Profesor John Paul Fischer

ALTERNATIVE INVESMENTS
CFA 1

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 Profesor John Paul Fischer

ALTERNATIVE INVESMENTS
1. Introduction to Alternative Investments
1. Alternative Investment Structures
2. Hedge Funds
3. Private Capital
4. Natural Resources, Real Estate, and Infrastructure
5. Performance Appraisal and Return Calculations

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 ALTERNATIVE INVESTMENT STRUCTURES
Alternative investments comprise various types of investments that do not
fall under traditional investments, which refers to long-only investments in
cash or publicly traded stocks and bonds.
Compared with traditional investments, alternative investments typically:
• Less liquidity of assets held.
• More specialization by investment managers.
• Less regulation and transparency.
• More problematic and less available historical return and volatility data.
• Different legal issues and tax treatments.
• Relatively low correlations with returns of traditional investments.
• Relatively higher management fees and incentive fees based on performance.
• Restrictions on redemptions.
• Relatively more concentrated portfolios.
• Different Fee structures 3
 ALTERNATIVE INVESTMENT STRUCTURES
Why diversification is important

Diversification
and Higher
Returns from
iliquid
investments are
the main
benefits from
alternative
investments

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 ALTERNATIVE INVESTMENT STRUCTURES
Why diversification is important

Cumulative
Return

B
A What asset is
prefered by a risk
averse investor?

Time
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 ALTERNATIVE INVESTMENT STRUCTURES
Why diversification is important
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Fond A: Fond B: A person invest its portfolio in 2

funds, with half of the investment 0
Exp Return: 10% Exp Return: 2% in each fund
Std Dev: 12% Std Dev: 6%
-1

Portfolio Expected Return:

10% x 50% + 2% x 50% = 6%

Ra Rb

CORRELATION IS KEY

Volatilidad esperado de portafolio:

X
12% x 50% + 6% x 50% = 9% 6
 ALTERNATIVE INVESTMENT STRUCTURES
Why diversification is important

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MAIN CATEGORIES OF ALTERNATIVE INVESTMENTS
• Hedge funds. More liquid assets underlying. Hold long and short positions, use
derivatives, and sometimes some illiquid investments
• Private equity. equity of companies that are not publicly traded . LBO and VC are the
most common strategies
• Private debt. Private loans or invest in the debt of firms that are financially distressed
• Real estate. Residential or commercial properties, as well as real estate–backed debt.
• Commodities. Investors can own physical commodities, derivatives, or the equity
• Farmland. leasing it out for farming or from raising crops or livestock for harvest and
sale.
• Timberland. Forested land is purchased or trees are planted for harvesting.
• Infrastructure. long-lived assets that provide public services, such as roads, airports, and
utility grids, and social infrastructure assets, such as schools and hospitals.
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DIRECT / FUND INVESTING / CO INVESTING

Pros Cons

No Fees Less diversification

Direct Investing More control o f the Higher min investment amount
investment Investor expertise

Expertise
Pay high fees
Fund Investing Diversification
Less control over asset selection
Lower minum

Reduce Fees
Requires more work for investor
Co Investing Manager expertise
than Fund Investing
More control over assets

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 LIMITED PARTNERSHIP

General partner (GP)

is the fund manager and makes
investment decisions

Limited partners (LPs)

are the investors, who own a
partnership share proportional
to their investment

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 FEE STRUCTURE
Management Fee: Fix fee, regardless of investment performance. Typically between
1% and 2% of AUM (HF) or Committed Capital (PE)

Performance Fee (Incentive Fee): portion of profits on fund investments. Typically

between 10%-20% Usually have a hurdle rate of return (min return, above that it
charges performance fees).
• Soft hurdle rate: total increase in the value
• Hard hurdle rate: only on gains above the hurdle rate
Other clauses
• Catch-up clause: Example: First 8% to LP, then next 2% to GP, everything above 10% is split 80% - 20% LP GP
• High-water mark: no incentive fee is paid on gains that only offset prior losses
• Waterfall: How Perf fee is paid: Deal by deal, “American” (good for GP) or whole-of-fund, “European” (good for
LP)
• Clawback provision: GP accrues or receives incentive payments on gains that are subsequently reversed as the
partnership exits deals, the LPs can recover previous (excess) incentive payment
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 HEDGE FUNDS
Hegde Funds seek to provide attractive returns, with low correlations
traditional asset classes, and with more liquidity than other Alternative
Investments (they still have lockout periods).
• Use leverage.
• Take both long and short positions.
• Use derivatives for speculation or hedging portfolio risk.

Fund-of-funds is an investment company that invests in hedge funds.

• Pros: diversification ,expertise in selecting individual hedge funds, access to hedge
funds for smaller investor
• Cons: Additional fees

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 HEDGE FUNDS
Hegde Funds Strategies:
1. Event-driven strategies are typically based on a corporate restructuring or M&A
• Merger arbitrage. Buy the shares of a firm being acquired and sell short the firm making the acquisition.
• Distressed/restructuring. Buy the (undervalued) securities of firms in financial distress when analysis indicates
that value will be increased by a successful restructuring; possibly short overvalued securities at the same time.
• Activist shareholder. Buy sufficient equity shares to influence a company’s policies, with the goal of increasing
company
• Special situations. Invest in the securities of firms that are issuing or repurchasing securities, spinning off
divisions, etc
2. Relative value strategies involve buying a security and selling short a related security, with the goal of
profiting when a perceived pricing discrepancy between the two is resolved.
• Convertible arbitrage fixed income. Exploit pricing discrepancies between convertible bonds and the
common stock
• Asset-backed fixed income. Exploit pricing discrepancies among various MBS or ABS
• General fixed income. Exploit pricing discrepancies between fixed-income securities of various issuers
and types.
• Volatility. Exploit pricing discrepancies arising from differences between returns volatility implied by options
prices and manager expectations of future volatility.
• Multistrategy. 13
 HEDGE FUNDS
Hegde Funds Strategies:
3 Macro strategies are based on global economic trends and events and may
involve long or short positions in equities, fixed income, currencies, or
commodities.

4 Equity hedge fund strategies seek to profit from long or short positions in
publicly traded equities and derivatives with equities as their underlying
assets.
• Market neutral. Use technical or fundamental analysis to select undervalued equities to be held long
and to select overvalued equities to be sold short (without exposure to market risk).
• Fundamental long/short growth. Use fundamental analysis to find high-growth companies. and short
equities of companies expected to have low or no revenue growth.
• Fundamental value. Buy equity shares that are believed to be undervalued based on fundamental
analysis and sometimes short an index or companies believed to be overvalued.
• Sector specific. Identify opportunities within a sector, such as health care, biotech, technology, and
financial services. Manager expertise within a specific sector is believed to lead to superior returns.
• Short bias. Employ technical and fundamental analysis and take predominantly short positions in
overvalued equities, possibly with smaller long positions but with negative market exposure overall. 14
 HEDGE FUNDS
Hegde Funds Benefits and risk
• Tended to be better than those of global equities in down equity markets
and to lag the returns of global equities in up markets
• Correlations tend to increase during periods of financial crisis
• Hedge fund indices may bias returns and correlations with traditional
investment returns
• Survivorship bias, bias index returns upward (bad HF go out of business)
• Backfill bias adding fund returns for prior years to index returns
• Valuations of certain assets could lead to false lower volatility

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 PRIVATE EQUITY
Private Equity Strategies
Leveraged buyouts (LBOs)
• Most Common type of PE
• Leverage: purchase of the portfolio company is funded primarily by debt.
• Management buyouts (MBOs), in which the existing management team is involved in the
purchase
• Management buy-ins (MBIs), in which an external management team will replace the existing one
• Also considered LBO if you buy a public firm to take it private (“going private”)
• PE firm adds value to the firm:
• New Management
• Management Incentives
• Restructuring
• Cost reduction
• Revenue Enhancement
• High cash flow firms are attractive to paydown debt
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 PRIVATE EQUITY
Private Equity Strategies
Venture capital
• Funds invest in companies in the early stages of their development
• Often is in the form of equity but can be in convertible preferred shares or convertible debt.
• High Risk Return – Risk strategy
• Managers actively involved in the development of portfolio companies (board or mgmt.)
• Categories (stage of development)
• Formative stage:
• Angel Investing (pre seed capital). Mainly done by individuals rather than funds
• Seed Capital: investments made for product development, marketing, and market research. VC funds
come in here usually
• Start up stage: investments made to fund initial commercial production and sales.
• Latter or expansion stage: company already has production and sales and is operating as a
commercial entity. Investments used to grow and expand
• Mezzanine-stage financing refers to capital provided to prepare the firm for an IPO
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 PRIVATE EQUITY
Private Equity Strategies
Exits of Private Equity (usually after 5 years)
• Trade sale. Sell a portfolio company to a competitor or another strategic buyer.
• IPO. Sell all or some shares of a portfolio company to the public.
• Recapitalization. The company issues debt to fund a dividend distribution to equity holders (the
fund). This is not an exit, in that the fund still controls the company, but is often a step toward an exit.
• Secondary sale. Sell a portfolio company to another private equity firm or a group of investors.
• Write-off/liquidation. Reassess and adjust to take losses from an unsuccessful outcome.

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 PRIVATE DEBT
Private Debt Strategies
• Direct lending. Loans made directly to a private entity without an intermediary.
Leveraged loan loan made by a private debt fund with leverage to magnify fund returns.
• Venture debt. Lending to venture firms (early stage) Often convertible to firm’s
common stock or warrants.
• Mezzanine loans. Private debt that is subordinated (lower priority of claims than senior
debt).
• Distressed debt. Purchasing the debt of firms in bankruptcy, in default on existing
loans, or for which default seems imminent. The fund becomes active in implementing a
plan for the debtor firm to restructure its existing debt or make other changes that will
result in an increase in the value of the acquired debt.

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 COMMODITIES
Returns are based on price changes and not on income streams.
Prices based on supply (production and storage cost)and demand (global economy) and
speculators. Supply Inelastic in short term. Agricultural commodities depend on weather.
How to invest:
• Derivatives: Futures, forwards, options, and swaps
• ETF: Good for investors that are not allowed to invest in derivatives
• Managed futures funds: Structures like a HF or Mutual Fund.
• Specialized funds: Focused on specific commodities

Historically: Low returns compared to stock and bonds, low correlation, good hedge
to inflation 20
 COMMODITIES
Convenience yield is the value of
having the physical commodity for use over
the period of the futures contract.

Contango: No convenience yield, futures

prices will be higher than spot prices.

Backwardation: When the convenience

yield is high, futures prices will be less than
spot prices

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 REAL ESTATE
• Return Source: rents, as well as the potential for capital gains
• Benefits: Diversification , Hedge to inflation
• Returns affected by: interest rates, global and local conditions, regulations, leverage

Type of strategies:
• Residential property MBS or direct investments
• Commercial real estate CMBS or direct investments
• Real estate investment trusts (REITs) issue shares that trade publicly like shares of
stock. REITs are often identified: mortgages, hotel properties, malls, office buildings, cell phone
towers, or other commercial property. 90% of income must be distributed to shareholders to
avoid taxes
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 INFRASTRUCTURE
Examples
• Transportation (roads, airports, ports, and railways)
• Utility (gas distribution facilities, electric generation and distribution facilities, and
waste disposal and treatment facilities)
• Communications (broadcast assets and cable systems)
• Social (prisons, schools, and health care facilities).
Type of assets:
• Brownfield: already constructed. Stable cash flow, high yield, low growth
• Greenfield: to be constructed. More uncertainty, lower yield, higher growth
Benefits and Risk
• Benefits: Diversification
• Risk: Regulatory, financial leverage, construction risk (if greenfield), operational risk
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 PERFORMANCE APPRAISAL
Additional risk of alternative investments
• Lack of transparency.
• Illiquidity, including restrictions on and performance impact of redemptions.
• Complexity of positions and strategies employed.
• Use of derivatives.
• Use of securities that are marked to market.
• Use of leverage.
• Variety of manager strategies and areas of expertise.
• Cash drag from significant drawdown periods (e.g., with private equity).
Problem of using Sharpe ratio:
• Std Deviation not a good measure of risk: Returns not normally distributed (high Skewness and
Kurtosis)
• Smoothness of returns: Model Pricing instead of market pricing (underestimate volatility)
• Sortino ratio could be more appropriate, but don’t consider diversification benefit
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 PERFORMANCE APPRAISAL
Measuring Performance
• Multiple of invested capital: The ratio of total capital returned plus the value
of any remaining assets, to the total capital paid in over the life of the
investment (good for PE, RE)
• Does not consider timing in cash flows
• IRR: Better for PE and RE

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 PERFORMANCE APPRAISAL
Example of Measuring performance
BJI Funds is a hedge fund with a value of $110 million at initiation. BJI Funds charges a 2%
management fee based on assets under management at the beginning of the year and a 20%
incentive fee with a 5% soft hurdle rate, and it uses a high-water mark. Incentive fees are
calculated on gains net of management fees. The year-end values before fees are as follows:
• Year 1: $100.2 million
• Year 2: $119.0 million
Calculate the total fees and the investor’s after-fee return for both years.

Answer:
• Year 1:
• Management fee : 110.0 million × 2% = $2.2 million
• Gross value end of year (given): $100.2 million 26
 PERFORMANCE APPRAISAL
Example of Measuring performance
• Return net of management fees:
• There is no incentive fee because the return after the management fee is less than the 5% hurdle
rate.
• Total fees: $2.2 million
• Ending value net of fees: 100.2 million – $2.2 million = $98.0 million
Year 1 after-fees return:
• Year 2:
• Management fees: 98.0 million × 2% = $1.96 million
• Year-end value net of management fees: $119.0 – $1.96 = $117.04 million
• The high-water mark is $110 million.
• Year 2 value net of management fees, above high-water mark: 117.04 million – 110.0 million = $7.04
million
• Year 2 return net of management fees, above high-water mark:
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 Profesor John Paul Fischer
PERFORMANCE APPRAISAL
Example of Measuring performance
• Note that the incentive fee is calculated based on gains in value above
$110 million because that is the high-water mark.
• The incentive fee is calculated on the entire gain above the high-water mark because 6.4% is greater
than the soft hurdle rate. If the 5% was a hard hurdle rate, the incentive fee would be calculated only
on the gains more than 5% above the high-water mark.
• Incentive fee: 7.04 × 0.20 = $1.41 million
• Total fees: $1.96 million + $1.41 million = $3.37 million
• Year 2 year-end value after fees: 119.0 – 3.37 = $115.63 million
• Year 2 after-fee return:

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