2015, Study Session # 18, Reading # 60

INTRODUCTION TO ALTERNATIVE INVESTMENTS

F.I =
PE =
RE =
VC =
LBO =
ABS =
AIs =
MBS =

Fixed Income
Private Equity
Real Estate
Venture Capital
Leverage Buyout
Asset Backed Securities
Alternative Investments
Mortgage Backed Securities

1. INTRODUCTION

AIs are perceived to behave differently (provide diversification) from traditional
investments.

Absolute return objective to provide +ve return throughout the economic
cycle.

Relative return objective return relative to an equity or F.I benchmark.

2. ALTERNATIVE INVESTMENTS

AIs are alternatives to long-only positions in stocks, bonds & cash.

AIs are almost always actively managed.

Characteristics common to many AIs:

Illiquid underlying investments.

Narrow manager specialization.


Correlation with traditional investments.

Less transparency & low level of regulation.

Limited historical data.

Unique tax & legal considerations.

High net worth individuals & institutions are the typical investors in AI.

HF indices may be inherently biased upwards due to survivorship & backfill biases.

Different weightings & constituents in index construction can significantly affect the indices & their
results & comparability.

2.1 Categories of Alternative Investments

Hedge Funds

Private Equity Funds

Manage portfolio of securities &

derivative positions using variety of
strategies.

Often highly leveraged & employ
long & short positions.

Generally invest in private

companies or public companies with
the intent to take them private.

Majority of PE activity involves LBOs
& VC investments.

Real Estate

Commodities

Direct or indirect investment in

buildings & / or land.

Securitization structures broadened
the definition of RE investing.

Physical commodity investments or

investments in businesses engaged
in the production of physical
commodities.

Main vehicles commodity futures
contracts & funds benchmarked to
commodity indices.

Others
These investments may include tangible assets (e.g.
wine, art, stamps etc) & intangible assets (e.g. patents).

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2015, Study Session # 18, Reading # 60

2.2 Return: General Strategies

Ways to Achieve Returns

Passive Return

Active Return

Assume that markets are efficient &

focus on drivers of return.

Expected alpha return is zero for
passive managers.

Efficiently take on market risk.

Assumption inefficiencies exist &

alpha return after adjusting for
risk is possible.

Alpha returns are results of
managers special skills in capturing
non-systematic opportunities in the
market.

Alpha Seeking Strategies

Absolute Return

Market segmentation

Return independent of market

returns.

No market index to beat.

Formal performance objective
cash rate, real return target or
absolute nominal return.

Capital cant migrate effortlessly from

lower expected return areas to higher
ones.

Segmentation brought on by investment
constraints that provide an opportunity
for more flexible managers to move into
higher returning segments quickly.

Concentrated Portfolios

Concentrating assets among fewer securities, strategies
& / or managers (less diversification).

Higher return if these concentrated positions
outperform the market (alpha potential).

Risks of AIs

Risks can be considered both on stand-alone basis & within the context of
portfolio.

Risks low liquidity, transparency & limited redemption availability.


  
  =

 

    


Sharpe ratio & downside risk measures ignore low correlation of AIs with
traditional investments.

2.3 Portfolio Context: Integration of Alternative Investments

with Traditional Investments

Key motivation for investing in AIs diversification
potential.

AIs also improves portfolios risk-return profile.

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2015, Study Session # 18, Reading # 60

2.4 Investment Structures

Most common structure partnership.

Fund is the general partner (GP) investors are limited partners (LPs).

Less regulation.

GP runs the business & bears unlimited liability.

Management fees are based on assets under management.

Incentive fees are based on realized profits.

Fee is only earned after the fund achieves a specified return (hurdle rate).

High water marks highest cumulative return used to calculate an incentive fee.

3. HEDGE FUNDS

Characteristics of HF:

Aggressively managed & highly leveraged portfolio of investments across asset
classes.

Fewer investment restrictions & goal of generating high returns.

Usually set up as a private investment partnership.

Often imposes restrictions on redemptions.

Funds of funds funds that hold a portfolio of HFs.

Provide diversification.

Available for smaller investors.

Expertise in conducting due diligence on HFs.

3.1 Hedge Fund Strategies

3.1.1 Event-Driven Strategies

Seek to profit from short-term events (e.g.
acquisitions or restructuring).

Bottom-up strategy.

Subdivisions

Merger Arbitrage

Generally involve going long on stock of
Target Company & short on stock of
acquiring company when merger is
announced.

Primary risk acquisition does not
occur.

Activist

Purchase of sufficient equity in order to
influence a companys policies or
direction.

These funds operate in public equity
market.

Distressed/Restructuring

Focus on the securities of companies
either in bankruptcy or near to
bankruptcy.

Variety of ways to profit from distressed
securities.

Special Situations

Opportunities in the equity of companies
that are currently engaged in
restructuring activities other than M&A
& bankruptcy.

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2015, Study Session # 18, Reading # 60

3.1.2 Relative Value Strategies

Seek profit from a pricing discrepancy b/w related securities.

Expectations pricing discrepancy will be resolved in time.

Examples

Fixed Income Convertible Arbitrage

Fixed Income Asset Backed

Zero investment strategies that seek to

exploit a perceived mispricing b/w a
convertible bond & its component parts.

Typically involves buying convertible
debt securities & selling the same
issuers common stock.

Focus on relative value b/w a variety of

ABS & MBS.

Seek to take advantage of mispricing
across different ABS.

Fixed Income General

Volatility

Focus on the relative value within the FI

markets.

Currency dynamics & govt yield curve are
important considerations.

Use options to go long or short market

volatility either in a specific asset class or
across asset classes.

Multi-Strategy

Relative value within & across asset classes.

Looks for investment opportunities wherever
they might exist.

3.1.3 Macro Strategies

Focus on top down approach to identify economic trends evolving across the world.

Trade in FI, equity, currency & commodity markets.

Use long &/or short positions to potentially profit from a view on overall market
direction.

3.1.4 Equity Hedge Strategies

They are focused on public equity markets & take long & short positions
in equity & equity derivative securities.

Use a bottom-up as opposed to top down approach.
Examples

Market Neutral

Use fundamental &/or quantitative analysis to
identify under/overvalued securities.

Portfolio should have a of approximately zero.

Intent profit from individual securities movement
while hedging against market risk.

Fundamental Growth

Fundamental analysis to identify
companies expected to exhibit high
growth & capital appreciation.

Long position in identified company
securities.

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2015, Study Session # 18, Reading # 60

Examples

Fundamental Value

Quantitative Directional

Fundamental analysis to identify

undervalued securities

Technical analysis to identify companies

that are under/overvalued.

Net long or short position depending
upon anticipated direction of market.

Short Bias

Sector Specific

Technical or fundamental analysis to

identify overvalued equity securities.

Net short exposure is based upon
market expectations.

Exploit expertise in a particular sector.

Use technical & fundamental analysis to
identify opportunities in the sector.

3.2 Hedge Funds and Diversification Benefits

HFs lack performance persistence.

Traditional view of HF arbitrage players seek to earn return while
hedging against risk.

HFs provides diversification benefit because of less than perfect
correlation with stock market.

3.3 Hedge Fund Fees and Other Considerations

3.3.1 Fees and Returns

Common fee structure in HF market is 2&20 which reflects a 2%
management fee & 20% incentive fee.

Incentive fee is calculated independent of management fees.

Hurdle rate is frequently set based on a RF rate proxy plus a premium.

Incentive fee can be based on returns in excess of the hurdle rate or on
the entire return (soft hurdle rate).

High watermark provision may also included in fee structure.

3.3.2 Other Considerations

Leverage has the effect of magnifying gains or losses because the HF can
take a large position relative to the capital committed.

HFs normally trade through prime brokers.

The
the margin requirement, the  leverage is available to the HF.

Redemptions can magnify losses for HF.

When drawdown occurs, investors may decide to exit the fund or
redeem at least a portion of their shares.

Redemption fees discourage redemption & help to recover
transaction costs.

Lock up period gives the HF manager time to implement & potentially
realize the expected result of a strategy.

FOFs may offer more redemption flexibility than afforded by direct
investment in HFs.

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2015, Study Session # 18, Reading # 60

3.4 Hedge Fund Valuation Issues

Valuations are important for calculating performance & meeting redemptions.

When market prices or quotes are used for valuation, funds may differ in which price
or quote they use:

Common practice use avg. quote.

Conservative practice use bid prices for longs & ask prices for shorts.

Any model should be independently tested, benchmarked & calibrated to industryaccepted standards to ensure a consistency of approach.

Liquidity discounts are necessary to reflect fair value.

Trading NAV incorporates liquidity discounts based on the size of the position
held.

Reporting NAV based on quoted market price.

3.5 Due Diligence for Investing In Hedge Funds

FOFs have an additional layer of fees.

Key due diligence factors include:

Investment strategy.

Investment process.

Competitive advantage.

Track record.

Size & longevity.

Management style.

Key person risk.

Reputation & plans for growth.

Systems risk management & investor relations.

4. PRIVATE EQUITY

There are different stages & types of PE investing.

The focus of PE firms may as business conditions & the availability of
financing change.

Categories of PE

Leveraged Buyouts

Venture Capital

LBO funds that acquire public

companies or established private
companies mainly through debt.

Assets of the target company serve as
the collateral for the debt.

After the buyout, the target becomes or
remains a privately owned company.

Invest or provide financing to private

companies with high growth potential.

VC can be provided at a variety of stages.

Development Capital

Distressed Investing

Minority equity investments in more

mature companies that are looking for
capital to expand or restructure operations

Buying the debt of mature companies in

financial difficulties.

Turnaround investors buy the
companys debt & plan to be more active
in the management & direction of the
company.

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2015, Study Session # 18, Reading # 60

4.1 Private Equity Structure and Fees

PE funds are typically structured as partnerships similar to HFs (outside investors
are LPs & PE firm as GP).

PE firms usually charge both a management fee & an incentive fee on a fund basis.

Management fees generally range from 1 to 3% of committed capital.

GP does not earn an incentive fee until the LPs have received their initial
investment back.

Claw back provision requires the GP to return any funds distributed as
incentive fees until the LPs have received back their initial investment & 80%
of the total profit.

4.2 Private Equity Strategies

4.2.1 Leveraged Buyouts

Management Buyouts (MBO) current management is involved in the acquisition.

Management buy-ins (MBIs) current management team is being replaced & the
acquiring team will be involved in managing the company.

Potential returns in this category are to a large extent due to the use of leverage.

4.2.1.1 LBO Financing

PE firms use debt to finance a significant proportion of each deal to  equity
returns & no. of transactions.

Typical LBO capital structure equity, bank debt & high yield bonds.

Mezzanine financing (MF) debt or preferred shares with a relationship to
common equity due to a feature such as attached warrants or conversion options.

Being subordinate to senior & high yield debt MF pays a higher coupon rate.

4.2.1.2 Characteristics of Attractive Target Companies for LBOs

Some characteristics of attractive target companies for LBOs include:

Depressed stock price.

Willing management.

Inefficient companies.

Strong & sustainable CF.

Low leverage & significant amount of physical assets.

4.2.2 Venture Capital

Portfolio Company the company that is being invested in & will
become part of the portfolio of the VC fund.

VC investors are actively involved in portfolio companies.

VC Fund Financing

Formative Financing

Company is in the process of being formed.

Angel investing capital provided at idea stage.

Seed-stage financing supports production development &
market research.

Early stage financing provide to companies moving
toward operation but before commercial production & sales
have occurred.

Later-Stage Financing

This financing is provided after
commercial production & sales have
begun but before any IPO.

Funds may be used for initial expansion
or major expansion.

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2015, Study Session # 18, Reading # 60

VC Fund Financing

Provided to prepare to go public.

Represents the bridge b/w the
expanding company & the IPO.

4.2.3 Other Private Equity Strategies

Several other specialties for PE firms include:

Minority equity investing.

Distressed investing purchasing the debt of a troubled company.

Distressed debt investors are called vulture investors.

Investing in companies in specific industries.

4.2.4 Exit Strategies

Ultimate goal for PE improve underperforming businesses & exit them at high
valuations.

Exit strategies:

Trade sale sale of a company to strategic buyer such a competitor.

IPO selling of shares to public investors through an IPO (highest price).

Recapitalization not a true exit strategy.

PE firm maintains control but allows the PE investor to extract money from
the company.

Popular strategy when IR is
.

Secondary sale sale to another PE firm or group of investors.

Liquidation occurs when transaction has not gone well.

4.3 Private Equity: Diversification Benefits, Performance, and Risk

Due to less than perfect correlation with traditional investments, PE
funds can add diversity to portfolio.

By identifying skillful PE fund managers, investors may benefit from
superior returns.

4.4 Portfolio Company Valuation

Approaches to PE Valuations

Market or Comparables Approach

Use multiples of different measures.

Large, mature private companies
EBITDA multiple.

Discounted Cash Flow Approach

Values a company or its equity as the PV
of the relevant expected future CF.

   =

  
 

Asset-Based Approach

Value of a company based on the values of its underlying assets
less the value of any related liabilities.

Value of the company to the equity holders.

Valuations can be arrived at using fair or liquidation values.

Liquidation value net amount that will be realized if
the business is terminated.

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2015, Study Session # 18, Reading # 60

4.5 Private Equity: Investment Considerations and Due Diligence

IR, capital availability expectations & refinancing risk must be
considered & evaluated.

PE investments are long-term illiquid investments.

5. REAL ESTATE

Direct or indirect equity investing in RE property such as land & buildings.

Debt investing in RE includes mortgage loans or MBS investing.

Reasons for investing in RE:

Competitive long-term total return potential.

Multiple year leases with fixed rents lessen CF impact from economic shocks.

Diversification benefits.

Provide inflation hedge if rents can be adjusted quickly for inflation.

Unique features of RE compared with other investment asset classes:

Indivisibility.

Unique characteristics.

Fixed location.

5.1 Forms of Real Estate Investment

Debt

Equity

Private

 Mortgages

Public

 Mortgage-backed securities (residential

and commercial)
 Collateralized mortgage obligations

 Direct ownership of real estate.

Ownership can be through sole
ownership, joint ventures, real estate
limited partnership, or other
commingled funds.
 Shares in real estate corporations
 Shares of real estate investment trusts

Reference: Level I Curriculum, Volume 6, Reading 66, Page 205

Leveraged ownership property title is obtained through an

equity purchase combined with mortgage financing.

Mortgage loans represent passive investments where the
lender expects to receive a predefined stream of payments.

5.2 Real Estate Investment Categories

5.2.1 Residential Property

Direct equity investment in a residence with the intent to occupy.

If purchase is partially financed, any (
) in the value of the home (
) the owners equity in the home.

Securitization provides indirect, debt investment opportunities in residential property.
5.2.2 Commercial Real Estate

Appropriate direct investment (equity & debt) for institutional funds or high-networth individuals with long time horizons & limited liquidity needs.

Direct investment requires active & experienced, professional management.

Lender conducts financial analyses to establish the creditworthiness of the borrower
before providing the debt financing.

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2015, Study Session # 18, Reading # 60

5.2.3 REIT Investing

Mortgage REITS risk & return characteristics similar to fixed income investments.

Equity REITS invest primarily in commercial or residential properties & employ
leverage.

Sources of return to equity REITS= rental income debt servicing.
5.2.4 Mortgage-Backed Securities (MBS)

MBS structure buying a pool of assets & assigning the income & principal returns
into individual security tranches for commercial MBS.

Collection of Assets

Combination of Funding

Assorted Securities
Investment-Grade
CMBS 60%-70%

Real
Estate
Asset

Debt
70%-75%

High-Yield
CMBS
5%-10%

Property
Owners Equity
25%-30%
Pool of
Properties

Pool of
Loans

BB Rated
B Rated
Unrated
Property Owners
Equity 25-30%
Commercial MortgageBacked Securities

Reference: Level I Curriculum, Volume 6, Reading 66, Page 208

5.2.5 Timberland and Farmland

Timberland offers an income stream based on the sale of timber products as a component of total return
(low correlation with other asset classes).

Flexible investment harvest more trees when timber prices are up & delaying harvests when prices
are down.

Farmland perceived to provide an inflation hedge.

Returns related to harvest quantities & agricultural commodity prices.

Two main property types:

Row crops planted & harvested annually.

Permanent crops grows on trees or vines.

Little flexibility in harvesting as compared to timberland.
5.3 Real Estate Performance and Diversification Benefits

RE index can generally be categorized as an appraisal index, transactions-based index
or a REIT index.

Appraisal indices use estimates of value as inputs to the indices.

Rely on comparable sales & CF analysis techniques.

These indices understate volatility because appraisals are done periodically.

Transactions-based indices use repeat sales of properties to construct the indices.

Sample selection bias.

Higher the no. of sales the more reliable & relevant is the index.

REIT indices use the prices of publicly traded shares of REITS to construct the
index.

Index may not represent the properties of interest to the investor.

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Last
Loss

First
Loss

2015, Study Session # 18, Reading # 60

5.4 Real Estate Valuation

Comparable Sale Approach

Income Approach

Approximate value based on recent sales

of similar properties.

Adjustments are made for differences in
key characteristics of property
condition, age, location & size.

Direct capitalization approach

Estimates the value of an income
producing property based upon the
level & quality of NOI.

NOI income to the property after
deducting operating exp (property tax,
insurance, maintenance utilities &
repairs) but before depreciation,
finance cost & income tax.

Cost Approach

Evaluates the replacement cost of the
property by estimating the value of land
& the costs of rebuilding using current
construction costs & standards.

  

 =



 

Cap rate discount rate-growth rate

Discounted CF approach discounts
future projected CFs to arrive at a PV of
the property.

5.4.1 REIT Valuations

Income Based Valuation

Asset Based Valuation

Typically similar to direct cap approach.

Funds from operation (FFO) & adjusted FFO
are used as measure of income.

FFO = NI + Dep gains (loss) from sale of RE
property.

AFFO adjusts the FFO for recurring capex.

This approach calculates a REITs NAV.

REITs NAV = Estimated MV of REITs total
assets value of its total liabilities.

REIT shares are often traded at value other
than NAV per share.

5.5 Real Estate Investment Risks

RE investment may fail to perform in accordance with expectations.

Other risks include:

Change in govt regulation.

Ability of fund management to select finance & manage real properties.

Leverage magnifies the impact of gains & losses.

6. COMMODITIES

Commodities physical products.

Return based on in price rather than on an income stream.

Most commodity investors trade in commodity derivatives to avoid storage &
transportation costs associated with holding the underlying commodity.

Commodities include precious & industrial metals, energy products & agri products.

Commodity derivatives may be attractive to investors because these investments
provide an inflation hedge & diversification benefits.

6.1 Commodity Derivatives and Indices

Commodity derivatives include futures, forwards, options & swaps.

Commodity indices typically use the price of futures contracts on the commodities included in them
rather than the prices of the commodities themselves.

Commodity indices vary in the commodities included in them & the weighting methods used.

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2015, Study Session # 18, Reading # 60

6.2 Other Commodity Investment Vehicles

Alternative means of achieving commodity exposure include:

ETF suitable for investors who can only buy equity shares or seek the
simplicity of trading them.

Common stock of companies exposed to a particular commodity.

Managed futures funds.

Individual managed accounts.

Funds that specialize in specific commodity sectors.

6.3 Commodity Performance and Diversification Benefits

Arguments for investing in commodities include:

Potential for return investors believe prices will  in the short or medium
term.

Portfolio diversification commodities behaved differently during the business
cycle from stocks & bonds.

Inflation hedge commodity prices affect inflation calculations.
6.4 Commodity Prices and Investments

Commodity spot prices are a function of:

Supply & demand.

Cost of production & storage.

Value of users.

Global economic conditions.

The inability of suppliers to quickly respond to changes in demand levels may results
in supply levels that are too low in times of eco. growth & too high in times of eco.
slowing.

6.4.1 Pricing of Commodity Future Contracts

The price of a commodity futures contract may be approximated by the following
formula

 

 1 +  +     convenience 
where
r = periods short term risk free rate.
Convenience yield yield related to convenience of having physical possession of
the commodity.

Contango (backwardation) futures price > (<) spot price & commodity forward
curve is upward (downward) sloping.

Source of return for commodity futures contract:

Roll yield Diff. b/w the spot price of a commodity & the price specified in the
future contract.

Collateral yield interest earned on the collateral posted as a good faith
deposit for the futures contract.

Spot prices primary determinant is relationship between current supply &
demand.

7. OTHER ALTERNATIVE INVESTMENTS

Collectibles:

Tangible assets such as antiques & fine art, fine wine, rare stamps & coins,
jewelry & watches etc.

Provide no current income but potential for higher capital gains.

Highly illiquid.

No. of indices that provide information about returns to these investments.

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2015, Study Session # 18, Reading # 60

8. RISK MANAGEMENT OVERVIEW

8.1 Investment and Risk Management Process

The manger of an investment portfolio makes investment decisions consistent with
the portfolios established investment policies, taking risk into account.

Investor due diligence should be used to ensure portfolio risk is effectively managed
by the portfolio manager.

8.1.1 Risk Management Issues

Risks vary across alternative investments.

PE & HF may have long lockup periods.

Poor manager selection can create a lingering drag on the portfolio.
8.1.2 Risk Issues for Implementation

Investors should recognize that past performance is not necessarily
representative of future performance.

In case of illiquid investments, portfolio should be diversified
sufficiently to reduce the possibility of 100% loss.
8.2 Risk Return Measures

Sharpe ratio may not be the appropriate risk return measure for
alternative investments because measure of return & SD may not be
relevant & reliable.

Returns are overstated & volatility is understated in alternative
investments.

Alternative investment returns tend to be leptokurtic &
negatively skewed.

Downside risk measure (e.g. 
) focus on the left side of the return
distribution curve & Sortino ratio uses downside deviation as
opposed to standard deviation as a measure of risk.

8.3 Due Diligence Overview

A Typical Due Diligence Process
Organization:

Portfolio Management:

Operations and
Controls:

Risk Management:






















Experience and quality of management team, compensation, and staffing

Analysis of prior and current funds
Track record/alignment of interests
Reputation and quality of third-party service providers, e.g., lawyers, auditors, prime brokers
Investment process
Target markets/asset types/strategies
Sourcing of investments
Role of operating partners
Underwriting
Environmental and engineering review process
Integration of asset management /acquisitions/ dispositions
Disposition process, including how initiated and executed
Reporting and accounting methodology
Audited financial statements and other internal controls
valuationfrequency and approach(es)
insurance and contingency plans
Fund policies and limits
Risk management policy
Portfolio risk and key risk factors
Leverage and currencyrisks/constraints/hedging

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2015, Study Session # 18, Reading # 60

8.3 Due Diligence Overview
A Typical Due Diligence Process
Legal Review:

Funds Terms:












Fund structure
Registrations
Existing/prior litigation
Fees (management and performance) and expenses
Contractual terms
Investment period and fund term and extensions
Carried interest
Distributions
Conflicts
Limited partners rights

Reference: Level I Curriculum, Volume 6, Reading 60, Exhibit 20.

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