ALTERNATIVE INVESTMENT NOTES

What are Alternative Investments?

They are highly risky, nontraditional investments
Features:
 Alternative Investments differs from traditional investments (publicly
traded stocks, bonds, cash) both in the types of assets and securities.
 Managers of alternative investment portfolio may use derivatives and
leverage and short securities.
 Fees structures are different with higher management fees on
average and often with additional incentives fees based on performance
 Alternative investment as a grp have had low returns correlations with
traditional investments.

Fund investing: Basically indirect investing, where investor contributes money

to a fund, and the fund makes investment on the investor’s behalf.
Co-investing: a hybrid between direct and indirect investing, where the investor
can make investing alongside a fund.
Direct investing: the investor makes a direct investment in a company or
project without using an intermediary.

Compared to Traditional Investments, they exhibit several of the following

Characteristics:
 Less liquidity of assets held.
 more specialisation by investment managers
 less regulation and transparency
 more problematic and less available historical returns and volatility data
 different legal issues and tax treatment
 low correlation with return of traditional investment
 high fees
 restriction on redemption
 relatively more concentrated portfolios
Categories of Alternative Investments:
 Private equity funds
 hedge funds.
 Real Estate
 Commodities
 Infrastructure
 other like fine wines stamps automobiles antique furniture and art as well
as patent and intangible asset.
What are PE funds?
 Private Equity Funds refers to one of the investments in companies.

 Recapitalisation is a strategy where the company issues debt to fund a distribution

to equity holders (PE firm)
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Where do PE Funds invest in?

o In private companies
o in public companies which they intend to take private
o in the case of public companies, such financing is referred to as private
investment in public equities (PIPEs)
Leveraged Buyout Funds
o Acquiring public companies or established private companies with the
significant percentage of the purchase price finance through debt.
o The asset of the target company typically served as the collateral for the
debt and the cash flow of the target company are expected to be sufficient
to service the debt.
Venture Capital Funds
o Entails investing in or providing financing to private companies with high
growth potential
o The investment by venture capitals is mostly into startup or young
companies
Development capital funds
o Also called as Minority equity investments they invest in more mature
companies that are looking for capital to expand (growth) or restructure
operations, enter new markets, or finance major acquisition
Distressed investment funds
o Typically in tales buying the death of mature companies in financial
difficulties
o The companies may be in bankruptcy proceedings, defaulted on deaths or
seem likely to default on debt
o Investors buy the company’s debt in expectation of the company and its
debt increasing in value
o Turn around investors by debt and plan to be more active in the
management and directions of the company
Private Equity strategies:
1. Leveraged buyouts (LBOs)
o They are the most common type of pvt equity fund investment
o Leveraged refers to the fact that the fund’s purchase of the portfolio
company is funded primarily by debt
o This may be bank debt (Leverage buyouts),high yield bonds, or
mezzanine Financing
Mezzanine Financing refers to debt or preferred shares that are subordinate to
the high yield bonds issued and carry warrants or conversion features that give
investors participation in equity value increases.
HOW DOES AN LBO WORK?
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In and LBO the PE firm seeks to increase the value of the firm through some
combination of new management, management incentives, restructuring, cost
reduction or revenue enhancement
firms with high cash flow are attractive LBO candidates because their cash
flow can be used to service and eventually pay down the debt taken on for
acquisitions
TYPES OF LBOs
1. Management buy-outs (MBOs) – existing management team is involved in
the purchase and
2. Management buy-ins (MBIs) - external management team will replace the
existing management team

2. VENTURE CAPITAL FUNDS

o Venture capital invest in companies in the early stage of their
development
o The investment often is in the form of equity but can be in convertible
preferred shares or convertible debts
o while the risk of startup companies is often great, returns on successful
companies can be very high
o This is often the case when a company has grown to a point where it
can be the sold (at least in part)to the public via an IPO
o The company that is being invested in is often called the portfolio
company
o Venture capitals are not passive investors but they are actively in world
with the companies in which they invest
Investment Stages of VC:
A. The Formative Stage
It refers to investment made during a firm’s earliest period and
comprises three distinct phases.
ANGEL INVESTING refers to investment made very early in a firm’s Life, open
the “idea” stage and the investment funds are used for business plans and
assessing market potential. The funding source is usually individuals rather than
venture capital funds
THE SEED STAGE refers to investment made for product development,
marketing and market research. This is typically the stage during which venture
capital funds make initial investment through ordinary or convertible preferred
shares.
EARLY STAGE refers to investment made to fund initial commercial production
and sales
B. Later Stage Financing (expansion venture capital) is provided after
commercial production and sales have begun before an IPO funds may be
used for initial expansion of company already producing and selling so that
or for major expansion
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C. Mezzanine stage financing is provided to prepare to go public and

represent the bridge between the expanding company and the IPO
STUCTURE AND FEES
PE structure and Fees: PE funds are typically structured as a partnerships where:
Limited Partners – are outside investors are and
General Partners – are the private equity firm, which may manage a number
of funds

Exit Strategy, Benefits, risks & Due Diligence

PVT EQUITY EXIT STRATEGIES : The avg holding period for companies in PE
portfolios is around Five Years.
There are several primary methods of exist exciting and investment in portfolio
company:
1. Trade sale: sale of portfolio company to a competitor or another strategic
buyer
2. IPO: Send on or some shares of a portfolio company to the public.
3. Recapitalization : the company issues debt fund a dividend
distribution to equity holder(the fund) .This is not an exit in that the fund
still controls the company but is often a step towards an exit
4. secondary sale: Sell a portfolio company to another PE firm or a group
of investors
5. write off/ liquidation: reassess and adjust to take losses from an
unsuccessful outcome
PRIVATE EQUITY POTIENTIAL BENEFITS AND RISKS:

Benefits Risks
 An immediate cash exit for the  Possible opposition by
PE fund management
 Potential for high valuation of  Lower attractiveness to
the asset employees of the portfolio
 Fast and simple execution company
 Lower transaction costs than an  Limited number of potential
IPO trade buyers
 Lower levels of disclosure and  A possible lower price than in
higher confidentiality an IPO
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PRIVATE EQUITY Due Diligence

Because of the language typically used for funds investor should investigate
below factors prior to investing in private equity
 Interest rates and availability of capital
 Choice of manager (general partner)
 Operating and financial experience of the manager
 The valuation methods loose mixed line the incentive fee structures and
drawdown procedure

PRIVATE EQUITY Company Valuation :

1. Market/comparable approach: Market or private transaction values of
similar companies may be used to estimate multiples of EBITDA, Net
Income, or Revenue to use in estimating the portfolio company’s value
2. Discounted cash flow approach: Under this we will calculate the PV of
free cash flow to the firm or free cash flow to equity
3. Asset-Based Approach: Either the liquidation values or fair MV of assets
can be used Liquidation values will be lower as they are values that could
be realized quickly in a situation of financial distress or termination of
company operations. Liabilities are subtracted so only the equity portion of
the firm’s value is being estimated.

HEDGE FUNDS: employ a large number of different strategies

A contemporary hedge fund may have the following characteristics:
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 Aggressively managed portfolio- leveraged, long short positions, uses

derivatives.
 Goal of generating high returns
 Return objectives- absolute basis or relative benchmark.
 Private Investment Partnership open to limited partner with large
ticket investment.
 Restrictions on redemptions - lockup period, notice period.

Funds of Hedge Funds (FOF)

 They Are funds that hold a portfolio of hedge funds. They has higher fees
 FOF invests in numerous HFs, diversifying across fund strategies,
investment regions and management styles.
Hedge funds Classification
Hedge funds are typically classified by strategy, although categorisation vary.
These classifications change over time as new strategis es, often bees on new
products and opportunities in the market are introduced
THE FOUR BROAD categories of strategies are
 Event Driven Strategy
 Relative Value Strategies
 Macro Strategies
 Equity Hedge Fund Strategies
1) Event Driven Strategy : They are typically based on a corporate
restructuring or acquisition that creates profit opportunities for long or
short positions in common equity , preferred equity, or debt of a specific
corporation. SUBCATEGORIES are :
 Merger arbitrage: buy shares of firm being acquired and sell short the
firm making the acquisition
 Distressed restructuring: buy the (undervalued) securities of firms in
financial distress when analysis indicates value will be increased by a
successful restructuring: possibly short overvalued securities types at the
same time
 Activist shareholder: buy sufficient equity shares to influence
companies policies with the goal of increasing company value
 special situation: invest in the securities of firms that are issuing or
repurchasing securities spinning off divisions, selling asset or
distributing capital

2) Relative Value Strategies : They involve buying a security with a gold of

profiting when a pursuit pricing discrepancy between the 2 is resolved
they include:
 Convertible arbitrage fixed income: exploit pricing discrepancies
between convertible bonds and the common stock of the issuing
companies
 Asset backed fixed income: exploit pricing discrepancies among
various mortageg backed securities (MBS) or (ABS)
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 General fixed income: exploit pricing discrepancies between fixed

income securities and the various bonds
 Multi-strategy: Exploit pricing discrepancies between securities in asset
classes different from those previously listed and across asset classes and
markets

3) Macro strategies: They are based on global economics trends and events
and may involve long and short positions in equities, fixed income,
currencies or commodities.

4) Equity hedge fund strategies : day seek to profit from long or short
positions in publicly trade equities and derivatives with equities as their
underlying assets and include:
o Market neutral: use technical and fundamental analysis to select
undervalued equities to be held long and to select overvalued
equities to be sold short in approximately equal amounts to profit
from their relative price movements without exposure to market risk
o Fundamental growth: use fundamental analysis to find high
growth companies. Identify and buy equity of companies that are
expected to sustain relatively high rates of capital appreciation
o Quantitative directional: buy equity securities believed to be
undervalued and short securities believed to be overvalued based
on technical analysis. Market exposure may vary depending on
relative size of long and short portfolio position
o Short bias: employee predominantly short positions in over valued
equities possibly with smaller long positions but with negative
market exposure overall.
NOTE: many hedge funds tend to specialise in a specific strategy at first
and overtime may develop or additional areas of expertise, becoming
multi strategies fund.

 HEGDE FUND FEES AND OTHER

CONSIDERATIONS
 Common fee structure in the hedge fund market is 2 and 20 which reflects
a 2% management fee and a 20 % incentive fees
 Fees structure specifies that the incentive fees is only earned after fund
achieved specified return known as hurdle rate
 The incentive fee can be based on returns in excess of the hurdle
rate(HARD) or on the return entire(SOFT HURDLE RATE)
 the fee structure may specify that before an incentive fee is paid following
year in which the funds value has declined, the funds value must return to
a previous high watermar Note that the high watermark is typically the
highest value reported by the fund; the amount reported is net of fees
OTHER CONSIDERATIONS
 Redemptions frequently occur when H fund is performing poorly
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 In the hedge fund industry drawndown is a reduction in net asset value.

When down occur, investors may decide to exit the fund or redeem at
least a portion of their shares
 Redemptions may require the H fund manager to liquidate some positions
and incur transaction costs and this may further magnify the loss says on
the position
 Redemption fees may serve to discourage redemption and to help H fund
managers recover transaction cost
 Notice periods may allow the Hedge funds manager to liquidate a position
in an orderly fashion without magnifying the losses.

 Hedge Fund Valuation Issues:

Multiple Valuation issues
1. When market prices or quotes are used for valuation, funds may differ
in which price or quote they use (for example, bid price, ask price, avg
quote, and median quote)
2. A common practice is use to the average quote [(bid+ask)/2]
3. A more conservative and theoretically accurate approach is to use bid
prices for longs and ask price for shorts

4. Management fees for PE is typically based on committed capital, not AUM.

Reliability
1. The underlying positions may be in highly illiquid or non-traded
investments and therefore, it is necessary to estimate values because
there are no reliable market values.
 HEDGE FUND POTENTIAL BENEDITS AND RISKS:
 Hedge funds returns have tended to be better than those of global
equities in down equity markets and to log the returns of global equities in
up markets
 Different hedge funds strategies have the best returns during different
time periods
 Statements about the performance of and diversification benefits of hedge
funds are problematic because of the great variety of strategies used
 Less than perfect correlations with global equity returns may offer same
diversification benefits, but correlations tend to increase during periods of
financial crisis.

Factors to consider when selecting hedge fund:

 Investment strategy Longevity
 Investment process Amt of asset
under mgmt.
 Historical returns Mgmt style
 Valuation and return calculation methods Key person risk
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 Reputation
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REAL ESTATE:
Real estate investment stand be depreciated according to their underlying
assets. Assets included under the heading of real estate investment include:
 Residential property - single family homes
 commercial property- produces income
 Loans - with residential or commercial property as collateral mortgages
construction loans ETC
Reasons for investing in real estate include the following:
 Potential for competitive long term total returns driven by both income
generation and capital appreciation
 Prospect that multiple year leases with fixed rent for some property types
may lessen cash flow impact from economic shocks
 Likelihood that diversification benefits may be provided by less than
perfect correlation with other asset classes
 Potential to provide an inflation hedge if rents can be adjusted quickly for
inflation
Real estate valuation:
THE COMPARABLE SALES APPROACH
 It is based on valuation and recent sales of similar properties
 Values for individual properties include adjustment for differences between
the characteristics such as age,location, condition ,and size of the specific
property and those are the properties for which recent sale prices are
available
THE INCOME APPROACH

Residential Property:
 Takes the form of direct equity investment (i.e., ownership) in a residence
with the intent to occupy
 Financial institutions are the main providers (originators) of debt financing
for home ownership
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 The originators of single-family residential mortgages are making a direct,

debt investment in the home
 Home loans may be held on the originator's balance sheet or securitized
and offered to the financial markets
 Securitization provides indirect, debt investment opportunities in
residential property via securitized debt products, such as residential
mortgage-backed securities (RMBS), to other investors
Commercial Real Estate:
 Commercial property has traditionally been considered an appropriate
direct investment Equity and Debt- for institutional funds or high-net-worth
individuals with long time horizons and limited liquidity needs
 In order to provide direct debt financing, the lender (investor) will conduct
financial analyses to establish the creditworthiness of the borrower, to
ensure that the property will generate cash flows sufficient to service the
debt, to estimate the value of the property, and to evaluate economic
conditions
Mortgage-Backed Securities (MBS):
The MBS structure is based on the securitization model of buying a pool of assets
and assigning the income and principal returns in individual security tranchase
Timberland and farmland

Real estate investment trusts (REITs):

 They issue shares that trade publicly like shares of stock
 REITs are often identified by the type of real estate assets they hold:
mortgages, hotel properties, malls, office buildings, or other commercial
property
 Income is used to pay dividends which is typically 90% of income must be
distributed to shareholders to avoid taxes on this income that would have
to be paid by the REIT before distribution to shareholders
 Equity REITs, which invest primarily in commercial or residential properties
and employ leverage, are similar to direct equity investments in leveraged
real estate
 Gross income from rents represents a relatively predictable income stream
and after servicing the debt, is a source of return to equity REITs
REITs Valuation:
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Income-based approach
A measure of income, which is a cash flow proxy, is capitalized into a value
indication by using a cap rate (Ke-g). It is similar to the Direct Capatalization
approach

Asset -based approach

 This approach calculates a REIT’S NAV
 RIET shares frequently trade at prices that differ from its NAV per share
 Both premiums and discounts to the NAV are observed in the market

Diversification benefit of including REITs:

Historically, REIT index returns and global equity returns have had a
relatively strong correlation and that between global bond returns and
REIT return has been very low
In either case diversification benefits can result from including real estate
in an investors portfolio
However, the methods of index construction (e.g., appraisal or repeat
sales indices) may be a factor in the low reported correlation, in which
case actual diversification benefits may be less than expected.
Real Estate Performance is measured by three different types of indices:
1. An appraisal index:
Prepared by the National Council of Real Estate Investment Fiduciaries
(NCREIF) in US
It is based on periodic estimates of property values
Appraisal index returns are smoother than those based on actual sales
and have the lowest standard deviation of return of the various index
methods
2. A Repeat sales index:
It is based on price changes for properties that have sold multiple time
(price*properties)
The sample of properties sold included in the index is not necessarily
random but may also not be representative of the broad spectrum of
properties available(an example of sample selection bias)
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3. REIT indices:
They are based on the actual trading prices of REIT shares, similar to
equity indices
Real Estate Investment Risks: