General Finance and AM Flashcards
Leverage
Measures the relative size of long and short positions in risky assets compared to the size of the portfolio. A true company with zero leverage is 100% cash.
- Leverage debt to adjusted EBITDA
- but not just debt, need to take into account deal based calculations, Credit agreement.
Leverage is provided to HF through a prime broker. Federal Reserve Board’s Regulation T (Reg T) allows investors to borrow up to a maximum 50% of a position on margin (which leads to a maximum level of exposure equal 1/0.5 = 2). For a short position, Reg T requires that short sale accounts hold collateral of 50% of the value of the short implying a maximum short exposure of two.
By establishing offshore investment vehicles, hedge funds can obtain “enhanced leverage” higher than levels than allowable by Reg T. Prime brokers have established facilities overseas in less restrictive jurisdictions in order to provide this service. Another way to obtain higher leverage than allowed by Reg T is “portfolio margining” which is another service provided by prime brokers. Portfolio margining was approved by the SEC in 2005 and allows margins to be calculated on a portfolio basis, rather than on a security by security basis.
Derivatives and options, have embedded leverage in addition to the leverage available from external financing. The highest leverage is available in Treasury, foreign exchange, and derivatives security markets such as interest rate and foreign exchange swaps. These swap transactions are over the counter and permit much higher levels of leverage than Reg T. These securities enable investors to have large notional exposure with little or no initial investment or collateral
traditional are not the best managers of leveraged funds, often will request 0 IA
if rated BBB- assume double BB and thrown a bone
Assets under management
cash plus delta of long and short positions
difference between AUM between traditional and Alt is the concept of committed capital. Day one is not necessarily funding of investment but commitment to fund the investments.
PE does not call for capital on day one? reduced duration and boost return in equities. Will not draw capital if no ability to deploy right away. Metric is Internal Rate of Return.
Net Asset Value
AUM divided by the number of shares
Gross Leverage
sum of long and short exposure per share divided by NAV
- This definition implicitly treats both the long and short positions as separate sources of profits in their own right, as would be the case for many long-short equity funds
- Overstates risk if the short position is used for hedging and does not constitute a separate active bet.
Net Leverage
difference between long and short exposure per share expressed as a proportion of NAV. The net leverage measure captures only the long positions representing active positions which are not perfectly offset by short hedges, assuming the short positions represent little risk by themselves.
Hedge funds
- Relatively high and sophisticated use of leverage to obtain notional exposure at levels greater than their capital base to achieve large returns.
- exclusive and limited partnership for high net worth individuals (200K per year after two years) or institutions that use pooled funds to achieve a high alpha for investors
- Unregulated = typically offshore due to the tax benefit
- Not regulated by the SEC = ability to invest in anything unique strategy
- the managers are typically people with pedigree and skin in the game
- Assets typically not easily accessible as they are with mutual funds
- 20 / 2 the managers take 20% of profits and 2% goes to the HF
- High water marks are used to protect investors by preventing fees from being applied to the same transaction
- Main buckets of strategies:
- Long / short
- Macro
- Relative
Debt Capital Markets
type of market where companies raise funds by trading debt securities like corporate and government bonds. When a company raises debt, it means that it borrows funds and pays interest on those funds. This is different than equity because there is no decrease in ownership.
Equity Capital Markets
Selling ownership in exchange for cash.
The Equity Capital Market group can be broken down into three subgroups:
- Equity Origination: This group pitches companies on raising capital and financing deals such as IPOs.
- Syndicate: This team works with other banks to execute the deal. This is necessary as most of the equity deals involve multiple banks.
- Convertible Bonds: Convertible bonds are debt issuances that convert into equity once a company’s stock price reaches a certain number. So, this group works with companies to raise capital using convertible bonds.
S&P 500
preferred index given its depth and breadth, representative of U.S. equity marketsbecause it comprises more stocks across all sectors (500 versus the Dow’s 30 Industrials).
Furthermore, the S&P 500 uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations, while the DJIA is a price-weighted index that gives companies with higher stock prices a higher index weighting. The market capitalization-weighting structure is more common than the price-weighted method across U.S. indexes.
Book Value Per Share
Green light to value investors, when a stock trades below its book value could be trading at a discount
(Shareholders’ Equity - Preferred Equity) / Total Outstanding Common Shares
balance sheet, you’ll find the accumulated depreciation of corporate assets, which aids in getting the most accurate outcome when it comes to book value per share
a company’s market value is significantly stronger than its book value, it’s a bull market scenario
Mutual Fund
actively managed fund that uses pooled assets of investors to trade on stocks, bonds, money market instruments so it can take on larger positions
Continuously offered, closed-end funds
Investors can buy into these funds each day at the fund’s net asset value (NAV).
Redemptions, however, are made via monthly or quarterly tenders rather than each day. To ensure they can meet redemptions, many of these funds, as well as daily-access funds, set up lines of credit to cover withdrawals above and beyond cash reserves
401K plans used by corporate America equate to $6.2 trillion with $4 trillion in mutual funds
Subject to regulation under the Investment Company Act of 1940 (“40 Act”)
A mutual fund is a type of investment where the money of a number of investors is pooled together and used by the fund manager to invest in underlying securities in line with the objectives of the mutual fund strategy
By structure, mutual fund strategies can be classified as open-ended or closed-ended mutual funds
On the basis of investing in asset classes, mutual funds can be broadly divided into three categories: Equity, Debt and Hybrid
Asset coverage requirement (“ACR”) for borrowing is 3.0x. (ACR is the ratio, which the value of the total assets of a given Borrower less all liabilities and indebtedness of the Borrower not represented by senior securities bears to the aggregate amount of all senior securities representing indebtedness of the Borrower)
Accounting: Must carry investments on balance sheet at fair value. Net adjustment to the fair value of the portfolio results in an unrealized gain or loss recognized on the income statement.
Reporting: Required to comply with 40 Act disclosure requirements (quarterly, semi-annual and annual filings, material events filings and fact sheets)
Shareholder Rights:
An investment company must abide by certain shareholder rights. The following activities are prohibited unless approved by a majority shareholder vote:
A mutual fund company may not borrow money, make loans, buy or sell real estate, or underwrite securities issued by other companies
A mutual fund company may not change its investment objectives
A mutual fund company may not change the nature of its business and cease acting as an investment company
A mutual fund company cannot change from a diversified form to an undiversified one
Failure to maintain >3.0x asset coverage
Unable to incur additional indebtedness
A fund’s failure to maintain its status as a mutual fund under the 1940 Act constitutes an event of default
- unlike stocks, no voting rights for shareholders but similarly buying ownership of “company”
- Price does not vary intraday like stocks, NAV calculated at the end of each day by dividing total value of securities by outstanding shares
- Investors make $ from dividends, capital gain (selling when increase in value), or when selling shares after holdings increase
- MF make $ from 1–3% in commission, redemption fees
- Structurally - trust (legal entity) - series with different share classes - each have sep liabilities.
- Strategies: Equity, Fixed Income (gov’t debt, corporate) index fund (stocks which correspond to index), money market (short term debt)
- 50-80% mutual funds fail to meet their objective. 23% of all active funds surpassed the average of their passive rivals over the 10-year period ended June 2019. Long-term success rates were generally higher among foreign-stock funds and bond funds and lowest among U.S. large-cap funds. Passively managed ETFs have a better track record.
- ACR 3.0x the value of the total assets of a given borrower - all liabilities and indebtedness
mimic the s&p 500 index of leading American stocks. An index fund holds stocks in proportion to their market capitalisation. Because the fund owns all the stocks in the index, it is diversified. Above all, it is cheap to run. It has no need for expensive analysts. Turnover costs are trivial. You buy stocks when they join the index, and sell them when they leave. In between you just hold them
One charge is that index investing adds to stockmarket volatility and inflates bubbles. This misunderstands the nature of a market-cap index. It weights each stock by its value. If a faddish stock’s price goes up rapidly, its weight in the index increases accordingly, and its value in the indexed portfolio increases automatically. No additional purchase is needed. If anything, index funds make markets less volatile. In panics they have generally been more stable than active funds.
Yield curve
comparing two interest rates of products with different maturity but similar credit quality.
- used as a litmus test to indicate the economy’s health
- When 0, loaning $ becomes a losing proposition. Credit tightens.
- The past 9 recessions were preceded by the inverted yield curve
LIBOR
London interbank offered rate = rate that a bank pays to borrow from another bank. represents $350TR in loans. LIBOR was used by several large banks to rig their trader’s positions. Now will be replaced in 2021.
Derivatives
a contract between two parties or more for stocks, commodities, bonds or interest rates
Futures
- Small movements in assets of underlying futures can cause disproportionately larger losses to the fund. Generally more liquid than other derivatives but are less liquid than stocks, bonds, or other investments.
- price of a futures contract depends to only on the price of the underlying asset but also other factors. more volatile than equity and bonds.
- subject to temporary distortions including lack of liquidity in the markets, government intervention which can result in volatile and unpredictable prices
Commodity Futures
- greater risk of low liquidity or volatile pricing around the maturity date due to a number of market participants take physical delivery of the underlying commodities. Many commodities like energy and industrial metals have liquid futures contracts that expire every month. These contracts are rolled forward monthly.
- Contracts in agricultural and livestock tend to have a few contract months each year and trade with substantial liquidity
- Commodities that expire infrequently than every month have further pronounced pricing volatility during extended periods of low liquidity
- sell security at high price and sell back at lower price. Borrowing shares from someone. When shares fall, buy back gain. Long only engage in securities lending HS who want to borrow shares and go short. Borrow shares, sell, get cash. Short losses uncapped losses = infinite.
TALF
Primary dealers are FI party to Master Loan and Services Agreement
TALF Agents are primary dealers to serve as agents to TALF borrowers
Fed SPV will not be our counterparty but JPM is acting as an agent between Fed SPV and fund that is borrowing. If structured like a HF vs. structured with a committed capital structure, use PE FBIs and risk manage like private equity or private credit fund
Treasury market
$20 tr - bedrock of the global financial system and the benchmark off of which almost every security in the world is priced
Fed Response Q1 2020
Federal Reserve announced that it will buy unlimited amounts of Treasuries and agency mortgages, including multifamily, to grease the wheels of the credit markets, smooth market functioning, support the flow of credit to households and businesses by addressing strains in the markets for Treasury securities and agency mortgage-backed securities.
The bond-buying is aimed at providing liquidity and pushing rates lower, which would bolster the economy.
REIT
More worryingly, cracks started forming in key lending markets. When investors expect economic trouble, they typically unload riskier assets like stocks and turn to more conservative investments like U.S. government bonds, sending yields lower. That wasn’t what happened in March. Treasury yields began rising even as stocks fell, a move many suspected stemmed from big banks being forced to sell Treasurys to quickly raise cash. Mortgage rates jumped, and traders reported unusual dislocations that suggested dealers were struggling with increasingly strained balance sheets.
- Purchase originating mortgages like MBS and earning income from interest
- REIT invest solely in real estate holdings, properties, mortgages
- 90% of REIT is paid out. That’s why we have to look at book value per share which is theoretically the value of real estate minus loans. Keep in mind that it’s the appraisal amount not what it actually sells for
- Markets may be too pessimistic on property owners.
- Property markets move slowly, and many owners prefer to wait and see if prices recover rather than sell at a loss. Banks are letting borrowers defer mortgage payments, putting owners under less pressure to sell. While most observers expect an increase in mortgage defaults and distressed real estate sales, they expect it to take time. Blackstone acquired $2bn in real estate stocks since March
- Stocks swing more wildly
- Real estate especially commercial suffer during the pandemic due to forced closure. Killed office culture.
- Events
- June 25th: Second securitization - prices $341.7mm of MBS
- June 23rd: Second quarter dividend suspended
ROE
return to the shareholders of the company which is meaningful shareholders
- can obscure a lot of potential problems: a) divert attention from business fundamentals and lead to surprises. Companies can resort to financial strategies to artificially maintain a healthy ROE — for a while — and hide deteriorating performance in business fundamentals I.e. growing debt leverage and stock buybacks funded through accumulated cash can help to maintain a company’s ROE even though operational profitability is eroding. Mounting competitive pressure combined with artificially low interest rates, characteristic of the last couple of decades, creates a potent incentive to engage in these strategies to keep investors happy.
ROA
analyze long-term profitability trends across all public companies in the US. Return on assets avoids the potential distortions created by financial saving tactics, it is a better metric of financial performance than income statement profitability measures like return on sales. ROA explicitly takes into account the assets used to support business activities. It determines whether the company is able to generate an adequate return on these assets rather than simply showing robust return on sales.
Long-term ROA
trends highlight the importance of capability leverage options. Our Shift Index revealed that since 1965 all US public companies experienced sustained and significant erosion in ROA — dropping by 75%. Mounting economic pressures are largely obscured by the metrics and time frames we use. This doesn’t just reflect the current economic downturn. These longer-term trends suggest our traditional approaches to business are fundamentally broken. This decline is occurring in spite of a movement to more asset-light business activities and the absence of a crucial asset from the balance sheet — the talent of the workforce.
Venture capital
aims to invest in a company at an early stage and benefit from exponential growth over time.
Private equity
used to take control of an existing company with a strategy to increase its growth. Private credit can be used to make high-yield (and high-risk) loans or buy the debt of an existing company.
Long-Only Leverage
long positions per share divided by NAV. Naturally, by ignoring the short positions, long-only leverage could result in a large under-estimate of leverage, but we examine this conservative measure because the reporting requirements of hedge fund positions by the SEC involve only long positions.4 We also investigate if long leverage behaves differently from gross or net leverage, or put another way, if hedge funds actively manage their long and short leverage positions differently.
Redemption rating methodology for regulated funds
Overview
Regulated funds are graded based on the obligor grade of the fund’s investment adviser (“IA”), the fund’s
Morningstar investment strategy category, the NAV of the fund, and the fund’s diversification status. The following
weights are applied to each criteria:
Obligor grade of the IA: 20% weighting
Morningstar investment strategy category: 50% weighting
Redemption facility rating methodology
Redemption facilities are assigned a default grade based on the OGs of the eligible borrowers; the facility grade is an average of the eligible borrowers’ OGs, weighted by the NAV of
each eligible borrower
Redemption facilities are utilized for liquidity and leverage. These facilities, however, rarely get drawn, as they are mostly set up for emergency purposes
IA Rating 20%
Morningstar category 50%
NAV Diversification 20%
Ongoing monitoring of eligible borrowers
The ongoing monitoring process for the eligible borrowers of redemption facilities is governed by the Rules policy
NAVs are typically updated on a monthly basis via a Morningstar NAV feed or via written communication from the client
– NAVs must be updated at least annually for a fund to remain rules compliant (however, we often require NAV monthly or quarterly based on ISDA reporting requirements)
All changes to any grading field (IA rating, Morningstar category, NAV, diversification status) are documented and factored into the grade upon the reapplication of the rules
process
– Morningstar categorizes regulated funds into different investment strategies, each of which are assigned a grade based on the average characteristics of the funds falling under
the category
Fund NAV: 10% weighting
Diversification status: 20% weighting
– In order for a fund to be classified as diversified, at least 75% of the total assets of the fund must be subject to a 5% single issuer limitation
Redemption facility - Transaction structure
A redemption facility is available to a specified number of funds under the Investment Advisor’s Group of Funds umbrella. Each Borrower is a regulated fund registered under the
Investment Company Act of 1940 (the “40 Act”) or foreign equivalent
Borrowing limits: Eligible Borrowers may borrow up to 33.3% of NAV (300% Asset Coverage). Funds may be labeled as Designated Borrowers due to their alternative
investment strategies, multi-manager structures, or other factors. Designated Borrowers assigned more restrictive borrowing limits in the form of higher asset coverage
requirements
Key facility terms:
– Security: Typically unsecured. Other indebtedness must be equally and ratably secured
– Tenor: 364-day maturity
– Additional terms:
– Rights to monitor for additional indebtedness, liens on assets, mergers and to inspect books and use of proceeds
– Failure to pay principal or interest or any other amounts due under the loan documentation constitutes an Event of Default
– Interfund lending (if applicable): Borrowers may be eligible for interfund lending, wherein each Borrower may lend to, or borrow from, one or more other registered investment
companies or investment portfolios, advised by the IA. The purpose of the interfund lending program is twofold:
– In order to earn a return on the money that an eligible borrower (EB) might not otherwise be able to invest or to earn a higher rate of interest on investment of their shortterm
balances
– In order to enable the EBs to access an available source of money and reduce costs incurred by the EBs that need to obtain loans for temporary purposes
Exchange-traded Funds
closed-end funds are funds trade on a stock exchange. Typically, the funds are capitalized by an initial public offering. Thereafter, investors can buy and sell shares, but may not redeem them. The manager can also expand the fund via rights offerings, but usually, they are only able to do so when the fund is trading at a premium to NAV—a provision that is typical of closed-end funds regardless of the asset class
