Trends And Topics In Alternative Investments

Sergey Rumyantsev, Ph.D., CFA Carlson Capital L.P.

June 2013

Disclaimer:

All materials and data are from publicly available sources

All opinions are personal

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Background: History and Classifications Of Alternative Investments

What Is Alternatives? Anything in the institutional investments markets beyond traditional stocks and bonds,

major alternative asset classes are (non-institutional “exotics” such as wine/luxury are excluded):

Hedge Funds: Original term comes from A.W.Jones who launched his first hedge fund in 1949 with his own

money after arguing in “Fashions in Forecasting” HBR article that it is impossible to predict future, later on

he allowed other investors to join and pay management and incentive fees. Current types include: macro,

equity L/S, distressed, FI arbitrage, event-driven, CTA, market-neutral, quant, volatility, other

(structured products)

Private Equity: KKR founders are regarded as pioneers of traditional LBO-based model (Orkin buy out deal,

1964) which was expanded into LBO, growth capital, mezzanine capital, turnaround/distressed

Venture Capital: in 1946, 2 first VC companies – American Research and Development Corporation and

J.H.Whitney and Co were created around future Silicon Valley area, currenlty classified by stages of

investment – angel, early-stage, late-stage

Real Assets: real estate, infrastructure, farmland, energy, maritime and commodities

Classification Of Alternatives By Directionality and Liquidity Profile (One Should Also Keep In Mind

Investment Capacity):

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Background: Investors’ Motivation In Alternatives

Why Invest In Alternatives – Early Movers? Yale Endowment Fund was one of the early pioneers, since 1970s

heavily allocating to non-traditional assets and massively outperforming public markets (25-30% IRR in PE):

Why Invest In Alternatives - Proponents?

Alternatives offer superior risk-adjusted returns

with lower correlation

Active managers do add value

Alternatives offer access to new investments

Why Invest In Alternatives - Opponents?

Performance data is noisy and does not include

survivorship bias, manager skills are more about

luck

Under efficient market theory most of alternatives

can be replicated, “alpha” in returns is actually

unknown “beta”

Typical U.S. Pension Fund Allocation

– up to 14-15% in Alternatives

4

Hedge Funds: State of The Industry

Already A Mature Industry? In 2013, HF assets are reaching 2.25 Tr USD with largest funds attracting most

of new capital, returns YTD are on average lagging equity markets by ~8-10%

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Hedge Funds: Recent Blow Ups

Examples Of Big Hedge Fund Scandals – Still Nothing Compared to Lehman Collapse:

LTCM and Misuse of Leverage: Greenwich, CT hedge fund that employed Nobel prize winner Merton

and Sholes, exploded in 1998 after Russian local debt default, recipe for disaster – 25X leverage and

expansion from its original FI arbitrage strategies in US into EM markets and equity volatility arbitrage

Madoff Case: Bernie Madoff was running the biggest in US history Ponzi scheme from 1960 to 2008 when

one of his sons revealed the truth. Estimated 18B USD losses to investors

Amarath Advisors And Natural Gas Single Bet Going Wrong: That was a Greenwich CT hedge fund

with 9B USD of assets that lost 6.5B on a single bullish bet in natural gas futures by Bruce Hunter.

Regulators charged fund and Hunter with market manipulation in 2007

Galleon Group and “Indian Circle”: Galleon was managing 7B USD at its peak before closing in 2009,

as its founder, Raj Rajaratnam, and 5 others were charged with insider trading. Raj is serving 11 years in

prison since 2011. Ex-McKinsey head, Rajat Gupta, is fighting a recent conviction decision

SAC Capital And Insider Trading Cases: 9 current and former traders of once one of the largest multi-

strategy hedge funds, 14B AUM SAC Capital, run by Steve Cohen, were convicted for insider trading. SAC

has been returning money in 2013 to outside investors to become a family office for Mr. Cohen.

Investigations continue

Flash Crash of 2010: at 2.45pm on May 6, 2010 Dow Jones dropped 9% to recover within few minutes.

The joint SEC report later identified that a large mutual fund upon mistake was trying to sell unusually large

number of shares of E-Mini S&P 500 contracts, and upon sell off of 3-4% chain reaction got triggered by

high-frequency trading robots that all started risk management/stop loss actions at the same time

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Selected Details on Investment Strategies

Event-Driven Investing: (most large managers

started in this area e.g. Paulson, Cohen)

Focus on catalysts/events: M&A, spin offs,

debt/equity buybacks, other

Binary outcome: creates a very low correlation

of returns to public markets

Key terms: deal spread (potential upside) –

typical range 100-300bps, deal closing date

Why does it work: historically 60-70% of

announced deals closed

Challenges: IT revolution removed information

asymmetry, M&A activity remains low

Long/Short Equity/Credit Investing: (SAC,

Millennium, Citadel, Highbridge)

Most Popular Strategy: 30-50% hedge funds

are involved in this

Manager Ability Is The Key: key premise is that

manager is able to buy cheap securities and sell

expensive ones

Is It Alpha Or Market Timing: No one knows for

sure as back-testing does not help in predicting

the future, managers are typically up to 20% net

long/short

Challenges: lack of knowledge of macro trends,

“crowding” of names (same research process)

Market Neutral Equity/Credit: (Carlson)

Focus on Alpha: no directional views, no net

exposures

Manager Ability Is The Key: again manager

claims that he/she can pick relative winners

Is It Alpha Or Noise or Carry: In the past, 2-

4% came from securities lending business

Challenges: in macro driven environment

correlations are very high, cost of trading

limits universe to most liquid securities

Macro Investing: (Soros, Bluecrest, Man, Winton,

Bridgewater)

Macro Bets in Most Liquid Markets: FX, Rates,

Futures

Soros Legacy: George Soros made macro

investing notoriously famous after crushing

British currency in 1992

Is It Macro or Geopolitics: It is both, investors

try to predict political events and trends as well

Challenges: In recent years most of market

moves were driven by political and QE decisions

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Selected Details on Investment Strategies (Continued)

Distressed Investing (Both Public and Private):

Debt Vultures: “distressed debt” is typically

defined as anything with 10%+ risk premium

Corporates – Activist Approach: typically,

funds are actively involved in restructuring

process, trying to capture value after buying in a

tier of debt (often secured debt)

Structured Products - Legacy Distress: After

2008, a large portion of US structured debt

markets was very discounted allowing niche

investors to capture price dislocations

Why does it work: for distressed deals, investor

demand is much lower due to legal and

operational complexity and illiquidity/complexity

Recent success stories: claims of Lehman and

Madoffs, Greek debt restructuring, CDOs

Challenges: outside of US, legal regimes can be

very different, proper restructuring often does not

happen

Large Investors: Lone Star, Cerberus, Oaktree,

Canyon, Centerbridge, Cerbesus, Third Point,

Silver Lake, Baupost, WL Ross, Blackstone,

KKR, TPG, Apollo, Fortress, Paulson

Quant Investing:

Math Geniuses Turn to Wall St: James

Simon from Renaissance Technologies

became a quant hero with 30%+ returns via

secretive computer strategies

Technology Race: Quant funds tend to

take pure data-driven approach and are run

by IT and physics people with no view on

economy, superior IT platforms is the key

competitive advantages

Self-Destructing Patterns: As the most

scalable strategy, quant traders tend to

mimic each other fast thus “arbitrage”

opportunities are self-depleted

Challenges: crowding out, more regulation

of high-frequency traders after market

failures (Flash Crash of 2010)

Large Investors: Renaissance

Technologies, DE Shaw, Two Sigma, AQR,

Getco

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Hedge Funds: Recent Returns Details – You Will Be Surprised

Most of recent top-performing hedge funds are in ABS/structured products with some in

global macro, while CTA (commodities) and short-bias funds lagged:

Barrons: Top Hedge Funds by 3-Year Annual Return

Fund Assets 3-Yr

Compound

2012 Total Firm

2012 2011 Fund Name (mil) Fund Strategy Annual Return Return Assets (mil)

1 1 Zais Opportunity Fund Class

B

$462 Structured Credit 52.39% 24.69% $5,400

2 N.R. Quantedge Global  488 Global Macro 50.07 39.46 488

3 N.R. Chenavari - Toro Capital IA

(Euro) 

362 Asset-Backed Securities 46.54 32.42 3,214

4 52 AQR Global Risk

Premium–Full Risk

400 Global Macro 39.2 40.8 70,700

5 2 Metacapital Mortgage

Opportunities Fund Ltd 

1,440 Mortgage-Backed

Securities

38.64 41.25 1,600

6 N.R. Hildene Opportunities Fund

Ltd 

655 Distressed Securities 30.62 45.46 1,070

7 N.R. STS Partners LP 652 Asset-Backed Securities 28.38 27.43 818

8 N.R. Asgard Fixed Income I Ltd

(Euro) 

348 Fixed-Income Relative

Value

26.57 34.12 348

9 N.R. SPM Core Ltd 1,831 Mortgage-Backed

Securities–Agency and

Non-Agency

25.88 19.65 3,708

10 9 VR Global Partners LP 1,816 Emerging

Markets/Distressed

25.53 20.62 1,816VR Advisory Services / Dubai

AQR Capital Management /

Greenwich, Conn.

Metacapital Management /

New York

Hildene Capital

Management / New York

Deer Park Road / Steamboat

Moma Advisors /

Copenhagen

Structured Portfolio

Management / Stamford,

Conn.

Rank

Company/Location

Zais Group / Red Bank, N.J.

Quantedge Capital /

Chenavari Investment

Managers / London

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Private Equity: Is It All About Financial Engineering?

History – Mega LBOs and Excessive Use Of Leverage (6-7X Debt/EBITDA, 1.5X HY markets and 2X IG

markets):

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Private Equity: Does Manager Caliber Matters? Yes, It Does

Investors Still Find Excess Returns in PE:

Academics find 150-250bps annually of average excess returns in PE funds, attributed to (i) access to larger

universe of private companies, (ii) usage of higher leverage and (iii) operational improvements

PE funds return dispersion is very high (20-25%) and persistent (top managers continue performing)

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Venture Capital: Out Of Favour Due To Low Returns

Venture Capital Funds – Low Chances of Success These Days:

Academic data shows less and less support for VC allocation with average returns in low single digits in

US and only top 5-10% of funds beating the markets with too much capital chasing a “new Facebook”

Kaufman Foundation 2012 critique report: most VC funds are not making money and try to charge

management fees, incentives are not aligned with new businesses creation

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“Real” Asset Investments: How Real is Real?

Real Assets – Tricky Definitions:

Broadly defined space - for any investable physical or inflation-protected assets: real estate/land, timber,

commodities, agriculture, maritime, infrastructure and TIPS – traditional claim is that those protect against

inflation and USD devaluation

Narrow definition – “real” cash flows: excludes commodities, gold, securities

Real estate – bulk of investment allocations: among real assets, real estate has the largest investment

capacity across the whole spectrum of funds (debt, income, opportunistic, value-adding, specialized –

office/retail/storage/multifamily, distressed)

Commodities – bets on inflation hedging and on gold being a “safe haven” have proven to be wrong:

commodity markets continue to be dominated by volatile spot markets and high leverage in derivatives, gold

has proven to be a tricky investment

Asset allocators (pension and endowment funds) are seeking “real” yields in the period of zero rates

and growth of population and consumption in EM, most of opportunities are private:

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Key Trends in Alternatives And Summary Points

Industry Is Maturing And Consolidation Is Under Way And HF/PE Difference Is Smaller: as at 15% of

investment universe (2Tr in HF, PE, RE industry each) and 60-70% of trading volumes and M&A deals

alternatives have become “the market”, and as regulation is more costly, large funds are getting larger while start

ups struggle. PE and HF “line” is crossed more and more with PE funds looking at public markets and vice versa

Hedge Funds – Winners Are Often Not Known In Advance But People Continue Looking At Past Results:

Past winners continue to be winners with only 51% probability according to Dr. Cochrane

In 2010-2012 best strategy was buying and holding distressed structured debt e.g. CDO, subprime, CMBS

In 2010, given lack of M&A activity and decline in commodities, risk arbitrage and CTAs did not perform

Recent market moves were dominated by big macro events – QE decisions by Fed and ECB

Hedge Funds – Is It Alpha or Beta?: Very hard to tell, as “alpha” is often a hidden risk factor, but academic

studies do show that hedge funds do better on risk-adjusted basis with lower correlation to the markets

Private Equity – Leverage is Back: as PE industry on average continues to show higher returns (thanks to high

leverage to a large extent), asset allocators continue chasing top performing funds as it has been proven that PE

track records are persistent. Mega LBO deals could be back soon with Dell deal, leverage is at historically high

levels as cheap financing in US is readily available and is again distributed via structured products

Venture Capital – A Lot of Talks, Not Delivering Returns: everyone wants to find/create a new Facebook but

abundance of capital chasing a limited number of winners has compressed returns, making VC funds on average

not attractive with only top 5% beating public benchmarks

Real Assets – Real Yielding Assets in Demand, Others Not: some “real” assets have been proven not to be so

real (gold), RE markets continue to dependent on macro and supply/demand for a specific region

Fees – Continue to Decline: Industry is no longer a 2/20 model (2% management fee, 20% incentive fee) but

rather a 1.5/15 average fees model, fees continue compressing given competition for capital

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CIS Alternatives: Domestic Long Term Capital Is Nowhere to Be Seen

Industry Structure – Challenging Limitations for Hedge Funds: predominantly selling Russian undervaluation

story vs EM peers via long-biased long only or L/S concentrated strategies

Liquidity constraints: 90%+ of liquidity concentrated in top 10 names, with Sberbank and Gazprom

capturing 50%+ liquidity (at 10-30M USD daily volumes, only 2-4 more names with 1M+ USD daily trading

volumes)

Markets are dominated by external capital flows: all “alpha” research can be overrun by a massive macro

shock and capital outflows as foreign capital dominates trading volumes at 80%+ and there is no local long-

term institutional capital

Information flows are not symmetric: a lot of second-tier names can have spikes of trading activity ahead

of events pointing out to insider activities

Danger of being an activist investor: Pushing for minority investors agenda has proven to be risky

Lack of clearing mechanisms in local FI markets: MICEX is finally moving to T+2 settlement and a

central creating platform

Selective examples of CIS HFs – survival rates are not high post 2008 crisis:

Verno Capital: created in 2009 by ex-Kazimir Partners people, long biased long/short strategy, reported

200M USD AUM, received 100M USD anchor capital contribution from a ME SWF in 2010

Altera Capital: created in 2010, long/short catalyst-focused equity strategy, reported 600M USD AUM in

hedge fund and private market strategies, reported 100M USD AUM in hedge fund strategy in 2011

Prosperity Capital: long-standing asset manager among its 3.8B USD AUM runs a number of long-only

Russia-focused funds in both blue chips and small cap/special situation stocks, some are considered HFs

VR Capital: with one of its offices in Moscow but not a sole focus on CIS, this fund predominantly invests in

various distressed situations in EM/globally, received top ranks for its recent performance

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CIS Alternatives: Do EM Hedge Funds Deliver Alpha?

Academic Evidence – Emerging Markets Hedge Funds Are Correlated to Markets: quite explainable by

market structure limitations and long-bias nature

Survivorship bias – much more present in EM: a large share of EM hedge funds have closed after large sell

offs, making industry data positive skewed. Lack of data is a general problem

Is This Alpha or Beta (This Fund Does Charge

Performance Fees)?:

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CIS Alternatives: Private Equity – A Rosier Picture For Best Funds

Private Equity Markets: CIS PE funds have tended to stay away from

commodities industry and focused on growing consumer via financials, IT,

retail, and RE investments. Industry was created in 1990s with involvement

of EBRD and USAID, and has 4 groups of participants:

state-related entities (RDIF, VTB, VEB)

captive multi-industry holdings (Onexim, Interos, ICT, A1, Millhouse)

EBRD and USAID-linked funds (New Russia Growth, Delta, others)

and independent PE funds of different vintages (Baring Vostok,

Russia Partners, UFG, Elbrus, Horizon Capital) including dedicated

RE funds (O1, Raven, Jensen)

Vintage Matters Much More Aside from Manager Itself: a lot of funds

were raised and invested at the peak of the market in 2007-2008 and never

recovered, most experienced and patient managers preserves capital and

track records and are able to raise new funds (Baring Vostok)

Not A Traditional LBO, More “Growth” Capital Mode: LBO/debt financial

engineering is less prevalent, a lot of investments are done pre-IPO stage

(e.g. MICEX) as otherwise it is challenging to find exits

Russian State – Much More Involved in 2012: Aside from state bank

investing internal capital (VTB), Russian Direct Investment Fund has been

increasingly active in investments and marketing of opportunities to foreign

funds

Track record – limited but high dispersion is prevalent: top funds have

achieved 20-25%+ IRRs for investors, bottom funds lost a lot after crisis

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Alternatives Use and Misuse: Few Case Studies

Biggest market losses tend to create biggest market opportunities (for others):

Lehman Principal Protected Notes – 80% loss vs 0% marketed: pre-2008 crisis, principal protected notes

was a popular sector allowing investors to get exposure to other markets (e.g. 50% equity market

participation) while supposedly have 100% principal protected. It was subject to counterparty credit risk, and

after Lehman collapse investors found themselves in the pool of unsecured creditors, recovering 20-30 cent.

At the same time, distressed investors made 50-100% returns buying Lehman claims at the lows

Greek debt restructuring of 2011-2012 – big losers, big winners: in the biggest ever sovereign debt

restructuring, Greek sovereign has been written off twice, wiping 90% of value for original investors. Hedge

funds stepped in and bought Greek debt after 2nd restructuring in 15-20 cents area and pushed EU/Troika to

offer exchange terms in the fall of 2012 at 100% above the cost

CDO and other structured products market – a lot of blame still goes around: pre-2008, in the period of

zero rates hunt for yield from investors and hunt for fees from Wall St led to a massive bubble of “re-

packaged” products CDO/CLOs/CMBS with investors buying AAA CDOs for 10-20bps spread pick up. Post

crisis, traditional investors lost 80-90% of value in those investments, while distressed debt funds allocating

to the asset class in 2009-2010, made 30-40% IRRs

Eurozone crisis and banking sector deleveraging: as PIIGS banks continue writing off assets,

distressed/PE funds are trying to buy those at heavy discounts and service NPLs better to extract value

Few observations:

Excess leverage is very dangerous as borrowed money can cause margin calls faster then you think

Investors often fail to understand products they invest in and marketing people are no better

Markets have short memory but panic faster then one can reposition

A lot of investors make decisions based on risk avoidance rather than returns seeking (“I’ll follow others”, “I

won’t get fired for investing in a famous fund”)

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Conclusion: Few Questions on Investments

Question 1: Would you invest in a Hedge Fund?

Yes: No:

Question 2: What investment strategy will work the best 2H 2013? Few options to be provided

Strategy:

Question 3: Would you want to create your own HF/PE/RE fund?

Yes: No:

Question 4: Will RUB depreciate during 2H 2013?

Yes: No:

Question 5: Will you prefer making 8% with certainty vs having 50/50 chances of making 20% or 0%?

Yes: No:

Question 6: What is your estimate for Moscow rental yields? Few options to be provided

Yield:

Question 7: Do you actively invest in financial markets?

Yes: No:

Question 9: Where would you buy RE right now? Few options to be provided

Location: