l2 flash cards alternative investments - ss 13

Study Session 13, Reading 38

Type of Real Estate Investments

Main value determinant: Land appreciation which depends on location, zoning and planning

Investment characteristics: Passive, illiquid, cannot generally be leveraged, capital gains taxes

Principal risks: No ongoing income, uncertainty in appreciationMost likely investors: Speculators, long term investors

1. Raw Land


Type of Real Estate Investments (cont.)

Main value determinant: Number of rental units which depends on location, economic growth, prestige and convenience

Investment characteristics: Periodic income as well as appreciation, relatively liquid, can be leveraged, hedge against inflation

Principal risks: Quality property management is needed, competition from single family homes

Most likely investors: Those who desire tax shelter

2. Residential Rentals (Apartments)



Main value determinant: Location, economic growth, prestige, perceived status and tenant mix

Investment characteristics: Periodic income as well as appreciation, relatively liquid, can be moderately leveraged

Principal risks: Quality property management is needed, obsolescenceMost likely investor: High income individuals, firms with capital resources,

public and private entities

3. Office Buildings



Main value determinant: Industrial and commercial activity, support to changing material handling property

Investment characteristics: Very passive, moderately liquid, modest leveraged, periodic income more important

Principal risks: Prone to oversupply, obsolescenceMost likely investors: Investors that determine high cash flows and tax

shelter

4. Warehouses



Main value determinant: Local population income, lease agreements, tenant mix, convenience

Investment characteristics: Active management, low liquidity, moderate leveragePrincipal risks: Difficult lease negotiations, obsolescence, development of

competing commercial propertiesMost likely investors: Investors that can make the initially high equity investment

and desire tax shelter

5. Community Shopping Centres



Main value determinant: Tourist and business travel, ability to hold conventions and business meetings

Investment characteristics: Active management, poor liquidity, poor leveragePrincipal risks: Sufficient size needed to capitalize on economies of scale,

competing business, obsolescenceMost likely investors: Investors that can make the initially high equity

investment and willing to manage the property

6. Hotels and Motels


How to Test Real Estate Investments

It will likely be a challenge to memorize all of the value determinates or principal risks for all of the types of real estate investments. Rather, you should focus on the logic behind them, which may tested in a single question as a part of case or fact pattern.


Real Estate: Characteristics, Classification, and Basic Segments

4 types of real estate investments:Private equity (direct ownership)Publicly traded equity (indirect ownership)Private debt (direct mortgage lending)Publicly traded debt (mortgage-backed securities)


Real Estate: Characteristics, Classification, and Basic Segments (cont.)

Characteristics of Real Estate InvestmentsEvery property is uniqueBasically indivisible.Needs to be managed in a hands-on manner.Transaction costs are highThey depreciate and their value may change accordinglySensitive to interest ratesNo public exchange exists for the tradingNo national, or international auction market


Benefits of Equity Real Estate Investments

Current incomePrice appreciation (capital appreciation)Inflation hedgeDiversificationTax benefits


Risk Factors of Real Estate InvestmentChanges in business conditions Long lead times for new developmentCost and availability of capital can make real estate prices fluctuateUnexpected inflationDemographics may change Lack of liquidity Environmental issues


Valuing Real Estate Investments

The inputs needed to evaluate real estate investments are the cash flows after taxes (CFAT) for each year in the investment holding period and the equity reversion after taxes (ERAT) associated with the sale of the property

NPV and IRR are used in making real estate investment decisions


Valuing Real Estate Investments: Different Approach

Income Approach - calculates a property's value as the present value of all its future income.Cost Approach - Value is derived by adding the value of the land to the replacement cost of a new building, less an adjustment

for estimated depreciation and obsolescence.Steps involved with applying the cost approach:

1. Estimate the market value of the land.2. Estimate the building's replacement cost.3. Deduct physical deterioration, functional obsolescence, locational obsolescence, and economic obsolescence. Sales Comparison Approach - the sales prices of similar (comparable) properties are adjusted for differences with the

subject property.


Due Diligence in Real Estate Investment

Due diligence - used to investigate factors that might affect the value of a property before an investor makes the final investment decisionFactors:leases and lease historyoperating expensesenvironmental issues;structural integritylien, ownership, and property tax historycompliance with relevant laws and regulations


Private Equity Real Estate Investment Indices

Real estate indices are used to track the performance of private real estate.Appraisal Based Indices - Properties do not transact very frequently. Hence, some valuation indices rely on appraised

property values.Transaction Based Indices - transaction price reflects the real market value of a property.

Types: Repeat Sales Index - requires repeat sales of the same property Hedonic Index - requires one sale of a property


Private Market Real Estate DebtDecrease equity exposure.Allow for the tax deductibility of interest.Positive leverage.

Before and after tax returns to equity are greater with than without debt. As long as debt costs are less than equity, it takes less than its proportionate share of a property’s cash flow.


Use of LeverageInvestors use debt financing (leverage) to increase returns. As long as the investment return is greater than the interest paid to lenders, there is positive leverage and

returns are magnified.Leverage results in higher risk.


Maximum Allowable DebtRatios used by lenders to determine the maximum amount of allowable debt:

Loan to Value (LTV): Mortgage amount / Appraised value of the property.Debt service coverage ratio (DSCR): NOI/Debt service. A DCSR of 0.90 would mean that there is only enough net operating income to cover 90% of annual debt

payments.

Equity investors calculate these ratios:Equity dividend rate: annual cash flow/cash initiated invested in the property.If the leverage is positive, the leveraged IRR is always greater than the unleveraged IRR.


Calculation of after tax cash flow and after tax equity reversion

Step 1 - Compute taxes payable Taxes = (net operating income (NOI) – depreciation – interest) × tax rate where tax rate = equity investors marginal income tax rateStep 2 - Compute cash flow after taxesStep 3 – Compute equity reversion after taxes (ERAT)

ERAT = selling price – selling costs – mortgage balance – taxes on saleStep 4 – Calculate NPV and IRR to help arrive at the investment decision


Recaptured Depreciation

- Represents depreciation that was taken in anticipation of a decline in the value of an asset that ultimately did not materialize.


Investment Decision RulesThe net present value (NPV) decision rule is to accept an investment if its NPV

≥ 0.The internal rate of return (IRR) decision rule is to accept an investment if its

IRR ≥ the investor’s required rate of return or some other stated hurdle rate.If there is a conflict between IRR and NPV, select the investment with the

higher positive NPV.


Income property appraisal using Capitalization RateThe valuation methodology whereby the market value of income-producing property is calculated by capitalizing

the annual net income generated by the property at an overall capitalization rate is known as direct capitalization.The market value under the direct capitalization method can be calculated as:

MVo = NOI / RoWhere MVo is market value

NOI is annual net income Ro is the capitalization rate necessary to attract investorsThe capitalization rate represents the required rate of return, or yield, on real estate, less the possibility of capital

appreciation.


Three Methods Used to Estimate Market Capitalization Rate (Ro)1. Market Extraction - useful for income generating property when sales data is available:

Ro = NOI / MVo

2. Band of Investment - useful for properties financed with debt and equity

Ro(BOI) = weighted mortgage cost + weighted equity cost

3. Built Up - can be used to separate various components of the capitalization rateR0(BU) = pure rate + liquidity premium + recapture premium + risk premium


Direct Capitalization Methoddirect capitalization method - , the value of a property is equal to Net Operating Income(NOI) divided by the

capitalization rate.

NOI value =Vo = NOI / Capitalization rateNet operating income (NOI) equals the amount left after subtracting vacancy and collection losses and property

operating expenses from an income property's first year gross potential rental income.The capitalization rate is a growth implicit rate.

Cap rate = Discount rate - Growth rate


Discounted Cash Flow MethodDCF method - the future cash flows, including the capital expenditures and terminal value, are projected over the

holding period and discounted to present using the discount rate.

Project the NOI for each year of a holding period.Project resale price at the end of the holding period.Discount the NOI and resale price to get present value.Value = NOI/(r-g)


Income property appraisal using Gross Income Multiplier (GIM)

The GIM approach to value relates total annual income to market value:Indicated market value = Gross income x Market-derived Gross

Income Multiplier

The Gross Income Multiplier is derived by looking at the sales prices of comparable properties, divided by their respective gross annual incomes.


Limitations of Direct Capitalization Approach

Difficult to select appropriate capitalization rate without adequate data.

Only applicable for income-generating properties.


Limitations of Gross Income Multiplier

Sales prices (for comparables) may not be current.Rental income may not be available.Gross rents may be inaccurate when building-to-land ratios and building ages are different.Sale prices may be affected by factors that render the gross income multiplier inaccurate unless comparables are exposed to these same factors.Not useful for unique properties or properties that produce benefits instead of income.


How to Test the Application of Ratios to Perform Valuation

The application of ratios to perform valuation may look simple, but the concepts of the capitalization and Gross Income Multiplier methods may be combined with the calculation of after tax cash flow and after tax equity revision (discussed in earlier readings). For example, you may be asked to calculate Net Operating Income, before you can apply the concept of capitalization rate for the valuation of real estate property


Principal Types of SecuritiesTypes of Securities1. Real estate investment trusts (REITs) Types of Publicly Traded REITs Equity REITs Mortgage REITs

2. Real estate operating companies (REOCs) 3. Mortgage-backed securities (MBS)


Advantages of REITSSuperior liquidity in small and large amounts. Greater potential for diversificationAccess to a superior quality and range of properties. The benefit of management services. Limited liability. The ability to use shares as tax-advantaged currency in making acquisitions. Protection accorded by corporate governance, disclosure, and other

securities regulations. Exemption from income taxation within the REIT if prescribed

requirements are met.


Disadvantages of REITSThe costs of maintaining a publicly traded corporate structure. Pricing determined by the stock market and returns that can

be volatile. Potential for structural conflicts of interest. Tax differences compared with direct ownership of property

that can be disadvantageous under some circumstances.


Real Estate Investment Trust (REIT) Shares

Economic Value Determinants GDP growth job creation retail sales growth population growth new space supply and demand


Real Estate Investment Trust (REIT) Shares (cont.)

Investment CharacteristicsExemption from income taxes at the corporate/trust level.High income distributions.Relatively low volatility of reported income.More frequent secondary equity offerings compared with

industrial companies.



Due Diligence ConsiderationsIn assessing the investment merits of REITs, investors analyse:

the effects of trends in general economic activityretail salesjob creationpopulation growthnew supply and demand for specific types of space



Due Diligence Considerations They also pay particular attention to

occupanciesleasing activitiesrental ratesremaining lease termsin-place rents compared with market rentscosts to maintain space and re-lease spacetenants’ financial health and tenant concentration in the portfoliofinancial leverage, debt maturities and costs, and the quality of management


Use of Net Asset Value Per Share (NAVPS) in REIT Valuation

Analysts use different methods to estimate NAV leading to variation in estimates.

The most common method is to capitalize NOI using the cap rate.Net asset value (NAV) = REIT Assets Value - REIT LiabilitiesMAVPS = NAV/No. of shares outstanding.

Adjustments are needed to exclude some "soft" assets (e.g. goodwill) liabilities (e.g. deferred tax liabilities).

The market price of a REIT may not be the same as its NAV.


Use of Funds from Operations (FFO) in REIT Valuation

Funds from Operations (FFO) - a measure of cash flow available to the REIT for distributions to shareholders.

FFO is calculated by adding back depreciation and amortization and other non-cash deductions to earnings.

1. Start with GAAP net income, then:2. Add back: depreciation expense.3. Add back: deferred tax charges.4. Deduct: Net gains from property sales and extraordinary items.5. FFO = Aggregate NOI – Interest


Use of Adjusted Funds from Operations (AFFO) in REIT Valuation

The adjusted funds from operation (AFFO) are equal to the REIT's funds from operations (FFO) with adjustments.

AFFO: Funds available for distribution.

1. Start with FFO, then:2. Deduct: recurring capital improvement expenditures.3. Adjust for: straight-line rents.


Sources of Value Creation in Private Equity

Some private equity firms have developed effective re-engineering capabilities.Many private equity firms have in-house staff which can share their expertise and contacts with portfolio firm management.Only a part of value added created by private equity houses may be explained by superior reorganization and re-engineering

capabilities.

1. Value Creating by re-engineering of companies


Sources of Value Creation in Private Equity (cont.)

Use of debt is thought to make private equity portfolio companies more efficient.The requirement to make interest payments forces the portfolio companies to use free cash flow more efficiently

because interest payments must be made.

2. Value Creating by favourable access to credit markets


Sources of Value Creation in Private Equity (cont.)

Private equity investors can align the interests of investors and managers by specifying the appropriate control mechanisms in the investment contract of managers. For example: Compensation: Managers of the portfolio companies receive compensation that is closely linked to the firm’s performance Tag-along, drag-along clauses: Anytime an investor acquires control of the company, they must extend the acquisition offer to all shareholders Board representation: The private equity firm is ensured control through board representation

Non compete clauses: Company founders must sign clauses that prevent them from leaving and competing against the firm Priority in claims: Private equity firms receive their distributions before other owners

Required approvals: For changes of strategic importance

3. Value Creating by alignment of interests


Buyouts and Venture Capital InvestmentsRelative to buyout firms, venture capital portfolios contain immature firms with risky prospects and cash flowsVenture Capital portfolio firms often require substantial fundingThe returns on venture capital often come from a small number of highly successful investments.


Types of BuyoutsBuyouts include takeovers, management buyouts (MBOs), and leveraged buyouts (LBOs).The financing of a LBO typically involves senior debt, junk bonds, equity, and mezzanine finance.The LBO model has three main inputs:

The target firm’s forecasted cash flows The expected returns to the providers of the financing The total amount of financing

Mezzanine finance is a hybrid between debt and equity and can be structured to suit each particular transaction.


Differences between Buyouts and Venture Capital Investments

Whereas a venture capital firm may have a specialized industry focus , LBO firms generally invest in a portfolio of firms with more predictable cash flow patterns.Venture capital firms seek revenue growth, whereas buyout firms focus more on EBIT or EBITDA growth. Buyout firms typically conducts a full blown due diligence approach before investing in the target firm.Venture capital firms tends to conduct primarily technology and commercial due diligence before investingBuyout firms monitor cash flow management, strategic, and business planning. Venture capital firms monitor achievement of milestones defined in the business plan and growth

management.


Valuation Methods in Private Equity

Discounted cash flow (DCF) analysis - most appropriate for companies with a significant operating historyRelative value or market approach applies a price multiple, such as the price earnings ratio. Real option analysis - applicable for immature firms.Replacement cost of the business - generally not applicable to mature firms.Other potential methods are the venture capital method and the leveraged buyout method.


Important considerations when valuing Private Equity

Control Premium: In buyouts, the private equity investors typically have complete controlCountry Risk Premium: When valuing firms in emerging markets, country risk premiums may be addedMarketability and illiquidity discounts: Refer to the ability and right to sell the firm’s shares.


Use of Price Multiples in Private Equity Valuation

Many investors use market data from similar publicly traded firms.Price multiples from comparable public firmsIt is often difficult to find public firms at the same stage of development, the same line of business, the same capital structure, and the same risk profile.


Use of DCF in Private Equity Valuation

The beta and the cost of capital can be estimated from public firms, while adjusting for differences in operating and financial leverage between the private and public comparables.A terminal value is calculated using a price multiple of the firm’s EBITDA.


Use of Exit Value in Private Equity Valuation

The purpose of calculating the exit value is to determine the investment’s internal rate of return sensitivity in the exit year.

The exit value can be viewed as:Exit value = Investment cost + earnings growth

+ increase in price multiple + reduction in debt


Alternative exit routes and impact on value

IPO: In an IPO, a firm’s equity is offered for public sale.Advantages: Usually results in the highest exit value due to increased liquidity, greater access to capital, and the potential to hire better quality managers. Most appropriate for firms with strong growth prospects and a significant operating history and size.

Secondary market sale: The firm is sold to another investor or to another firm interested in the purchase for strategic reasons. Advantages: Second highest firm values after IPOs


Alternative exit routes and impact on value (cont.)

Management Buyout: The firm is sold to management which employs a large amount of leverage. Advantages: Management usually has a strong interest in the subsequent success of the firm.

Liquidation: Outright sale of firms assets


Role of Exit Timing in Private Equity Valuation

Exit multiples become uncertain if the exit time horizon is more than a couple of years and stress testing should be performed on a wide range of possible values.


Limited Partnership and other key features of fund structure

Limited partners (LPs) provide funding and do not have an active role in the management of the investments. The general partner (GP) in a limited partnership is liable for all the firm’s debts and, thus, has unlimited liability.The general partner (GP) is the manager of the fund. Most fund structures are closed end, meaning that investors can only redeem the investment at specified points in time.


Duration of Private Equity Funds

Have a duration of 10–12 years, which is generally extendable to an additional 2–3 years. The typical stages are:

Marketing (1-2 years): commitment by investors Draw down or investment (3-5 years) Realisation of returns and exit (3-5 years): cash flows are returned back to investors Extension (2-3 years)


Economic Terms of a Private Equity Fund

Management fees - represent a percentage of committed capital paid annually to the general partner during the lifetime of the fund.Transaction fees - fees paid to GPs in their advisory capacity when they provide investment banking services.Carried interest - represents the general partner’s share of profits generated by a private equity fund (typically 20%). Ratchet - a mechanism that determines the allocation of equity between shareholders and the management team.Hurdle rate - the internal rate of return that a private equity fund must achieve before the GP receives any carried interest (typically 7-8%).Vintage year - the year the private equity fund was launched


Corporate Governance Terms of a Private Equity Fund

Key man clause - Under this, a certain number of key named executives are expected to play an active role in the management of the fund. Clawback provision - requires the GP to return capital to LPs in excess of the agreed profit split between the GP and LPs.Distribution waterfall - a mechanism providing an order of distributions to LPs first before the GP receives carried interest.

deal-by-deal waterfalls allow earlier distribution of carried interest to the GP after each individual deal total return waterfalls result in earlier distributions to LPs as carried interest is calculated on the profits of the entire portfolio

Tag-along, drag along rights - contractual provisions in share purchase agreements that ensure any potential future acquirer of the company may not acquire control without extending an acquisition offer to all shareholders.


Corporate Governance Terms of a Private Equity Fund (cont.)

No-fault divorce - A GP may be removed without cause, provided that a super majority (generally >75%) of LPs approve that removal.Removal for “cause” is a clause that allows either a removal of the GP or an earlier termination of the fund for reasons such gross negligence of the GP, a “key person” event, a felony conviction of a key management person, bankruptcy of the GP, or a material breach of the fund prospectus. Investment restrictions generally impose a minimum level of diversification of the fund’s investments, a geographic and/or sector focus, or limits on borrowing.Co-investment - LPs generally have a first right of co-investing along with the GP.


General Private Equity Risk Factors

Illiquidity of investments: Private equity investments are generally not traded on any securities market.Government regulations: Investee companies’ products and services may be subject to changes in government regulations that adversely impact their business models.Competition for attractive investment opportunities: Competition for finding investment opportunities on attractive terms may be high. Reliance on the management of investee companies (agency risk): There is no assurance that the management of the investee companies will run the company in the best interests of the private equity holders.


General Private Equity Risk Factors (cont.)

Lack of investment capital: Investee companies may require additional future financing that may not be available.Lack of diversification: Investment portfolios may be highly concentrated and may, therefore, be exposed to significant losses.Other risk factors include risk due to unquoted investments, risk of loss of capital, uncertainty in valuation, and market risk (risk due to change in market conditions).


Costs associated with private equity investing

Transaction fees: Corresponding to due diligence, bank financing costs, legal fees for arranging acquisition, and sale transactions in investee companies.Investment vehicle fund setup costs: Comprise mainly of legal costs for the setup of the investment vehicle. Such costs are typically amortized over the life of the investment vehicle.Management and performance fees: These are generally more significant relative to plain investment funds. A 2% management fee and a 20% performance fee are common in the private equity industry.


Costs associated with private equity investing (cont.)

Dilution costs: Additional rounds of financing and stock options granted to the portfolio company management will result in dilution. Placement fees: Placement agents who raise funds for private equity firms may charge up-front fees as much as 2% or annual trailer fees as a percentage of funds raised through limited partners.Other costs associated with the funds are administrative costs and audit costs.


Financial Performance of Private Equity Funds

Financial performance can be measured in quantitative and qualitative termsMeasuring performance is easier, comparing it is harder


Quantitative Measures of Performance

Internal rate of return (IRR): The return metric recommended for private equity by the Global Investment Performance Standards (GIPS). Gross IRR: The IRR can be calculated gross or net of fees. Gross IRR reflects the fund’s ability to generate a return from portfolio companies. Net IRR: Net IRR is the relevant measure for the cash flows between the fund and LPs and is therefore the relevant return metric for the LPs. PIC (paid-in capital): This is the capital utilized by the GP. It can be specified in percentage terms as the paid-in capital to date divided by the committed capital.


Quantitative Measures of Performance (cont.)

DPI (distributed to paid-in capital): This measures the LP’s realized return and is the cumulative distributions paid to the LPs divided by the cumulative invested capital.RVPI (residual value to paid-in capital). This measures the LP’s unrealized return and is the value of the LP’s holdings in the fund divided by the cumulative invested capital.TVPI (total value to paid-in capital). This measures the LP’s realized and unrealized return and is the sum of DPI and RVPI.


Qualitative Measures

The realized investments, with an evaluation of successes and failures.The unrealized investments, with an evaluation of exit horizons and potential problems.Cash flow projections at the fund and portfolio company level along with fund valuation statements, NAV, and financial statements.


Benchmarks

Public Market Equivalent (PME) was proposed by Austin Long and Craig Nickles in the mid-1990s as a solution to benchmarking issues.PME is the cash-flow-weighted rate of return of an index (S&P 500 or any other index) assuming the same cash flow pattern as a private equity fund. It is thus an index return measure.


Pre Money Value and Post Money Value

At the time of a new investment in the firm, the discounted present value of the estimated exit value, PV (exit value), is called the post-money value.POST = PV(exit value)

The value before the investment is made can be calculated as the post-money value minus the investment amount and is called the pre-money value.PRE = POST – INV


Two Methods to Compute Fraction of VC Ownership

1. First method is the NPV methodf = INV/ POST

INV = amount of new investment for the venture capital investmentPOST = post-money value after the investment = exit value / (1+r)n

2. Second method is the NPV methodf = FV (INV) / exit value

FV(INV) = future value of the investment in round 1 at the expected exit date

exit value = value of the firm upon exit


Calculation of Price Per Share

Number of shares issued to the VC(sharesVC) is calculated based on the number of existing shares owned by the firm founders prior to investment (shares Founders).

SharesVc = Shares Founders (f/ (1-f)

Price per share at the time of the investment (price) is then simply the amount of the investment divided by the number of new shares issued.Price = INV / (SharesVc)


Calculation of Price Per Share (cont.)

If there is a second round of financing: first calculate the proportion of the firm (f2) purchased for the second round of financing

f2 = INV2 / POST2

second calculate the fractional ownership from the first round of financing asf1 = INV1 / POST1

where POST1 = PRE2 / (1+r1)n1

finally compute number of shares issued and price per share in each round as:SharesVc1 = Shares Founders (f1/(1-f1))

Price1 = INV1/(SharesVc1)

SharesVc2 = Shares Founders (f2/(1-f2))

Price2 = INV2/(SharesVc2)


Interest Alignment Between Private Equity Firms and Managers of Portfolio Companies

IncentivesIncentives that motivate managers to "behave like owners“:Manager's compensation tied to the company's performance.Priority in claims. Earn-outs.


Interest Alignment Between Private Equity Firms and Managers of Portfolio Companies (cont.)

Contractual StructuringEffective contractual structuring is achieved by:Board representation by private equity firm.Tag-along, drag-along clausesNon-compete clauses required for company founders.Required approval by PE firm for changes of strategic importance.


Alternative Exit Routes in Private Equity

1. Initial Public Offering (IPO) - shares of the company are offered to the public

2. Secondary market - the company is sold to other investors 3. Management Buyout (MBO) - buyers are managers of the company4. Liquidation of the company


DPI, RVPI and TVPIFee and Asset ValueDPI(Distribution to Paid-In Ratio) - measures the ratio of distributions to the limited partners

compared to the amount of capital contributed by the limited partnersRVPI(Residual Value to Paid-In Ratio) - measures the net asset value of the funds (unrealized

gains), compared to the amount of capital contributed by the limited partners.

Realization RatiosTVPI(Total Value to Paid-In Ratio) - DPI and RVPI added together


Post Money Valueand Ownership Fraction

The post-money value of the company is calculated by discounting the estimated exit value for the company to its present value (exit value), as of the time the investment is made.

Ownership FractionThe required current ownership percentage given expected dilution is calculated as follows:

Required Current Ownership = Required Final Ownership / Retention Ratio


Alternative Methods to Account for Risk in Venture Capital

Two Approaches for Accounting for RiskThe discount rate is adjusted to reflect the risk that the company

may fail in any given year.Scenario analysis is used to calculate an expected terminal value,

reflecting different values under different assumptions.

liquidity riskunquoted investments riskcompetitive environment riskagency riskcapital risk

regulatory risktax riskvaluation riskdiversification riskmarket risk

General Private Equity Risk Factors


Two Methods to Assess the Risk of Investment

1. The discount rate is adjusted to reflect the risk that the company may fail in any given year:r*= {(1+r)/(1-q)} -1

where: r* =discount rate adjusted for probability of failurer = discount rate unadjusted for probability of failureq = probability of failure in a year

2. Scenario analysis is used to calculate an expected terminal value, reflecting different values under different assumptions.


Hedge Funds and Mutual Funds

Hedge funds typically use more leverage and derivatives than mutual funds

Disclosure requirements of hedge funds are not as strict as typical mutual funds

Hedge funds typically have longer lock up periods for investorsHedge funds typically have more performance focused fee

structures


Use of Leverage

Hedge funds often use leverage.Fixed income funds often use more leverage than equity

funds.The amount of leverage used often varies within a month with

leverage amounts usually changing more dramatically for fixed income funds.


Disclosure Requirements for Hedge Funds

Mutual funds are required to report to the U.S. Securities and Exchange Commission (SEC).

By choosing to not market their investments to the public and restricting fund investments to certain types of high-net-worth investors, hedge funds are exempt from disclosure requirements.

Hedge fund managers must still follow other laws determined by securities regulators


Lockup Periods for Hedge Funds

1. A “hard lockup” states that no provisions exist for the redemption of hedge fund investments for a stated period of time.

2. A “soft lockup” period suggests a minimum investment period, but investors have the ability to sell their shares before the expiration of the lockup period by paying a redemption fee, which is often in the range of 1–3%.

Popular lockup periods for hedge funds are one and two years, although three-year lockups are becoming more common.


Fee Structures for Hedge Funds

Hedge funds can earn both management fees and incentive fees. A typical management fee is 1–2% annually, based on the assets

under management. Incentive fees (also called performance fees) are calculated as a set

percentage of the profits on the underlying pool of assets.A hedge fund manager might earn 15–25% of profits in addition

to the management fee.Few mutual funds charge performance fees because U.S.

regulators require the fees to be symmetrical, meaning the investment manager must share equally in both gains and losses.


Types of Hedge Fund Strategies

Arbitrage-based funds - are short volatility exposures that lead to gains in quiet markets and losses in turbulent markets.

Convertible bond arbitrage strategies - purchase a portfolio of convertible bonds and take short positions in the related equity security.

Equity market neutral funds - seek to take a zero beta exposure to equity markets.

Event driven funds - focused on a single strategy, such as distressed investments or risk arbitrage. Distressed funds typically invest in debt securities of issuers currently in default

or expected to default soon. Risk arbitrage, or merger arbitrage, funds seek to predict the outcome of

announced corporate merger transactions.


Types of Hedge Fund Strategies (cont.)

Fixed-income arbitrage - invests with a positive income orientation that benefits from declining credit spreads.

Medium volatility hedge fund strategies - take both long and short positions, but these positions are not always designed as hedges.

Global macro funds - focus on long and short investments in broad markets, such as equity indices, currencies, commodities, and interest rate markets.

Long–short equity funds - very similar to that of equity market neutral hedge funds, except that long– short funds do not target a zero beta exposure to underlying equity markets.


Types of Hedge Fund Strategies (cont.)

Managed futures funds - managers are also called commodity trading advisers (CTAs), use a strategy dominated by systematic trend following that seeks to profit through the quantitative prediction of market trends.

Directional hedge fund strategies - the most volatile of all because little to no hedging activity is used.

Dedicated short bias funds - invest exclusively in the short sale of equity securities.


Reported Hedge Fund Performance

Hedge fund reporting suffers from biases such as survivorship bias and selection bias

Regression analysis can be used to assess hedge fund performance

Normality assumptions which are often the backbone of financial models, are often violated in the case of hedge funds

Since normality assumptions are violated, traditional models should be applied with care


Possible Biases in Performance Reports of Hedge FundsDifferences in fund weighting methodologyLack of reporting leads to selection bias or self-reporting biasSelection bias is closely related to backfill biasAnalysis which doesn’t consider the track records of non

surviving funds


Factor Models for Hedge Fund Returns

A regression is performed to determine the portion of risk derived from the market and the value added by the hedge fund manager.

The typical regression is:

Hedge fund return = Alpha + Risk free rate+ ∑ Betai * FactoriAlpha in this model is the total return of the hedge fund in excess

of the risk free rate and the included factor or market exposures. Most models use a multitude of traditional market factors, such as

local and global stock and bond indices, currency, and commodity market returns.


Non-normality in Hedge Fund Returns

Implicit assumption that investment returns are normally distributed and linearly related to asset class returns.

Unfortunately, many of these assumptions are violated when investing in hedge funds

Investors prefer a large mean and positive skewness of returns


Use of IndexesMarket indexes, hedge fund indexes, and positive risk-free

rates can be used as guidelines for hedge fund performance, but should not be used for the final assessment of manager performance.

If a manager performs outside of these benchmarks, the investor should investigate whether the manager has shifted her strategy, taken more risk, and/or is just lucky.


Theoretical Basis for Hedge Fund Replication

Hedge fund replication is based on the factor models and the concept of alpha–beta separation.

If traditional stock and bond market indices can explain the majority of hedge fund return variance, then investors may be able to replicate hedge fund returns by using index funds and swaps.


Types of Hedge Fund Replication StrategiesStatic weightsLong–short equity, emerging market, short selling, and

distressed strategiesNeutral, risk arbitrage, fixed-income arbitrage, convertible

bond arbitrage, global macro, and managed futures strategies.Hedge fund replication using factor models and liquid index

products


Difficulties in modelling hedge funds as part of portfoliosFor hedge funds given the survivor, selection, stale pricing,

and backfill biases inherent in hedge fund databases.Hedge fund performance can be quite dynamic, with

correlation, volatility, and beta exposures that can change significantly over time.

Hedge funds have asymmetrical beta exposures


Caveats in analysing hedge funds as part of portfoliosSome hedge fund styles are known to smooth returns, as well

as experience negative skewness and excess kurtosis.Investors need to determine whether the trading strategy is a

short volatility, convergence related, or event- risk-laden strategy in which future risks could potentially be larger than historical risk.

If mean–variance optimization is to be used to add hedge funds to traditional investment portfolios, constraints on the deterioration of skewness and kurtosis risks should be added to the optimization equation.


Advantages of Fund of Funds over Single Manager Hedge Funds

Funds of funds can reduce the standard deviation of a hedge fund portfolio.

Access a fund of funds portfolio with a minimum investment as low as $100,000.

May appreciate the due diligence performed by funds-of-funds managers.


Disadvantages of Fund of Funds over Single Manager Hedge Funds

Double layer of fees presents a high hurdle for funds of fundsFund of funds tend to have average performance.Fund of funds with proven alpha tend to have longer lives and

larger asset inflows


Types of Risks in Hedge FundInvestments

Beyond investment risks, hedge fund investors need to understand and manage a number of other risks. These include event risk, operational risk, leverage, and counterparty risks.

Given many of these risks tend to magnify investment risks, a global view of risk is very important for hedge fund investors and fund-of-funds managers.


Measures of Risks in Hedge Fund Investments

Because hedge fund returns are often not normally distributed, investors should evaluate a downside measure of risk. Maximum drawdown provides an estimate of the magnitude of the largest percentage loss (preferred

measure of risk) Value at Risk (VAR) provides both the amount of an expected largest loss as well as its probability.VAR is not preferred due to the following reasons: VAR is usually estimated using historical data, which is not indicative of future risk when a fund changes

its investment strategy over time. The interpretation of VAR is meaningful only when the return distribution is normal. Hedge fund returns

are rarely normally distributed. VAR is often computed assuming that component risks are additive, when in fact they can be

multiplicative.The Sortino ratio (similar to the Sharpe Ratio) uses the downside deviation and the minimum

acceptable return in place of the risk-free rate.

l2 flash cards alternative investments - ss 13

Business

real estate prices

likely investors

high equity investment

market value

cost approach value

propertys value

value determinates

securitiesstudy session