Reading 50: Introduction Alternative Investments

Question 1

Define funds of funds.

Answer 1

These are funds that invest in a number of hedge funds, hence diversifying across hedge fund strategies, investment regions, and management styles. Funds of funds allow smaller investors access to hedge funds in which they may not be able to invest directly.

Question 2

Characterize hedge funds.

Answer 2

Hedge funds are designed to give the hedge fund manager more choices than the traditional mutual fund manager has. Hedge funds have the ability to invest in any asset that can increase in value over time, as long as the asset involves legal activity and the hedge fund manager discloses the investment strategy.

Question 3

Differentiate between a hurdle rate and a high-water mark provision.

Answer 3

A hurdle rate defines the minimum return threshold that the fund must earn before any incentive fee is paid.

A high-water mark refers to the highest value, net of fees, that the fund has reached.

Question 4

List the key due diligence points when investing in hedge funds.

Answer 4

Investment strategy and process

Competitive advantage

Track record

Size and longevity

Management style and key-person risk

Reputation and investor relations

Plans for growth

Methodology used for return calculations

Systems for risk management

Question 5

Identify the challenges of alternative investments.

Answer 5

Obtaining reliable measures of risk and return

Identifying the appropriate allocation

Selecting portfolio managers

Question 6

Describe the 3 sources of return on a commodity futures contract.

Answer 6

1. Roll yield: The difference between the spot price of a commodity and the futures price, or the difference between the futures prices of contracts expiring at different dates.
2. Collateral yield: The interest earned on the collateral (margin) deposited to enter into the futures contract.
3. Spot prices: These are influenced by current supply and demand.

Question 7

Why do alternative investments generally have higher returns?

Answer 7

Tax advantages

Portfolio managers’ ability to exploit mispricings

Return premiums for illiquidity

Significant use of leverage

Question 8

Give the reasons investors generally invest in real estate.

Answer 8

It can offer competitive long-term total returns, driven by income generation and capital appreciation.

Multiple-year leases with fixed rents for some property types provide stable cash flow that is relatively immune to economic shocks.

It may offer diversification benefits due to its less than perfect positive correlation with other asset classes.

It serves as an inflation hedge if rents can be adjusted quickly for inflation.

Question 9

List the categories of the underlying assets of infrastructure investments.

Answer 9

Economic or social infrastructure assets

Brownfield or greenfield investments

Geographical location

Question 10

Explain the risk management issues of alternative investments.

Answer 10

Investments in certain types of alternative investments require long holding periods.

Hedge funds and private equity funds are less transparent than other investments, as they may consider their investment strategies to be proprietary information.

Investments in many alternative investments are relatively illiquid.

Question 11

Explain the common exit strategies.

Answer 11

Trade sale: This occurs when a company is sold to a strategic buyer, either through an auction or through a private negotiation.

Initial public offering (IPO): This involves taking the private company public.

Recapitalization: This is a very popular strategy when interest rates are low.

Question 12

Identify the critical aspects of a hedge fund.

Answer 12

Hedge funds are aggressively managed portfolios of investments.

They aim to generate high returns (either on an absolute basis or relative to a specified benchmark).

They are set up as private investment partnerships, where the fund is the general partner (GP) and the investors are limited partners (LPs).

Hedge funds usually impose restrictions on redemptions.

Question 13

List the 4 broad categories of hedge fund strategies and give examples of each.

Answer 13

Event-driven strategies: merger arbitrage; distress/restructuring; activist; and special situations

Relative value strategies: fixed-income convertible arbitrage; fixed-income asset-backed; fixed-income general; volatility; and multistrategy

Macro strategies: taking positions in broad markets currencies, commodities, etc.

Equity hedge strategies: market neutral; fundamental growth/value; quantitative directional; short bias; and sector specific

Question 14

Give the formula used to calculate the price of a futures contract on a commodity.

Answer 14

Futures price = Spot price × (1 + Risk-free short-term rate) + Storage costs − Convenience yield

Question 15

Identify the approaches typically used to value companies in the private equity industry.

Answer 15

Market or comparables approach: This is a relative valuation technique that uses equity multiples of different measures to value a company.

Discounted cash flow (DCF) approach: This is an absolute valuation technique in which the value of a company is determined as the present value of its expected future cash flows.

Asset-based approach: This approach values the equity of a company as the total value of its assets minus the value of its liabilities.

Question 16

List the categories of alternative investments.

Answer 16

Hedge funds

Private equity funds

Real estate

Commodities

Infrastructure

Tangible and intangible assets

Question 17

List the strategies used in private equity (PE) investments.

Answer 17

Leveraged buyouts (LBOs)

Venture capital (VC)

Development capital

Distressed investing

Question 18

Differentiate between self-selection bias and survivorship bias.

Answer 18

Self-selection bias: Since disclosure of performance data to hedge fund indexes is voluntary, fund managers tend to reveal their performance only if it is impressive.

Survivorship bias: This occurs due to the fact that unsuccessful funds tend to go out of business and only well-performing funds are willing to disclose their historical performance for inclusion in hedge fund indexes.

Question 19

What are the due diligence factors of risk management?

Answer 19

Fund policies and limits

Risk management policy

Portfolio risk and key risk factors

Leverage and currency risks, constraints, and hedging

Question 20

Name the types of commodity investment vehicles.

Answer 20

Exchange-traded funds (ETFs)

Common stock of companies exposed to a particular commodity

Managed futures funds

Individual managed accounts

Specialized funds

Question 21

Identify the advantages of investing in infrastructure.

Answer 21

Enables investors to add a steady income stream to their portfolios.

Enables investors to further diversify their portfolios, as infrastructure assets exhibit low correlation with other investments.

Enables investors to gain some inflation protection.

Question 22

Identify the downside risk measures.

Answer 22

Value at risk (VaR): This estimates the minimum amount of loss expected over a given time period at a given probability.

Shortfall or safety-first measures: These measure the probability that the value of the portfolio will fall below a minimum acceptable level over a given period. These measures use the standard deviation, so they underestimate risk for a negatively skewed distribution.

Sortino ratio: This measure of downside risk uses downside deviation as opposed to standard deviation as a measure of risk.

Question 23

Describe leveraged buyouts (LBOs).

Answer 23

They refer to acquisitions of public companies or established private companies, where debt is used to finance a significant proportion of the acquisition. Cash flows from the acquired company are the primary source of debt service payments, while assets of the acquired company serve as collateral for the debt.

Question 24

List the due diligence factors of portfolio management.

Answer 24

Investment process

Target market and asset types and strategies

Sourcing of investments

Role of operating partners

Underwriting

Environmental and engineering review process

Integration of asset management, acquisitions, and dispositions

Disposition process, including how initiated and executed

Question 25

Identify the characteristics of companies that are attractive targets for LBOs.

Answer 25

Their stock prices are undervalued.

Their management is willing to enter into a deal.

They are currently inefficiently managed and have the potential to perform well if managed better.

They have strong and sustainable cash flows, which is necessary to make interest payments on the increased debt load from the buyout.

They have low leverage, which makes it easier to raise additional debt to finance a large portion of the purchase price.

They have a significant amount of physical assets, which can be used as collateral for loans.

Question 26

Describe real estate investment trust (REIT) investing.

Answer 26

REITs issue shares that are publicly traded. They invest in different types of real estate and provide retail investors access to a diversified real estate property portfolio that is professionally managed. REITs usually distribute all their taxable income to shareholders.

Question 27

Identify the approaches to value real estate.

Answer 27

Comparable sales approach: The value of a property is estimated based on recent sales of comparable properties. Adjustments are made for differences between the subject and comparable properties with respect to size, age, location, and condition.

Income approach: They are similar to the direct capitalization approach for valuing individual properties in that a measure of income is capitalized into a value using an appropriate cap rate.

Cost approach: This is the estimate to replace the real estate.

Question 28

Explain the development capital strategy.

Answer 28

This generally involves providing financing to more mature companies to help them expand, restructure operations, enter new markets, or finance major acquisitions. Although development capital is usually sought by private companies, public companies may also sometimes seek private equity capital. These investments are known as “private investment in public equities” (PIPEs).

Question 29

List the risks of investing in infrastructure.

Answer 29

Revenues not meeting expectations.

Leverage, which may give rise to financing risk.

Operational risk.

Construction risk.

Regulatory risk. Since infrastructure assets often provide services that are very important to society, governments typically regulate certain aspects, including the sale of the underlying assets, and operations of the assets, including service quality, and prices/profit margins.

Question 30

Distinguish between brownfield investments and greenfield investments.

Answer 30

Brownfield investments refer to investments in existing investable infrastructure assets.

Greenfield investments refer to investments in infrastructure assets that are to be constructed.

Question 31

Give the 3 steps in the formative stage of VC investments.

Answer 31

1. Angel investing
2. Seed-stage financing
3. Early-stage financing