated process in which companies offer crypto tokens for money or other cryptocurrency.
direct investment=transaction recorded and validated on blockchain, purchase token on crypto exchange, trade NFT, invest ICO, FRAUD RISK
digital asset vs other assets
digital has no cash flows (interest, dividends), no fundamental value;
transaction valuation difference: recorded on decentralized digital ledgers;
mainly used for online transactions vs fiat currency in traditional assets;
lack standardizations, unregulated
exchanges for crypto trading
CENTRALIZED EXCHANGE=privately held, price transparentcy and volume, most popular type of exchange, trade directly and electronically on private servers;
decentralized changes=implemnet decentralized BLOCKCHAIN principles, no centralized authority, on a distribution framework;
For decentralized exchanges, multiple computers service the exchange, so if one computer is attacked, the exchange will remain operational. Thus, attacks on decentralized exchanges are more difficult than on centralized exchanges. However, centralized exchanges are the prevalent type of cryptocurrency exchange. Both types of exchange currently lack significant regulatory oversight.
asset backed tokens
digital ownership of physical assets collateralized by underlying asset and derive value directly from unerlying asset; a security; increase liquidity allowing fractional ownership, immutable record of ownership;
e.g. gold, oil, re, equities
Cryptocurrency coin trusts invest in a large pool of a cryptocurrency. Cryptocurrency ETFs do not invest directly in cryptocurrencies but attempt to mimic their returns using cash or derivatives. Cryptocurrency futures contracts are based on cryptocurrency prices but are cash-settled.
Stablecoins are designed to provide price stability by linking their value to a collateralized basket of assets. However, they cannot be exchanged for fiat currency, and they do not have legal and regulatory backing.
Tokens represent ownership rights to physical assets in a blockchain or distributed ledger technology. Smart contracts are computer programs that can execute contracts based on pre-agreed upon conditions.
Money market funds invest primarily in short-term debt securities and are managed to maintain a constant net asset value, typically one unit of currency per share. A bond mutual fund typically invests in longer-maturity securities than a money market fund. A balanced fund invests in both debt and equity securities.
