Chapter 5: Special asset classes (2) Flashcards
Asset-backed securities
Result from the securitisation of a revenue generating asset held by the borrower.
Securitisation
The issue of securities, usually bonds, where the bonds are serviced and repaid exclusively out of a defined element of future cashflow owned by the issuer.
Converts a bundle of often unmarketable assets (below investment grade normally) into a structured financial instrument which is then negotiable
Key requirement for asset to be used is that it generates reasonably predictable income stream
Bondholders have no recourse to any other cashflow or assets of the issuer (due to SPV)
Classes of securitised assets
- residential and commercial mortgage-backed securities (MBS)
- credit card receivables (CCABS)
- collateralised loan, bond and debt obligations (CLO, CBO and CDOs)
- insurance securitisations
Risks with securitisation
- Prepayment risk - risk that loan is repaid earlier than expected because underlying assets have been redeemed (most relevant for mortgage-backed securities).
- Credit risk - risk that cashflows generated by the securitised assets proves insufficient to cover the promised payments on the ABS
SPV
Sketch the graph and explain the SPV framework
- Originator sells assets that are meant to be the basis of the securitisation to a special purpose vehicle (SPV).
- SPV is designed to be its own legal entity and structured to be bankruptcy remote in event of the failure of the borrower or SPV (seperate legal entity) - investors don’t have recourse to the cmpany’s assets and company doesn’t have recourse to the securities held by the investors.
- The SPV raises funds to purchase the assets by issuing debt securities, usually bonds
- The receivables transferred into the SPV meet the principal and interest liabilities on the debt.
- SPV may grant security over the receivables to secure obligations to repay principal and interest.
Structure of asset-backed securities
Pool of securitised assets are used to back several different tranches of ABS
Cashflows from the portfolio are divided up into tranches and assigned to the different new securities created
Thus the cashflows from the underlying portfolio might be used to create:
- Bond with a fixed coupon. Most senior security and its coupons are paid first. It is termed senior debt and might carry a AAA rating
- Bond whose coupons are paid as long as there is enough left after the payments to the senior debt is made. BB rating. Known as the mezzanine piece or tranche
- Claim on the residual cashflows (equity claim)
Thus new securities have different credit risk features by construction and appeal to a wider range of investors
Why might a company that wants to raise money (via a securitisation) go to the trouble and expense of setting up a multi-tranche securitisation, rather than just issuing a single asset-backed security?
- Able to appeal to the different risk and return preferences of a range of different investors.
- This enables the company to sell the asset-backed securities for a higher combined price, so reducing the overall cost of borrowing.
Private equity
Private equity is the provision of equity capital where there is no immediate exit route via the secondary market
Forms of private equity
- Venture capital
- Leveraged buy-outs (Management buy-outs and buy-ins)
- Development capital
- Restructuring capital
Venture capital
Capital for businesses in the conceptual stage or where products aren’t developed and revenues and/or profits may not have been achieved.
Leveraged buy-outs
Equity capital for acquisition or refinancing of a larger company.
Management buy-outs - existing management buy-out the owners of the company
Management buy-ins - when the buyer is an external management team
Development capital
Growth or expansion working capital for mature businesses in need of product extension and/or market expansion
Restructuring capital
New equity for financially or operationally distressed companies
Advantages of taking public company into private ownership
- fewer regulatory restrictions on activities = greater freedom to make profits
- closer relationship with typically smaller number of more sophisticated investors who may provide management input
- lower cost in complying with less onerous financial reporting requirements
- lack of a quoted market share price - enable management to take a longer-term view when making investment decisions.
- possibly able to reduce cost of capital under private ownership
Private equity funds
Comment on selling and buying
Private equity funds make unlisted investments.
- unlikely a quoted price = no easy way to sell the investments
- may be restrictions on when and how investments may be sold
Advantages of private equity
- Out-performs over the long term
- Loosely correlated asset = enhance portfolio performance without materially increasing risk - diversification
Disadvantages of private equity to institutional investors
- lack of liquidity and marketability
- variable past performance record and impacted by survisorship bias
- difficulty in valuation
- need for specialist investment advice
- high costs
- lack of reliable information
- regulatory constraints
- high risk
Ways to invest in private equity
- directly by purchasing shares in private companies
- pay private equity firm to invest capital for you
- invest in private equity collective vehicle (investment trust)
- invest in funds-of-funds
How does a private equity fund work? (i.e. what cashflows are involved?)
Initial Fundraising (3-6 months)
- The fund manager and marketing agents work to raise capital commitments from investors.
- Marketing agents receive a percentage of the funds committed as a fee.
Initial/First Closing Date
- The fund officially launches.
- The manager gains the right to call on committed capital, make investments, and earn management fees.
- Investors begin paying annual management fees.
Final Closing Date
- The fund stops accepting new commitments.
- The total amount of committed capital is finalized.
Investment Period (2-3 years post Final Closing Date)
- The manager makes capital calls, and investors pay in the committed capital over this period.
- The fund makes investments in portfolio companies.
- Annual management fees continue to be paid.
- Typical investments are held for 3-5 years.
Sale Proceeds and Distributions (Throughout Investment Period and Beyond)
- As investments are sold, proceeds are returned to investors.
- Carried interest (performance bonus/profit share) is paid to the fund manager if profits exceed a certain threshold.
End of Investment Period
- Any undrawn capital commitments expire.
- Investors are free to use the uncalled capital for other purposes.
- Remaining investments may still be held, with the possibility of further distributions.
Hedge fund and comment on investment strategy
Investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments.
Type of collective investment vehicle.
Aren’t restricted to long-only, non-leveraged investment strategy and have less restriction on:
- borrowing
- short-selling
- use of derivatives
Additional features of a hedge fund (except obvious ones)
- manager - great deal of investment freedom
- fees include performance related component in addition to annual management charge
- minimum investment amount often high & may be limits on total size of the fund.
- may be lock-up periods - minimum investment periods & notice periods.
What were hedge funds originally characterised by?
- placing many aggressive positions on different assets
- high level of borrowing given limited size of the capital of the funds compared to size of individual investments
- mix of investments - price movements of which were expected to mostly cancel each other out
- willingness to trade in derivatives, commodities and non-income bearing securities
- higher risk tolerance
- high fees
- illiquidity
- opaqueness
Classes of hedge funds
- Global macro funds
- Event-driven funds
- Market-neutral funds
- Multi-strategy funds
Global macro funds
These concentrate on economic change around the world and sometimes make extensive use of leverage and derivatives.
Combination of long and short positions that reflect the hedge fund manager’s view on how macroeconomic factors like levels of international asset markets, interest rates and currencies will move.
Event-driven funds
Trade securities of companies in reorganisation and/or bankruptcy (‘distressed’ securities) or companies involved in a merger or aquisition (‘risk arbitrage’)
Market-neutral funds
Simultaneously enter into long as well as short positions at a market or sector level, while trying to exploit individual security price movements
Designed to be market-neutral (beta or currency)
- long portfolio beta is equal to short portfolio beta
- thus performance of fund is not affected by general market movements
- just focus on stock selection profits by exploiting market inefficiencies.
Multi-strategy funds
Invest in a range of investment strategies to provide a level of diversification (of stretegy) and helps smooth profits.
- combination of strategies on the same set of assets.
Problems with distribution of hedge funds’ returns
- return distributions tend to be negatively skewed (coefficient of skewness <0) = likely to be more big falls than increases.
- standard measures of performance such as portfolio’s alpha and its Sharpe ratio will be biased upwards as a result
- practical problems (lack of data/too short a time period)
