Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 8
Property, Infrastructure, Private Equity and Hedge Funds
Greg Vaughan

Institutional Property
Commercial, usually CBD differentiated by grade (A, B,C,
D)
Retail centres (eg Westfield) categorised by number of
department stores, supermarkets and specialty shops.
Bulky Goods centres (eg Bunnings) are a separate retail
category
Industrial categorised by function warehouse, distribution,
industrial estate , high-tech business park
Also miscellaneous specialist properties including hotels,
carparks, conference centres

Investment considerations
Aside from LOCATION, other investment considerations
include:
The forecast levels of new supply of that property type in
the area
The quality of tenants (eg public sector often avoided)
The Weighted Average Lease Expiry (WALE) is there
vacancy risk on lease expiries?
Is the property in need of substantial refurbishment in the
near term?
Are there zoning options available (eg dual commercial/
residential)?
Will transport network developments affect location?
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Property terminology (1)

Outgoings property rates, insurance, repairs and
maintenance.
A lease can charge a gross rent where the landlord pays
outgoings, or a net rent where the tenant pays outgoings.
Either way the tenant effectively pays outgoings and the
landlord receives net rent after outgoings.
A leasing incentive is a benefit, usually confidential, offered
to a new tenant (eg four months rent free)
Effective rent = face rent incentives
Passing rent is term used to distinguish from market rent.
For example a tenant may be paying a rent below market
rates, but that might change at the next rental review
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Property Terminology (2)

Retail leases usually consist of a base rent and a
percentage of turnover which applies beyond a break-even
level. On review the base rent and break-even will reset to
recent levels.
Occupancy Cost is the total cost incurred by a tenant to
provide for there occupancy including net rent, outgoings,
capital costs, depreciation allowances.
Vacancy rate is the proportion of empty but occupiable
space (high vacancy rates indicate oversupply)
Occupancy Cost Ratio (OCR) is total occupancy cost
divided by gross turnover (retail property). When OCR is
high landlords face greater risk of higher vacancy rates
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Accounting Definitions for REITS (1)

Net Income = Rent management and operating expenses
depreciation of capital improvements
amortisation of lease incentives
interest
Funds from Operations (FFO) seeks to remove non-cash
adjustments and get back to an operating income concept
FFO = Net Income + Depreciation + Amortisation
As an accounting concept this ignores important
adjustments. Adjusted Funds From Operations (AFFO)
replaces depreciation and amortisation with current cash
equivalents, similar to equity free cash flow concept
AFFO = FFO current capex current lease incentives
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Property Valuation
Three basic approaches:
Comparison to similar buildings that have sold recently,
although no two properties are identical
Summation land value plus cost of improvements. Useful
when building is new
Capitalisation of net income. Calculate net income and
capitalise at the appropriate market capitalisation rate for
the property, (Net Rent)/(Capitalisation Rate)
Properties are valued for highest and best use which may be
different to their current function.

Property Valuation Capitalisation of Net Income

Typically new tenants are given incentives usually in the
form of a rent free period at the start of the lease
This assists a new tenant with the cost of fit-out
The valuation typically applies a capitalisation rate to net
income = rent after outgoings but before incentives
The capitalisation rate may be increased as an allowance
for the artificially high net income
For example Sydneys current office capitalisation rate is
6.1% (JLL), but would be 5.3% if applied to rent after
incentives
The calculation may be further adjusted for expected
capital expenditure in the short-term (eg two years)
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Capitalisation Rates

Capitalisation Rates (2)

The capitalisation rate is similar in concept to the dividend
discount model, V=Net Rent/Capitalisation Rate
Capitalisation rate = bond yield + risk premium growth
Since the GFC the growth outlook has dimmed and risk
premiums have increased
Hence although bond yields have fallen, capitalisation rates
have not followed
In a portfolio of properties, valuations are reviewed on a
staggered basis so only a fraction of properties (say a third
to a half) are revalued every quarter
This considerably smooths the volatility of reported returns
which is attractive to DC superannuation funds
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Direct property returns are different

Smoothed volatility because of staggered valuations also
suppresses measured covariance
In mean-variance portfolio optimisation the distorted risk
characteristics of direct property will often drive excessive
allocations unless constrained
Property returns are also strongly autocorrelated in the
short-term because of staggered valuations. If capitalisation
rates change, portfolio valuations are impacted gradually.
This means annualised volatility calculated from quarterly
returns for example can be significantly understated. From
1985-2012 annual volatility is 8%, but annualised quarterly
volatility is 4%!
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Property Sector Total Returns (1)

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Property Sector Total Returns (2)

Spikes in business credit have preceded property collapses

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Property Sector Total Returns (3)

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Observations on historical performance

The property slump of the early 1990s followed a building
boom in commercial property (cranes throughout the CBD)
The construction boom was supported by easy lending by
banks (30%pa growth in business lending)
Easy credit also supports business expansion and tenancy
demand, but supply ultimately exceeds demand
The commercial market suffered from oversupply for several
years, collapsing rents and property values
The lesson is that acceleration in supply of new space,
usually coincident with easy credit conditions, increases risk
This is a slow moving phenomenon
It may contaminate the economy more widely than property
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Some similarity to an indexed bond

The income stream is a perpetuity
The natural growth in property rental is broadly in line with
inflation
However ebb and flow of new property development can
disrupt capital values and rental growth
Retailing may also be subject to structural change
Properties need to be redeveloped periodically
This involves a substantial investment (eg 10-15% of value
every 10-15 years) to ensure rents are sustainable.
Allowing for this investment is equivalent to a reduction in
income growth of circa 0.5% pa.
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Alternative approaches to institutional property

investment (1)
Direct Ownership
will restrict diversification unless the institution is very large
full control on prices payed and received for individual
properties
significant management overhead
can the institution attract appropriately experienced
people?
An institutional superannuation fund cannot directly
leverage property investment
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Alternative approaches to institutional property

investment (2)
Unlisted pooled vehicles
retain the advantage of smoothed property volatility via the
staggered valuation process
better diversification than direct ownership
infrequent capital raisings and redemption windows cant
add to or redeem as you wish
management is usually external to the fund who are they
looking after?
The vehicle may or may not be leveraged

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Alternative approaches to institutional property

investment (3)
A-REITS
pooled vehicles listed on the ASX, also know as Australian
Real Estate Investment Trusts (A-REITS)
better liquidity than unlisted pools but returns are much
more volatile because the market values constantly
Management may be internal or external
Other things being equal, internal management is attractive
as management is then provided at cost
A-REITS are usually leveraged
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Property trusts and leverage

Property trusts (REITS) are typically leveraged with a debt to
total assets currently around 30%.
This leverage changes the income and growth characteristics
of the investment compared to the underlying property.
Let leverage L = Debt/Assets
y = cost of debt
r = net rental yield on underlying property
g = expected growth in net rental income
v = return volatility of the ungeared REIT
The income yield of the REIT = (r yL)/(1-L)
The growth in income of the REIT = gr/(r-Ly)
The volatility of REIT return = v/(1-L)
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Property trusts and leverage (2)

Example
Assume net rental yield of 6%, cost of debt of 5.5%,
underlying rental growth of 2%, unleveraged volatility of 7%,
and leverage of 30%
The leveraged yield of the trust = (6%-0.3x5.5%)/(1-0.3) =
6.2%
The leveraged growth = 2%x6%/(6%-0.3x5.5%)= 2.76%
The leveraged volatility = 7%/(1-0.3) = 10%
The important point is that the underlying asset has been
transformed by leverage. Income and expected growth are
higher, but so is return volatility.
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Property trusts and leverage (3)

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Property trust shareholder versus fundamental

return (change in NTA + income)

Note shareholder return is circa twice as volatile as fundamental

return
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Property key considerations

Regardless of vehicle (direct, unlisted or listed pool) the
characteristics of the property portfolio will depend on
Diversification by type and location
The management arrangements
The inclusion of development activity
The degree of leverage (if any)

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Alternative assets infrastructure, private

equity and hedge funds
Conventional asset classes (equity, fixed interest, and
property) are defined by a commonality of risk and return
drivers
The alternative asset basket is for leftovers assets which
arent like equity, fixed interest or property
Although these other assets are grouped, they are not like
each other fail asset class homogeneity criteria
The Yale endowment model pioneered significant allocations
to alternative assets but their success has not been easy to
emulate

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Alternative assets infrastructure, private

equity and hedge funds

Source: Chambers and Dimson (2015) The British Origins of the US Endowment Model FAJ Vol 71

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Alternative assets infrastructure, private

equity and hedge funds
Liquidity often restricted or conditional
Fees high and not always fully disclosed
Leverage the attractive stability of an infrastructure asset
can be transformed via a leveraged equity position
Performance measurement valuation is often appraisal
based and staggered so measures of volatility are
meaningless; serial dependence of returns
Not well represented by indices high idiosyncratic risk

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Private equity (1)

This refers to equity investment in unlisted firms
Superannuation funds place money with private equity
managers (general partners) who take majority (usually
complete) ownership positions in companies
The investing funds (limited partners) participate in a finite
capital raising. The investments are made over a period of
time and gradually sold, sometimes via IPO
Commitments from limited partners are drawn down as
required
Fee levels (including performance carried interest) are
high, and often not fully disclosed under agreements
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Private equity (2)

Most private equity acquisitions are highly leveraged
This amplifies expected returns, potential fees, and risks
Long-term investors are attracted to private equity because
it allows them to earn the liquidity premium
In valuation, small companies are generally valued with a
higher cost of equity (eg +5%) and there is further
adjustment for high leverage
So private equity investments are expected to outperform
public equity investments this is no miracle of active
management
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Private equity (3)

Harris, Jenkinson and Kaplan (2014) surveyed 1,400
private equity buyout and venture capital funds
They observed outperformance relative to public market
equivalents (eg SP500) of circa 3%pa, but did not adjust for
higher leverage
Private equity performance varies significantly by vintage
year (in which funds are committed)
Performance is lower for vintage years with higher raisings
There is evidence of strong performance persistence with
private equity managers

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Infrastructure
Two broad categories
Regulated monopolies (eg electricity and gas transmission
and distribution) with revenue controlled by the Australian
Energy Regulator. Defensive in nature.
Competitive segments (eg roads, ports, airports). Cyclical
exposure to the economy
Assets can range from development to maturity, with varying
income/growth profiles
Infrastructure funds can be listed or unlisted
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Infrastructure and Leverage

Leverage, expressed as debt to assets, is commonly in the
range 50-70%
The Australian Energy Regulator assumes leverage of 60%
in its decisions
Although the unlevered asset may seem tame, the effect of
gearing substantially alters the risk/return profile
Pricing of assets is also affected by leverage so that the
return to an unleveraged investor is often unappealing
Cyclicality of asset income in the case of ports and airports
further amplifies risk

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Finite concessions
Governments grant concessions for the operation of certain
assets including toll roads and airports
Where the concession has a sunset in the foreseeable
future (eg < 20 years in the case of Melbourne CitiLink) the
income stream is finite
Although asset income may increase over time, asset value
can be in decline.
Hence income yields are not always comparable across
assets

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Infrastructure Valuation
In the 2015 Valuation Practices Survey by KPMG, 63% of
respondents thought there might be a bubble in
infrastructure too much money chasing too few assets
The valuation model commonly used is a Discounted Cash
Flow to Equity approach
This enables explicit recognition of refinancing benefits
Cash Flow forecasts are very detailed, because of the
relative stability compared to a typical company
Imputation benefits are explicitly valued
Cost of equity assumptions need to adequately reflect the
risk of more cyclically exposed assets

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Hedge Fund Strategies (1)

Convertible Arbitrage buy convertible bonds and short
underlying equity to access mispricing, maintaining delta
neutrality
Long/short equity may be long biased, market neutral or
short biased
Event Driven Distressed invest across the capital
structure of companies close to bankruptcy. Exploiting
forced sale by institutional investors. Bankruptcy process
may provide exit strategy

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Hedge Fund Strategies (2)

Event Driven Risk Arbitrage capture the spread in merger
or acquisition transactions post announcement (eg buy
target and wait for price to approach bid level)
Fixed Income Arbitrage trading anomalies in the yields of
similar securities or baskets of securities
Global macro aggressive tactical asset allocation across
global bonds, equities and currencies sometimes involving
leverage

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Long/Short Equity (1)

The manager usually enters into a securities lending
agreement with a prime broker or custody bank
To short a stock the manager borrows the stock from the
prime broker and sells it, pledging collateral of either cash
or securities. Collateral will exceed the value of the stock
borrowed. The stock is returned when the manager buys
back to close the position, hopefully after price declines
A long/short fund will consist of long positions in stocks the
manager expects to outperform, short positions in stocks
expected to outperform and cash.
For example for every $100 of a market neutral fund there
could be $75 of long equity positions, $75 dollars of short
equity positions and $100 cash.
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Long/Short Equity (2)

A standard variant is a 130/30 fund where per $100 the
manager is long $130 and short $30. This will have a
market exposure of $100 rather than being market neutral.
Compared to long only investment, a 130/30 fund benefits
from relaxation of a constraint and so the transfer of skill to
performance should in theory be better
In practice the investment process behind buy decisions is
not always as effective for shorting stocks. For example
although cheap stocks might appreciate over time, does
that mean expensive stocks decline just as reliably?
What is more certain about long/short investment is that
management fees are higher
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Hedge Fund Performance

Source: Hedge Fund Research

Hedge Funds did well in the bear market of early 2000s but suffered during GFC
This spoiled their absolute return perception as they demonstrated a market beta
Note the HRFX index is investible not all hedge fund indices are
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Hedge Fund Fees

The typical structure is a base (say 1.5-2.0%pa) and a
performance fee (say 15-20% of performance, sometimes
subject to a hurdle like the cash rate)
A high water mark will carry forward any underperformance
so that the manager is not simply rewarded for volatility
Hedge fund managers can sidestep the discipline of high
water marks by closing funds to new business and opening
new funds.
The aggregate fees (base and performance) are generally
excessive relative to the outperformance generated.
For example a 130/30 manager outperforming by 4% could
claim fees of 2.8% (2% base plus 20% performance)
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Hedge Fund Replication

Studies suggest that despite claims of alpha hunting the
hedge fund industry is largely beta grazing.
If hedge funds are simply creating factor exposures (eg to
equity markets, corporate bond spreads etc) these might be
passively mimiced at much lower fees.
A factor profile of a hedge fund composite index may
facilitate cheap replication, but are those factors well
rewarded?

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Hedge Fund Transparency

Hedge funds have long argued that keeping their strategies
and portfolios hidden, even from investors, was key to
competitive performance
For some funds exposing large illiquid positions, especially
on the short side, could be problematic
Recent research (Aggarwal and Jorion, 2012, FAJ) has
shown that in fact transparent hedge funds perform better
Opaque portfolios complicate risk measurement
No justification for institutional funds accepting lack of
transparency
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Hedge Funds in portfolio construction

As an asset class, hedge funds are awkward to
characterise in terms of risk and return
Hedge Fund Indices are often not replicable, vary widely
depending on which funds they include, and are prone to
several important biases (selection and survivorship)
Modelling an allocation to hedge funds based on the
performance of a hedge fund index is not a good idea.
A fund allocating to hedge funds typically takes on a
concentrated exposure to a few managers or funds of funds
A skeptical view is that hedge funds are an expensive blind
bet on active management skill.

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Next Week

Maginn, Tuttle et al Managing Investment Portfolios

Chapter 5. Prescribed reading as follows:
Sections 1; 2.1-2.3 ; 3.1 ; 4.1-4.3 ; 5 ; 6.6; 7.1-7.3; 9.1-9.4; 10
Group K to cover 2.3, 3.1, and 4.1
Group L to cover Grinold et al A Supply Model of the
Equity Premium and also Dimson Rethinking the Equity
Risk Premium
Group M to cover Section 10 of Maginn and Tuttle, and
Perold and Sharpe Dynamic Strategies for Asset
Allocation

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