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Introduction to Alternative Investments



Alternative investments include:

1) Alternative assets (i.e. real estate and commodities).
2) Alternative strategies (i.e. private equity funds, hedge
funds, and some exchange traded funds (ETFs). These
funds can
Use derivatives and leverage;
Invest in illiquid assets;
Take short positions;
Such funds tend to have:

High fees
Low diversification of managers and investments
High leverage
Restrictions on redemptions.

Characteristics of Alternative Investments:



Illiquidity of underlying investments

Narrow manager specialization
Low correlation with traditional investments
Low level of regulation and less transparency
Difficulty in determining current market values
Limited and potentially problematic historical risk and
return data
Longer time horizon
Higher fees
Unique legal and tax considerations
Involves active management and extensive
investment analysis
Trade in less efficient markets and tend to be less
efficiently priced than traditional marketable
Use high leverage compared to traditional

The reported returns and S.D. of those returns

represent average amount and thus may not
appropriately represent risk and return of sub-periods
within the reported period or future periods.
In addition, due to use of appraised values, the
volatility of returns and the correlations of returns with
traditional assets returns are underestimated.
Assets under management in alternative investments
have increased over time; however, they still represent a
small % of total investable assets.

Categories of Alternative Investments

1) Hedge funds: Hedge funds represent private

investment vehicles. They manage portfolios of
securities and derivative positions employing various
2) Private Equity Funds: Private equity funds invest in
equity investments that are not publicly traded on
exchanges or in public companies with an objective
to take them private
3) Real Estate: Real estate is a form of tangible and
immoveable asset. It includes buildings, building land,
offices, industrial warehouses, natural resources,
timber, containers, and artwork etc.
4) Commodities: Commodities investments refer to
investing in physical commodity products i.e. grains,
metals, and crude oil, through various ways e.g.
Investing in cash instruments
Using derivative products (e.g. futures contracts)
Investing in companies engaged in the production
of physical commodities
Investing in commodity funds which are linked to
commodity indices

Investors of Alternative Investments:

Institutional investors including endowments, pension
funds, foundations, sovereign wealth funds
High net worth individuals
Arguments for investing in Alternative Investments:
a) Provide diversification benefits as they tend to have
low correlation with traditional assets.
b) Enhance risk-return profiles as they tend to provide
positive absolute return.
c) Provide hedge against inflation
Alternative investments generally have an absolute
return objective i.e. provide positive returns throughout
the economic cycle. However, alternative investments
are not risk-free and may tend to have high correlation
with traditional investments (stocks and bonds)
particularly during periods of financial crisis.

5) Other: Other alternative investments include tangible

assets (i.e. fine wine, art, antique furniture and
automobiles, stamps, coins, and other collectibles)
and intangible assets i.e. patents.

Return: General Strategies

Total return = Alpha return + Beta return

Beta return: Beta represents the sensitivity of an asset to

changes in particular market index. It reflects the
systematic risk of an asset. Passive investors assume that
markets are efficient and seek to generate beta-driven
E.g. A portfolio that closely tracks the performance
of S&P 500 index will represent passive investment
and will have +1 correlation with the market
(represented by S&P 500 index).

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Reading 60

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Introduction to Alternative Investments

Systemic risk is different from systematic risk. It is used in
the credit markets to indicate highly correlated default
Alpha return: Active investors assume that markets
are inefficient and provide opportunities to earn
positive excess return after adjusting for beta risk.
The positive excess beta risk adjusted return is
referred to as alpha return.
o For passive investors, expected alpha return = 0.
o Theoretically, alpha returns are uncorrelated with
beta returns.
o Typically, alternative investments are actively
managed with an objective to earn positive alpha
Basic Alpha-seeking strategies (these are not mutually
1) Absolute return: Absolute return strategies seek to
generate returns that are unrelated to the market
returns. Benchmarks used by such strategies include:
Cash rate (i.e. LIBOR)
Real return target (return in excess of inflation)
Absolute, nominal return target (i.e. 7%)
Theoretically, beta of funds that use absolute return
strategies should be close to 0.
2) Market segmentation: Market segmentation refers to
opportunity available to more flexible investors to
quickly move capital from lower returns areas to
higher expected return areas when it is difficult to do
so for restricted or conservative investors due to
following reasons i.e.
Institutional, contractual, or regulatory restrictions on
traditional asset managers with regard to
investments e.g. constraints regarding use of
derivatives, investing in low quality or foreign
securities, managing portfolio relative to a particular
market index etc.
Different investment objectives or liabilities.

higher alpha returns). However, as the name implies,

this strategy results in lower diversification.

Investment Structures

Limited Partnership is the most common structure for

many alternative investments (i.e. hedge funds and
private equity funds). In partnerships,
Investors are referred to as limited partners (LPs). The
LPs have fractional investment in the partnership.
The fund is referred to as general partner (GP). The
GP manages the business and has unlimited liability.
Hence, to avoid unlimited liability, the GP is usually
set as a limited liability corporation.
Limited partnerships are not offered to general
public. They are only offered to accredited investors
and/or qualified purchasers i.e.
o Accredited investors refer to individuals with at
least $1 million and institutions with at least $5
million in investable assets.
o Qualified Purchasers refer to individuals with at
least $5 million and institutions with at least $25
million in investable assets.
Limited partnerships are not highly regulated.
Limited partnerships are located in tax-efficient
Limited partnerships are generally offered to a
limited number of LPs i.e. accredited investors must
be 100 or qualified purchasers must be 500.
Fee structure of Limited Partnerships:
Management fee (or base fee) + Incentive fee (or
performance fee)
Base fee is paid irrespective of performance of the
fund and is based on assets under management.
Incentive fee is based on realized profits. The
incentive fee cannot be negative. So when a fund
generates negative return, it implies a zero incentive

3) Concentrated portfolios: Concentrated portfolio

strategy refers to investing in assets among fewer
securities and/or managers to enhance returns (i.e.

Typical characteristics of Hedge funds:


They aggressively manages portfolio of investments.

They can take long and short positions.
They have the ability to use derivatives and leverage.
They have the ability to use short selling.
They have absolute return objectives.


6) They are subject to fewer regulations and thus have

the flexibility to invest in any assets.
Side pocket: It refers to the flexibility provided to
hedge funds that allows them to invest a specific %
of the assets under management (generally < 20%)
anywhere they feel.

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Introduction to Alternative Investments

7) They impose restrictions on redemptions i.e.

Lockup period: It refers to a minimum period before
which investors are not allowed to withdraw their
money or redeem their shares from the hedge fund.
Lock-up periods facilitate the hedge fund manager
to implement and potentially realize the expected
outcomes of a strategy.
Notice period: It refers to a number of days
(generally 30-90 days) before which investors are
required to give notice of their willingness to redeem.
Notice period facilitates the hedge fund manager to
liquidate a position in an orderly fashion without
magnifying the losses.
8) Hedge funds tend to have low correlations with
traditional investments. However, the correlation
between hedge fund and stock market
performances may increase during periods of
financial crisis.
9) Hedge funds are often referred to as arbitrage
players as they seek to earn returns while hedging
against risks.
Funds of funds (FOFs): FOF invests in a number of
underlying hedge funds (typically 10-30 hedge funds).
Benefits of Funds of Funds:
a) Retailing: An FOF can facilitate smaller investors to get
exposure to a large number of hedge funds at
relatively lower costs.
b) Access: FOF provide individual investors an easy
access to successful hedge funds that are closed to
individual investors because funds have reached
maximum number of investors.
c) Diversification: FOF facilitate diversification across
various hedge fund managers, fund strategies,
investment regions and management styles.
d) Expertise: FOF provide investors the expertise of the
managers regarding selecting hedge funds and
providing professional management.
e) Due diligence process: The due diligence process of
investing in hedge funds is a highly specialized and
time consuming process. FOF facilitate investors to
shorten the due diligence process to a single
f) Better redemption terms: FOFs are able to negotiate
better redemption terms (e.g. a shorter lock-up period
and/or notice period) relative to investors.
FOFs money is considered as fast money by hedge
fund managers because managers of FOFs have the 1st
right to redeem their money when hedge funds start to
generate poor returns and have the ability to negotiate
more favorable redemption terms.

c) Diversification is a doubled-edged sword: Due to risk

diversification, both risk and expected return of FOF
will be lowered relative to hedge funds. However, the
fees paid are considerably higher relative to hedge
Besides FOFs, there are some hedge funds that invest in
various hedge funds. Such funds are large, multi-strategy
hedge funds.
Hedge Fund Indices: The Hedge fund research indices
(HRFI) include:
a) HFRI Fund weighted composite index: It is an equally
weighted performance index and is constructed
using self-reported data of over 2,000 individual funds
included in the hedge fund research (HFR) database.
It suffers from self-reporting bias, survivorship bias and
backfilling bias.
Due to such biases, hedge fund indices may not
reflect actual average hedge fund performance but
rather reflect the performance of best performing
hedge funds only.
b) HFRI fund of funds index: It is an equally weighted
performance index of FOFs included in the HFR
It suffers from self-reporting bias.
It may exhibit lower reported returns due to two
layers of fees.
Nonetheless, it reflects the actual performance of
portfolios of hedge funds.
Biases in Hedge Funds Performance Data: Due to biases
in hedge funds historical performance data, the
performance of the hedge fund index is biased upward
(i.e. overestimated) and provides misleading results.
A. Survivorship bias: Hedge fund indexes and databases
may include only successful funds (i.e. funds that have
survived) whereas funds with poor performance may
disappear and are removed from the database and
the past index values are adjusted accordingly. This
results in overestimated historical returns.
B. Backfilling bias: When a new hedge fund is included
in a database, its past performance is (included)
back-filled in the index. Since high-performing funds
are more likely to be added to an index, it results in
overestimation of good results.

Hedge Fund Strategies (3.1.1 3.1.4)

Drawbacks with an FOF:

Four broad categories of Hedge Fund Strategies:

a) Fee: FOFs involve two layers of fees i.e. one to the

hedge fund manager and other to the manager of
b) Performance: An FOF does not necessarily provide
better and/or persistent returns.

1) Event-driven: These funds seek to generate positive

return by exploiting opportunities created by corporate
events (i.e. merger, bankruptcies, liquidation, buy-back,

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This strategy involves bottom-up analysis (i.e.

company level analysis followed by industry analysis
followed by global macro analysis).
This strategy takes long and short positions in
common and preferred stocks, as well as debt
securities and options.
Categories of Equity-driven funds include:
a) Distressed/Restructuring: These funds invest in the
debt or equity of companies experiencing financial or
operational difficulty. This strategy involves buying
fixed income securities trading at a significant
discount to par due to distressed situations and
subsequently selling them at a higher price to
generate profit.
Complicated form of such strategies may involve
buying senior debt and taking short position in junior
debt or buying preferred stock and shorting
common stock to generate profits from widening of
spread between the securities.
In addition, such strategies may take short position in
the companies, which are expected to
underperform in the short-term. However, if the
companys prospects improve, loss occurs.
b) Merger arbitrage: These funds seek to generate
returns from corporate merger and takeover activity
and attempts to exploit the price spread between
current market prices of corporate securities and their
value after successful completion of a takeover,
merger, spin-off etc.
Under these funds, the manager buys the stock of a
target company after a merger announcement and
takes a short position in the acquiring companys
stock with an anticipation of overpayment by an
acquirer for acquiring the target company and the
subsequent increase in debt burden.
It suffers from risk that the announced merger or
acquisition does not occur and the hedge fund may
not close its position on a timely basis.
c) Activist: It refers to an activist shareholder. It involves
buying sufficient equity with an attempt to have
control on the company (have influence on a
companys policies or direction e.g. divestitures,
restructuring, capital distributions to shareholders,
and/or changes in management and company
strategy). In contrast to private equity, activist hedge
funds operate in the public equity market.
d) Special situations: These strategies invest in the equity
of companies that are currently engaged in
restructuring activities other than merger/acquisitions
and bankruptcy e.g. security issuance/repurchase,
special capital distributions and asset sales/spin-offs.
2) Relative value: They seek to profit from mispricing in
related securities. These strategies include:
a) Fixed income convertible arbitrage: This strategy
involves exploiting mispricing in convertible securities

by buying convertible debt securities and

simultaneously selling the same issuers common
stock. These strategies are considered as market
neutral i.e. have zero beta.
b) Fixed income asset backed: These strategies involve
exploiting mispricing in the asset-backed securities
(ABS) and mortgage-backed securities (MBS).
c) Fixed income general: It involves identifying
overvalued and undervalued fixed-income securities
on the basis of expectations of changes in the term
structure of interest rates or credit quality of the
various related issues or market sectors. Due to
combination of long and short positions, they are
market neutral.
d) Volatility: These strategies involve taking long or short
positions in the market volatility either in a specific
asset class or across asset classes.
e) Multi-strategy: These strategies employ relative value
strategies within and across various asset classes or
3) Macro: This strategy focuses on top-down analysis
(i.e. global macro analysis followed by industry analysis
followed by company analysis). It seeks to exploit
systematic moves in major financial and non-financial
markets through trading in interest rates, currencies,
futures and option contracts, commodities or may take
major positions in traditional equity and bond markets.
4) Equity hedge: It involves identifying overvalued and
undervalued publicly traded equity securities and taking
long and short positions in equity and equity derivative
securities. However, portfolios are not structured as
market neutral and may be concentrated i.e. may have
a net long exposure to the equity market. These
strategies use bottom-up approach.
Categories of Equity Hedge:
a) Market neutral: It involves taking long position in
perceived undervalued securities and short position in
perceived overvalued equities and neutralizing the
portfolios exposure to market risk (i.e. beta = 0) by
combination of long and short positions with roughly
equal $ exposure (i.e. dollar neutrality) and equal
sensitivity to the related market or sector factors (i.e.
beta neutrality).It employs quantitative (technical)
and/or fundamental analysis.
b) Fundamental growth: These strategies take long
positions in companies that are expected to have
high growth and capital appreciation. They use
fundamental analysis to identify such companies.
c) Fundamental value: These strategies seek to identify
undervalued companies by using fundamental
analysis and take long positions in those companies.
d) Quantitative directional: These strategies use
technical analysis to identify under and over valued
companies using fundamental analysis. It involves
taking long positions in undervalued securities and
short positions in overvalued securities. The hedge
fund typically varies with regard to levels of net long
or short exposure depending upon the anticipated
direction of the market and stage in the market cycle.

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e) Short bias: These strategies use quantitative

(technical) and/or fundamental analysis to identify
overvalued equity securities and take short positions in
those overvalued securities. The net short exposure of
the fund depends on market expectations i.e., during
declining markets, the fund may take full short
f) Sector specific: These strategies use quantitative
(technical) and/or fundamental analysis to identify
outperforming sectors.
3.3.1) Fees and Returns
The return to an investor in a fund is not the same as the
return to the fund due to fees paid to the fund. Hedge
fund indices generally report performance net of fees.
A common fee structure in the hedge fund market is
2 and 20 which reflects a 2% management fee
and a 20% incentive fee. However, different classes
of investors may have different fee structures.
A common fee structure in the FOFs is 1 and 10
which reflects a 1% management fee and a 10%
incentive fee.
The incentive fees may be calculated net of
management fees or before management fees (i.e.
independent of management fees).
Hurdle rate provision: Under this provision, incentive
fee is paid only when the fund generates a specified
return, called hurdle rate. Hurdle rate can be
specified as an absolute, nominal, or real return
Types of Hurdle Rate:
a) Hard hurdle rate: When incentive fees can be paid
only on returns in excess of the hurdle rate, it is
referred to as hard hurdle rate.
b) Soft hurdle rate: When incentive fees can be paid on
entire returns, it is referred to as soft hurdle rate.
High water mark provision (HWM): According to high
water mark provision, once the first incentive fee has
been paid, the highest month end net asset value
(NAV), net of fees establishes a high water mark i.e.
no incentive fee is paid until the funds NAV>HWM. It
helps to protect clients from paying twice for the
same performance.
Hedge fund fees depend on various factors i.e.
supply and demand, historical performance and the
lockup period i.e. the longer investors agree to keep
their money in the hedge fund, the lower the fees.
Initial investment capital = $100 million
Management fee = 2%  based on assets under
management at year-end.
Incentive fee = 20%
The return earned in the 1st year = 25%
Value of fund at the end of 2nd year = $115 million
Value of fund at the end of 3rd year = $130 million
Hurdle rate = 3%

A. Fee in the 1st year: When incentive fee is independent

of management fee
Value of fund at the end of 1st year = $100 million (1.25)
= $125 million
Management fee = $125 million (2%)
= $2.5 million
Incentive fee = ($125 million $100 million) (20%)
= $5 million
Total fees = $2.5 million + $5
= $7.5 million
Investor return = ($125 $100 $7.5) / $100
= 17.50%
B. Fee in the 1st year: When incentive fee is NOT
independent of management fee
Management fee = $125 million (2%)
= $2.5 million
Incentive fee = ($125 million $100 million $2.5 million)
= $4.5 million
Total fees = $2.5 million + $4.5
= $7 million
Investor return = ($125 $100 $7) / $100
= 18%
C. Fee in the 1st year: When incentive fee is NOT
independent of management fee and hurdle rate is
Hurdle rate = 3% ($100 million)
= $3 million
Management fee = $125 million (2%)
= $2.5 million
Incentive fee = ($125 $100 $3$2.5 million) (20%)
= $3.90 million
Total fees = $2.5 million + $3.9 million
= $6.4 million
Investor return = ($125 $100 $6.4) / $100
= 18.60%
D. Fee in the 2nd year with High-water mark provision:
Management fee = $115 million (2%)
= $2.3 million
Incentive fee = 0  because the fund has declined in
Total fees = $2.3 million
Beginning capital in the 2nd year for the investor =
Value of fund at the end of 1st year Total Fees in the 1st
year (independent of management fee) = $125 $7.5
million = $117.5 million
Ending capital at the end of the 2nd year = $115 $2.3
= $112.7 million
Investor return = ($115 $2.3 $117.5) / $117.5
= 4.085%
E. Fee in the 3rd year with High-water mark provision:
Management fee = $130 million (2%) = $2.6 million
Incentive fee = ($130 million $117.5 million) (20%)
= $2.5 million
$117.5 million represents the high-water mark

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established at the end of Year 1.

Total fees = $2.6 million + $2.5 million
= $5.1 million
Investor return = ($130 $5.1 $112.7) / $112.7
= 10.825%
$112.7 million is the ending capital at the end of 2nd
The ending capital position at the end of Year 3 =
$130 million $5.1 = $124.9 million  this is the new
high-water mark.
Arithmetic mean annual return = (17.50% 4.085% +
10.825) / 3 = 8.08%
From part A, D and E.
Geometric mean annual return = (New HWM at the end
of 3rd year / Initial
investment) 1/3 1
= (124.9 / 100) 1/3 1
= 7.69%
Capital gain to the investor = (New HWM at the end of 3rd
year Initial investment)
= ($124.9 - $100) million
= $24.9 million
Total fees = ($7.5 + $2.3 + $5.1) million
= $14.9 million
From part A, D and E.

Practice: Example 2,
Volume 6, Reading 60.

Initial investment = $100 million
Hedge fund has 2 and 20 fee structure with no
hurdle rate.
Funds of funds has 1 and 10 fee structure.
Management fees are calculated on an annual
basis on assets under management at the beginning
of the year.
Management fees and incentive fees are
calculated independently.
Hedge fund has a 15% return for the year before
management and incentive fees.
FOF has a 10% return for the year after fees of hedge
Profit of hedge fund before fees = $100 million (15%)
= $15 million
Management fee = $100 million 2%
= $2 million
Incentive fee = $15 million 20%
= $3 million

Investor Return = (15 2 3) / 100

= 10%
Profit of FOF = $100 million (10%)
= $10 million
Management fee of FOF = $100 million 1%
= $1 million
Incentive fee = $10 million 10%
= $1 million
Investor return = (10 1 1) / 100
= 8%

Practice: Example 3,
Volume 6, Reading 60.

3.3.2) Other Considerations

Most hedge funds (but not all), use leverage in their
trading strategies to seek higher returns. However,
leverage magnifies both profit and losses. Thus, use of
high leverage is viewed as a source of risk for hedge
Hedge Funds can create leverage in many forms i.e. by
a) Borrowing capital.
b) Buying securities on margin.
c) Using financial instruments and derivatives.
For example, a hedge fund can realize profit from
expected increase in the value of a company, (say
Company A) in either of the following ways:
i. Hedge fund can buy 1000 shares of Company A.
ii. Hedge fund can buy 10 futures contracts on
Company A.
The profit or loss from holding the futures will be
similar to the profit or loss from holding the shares.
However, futures contracts involve less capital to
invest than that of buying shares.
In futures contracts, investors are subject to collateral
requirement to protect against default risk. The
amount of collateral depends on the riskiness of the
investment and the creditworthiness of the hedge
fund or other investor.
iii. Hedge fund can buy calls on a 1000 shares of
Company A.
It involves less capital to invest i.e. buyer is only
required to pay option premium.
Maximum loss to the long Call is option premium
iv. Hedge fund can sell puts on a 1000 shares of
Company A.
Maximum profit to the Short Put is option premium
If price fall, potential loss is extremely large for the

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A more conservative and theoretically accurate

approach is to use:

Short Put.
Prime Brokers: Normally, hedge funds trade through
prime brokers. Besides trading on behalf of clients, prime
brokers provide following services:

Short borrowing

Margin account: The margin account represents the

hedge funds equity in the position.
The smaller (greater) the margin requirement, the
more (less) leverage is available to the hedge fund.
When the margin account declines below a certain
level  hedge fund receives margin call from the
broker (lender) to deposit more collateral.
Margin calls may increase losses when the hedge
fund closes its losing position at unfavorable prices.
Redemptions: When investors decide to exit the fund or
redeem some portion of their shares, it is referred to as
redemption. Redemptions frequently occur during poor
performance of hedge funds i.e. when net asset value
starts to fall.
Redemptions involve transaction costs. Thus, to
avoid such costs and to avoid losses associated with
liquidating positions, hedge funds may charge
redemption fees.
Decline in net asset value (NAV) is referred to as

Practice: Example 4,
Volume 6, Reading 60.


Hedge Fund Valuation Issues

Bid prices for longs

Ask prices for shorts
It is recommended that hedge funds should set up
procedures and guidelines for in-house valuations.
For illiquid investments (i.e. convertible bonds,
collateralized debt obligations, distressed debt and
emerging markets fixed income securities), liquidity
discounts or haircuts are used to reflect fair value.
Hedge funds generally use two NAVs i.e.
1. Trading NAV: It represents NAV adjusted for liquidity
discounts based on the size of the position held
relative to the total amount outstanding in the issue
and its trading volume.
2. Reporting NAV: It represents NAV based on quoted
market price; it does not incorporate liquidity

Practice: Example 5,
Volume 6, Reading 60.


Due Diligence Process for Hedge Funds includes

following factors:

Generally, hedge funds are valued on a daily, weekly,

monthly and/or quarterly basis using either market values
or estimated values of underlying positions when reliable
market values are not available (e.g. for illiquid or nontraded investments).
Different prices or quotes are available in the market:
Bid price
Ask price
Average quote i.e. [(bid + ask)] / 2: It is most
commonly used.
Median quote

Due Diligence for Investing in Hedge Funds

Investment strategy
Investment process
Competitive advantage
Track record: Mostly, hedge funds are required to
have track record of at least 2 years. The longer the
track record period requirement, the more difficult it
is for hedge funds to raise capital.
Size and longevity: The older the fund, the better it is
because it reflects that the fund has experienced
lower losses and higher growth in assets under
management via both capital appreciation and
additional investments (capital injections).
o The minimum hedge fund size the investor can
consider depends on the minimum size of the
investments by investors and their investments
maximum % of a fund e.g. if an investors minimum
investment size is $15 million and the investors
maximum % of a fund is 8.5%, then
The minimum hedge fund size the investor can
consider = $15 million / 0.085 = $176.47 million
Management style
Markets in which the hedge fund invests
Hedge fund benchmarks
How returns are calculated and reported
Key-person risk
Investor relations

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Plans for growth

Systems risk management
Management procedures (i.e. leverage, brokerage,
and diversification policies)
Fee structures and their affect on the returns to
Additional things to consider include funds prime
broker and custody arrangements for securities;
auditor of the hedge fund.

Due to lack of transparency and fewer regulations,

conducting due diligence for hedge funds can be very
challenging. The investor should also conduct due
diligence when choosing a fund of funds (FOFs).

Practice: Example 6,
Volume 6, Reading 60.


Private equity investments are equity investments that

are not publicly traded on exchanges or investments in
public companies with the intent to take them private.
Private equity investments are sensitive to business
Categories of Private equity strategies (Section 4.2):
A. Leveraged buyouts (LBOs): LBOs involve buying all the
shares of a public company or established private
company partially through equity (i.e. 20-40%) and
partially issuing debt and converting it into a private
The private equity firm restructures and improves the
operations of the company to increase revenues
and ultimately increase companys value to resell
the acquired company or part of it at a higher price
later on and/or to improve companys cash flows
which can be used to pay down the debt.
LBOs financing: LBOs use a greater amount of
leverage to finance a significant proportion of each
deal and thus are also known as highly leveraged
Capital structure: It includes equity, bank debt
(leveraged loans), and high yield bonds (with low
quality ratings and high coupons).
o Leveraged loans represent the largest % of total
capital. They also have covenants to protect the
investors. Leveraged loans are generally senior
secured debt whereas the bonds are unsecured
with respect to bankruptcy.
o The assets of the target company typically serve as
the collateral for the debt, and the debt
obligations are met using companys cash flows.
o Mezzanine financing: Mezzanine financing is a
hybrid of debt and equity financing. It is a debt
capital, with current repayment requirements and
has warrants or conversion options i.e. can be
converted into common equity interest in a
company. It is generally subordinated to both
senior and high yield debt and offers higher
coupon rate. Besides interest or dividends,
mezzanine financing also provides return when
value of common equity increases.
o It is important to note that different deals have
different optimal capital structure.
Sources of growth in EBITDA include organic revenue
growth; cost reduction/restructuring, acquisition etc.

Types of LBOs:
Management buyouts: MBO is similar to LBOs, however,
in MBOs, internal management acts as (co-) buyer of the
company and eventually become large investors in the
company after its privatization.
Management buy-ins (MBIs): In MBIs, the acquiring
company management replaces the current
management team.
B. Venture capital (VC): VC investments are private
equity investments used to finance a start-up (new)
business or growing private companies. Each
company in which the VC fund invests is referred to as
portfolio company. It involves various financing
stages i.e. formative-stage, expansion stage, pre-IPO
stage, and exit stage.
VC firms are active investors and actively manage
their portfolio companies. Typically, they have equity
interests in the portfolio companies.
VC investments require a long time horizon and are
subject to high risk of failures.
Due to higher risk of failure during early stage, earlystage investors demand higher expected returns
relative to later stage investors.
It represents a small portion of the private equity
market relative to LBOs.
Stages of Venture Capital Investing
A. Formative-stage financing includes seed stage and
early stage financing.
1) Seed-stage financing: In seed stage, small amount of
money is provided to form a company or to transform
the idea into a business plan and to assess market
In the initial seed-stage when business idea is being
transformed into a business plan, amount of capital
is typically small and is primarily provided by
founders, founders friends and family (called angel
investors) rather than by VC funds. This stage is also
known as Angel investing stage.
Later on, the seed capital is also provided by VC
funds to finance the product development and
market research.

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Form of financing used during Formative-stage:

Typically, ordinary or convertible preferred shares are
issued to the VC fund while the company is
controlled by the companys management.
2) Early stage financing: In this stage, capital is provided
to support operations of companies before
commercialization and sales of product.
Start-up financing refers to the capital provided to
commercialize the product or idea and to support
product development and initial marketing.
First-stage financing is capital provided to initiate
commercial manufacturing and sales.

Distressed investing involves buying the debt of a

financially distressed company at discounted price
(i.e. < face value of the debt).
The turnaround equity investors actively manage the
company and restructure the company either
operationally or financially to increase the value of
Besides equity investors, debt investors (known as
vulture investors) may also play an active role in
the management or in the reorganization of the
company. It must be stressed that distressed debt
investors have a prior claim on the company assets.
Some distressed investors are passive investors.

B. Later-stage financing is provided to companies who

need funds to expand sales. It includes:
Second-stage financing is the capital provided for
initial expansion of a company already producing
and selling a product i.e. revenue has started but
may not be yet profitable.
Third-stage financing is capital provided for major
expansion i.e. physical plant expansion, product
improvement, or a major marketing campaign.
Mezzanine (bridge) financing is capital provided to
prepare for an IPO. It represents the bridge between
the expanding company and the IPO.
Form of financing used during Later-stage: Typically,
equity and debt (including convertible bonds or
convertible preferred shares) are issued to the VC
fund while the control of the company is handed
over to the VC fund.
Debt financing is used to have control over
companys assets and to recover them during
bankruptcy. It is considered as a more secured
financing for VC funds than equity financing.
Due to lack of operational and financial
performance history and performance data, it is
more difficult for VC funds (investors) to estimate
value of such companies compared to LBOs, which
invest in mature, underperforming public companies.
C. Development capital: It involves minority equity
investments in more mature (typically private)
companies that need capital to expand or restructure
operations, enter new markets or finance major
It is often used by management of the company.
Sometimes, private equity capital is also used by
publicly quoted companies. This strategy is referred
to as PIPEs (private investment in public equities).
D. Distressed investing: It involves investing in the debt of
operationally sound BUT financially distressed
companies (companies that are bankrupt, in default,
or likely to default).

Private Equity Structure and Fees

Like hedge funds, institutional and individual investors

can invest in private equity through limited partnerships
which is known as Fund.
Outside investors are known as Limited partners (LPs).
The private equity firm, which manages a number of
funds, is known as the General partner (GP).
Fee Structure: Management fee + Incentive fee
Generally, management fees range from 1-3% of
Committed Capital (not invested capital), until the
committed capital is fully drawn and invested.
Committed capital: It represents the amount that the
LPs have agreed to provide to the private equity
fund. The committed capital is drawdown by the
fund over 3-5 years.
Once the committed capital is fully invested,
management fees are based only on the funds
remaining in the investment.
As investors exit from the fund, capital is paid back
to them and they are no more required to pay fees
on that portion of their investment.
Commonly, the incentive fees represent 20% of the
total profit of the private equity fund and are not
paid to the GP fee until the initial investment has
been received back by the LPs. The incentive fee
may also be calculated on a deal-by-deal basis.
Amount received by the LPs = 80% of the total profit
of the equity fund +
Return of their initial
When distributions are made based on profits
earned over time, the GP may receive more than
20% of the total profit. However, to protect the LPs
interests, the fund may set up an escrow account for
a part of incentive fees and/or may impose a clawback provision under which the GP is obligated to
return any funds distributed as incentive fees until the
LPs have received back their initial investment and
80% of the total profit.
Besides management and incentive fees, LBOs firms
include other fees i.e. arrangement fee for the buyout of

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a company, fee in case a deal fails, and arrangement

fee for divestitures of assets. Characteristics of Attractive Target Companies
for LBOs
a) Undervalued/depressed stock price: Private equity
firms seek to buy undervalued or cheaply priced
companies that are out of favor in the public markets.
b) Willing management: Existing management is willing
to exploit long-term growth opportunities but lack
capital needed to finance investments in new
processes, personnel, equipment etc.
c) Inefficient companies: Private equity firms seek to buy
inefficient companies and generate attractive returns
by restructuring and improving the operations of the
d) Strong and sustainable cash flow: Companies with
strong cash flows are attractive for LBOs because
cash flows are used to make interest payments on the
debt associated with LBOs transactions.
e) Low leverage: Companies with low leverage are
attractive for private equity firms as it facilitates them
to use higher leverage to finance a substantial portion
of the purchase price.
f) Assets: Companies with a significant amount of
physical assets are preferred by private equity firms
because physical assets can serve as collateral for
debt and helps to reduce cost of debt as secured
debt is cheaper than unsecured debt.
4.2.4) Exit Strategies
Exit strategies are significantly important for private
equity investing because the ultimate goal for private
equity investors is to exit the fund at high valuations.
An average buy-and-hold period for private equity
investments is 5 years.
The time to exit can range from less than 6 months to
over 10 years.
Selection of an optimal exit strategy depends on the
dynamics of the industry of portfolio company,
overall economic cycles, interest rates, and
company performance.
The major types of exit strategies are as follows:
A. Trade Sales: In this type of exit strategy, the private
firm is sold to a strategic buyer (i.e. competitor) for
stocks, cash, or a combination of both either through
an auction process or by private negotiation.
Benefits of a trade sale:
Facilitates a private equity fund to have an
immediate cash exit.
May receive high valuations from willing and able
strategic buyers who seek to capture anticipated
It is simple and quick to execute.
It incurs lower transaction costs relative to an IPO.
It is relatively a highly confidential process and
involves less information disclosure.

Disadvantages of trade sale:

Trade sales are not preferred by portfolio companys
employees and thus may face management
Number of potential buyers is very limited.
Trade sales tend to receive lower price compared to
an IPO.
B. IPOs: In an IPO, the portfolio company initially issues
some or all of the shares to public investors through an
Benefits of an IPO:
In an IPO, investors may receive the highest price.
IPOs also enjoy management approval because
companys existing management is retained.
IPOs are considered a source of publicity for the
private equity firms.
IPOs facilitate private equity investors to retain future
upside potential by allowing them to remain a large
Disadvantages of an IPO:
It involves high transaction costs e.g. fees paid to
investment banks and lawyers
IPOs have long lead times.
It is subject to stock market volatility risk.
It has high disclosure requirements.
An IPO imposes a lock-up period on private investors
as they are prohibited to sell an equity position for a
specific period after the IPO.
An IPO is more appropriate for larger companies
with attractive growth profiles.
C. Write-offs: Write-offs refer to voluntary liquidations of a
portfolio company that may or may not generate any
D. Secondary sales: Under secondary sales, securities of
a private equity firm are sold to another private equity
firm or other group of investors.
E. Recapitalization: In a recapitalization, the private
equity firm pays itself dividends by using debt. It is not
considered a true exit strategy because in
recapitalization, the private equity firm retains
companys control.
The above exit strategies can be employed individually,
combined together, or used for a partial exit strategy.

Private Equity: Diversification Benefits,

Performance, and Risk

Private equity funds may generate higher returns

relative to traditional investments due to use of high
leverage and by playing an active role in the
management and operations of the portfolio

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Private equity investments also have higher risks

(including market, illiquidity and leverage risks) than
traditional investments.
Private equity investments also provide diversification
benefits because they have less than perfect
correlation with traditional investments.
Private equity performance index (PEPI) is an index
used to measure performance of private equity
investments. However, it is not a reliable
performance measure because, like hedge fund
indices, private equity indices are subject to selfreporting, survivorship, backfill, and other biases,
resulting in overstated returns. In addition, such
investments are not marked-to-market on a regular
basis which tends to underestimate volatility and
correlations with other investments.

3. Asset-based: Under asset-based approach, value of

a private company is estimated as follows:
Value of a company = Value of a companys assets
Value of a companys liabilities
This value reflects the value of the company to the
equity holders.
Value of companys assets and liabilities can be
estimated either using market (fair) values or
liquidation values.
Values estimated using fair (market) values represent
an orderly transaction.
Values estimated using liquidation values represent a
distressed transaction when a business is terminated.
During weak economy, liquidation values tend to <
fair values due to fewer potential buyers.

Portfolio Company Valuation

The following three common approaches are used to

value a company in the private equity investments:
1. Market or comparable: Under the comparable
approach, company is valued using various multiples.
These multiples are determined using market value or
recent transaction price of a similar publicly traded
company. Multiples include:
EBITDA multiple: It is used for valuing large and
mature private companies.
Net income or revenue multiples: They are preferred
to use for small and less mature private companies.
2. Discounted cash flow (DCF): The DCF approach
involves valuing a company by discounting relevant
expected future cash flows at the required rate of
return e.g.
Discounting free cash flow to the firm at the
weighted average cost of capital; or
Discounting free cash flow to equity at the cost of
equity; or simply
Discounting Net income or cash flow by using a
capitalization rate.
When the estimated value (using DCF approach) >
(<) current market price of the investment, the
investor should (should not) invest in the company.

Real estate is a form of tangible and immoveable asset.

It includes buildings, building land, offices, industrial
warehouses, natural resources, timber, containers,
&artwork etc. Real estate property ownership is
represented by a title which can be purchased, leased,
sold, mortgaged, or transferred together or separately, in
whole or in part.

Practice: Example 7,
Volume 6, Reading 60.


Private Equity: Investment Considerations and Due


Private equity investments are appropriate for

investors with long time horizon and limited liquidity
Factors important for Private equity investment
evaluation include:
o Current and expected future economic
o Interest rate and capital availability expectations
o Undrawn and committed capital
The due diligence process of private equity is similar
to that of hedge funds i.e. it involves identifying
o GPs experience and knowledge
o Financial and operating conditions
o Valuation methodology
o Alignment of the GPs incentives with the interests
of the LPs
o Drawdown and committed capital
o Exit strategies


Key Benefits of investing in real estate:

Provide attractive long-term returns through both
rental income and capital appreciation.
Due to multiple-year leases with fixed rents, some
properties generate stable cash flows.
Provide diversification due to less than perfect
correlation with traditional investments.
May provide some inflation hedge when rents can

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be adjusted quickly for inflation.

Features of Real Estate:
A. Heterogeneity and fixed location: Unlike stocks and
bonds, real estate properties are not homogeneous
i.e. they differ in use, size, location, age, type of
construction, quality, and tenant and leasing
arrangements. In addition, they are immobile due to
their fixed location.
B. High unit value: Due to large sizes and indivisibility, real
estate investments have greater unit value compared
to stocks and bonds and thus require greater amount
of investment.
C. Management intensive: Unlike stocks or bonds, a
private real estate equity investment or direct
ownership of real estate requires active management
by investors or by hired property managers.
D. High transaction costs: Buying and selling real estate
properties involve higher transactions costs and is
more time-consuming.
E. Illiquidity: Real estate properties are relatively illiquid
due to
Large transaction sizes
Lack of availability and timeliness of information
which requires extensive valuation and due
F. Difficulty in Price determination and valuations:
Heterogeneity of real estate properties, low volume of
transactions and less informationally efficient markets
relative to equity and bonds markets, changes in real
estate value or expected selling price over time are
determined based on estimates of value or appraisals
rather than transaction prices.
G. Government regulation and local or regional market
factors: Real estate properties are subject to
government regulations and depend on local or
regional market factors rather than country-wide or
global price movements.
The aforementioned properties imply that private real
estate investments are suitable for investors with longterm investment horizon and greater ability to tolerate
relatively lower liquidity.

Forms of Real Estate Investment

Private equity investment in real estate properties. It

refers to a direct ownership of real estate properties.
Publicly traded debt investment. It refers to an
indirect ownership of real estate properties i.e. via
investing in mortgage-backed securities; real estate
investment trusts (REITs) etc.

Forms of real estate investment:

1) Equity investment: Equity investment refers to a direct
ownership interest in a real estate or investment in
securities of a company or a REIT that owns the real
estate property.
Direct, equity investing requires active and
experienced professional management.
Equity investment performance depends on general
economic and specific real estate market
conditions, the way property is managed, terms of
debt financing and the amount of borrowers equity
in the property (the higher the borrowers equity, the
greater the cushion available for lender and thus the
lower the risk).
2) Debt investment: Debt investment refers to lending
funds to the buyer of real estate where the real estate
property serve as collateral for a mortgage loan or
investment in securities based on real estate lending
e.g. mortgage-backed securities (MBSs).
Private, debt-based real estate investments include:
Construction lending
Private, equity-based real estate investments:
Direct ownership of real estate i.e. through sole
ownership, joint ventures, real estate limited
partnerships, or other commingled funds.
Public, debt-based real estate investments:
Mortgage-backed securities (residential and
Collateralized mortgage obligations
Public, equity-based real estate investments:
Shares in real estate corporations
Shares in real estate investment trusts
Variations within the basic forms:
1) Free and Clear Equity or Fee simple: It is a form of
direct ownership. It refers to an unlevered 100%
equity-financed investment in real estate i.e. simple
purchase of some real estate property without use of
borrowed funds.
Initial purchase costs associated with direct
ownership include legal expenses, survey costs,
engineering/environmental studies, valuation
(appraisal) fees, maintenance & refurbishment
charges, and costs associated with property
The property can be managed either by the owner
itself or by a hired managing agent.
The owner has the right to lease the property to

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tenants and to resell the property at will.

2) Leveraged Equity: Leveraged Equity involves use of
both equity and borrowed funds to purchase some
real estate property.
Initial purchase costs associated with direct
ownership include legal expenses, survey costs,
engineering/environmental studies, valuation
(appraisal) fees, maintenance& refurbishment
charges, costs associated with property
management and mortgage arrangement fees.
Investors earn return in the form of appreciation
(depreciation) of the value of the property + net
operating income in excess of the debt servicing
Any appreciation (depreciation) in the value of the
home increases (decreases) the owners equity in
the home.
In case borrower defaults, the owner has the right to
transfer ownership of the equity.
Leverage financing can be provided in the form of
mortgage loans, including whole loans or pool of
mortgage loans (e.g. mortgage-backed securities).
However, leverage magnifies both gains and losses.
Leverage increases the risk to both equity and debt
investors. As the loan-to-value ratio increases, the risk
Mortgages: Mortgages or mortgage loans represent a
type of secured debt investment in real estate in which
the real estate property serves as collateral. In this form
of investment, lenders (investors) earn return in the form
of net interest, net of mortgage servicing fees, a
scheduled repayment of principal and excess principal
repayments (called mortgage prepayments).
The due diligence process in a Mortgage loan involves:
Identifying borrowers equity investment in the
purchase of property (e.g. home).
Evaluating creditworthiness of the borrower e.g.
borrowers ability to make the required payments on
the mortgage and to maintain the home etc.
Estimating value of the property.
Ensuring that the property (e.g. home) is adequately
and appropriately insured.
3) Pooled real estate investment vehicles: These
investments include:
a) Real estate limited partnerships (RELPs): In RELPs,
investors (called limited partners) can participate in
real estate projects and have limited liability (i.e. to
the amount of initial investment). It is managed by the
general partners who are real estate experts.
b) Real estate investment trusts (REITs): REITs represent
shares of publicly-traded companies that buy and sell
real estate. It is a form of pooled real estate
investment and represent an indirect investment in
real estate property.

REITs are highly liquid and provide retail investors with

access to a diversified real estate property portfolio
and professional management;
REITs can be used by investors with short investment
horizons and higher liquidity needs;
REITs have higher correlation with stocks and bonds
than direct ownership of real estate; hence, it does
not provide the same diversification benefits as that
of private real estate.
REITs are required to distribute at least 90% of their
taxable income to shareholders in the form of
REITs and partnerships involve investment
management fees based on either committed
capital or invested capital and incentive fees.
Investment management fees typically range from
1-2% of capital per annum.
4) Mortgage-backed securities (MBS): MBSs represent
investment in a diversified pool of mortgages i.e.
each pool is divided into various tranches (with
different payment characteristics) and sold to
These include residential mortgage-backed
securities (RMBS) and commercial mortgagebacked securities (CMBS). See exhibit 14, pg 208.
MBS may be issued privately or publicly.

Real Estate Investment Categories

Categories of Real Estate Properties:

1. Residential properties: These include only owneroccupied, single residences (single-family residential
2. Commercial properties (income-producing
properties): These include office, retail, industrial and
warehouse, and hospitality (e.g. hotels and motels)
Commercial properties investment is preferred by
institutional funds or high-net-worth individuals with
long time horizons and limited liquidity needs.
Commercial properties may have mixed uses.
Sources of income for commercial properties include
rental income and capital appreciation.
Value of commercial properties is affected by
factors including development strategies, market
conditions, and property-specific features.
3. Timberland: They refer to properties that are used to
produce timber (wood) for industrial use purposes. It
can function both as a factory and a warehouse.
Unlike crops production, timber can be grown and
stored easily. As a result, harvesting of timber is more
flexible i.e. it can be increased during rising timber
prices and postponed during falling timber prices.
Timberland does not have high correlation with

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traditional asset classes.

Three primary Return Drivers:
i. Biological growth
ii. Commodity price changes
iii. Land price changes
4. Farmland: They refer to properties that are used to
produce crops or as pastureland for livestock.
Major types of Farmland:
1) Row crops that are planted and harvested annually.
2) Permanent crops that grow on trees or vines.
Farmland tends to provide inflation hedge.
Three primary Return Drivers:
i. Harvest quantities
ii. Commodity price changes
iii. Land price changes
Farmland harvesting has less flexibility than timberland.
Return components on farmland and timberland:
i. Capital appreciation (i.e. sale of the commodities);
ii. Income streams from leasing the land to another
Residential properties are considered as commercial
property when they are maintained as rental properties.
5.2.3) REIT Investing
REITs are classified into three types:
1. Equity REITs: Equity REITs are tax-advantaged entities
(companies or trusts) that generally hold, own,
operate, manage and develop commercial or
residential properties. They use leverage and are
similar to direct equity investments in leveraged real
Primary source of revenue: Rent income from
To qualify for tax-advantaged status, they are
required to distribute at least 90% of revenue
(including rent and realized capital gains), net of
expenses, to shareholders in the form of dividends. In
addition, they are required to report earnings per
share based on net income as defined by GAAP
(like other public companies).
Objective of equity REITs: Maximize income and
dividends by maximizing property occupancy rates
and rents.

3. Hybrid REITs: Hybrid REITs own & operate incomeproducing real estate properties and make loans as

Real Estate Performance and Diversification


A real estate index can generally be categorized as

1) An appraisal index: These indices use appraised
values of individual real estate properties rather than
their transaction prices to construct the indices.
The appraised values represent subjective values
determined by experts.
These indices suffer from appraisal lag because
appraisals are done infrequently. As a result, they
underestimate volatility of returns and correlation
with other asset classes.
The National Council of Real Estate Investment
Fiduciaries (NCREIF) Property Index is a type of
appraisal-based index.
2) A repeat sales (transactions-based) index: This index is
based on repeat sales (i.e. more than once) of the
same property. For example, if the same property sold
twice, then the difference in value between the two
sales dates indicate changes in market conditions
over time.
The greater the number of repeat sales, the more
reliable and relevant is the index.
These indices are subject to sample selection bias
because different properties may sell in each period
and thus may not truly represent the subject
properties. In addition, they may be based on nonrandom sample of properties e.g. the index may be
biased towards properties that have either
increased or decreased in value.
3) REIT index: REIT indices use the prices of publicly
traded shares of REITs to construct the indices.
The more frequently the REITs shares are traded, the
more reliable is the index.
However, the index does not necessarily represent
the properties of interest to the investor.
The National Association of Real Estate Investment
Trusts (NAREIT) is a type of REIT index.
REIT indexes are more strongly correlated with the
stock market than bonds and they reflect more
volatile performance than appraisal-based indices.

2. Mortgage REITs: Mortgage REITs finance real estate

investments by making mortgage loans to real estate
owners or invest in existing mortgages or mortgage
backed securities. They are similar to fixed income
Primary source of revenue: Interest on mortgages.

It is important to note that real estate investment returns

vary across countries and regions.

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Real Estate Valuation

Real estate values need to be estimated and the

process of estimating values is known as appraising the
property. Common techniques for appraising real estate
property include:
1) Comparable sales approach: In this approach, recent
sales (transaction) prices of similar (comparable)
properties are compared to a subject property. Sales
prices are adjusted for each of the comparables for
the differences in size, age, location, quality of
construction, amenities, view, condition of the
property, market conditions at the times of sale and
the price changes in the relevant real estate market
between dates of sales.
2) Income approach: Two major types of income
approach are:
i. Direct capitalization approach: In this approach, the
net operating income (NOI) of a property is
capitalized using a growth implicit capitalization
Value of a property = NOI / Capitalization rate
NOI = Gross potential income Estimated vacancy
losses Estimated collective losses Insurance
Property Taxes Utilities - Repairs and
maintenance expenses
Financing costs, federal income taxes and
depreciation are not subtracted to determine the
Capitalization rate = Discount rate Growth rate
The cap rate depends on strength of tenants, level
of landlord involvement, the extent and adequacy
of repairs and improvements, vacancy rate,
management and operating costs, and expected
inflation costs and rent.
ii. Discounted cash flow approach: In this approach,
after-tax future projected cash flows (i.e. annual
operating cash flows for a finite number of periods
and a resale or reversion value at the end of that
total period) are discounted at the investors
required rate of return (i.e. discount rate) on equity
to estimate the Present Value of the property.
3) Cost approach: In the cost approach, value of the
property (i.e. building) is estimated based on adjusted
replacement cost. The cost approach involves
estimating the value of the land and the costs of
rebuilding using current construction costs and
Costs of rebuilding (replacement costs) include
building materials, labor to build, tenant
improvements, and various soft costs i.e.
architectural and engineering costs, legal, insurance

and brokerage fees, and environmental assessment

The replacement cost is adjusted for the differences
in location and condition of the existing building (s).
Three valuation approaches do not necessarily provide
the same value. Hence, it is recommended that final
estimate of value for the subject property should be
determined after reconciliation of the differences in the
estimates of value from each approach.
5.4.1) REIT Valuations
There are two basic approaches to estimating the
intrinsic value of a REIT:
1) Income-based approach: It is similar to the direct
capitalization approach. Two commonly used
income measures are:
Funds from operations (FFO): FFO = Net earnings +
Depreciation expense on real estate + Deferred tax
charges gains from sales of real estate property + losses
on sales of real estate property.
Depreciation is added back because it represents a
non-cash expense and is generally considered
unrelated to changes in the value of the property.
Gains and losses from sales are excluded because
they represent non-recurring items.
Adjusted funds from operations (AFFO): AFFO = FFO
Recurring capital expenditures.
AFFO is similar to free cash flow measure.
2) Asset-based approach: Asset-based approach
involves estimating the net asset value (NAV) of REITs.
REITs NAV = Estimated market value of a REITs total
assets Value of REITs total liabilities
REITs shares may trade at discount or premium to
NAV per share.

Real Estate Investment Risks

Real estate property values are highly sensitive to

changes in national and global economic
conditions, local real estate conditions, and interest
rate levels.
Real estate investment performance highly depends
on the ability of a fund management to select,
finance, and manage real properties, and changes
in government regulations.
Real estate investment in distressed properties and
property development are more risky than
investment in financially sound and operationally
stable properties.

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Commodities are physical products. Commodities

Precious metals: Gold, silver, platinum
Base (industrial) metals: Copper, aluminum, zinc,
lead, tin, nickel
Energy products: Oil, natural gas, electricity, coal
Agricultural products: Grains, livestock, coffee
Other: Carbon credits, freight, forest products
It is important to note that returns on commodity
investments depend on changes in price rather than on
income i.e. interest, dividends or rent.
Types of Commodity Investment:
1) Direct Commodity Investment: It refers to cash (spot)
market purchase of physical commodities. It is preferred
by investors that are part of the physical supply chain i.e.
producers of commodities, users of the commodities,
and participants in between.
2) Indirect Commodity Investment: It refers to getting
indirect exposures to changes in spot market values of
commodities. Indirect investment in commodities can be
made in various ways, including
a) Stocks/Equity of companies producing the
commodity or exposed to a particular commodity:
However, such companies do not provide effective
exposure to commodity price changes because
these companies themselves hedge commodity risk.
b) Commodity derivative contracts: Commodity
derivatives include futures, forwards, options and
swaps. These contracts may trade on exchanges or
over the counter. To avoid incurring transportation
and storage costs, investors prefer to invest in
commodity derivatives instead of investing in physical
The underlying for a commodity derivative may be a
single commodity or an index of commodities.
Commodities derivative contracts specify terms with
respect to quantity, quality, maturity date, and
delivery location.
o Futures and forward contracts represent
obligations to buy or sell a specific amount of a
given commodity at a fixed price, location and
date in the future.
o Futures contracts are exchange-traded products
o Forward contracts trade OTC. They have higher
counterparty risk.
o Options contracts represent the right (not
obligation) to buy or sell specific amount of a
given commodity at a specified price and delivery
location on or before a specified date in the
future. Options can be ETPs or OTC traded.

o In swaps, one party agrees to make fixed

payments and in exchange receives floating
payments based on future commodity or
commodity index prices.
The prices of commodity derivatives largely depend
on the underlying commodity prices.
Commodity derivatives can be used by investors
(e.g. producers and consumers) for hedging
purposes or by speculators (e.g. retail and
institutional investors, hedge funds) to capture profits
associated with changes or expected changes in
the price of the underlying commodities.
c) Commodity Exchange traded funds (ETFs): ETFs
provide indirect exposures to commodities. ETFs may
invest in commodities or commodities futures.
Commodity index-linked ETFs also exist.
ETFs are appropriate for investors who are allowed to
invest in equity shares only.
ETFs are easy to trade.
ETFs may employ leverage.
ETFs involve management fees (like mutual funds or
unit trusts); however, the expense ratios of ETFs are
lower than that of mutual funds.
d) Commodity-linked Bonds

Commodity Derivatives and Indices

Typically, commodity indices are constructed using

the price of futures contracts on the commodities
rather than the prices of underlying commodities.
Therefore, the performance of a commodity index
may significantly differ from the performance of the
underlying commodities.
In addition, commodity indices vary with respect to
weighting systems and constituent commodities.
E.g., the S&P GSCI commodity index is overweighted in energy sector. As a result, different
indices have different commodity exposures, making
comparison difficult across indices.

Other Commodity Investment Vehicles

Alternative means of commodity investments include:

A. Managed futures funds: These are actively managed
investment funds, which invest in exchange-traded
derivatives on commodities and focus on either
specific commodity sectors or on a broadly diversified
portfolio of commodities.
Like hedge funds, they are managed by professional
money managers (called the general partner) and
has fee structure of 2-20%.
They may operate like mutual funds where the

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Introduction to Alternative Investments

general public can invest or like hedge funds where

investment is restricted to high net worth and
institutional investors.
Managed futures funds operating like mutual funds
provide retail investors with an access to the
professional management at low investment and
relatively high liquidity.
B. Individual managed accounts: These funds are
managed by selected professional money managers
who have expertise in commodities and futures. These
funds are offered to high net worth individuals or
institutional investors.
C. Funds exist that specialize in specific commodity
sectors(e.g. private equity partnerships): Such funds
can be used to gain exposure to specific sector e.g.
energy sector. Like private equity funds, they charge
management fee (range from 1-3% of committed
capital) and have lockup period of 10 years (with
extensions of 1-2 years).

Commodity Performance and Diversification


Value to users
Global economic conditions
Supply of Commodities depend on:
Production levels
Inventory levels
Actions of non-hedging investors
o Supply of commodities is difficult to adjust quickly
to the changes in demand levels due to long lead
times associated with production. As a result,
during strong (weak) economy, supply is too low
(high) than demand. This mismatch between
supply and demand results in greater price
o The cost of new supply also increases over time.
Demand for commodities depend on:
Needs of end users which depend on
o Global manufacturing dynamics
o Economic growth
o Government policy
Actions of non-hedging investors

Benefits of Commodities:
6.4.1) Pricing of Commodity Futures Contracts
They provide potentially attractive returns.
They provide inflation hedge because inflation index
levels are determined by commodities prices e.g.
energy and food prices impact the cost of living for
They provide diversification benefits as they have
low positive correlation with traditional assets i.e.
stocks and bonds.
Commodity futures contracts may provide higher
liquidity and opportunities to earn a positive real

where, r = periods short-term risk-free interest rate.

When Futures price the spot price compounded at the
risk-free rate  arbitrage opportunities exist i.e. if Futures
price >(<) the spot price compounded at the risk-free
rate  an arbitrageur can sell (buy) futures contract
and buy (sell) the commodity at spot price.
Cost of carry: The combination of storage and interest
costs is sometimes referred to as cost of carry or the

Leverage risk: Leveraged investment in commodities
has high volatility and results in higher risk.
Counterparty risk associated with commodity
derivatives contracts.
When inflation index levels are determined by
commodity prices, then on average, investment in
commodities tend to generate zero return over time.
Investors of commodities: Institutional investors including
endowments, foundations, corporate and public
pension funds, and sovereign wealth funds.

Futures price Spot price (1 +r) + Storage costs

Convenience yield

Convenience yield: It refers to nonmonetary benefits

from owning the spot commodity. Therefore, futures
price is adjusted for the loss of convenience. The value
of convenience may vary over time and across users.
When there is little or no convenience yield futures
prices are higher than the spot price  commodity
forward curve is upward sloping  this situation is
referred to as Contango.
When the convenience yield is high futures prices
are lower than the spot price  commodity forward
curve is downward sloping  this situation is referred
to as Backwardation.

Commodity Prices and Investments

Commodity spot prices depend on:

Supply and demand
Costs of production and storage

Sources of return for Commodity futures contract: There

are three sources of return for each commodity futures

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Introduction to Alternative Investments

1) Roll Return/ yield: Roll yield refers to the return that

can be earned by rolling long futures positions
forward through time.
Roll yield = Spot price of a commodity Futures
contract price
Roll yield = Futures contract price with expiration date
X Futures contract price with expiration
date Y
When the convenience yield is significantly higher
(and thus futures price < spot price), the futures
contract price tends to roll up to the spot price as
the maturity date approaches, generating positive
roll yield. Opposite occurs when there is little or no
convenience yield. This concept is referred to as
Theory of Storage.
Hedging Pressure Hypothesis: According to this
theory, the difference between the spot and futures
price depends on user preferences and risk

2) Collateral yield: It is the return (i.e. risk-free interest
rate) earned on a fully margined/collateralized
position in a long futures contract (i.e. posting 100%
margin in the form of T-bills).
3) Spot Return/Price Return: It refers to the change in
commodity futures prices that result from changes in
the underlying spot prices. It is calculated as change
in the spot price of the underlying commodity over a
specified time period.
The spot (or current) prices primarily depend on
current supply and demand.
Returns on a passive investment in commodity futures =
Return on the collateral + Risk premium (i.e. hedging
pressure hypothesis) or the convenience yield net of
storage costs (i.e. theory of storage)


Collectibles: Collectibles are tangible assets e.g.

antiques and fine art, fine wine, rare stamps and coins,
jewelry and watches, and sports memorabilia.
Sources of return for Collectibles: They provide longterm capital appreciation and do not provide any
current income.
They can also be used for diversification purposes.
Risks associated with collectibles:
o Their value is subject to substantial fluctuations.
o They are highly illiquid.
o To earn superior returns, investors need to have
high expertise.
o To preserve their conditions and value, some
collectibles must be stored in appropriate

Collectibles can be traded in various ways including
through professional auctioneers, in local flea
markets, online auctions, garage sales, and antique
stores or directly with personal collectors.
Different collectibles indices exist in the market
which provide information about their performance.
However, they may not reliably represent
performance of such asset class.


Following are some of the challenges of alternative

investments due diligence:
Asymmetric risk and return profiles. As a result,
traditional risk and return measures (i.e. mean return,
S.D. of returns, Sharpe ratio and beta) may not be
appropriate to use.
Limited portfolio transparency.
Illiquidity and long time horizon (i.e. long-term
commitment required).
Complex structures and investment strategies.
Difficulty in valuations i.e. valuations based on
appraised (estimated) values due to lack of
observable prices and infrequent transactions.
Minimal regulatory oversight.
Risks associated with use of alternatives derivatives

contracts i.e., operational risk, financial risk,

counterparty risk and liquidity risk.
Limited historical risk and return data.
Lack of manager diversification.
8.1.2) Risk Issues for Implementation
Historical returns and the S.D. of those returns may not
reliably represent the returns and volatility of alternative
investments because:
The reported correlations of alternative investments
with other investments may significantly differ from
the actual correlations.
Past performance can be a poor predictor of future
performance because:

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Introduction to Alternative Investments

o It may be highly sensitive to business cycle (e.g.

commodities and real estate investments).
o It may suffer from price bubbles.
8.1.3) Due Diligence Issues Regarding Risk
Due to lack of transparency in alternative investment, it
is difficult for investors to effectively manage
diversification across funds and to conduct adequate
due diligence.
To deal with aforementioned risks, it is critically
important for investors to select good managers with
verifiable track record, a high level of expertise and
experience with the asset type.
To avoid risk of 100% loss of equity on individual
investments, investors should diversify portfolios
across various investments and managers.
Investors should ensure that risk associated with use
of leverage is effectively managed by portfolio
Fee structure (compensation package) should be
critically analyzed to ensure alignment of interest
because managers may seek to attract large
amounts of capital to increase their management
fess which are based on assets under management
or committed capital. In addition, due to option like
feature of incentive fees, portfolio managers may
take unduly high risk to generate higher returns.
Investors should ensure that investment is in
compliance with its stated policies in the prospectus.
Due diligence also requires to assess organizational
structural and terms of the fund including the
policies and procedures for managing operations
and risks.
Due to use of appraised values for valuations,
independent valuation of illiquid underlying assets
should be performed on a periodic basis.
Rationale, analysis, and suitability of every
investment, exit strategies of investments, (including
timing and realization price) should be adequately
Investment policy should be clearly defined which
properly define limits on security type, leverage,
sector, geography and individual positions.
Investors should ensure that all positions and risk
exposures are carefully & effectively monitored and
managed by the manager. Generally, hedge funds
are monitored by a chief risk officer, who is not
involved in the investment process.
To reduce risks, unusually good and overly consistent
reported performance should be scrutinized.
Investment performance results should be reported
to investors on a regular basis.


Risk-Return Measures

A. Sharpe ratio can be used to measure the

performance of alternative investments.
Sharpe ratio = (Investment return Risk-free rate of
return) / S.D. of return
The Sharpe ratio may not be the appropriate risk-return
measure for alternative investments because
Due to illiquidity and use of appraised values rather
than transaction prices for valuation purposes,
returns may be smoothed and/or overstated and
the volatility (represented by S.Ds) of returns
The standard deviation (S.D.) measure fails to
consider the impact of diversification in a broadly
diversified portfolio.
Alternative investment returns are not normally
distributed; rather, they tend to be leptokurtic (fat
tails i.e. positive average returns), negatively skewed
(long-tails i.e. potential extreme losses). Hence, it not
appropriate to use S.D. as a measure of risk.
B. Downside Risk: It refers to the probability of losing a
certain amount of money in a given time period. For
1. Value at risk (VAR) measures the minimum amount
of loss expected over a given time period at a given
level of probability. It uses S.D. as a measure of risk.
2. Shortfall or safety-first risk measures the probability
that the portfolio value will fall below some minimum
acceptable level over a given time period. It uses
S.D. as a measure of risk.
3. Sortino Ratio = (Annualized rate of return Annualized
risk-free rate*) / Downside Deviation
*Minimum acceptable return or risk free rate is typically used.

Downside risk measures provide incomplete
information because they focus only on losses i.e. left
side of the return distribution curve.
For a negatively skewed distribution, estimating VAR
and shortfall risk using S.D. lead to an
underestimation of downside risk.
In addition, both Sharpe ratio and downside risk do
not consider the low correlation of alternative
investments with traditional investments.

For investors (particularly small investors) with high
liquidity needs, publicly traded securities (i.e. REITs shares,
ETFs shares and publicly traded private equity firms) are
more suitable.

C. Stress testing/scenario analysis: It involves estimating

losses under extremely unfavorable conditions. Due to
limitations of VAR, stress testing/scenario analysis
should be used as a complement to VAR. Stress
testing/scenario analysis is useful under both normal
and stressed market conditions.

Reading 60


Introduction to Alternative Investments

Due Diligence Overview

Read Exhibit 20, Volume 6, Reading 60.

Practice: End of Chapter Practice

Problems for Reading 60.