the fundamentals of alternative investments laney sanders, cfa assistant chief investment officer...
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The Fundamentals of Alternative InvestmentsLaney Sanders, CFAAssistant Chief Investment Officer LASERS
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1. Alternative vs Traditional Investments2. Types of Alternative Investments3. More On: Alternative Investments4. Fund of Funds vs Direct Funds5. Alternative Manager Selection6. Goals of Alternative Investing
Topics
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Include long positions in cash, bonds, and stocks. These are the most well known and widely used by investors.
A “non-traditional” asset. Encompass many different categories including:1. Real Assets2. Hedge Funds3. Commodities4. Private Equity
Alternative Assets vs Traditional Assets
What is a traditional asset?
What is an alternative asset?
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• A typical “financial asset” such as a bond, is a claim on a set of cash flows of a firm
• Whereas a real asset is the investment in an actual physical asset such as:• Real Estate: land and permanent improvements to the land• Timberland: trees (underlying land is not always part of the
investment)• Infrastructure: toll roads, utility companies, etc. Claim on the cash
flow generated by these assets. • Intellectual Property: copyrights, patents, trademarks, royalties, etc.
Types of Alternative Assets: Real Assets
Real assets are investments that directly control nonfinancial assets and represent actual rights to consumption rather than indirect financial claims on cash flows generated by the tangible assets of a firm
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• Classifications of hedge funds include: • Futures Funds: Macro and managed• Event Driven: Activist, Merger Arbitrage, Distressed, Event Driven
Multi Strategy• Relative Value Hedge Funds: Convertible, Volatility, Fixed Income,
Event Driven• Equity Hedge Funds: Long-Short, Market Neutral, Short Selling,
130/30• Fund of Funds: Hedge fund manager chooses and invests in
underlying hedge funds
Types of Alternative Assets: Hedge Funds
Hedge Funds are private investment vehicles that capitalize on various investment opportunities. Funds often use derivatives, leverage, short positions, and other strategies.
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• Commodity investments can take the form of:• Ownership of the physical commodity• Forward or futures contracts• Securities of commodity producing firms• Exchange traded funds (ETFs) – these provide passive commodity
price exposure
Types of Alternative Assets: Commodities
Commodities are standardized goods (metals, agriculture products, energy products, and building materials) delivered to markets by many producers in large quantities
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• Greater risk than public counterparts – more likely to achieve greater returns
• Willing to accept long term investment horizons and conduct extensive due diligence
• 5 types:• Venture capital• Leveraged buyouts (LBOs)• Mezzanine financing• Distressed debt investing• Special situations/opportunistic
Types of Alternative Assets: Private Equity
Private Equity includes debt and equity securities that are not publically traded
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Diversification• Many alternative products have low correlation to traditional assets• Allow reduced risk without significantly lowering return expectations
Illiquidity• Illiquidity refers to securities with infrequent trading and/or low volume
trading• Difficult to observe price and returns through trades• “Lumpy assets” are difficult to divide and can only be traded in certain
quantities• Illiquidity premium
Return Characteristics of Alternatives
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• Efficiency in markets means all available information is incorporated into asset prices
• Efficient market prices reflect highly competitive bidding process• Inefficiency indicates that prices are different than those expected from an
efficient market• Fewer participants, lower competition• Excess returns can be generated due to market inefficiency
Return Characteristics of Alternatives
Market Inefficiency
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Regulatory Structure• Privately organized and generally unlisted• Not heavily regulated – exempt from Investment Company Act of 1940 –
do not adhere to same filing and disclosure requirements and record keeping as mutual funds
• Must meet certain standards to invest such as “qualified purchaser” – net worth greater than $5 million for individuals or $25 million for institutions
Trading Structure• Private securities, real assets, derivatives, structured products, leverage,
long/shortIndustry Growth• $500 billion in 2000 to $1.8 trillion in 2010
More on: Hedge Funds
Primary Elements of Hedge Funds
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• Performance-based incentive fees that attract elite managers• Management fee – collected on a quarterly, semi-annual, or annual basis
• Collected regardless of performance (1% - 3%)• Performance fee – collected annually but only if fund is profitable (usually
20%)• High water mark provision – incentive fee only paid if NAV is above previous
NAV• Hurdle rate – incentive fee only paid after fund exceeds a set threshold
return
More on: Hedge Funds
Compensation Structure
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More on: Hedge Funds
Benefits of Hedge Funds
100% T-Bonds
50% S&P 500 50% T-Bonds
100% S&P 500
5%
7%
9%
11%
13%
15%
17%
19%
7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17%
Annualized Standard Deviation
Annualiz
ed R
ate
of
Retu
rn
Traditional Stock and Bond Portfolio
10% Allocation to AR Portfolio
20% Allocation to AR Portfolio
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• Long Position – owning a security• Short Position – selling a borrowed security (sell high, buy low)• Derivative – instruments which derive their value from an underlying asset• Alpha – value added or subtracted by a fund manager (above or below a
benchmark)• Beta – market driven performance• Leverage – increasing exposure to markets by borrowing and/or using derivatives• Absolute Return Fund – euphemism for a hedge fund/ these funds were supposed
to deliver “absolute returns” no matter what state the markets were in• Fund of Fund – a fund that aggregates investor money and invests in hedge funds
as opposed to stocks, bonds, and other assets
More on: Hedge Funds
Definitions
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More on: Hedge Funds
Traditional Funds vs Hedge Funds
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• Most managers do not want to share their positions• Provides the ability to evaluate and understand the manager’s
process/strategy• Institutions have asked for more transparency over recent years• Information usefulness• Many HFs now report to 3rd party risk aggregators (Measurisk and
RiskMetrics)
More on: Hedge Funds
Transparency
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• Usually a 6 month to 1 year initial lock up unless some event occurs (key man provision)
• Redemptions can usually occur every quarter with a 60 – 90 day notice• Gates/Suspensions• Side pocket investments
More on: Hedge Funds
Liquidity
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• Employed by HFs to magnify gains, but magnifies losses as well• Funds can employ different types of leverage
• Financial (borrowing)• Use of derivatives• Can these exposures be quantified and monitored?
More on: Hedge Funds
Leverage
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More on: Hedge Funds
StrategiesHedge Funds
Market Directional
Equity Long/Short
Emerging Markets
Short Selling
Activist Investing
Corporate Restructuring
Distressed Securities
Merger Arbitrage
Event Driven
Regulation D
Convergence Trading
Fixed Income Arbitrage
Convertible Bond Arbitrage
Equity Market Neutral
Fixed Income Yield Alternative
Relative Value Arbitrage
Opportunistic
Global Macro
Fund of Funds
Multi-Strategy
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• Like long-only traditional equity managers, these HFs will go long on the stocks they like
• Also go short• Stocks they do not like or• An ETF (S&P 500) or• An index future
• These managers tend to maintain a net long position • Shortcut: buy the good, sell the bad
More on: Hedge Funds
Equity Long/Short
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• Loose use of the word “arbitrage” by hedge fund managers• “The exploitation of security mispricing in such a way that risk-free economic
profits may be earned” • 1 security, 2 exchanges example
• In HF world, this usually means the purchase and sale of similar investments (not a risk free exercise)
• Empirical evidence suggests that corporations tend to overpay for acquisitions• The stock of the company being acquired will trade at a discount to the offering
price (reflects the risk of the deal not taking place)• Merger Arbitrage managers will short the stock of the acquirer and buy the stock of
the company being targeted• Spread must be sufficient to compensate for the possibility of deal failing • Shortcut: Short the acquirer, buy the target
More on: Hedge Funds
Arbitrage and Merger Arbitrage
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• Macro-economic approach/Global reach• These managers invest opportunistically across currencies, commodities,
equities, fixed income, derivatives, etc. in any country or market• Use other strategies under their umbrella (fixed income arbitrage, equity
long/short, etc.)
More on: Hedge Funds
Global Macro
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• Ability to invest in different strategies• Ability to shift capital across strategies to reflect their views on markets• Sometimes these funds will grow based on their “bread and butter” and
then branch into other strategies• Use other strategies under their umbrella
More on: Hedge Funds
Multi-Strategy
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• Hedge fund managers that invest their capital into other hedge fund managers
• Tactically allocate capital• Pros:
• Immediate hedge fund diversification• Fund of Funds (FoF) have infrastructure and expertise to conduct due diligence and
monitor underlying managers• Knowledge transfer to staff
• Cons: • Double layer of fees (investors pay underlying hedge fund fee and FoF manager fee) could
be substantial• Asset allocation in the hands of the FoF manager• Over-diversification is possible
More on: Hedge Funds
Fund of Funds
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The Good• Potential for non-correlated returns to traditional assets• Potential to reduce overall portfolio volatility• Access to the best• Rapidly evolving • Incentive structure
The Bad• Complicated • Lack of transparency• Difficult to evaluate• Infrequent liquidity• Expensive
More on: Hedge Funds
The Good and the Bad
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• Limited Partnership Agreement (LPA) – legal framework for partnership and terms and conditions of fund investments in companies that are not listed on a publicly-traded exchange.
• Private markets are usually less efficient. • Exposure to carefully selected and efficiently structured companies with
strong corporate governance and growth potential.• A fund is managed by a General Partner (GP) who invests on behalf of the
Limited Partners (LPs)• Ten to twelve-year limited partnership• Commitment called over four to five years• Distributions typically begin by year three or four• Partnerships are terminated once all investments have been liquidated
More on: Private Equity
What is Private Equity
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Three levels1. Private Equity Firms (Zeus Global Management)2. Private Equity Funds (Zeus Buyout Fund IV)3. Private Equity Portfolio Companies (Sanders Bake Shop)Partnership Structure• General Partner – money management firm• Limited Partners – institutions and wealthy individuals• Limited Partnership Agreement (LPA) – legal framework for partnership
and terms and conditions of fund
More on: Private Equity
Private Equity Structure
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More on: Private Equity
PE Investor (Pension)
PE Firm Fund
(Zeus IV)
Portfolio Company (Bakery)
Investment (capital calls)
Partnership Interests
(distributions)
Equity Position
Investment
Limited Partner
General Partner
Limited Partnership Agreement
Portfolio Company
(Shoe Store)
PE Firm(Zeus Global
Management)
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– Years 1-3 returns are negative, little income is generated, management fees are collected on committed (not invested) base, additionally there are some early investments which fail;
– Years 3-5 returns flatten out and gradually turn positive as values are written up to reflect transactions and some income is received;
– Years 5-10 returns spike as assets are sold and accumulated increases in value are reflected, and income is received as businesses become profitable;
– All years combined leads to what has been termed the “J-Curve.”
More on: Private Equity
Cash flow pattern of investing in private equity
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More on: Private Equity
The “J Curve”
Projected Cash Flows for a $10 Million Commitment
-$10,000,000
-$5,000,000
$0
$5,000,000
$10,000,000
$15,000,000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year10
Drawdown Distribution Cumulative Net Cash Flow J Curve
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More on: Private Equity
Venture Capital, Growth Equity, Buyouts
Investment Style
Description of Investment Strategy
Main Sector Types
Time Horizon
to Liquidity
IRR Range
-DPI
Multiple
Primary Return Drivers
Venture Capital Investments in early stage of companies with an innovative and or a disruptive business idea for a proprietary product or service. Investments are made in the early life of the company, seed stage, early stage and pre-revenue.
TechnologyCommunications
SoftwareBio-tech
HealthcareClean Tech
8 – 12 years 10% - 15%2.00x
Capital Appreciation
Growth Equity Provides expansion capital for small, growing businesses, that are generating cash flow and profits. Generally, these types of investments have minimal exposure to technology risk
Diversified
Business ServicesIndustrialConsumer
5 – 7 years 15% - 20%2.00x
Capital Appreciation
Buyouts Investments in established companies that require capital to expand and or restructure
Diversified
Business ServicesIndustrialConsumer
5 – 7 years 15% - 20%2.00x
Current Income and Capital
Appreciation
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More on: Private Equity
Mezzanine
Investment Style
Description of Investment Strategy
Main Sector Types
Time Horizon
to Liquidity
IRR Range
-DPI
Multiple
Primary Return Drivers
Mezzanine Investment strategy involving subordinated debt, (the level of financing senior to equity and below senior debt). Investments are generally shorter in duration, loans are 3 – 5 years, returns, generated are primarily current income with a lesser emphasis on capital appreciation
Capital supplied by mezzanine financing is used for various situations such as facilitating changes in ownership through leveraged buyouts or recapitalizations, financing acquisitions, or enabling growth
Revenue and Royalty interests are a subset of mezzanine financing that targets intellectual property, license agreements and other similar property that has the ability to restrict the rights to commercialization.
Companies in a variety of industries that are backed by
Private Equity Managers (Sponsored)
Or Not backed by a Private Equity
Manager(Sponsor-less)
Venture backed technology and healthcare companies
Royalty and Revenue Interests generally targets intellectual
property and pharmaceuticals
Corporate Finance
1 – 4 years
Venture Lending
1 – 3 years
Royalty & Revenue Interests
1 – 4 years
11% - 14%1.50x
11% - 16%1.60x
12% - 16%1.60x
Current Income and
Capital Appreciation
Current Incomeand
Capital Appreciation
Current Income
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More on: Private Equity
Distressed, Secondaries
Investment Style
Description of Investment Strategy
Main Sector Types
Time Horizon
to Liquidity
IRR Range
-DPI
Multiple
Primary Return Drivers
Distressed Investments in companies that have poorly organized capital structures or failing operations.
Distressed strategies includes trading strategies, significant influence and control positions. Long and short positions are commonly used as a technique to lock in profit or reduce risk.
Trading strategies, Investment instruments include publicly traded debt securities, private debt, trade
claims, mortgage debt, common and preferred stock and commercial
paper.
Significant influence and Control strategies involve companies with
poorly organized capital structures, turnaround situations and bankrupt
companies.
3 – 4 years 13% - 17%1.65x
Capital Appreciation
Secondaries Private equity interests are generally purchased at a discount from valuation from motivated owners of private equity interests. The interests purchased are generally venture and buyout interests with limited exposure to unfunded capital commitments.
The strategy also includes the purchase of direct interests in companies through the secondary market
Diversified
Venture and Buyout investors’ interests with limited exposure to unfunded capital commitments.
Direct interests in companies through the secondary market
2 – 3 years 14% - 22%1.50x
Capital Appreciation
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Energy, Infrastructure, Timber, Agriculture
Investment Style
Description of Investment Strategy
Main Sector TypesTime
Horizon to Liquidity
IRR Range
-DPI
Multiple
Primary Return Drivers
Energy Investments will include exploration & production, generation, storage, transmission, distribution, renewable energy sources, clean technologies, energy technologies and other like-kind investments
Up-StreamMid-Stream
Down-StreamPower
CleantechRenewables
Energy efficiency
5 – 7 years 15% - 20%2.00x
Capital Appreciation, some income
from production
Infrastructure Investments in physical assets or companies that operate assets that provides essential services to society and typically exhibit one or more of the following qualities: monopolistic or quasi-monopolistic, high barriers to entry, long term assets, regulatory or permitting constraints
Infrastructure strategies may be classified into four broad
categories: Transportation, Energy and Utilities, Communications, and
Social Infrastructure
5-15 years 6% - 15%1.75x
Current Incomeand
Capital Appreciation
Timber Investment in producing timber properties for forest products
HardwoodsSoftwood Plantations
Growth only
10-15 years 6%-12%1.50x
Current Income and Capital
Appreciation
Agriculture Ownership of properties leased to farm operators
Row & Field CropsPermanent Crops
6-10 years 6%-12%1.75x
Current Income and Capital
Appreciation
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The Good• Precedent of 20% + annual returns over long horizon• Diversification resulting in improved risk and volatility
characteristics• Imperfect correlation with other asset classes• Market inefficiency; transactions are negotiated
The Bad• High risk, particularly on an individual transaction basis• Illiquidity• Lack of transparency• Valuations somewhat judgmental
More on: Private Equity
The Good and the Bad
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More on: Private Equity
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Fundraising (0 to 1.5 years)• Private Equity Manager raises sufficient funds for the strategy• Investors make capital commitments to the fund
Investing (1-6 years)• Private Equity manager calls capital from investors to source investment
opportunities and create value
Harvesting (7-10 years)• Private Equity Manager exits investments through IPOs and Mergers and
Acquisitions• Proceeds of the exits are distributed to the fund’s investors according to provisions
in LPA
Liquidating (10-12 years)• Private Equity Manager exits the few remaining investments in fund
More on: Private Equity
Lifecycle
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More on: Private Equity
Projected Cash Flows for a $10 million Commitment
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Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10-$10,000,000
-$5,000,000
$0
$5,000,000
$10,000,000
$15,000,000
Drawdown Distribution Cumulative Net Cash Flow J Curve
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• General Partner is compensated through fees and shares of profits• Annual fee based on committed capital
– Venture Funds: 2 - 2.5%– Buyout Funds: 1.5 - 2%
• Profit participation– Most often set at 20% of gains– Usually above a preferred return of 5 - 10%
More on: Private Equity
Management Fees
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• Tangible assets that have their own intrinsic worth based on utility• Assets whose intrinsic value is less eroded by inflation compared to paper
assets – provide real returns over inflation• Examples
More on: Real Assets
General Definition
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Real Estate Energy
Commodities Timber
Infrastructure TIPS/Inflation Linked Bonds
Natural Resource Equities REITS
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Purchase the commodity outright• Shipping and Storage costs/logistics
Commodity Linked Notes/ Exchange Traded Funds• CLNs: Debt instrument whose value at maturity will be a function
of the value of an underlying commodity index• ETFs: Simple, but higher fees for commodity index exposure and
added layer of complexityNatural resource companies
• Stocks and bonds of the companies• Do you get pure exposure to the commodity?• Equity Market Risk
More on: Real Assets
Commodities
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More on: Real Assets
The Business Cycle and Stock, Bond and Commodity Prices
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Source: CAIA Level I Text (Anson)
Commodities Bottom
Bonds Rising
Equities Rising
Commodities Rising
Bonds Falling
Equities Falling
Commodities Falling
Time
GDP
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• Many alternative investments are in a fund structure (hedge fund, private equity fund, etc.)
• There are two general ways to implement an investment:• Direct Fund• Fund of Funds
Fund of Funds vs Direct Investing
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• A direct fund is when a pension system invests directly in an individual fund
• Louisiana Retirement System invests in the Zeus IV Fund• Zeus IV Fund invests in individual companies
• A fund of funds is when a pension system invests in a fund that in turn invests the capital in a group of different underlying funds
• Louisiana Retirement invests in the Cronus I Fund• Cronus I fund invests in the following funds:
• Zeus IV Fund• Poseidon III Fund• Hades II Fund• Hestia IV Fund
Fund of Funds vs Direct Investing
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• Strong reputation• Established firm• Stable investment team• Relevant experience• Demonstrated track record• Thorough due diligence process• Ability to accommodate client needs
Alternative Manager Selection
Key drivers
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1. Structure of the fund2. Investment strategy review3. Performance review4. Risk assessment5. Administrative review6. Legal review7. Checking references
3 fundamental questions in order to understand a fund’s investment program:
8. What is the fund manager’s investment objectives?9. What is the fund manager’s investment process?10. What is the fund manager’s competitive advantage?
Alternative Manager Selection
Due Diligence Process
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• Higher returns• Higher risk• Illiquidity premium
• Diversification• Structure program so that returns of alternatives are uncorrelated
to traditional portfolio returns• Unique Opportunities
• Alternative investments allow strategies that are often not available in traditional long only investments
Goals of Alternative Investing
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Questions?