Volume 5 - Alternatives Investments Flashcards
While there are several categories of alternative investments, they generally share the following characteristics:
Specialized managers focused on valuing unique cash flows and risks
Low correlation with traditional asset classes
Large capital outlays
Long investment horizons
Illiquidity concerns due to underlying assets and/or restrictions on redemptions
Investment vehicles designed to overcome the challenges of investing directly
Incentive-based compensation arrangements designed to overcome information asymmetry between managers and investors
Performance appraisal challenges
There are three broad categories of alternative investments:
Private capital
Real assets
Hedge funds
Other real assets that investors hold in their portfolios include collectibles, such as art, wine, or antique furniture. Intangible digital assets are an emerging source of investment in this sector.
Fund Investment
Advantages:
Fund managers offer investment services and expertise
Lower level of investor involvement required
Lower minimum capital requirements
Access to a diverse range of alternative investments without possessing specialized knowledge
Disadvantages:
Costly management and performance fees
Investors still need to conduct due diligence when selecting the right fund
Lockups and other restrictions limit investors’ ability to access to their funds
Co-Investment
Advantages:
Provides learning opportunities for investors seeking adopt the direct investing model
Reduced management fees
Allows for more active management compared to fund investing
Opportunity to develop a deeper relationship with the manager
Disadvantages:
Lower level of control over the investment selection process compared to direct investing
Exposure to the risk that managers will make less attractive investment opportunities available to co-investors
Investors are required to be more actively involved in evaluating opportunities
Direct Investment
Advantages:
No fees are paid to external managers
Flexibility to pursue different investment opportunities
Control over asset management decisions
Disadvantages:
In-house expertise is expensive to develop and maintain
The lack of diversification benefits compared to fund investing increases concentration risk
Investors must evaluate opportunities without the benefit of managers and their sourcing networks
Higher minimum capital requirements
Comparability with Traditional Asset Classes
Lags between the timing of when capital is committed, when it is actually invested, and when redemptions are received.
The impact of leverage
Differences in methods used to value different types of positions or the same positions over the course of their investment horizon
Complex fee structures and tax considerations
Management Fees on PE are based on commited capital
Hedge Fund are on AUM
A simpler approach used to measure the performance of alternative investments is the multiple of invested capital (MOIC) metric, also known as the money multiple on total paid-in capital (paid-in capital less management fees and fund expenses). MOIC measures the total value of all distributions and residual asset values relative to an initial total investment.
GAAP categorizes investments into three buckets:
Level 1 pricing uses exchange-traded, publicly-traded prices.
Level 2 pricing relies on outside broker quotes.
Level 3 pricing uses values computed using internal models.
The vehicles that are commonly used for investing in alternative assets are typically designed to meet the following objectives:
The return of capital to investors
A minimum level of return on capital (i.e., hurdle rate)
Performance-based compensation for managers if the first two objectives are achieved
Additionally, managers want to avoid forced asset sales to meet redemption requests, particularly during periods of market turmoil. Common restrictions on withdrawals include:
Redemption fees to offset the transaction costs incurred on sales needed to meet redemption requests.
Notice periods that give managers a greater opportunity to liquidate positions in an orderly manner.
Lockup periods during which investors are prohibited from making any withdrawals, even with advance notice.
Liquidity gates that establish limits on the amount that investors may withdraw during a specified period.
Custom Fee Arrangements
Other than the most commonly quoted fee structures of “2 and 20” and “1 and 10”, variations of fee arrangements include:
Fees based on liquidity terms and asset size
Hedge funds may charge lower fees to larger investors or investors who are willing to accept longer lockup periods. Funds with strong performance records and capacity constraints are often in a position to turn down new, larger investors seeking preferential fee arrangements in side letter agreements.
Founders’ shares
Founders’ shares are used to entice early participation in start-up and emerging hedge funds. They entitle investors to a lower fee structure. These shares are typically available to investors who contribute before a certain cutoff threshold, such as the first $100 million in assets.
“Either/or” fees
It has become increasingly common for large institutional investors to deviate from the traditional 2 and 20 fee structure by requiring a fee structure in which the manager’s annual compensation is the greater of (1) a relatively low management fee (e.g., 1%), or (2) a relatively high performance fee (e.g., 30%) on returns in excess of a mutually agreed-upon annual hurdle rate. This fee structure is designed to reward performance and delivery of true alpha above a benchmark.
In an either/or compensation structure, managers agree that their annual compensation will be either a relatively low management fee (e.g., 1%) or a relatively high incentive fee rate (e.g., 30%) on gains above a specified hurdle rate.
Trade Sale
In a trade sale, the portfolio company is sold to a strategic buyer, which is typically a competitor within the same industry. The acquisition price may be negotiated directly, or it may emerge from a competitive bidding process, such as an auction. Trade sales offer the following advantages:
Cash is received immediately
Strategic buyers typically offer higher valuations due to synergies
Execution is relatively fast and simple
Transaction costs and disclosure requirements are lower compared to an IPO
The disadvantage of a trade sale include:
The pool of potential buyers is limited
Managers may object out of concern for losing their jobs if the company is acquired by a competitor
Employees may prefer to monetize their shares through an IPO, which may produce a higher valuation
Other Exit Strategies
Three additional exit strategies are recapitalizations, secondary sales, and liquidations.
A recapitalization is executed by having the portfolio company take on additional debt and redistributing part of the proceeds as dividend payments to shareholders. In fact, this is not a true exit strategy because the private equity firm retains its shares and control over the company. This is a complementary approach that is often used to monetize a position and improve the investment’s internal rate of return before selling shares at a later date through an IPO or a trade sale.
A secondary sale involves selling a position to another private equity firm or group of investors. This exit strategy has become more common as the private equity market has grown.
A liquidation strategy, also known as a write-off, is used when an investment does not work out as expected. Underperforming companies, or some of their assets, are sold for the purpose of salvaging any value.
B is correct. IPOs can gain public attention for sponsors by high-profile business launches, and SPACs often have high-profile, seasoned sponsors and their investor networks as participants.
Direct lending is a form of private debt investing where investors provide capital directly to borrowers. The loan provided is typically senior and secured, with covenants in place to protect investors. Unlike traditional debt instruments, the loan in direct lending is provided by a small number of investors and cannot be publicly traded in the market.
Leveraged loans are commonly used in direct lending to enhance the return on the loan portfolio of a private debt firm.
A is correct. For both public debt and private debt, return on debt capital tends to follow and change with the benchmark interest rate environment.
B is incorrect because there is a need for specialized knowledge for private debt financing to add value to the investor through consideration of such factors as the debt’s life cycle timing, its place in the financial structure, and the quality of underlying assets.
C is incorrect because in market disruptions, such as the 2008 financial crisis, private debt exclusively benefited from an illiquidity premium when private lending funds filled the financing gap left by traditional lenders because traditional lenders were reluctant to underwrite public debt.
C is correct. Fund performance is greatly determined by the vintage year and the coinciding phase of the business cycle. Funds seeded during the expanding phase tend to earn excess returns investing in early-stage companies. Funds seeded during the contracting phase tend to do best with distressed companies. Results may be intermediate with mature, stable companies.
Direct Real Estate Investment
Control: Investors who own properties directly have full control over matters such as lease terms, tenants, capital improvements, and property maintenance. Owners enjoy the full benefit of lease payments and capital appreciation.
Tax benefits: Direct real estate owners can also reduce their taxable income by the amount of non-cash depreciation expenses and interest expense on the property.
Diversification: Direct real estate investments have historically exhibited low correlations with returns on traditional asset classes. Investors can improve the risk-return profile of their overall portfolio.
The disadvantages of direct real estate investing include:
Complexity: Real estate purchases are complicated transactions. Investors must identify properties to purchase, perform due diligence, and negotiate sale terms with the current owners. Once a sale is completed, the new owner must actively manage their properties, which can be time-consuming.
Need for specialized knowledge: Direct real estate investing requires specialist knowledge about the overall asset class as well as local markets.
Significant capital needs: Investors must raise large amounts of debt and equity to finance direct real estate purchases. Refinancing mortgage loans may be particularly challenging during periods of market stress.
Concentration risk: Only the very largest investors (e.g., endowments) have the financial resources necessary to assemble a diversified portfolio of individual properties. Additionally, real estate may represent an unjustifiably large share of an investor’s overall portfolio.
Illiquidity: Unlike publicly-traded stocks, real estate properties cannot be sold quickly and transaction costs are very high. Owners may need to accept a significant discount from a property’s assessed value in order to complete a sale in a timely manner.
Real Estate
High initial investment: The indivisibility of real estate property makes the unit value high and limits the number of potential investors in private transactions.
Unique assets: No two properties are the same. Each has its own unique combination of risk exposures. Buildings differ in terms of size, age, location, construction quality, and leasing arrangements.
Multiple investment alternatives: Investors can choose to access real estate directly or indirectly. Certain real estate investment vehicles are as liquid as large-cap stocks, while other investments are highly illiquid and require long holding periods. There are many different ways to classify various segments of the real estate market.
Limits to diversification: While there are a wide variety of unique properties, it can be difficult to assemble a diversified portfolio of real estate assets due to high cost of individual units.
Lack of investable indexes: Unlike equity or fixed-income indexes, real estate indexes are not investable. They reflect the collective performance of properties that are owned by institutional investors.
Price determination: Historical prices are unlikely to be reflective of current market conditions.
High transaction costs: Buying and selling real estate is costly and time-consuming.
Limited transaction activity: Because individual properties are unique and sold relatively infrequently, it is difficult to establish market-based valuations. Additionally, market-wide transaction activity can fluctuate significantly with changes in economic conditions.
Infinite-life open-end funds allow investors to make contributions or redemption anytime, and the GP will typically accept them on a quarterly basis. Open-end funds tend to focus on the following approaches to real estate investing:
Core real estate consists of well-leased, high-quality commercial and residential properties in the best markets. They are expected to deliver stable returns, which are typically driven by real estate beta.
Finite-life closed-end funds are commonly used to earn higher returns from alpha and beta. Investment strategies used by these funds include:
Core-plus real estate involves greater risk thana core strategy, with investments in modest redevelopment or upgrades to vacant space and consideration of alternative uses of existing properties.
Value-add investments seek higher returns through larger-scale redevelopment or repositioning existing properties.
Opportunistic investing accepts the much higher risks of development, major redevelopment, repurposing properties, taking on large vacancies, and speculating on changing market conditions.
The benefits of real estate investments include:
Stable, predictable income from rental payments, often over multi-year terms. This component of return is bond-like.
Price appreciation over longer holding periods In addition to rental income, real estate investors generally expect to benefit from increases in property values over their holding period. In this respect, real estate investments are similar to equities.
Inflation hedging due to both rents and price appreciation.
Portfolio diversification due to low correlations with traditional assets.
Tax benefits from writing off the expenses of direct investments or the tax-advantaged status of REITs.
Beyond derivatives, investors can also use the following vehicles to gain exposure to commodities:
Exchange-traded products (ETPs) offer the advantage of simplicity because they can be traded like ordinary common shares. ETP managers may use leverage or hold physical assets in an effort to track the price of a particular commodity or commodity index. “Bearish” ETPs replicate short commodity positions. Fees are based on a percentage of assets.
Commodity trading advisors (CTAs) are managed futures funds that take directional positions in one or more commodities based on technical and fundamental analysis. While CTAs once took commodity positions exclusively, it is now common for them to supplement their portfolios with positions in equities, bond, and foreign currencies. Individual investors may establish separately managed accounts that are managed according to their specific objectives and constraints.
Specialized commodity funds are used to gain exposure to specific commodity sectors. These vehicles are similar to private equity funds in that investors are subject to lockup periods and other constraints that limit their ability to access their funds before the end of the fund’s lifetime, which may be as long as a decade. Specialized commodity funds are popular with institutions that have relatively long time horizons and are willing to pay fees for access to a manager’s investing skills. Commodity-based mutual funds are a more popular option for individual investors due to their greater liquidity and lower management fees.
Commodities:
Supply is dependent on production and inventory levels. Production quantities are stable in the short-term because adjustments take time to implement. For example, it can take years to build up the capacity to increase mineral extraction. However, severe weather events can lead to supply shortages, particularly if they negatively impact crop yields for soft commodities.
Demand is based on the needs of end-users, which will grow during economic expansions and contract during downturns. Non-hedging market participants also have a short-term impact on demand, particularly for certain commodities. For example, investors hold more physical gold as a safe haven asset and store of value during periods of market turmoil.
B is correct. Commodity investments are typically entered into through derivative contracts, which are highly leveraged financial instruments. As a result, observed returns are highly volatile.
