Alternative Investment Strategies

● Classical = bank deposits ie cash (most basic, not best), equity, bonds, mutual funds,
etfs
● Anything not classical = alt
● Mf, etf: long posn in equity/bonds (maybe like tracking specific indices)
● Alt - directly going long, or going into complex strategies
○ Direct: real estate, crypto, private companies, commodities
○ Strategies: hedge funds, vc funds, pe funds, commodities futures
● Categories of inv strategies:
○ What it invests in
■ Classic vs alternative assets
● Cash, equity, bonds
● Real estate, crypto, private cos
■ Capital vs non capital assets
● Value of capital assets depends on cashflows
● Value of non capital assets depends on the asset itself, not
cashflows
○ How it invests in it
■ Beta v alpha
● Beta = follow the market, passive or defensive
● Alpha = try to beat the market, aggressive
■ Constrained v unconstrained
● by a benchmark, like the s&p500
● Constrained - tracks the index, so also passive
■ Passive v active
● Actively managed by a portfolio manager or not, ie do the
managers pick the assets or is it simply tracking an index
■ Long term v short term
● Strategic lt holding or st tactical invst
■ Beta, constrained, passive, long term = mf v/s alpha, unconstrained,
active, short term = hf

Concept of alpha and beta

● Beta of an asset = sensitivity of the asset to changes in the market, ie exposure to

market/systematic risk
○ Beta = 1 : asset is as risky as overall market, moves exactly w market
○ Beta > 1 : asset is riskier than the market, moves more strongly than market,
exacerbated movement of market ie more volatile
○ Beta < 1 : asset is less risky than market, moves less strongly than market and
so less volatile
● Alpha = invst strategy’s ability to beat the market, called excess or abnormal return
○ Returns that arise from idiosyncratic risk
 ■ Dot com bust : systematic risk, standalone events in tech companies :
idiosyncratic risk
○ Used as performance measure against a benchmark (excess returns over and
above market represented by benchmark)
○ 1980 - 2000: s&p500 returned an avg of 17% annualised returns
■ Beta strat wouldve earned this eg MF indexed to S&P500
● The returns have been much smaller in recent years: historical
returns do not guarantee better returns, they can be completely
different from current picture
■ Alt alpha invst strats promise higher returns bec alpha drivers reflect
excess returns regardless of benchmarks
● Exploit market inefficiencies ie arbitrage opportunities where price
does not reflect the true value

HEDGE FUNDS

● There is no strict definition because they are unregulated

○ Implicit defn - through fees charged by managers, 2-20 structure
■ 2 : fixed component generated irrespective of p&l
■ 20 : incentive component dependent on profits, 20% of profits {more
nuanced than that}
○ Avg mgmt fee = 1.47% 2017 q1
○ Performance fee = 17.3% 2017 q1 (basically both are on avg falling)
● Invst vehicles w the following
○ Investment
■ In both classical and alt assets
■ Alpha strat
■ Not constrained by benchmark
■ Active mgmt
■ Short term
■ Complex trading st vs just long posn, goes into shorting and use of
derivatives
○ Funding
■ Capital from institutional invst, high wealth individual invst
● Institutional investors include pension funds, university
endowment funds, insurance companies, other hedge funds,
mutual funds, other endowment funds, etc
■ Leverage (v imp)
● Borrowing money to invest creates leverage, so investing 10x the
capital raised is creating leverage - greater investment and greater
risk as well {magnifies potential gains but also amplifies potential
losses}
 ● Mutual funds are restricted to borrowing only up to 33% of their
net asset base to employ leverage, hedge funds have no such
restrictions
● Leverage ratio shows how much of the total investment is your
own capital
○ Eg 25:1 leverage ratio is you have 1/25th of the total
investment as your own capital or as assets on your
balance sheet, the other 24/25th is borrowed.
● The use of leverage can turn an otherwise conservative
investment into an extremely risky investment
■ Capital AND leverage are used to invest
■ Gives AUM = mkt value of assets managed

HF Fees

● Management fee : annual fee charged as percentage of managed assets {fixed}

● Perfomance/Incentive fee : fee charged based on the fund’s performance
○ Depends greatly on what the manager is able to do w the fund in terms of growth
● Historically, fee structure = 2-20
○ Fund AUM at beginning of year 1 = $1,000M
○ Fund AUM at the end of year 1 = $1,150M
○ Management fee = 2% of year end AUM = $23M
○ Performance fee = 20% of fund growth = 20% (1150-1000) = $30M
○ Total fund fees = $23M + $30M = $53M
● We have now been seeing a steady decline in the fund fees
○ The Agency Problem/Principal-Agent Problem
■ Type of conflict of interest where agents dont fully represent the best
interests of their principals
○ Moral Hazard
■ Behaviour in which a party has incentive to take unusual risks in a
desperate attempt to earn a profit before the contract settles
■ After the contract has been signed, the party acts in a way that is
exposing them and the counterparty to risks in order to make gains before
the contract terminates
● HFs actually keep more than 20 cents on each dollar of profits over and above the
incentive fees = due to an asymmetry of the performance incentive fees
○ The hf industry receives a portion of investors profits but does not to the same
extent share in their losses
○ The asymmetry is easily overlooked - becomes evident only when focusing on
the industry as a whole
■ individual fund level : incentive fees are only levied on performance that
exceeds prior performance (exceeds previous high water marks)
○ The consequence of performance incentive fees is entirely mathematical
 ■ Until hf industry adopts a symmetrical performance fee structure, the total
fees collected by the industry as a whole will exceed the amount
otherwise expected when focusing on the average performance incentive
fee
○ There are also several behavioural factors that exacerbate the situation
■ Hf managers may decide to create several distinct hfs rather than just one
● Cross fund performance netting : within a fund, if there are 3 invst
sts, the same high water mark would apply to all three; if the same
3 invst sts are now divided over 3 sep hfs (sep vehicles), there are
now sep high water marks for all three, which is beneficial to the
managers
○ You invest in a single hf : yr 1 - gains 20%, yr 2 - gives up
all that gain, loss of 16.67%, yr 3 - gains 30%
■ Assuming 20% pif, pay pif of 4% in yr 1, 0 in yr 2,
2% in yr 3 {since pay fees on excess over high
water mark, here 10%} - overly simplified, total pif
payment for 3 years is 6% of AUM
○ If the same is over 3 separate hfs with the same
gains/losses
■ The losing hf cant be used to offset the other twos
gains, will have to pay a pif of : 4% + 0 + 6% ie
10% which is > by 4% {since there is no high water
mark of 20% applicable in this situation}
● Incentivises hf managers to offer multiple invst sts using sep
vehicles and become fund families rather than consolidating them
into a single fund
■ Manager will often choose to close an unprofitable hedge
● They have nothing to lose from the losses, and they will anyways
not be making any profits, so they dont mind closing an
unprofitable hedge if they can use those funds somewhere else
● Investors lose the ability to offset any future profits
■ Investors in losing hedge funds often throw in the towel and sell
● They also forfeit the ability to offset any future profits produced by
those funds
● Do performance incentive fees even work?
○ Might argue that 36% of a large number coud be better than lower % of smaller
number
○ Do hf managers produces sufficiently more profit to justify higher fees? No
■ If incentive fees worked as advertised, you’d expect hfs w 25% pif to on
avg outperform those w 20% pif and those to on avg outperform those w
15% pif
■ There is no causal relation b/w incentive fee rate and performance
○ Skepticism of high hf fees is justified : price value bias = the belief that something
that is more expensive is better and more valuable (this is not necessarily true)
 ○ Not to automatically avoid hf, some have produced phenomenal profits, but huge
fees have attracted mediocre or worse managers: so imp to be extremely choosy
when picking high priced hfs

Case discussion:
1. What are some possible explanations for the decline in advertised fees?
- rise in index funds (mfs, etfs); growth in alt invsts (vc, pe, etc) and other invst vehicles
as competition increases, fees decrease
- tech advances reduce txn costs, fees harder to justify
- investors become more educated, awareness inc for things like fees increasing doesnt
necessarily mean better performance
- increased transparency b/w principal and agent {reduces agency problem}

2. From an investor’s standpoint, why are performance incentives useful?

- to align the interests of the principals and agents (the manager gains when the investor
gains, need to give fair share of the upside to the agents)
- another similar example : employee stock options / stock options to executives

3. Why could it be problematic for hedge funds to not share-in on losses?

- they only share in upside, not downside {so losses do not affect them as much}
- the riskier the bet, the better off they are - incentive to take more risk for higher
potential return
- moral hazard issue : agents take excessive risk in hopes of higher gains

4. How could we factor in penalization for losses for managers?

- make the agents buy in : skin in the game, ie if managers’ money is on the line they
would be more careful with the decisions they make and not close potentially
unprofitable strategies
- set hurdle rates: min amt of profit the fund must earn before pif can be claimed
- high eater mark: if fund loses money, must be brought back to above the previous high
before receiving performance bonus
- fulcrum fees: fixed component at low and high ends, variable component in between
{there is a fee floor and fee cap/ceiling, the range in between varies}
HISTORY OF HFs

● 1st = equity long/short fund in 1949, Jones HF

● 140 by 1968 (SEC survey)
● 3500 by 1998
○ 1.5x mf
○ 300bn in capitalisation, 1tn aum (5tn for mf)
● Bns in capital
○ Bull market of early ‘00s
○ More risk appetite
○ Recognize adv of long/short strategies
● V fragmented industry
○ Only <20 funds have >3bn in aum

THE COLLAPSE OF LONG TERM CAPITAL MANAGEMENT

● Founded 1994 by rockstars: ex-soloman brothers traders, nobel laureates

● Relative value trades
Buy low, sell high
Wait for things to converge
Exposed to convergence risk
● Returns:
40% in ‘95, ‘96
20% in ‘97
135.2% by the end of ‘98: in 3 years
■ $1 invested in LTCM in the beginning of ‘95 became $2.353 at the end of
‘98
● Leverage!
Lvg ratio of 1 to 25
● Secretive about posns
● Convergence Risk
 ○ May/June ‘98
■ 4.7bn in capital, 124bn assets on balance sheet
■ Leverage ratio 1 to 25
○ September ‘98
■ Only 400mn in capital
○ Russian bond market default {trigger event}
■ Led to liquidity crisis
● Delayed convergence of underlying posns
● Margin calls led to losses
○ Margin calls = broker demands more cash/assets as
collateral to cover the short posns or borrowing from the
broker used to create leverage
● Liquidations in illiquid markets to meet margin calls, ie fire sales,
exacerbated the losses
○ Eg of convergence risk
■ Royal Dutch/Shell parity - they were identical stocks traded on the
amsterdam and london exchanges respectively and by law of one price,
we would expect them to converge to the same price, but in reality it took
them almost 5 years to converge in the two markets (1980-1985)

CATEGORIES OF HFs

1. Market Directional
a. Equity Long/Short
■ Long posn + short posn
■ Usually net +ve {long market exposure}
■ Focus = stock selection, skill based
Quantitative/technical: consistent patterns, historical data
Fundamental: analyse company + prospects, focus on
sector/segment
■ Eg. 2005: long 150% tobacco, short 50% computer tech {net long 100%}
Beta of the portfolio:
βT = .85, βC = 1.4, βP = 1.5 x 0.85 + (-0.5) x 1.4 = 0.58 < 1 = βmkt
CAPM :
E(R) = rf + βP(E(Rmkt) - rf) = 4.49% - 0.58(12.43-4.49)% = 9.10%
{4.49% and 12,43% are historic avg ret in period 1990-2005}
2005: return on tobacco = 30.5%, computer tech = -4%
Realised ret 2005 = 1.5(30.5%) + (-0.5)(-4%) = 47.75% > CAPM
predicted ret (9.10%) - is capm wrong?
○ Capm assumes well diversified portfolio, not the case here
Long only st allow traders to speculate on upward movements on
a stock, shorting allows also the reverse speculation to be made:
enriches opportunity set
 Portfolio beta = 0.58 - might seem small, implicit in that is leverage
in the short posn, so not the correct measure of risk in this case
Manager made a bet on tobacco and computer tech industries
which was fulfilled in 2005 - not necessary (it might not have
either)
b. Market Timing
■ Time strategy to be fully invested during bull mkts and liquidate (have
cash) during bear mkts - easier said than done {v diff to predict in which
dirn mkt is going to go}
■ Obj: to capitalise on mkt timing/mkt mvmt - timing of entry and exit is
crucial
■ Uses a top-down approach {broader macro perspective first, followed by
more specific details}
Relies on macro factors to forecast gdp [business cycle]
■ Bullish - buy futures, bearish - sell
c. Short Selling
■ Net short exposure on mkt {short entire mkt = bet entire mkt is going
down : wouldve helped before gfc like in the big short}
■ Good downside protection in bear mkt (financial crisis of 2008)

2. Corporate Restructuring
a. Distressed Securities
■ Invest in securities of companies in bankruptcy or likely to fall into
bankruptcy
Reasons for bankruptcy
○ Too much leverage
○ Flawed a/cing practices
○ Senseless risk taking
○ Could also be bec of external factors like COVID which isnt
the company’s own fault
■ Like PE investing but HFs less concerned w fundamental value and more
focused on trading opportunities
■ Several ways to profit
Short sell distressed securities
○ V risky since outcome may not be the desired one
○ Puts downward pressure on stock prices - ethically, dont
want to be responsible for a good company losing value
bec of you
Capital structure arbitrage (long-short strategy)
○ Long senior debt, short junior debt
■ If prob of default increases - senior debt gains
value and junior debt loses value, so ideally long
senior short junior to gain
○ Long preferred stock, short common stock
 ■ Preferred stockholders are compensated after
creditors and before common stockholders, so
same logic as above applies
○ The former in both statements have priority over the latter
in event of bankruptcy
Find undervalued securities, sit on the creditors board {eg bank},
and influence voting outcomes to move stock prices in their favour

b. Merger Arbitrage
■ Buy/long - target firm + sell/short - the acquirer before a merger
● Lots of insider info reqd to know smth is happening : v risky
■ Stock of target at a discount relative to announced merger price
■ Deal may fail due to another firm stepping in or monopoly regulation
● Study companies, assess ROI relative to event risk
■ Significant due diligence reqd : current/past financial statements, SEC
EDGAR filings, proxy statements, management structures, cost savings
from redundant operations, strategic reasons for the merger, regulatory
issues, press releases, competitive posn of the combined company
■ Eg: LVMH and Tiffany’s

■ Eg: MCI purchase

Background -
○ Feb ‘05: Verizon competing w Qwest for MCI
○ Qwest offer $6.5bn
○ Oct ‘05: Verizon won bidding war (thus acquired MCI) for
$8.44bn
2 possible merger arbitrage strategies
○ Long MCI - know price will increase either way bec it is the
target (seen historically)
■ Short Verizon - will lose value if MCI acquired
■ Short Qwest - will lose value if MCI acquired
○ Math for both -
■ P/L on short
■ P/L on long
■ Short rebate
■ Total P/L
■ Return on invested capital
■ Return w leverage at x% int
■ Merger arbitrage is DEAL DRIVEN - should not be correlated w mkt
Company specific: exposed to idiosyncratic risk, not market risk -
that’s why affected by the dot com bust as seen below
c. Event Driven
■ Broader invst mandate than other corporate restructuring strategies
● Except m&a, also invest in
○ Spin-offs
○ Liquidations
○ Reorganisations
○ Share buy-backs
○ Special dividends
○ Recapitalisations
● Less efficient the financial mkts in large isolated txns, the more
arbitrage opportunities
● More influenced by the general mkt w outperformance
○ M&A events during bull mkt
○ Corporate reorganisation events during bear mkt

○
3. Convergence Trading
- theoretically, arbitrage usually refers to riskless profits, irl refers to low risk profits
- usual recipe: buy low - sell high for same/similar securities
* no/limited market risk - both txns instantaneous
* no basis risk when securities same (low when similar)
* no credit risk if txns are done using cash instead of borrowed funds
In reality, most of these are not perfectly true

a. Fixed Income Arbitrage

■ Fi securities = t-bills, gilts, corp bonds, municipal bonds, sovereign debt,
mbs
■ Buying (low) one fi sec and selling (high) another similar one in the hope
that prices will converge
● Contributes to mkt efficiency - wipes off arbitrage opportunities
○ Selling overpriced reduces price, buying underprice
increases price, both move closer to true value
● Price discrepancies are in general small - use leverage to boost
returns - directly or through derivatives
■ Eg. bonds
● Buy off the run, sell on the run US treasury bonds
○ Off the run = issued some time ago, traded at discount,
less liquid
○ On the run = just issued, traded at premium, more liquid
● One year maturity bond issued today vs three year maturity bond
issued two years ago
● Expect prices to converge at maturity - convergence risk (may not
actually converge, if things go another way)
● During russian sovereign debt default, on the run bonds were
$100 more expensive than off the run ones for essentially same
maturities
■ eg . MBS
Mbs = ownership interest in an underlying pool of individual
mortgages loaned by banks
○ Fi sec w/ underlying prepayment options which make it
tough to value the sec bec it is difficult to identify when
cashflows are coming in [prepayment time unknown]
○ Cant determine convergence easily
○ Proprietary models used to assess option-adjusted spread
and prob of prepayment option being exercised
Mbs, us govt sec - diff credit risks
○ Mbs - high credit risk, esp ninja loans
○ Us govt sec - pretty safe
■ Does not depend on the dirn of general financial mkts
■ Exploit pricing inefficiencies b/w 2 secs instead of making bets on mkt dirn
 ■ Steady consistent rate year after year, regardless of movement in stock
mkt, w exception of dual crisis of russian bond default and ltcm bailout

b. Convertible Bonds
■ Corporate bonds that contain the option to convert the bond into
company’s stock
■ Fi sec w equity like characteristics
■ Defns:
● Convertible bond price = price of conv bond is you buy it
● Conversion value = amt inv receives after changed into stock
● Conversion premium = return from conversion
○ (Convertible Bond Price - Conversion Value)
Conversion Value
● Conversion ratio = no of stocks for every unit of the bond owned
● Conversion price = price at which a convertible security can be
converted into common stock {is it like a premium?}
■ Trading strategies
● Bond w price > conv value, do not convert - less correlated w the
underlying stock (less like equity)
● Bond w price < conv value, convert - more correlated w the
underlying stock (more like equity)
● goal/obj: eliminate risk from stock-price movement
● Strategy: buy convertible, short stock - DELTA HEDGING
○ Delta = sensitivity of option price to price of underlying
■ Eg. conv bond - par 1000, coupon 7.5% pa, conv ratio 20, trades for 900,
stock price 45, delta for bond 0.5 - how can you eliminate stock price risk?
● Buy 10 convertible bonds, sell 10 bonds x 20 conv ratio x 0.5
delta = 100 shares
 ● Hedge - pure fi sec + short rebate at 4.5%
● Math steps
○ No of shares given no of bonds, delta, conv ratio
○ Change in bp * no of bonds
○ Change in sp * no of stocks
○ Coupon earned on bonds
○ Short rebate
○ Total earning
○ Return on invst capital
○ Return w x leverage ratio at y%
■ Delta hedging neutralises effect of stock price movements {obj}
■ Risks exacerbated by leverage
● Two types of lev
○ Money borrowed to finance long posn
○ Stocks/underlying borrowed in short posn
● Hf managers - everything to gain from leverage, nothing to lose
○ Moral hazard - incentive to take on more and more risk for
potentially big gains
● Risks (magnified by leverage)
○ Liquidity - usually not publicly traded, harder to liquidate
○ Credit - issued by less than invst grade companies
○ Event - company may be downgraded
○ Interest rate - due to fixed inc component
○ Risk of being called - most conv bonds have pre-payment
option
○ Model - complexity of pricing
■ There is little impact from stock mkt (we neutralise stock mvmt)
c. Market Neutral
■ Similar to equity long/short, obj : beta = 0
■ Unlike it (which is still exposed to mkt risk - beta), takes a long and short
posn that neutralise mkt risk
■ Find liquid stocks usually of some specific characteristics eg midcap, in
local mkt
d. Statistical Arbitrage
■ Similar to mkt neutral
■ Neutralise more risk factors - small vs large cap, growth vs value etc.
● There is a whole factoral zoo (>100 factors which affect returns)
■ Mkt neutral: funda analysis, stat arbitrage : quantitatively driven models
e. Stub Trading
■ Stub = remaining outstanding stock of company (in bankruptcy event), or
when a smaller company spins off from a larger one
■ Eg. company a owns company b
● B contributes 20% to a’s consolidated profits
● A’s stock price = a’s profits + 20% of b’s profits
● To hedge 1 share of B, need 5 shares of A
● Obj: like delta hedging, want to eliminate stock price risk of stock b
○ A’s profit 45, b’s profit 40
○ A trading at only 50, not (45 + 0.2*40=) 53, ie undervalued
○ B trading correctly at 40
○ Take adv of mispricing
■ Go long A - undervalued + eliminate risk from B
■ Hedge 1B, need 5A
● Buy 5a for 5*50 = 250
● Sell 1b for 40
○ 2 scenarios -
■ B goes up
● A profit 45, b profit 42
● A trades correctly at 53.4 {convergence}
● B trades correctly at 42
■ B goes down
● A profit 45, b profit 30
● A trades correctly at 51 {convergence}
● B correctly trades at 30
■ Math for both-
● P/L on long A
● P/L on short B
● Short rebate
● Total
● Return on inv capital
● Return w x lev ratio at y%
■ Return is independent from price of B
 f. Volatility Arbitrage
■ Trading of options and warrants
● Warrants = issued by companies for immediate financing needs,
usually not publicly traded (vs publicly traded options)
■ Option prices reflect implied volatility (Black Scholes) - more volatile,
more the option price
■ Options can also be over or under valued
■ If the forecasted and implied volatility differ, option = mispriced

4. Opportunistic
- Instead of using HF to hedge, it is used as a vehicle to open up other invst avenues
that would otherwise not be available through long only invst - expands investment
opportunity set
a. Global Macro
■ Broadest and most diversified instrument universe - lacks focus
■ Hurt by tech bubble and russian bond default
b. Fund of Funds
■ Managers who invest money in other hfs - added layer of fees
● Pro: diversified portfolio
● Con: too much fees bec pay fee to multiple managers
■ Use tactical asset allocation
■ Better risk control from diversified portfolios

PERFORMANCE DATA

● Based on past returns, not forward looking; also older data, not necessarily more recent
● Severe ripple effects - potential unlimited losses : can trickle down to other things
● Increasing size of the portfolio mitigates returns of adding hedge funds (diminishing
added value)
● Survivorship bias in data - we only observe remaining funds, not the ones that have
failed and dropped out like LTCM which biases the data upwards

PERFORMANCE PERSISTENCE

● Important parameter to judge hfs bec funds claim skill, but it could be just luck
● Some studies find no evidence of performance persistence while others find persistence
only in the short term - mixed answers
● -ve serial correlation of performance is prevalent in many cases

ADDING HFs TO PORTFOLIO

● Objective:
○ Search for an addnl source of return
○ Risk management
● Hfs can be selected
○ On an opportunistic basis - to expand investment opportunities beyond what can
be achieved through long only
○ As fof - to reduce idiosyncratic risk through diversification
○ As an absolute return vehicle

1. Opportunistic strategy
○ Hfs expand the opportunity set rather than hedge it
■ Do not hedge but complement risk and return characteristics
■ Add value to portfolio by focus (sector, strategy, etc)
● Eg. the ability to extract value on both long and short side of
biotech industry {if that is the sector they specialise in}
○ Usually opportunistic strategies have a benchmark (not abs return)
■ Benchmarking reduces flexibility since forces manager to worry about
tracking error
2. Fund of Funds
○ Usually invest in 5-20 HFs
○ Goal = diversify b/w hfs - even funds w/in same style have diff return patterns
○ Most studies show 5 funds are adequate to capture most diversification benefits
○ Result = return of cash + 500 bp (5%)
○ FOF investing is useful in
■ Risk budgeting
● Part of risk mgmt process - deciding how to allocate risk amongst
components of a well diversified portfolio
● Correlation - key parameter when assessing value of adding
security to portfolio
● Hurdle rate - measures at least how much return an asset should
earn so that it is a valuable addition for risk budgeting purposes
● HRY = Rf + (E(RP) - Rf) x corrYP x sdY/sdP
○ E(R) > HR - add to portfolio
○ E(R) < HR - don’t add
○ HR helps filter out sec w low sharpe ratio and high correln
w existing portfolio
■ Bond Substitute
● Acc to studies, hfs can displace bonds and cash in efficient
portfolios
○ HF fees!
● Higher return, similar sd and higher sharpe ratio
■ Portable Alpha
● Inc returns w/o inc beta
● Can be obtained from a diversified pool of hybrid managers w low
corr to traditional asset classes
○ Eg HFRI FOF earns an annual return 2% higher than that
for UST but has low correl w both equity and bond mkt
 ■ Inv $1bn in S&P500 - beta = 1, alpha = 0
■ Invst strategy - not increasing beta, earning alpha
● Beta of FOF = 0.17
● Need to buy into market exposure of
remaining 0.83 to maintain beta of invst at 1
● Use S&P500 futures to accomplish this
■ Inv $500mn in S&P500 w beta 1 + $500mn in FOF
w beta 0.17
● Gain rest of beta exposure by buying
futures in the S&P500
○ Financed by borrowing at cost of
4.5%
○ Beta = 0.83, so need to buy 83% of
$500mn = $415 mn
● Alt st: higher returns if the financing cost
implicit in the futures contract is not too high
● Final portfolio will have portable alpha and
beta 1
● E(R) of the $500mn in FOF = 10.43% +
0.83(12.43%) + 4.5% = 16.25% > 12.43%
■ Absolute Return
● Hf managers claim their ret are derived from skill at sec selection
rather than that of broad asset class
● Target an abs return (10%) rather than determine performance
relative to an index/benchmark or focus on risk mgmt
● Parameters - 2 levels
○ Individual hf manager
○ Overall hf program
● Limited or no correl to broader fin mkts - effectively zero beta

RISK DUE TO FINANCIAL STRATEGIES

● Prior research indicates that hfs are a valuable addn to a diversified portfolio w/in M-Var
efficient frontier
○ Hf may pursue invst st that have non-linear p/o and are exposed to significant
event risks - not simply captured by two statistics of mean and variance, other
risk measures reqd
■ Sharpe: 90% of mf returns can be explained by trad asset classes
■ Fung-Hsieh: for hfs, only 25% of return = trad asset classes
● Return characteristics of hfs are v diff from other asset classes
● Market Directional - subject to Market Exposure
○ Eq long/short have net long mkt exp
○ Short sellers have net short mkt exp
○ Mkt timers have {in theory} insignificant mkt exp
 ○ Mkt doesnt always move acc to expectations - source of mkt risk is this
uncertainty
● Corporate Restructuring - subject to Event Risk
○ Risk that txns dont go through as expected
■ Eg lvmh - tiffany m&a process almost fell through
● Convergence Trading - subject to Convergence Risk
○ If conv of similar sec happens, manager pockets spread - otherwise, might be big
losses (eg lvmh - tiffanys m&a)
○ Risk that price of two similar sec does not converge
● Measurement of other risk forms
○ Volatility (sd) or variance (sd^2)
■ Normal dist - symmetric around mean
■ 1 sd around man = 68.2% data
■ 68.2 - 95.4 - 99.7
○ Kurtosis - how fat/thin the tails of the dist are, compared to nd w/ kurt 0
■ Fatter tails = +ve kurt, dist of returns has significant mass concentrated in
outlier events (outlier events more probable) - chances of extreme gains
or extreme losses higher
■ Thinner tails = -ve kurt, dist of returns has less prob mass concentrated in
outlier events (outlier events less probable) - chances of extreme gains or
extreme losses is lower, more prob mass around mean

○ Skewness - how symmetric a dist is, symm dist (equal prob mass on each side of
mean) has skew 0
■ -ve values of skewness indicate data skewed left
● Skewed left = left tail long relative to right tail
● For continuous, unimodal densities, -ve skewness => median
larger than mean
 ■ +ve values of skewness indicate data skewed right
● Skewed right = right tail long relative to left tail
● For continuous, unimodal densities, +ve skewness => median
smaller than mean

■ Risk averse investors like +ve skewness : +ve outliers > -ve outliers

● r1 and r2 - same mean and sd

○ r1 : -vely skewed
■ higher % of +ve return
■ v large -ve returns w v small prob
○ r2 : +vely skewed
■ higher % of -ve return
■ v large +ve returns w v small prob
● Theory says prefer r2
○ Mkt and high yield bonds return dist : -ve skewness, +ve kurtosis
 ○ Combination of +ve kurt and -ve skew = large downside tails associated w ret dist
■ This is what HFs generally engage in
■ Considerable downside risk aka FAT TAIL RISK
■ Expect st w mkt exposure to have low skewness and some positive
kurtosis (like mkt)
■ Strategies w event risk and credit risk to be -vely skewed w large +ve
kurtosis (longer left tail, flatter dist)
● Eg investing in a company that then goes broke
■ Most diversified hf strats should have low skewness and should also
exhibit relative -ve kurtosis
● HF w Market Risk
○ 3 mkt dirnl str - all have +ve skew : preferred to -ve skew of s&p500
○ Eq long/short
■ better risk/return profile than stock mkt
■ To reduce impact of outlier events, diversify across industry sectors, mkt
cap, etc
○ Short sellers
■ Most volatile
■ If someone can predict bad times, can be most profitable (mirror image of
long-only - +ve skewness, similar kurtosis)
■ Eg the big short - predicted GFC due to overuse of CDOs and MBSs
○ Market timers
■ Excellent option for risk averse invst
■ Offer one of the lowest kurtosis/highest skewness pairs
■ Jump in and out of mkt based on skills, hence +ve skewness and lower
exposure to outlier events
● HF w Event Risk
○ Ret dists for both corporate restructuring and convergence trading exhibit large
downside risk exposure
■ Deals break down - significant losses will be incurred
■ Large +ve kurtosis and -ve skewness
○ This risk is off-balance sheet
■ Balance sheet contains offsetting long/short posns (eg in target and
acquirer of an m&a deal)
■ Hides true nature of posn - tough to figure out risk exposure
■ Observing trade posns is not enough - invsts must understand underlying
risk exposure which requires a lot of research
○ To avoid this risk
■ Divesfiy amongst funds in the same family for reinsurance
● Eg one fund - m&a in biotech industry, another fund - m&a in
pharma industry
■ Avoid funds that concentrate on same industry or mkt
■ Try to limit leverage of fund
● Mkt neutral, mkt timers exhibit low market and event risk
 ○ Mkt neutral has more consistent returns most of the time (71%) in contrast to mkt
timers (35%) - also reflected in volatility
○ Benefits can be obtained by diversifying amongst hf classes - but not captured by
FOF (kurt 4.34)
● Sharpe ratio is not a complete picture for HFs - the skewness adn kurtosis help to
understand more about the extreme events which could change our decision compared
to simply looking at the sharpe ratio
○ Eg merger arbitrage -
■ Skewness = -2.63
■ Kurtosis = 11.64
■ Sharpe ratio = 0.34

RISK DUE TO HF MANAGEMENT

● 2 major issues w hf mgmt due to lack of regulation

○ No std platform for measuring risk
○ No std way of reporting risk
● No universal data for hf - even though you know how to measure risk in theory, there is
not enough data or evidence to actually carry out the calculations
● 90% mf returns explained by std asset classes vs 25% hf returns

● Mapping Risk
○ 45% cross-sectional variation of hf ret explained by 5 diff trading styles -
opportunistic, global macro, value, momentum, distressed securities
○ Including other factors (characteristics of asset that help explain returns eg size),
70% of the variation of returns on the HFRI composite index are explained which
is still small
○ Point = hf returns do not map as well to std assets as mf
■ non-diversified /concentrated portfolios
■ use of derivatives w non-linear payoffs
○ Eg, what factors explain hf conv bond returns?
■ Interest-rate risk (prices fall if int rates inc) - captured by treasury bonds
factor
■ Market risk (prices depend on how well the stock is doing) - captured by
s&p500 index
■ Credit risk (company defaults on the bond) - captured by sb high yield
cash pay index
■ Market volatility (conv bond is like a call option) - captured by VIX index
● Conv bond is like a call option: at some point you have the right to
convert your bond to equity, and thus payoff structure is similar to
a call option - payoff increases w volatility - prob of S > X
increases so payoff increases
 ■
● Only 37% of the variation in conv bond arb returns is explained
● Bonds and stocks not explaining returns - not significant : can
eliminate int rate and mkt risks
● Some return attributed to volatility but most attributed to the return
of junk bonds
○ Even in a single hf strat, mapping risk is difficult
■ Even more challenging when trying to compare b/w diff invst st that
manage or try to manage diff types of risk
■ Mapping into a single metric - usually not adequate, if not misleading
■ Possible solns-
● Individual inv choose hf to generate excess returns but manage
risk themselves
● Demand more transparency from hf and try to see underlying inv
posns

● Transparency Risk
○ Arises from lax reguln and filing req of hfs
○ Issues for investor due to lack of transparency
■ Authenticity of return claims - cant tell whether reported returns are
correct or there are some sneaky accounting practices behind the scenes
■ Cannot measure/manage risk
○ Managers are reluctant to disclose more
■ It is a highly competitive industry
■ To avoid replication of their strategies and hence losing profits
■ To avoid others picking off on their trades, eg short squeeze
○ Reasonable compromise = lagged reporting of aggregate risk exposure
■ Lagged = not forced to report from v recent years
■ Aggregate = of all hfs in a particular strategy, not really fund specific
■ Report agg - sector/industry, top 10 inv posns, net mkt exposure, total
long/short exposure, lev, durn and convexity, exposure to mkt events
{short volatility}

● Data Risk
○ Selection bias
■ Upward - hfs that do well have incentive to report to advertise that they’re
doing better than others, to draw clients
■ Downward - hfs that do REALLY well do not want to report to avoid
diluting their performance (eg regulators, peer funds)
 ● May be involved in some malpractices, insider trading etc which
could get them in trouble w regulators - want to avoid attention
○ Liquidation / Survivorship / Catastrophe Bias
■ Hfs that are performing poorly may cease to exist - stop reporting their
performance even before
■ Upward bias of 0.70%
○ Overall upward bias in reported hf performance is 4.5%

● Performance Measurement Risk

○ Sharpe ratio most used stat to compare performance across managers when dist
is normal
○ Hf managers have other types of risk {eg event risk} and use derivatives w
non-linear payoffs - hence make the sharpe ratio not the best metric to use
■ Eg if all works well, make some return on merger strat but if merger falls
through, make big losses
○ Optimisers (computer programs) when allocating money to specific opportunities
eg hfs do not consider this latent risk which leads to an overallocation of capital
○ Eg, PF invests $1mn w hf manager
■ Hf manager promises 9% annual return, T bills returning 6%
■ Strategy = sell an option strangle on S&P500 and invest premium + pf
money on a t bill
● Strangle = simultaneous selling a put and call, both otm, strike of
call > strike of put
● Current stock price when strangle written is 2.5 sd from each K ie
2.5 sd more than Kput and 2.5 sd less than Kcall
■ Sd of s&p500 in 1990-2005 = 4% so manager is betting on a movement
of less than 10% {4% x 2.5sd} in either dirn
■ Monthly strangle provides premium = 7.50
■ For manager to yield 9% {0.75% per month} - should sell y strangles that
solve the following eqn
● (1mn + 7.50y)(1+6%/12) = 1,007,500mn
● y = 331.67
■ If the volatility event occurs, the options will be exercised and the
manager will have to sell more strangles and might have to liquidate other
posns to meet the margin calls - fire sales possible
■ Simulation results show that a consistent performance of 9% for 6 years
followed by a single volatility event in yr 7 will make the annual return over
the 7 years = 2.85% << rf 6%
● Latent risk revealed only after the volatility event
○ Careful due diligence should focus on strategies and look beyond impressive
track records and high historical sharpe ratios
○ Emergence of new analytical tools - also v imp - need to look beyond risk
adjusted ratios developed for linear invst world w long only managers
● Event Risk
○ Not earlier event risk for underlying but whether HF returns are highly correlated
during global crisis
○ Usual lack of identifiable benchmark for a hf would indicate that returns are
■ Independent of fin mkt
■ Uncorrel b/w funds
■ Implying a skill factor - diff skills for diff managers - individual strats and
management
○ Event study to test how hf rets were affected
■ Default of russian sov debt in aug ‘98
■ Collapse of ltcm in sep ‘98
○ Event study computes abnormal return during a particular event
■ Abnormal return is diff b/w return around the event and what wouldve
been the expected return if the event had not happened
■ If hypothesis = hfs are skill based, then expect no abnormal returns for
their strategies

○
■ Except for short sellers and market timers, hedge funds did not offer
diversification benefits to this event
■ Even mkt neutral funds had significant -ve abnormal returns
■ Many funds req several months for their arbitrage strategies to work and
req normal mkt liquidity - when events in ‘98 happened, mkt dried up
causing margin calls that led to big losses
■ Funds couldnt support each other bec most had similar risk exposures
HF BENCHMARKS

● Inv demand relative returns amongst other things

○ Main reason for index construction - to have meaningful comparison for
comparison
○ Saw alr that inv in hf is basically a bet on the manager’s skill
● Issues w constructing a hf index
○ Size of hf universe is not known
○ Data biases - survivorship, selection, etc
○ Dynamic nature of trading strategy/style and consistency
○ Investability {not all strats can have large initial inv - eg less profitable, easy for
S&P500}
● Several hf indices but each is unique and v little overlap
● Most report monthly reports that are net of fees - fees are deducted
○ Caveat =
■ Incentive fee estimated on a monthly basis is not ideal - annual
performance not equal to monthly performance times 12
■ Different fee structures apply for diff inv
COMMODITIES

● Oft -ve corr w stock mkt

● Dont provide ongoing stream of revenue
○ Cannot be valued using npv
● Consumable or transformable
● Real assets - tangible, have physical presence
● Value dependent on global supply and demand imbalances rather than regional ones
● Do not conform to CAPM for two reasons
○ Returns map poorly onto fin mkt returns, hard to distinguish b/w systematic and
unsystematic risk {no cashflows, beta vague}
○ Dependent on global supply/demand issues instead of risk premium -
fundamental diff is NPV cannot be applied
● Purchasing underlying
○ Most inv ignore storage issues let alone willing to bear storage costs
■ In certain mkts, eg india, physical ownership of commodities like valuable
minerals eg gold is still valuable where banking is not that common
○ Own sec of companies that derive most revenues from purchase and sale of
commodities eg sunpower elec - several issues
■ Dependency on stock mky - resulting in systematic risk
● Eg exxonmobil has 0.86 correl w s&p500 and -0.14 w crude oil
■ Inv in company also exposes investors to idiosyncratic risks of the
company
● If a company for ex faces a lawsuit for unlawful actions, this
affects its stock price but does not affect the fundamental value of
the commodity
● Another example is financial and operating leverage, which again
affect stock price but not the commodity
■ Even if both systematic and idiosyncratic risks are acceptable by the
investor, it might be the case that the company has hedged away its
exposure on the commodity - low correl of exxonmobil w crude oil
suggests hedging
○ Purchase of commodity futures contracts is the easiest way to gain exposure to
commodity prices, several adv
■ Trades in an exch - central mkt place, transparent pricing, clearinghouse
security, uniform contract size and terms, daily liquidity
■ Purchase of futures contracts does not req physical delivery if an
offsetting posn has been initiated as well
■ Purchase doesnt req paying full price for the commodity but comes w
margin requirements
RETURN PREDICTABILITY

Event Studies
● Eg debt issuance
○ Challenge - not all firms issue debt and those which do dont do so at the same
time - firm specific, some issue multiple times
○ Decision studied in event time
■ Identify firms issuing debt in dataset
■ t=0 when debt issued
● Multiple issuances = separate events
■ Calc avg ret around t=0 {t=-10,-9,...9,10}

Abnormal Returns
+ve ret alone means nothing, may be exp comp for risk
Most cases: abnormal return used rather than raw returns
AR = ret over and above what wouldve otherwise been expected
○ Ret associated w event that cannot be explained by current knowledge of risks
○ AR non zero - inv can use event as signal
Ways to compute
○ Factor models
■ Estimate factor model on pre event data by reg return on factors and
obtain coeffs
● Rit - Rft = α + β(Rmt - Rft) + et
■ Use α, β to calc exp return around event
● E(Rit) = Rft + α + β(Rmt - Rft)
■ The abnormal return is
● ARit = Rit - E(Rit)
○ Control Group
■ Identify group of stocks that did not undergo event simultaneously to
chosen sec in real time
● Pref - similar risk characteristics as treatment group
● Eg. if intel issued debt in may ‘95 - identify stocks in microchip
industry that did not issue debt in 1994-1997, ie AMD
● Abnormal return = RINTC - RAMD
○ Two approaches - which is better?
■ Factor models
● Theoretically disciplined - based on statistics
● What if model itself is wrong? Eg missing factor
■ Control group
● Simple to perform
● Market disciplined - directly comparing returns
● Subject to choices of comparing firms - at the end of the day the
two secs will never be the same/identical
Application - Leverage Events
● Event study to understand effects of firms’ capital structure decisions
● Leverage - proxy for capital structure
○ Lev = D/A = D/(D+E)
○ Higher D or lower E – higher lev
○ Higher lev = more volatile cf and more risk
● Finding = prices jump up if lev inc and drop if lev dec

Slide 11 = ?

Trading Opportunities
● Jump at t=0 - says nothing about mkt ineff (mkt reacts to newly released info)
○ Meaningless for trading unless private info available
● Non zero AR post event (t>0) may indicate mkt indeed - prices did not fully adjust to new
info
○ Buy after event if AR +ve, sell if AR -ve
○ It may be that event changes risk characteristics of firm and previously est beta
no longer valid - ar not really diff from 0
● Non zero AR prior to event (t<0) - possible anticipation of event / limited early release of
info / insider trading
○ Observing run up - possibility to anticipate event, trade on it ahead of time
○ Alt expln (less sinister) - non zero ar at t<0 make the event more likely

Over/Under rn
● Psychology
○ Overrn - people get excited about +ve info, stocks that did well are overpriced,
will do poorly in future
○ Underrn - people do not fully react to +ve info, stocks that did well are
underpriced, will continue doing well
● Criticism of psychology - lack of discipline: close to assuming result

RETURN ANOMALIES
Observed return patterns that cannot be explained by known risk stories

Momentum
● Stocks that did well continue to do so over the next 12 months, then a reversal in the
following 24 months
○ Jegadeesh and Titman, 1993
○ Consistent w initial underrn, long term overrn
● Seems to be fairly robust, addnl studies have not yet found evidence of it having gone
away
○ Many funds still trading momentum
○ The refine the strategy to minimise stock turnover and txn costs
● Strategy Implementation
○ Each july 1st, compute the return for ach sec over the previous J quarters
■ J = 1, 2, 3, 4
○ Sort all of the returns and assign secs into one of 10 portfolios based on their
prev J qtr returns
■ Portfolio 10 - best 10% performers, Portfolio 1 - worst 10%
○ Buy portfolio 10 and short portfolio 1 and maintain this posn for K quarters
■ K = 1, 2, 3, 4
○ Results in 16 possible strategies - J month / K month strategy

○
● Can momentum be explained by known risk stories?
○ It is poss that p10 is more risky than p1 {higher ret, smaller size} therefore earns
higher ret
○ Double sort portfolios based on past performance and historical beta (β3 is the
largest, captures correlation with market risks)
■ If momentum is coming from beta risk, high returns should be
concentrated in high beta portfolios only
○ Double sort portfolios based on past performance and size (S3 is the largest)
■ If momentum is coming from small firm risk, high returns should be
concentrated in small portfolios only
○ Neither size nor market risk seem to explain momentum

○
● Regression approach to account for known risk factors
○ Reg momentum pf on mkt ret
■ Intercept is capm alpha (AR)
■ If ret +ve for p10-p1 then momentum ret not acc for by capm risk
■ Non zero alphas remain
○ Alt: reg momentum pf on ff’s 3 factors and check for alpha
■ Int : ff 3 fac alpha
■ If +ve for p10 - p1, then momentum ret not acc for by ff 3f risk
■ Ff model not yet popularised when jeg and titman wrote about momentum

○
 ○ Event time analysis
■ Useful to consider performance of strat in event time to know when to get
out
● Cum ret (not ar) is 9.5% over 1st 12 mths
○ Likely big enough to withstand txn costs
● Cum ret 5.5% after 24 mths
○ Reversal in mths 12-24
● Cum ret 4%, not significant after 36 mths

● Momentum strat over time

○ Performs well in post war subsamples as well
■ Good for strat as it suggests consistency
■ Did not perform well in 1927-1940
● J&T attribute this to high no of reversals in this period - momentum
crash
■ 41% of total momentum ret is conc w/in 3 days following a firms earning
announcement
● Fund flows and momentum
○ Partially explained by mf flows
■ Fund a : 75% in stock 1, 25% in stock 2
■ Fund b : 25% in stock 1, 75% in stock 2
■ Suppose unanticipated +ve shock to 1 and unanticipated -ve shock to 2
 ■ Fund a outperforms b (luck)
■ Inv : inv more in outperforming funds
● +ve flows to a, -ve to b
● If a lucky, then why?
■ Funds : tend to not change allocations
● A inv 75% of new money in stock 1, 25% in stock 2
● B divests 25% of lost money from stock 1, 75% from stock 2
■ Excess demand pushes price of 1 up and 2 down
■ Eventually as inv realise true val, price goes back down/up

POST EARNINGS ANNOUNCEMENT DRIFT (PEAD)

● Firms regularly announce earnings - usually once per quarter
● When earnings are above (below) expectations, subsequent abnormal returns are +ve
(-ve) for 60-180 days
○ What matters is +ve (-ve) surprise to earnings, not +ve (-ve) earnings
themselves
○ Consistent w underrn
○ Pre-event ar’s are also +ve (-ve) : reln w momentum

Expected Earnings
● In order to identify an earnings surprise, first id exp earnings
○ Note- for many firms, earnings are highly seasonal (more iphone buyers after
new product announcement)
● Common factor in earnings
○ Reg a firms earnings on some factors (mkt earnings) using lagged data
■ Et = A + BEMt + et
■ Calc abnormal earnings to be diff b/w announced earnings and earnings
predicted by reg: AEt = Et - (A + BEMt)
● Standardised unexpected earnings
○ A simple model where past earnings are the best forecast of future earnings
○ To control for seasonality, the surprise is the difference b/w todays earnings and
earnings 4 qtrs ago
○ The surprise is normalised by the std dev of the past 8 surprises

○
● Many firms followed by analysts who forecast earnings, any time an analyst revises
forecast can be considered a surprise
○ Analysts’ estimates are not always revised every mth, so take 6 mth avg
○ REV6: 6 mth MA of rev earnings forecasts by analysts

■ f is the consensus IBES estimate, est are scaled by price

● Proxy for expected earnings
○ Ultimately care about the mkt’s perception of announced earnings
○ Why not just use cum ar at announcement time?

○ If earnings were truly a +ve/-ve surprise, the firms stock returns should be v
+ve/-ve at the time of announcement
■ Pro: no need for model of exp earnings
■ Con: need to model exp returns
● This eqn assumes capm and beta 1, could estimate beta on
historical data or use ff3f model to get exp return
● Implementation
○ Measure of earnings surprises - SUE
○ Look back 6 mths, sort all firms based on SUE, set cutoffs to assign firms
■ ie what is SUE of top 10%, top 20%, bottom 10%, etc
■ Look back bec only use info currently available
■ Assign firms to one of the pfs based on these cutoffs
○ Track AR of these pfs in event time
■ BT simply uses Rit - Rmt as abnormal return
○ This is not a trading strat yet - trading strat would need to specify
■ Which of the 10 portfolios to long/short
■ When to unwind posns
○ Looking at performance in event time helps formulate a trading strat

● After +ve/-ve announcement, drift is +ve/-ve

 ○ P10 - P1 has 60 day CAR of 5.3%, 4.5%, 2.7% for small, med, large firms
○ Disproportionate amt in first 5 days but significant through 180 days
● Potentially v useful to trader:
○ Buy pfs w +ve surprises, short pfs w -ve surprises
○ Unwind posn 60-180 days after announcement (max car)

Event Time Analysis

Pre- and post- announcement

Large firms only

Can you pocket the pre-announcement returns?

● Prior to a +ve/-ve announcement, drift is +ve/-ve and large compared to
post-announcement returns
○ Not necessarily useful info since at t=-60, dont know what the announcement
surprise will be
○ On the other hand, can use the drift to predict dirn of announcement
■ An announcement is coming and you observe a drift up, expect
announcement to be +ve
■ May be indicative of mkt antiicipating surprise or early release of info
■ Drift speeds up just before announcement

Potential Explns
● Reverse causality
○ Could be that firms w +ve ar are more likely to have +ve earnings ‘surprises’
○ Rule out this expln if measure of surprise is perfect
● Similarity to momentum - firms that do well continue to do well
● Could also be risk - perhaps these firms have higher beta?
Can risk explain PEAD?

● Could it be that +ve ret are explained by higher risk?

○ Indeed p10 has higher beta than p1 exactly during the period of higher return
■ High betas (-59, 0) and (1,180)
■ No difference (-120, -59) and (181, 240)
○ However beta diff seem too small
■ ∆β *RM = 0.2*1.5% = 1.3% but differences are about 4%
■ Furthermore, p10-p1 is consistently +ve
● Perhaps capm is not a good model of risk and risk based expln exists?

An expln from psychology

● People care about gains and losses relative to some starting point, not their total amount
of money
● Disposition effect - value fn concave over gains (risk averse) but convex over losses (risk
loving)
○ -ve announcement = in the loss region : risk loving and do not sell - underrn
○ +ve announcement = in the gain region : risk averse and sell too early - underrn
● Frazzini 2005: finds empirical support - stock prices under react to more bad news when
more current holders are facing a capital loss, under react to good news when more
current holders are facing a capital gain
 ● Utility fn:

Why do we have anomalies?

● Any strategy creates price pressures
○ Momentum - long past winners, short losers = current price of past winners
increases due to extra buy pressures, if enough people trade momentum, then
the winners’ price will be so high to wipe out any +ve future returns
● People have been trading strategies like pead and momentum for decades, why are
there still return anomalies?
○ There is something that prevents traders from taking posns or realising returns?
○ Margin requirements
■ Margin = whenever you buy/sell asset, need to post some capital as
collateral
● No margin - short $1 of A, long $1 of B
○ Initial cost of trade = 0, make this trade as large as you
want ($1 gazillion)
○ A goes up by 1%, B goes down by 1%
■ Profit = -0.02, percent return = -∞
○ A goes down by 1%, B goes up by 1%
■ Profit = 0.02, percent return = ∞
● 10% margin - short $1 of A, long $1 of B
○ Deposit w broker $0.10 (10% size of short posn)
■ Initial cost of trade = 0.10
○ A goes up by 1%, B goes down by 1%
■ Profit = -0.02, percent return = -20%
○ A goes down by 1%, B goes up by 1%
■ Profit = 0.02, percent return = 20%
○ If you have $1mn, at most you can take a posn of $10mn
FRICTIONS

● Bid/ask spread - you buy for more than avg price, you sell for less
○ Diff is how mkt maker makes money
○ Spread is small for large, liquid stocks and high for smaller, illiquid stocks
○ If a strat relies heavily on small illiquid stocks, it is less likely to survive txn costs
● Short sale constraints - it is impossible to short sell certain stocks, and even if short
selling is possible, it is usually costly
○ Margin requirements limit size of posn
○ If a strat relies heavily on short selling, it is less likely to work in real world
● Liquidity - some stocks may be difficult to sell
○ This is esp true during extreme times
○ Liquidity risk may make strategies much riskier than they appear (LTCM)

Bid/Ask Spread (BAS)

● BT also consider txn costs associated w a pead strat
● They consider BAS of 4% for small and 2% for large firms
○ Since strat involves going long in p10 and short in p1, we must multiply these
numbers by 2 {bas as a cost applies to both}
○ Their strat involves 78% turnover each qtr - 22% of firms that were in either p10
or p1 stayed in p10 or p1 so no need to rebalance
● Implied cost is 0.78*2*4% = 6% for small firms and 0.78*2*2% = 3% or large firms
○ These are above 60 day car but below `80 day car so strategy may still be
profitable after txn costs
○ However, it is far less profitable, and will be consistently +ve far less often

Liquidity
● A pead long/short start provides a return of 0.24% per month in the most liquid stocks
but 1.79% per month in the most illiquid stocks (before subtracting out costs)
● Illiquid stocks have high trading costs and market impact costs - they find that txn costs
account for 66% to 100% of apparent pead long/short strat
 ●

For many strategies, rebalancing is the biggest headwind - everyone knows about momentum,
many people trade momentum - the best funds dont just trade momentum, but minimise
associated costs - higher frequency strategy = more costs
Value Premium
● Book to market ratio = B/M = book value of eq/mkt value of eq
○ High b/m stocks - value ; low b/m stocks - growth
○ Value stocks - low expected growth, bad past performance
● Value premium = long value stocks and short growth stocks generate +ve ar4

Value and Momentum

S&P500 Inclusion Effect
Carry Trade

VENTURE CAPITAL

FINANCING STARTUPS

How do young small firms obtain invst capital?

● Primarily self financed w equity, supplemented w informal fin - debt from fam/friends
● As firm grows - ability/willingness of informal fin fails to meet needs of business
○ Retained earnings - firm can reinv profits: this many not be enough for fast
growing companies
○ Banks - predominant source of small business fin but limits here as well: banks
usually req tangible assets and/or predictable cfs along w historical and personal
knowledge of borrower quality
○ Venture capital - increasingly imp alt: an insti specialising in financing risky,
opaque, intangible firms
○

Debt vs Equity
● Debt - you are the full owner of the project but you promise to pay back creditors some
prespecified amount
○ Monthly mortgage
○ Coupons and principal on corporate debt
● Equity - your investor becomes your partner and owns a piece of the project
○ Any cfs from your project are split among all eq holders
○ Dividends and share repurchases
○ Equity holders typically have a say (vote) in how the firm is run

Public vs Private Equity

● Public eq - shares of the firm are traded on a public mkt
○ Typically large no of dispersed shareholders
○ Typically liquid (easy to buy/sell)
● Private eq - pieces of firm (or part of firm) are owned by small no of conc owners
○ No liq public mkt for shares, invst horizons up to 10 yrs
○ Asymmetric info problems for outsiders, monitoring benefits for insiders
 ● PE overview
○ Venture Capital
■ Financing of startups
■ Eventual goal = ipo or to be acquired
○ Leveraged Buyout
■ A small group, often insiders, buys out all the public eq and takes the firm
private
■ Often financed by a large amount of debt (leverage) - undertaken by the
underlying firm
■ Often done to poorly run firms, firm taken public after the problems fixed
○ Mezzanine Financing
■ Mix of private debt and private equity
○ Distressed Debt
■ Pe invst in established but troubled firms
■ If the firm is close to bankruptcy, debt is cheap (but risky)

Problems of debt and public eq

● A large amt of debt creates problems
○ Risk shifting problem - incentive to invest in inefficient (low mean return) high risk
projects
○ Debt overhang problem - lack of incentive to make effort and improve the
company
● Public equity is generally not an option
○ No history, so cost of learning whether firm is good/bad = high
○ Small, uninformed inv will not pay such a cost so going public is infeasible

RISK SHIFTING
● Firm financed w a lot of debt - its downside is limited but its upside is unlimited
○ Will want to take a lot of risk - increase option value
○ Inv know this and ask for higher stake in the firm to compensate for more risk
○ The entrepreneurs receive less money, hurting their willingness to take on the
project upfront - equity does not have this problem
● Example - 2 projects available
○ Safe/good (SG) - invest I = 1 at t = 1, receive 2 or 1 w prob 0.5 at t=2
○ risky/bad (RB) - invest I =1 at t = 1, receive 9 w p = 0.1 or 0 otherwise at t=2
○ Rb is riskier and has a lower expected value than sg
○ Simplifying assumption - risk neutrality, no discount, reqd ret = 0% {only need to
breakeven}
○ Debt
■ Suppose debt financing and tell creditors will take sg project
● Must promise to pay some face value FSG
 ■ If sg carried out as promised
● can issue rf debt FSG = 1 and always honour it
● p/o to you = 0.5(2-Fsg) + 0.5(1-Fsg) = 0.5
■ If deviate and take rb project
● p/o to you = 0.1(9-Fsg) + 0.9(0) > 0.5
● Incentive to bait and switch
■ When obligation is fixed and downside is limited, want to take on as much
risk as possible
○ Many creditors will anticipate firms may want to risk shift - will charge a higher
interest rate
■ Creditors anticipate rb chosen:
● 1 = 0.1Frb+0.9*0 => Frb = 10 > 9
● This suggests - even in the good state, the project will not be
valuable enough to pay back the debt ↔ npv < 0
● No project funded
● For young firms w high risk and little available info, debt and public eq face major
problems
○ Debt induces risk shifting
○ Equity is the better choice

● Back to example
○ Equity
■ Suppose equity financing
● Promise share a to outside investors
■ If implement sg
● 1 = asg(0.5*2 + 0.5*1) ⇒ asg = ⅔
● p/o to you = (1-asg)(0.5*2 + 0.5*1) = 0.5
■ If implement rb
● 1 = arb(0.1*9 + 0.9*0) ⇒ arb = 1.1
● a>1 impossible, project not funded
● p/o to you = 0
■ Tell investors sg but take rb
● p/o = (1-asg)(0.1*9 + 0.9*0) = 0.3 < 0.5
● No incentive to bait and switch - w equity financing, you have the
incentive to credibly choose the best project

DEBT OVERHANG
● Suppose the firm has a lot of debt in place, and there is a good chance that it wont be
able to pay back
● Debt overhang = the firms has little or no incentive to make improvement. Why?
○ Bec the eq holder have to make effort and absorb the costs of the improvements
but the benefits of the improvement goes mostly to the creditors - they are more
likely to get paid in full
 ○ So eq holders have no incentive to make costly effort that improves the firm
● Example - consider a troubled firm w face value of debt F = 50 maturing tomorrow
○ Cf tomorrow can be 60 or 40 w p = 0.5 each
○ Assuming risk neutrality and no discount
○ Value of debt today is 0.5(50) + 0.5(40) = 45
○ Value of equity today is 0.5(60-50) + 0.5(0) = 5
○ Suppose eq holders can spend 6 and improve tomorrows cf by 10 uniformly to 70
or 50 → +ve npv of the improvement : 10-6 = 4 ie efficient
■ Do eq holders have the incentive to make such improvements?
■ Calc p/o after making the improvement, including the cost of doing so
■ Value of debt - given improved cf 70 or 50, debt becomes rf, so value of
debt is 50
■ Value of equity - including the cost of making improvement, 6
● 0.5*(70-50) + 0.5*(50-50) - 6 = 4
● This is less than before the improvement (5)
● So +ve npv improvementg is passed up
● Eq absorbs the full costs of the improvement but not its full benefit

FREE-RIDER PROBLEM W PUBLIC EQUITY

● Suppose manager needs monitoring from some eq holders - eg. otherwise starts wasting
company money on personal hobbies
○ Ofc monitoring = costly - have to spend time and resources to oversee manager
○ As long as any inv monitors - manager will behave
○ Free-rider problem = if you are a small inv, you dont want to do costly
monitoring and always have hope someone else will do it - in the end, no one
monitors
● Example - tomorrows cf = 10 if some eq holder monitors, 0 otherwise
○ Suppose cost of monitoring = 4
○ Small inv w 20% stake → dont monitor bec p/o from monitor is 20%*10 - 4 = -2
■ If every investor hold less than 20%, no one monitors (almost always true
for public companies)
■ This is the free rider problem
○ Big inv w 70% stake → monitor bec anticipate no one else will. p/o from
monitoring is 70%* 10 - 4 = 3 > 0 ⇒ better off monitoring

ADV OF VC
● Single large shareholder - incentive to pay informational cost of learning firm quality
○ Vcs often specialise in a sector eg biotech, software
○ Avoids free rider problem which prevails ampng small public investors
● VC are equity investors - alleviate risk shifting and debt overhang problems

VENTURE CAPITAL
● Vcs fin high risk ilia unproven firms by purchasing senior eq stakes
● For their services (monitoring) they often get high rates of return
SPECIALISATION
● By industry
● By region
○ Certain regions have amassed concentrations of new tech and vcs find it
convenient to concentrate on a particular region
○ Easier to monitor capital but may lack diversifcation
● Turnarounds
○ Buy near failed startups from other vcs
○ High tisk since firm likely to be bad
○ However firm bought at deep discount

DRAWBACKS OF PE
● Illiquidity
○ By defn, pe has no secondary mkt to liquidate posns into cash
○ If inv exp to have occasional need for cash then pe may not be suitable
○ Inv who prefer long term inv are interested in pe
■ Ultimate inv - pension funds, wealthy people, funds of funds
■ Contribution to vc is typically committed for 5-10 yrs
○ Example- suppose there is a project which req initial inv of I=1 at t=1
■ Risk neutral, appropriate discount rate is 10%
■ Will pay 1.5 w certainty at t=3 ⇒ NPV = -1 + 1.5/1.12 = 0.24
● At t=1 you borrow 1 at 10% by promising to repay 1.1 tomorrow
● At t=2 you owe 1.1, you refinance - borrow 1,1 use it to pay off
initial debt, by promising to repay 1.1(1=10%) = 1.21 tomorrow
● At t=3 you owe loan from t=2, pay off 1.1*1.1=1.21 and are left w
1.5-1.21=0.29 profit → PV = 0.29/1.12 = 0.24 = NPV
■ However, suppose there is a 33% chance that no new financing is
available at t=2 – liq crunch
● If a project is liquid, you sell it at t=2 for its pv and use it to pay off
creditors
● If a project is illiq, you cannot sell it for its full value - you can only
sell it for a*value
○ mayb e you are the only one who can run it
○ Banks know quality of loans it gave but outside banks do
not
● If a is low enough, you will never fund the project
○ Suppose a = 0.25, then in period 2, project is liq for 0.34 all
of which goes to creditors
○ Creditors will n% interest rate - will ask for 1 = (0.67(1+r) +
0.33*0.34)/1.1 ⇒ r=47%
○ If r=47%, at t=3, you will owe 1.47*1.1 = 1.62 > 1.5
● Illiquidity is costly
DETERMINANTS OF VC ACTIVITY
● Supply of funds
○ Int rates
○ Cap gain taxes
○ General mkt performance
○ Outside opp
● Demand of funds
○ r&d activity
○ Gdp growth
○ Active stock mkt
● Vc activity is +vely related to r&d activity and job growth (cross sectionally by state)

CORPORATE VC FUND
● Many larger firms created their own vc funds
○ Often but not always to nurture and bring to mkt internally developed ideas
○ Parent company’s capital only
● Eg intel started intel capital w focuses on the internet economy
○ 1991-2005: $4b inv in 1000 companies
○ 160 acquired, 150 ipod
○ Microsoft, xerox, hp, amaco, oracle
○ Universities - mit, stanford
● Potential problems
○ Possible conflicts of interest b/w parent and subsidiary
○ 10yr horizon and ilia may be too long for short term profits reqd by public
shareholders (of the parent company)
○ Increased risk of loss - doubling down
■ Vc alr operates in parents main line of business
■ Dell lost $200m in 2001 on dell ventures in addn to $1b on its general
investment portfolio

LIMITED LIABILITY
● Typical of us corporations
● Inv cannot be asked to contribute more than what they have alr put in
○ I buy $1m worth of onlinecasino.com
○ I now own 20% of its shares - $5m mkt cap
○ Joe college gambles away his tuition and whines to congress
○ Court awards $100m in punitive damages to joe - i lose by $1m but cannot be
asked to contribute more towards the $100m

LIMITED PARTNERSHIP
● Most pe firms today are limited partnerships (80%)
● Gps have joint unlimited liability for the partnership
○ Debt, lawsuits, etc
 ○ More risk for gp but signals gp is serious and committed
○ No corp tax on partnerships
● Lps have limited liability
○ Cannot lose more than initial inv
○ Are promised some rate of return
○ Commit initial inv but are not asked to contribute until called - when vc finds invst
■ This makes it easier for vc to raise money

Raising Funds
● Vc is typically the gp and outside inv are lps
● Gp has full auth to manage the fund subject to covenants
○ Covenants = restrictions put on the manager in charter
○ These restrict the gp from expropriating from the lps
● If these covenant did not exist then the lps would be less likely to inv w the gp
○ Thus gp is actually better off from installing the covenants even though they are
restricting him ex-post

Covenants on overall fund management

● Limit on amount inv in any one firm
○ Prevednts gp from throwing good money after bad
○ Gp typically paid after lp so has incentive to risk shift
● Limits use of debt
○ Debt allows higher lev so higher volatility so again risk shifting
● Directs reinv of profits
○ Board or lps must approve profits being reinv rather than distributed

Covenants on types of investments

● Aimed to keep gp focused on inv in areas he knows and has promised to invest in
● Typically restrictions on inv in lbos, other vcs, fx, certain industries, etc

Covenant on GPs Activity

● Limit on investing personal funds in firm
○ Otherwise might devote too much time in that firm or refuse to pull the plug
○ Money tunneling
○ Typically gp can invest in underlying portfolio only in same proportion as full fund
● Limit on selling personal interests
○ Otherwise gps have less incentive to work hard
● Limit on future fundraising and outside interests
○ Keep gps focus solely on running fund

Example - Money Tunneling

● Gp of a vc fund, managing $1b capital, stake = 10% - lp 90%
● Can also own 100% of a startup joke inc w no business ie shell co
● Invest all vc capital in joke for 1% eq → ownership of joke = 99% you, 1% vc
 ● Pay out $1b as dividend, close business – you rec $990m, vc receives $10m
○ Lp has 90% of vc, gets $9m, you get $1m
○ Overall you get $991m
● essem=ntially tunneling lps capital into personal a/c
● Stake in joke limited to below 10% - this problem disappears

Determinants of Covenants
● Managers w high pay performance sensitivity (PPS) face fewer covenants - PPS is a
substitute
● When vc activity is high, there are fewer covenants - gp has more bargaining power

SOURCES OF FUNDING
● Initially - 70% pf + 11% govt
● 2005 - 50% pf, rest private sources (uni endowment funds, high net worth individuals,
hfs, fofs, etc)

COMPENSATION
● Two types of fees - management + percent of profits
○ Management = fixed fee, irrespective of how well vc performs
■ Typically 1%-3.5% of committed capital per year (not inv cap)
○ Percent of profit aka carry
■ Typically 20% for most funds, 35% for best funds
■ If vcs invst go bust, gp loses nothing - except reputation
■ Strong incentive to risk shift - increase volatility
○ Clawback provision - lps can claim back previously paid incentive fee if at the
end of fund, the lps did not earn some prespecified amount of money
○ Escrow agreement - portion of vcs incentive fees held in separate a/c until fund
is liquidated
○ Timing of distribution - profit sharing fees cannot be distributed until after all
committed capital is paid back to lps
■ Year 3 - fund receives first profits and pays them to lps
■ Year 5 - lps initial inv fully paid
■ Year 6 - all future profits are paid out, 80% lps and 20% gp

Risk Shifting
● Fund manager = you, raise $100m from lp
○ Pay package = std, $200k/year salary, 1% of managed funds, 20% of all profits
○ Fund duration 7 years
○ 2 available projects
■ A: I=100M, pays 200M or 150M with p=50%
■ B: I=100M, pays 1B with p=40%, 0 otherwise
○ Utility calc - yours higher when choosing b vs lps higher when choosing a :
clashing preferences, you choose to take on much more risk than lps prefer
Other Agency Costs
● W risk shifting, we saw that when compensation involves too much equity, gp has
incentives to take on too much risk
● However, when there is not enough incentive based compensation (equity, options),
other problems arise
○ Managers receive perks from firm - even if it v costly to the firm and unnecessary
○ Empire building - managers like to feel v imp, may acquire lots of projects so that
they are in charge of large empires even when projects are unprofitable
● In general, there is a v fine line b/w the dangers of too much incentive based
compensation (risk shifting) and too little (lack of effort, perks, empire building)
● Smart design of security can alleviate many kinds of agency problems

Financing Securities
● Preferred shares
○ Typically senior to common shares in liq of assets
○ Often have some guaranteed dividend
○ May have stronger or weaker voting rights
● Convertible preferred shares
○ Preferred shares that can be converted into a prespecified number of common
shares - bought for potential liquidity
○ Can be done at any time, but cannot be undone
● Convertible debentures
○ Bond (>10 yrs mat) that can be converted into shares in some prespecified
amount

Compensation - Manager’s Career Concern

● The learning (effort) model
○ Vc raises two funds, on after another
■ Investors cannot observe vc’s effort but can observe outcome - which
depends on effort and luck
■ Pps higher in vcs 2nd fund - vc must work v hard in 1st fund to develop
reputation - no need for high pps
■ Level of pps across funds - unrelated to performance
● Young funds have low pps but high effort vs older funds need
higher pps to produce high effort
● Must control for age of fund to see reln b/w pps and performance
● Older funds rend to have higher pps and lower fixed pay - learning effect dominates
● No relationship b/w pps and ex-post success - consistent w learning
● No reln b/w compensation and ex-post success is counter to findings on mf
○ After fee return = pre fee return - fees
○ Mf - net return is lower for funds w higher compensation : this suggests that all
funds should have similar skill and similar gross returns, inv should choose funds
w lower fees
○ Pe - net return is unreal to compensation : this suggests that better funds (higher
fees) have higher gross return and gps take away the extra gross return through
higher fees
● Older, larger reputable funds receive larger capital commitments than similar younger
funds
● On avg pps has been falling - perhaps supply of funds to vs has grown given vs more
bargaining power over compensation
● High tech and early stage funds have higher base comp - for higher risk?
● Comp grows in booms and shifts towards fixed - more bargaining power for gps?
VC LIFECYCLE
● Stage 1 - fund raising
○ Capital committed, not collected
● Stage 2 - looking for investments
○ Fund is closed to new capital
○ Losses, not profits (costs of operation, fees)
● Stage 3 - investment of capital
○ How much to each start up?
○ What type of financing?
● Stage 4 - monitoring and managing portfolio
○ Vc works w investments
○ Improves management team, consults, positions firm for resale
○ Positive cahsflows begin
● Stage 5 - liquidation
○ Assets solf off to private or public buyers, or liquidated

STAGES OF INVESTMENT
● Angel investor
● Seed capital
● Early stafe vc
● Late stage vc
● Mezzanine stage
● If at some stage product proves to be not viable, no more financing at later stages - what
can be sold off is sold off and vc cuts losses
● Valuation is analogous to real options framework

Angel Investor
● An inv who provides fin to ent at a v early stage
● Agreement may be formal or informal but typical angel investor is promised some eq
● Amount typically small - $50k-$500k which allows ent to begin development

Seed Capital
● 1st stage where vcs inv w startup
● Business plan created, parts of mgmt team assembled
● $1m-$5m provided to complete dev + begin marketing
● Prototype may be complete and testing w customers may have began - beta testing
product sent to potential customers for free, they provide input
● little/no revenue - start up still a long shot at this point

The Business Plan

● Start up submits a plan to vc based on which vc decides whether to fund it or not
● States business strategy, how to make profit, resources needed
● Provides qualifications of management team
● Assumptions about revenue growth, cash burn rate, additional financing rounds,
timing/value of future ipo
● Executive summary
○ The market
■ Is there an existing market? Whats the size, is there too much
competition, if not is there demand for the product?
■ How is the product better than competitors? Compare products including
price, quality, warranty, ease of use, distribution, audience
● Pricing - if product is new, can start out w high price - will comp
erode future prices? What are expected margins?
● Distribution - wholesalers, retailers, internet, direct sales?
size/cost of sales team? Help desk? Discount to wholesalers?
● Marketing - trade shows, internet, mass media, tie-ins to other
products, audience, cost of advertising?
○ The product/service
■ What makes this unique/better than comp?
■ New, lower price, higher quality?
■ Address long term future - 2nd generation?
○ Intellectual property rights
■ Does the startup own full rights to its tech?
■ If firm merely owns license, it is not good - license can expire
■ Other erosions of intellectual rights - expiry of patents, software piracy, etc
■ Non-disclosure and non-competition agreements for employees
○ The management team
■ All skills covered? Marketing, tech, fin, operations
■ Academic bgs, professional work, references, arrests, facebook
■ Good plan w bad team : vc can add value
○ Operations and prior operating history
■ Already existing operations
■ Barriers to entry
■ Legal standing, charter, bylaws
■ Existing inventories - employees, family, angel investors : each eq stake
must be clearly defined
○ Financial projections
■ All existing income and balance sheet statements and cf projections
■ Sales forecasts, cogs, marketing and other costs, margins
■ Cf statement - how fast is firm using up cash (burn rate)
■ When will b/e point occur
■ Several possible future scenarios
○ Amount of financing
■ How much money is needed?
■ Financing requested must equal future financial needs (burn rate) + some
slack
○ Exit opportunities
Early Stage Investor
● $2m +
● Su alr has viable product
● Some price may alr be charged for product
● Revenue generated bu su still not profitable
● This fin is used to build commercial scale manufacturing services and grow mkt share

VALUATION
● During early rounds of financing, valuation is usually rough
○ Maybe no way to precisely value raw idea
○ Maybe angel inv doesnt care about how much eq recd
● In later rounds - precise evaluation becomes extremely imp
○ 1% eq may turn out to be worth millions of $s
● Vcs rely heavily on past fin statements as well as projected ones

● Accounting
○ FCFs!!!
■ EBIT = Revenue - Cost - Depreciation
■ FCF = EBIT(1-T) + Dep - CapEx
= (Rev - Cost)(1-T) - Dep(1-T) + Dep - CapEx
= (Rev - Cost)(1-T) + T*Dep - CapEx
■ Other things like NWC ignored for simplicity

○ Depreciation is not real → concept made up for tax purposes, not an actual cash
outflow but can affect cf bec is tax deductible
■ Dep tax shield
● If ignore dep altogether, get the wrong numbers!
● Eg diff in operating cf is 24 (correct) - 21 (wrong) = 3
○ Exactly the dep tax shield : 10*0.3 = 3

○ Present Value
■ Value of any project/firm = pv of all future fcfs coming from it
■ Pv of future cfs must be discounted at an appropriate disc rate
● If you can put money in an invst w similar risk and earn 2% return,
then $1.02 next year is worth $1 today
● Similarly 1.022 = $1.04 in 2 years or 1.023 = 1.061 in 3 years or
$1.02T in T years are all worth $1 today
■ A project that costs $1 to implement today and will pay $0.5 next year and
$0.6 the following year is worth -1 + 0.5d + 0.6d2 = 0.0669 if d = 1/1.02,
discount rate = 2%

○ Gordon Growth Model

■ A project that pays D every year starting next year is worth D/r in today’s
value
 ■ A project that pays D next year, and payment growing at g% each year
after that is worth D/(r-g) in today’s value
■ This is the gordon growth model - timing is extremely imp
● Valuation
○ Estimate the VC’s exit date
○ Forecast cfs to eq until exit date
○ Estimate exit price, use it as terminal value (TV)
○ Choose a disc rate - typically v high for vcs
○ Disc cf and tv using the disc rate
○ Determine the vcs stake in the company
○ Post money value - firm value after the vc has injected funds
■ Post money value = pre money value + vc invst
■ This is what an inv would pay for the firm once it is up and running
○ Post funding vcs stake is worth a fraction a of the post money value - for an eq
stake, the vc should be willing to pay VC invst = a * Post money value
■ This implies the vc’s stake is : a = VC invst/post money value
○ Eg biotech su : drug in 4 yrs → 0.5 prob worthless. 0.5 prob worth $100m
■ Appropriate disc rate = 25%
■ Su asks for 25m inv or 15m inv, what stake of eq do you ask for?
● Pv of company = 0*5*100/1.254 = 20.48m
● a = share recd today
● 25m invst – reqs greater than 100% equity, and a cannot exceed
1, so do not invest 25m at all
● 15m invst – 15 = aV ⇒ a = 15/20.48 = 73.24%
○ Eg cyberdyne skynet
■ Operating inc $30m in 2015, grow at 2% per year
■ Req 120m initial inv in 2010
■ r=15%
■ For simplicity - no taxes or addnl expenses after 2014, so net inc fully
paid out as div
■ Pv as of 2014 is TV = 30/(0.15-0.02) = 230.77m
● Suppose ipo in 2014 where 100% of the firm is sold off for
230.77m - assumption about type of final payout does not matter,
only its value does
■ Pv as of 2010 = 230.77/1.154 = 131.94m
■ Thus npv = -120 + 131.94 = 11.94m

■ Cyberdyne approaches jc cap w req for funding

■ Jc knows after initial inv, cyberdyne will be worth 131.94m, thus asks for a
share a = 120/131.94 = 90.95% stake in the firm
● This share makes it worth his while to invest
● In a comp mkt, he cannot ask for more since other vcs would
agree to 90.95% (fair valuation)
 ■ Cyberdyne’s initial inv will keep 9.05% which is valued at 11,94m = npv, if
npv < 0, a > 1 and the project is unfundable
■ Cyberdyne creates 10000 class a shares, gives 9095 to jc and keeps 905
for the founders

○ Valuation by Multiples - assess the firms value based on that of publicly traded
comparables
■ Cf based value multiples
● MV of firm/Earnings, MV of firm/EBITDA, MV of firm/FCF
■ Cf based price multiples
● Price/earnings (P/E), Price/EBITDA, Price/FCF
■ Asset Based multiples
● Mv of firm/BV of assets, MV of eq/BV of eq
○ Procedure
■ Hope - firms in the same business should have similar multiples (P/E)
■ Step 1 - identify firms in the same business as the firm you want to value
■ Step 2 - calculate p/e ratio for comps and come up w an estimate of p/e
for the firm you want to value {eg take avg of comps’ p/e}
■ Multiply the estimated p/e by the actual net inc of the firm you want to
value
○ Example - cyberdyne
■ Uac: oi = 200m, mkt cap = 1.6b
● Similar business model to cyberdyne
● Uac has 100% eq - otherwise must take into a/c tax adv of debt
■ Uac’s mv/ebit = 1600/200 = 8
● Since cyb is similar, we can assume it will also trade at same
multiple once public
● Ebit in 2014 is 30, so its value in 2014 (TV) should be 30*8 =
240m – could use this instead of earlier 230.77m
■ Multiple method works well bec it incorporates mkt belief instead of
relying on cf and disc rate forecasts
● What if mkt is wrong?
● What if cyb is not similar to uac?

Late Stage VC
● $5m - $15m
● By now su may have experienced 1st profitable qtr, product is likely to be commercially
viable
● However, firm is still vulnerable - needs addnl cash infusions for stable profitability and to
reach potential
● Attract new talent, expand manufacturing, improve distribution channels, etc
● Often firm has large a/c receivable but needs cash immediately to grow
● The amount of financing is getting bigger at each stage
○ Only the best firms have made it to this stage - bad ideas dropped out early
 ○ Once the idea has proven to be good, it makes sense to increase its scale
■ This costs more money
■ Real options - option to expand
● Real Opftions
○ Option to abandon
■ The full invst does not have to be made at t=0
■ Small initial invst can be made, if it turns out project is not good, no further
invst made
○ Option to expand
■ After first invst is made, it turns out product is better than all competitors
■ Large secondary invst is made to expand product reach
○ Option to wait
■ We can wait and learn about project before committing any money
○ All of these are why multi-stage financing makes sense - this also explains why
firms in later stages are worth more, and why invsts are bigger
○ Example - rights to operate a gold mine for 3 yrs
■ Mine produces 50k ounces
■ Cost of extraction = 230/ounce
■ Gold price currently = 220/ounce
■ Price can change by 20% or -10% w equal probability every year (given
by the next figure)
■ R = 5%
■ 1st cf occurs immediately

● w/o option to abandon -

○ Trad npv calc:
■ Npv = 50(220-230) + 50(231-230)/1.05 +
50(242.75-230)/1.052 = 126
● Temporary abandonment

○ Need to consider open and close decision!!!

○ Insert 0 at nodes w -ve cfs bec wouldnt operate the mine in
those states

○ Now npv = 1978

■ The project is much more valuable
● Option to wait
○ Even projects w +ve npv may be more valuable if deferred
○ The actual npv is then the current value of some future
value of the deferred project
■ Current npv = net future value as of date t / (1+r)^t
○ Pick the best future date w the highest current npv
○ Example - may harvest a set of trees at any time over the
next 5 years
○ Given the fv of delaying the harvest, which harvest date
maximises current npv?
○ Assume r = 10%

○
 ○ Harvest in year 4

TOLERANCE FOR FAILURE

● Tendency to continue investing in venture conditional on venture not meeting milestones
● Benefit of tolerance - ipo firms backed by more tolerant vcs are more innovative
○ Due to endogenous matching b/w tolerant vcs and high ex-ante innovative firms,
being financed by tolerant vcs is especially important for ventures w high failure
risk
○ Younger and less experienced vcs are less tolerant due to career concerns -
conservatism

ANGEL VS VC - RISK/RETURN TRADE-OFF

● The angel inv who contributed 100k may at this point have the same number of shares
as a vc who contributed 15m - early inv rook a chance, got in on the ground floor
● Consider a situation where an initial 100k allowed the inventor to create a project w npv
= 30m
○ Angel and inventor both own 50% each
○ Npv = pv(rev) - cost(factory) = 45m - 15m
○ Inventor and angel still only have an idea - v valuable idea
■ Vc contributes 15m for factory
● Post money value - 45m, vc share ⅓
● Angel investor contributed 0.1m and owns ⅓ (= 0.5 * ⅔)
○ Late stage invsts are relatively less risky but earn lower expected returns
● Eg Facebook
○ Oct 2007 - microsoft paid 240m for 1.6% stake of fb
■ This implies ms thinks fb is worth 240/0.016 = 15bn
■ This is a private valuation, it could be fb’s future cfs not worth 15b but ms
+ fb creates synergies
○ Zuck’s 20% stake estimated at 0.2*15 = 3bn
■ note - illiq of his invst - highly unlikely he can sell his shares for 3b at this
time
○ Accel partners inv 12.7m for 11% in may 2005, stake now worth 1.65bn
○ Fb promises to use money for doubling workforce and expanding internationally

Mezzanine Stage
● $5m-$15m
● Final stage before ipo or strategic sale
● Su is now fairly grown, w solid management team, proven product but further growth
aspirations
● Financing needed to keep firm from running out of cash before ipo
● Often in form of convertible debt
● Regular bank debt often added at this stage
● During tech bubble - many firms far from ready (later proved to be disasters) were
quickly brought through all stages
Benefit of Debt
● Why do firms want to issue debt?
○ Can produce larger project + higher return
■ Suppose company can turn 2m invst into 2.2m
■ A 10% return if you inv 2m out of pocket
■ But if you borrow 1m w 5% int rate and pay 1m out of pocket, your return
on the 1m personal inv is 2.2-1.05m-1m = 0.15m: 15% return
● The levered production is more risky too
● Tax benefit - the interest payment is tax deductible = interest tax shield

Security Design
● We also know having too much debt creates problems - risk shifting, debt overhang, etc
● How can we take adv of the benefit of debt and avoid its potential problem?
○ Smart design of securities - convertible debt alleviates risk-shifting problem
● Convertible Bonds
○ Starts life as a bond but subsequently may turn into common stocks if the
investors wish to
○ Conversion ratio - the number of shares into which each bond can be converted
○ Conversion price - value of a convertible bond divided by the number of shares
into which it may be exchanged
■ Can be quoted in terms of fv or mv - when quoted in terms of the mkt
value of the bond, refer to this as mkt conv price
○ Conv bond = straight bond + option to acquire common stock
○ Example - firm w 1000 shares
■ 1000 outstanding conv bonds w fv 1000 each → total fv = 1m
■ At maturity, bond holder have the option to convert each bond into 1
share
● For each bond, the bond holder gives up the bond
● The firm creates 1 new share and hands it to the bondholder
● Conv ratio = 1
● Conv price = 1000/share conv = 1k
■ Decision to convert - when to convert?
● Compare two payoffs
○ Straight bond payoff (if not converted)
■ If at maturity, the firm value x < 1m, bond holders
receive the whole firm value x
■ if x > 1m, bond holders receive the full face value
○ Conversion value (if converted)
■ Bond holders receive 1k shares, receive 1k/(1k+1k)
= 50% of the firm value (0.5x) - old shareholders
still have 1k shares
■ Convert if conversion value is higher
● 0.5x > 1m ⇒ x > 2m
 ○ Convertible bonds and risk shifting problems
■ The firms has two invst opportunities, both requiring 100 inv
■ Firm is risk neutral, no discount
■ A pays 200 w prob 0.4, 0 w prob 0.6 → npv = -20
■ B pays 120 for sure → npv = 20
■ W straight debt, the firm cannot get financing
● If firm says its taking a then no financing bec neg npv
● If firm says its taking b then promised fv is 100 - issue rf debt
○ But given 100 liability
■ Exp p/o from b is 120 - 100 = 20
■ Exp p/o from a is (200-100)0.4 = 40
○ The firm would deviate and switch to a
○ So no debt financing available
■ Smarter design - convertible bond financing to raise 100
● Suppose company has 10 shares
● Issue rf debt w fv 100 - convertible to 40 shares at maturity
○ If convert, bondholders receive 40/(40+10) = 80% of firm
○ Otherwise, min (x,100) where x denotes total final p/o
■ If outcome 120 - dont convert (120*0.8 < 100)
■ If outcome 200 - convert (200*0.8 > 100)
● Given the conversion decision, firms p/o
○ If b, 120 -100 = 20
○ If a, 200(1-0.8)0.4 + 0*0.6 = 16 < 20
○ Thus firm has no incentive to deviate from b to a
■ Why can conv bond alleviate risk shifting problem?
● Forces eq holders to share upside w bond holders
● Reduces benefit of a risky project to the eq holders and reduces
their gambling incentives

Stylised Facts
● Avg early st invst 1.3-2m smaller than comparable late st invst
○ Greater invst needed to expand firm
○ Exp justified by higher prob of success
● Most imp determinant of total vc financing is number of financing rounds
○ correl - not necessarily causation
■ More rounds - get more money
■ Need more money - must have more rounds
● Firms in industries w more tangible assets receive less vc financing
○ Less informational asymmetry
○ Easier to get alternate financing
■ Eg use tangible asset as collateral to get bank debt
● Firms in industries w high m/b ratios, r&d intensive industries receive more vc financing
● Firms that end up going public receive 3-5m more than firms that stay private - also
receive more financing rounds
 ○ Ipo is a valuable exit for vcs
○ Vcs learn about firms’ quality and contribute more if there is a good chance of
going public

Monitoring
● Risk shifting - disadv of debt fin
● Free rider problem - disadv of weak eq
● Vcs combination of eq fin + monitoring - crucial for young firms
● Vc - often on bod
○ Provide advice, set goals
○ fire/hire managers
○ Have access to consultants, accountants, bankers, lawyers, potential customers

Syndication
● Multiple vcs inv in the same project - sometimes in multiple stages
● This helps vcs diversify
○ 100m fund can only inv in 10 10m firms - 10 is small enough for idiosyncratic risk
to really matter
○ 100m fund can invest in 20 10m firms if it settles for ½ of each firm
● Added benefit of getting 2nd opinion on su’s viability

EXIT PLAN
● After several years vc want to cash out
● Firm may be sold to existing company or to public (ipo)
● Existing firm may want to acquire su’s tech or mkt share or brand name
● Ipo - shares sold to public
○ Ib acts as intermediary
○ Ipo underpricing

IPOs
● Privately owned firm goes to public mkt to raise funds by selling eq for the first time
● Benefits
○ Funds for invst
○ Diversify the initial inv
■ Founders and other early inv bear idiosyncratic risk for which they are not
rewarded
■ Current eq holders usually sell a fraction of their shares - but not a large
fraction
● Need to maintain the original owners’ incentive to work
○ Exit strategy for vcs and other investors
■ Founders want vcs and banks out (would rather have dispersed
shareholders)
■ Vcs and other early investors want out - typically have a 5 to 10 yr
timeframe, want to realise return and move on
● Costs
○ Monetary costs
■ Admin costs
● 2-10% - big economies of scale in ipos
● After ipo, expensive to comply w regulatory filing req after
becoming a publicly traded company
■ Underwriting costs
● 7-11% - this is the fee that ib charge for their services
■ Underpricing
○ Disclosure requirements
○ Loss of control
○ Loss of freedom - there is now oversight by the regulator
● Role of Investment Banks
○ Help the firm to meet the requirements of the sec in preparing and filing the
necessary registration statements
○ Provide the credibility that a small priv firm may need to induce inv to buy their
stock
○ Provide their expert advice on the valuation of the company and the pricing of the
issue
○ Absorb some of the risk in the issue by underwriting the issue and guaranteeing
the proceeds on the issue
○ Help to sell the issue by assembling a syndicate of underwriters who place the
issue w their clients
● IPO Mechanics
○ Selects a lead IB
○ Due diligence
■ The ib performs a financial analysis and a strategic analysis - the risks
must be known and disclosed
■ It is common for the underwriters to request a ‘comfort letter’ from the
issuers accountants explaining the methods used to generate unaudited
financial results
○ File w regulatory agencies
■ Eg sec filing in the us
● Registration statements are filed w the sec
● The sec has 20 days in which to respond
● During this ‘cooling off’ period, the firm may survey the market to
get an idea of demand
● The mgmt goes on a road show accompanied by ibs
● Price and number of shares are only preliminary at this stage, they
are not fixed until the day before the actual offering
○ Regulatory approval
○ After regulatory approval
■ Final offering price and quantity are determined
 ■ Only then does the ib formally contract w the issuer to buy and sell the
securities
○ Securities sold

● Ways to issue - firm commitment

○ Underwriter agrees to bear risk by purchasing all shares minus underwriting
discount
○ Preliminary prospectus issued w tentative proce
○ Marketing campaign, sec approval, final price
■ Info is acquired during pre sell period
○ Bank must sell all shares at price no higher than offering price
○ Used mainly by larger ipos >10m
○ 60% of ipos in usa
● Ways to issue - best effort
○ Firm and underwriter agree on offer price and min/max number of shares -
underwriter bears no risk
○ If min not sold after 90 days, offer withdrawn and money refunded
○ Allows for greater range of shares to be sold
● International
○ Japan - similar to USA - offer price set, underwriters have considerable latitude in
allocation of shares
○ UK - offer for sale {similar to firm commitment} or placing {similar to best effort}
○ France and Netherlands - much more like an auction, less ipo underpricing than
in most countries
● IPO Waves
○ Hot issue markets
■ Lots of ipos in early 70s, few in mid 70s, lots in mid 80s, few in early 90s,
lots in late 90s
■ Possibly there are more projects/ideas available at certain times -
expansions - so more firms do ipos
● There is cyclicality in raising of funds
■ Possibly certain times are more risky so firms choose not to do ipos
■ Possibly not fundamentals at all but sentiment/bubbles - firm can choose
when to go public (asymmetric info) so firms go public when market
sentiment is high and they can receive higher price
● Ipos are hard to short so rational inv may not be able to undo this
● Underpricing is biggest when recent stock market did well (korea)
● Long term underperformance worst after ‘hot’ markets, related to
sentiment or market timing (UK)
● IPO Short Term Return
○ New issue underpricing - large +ve rets in the first day
■ 16% on avg
● 1st trading day ret for ipos occurring during 1960 - 1987
● There were 8688 issues over this period, of 1.5m or more
 ■ Google rose 20% on first day of trading (2004) - success or failure?
■ Firm receives far less than market seems to be willing to pay - why not
raise price?
○ Logic of underpricing
■ Winner’s Curse
● Some firms ‘good’, some ‘bad’
○ Firms cannot reveal this credibly so price is the same for
all firms
● Informed inv can tell ‘good’ firms from ‘bad’ but uninformed cannot
○ Informed inv only buy ‘good’ firms
○ All buyers of ‘bad’ firms are uninformed - buyers of ‘good’
firms are mixed (rationing)
● If price is fair - avgd over all firms - informed inv have +ve returns,
uninformed have -ve
● Since uninformed buyers know this, they demand all firms to be
underpriced to compensate them
● Underpricing causes uninformed inv to have 0 ret (b/e), informed
inv to have +ve ret - total ret +ve on avg
● Example
○ Suppose mm ent is going public w an offer of 1000 shares
at 1/share
○ W 40% chance, mm ent is a dog and w 60% chance, its a
jewel
○ We’ll assume dogs have an initial return of -20%
○ Assume for simplicity: reqd ret is 0 - just need to b/e
○ There exists both informed and uninformed inv
■ Informed inv know w 100% accuracy whether or not
mm is a dog or jewel, and subscribe only to jewels
■ Informed can buy 500 shares if they wish
■ Uninformed subscribe to all issues
■ In the event of oversubscription, shares are
rationed

■
■ We need participation from uninformed inv -
otherwise ipo market liquidity would be severely
constrained
● What would it take for uninformed inv to buy
an ipo?
● Must earn an expected 1 day ret of 0%
 ○ Uninformed inv must earn an expected one day ret of 0%
{the exp ret on a 0 beta posn when the rfr is 0} - otherwise
they will not participate
○ 0.4(1000)(1-0.20) + 0.6(500)(1+Rj) + 0.6(500)(1+0) =
1000(1+0) ⇒ Rj = 26.67%
○ What is the expected return on any ipo?
■ E(RIPO) = 0.4(-20%) + 0.6(26.67%) = 8%
■ Cascades Hypothesis
● Inv pay attn to world around them
● If no one else willing to buy, even inv w +ve info may not enter mkt
● Banks underprice to get first few inv to buy - hope to start a
cascade or a snowball effect
● Underpricing is like paying to advertise and build a brand name
■ Risk Averse Underwriter
● Underwriter bears all risk for IPO since agrees to buy at some
predetermined price
● Underwriter underprices to reduce risk of getting stuck w an
unsuccessful issue
○ This implies riskier issues have most underpricing -
confirmed by several studies
● Challenge - underwriter alr recs underwriting fee which should
compensate for risk, why not act directly and make fee higher
instead of underpricing?
● The Long Run
○ Ipos underperform in the long run (6-36 months)
○ Cum ret over next 3 years relative to similar firms {numbers rel to early mkt price,
not offer price – long run underperformance less severe if using offer price bec of
underpricing}

■
● Not only stock mkt, a/cing performance underperforms too
● Decline in operating performance over 3 years after ipo relative to
matched sample
○ Winner’s curse
■ When high divergence of opinion, buyers are likely those inv who were
most optimistic
● High initial valuation - not necessarily correct
● Little chance for pessimists to short
 ■ As more info arrives, diff b/w pessimists and optimists narrows - on avg
this will be at the midpoint of their views
● This leads to initially high ret, followed by declines over longer
horizon
■ This hypothesis suggests that long run performance is worst when
divergence of opinion is high
● Proxies for divergence of opinion - percentage opening spread +
time of first trade
● After controlling for issue quality, wide opening spread + late
opening trade are associated with poor long run returns
○ Survivorship Bias
■ Returns of 1000% not unheard of - why so high?
● You can only observe returns when invst survives
● You wont observe the failed ones
○ Suppose you want to estimate avg 10 yr ret of holding
stocks - can you simply use the avg ret of all public
companies that have survived the past 10 yrs?
■ Survivorship bias is present in most financial data, but it is esp severe in
high risk low disclosure right-skewed data such as PE and HFs
■ Example - vc inv 1m each in 10 diff ventures
● One ipo and vc rec 5m, another sold to competitor and vc rec 5m -
all others fail, vc takes a loss
● True ret: vc inv 10m and rec 10m, r= -1 + 10/10 = 0%
● Suppose we dont observe the failed ventures and only see the two
successes-
○ Return on each success : -1 + 5/1 = 400%
○ Perceived ret to vc is the avg of the 2 successes = 400%