712-5c Alternative Investments (Venture Capital, Hedge Funds and REIT'

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ECON 712 – Financial Institutions:

ECON 712 – Financial Institutions Professor Jim Keene, CFA, CFP

Class 5:

Class 5 Alternative Investments

PowerPoint Presentation:

ECON 712 Class 5 3 Alternative Investments/Strategies (Including Exchange-Traded Funds)

Alternative Investments/Strategies:

ECON 712 Class 5 4 Alternative Investments/Strategies Investors demand higher returns due to the lower liquidity (a liquidity premium) and more in-depth analysis required of the assets. Four primary characteristics of alternative investments/strategies are: Lower liquidity than traditional investments Difficulty in determining accurate market values Limited historical performance data Extensive investment analysis required

Alternative Investments/Strategies:

ECON 712 Class 5 5 Alternative Investments/Strategies Alternative investments/strategies include: Real Estate – private and not exchange-traded (except for REITs which represents ~ 4% of the total market value of investment grade real estate) Venture Capital – private and not-exchange-traded Distressed Debt – private and not-exchange-traded Hedge Funds – mostly liquid investments using strategies where pricing anomalies are exploited Commodities – primarily accessed by futures markets and are fairly liquid depending on commodity

PowerPoint Presentation:

I.) Real Estate

Real Estate Ownership Forms:

ECON 712 Class 5 7 Real Estate Ownership Forms Four main forms of ownership interests in real estate: Direct ownership (no debt) – Fee simple ownership of land and improvements on land with a bundle of rights to the property. Leveraged equity – Ownership of real estate subject to debt Mortgages – Holder of mortgage usually receives principal and interest payments. Uncured defaults allow mortgage-holder to foreclose on the property. Real estate limited partnerships, commingled funds and real estate investment trusts are vehicles that are used to aggregate investments in real estate.

Real Estate Characteristics:

ECON 712 Class 5 8 Real Estate Characteristics Unique real estate characteristics include: It’s immobile and indivisible Each property is different so valuations are very judgmental Investments are largely illiquid

Approaches to Valuation:

ECON 712 Class 5 9 Approaches to Valuation Cost approach – investor should not pay more for a property than it would cost to rebuild at today’s prices. Value is estimated based on comparable land sales and compilation of direct and indirect cost to construct property using the same materials. Comparative sales approach – looks initially at sales prices of similar properties and then adjusts upward or downward based on superiority or inferiority of subject property (comparing age, functional obsolescence, location, amenities, etc.) Income approach – property valued at present value of its future income a shortcut is to capitalize the current net operating income at the appropriate capitalization rate to arrive at value

PowerPoint Presentation:

II.) Venture Capital

Venture Capital Investments:

ECON 712 Class 5 11 Venture Capital Investments Stages of investment in venture capital investing are: Seed stage – capital provided for a business idea – product dev./market research Early stage – companies moving into operations prior to manufacturing First stage – capital to initiate commercial manufacturing and sales Second stage – capital used for initial expansion of company already producing and selling a product Third stage – capital provided for major expansion (physical plant, marketing, etc.) Mezzanine (bridge) financing – capital provided to prepare for going public

Venture Capital Characteristics:

ECON 712 Class 5 12 Venture Capital Characteristics Illiquidity – cash out mainly comes from IPOs and merger/acquisitions. Long-term investment horizon – in normal times, the investment horizon is fairly long-term. Companies usually have to operate profitably for a period, generate a minimum of revenues and have a positive initial public offering market Valuation difficulty – there are no comparable assets to apply meaningful valuation metrics – public securities are often the best, after which lack of liquidity discounts are applied Nature of start-up investments – there is no operating history to the start-ups and relatively limited data to venture capital investing

Venture Capital Characteristics:

ECON 712 Class 5 13 Venture Capital Characteristics GP incentive – the general partner needs to be properly incented so that profits are maximized vs. expenses of the partnership Management and entrepreneurial mismatches – as the company grows, the skills required to profitably operate and manage the company changes and the inherent conflict between entrepreneurial fortitude and management discipline arise The IPO and M & A markets need to be fairly active for a successful exit strategy in venture capital investing

Venture Capital Performance Measurement:

ECON 712 Class 5 14 Venture Capital Performance Measurement The valuation and performance measurement of venture capital investments is very challenging. The companies are unique and cash flow projections are speculative. Revenues come at very different times than planned for while expenses are varied and unexpected. Some companies fail, some go public, some are acquired and some operate for a long period without an exit.

Venture Capital Performance Measurement:

ECON 712 Class 5 15 The three key factors to assess are: Expected payoff at exit Timing of exit Probability of failure There are unreliable performance measures and loose benchmarks to evaluate performance against. Venture Capital Performance Measurement

Venture Capital NPV:

ECON 712 Class 5 16 Venture Capital NPV Assume a venture capital project has the following initial investment, payoffs expected time frame, discount rate and failure probabilities: Initial investment - $5,000,000 Payoff if successful - $30,000,000 Time period – 5 years Discount Rate – 20%/year Failure Probability by year: Yr.1 – 20% 2 – 18% 3 – 16% 4 – 14% 5 – 12%

Venture Capital NPV:

ECON 712 Class 5 17 Venture Capital NPV The probability of project survival after five years is: (1 – 20%)*(1 – 18%)*(1 – 16%)*(1 – 14%)*(1 – 12%) = .417 The net present value of a successful project outcome is: -$5,000,000 + ($30,000,000/1.2 5 ) = $7,056,327 The net present value of the project if it fails is -$5,000,000 The probability-weighted average of the two possible outcomes is: ($7,056,327*.417) + (-$5,000,000 * .583) = $27,488

PowerPoint Presentation:

ECON 712 Class 5 18 III. Hedge Funds

Hedge Fund Objectives:

ECON 712 Class 5 19 Hedge Fund Objectives Hedge funds originated with long and short positions. Current usage of term “hedge fund” does not necessarily include short positions Primary objectives of hedge funds are to: Generate absolute return in any market condition Provide returns independent of market beta

Structure and Fees:

ECON 712 Class 5 20 Structure and Fees Hedge fund structures are limited partnership (in U.S. may be exempt from most SEC regulations), limited liability corporation or offshore corporation Fees consist of two parts (three parts for fund of funds investment): Annual management expenses (average 1.4%/year) Incentive compensation ranging from 15 – 30% of profits or profits in excess of a benchmark (risk-free rate, for example) Fund of fund managers can also charge fees for management (1%) and backend profits (10%,for example)

Return Composition:

ECON 712 Class 5 21 Return Composition Assume a hedge fund has a fee structure of 1% annual management fees and incentive fees of 25% above the risk-free rate of return (3%). Calculate the hedge fund net return if the gross return is 22%. Gross return is broken down into a hedge fund manager fee and the net investor return. Hedge fund manager return = 1% + (25% * (22% - 3%)) = 1% + 4.75% = 5.75% Hedge fund investor return = 22% - 5.75% = 16.25%

Major Hedge Fund Strategies:

ECON 712 Class 5 22 Major Hedge Fund Strategies There are over 30 strategies recognized in the hedge fund industry, but they can be broken down into four broad categories: Long/short funds – take long and short positions; largest hedge fund category, use leverage in varying degrees depending on the strategy and are invested worldwide; they are not market neutral – they have a long or short bias Market Neutral funds – A long/short fund that has a net market exposure of 0; the long and short offset each-other; the returns come from alpha on the long plus alpha on the short plus the risk-free rate of return on funds

Major Hedge Fund Strategies:

ECON 712 Class 5 23 Global Macro funds – Generally one of most volatile strategies because it takes large directional bets on currencies, interest rates, market directions, etc. and leverages highly using derivatives. Significant volatility of returns Event-Driven funds – strategies designed to capitalize on certain events happening in the economy such as mergers and acquisitions or distressed company investing (bankruptcy or near bankruptcy investing) Major Hedge Fund Strategies

Fund of Hedge Fund Benefits:

ECON 712 Class 5 24 Hedge fund of funds attempt to put together numerous strategies and managers in a risk-optimal mix in an attempt to maximize risk-adjusted returns. Benefits include: Allow smaller investors to invest across a broad strategy of hedge funds Can allow investor to have access to hedge funds that previously didn’t have it Fund of funds manager expertise in putting together proper fund managers and strategies can be beneficial Can reduce leptokurtosis (fat tails in distribution of outcomes) if properly diversified Can reduce single manager or small number of manager risks (this can be single biggest risk in single hedge fund investing) Can shift tactically between strategies if there is confidence in one vs. others Fund of Hedge Fund Benefits

Fund of Hedge Fund Disadvantages:

ECON 712 Class 5 25 Fund of Hedge Fund Disadvantages Drawbacks include: Additional layering of fees Return prospects are diminished with fund of fund managers from single fund prospects Tactical shifts may not add to returns

Leverage/Unique Risks:

ECON 712 Class 5 26 Leverage/Unique Risks Leverage (borrowing) is used to enhance returns. If the returns on the investment exceed the cost of the borrowing, then there is positive leverage. If it doesn’t work, the cost can be very high. There tends to be no risk to the cost of the borrowing, but there can be large variability to the outcome of risky returns. Most hedge funds use leverage in one form or another.

Leverage/Unique Risks:

ECON 712 Class 5 27 Leverage/Unique Risks The three main forms of leverage used by managers are: using margin in a margin account (borrowing against the collateral value of the assets) – pay a margin rate of interest which usually decreases as borrowing increases borrowing funds externally and increasing the long and/or short positions accordingly using derivatives such as options and futures and swaps whose returns are magnified because only a small margin, if any, is required to effectively invest in a market or security

Hedge Fund Performance:

ECON 712 Class 5 28 Hedge Fund Performance There are some generalizations that can be made concerning hedge fund investment characteristics: Over the period 1/96 – 9/02, hedge funds outperformed both the S&P 500 (equities) and Lehman Brothers Aggregate Bond Index (bonds) –an extremely short period historically to draw long-term conclusions about Hedge funds have a lower standard deviation of returns than equities; there are more measurement problems with standard deviation for hedge funds and standard deviation is a less important measurement for hedge fund risk measurement Hedge funds have higher risk-adjusted returns than equities or fixed income investments – the Sharpe ratio measures this; however, the validity of the Sharpe ratio where returns have option-like characteristics is not the most appropriate The correlation of hedge funds with conventional investments (stocks and bonds) is generally low, though still positive.

Survivorship Bias Impact:

ECON 712 Class 5 29 Survivorship Bias Impact As there are no reporting requirements for hedge funds (they are loosely regulated or not regulated at all by the SEC), poor performing funds do not report results to the data collectors. As a result, the survivorship bias is greater in the hedge fund asset class than in most others. Returns are overstated. Risk measurement for hedge funds tends to be overstated. The poorer funds with higher volatility tend to fail more often and the failed funds are not included in the databases for performance. Risk measures are understated.

PowerPoint Presentation:

ECON 712 Class 5 30 V. Distressed Securities

Distressed Companies:

ECON 712 Class 5 31 Distressed Companies Distressed companies are: Those that have filed for bankruptcy Those that are near bankruptcy (including those attempting pre-packaged bankruptcy resolutions)

Distressed Security Strategy:

ECON 712 Class 5 32 Distressed Security Strategy Typical distressed security investing strategy is as follows: Investor acquires low-priced debt of struggling company (in or out of bankruptcy) Investors either makes money as company’s situation improves without any bankruptcy (akin to a value investor the distressed security investor attempts to find discounted values of securities that he thinks will rebound) or the company enters bankruptcy , the investor acquires controlling debt interests and negotiates for equity in the restructured company

Distressed Security Strategy:

ECON 712 Class 5 33 Distressed Security Strategy The value proposition tends to be longer-term especially for scenarios where the company restructures and emerges from bankruptcy where debt has been exchanged for equity Distressed security strategy requires a venture capital perspective because often the company needs to be restructured and operated differently (skill sets required are similar to those of venture capitalists), requires a long-term perspective, involve illiquid securities and require heavy involvement by the investor

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