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Type of Real Estate Investments
1. Raw Land
Main value determinant: Land appreciation which depends on

location, zoning ...
Type of Real Estate Investments (cont.)
2. Residential Rentals (Apartments)
Main value determinant: Number of rental unit...
Type of Real Estate Investments (cont.)
3. Office Buildings
Main value determinant: Location, economic growth, prestige,
...
Type of Real Estate Investments (cont.)
4. Warehouses
Main value determinant: Industrial and commercial activity,

suppor...
Type of Real Estate Investments (cont.)
5. Community Shopping Centres
Main value determinant: Local population income, le...
Type of Real Estate Investments (cont.)
6. Hotels and Motels
Main value determinant: Tourist and business travel, ability...
How to Test Real Estate Investments
It will likely be a challenge to memorize all of the value
determinates or principal r...
Real Estate:
Characteristics, Classification,
and Basic Segments
4 types of real estate investments:
Private equity (dire...
Real Estate:
Characteristics, Classification,
and Basic Segments (cont.)
Characteristics of Real Estate Investments
Every...
Benefits of Equity Real Estate
Investments
Current income
Price appreciation (capital appreciation)
Inflation hedge
Di...
Risk Factors of Real Estate Investment
Changes in business conditions
Long lead times for new development
Cost and avai...
Valuing Real Estate Investments
The inputs needed to evaluate real estate investments are the

cash flows after taxes (CF...
Valuing Real Estate Investments:
Different Approach

Income Approach - calculates a property's value as the present

valu...
Due Diligence in Real Estate
Investment
Due diligence - used to investigate factors that might affect the
value of a prope...
Private Equity Real Estate
Investment Indices
Real estate indices are used to track the performance of private
real estate...
Private Market Real Estate Debt
Decrease equity exposure.
Allow for the tax deductibility of interest.
Positive leverag...
Use of Leverage
Investors use debt financing (leverage) to increase returns.
As long as the investment return is greater...
Maximum Allowable Debt
Ratios used by lenders to determine the maximum amount of
allowable debt:
 Loan to Value (LTV): Mo...
Calculation of after tax cash flow
and after tax equity reversion
Step 1 - Compute taxes payable

Taxes = (net operating ...
Recaptured Depreciation
- Represents depreciation that was taken in anticipation of a
decline in the value of an asset tha...
Investment Decision Rules
The net present value (NPV) decision rule is to accept an

investment if its NPV ≥ 0.
The inte...
Income property appraisal using
Capitalization Rate

The valuation methodology whereby the market value of income-

produ...
Three Methods Used to Estimate
Market Capitalization Rate (Ro)
1. Market Extraction - useful for income generating propert...
Direct Capitalization Method
direct capitalization method - , the value of a property is equal to
Net Operating Income(NOI...
Discounted Cash Flow Method
DCF method - the future cash flows, including the capital
expenditures and terminal value, are...
Income property appraisal using
Gross Income Multiplier (GIM)
The GIM approach to value relates total annual income to

m...
Limitations of Direct
Capitalization Approach
Difficult to select appropriate capitalization rate without

adequate data....
Limitations of Gross Income
Multiplier
Sales prices (for comparables) may not be current.
Rental income may not be avail...
How to Test the Application of
Ratios to Perform Valuation
The application of ratios to perform valuation may look simple,...
Principal Types of Securities
Types of Securities
1. Real estate investment trusts (REITs)
Types of Publicly Traded REITs
...
Advantages of REITS
Superior liquidity in small and large amounts.
Greater potential for diversification
Access to a su...
Disadvantages of REITS
The costs of maintaining a publicly traded corporate structure.
Pricing determined by the stock m...
Real Estate Investment Trust (REIT)
Shares
Economic Value Determinants
 GDP growth
 job creation
 retail sales growth
...
Real Estate Investment Trust (REIT)
Shares (cont.)
Investment Characteristics
Exemption from income taxes at the corporat...
Real Estate Investment Trust (REIT)
Shares (cont.)
Due Diligence Considerations
In assessing the investment merits of REIT...
Real Estate Investment Trust (REIT)
Shares (cont.)
Due Diligence Considerations
They also pay particular attention to
 oc...
Use of Net Asset Value Per Share
(NAVPS) in REIT Valuation
Analysts use different methods to estimate NAV leading to vari...
Use of Funds from Operations (FFO)
in REIT Valuation
Funds from Operations (FFO) - a measure of cash flow available to the...
Use of Adjusted Funds from
Operations (AFFO) in REIT Valuation
The adjusted funds from operation (AFFO) are equal to the R...
Sources of Value Creation
in Private Equity
1. Value Creating by re-engineering of companies
Some private equity firms ha...
Sources of Value Creation
in Private Equity (cont.)
2. Value Creating by favourable access to credit markets
Use of debt ...
Sources of Value Creation
in Private Equity (cont.)
3. Value Creating by alignment of interests

Private equity investors...
Buyouts and Venture Capital
Investments
Relative to buyout firms, venture capital portfolios contain

immature firms with...
Types of Buyouts
Buyouts include takeovers, management buyouts (MBOs),

and leveraged buyouts (LBOs).
The financing of a...
Differences between Buyouts and
Venture Capital Investments
Whereas a venture capital firm may have a specialized industr...
Valuation Methods in Private
Equity
Discounted cash flow (DCF) analysis - most appropriate for

companies with a signific...
Important considerations when
valuing Private Equity
Control Premium: In buyouts, the private equity investors

typically...
Use of Price Multiples
in Private Equity Valuation
Many investors use market data from similar publicly traded

firms.
P...
Use of DCF in Private Equity Valuation
The beta and the cost of capital can be estimated from public

firms, while adjust...
Use of Exit Value in Private Equity Valuation
The purpose of calculating the exit value is to determine the

investment’s...
Alternative exit routes
and impact on value
IPO: In an IPO, a firm’s equity is offered for public sale.
 Advantages:
 U...
Alternative exit routes
and impact on value (cont.)
Management Buyout: The firm is sold to management which

employs a la...
Role of Exit Timing in Private Equity
Valuation
Exit multiples become uncertain if the exit time horizon is

more than a ...
Limited Partnership and other key
features of fund structure
Limited partners (LPs) provide funding and do not have an

a...
Duration of Private Equity Funds
Have a duration of 10–12 years, which is generally extendable

to an additional 2–3 year...
Economic Terms of a Private
Equity Fund

Management fees - represent a percentage of committed

capital paid annually to ...
Corporate Governance Terms of a
Private Equity Fund

Key man clause - Under this, a certain number of key named

executiv...
Corporate Governance Terms of a
Private Equity Fund (cont.)
No-fault divorce - A GP may be removed without cause, provide...
General Private Equity Risk Factors
Illiquidity of investments: Private equity investments are

generally not traded on a...
General Private Equity Risk Factors (cont.)
Lack of investment capital: Investee companies may require

additional future...
Costs associated with private equity investing
Transaction fees: Corresponding to due diligence, bank

financing costs, l...
Costs associated with private equity investing
(cont.)
Dilution costs: Additional rounds of financing and stock

options ...
Financial Performance of Private Equity Funds
Financial performance can be measured in quantitative and

qualitative term...
Quantitative Measures
of Performance
Internal rate of return (IRR): The return metric recommended

for private equity by ...
Quantitative Measures
of Performance (cont.)
DPI (distributed to paid-in capital): This measures the LP’s

realized retur...
Qualitative Measures
The realized investments, with an evaluation of successes and

failures.
The unrealized investments...
Benchmarks
Public Market Equivalent (PME) was proposed by Austin Long

and Craig Nickles in the mid-1990s as a solution t...
Pre Money Value and Post Money Value
At the time of a new investment in the firm, the discounted

present value of the es...
Two Methods to Compute
Fraction of VC Ownership
1. First method is the NPV method
f = INV/ POST
INV = amount of new invest...
Calculation of Price Per Share
Number of shares issued to the VC(sharesVC) is calculated

based on the number of existing...
Calculation of Price Per Share (cont.)
If there is a second round of financing:
 first calculate the proportion of the f...
Interest Alignment Between Private
Equity Firms and Managers of Portfolio Companies
Incentives
Incentives that motivate ma...
Interest Alignment Between Private
Equity Firms and Managers
of Portfolio Companies (cont.)
Contractual Structuring
Effect...
Alternative Exit Routes in Private Equity
1. Initial Public Offering (IPO) - shares of the company are

offered to the pub...
DPI, RVPI and TVPI
Fee and Asset Value
DPI(Distribution to Paid-In Ratio) - measures the ratio of
distributions to the lim...
Post Money Value
and Ownership Fraction
The post-money value of the company is calculated by discounting the
estimated exi...
Alternative Methods to Account
for Risk in Venture Capital
Two Approaches for Accounting for Risk
The discount rate is ad...
Two Methods to Assess the
Risk of Investment
1. The discount rate is adjusted to reflect the risk that the

company may fa...
Hedge Funds and Mutual Funds
Hedge funds typically use more leverage and derivatives than

mutual funds
Disclosure requi...
Use of Leverage
Hedge funds often use leverage.
Fixed income funds often use more leverage than equity

funds.
The amou...
Disclosure Requirements
for Hedge Funds

Mutual funds are required to report to the U.S. Securities and

Exchange Commiss...
Lockup Periods for Hedge Funds
1. A “hard lockup” states that no provisions exist for the

redemption of hedge fund invest...
Fee Structures for Hedge Funds
Hedge funds can earn both management fees and incentive

fees.

 A typical management fee...
Types of Hedge Fund Strategies
Arbitrage-based funds - are short volatility exposures that

lead to gains in quiet market...
Types of Hedge Fund Strategies (cont.)
Fixed-income arbitrage - invests with a positive income

orientation that benefits...
Types of Hedge Fund Strategies (cont.)
Managed futures funds - managers are also called commodity

trading advisers (CTAs...
Reported Hedge Fund Performance
Hedge fund reporting suffers from biases such as survivorship

bias and selection bias
R...
Possible Biases in Performance Reports
of Hedge Funds
Differences in fund weighting methodology
Lack of reporting leads ...
Factor Models for Hedge Fund Returns
A regression is performed to determine the portion of risk

derived from the market ...
Non-normality in Hedge Fund Returns
Implicit assumption that investment returns are normally

distributed and linearly re...
Use of Indexes
Market indexes, hedge fund indexes, and positive risk-free

rates can be used as guidelines for hedge fund...
Theoretical Basis for
Hedge Fund Replication
Hedge fund replication is based on the factor models and the

concept of alp...
Types of Hedge Fund Replication
Strategies
Static weights
Long–short equity, emerging market, short selling, and

distre...
Difficulties in modelling hedge funds
as part of portfolios
For hedge funds given the survivor, selection, stale pricing,...
Caveats in analysing hedge funds
as part of portfolios
Some hedge fund styles are known to smooth returns, as well

as ex...
Advantages of Fund of Funds
over Single Manager Hedge Funds
Funds of funds can reduce the standard deviation of a hedge

...
Disadvantages of Fund of Funds
over Single Manager Hedge Funds
Double layer of fees presents a high hurdle for funds of f...
Types of Risks in Hedge Fund
Investments
Beyond investment risks, hedge fund investors need to

understand and manage a n...
Measures of Risks in Hedge Fund
Investments
Because hedge fund returns are often not normally

distributed, investors sho...
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L2 flash cards alternative investments - SS 13

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  1. 1. Type of Real Estate Investments 1. Raw Land Main value determinant: Land appreciation which depends on location, zoning and planning Investment characteristics: Passive, illiquid, cannot generally be leveraged, capital gains taxes Principal risks: No ongoing income, uncertainty in appreciation Most likely investors: Speculators, long term investors Study Session 13, Reading 38
  2. 2. Type of Real Estate Investments (cont.) 2. Residential Rentals (Apartments) Main value determinant: Number of rental units which depends on location, economic growth, prestige and convenience Investment characteristics: Periodic income as well as appreciation, relatively liquid, can be leveraged, hedge against inflation Principal risks: Quality property management is needed, competition from single family homes Most likely investors: Those who desire tax shelter Study Session 13, Reading 38
  3. 3. Type of Real Estate Investments (cont.) 3. Office Buildings Main value determinant: Location, economic growth, prestige, perceived status and tenant mix Investment characteristics: Periodic income as well as appreciation, relatively liquid, can be moderately leveraged Principal risks: Quality property management is needed, obsolescence Most likely investor: High income individuals, firms with capital resources, public and private entities Study Session 13, Reading 38
  4. 4. Type of Real Estate Investments (cont.) 4. Warehouses Main value determinant: Industrial and commercial activity, support to changing material handling property Investment characteristics: Very passive, moderately liquid, modest leveraged, periodic income more important Principal risks: Prone to oversupply, obsolescence Most likely investors: Investors that determine high cash flows and tax shelter Study Session 13, Reading 38
  5. 5. Type of Real Estate Investments (cont.) 5. Community Shopping Centres Main value determinant: Local population income, lease agreements, tenant mix, convenience Investment characteristics: Active management, low liquidity, moderate leverage Principal risks: Difficult lease negotiations, obsolescence, development of competing commercial properties Most likely investors: Investors that can make the initially high equity investment and desire tax shelter Study Session 13, Reading 38
  6. 6. Type of Real Estate Investments (cont.) 6. Hotels and Motels Main value determinant: Tourist and business travel, ability to hold conventions and business meetings Investment characteristics: Active management, poor liquidity, poor leverage Principal risks: Sufficient size needed to capitalize on economies of scale, competing business, obsolescence Most likely investors: Investors that can make the initially high equity investment and willing to manage the property Study Session 13, Reading 38
  7. 7. How to Test Real Estate Investments It will likely be a challenge to memorize all of the value determinates or principal risks for all of the types of real estate investments. Rather, you should focus on the logic behind them, which may tested in a single question as a part of case or fact pattern. Study Session 13, Reading 38
  8. 8. Real Estate: Characteristics, Classification, and Basic Segments 4 types of real estate investments: Private equity (direct ownership) Publicly traded equity (indirect ownership) Private debt (direct mortgage lending) Publicly traded debt (mortgage-backed securities) Study Session 13, Reading 38
  9. 9. Real Estate: Characteristics, Classification, and Basic Segments (cont.) Characteristics of Real Estate Investments Every property is unique Basically indivisible. Needs to be managed in a hands-on manner. Transaction costs are high They depreciate and their value may change accordingly Sensitive to interest rates No public exchange exists for the trading No national, or international auction market Study Session 13, Reading 38
  10. 10. Benefits of Equity Real Estate Investments Current income Price appreciation (capital appreciation) Inflation hedge Diversification Tax benefits Study Session 13, Reading 38
  11. 11. Risk Factors of Real Estate Investment Changes in business conditions Long lead times for new development Cost and availability of capital can make real estate prices fluctuate Unexpected inflation Demographics may change Lack of liquidity Environmental issues Study Session 13, Reading 38
  12. 12. Valuing Real Estate Investments The inputs needed to evaluate real estate investments are the cash flows after taxes (CFAT) for each year in the investment holding period and the equity reversion after taxes (ERAT) associated with the sale of the property NPV and IRR are used in making real estate investment decisions Study Session 13, Reading 38
  13. 13. Valuing Real Estate Investments: Different Approach Income Approach - calculates a property's value as the present value of all its future income. Cost Approach - Value is derived by adding the value of the land to the replacement cost of a new building, less an adjustment for estimated depreciation and obsolescence. Steps involved with applying the cost approach: 1. 2. 3. Estimate the market value of the land. Estimate the building's replacement cost. Deduct physical deterioration, functional obsolescence, locational obsolescence, and economic obsolescence.  Sales Comparison Approach - the sales prices of similar (comparable) properties are adjusted for differences with the subject property. Study Session 13, Reading 38
  14. 14. Due Diligence in Real Estate Investment Due diligence - used to investigate factors that might affect the value of a property before an investor makes the final investment decision Factors:  leases and lease history  operating expenses  environmental issues;  structural integrity  lien, ownership, and property tax history  compliance with relevant laws and regulations Study Session 13, Reading 38
  15. 15. Private Equity Real Estate Investment Indices Real estate indices are used to track the performance of private real estate. Appraisal Based Indices - Properties do not transact very frequently. Hence, some valuation indices rely on appraised property values. Transaction Based Indices - transaction price reflects the real market value of a property. Types:  Repeat Sales Index - requires repeat sales of the same property  Hedonic Index - requires one sale of a property Study Session 13, Reading 38
  16. 16. Private Market Real Estate Debt Decrease equity exposure. Allow for the tax deductibility of interest. Positive leverage.  Before and after tax returns to equity are greater with than without debt.  As long as debt costs are less than equity, it takes less than its proportionate share of a property’s cash flow. Study Session 13, Reading 38
  17. 17. Use of Leverage Investors use debt financing (leverage) to increase returns. As long as the investment return is greater than the interest paid to lenders, there is positive leverage and returns are magnified. Leverage results in higher risk. Study Session 13, Reading 38
  18. 18. Maximum Allowable Debt Ratios used by lenders to determine the maximum amount of allowable debt:  Loan to Value (LTV): Mortgage amount / Appraised value of the property.  Debt service coverage ratio (DSCR): NOI/Debt service. A DCSR of 0.90 would mean that there is only enough net operating income to cover 90% of annual debt payments. Equity investors calculate these ratios:  Equity dividend rate: annual cash flow/cash initiated invested in the property.  If the leverage is positive, the leveraged IRR is always greater than the unleveraged IRR. Study Session 13, Reading 38
  19. 19. Calculation of after tax cash flow and after tax equity reversion Step 1 - Compute taxes payable Taxes = (net operating income (NOI) – depreciation – interest) × tax rate where tax rate = equity investors marginal income tax rate Step 2 - Compute cash flow after taxes Step 3 – Compute equity reversion after taxes (ERAT) ERAT = selling price – selling costs – mortgage balance – taxes on sale Step 4 – Calculate NPV and IRR to help arrive at the investment decision Study Session 13, Reading 38
  20. 20. Recaptured Depreciation - Represents depreciation that was taken in anticipation of a decline in the value of an asset that ultimately did not materialize. Study Session 13, Reading 38
  21. 21. Investment Decision Rules The net present value (NPV) decision rule is to accept an investment if its NPV ≥ 0. The internal rate of return (IRR) decision rule is to accept an investment if its IRR ≥ the investor’s required rate of return or some other stated hurdle rate. If there is a conflict between IRR and NPV, select the investment with the higher positive NPV. Study Session 13, Reading 38
  22. 22. Income property appraisal using Capitalization Rate The valuation methodology whereby the market value of income- producing property is calculated by capitalizing the annual net income generated by the property at an overall capitalization rate is known as direct capitalization. The market value under the direct capitalization method can be calculated as: MVo = NOI / Ro Where MVo is market value NOI is annual net income Ro is the capitalization rate necessary to attract investors The capitalization rate represents the required rate of return, or yield, on real estate, less the possibility of capital appreciation. Study Session 13, Reading 38
  23. 23. Three Methods Used to Estimate Market Capitalization Rate (Ro) 1. Market Extraction - useful for income generating property when sales data is available: Ro = NOI / MVo 2. Band of Investment - useful for properties financed with debt and equity Ro(BOI) = weighted mortgage cost + weighted equity cost 3. Built Up - can be used to separate various components of the capitalization rate R0(BU) = pure rate + liquidity premium + recapture premium + risk premium Study Session 13, Reading 38
  24. 24. Direct Capitalization Method direct capitalization method - , the value of a property is equal to Net Operating Income(NOI) divided by the capitalization rate. NOI value =Vo = NOI / Capitalization rate Net operating income (NOI) equals the amount left after subtracting vacancy and collection losses and property operating expenses from an income property's first year gross potential rental income. The capitalization rate is a growth implicit rate. Cap rate = Discount rate - Growth rate Study Session 13, Reading 38
  25. 25. Discounted Cash Flow Method DCF method - the future cash flows, including the capital expenditures and terminal value, are projected over the holding period and discounted to present using the discount rate. Project the NOI for each year of a holding period. Project resale price at the end of the holding period. Discount the NOI and resale price to get present value. Value = NOI/(r-g) Study Session 13, Reading 38
  26. 26. Income property appraisal using Gross Income Multiplier (GIM) The GIM approach to value relates total annual income to market value: Indicated market value = Gross income x Market-derived Gross Income Multiplier The Gross Income Multiplier is derived by looking at the sales prices of comparable properties, divided by their respective gross annual incomes. Study Session 13, Reading 38
  27. 27. Limitations of Direct Capitalization Approach Difficult to select appropriate capitalization rate without adequate data. Only applicable for income-generating properties. Study Session 13, Reading 38
  28. 28. Limitations of Gross Income Multiplier Sales prices (for comparables) may not be current. Rental income may not be available. Gross rents may be inaccurate when building-to-land ratios and building ages are different. Sale prices may be affected by factors that render the gross income multiplier inaccurate unless comparables are exposed to these same factors. Not useful for unique properties or properties that produce benefits instead of income. Study Session 13, Reading 38
  29. 29. How to Test the Application of Ratios to Perform Valuation The application of ratios to perform valuation may look simple, but the concepts of the capitalization and Gross Income Multiplier methods may be combined with the calculation of after tax cash flow and after tax equity revision (discussed in earlier readings). For example, you may be asked to calculate Net Operating Income, before you can apply the concept of capitalization rate for the valuation of real estate property Study Session 13, Reading 38
  30. 30. Principal Types of Securities Types of Securities 1. Real estate investment trusts (REITs) Types of Publicly Traded REITs  Equity REITs  Mortgage REITs 2. Real estate operating companies (REOCs) 3. Mortgage-backed securities (MBS) Study Session 13, Reading 39
  31. 31. Advantages of REITS Superior liquidity in small and large amounts. Greater potential for diversification Access to a superior quality and range of properties. The benefit of management services. Limited liability. The ability to use shares as tax-advantaged currency in making acquisitions. Protection accorded by corporate governance, disclosure, and other securities regulations. Exemption from income taxation within the REIT if prescribed requirements are met. Study Session 13, Reading 39
  32. 32. Disadvantages of REITS The costs of maintaining a publicly traded corporate structure. Pricing determined by the stock market and returns that can be volatile. Potential for structural conflicts of interest. Tax differences compared with direct ownership of property that can be disadvantageous under some circumstances. Study Session 13, Reading 39
  33. 33. Real Estate Investment Trust (REIT) Shares Economic Value Determinants  GDP growth  job creation  retail sales growth  population growth  new space supply and demand Study Session 13, Reading 39
  34. 34. Real Estate Investment Trust (REIT) Shares (cont.) Investment Characteristics Exemption from income taxes at the corporate/trust level. High income distributions. Relatively low volatility of reported income. More frequent secondary equity offerings compared with industrial companies. Study Session 13, Reading 39
  35. 35. Real Estate Investment Trust (REIT) Shares (cont.) Due Diligence Considerations In assessing the investment merits of REITs, investors analyse: the effects of trends in general economic activity retail sales job creation population growth new supply and demand for specific types of space Study Session 13, Reading 39
  36. 36. Real Estate Investment Trust (REIT) Shares (cont.) Due Diligence Considerations They also pay particular attention to  occupancies  leasing activities  rental rates  remaining lease terms  in-place rents compared with market rents  costs to maintain space and re-lease space  tenants’ financial health and tenant concentration in the portfolio  financial leverage, debt maturities and costs, and the quality of management Study Session 13, Reading 39
  37. 37. Use of Net Asset Value Per Share (NAVPS) in REIT Valuation Analysts use different methods to estimate NAV leading to variation in estimates. The most common method is to capitalize NOI using the cap rate.  Net asset value (NAV) = REIT Assets Value - REIT Liabilities  MAVPS = NAV/No. of shares outstanding. Adjustments are needed to exclude some "soft" assets (e.g. goodwill) liabilities (e.g. deferred tax liabilities). The market price of a REIT may not be the same as its NAV. Study Session 13, Reading 39
  38. 38. Use of Funds from Operations (FFO) in REIT Valuation Funds from Operations (FFO) - a measure of cash flow available to the REIT for distributions to shareholders. FFO is calculated by adding back depreciation and amortization and other non-cash deductions to earnings. 1. Start with GAAP net income, then: 2. Add back: depreciation expense. 3. Add back: deferred tax charges. 4. Deduct: Net gains from property sales and extraordinary items. 5. FFO = Aggregate NOI – Interest Study Session 13, Reading 39
  39. 39. Use of Adjusted Funds from Operations (AFFO) in REIT Valuation The adjusted funds from operation (AFFO) are equal to the REIT's funds from operations (FFO) with adjustments. AFFO: Funds available for distribution. 1. Start with FFO, then: 2. Deduct: recurring capital improvement expenditures. 3. Adjust for: straight-line rents. Study Session 13, Reading 39
  40. 40. Sources of Value Creation in Private Equity 1. Value Creating by re-engineering of companies Some private equity firms have developed effective re- engineering capabilities. Many private equity firms have in-house staff which can share their expertise and contacts with portfolio firm management. Only a part of value added created by private equity houses may be explained by superior reorganization and reengineering capabilities. Study Session 13, Reading 40
  41. 41. Sources of Value Creation in Private Equity (cont.) 2. Value Creating by favourable access to credit markets Use of debt is thought to make private equity portfolio companies more efficient. The requirement to make interest payments forces the portfolio companies to use free cash flow more efficiently because interest payments must be made. Study Session 13, Reading 40
  42. 42. Sources of Value Creation in Private Equity (cont.) 3. Value Creating by alignment of interests Private equity investors can align the interests of investors and managers by specifying the appropriate control mechanisms in the investment contract of managers. For example:  Compensation: Managers of the portfolio companies receive compensation that is closely linked to the firm’s performance  Tag-along, drag-along clauses: Anytime an investor acquires control of the company, they must extend the acquisition offer to all shareholders  Board representation: The private equity firm is ensured control through board representation  Non compete clauses: Company founders must sign clauses that prevent them from leaving and competing against the firm  Priority in claims: Private equity firms receive their distributions before other owners  Required approvals: For changes of strategic importance Study Session 13, Reading 40
  43. 43. Buyouts and Venture Capital Investments Relative to buyout firms, venture capital portfolios contain immature firms with risky prospects and cash flows Venture Capital portfolio firms often require substantial funding The returns on venture capital often come from a small number of highly successful investments. Study Session 13, Reading 40
  44. 44. Types of Buyouts Buyouts include takeovers, management buyouts (MBOs), and leveraged buyouts (LBOs). The financing of a LBO typically involves senior debt, junk bonds, equity, and mezzanine finance. The LBO model has three main inputs:  The target firm’s forecasted cash flows  The expected returns to the providers of the financing  The total amount of financing Mezzanine finance is a hybrid between debt and equity and can be structured to suit each particular transaction. Study Session 13, Reading 40
  45. 45. Differences between Buyouts and Venture Capital Investments Whereas a venture capital firm may have a specialized industry focus , LBO firms generally invest in a portfolio of firms with more predictable cash flow patterns. Venture capital firms seek revenue growth, whereas buyout firms focus more on EBIT or EBITDA growth. Buyout firms typically conducts a full blown due diligence approach before investing in the target firm. Venture capital firms tends to conduct primarily technology and commercial due diligence before investing Buyout firms monitor cash flow management, strategic, and business planning. Venture capital firms monitor achievement of milestones defined in the business plan and growth management. Study Session 13, Reading 40
  46. 46. Valuation Methods in Private Equity Discounted cash flow (DCF) analysis - most appropriate for companies with a significant operating history Relative value or market approach applies a price multiple, such as the price earnings ratio. Real option analysis - applicable for immature firms. Replacement cost of the business - generally not applicable to mature firms. Other potential methods are the venture capital method and the leveraged buyout method. Study Session 13, Reading 40
  47. 47. Important considerations when valuing Private Equity Control Premium: In buyouts, the private equity investors typically have complete control Country Risk Premium: When valuing firms in emerging markets, country risk premiums may be added Marketability and illiquidity discounts: Refer to the ability and right to sell the firm’s shares. Study Session 13, Reading 40
  48. 48. Use of Price Multiples in Private Equity Valuation Many investors use market data from similar publicly traded firms. Price multiples from comparable public firms It is often difficult to find public firms at the same stage of development, the same line of business, the same capital structure, and the same risk profile. Study Session 13, Reading 40
  49. 49. Use of DCF in Private Equity Valuation The beta and the cost of capital can be estimated from public firms, while adjusting for differences in operating and financial leverage between the private and public comparables. A terminal value is calculated using a price multiple of the firm’s EBITDA. Study Session 13, Reading 40
  50. 50. Use of Exit Value in Private Equity Valuation The purpose of calculating the exit value is to determine the investment’s internal rate of return sensitivity in the exit year. The exit value can be viewed as: Exit value = Investment cost + earnings growth + increase in price multiple + reduction in debt Study Session 13, Reading 40
  51. 51. Alternative exit routes and impact on value IPO: In an IPO, a firm’s equity is offered for public sale.  Advantages:  Usually results in the highest exit value due to increased liquidity, greater access to capital, and the potential to hire better quality managers.  Most appropriate for firms with strong growth prospects and a significant operating history and size. Secondary market sale: The firm is sold to another investor or to another firm interested in the purchase for strategic reasons.  Advantages:  Second highest firm values after IPOs Study Session 13, Reading 40
  52. 52. Alternative exit routes and impact on value (cont.) Management Buyout: The firm is sold to management which employs a large amount of leverage.  Advantages:  Management usually has a strong interest in the subsequent success of the firm. Liquidation: Outright sale of firms assets Study Session 13, Reading 40
  53. 53. Role of Exit Timing in Private Equity Valuation Exit multiples become uncertain if the exit time horizon is more than a couple of years and stress testing should be performed on a wide range of possible values. Study Session 13, Reading 40
  54. 54. Limited Partnership and other key features of fund structure Limited partners (LPs) provide funding and do not have an active role in the management of the investments. The general partner (GP) in a limited partnership is liable for all the firm’s debts and, thus, has unlimited liability. The general partner (GP) is the manager of the fund. Most fund structures are closed end, meaning that investors can only redeem the investment at specified points in time. Study Session 13, Reading 40
  55. 55. Duration of Private Equity Funds Have a duration of 10–12 years, which is generally extendable to an additional 2–3 years. The typical stages are:  Marketing (1-2 years): commitment by investors  Draw down or investment (3-5 years)  Realisation of returns and exit (3-5 years): cash flows are returned back to investors  Extension (2-3 years) Study Session 13, Reading 40
  56. 56. Economic Terms of a Private Equity Fund Management fees - represent a percentage of committed capital paid annually to the general partner during the lifetime of the fund. Transaction fees - fees paid to GPs in their advisory capacity when they provide investment banking services. Carried interest - represents the general partner’s share of profits generated by a private equity fund (typically 20%). Ratchet - a mechanism that determines the allocation of equity between shareholders and the management team. Hurdle rate - the internal rate of return that a private equity fund must achieve before the GP receives any carried interest (typically 7-8%). Vintage year - the year the private equity fund was launched Study Session 13, Reading 40
  57. 57. Corporate Governance Terms of a Private Equity Fund Key man clause - Under this, a certain number of key named executives are expected to play an active role in the management of the fund. Clawback provision - requires the GP to return capital to LPs in excess of the agreed profit split between the GP and LPs. Distribution waterfall - a mechanism providing an order of distributions to LPs first before the GP receives carried interest.  deal-by-deal waterfalls allow earlier distribution of carried interest to the GP after each individual deal  total return waterfalls result in earlier distributions to LPs as carried interest is calculated on the profits of the entire portfolio Tag-along, drag along rights - contractual provisions in share purchase agreements that ensure any potential future acquirer of the company may not acquire control without extending an acquisition offer to all shareholders. Study Session 13, Reading 40
  58. 58. Corporate Governance Terms of a Private Equity Fund (cont.) No-fault divorce - A GP may be removed without cause, provided that a super majority (generally >75%) of LPs approve that removal. Removal for “cause” is a clause that allows either a removal of the GP or an earlier termination of the fund for reasons such gross negligence of the GP, a “key person” event, a felony conviction of a key management person, bankruptcy of the GP, or a material breach of the fund prospectus. Investment restrictions generally impose a minimum level of diversification of the fund’s investments, a geographic and/or sector focus, or limits on borrowing. Co-investment - LPs generally have a first right of co-investing along with the GP. Study Session 13, Reading 40
  59. 59. General Private Equity Risk Factors Illiquidity of investments: Private equity investments are generally not traded on any securities market. Government regulations: Investee companies’ products and services may be subject to changes in government regulations that adversely impact their business models. Competition for attractive investment opportunities: Competition for finding investment opportunities on attractive terms may be high. Reliance on the management of investee companies (agency risk): There is no assurance that the management of the investee companies will run the company in the best interests of the private equity holders. Study Session 13, Reading 40
  60. 60. General Private Equity Risk Factors (cont.) Lack of investment capital: Investee companies may require additional future financing that may not be available. Lack of diversification: Investment portfolios may be highly concentrated and may, therefore, be exposed to significant losses. Other risk factors include risk due to unquoted investments, risk of loss of capital, uncertainty in valuation, and market risk (risk due to change in market conditions). Study Session 13, Reading 40
  61. 61. Costs associated with private equity investing Transaction fees: Corresponding to due diligence, bank financing costs, legal fees for arranging acquisition, and sale transactions in investee companies. Investment vehicle fund setup costs: Comprise mainly of legal costs for the setup of the investment vehicle. Such costs are typically amortized over the life of the investment vehicle. Management and performance fees: These are generally more significant relative to plain investment funds. A 2% management fee and a 20% performance fee are common in the private equity industry. Study Session 13, Reading 40
  62. 62. Costs associated with private equity investing (cont.) Dilution costs: Additional rounds of financing and stock options granted to the portfolio company management will result in dilution. Placement fees: Placement agents who raise funds for private equity firms may charge up-front fees as much as 2% or annual trailer fees as a percentage of funds raised through limited partners. Other costs associated with the funds are administrative costs and audit costs. Study Session 13, Reading 40
  63. 63. Financial Performance of Private Equity Funds Financial performance can be measured in quantitative and qualitative terms Measuring performance is easier, comparing it is harder Study Session 13, Reading 40
  64. 64. Quantitative Measures of Performance Internal rate of return (IRR): The return metric recommended for private equity by the Global Investment Performance Standards (GIPS).  Gross IRR: The IRR can be calculated gross or net of fees. Gross IRR reflects the fund’s ability to generate a return from portfolio companies.  Net IRR: Net IRR is the relevant measure for the cash flows between the fund and LPs and is therefore the relevant return metric for the LPs. PIC (paid-in capital): This is the capital utilized by the GP. It can be specified in percentage terms as the paid-in capital to date divided by the committed capital. Study Session 13, Reading 40
  65. 65. Quantitative Measures of Performance (cont.) DPI (distributed to paid-in capital): This measures the LP’s realized return and is the cumulative distributions paid to the LPs divided by the cumulative invested capital. RVPI (residual value to paid-in capital). This measures the LP’s unrealized return and is the value of the LP’s holdings in the fund divided by the cumulative invested capital. TVPI (total value to paid-in capital). This measures the LP’s realized and unrealized return and is the sum of DPI and RVPI. Study Session 13, Reading 40
  66. 66. Qualitative Measures The realized investments, with an evaluation of successes and failures. The unrealized investments, with an evaluation of exit horizons and potential problems. Cash flow projections at the fund and portfolio company level along with fund valuation statements, NAV, and financial statements. Study Session 13, Reading 40
  67. 67. Benchmarks Public Market Equivalent (PME) was proposed by Austin Long and Craig Nickles in the mid-1990s as a solution to benchmarking issues. PME is the cash-flow-weighted rate of return of an index (S&P 500 or any other index) assuming the same cash flow pattern as a private equity fund. It is thus an index return measure. Study Session 13, Reading 40
  68. 68. Pre Money Value and Post Money Value At the time of a new investment in the firm, the discounted present value of the estimated exit value, PV (exit value), is called the post-money value. POST = PV(exit value) The value before the investment is made can be calculated as the post-money value minus the investment amount and is called the pre-money value. PRE = POST – INV Study Session 13, Reading 40
  69. 69. Two Methods to Compute Fraction of VC Ownership 1. First method is the NPV method f = INV/ POST INV = amount of new investment for the venture capital investment POST = post-money value after the investment = exit value / (1+r)n 2. Second method is the NPV method f = FV (INV) / exit value FV(INV) = future value of the investment in round 1 at the expected exit date exit value = value of the firm upon exit Study Session 13, Reading 40
  70. 70. Calculation of Price Per Share Number of shares issued to the VC(sharesVC) is calculated based on the number of existing shares owned by the firm founders prior to investment (shares Founders). SharesVc = Shares Founders (f/ (1-f) Price per share at the time of the investment (price) is then simply the amount of the investment divided by the number of new shares issued. Price = INV / (SharesVc) Study Session 13, Reading 40
  71. 71. Calculation of Price Per Share (cont.) If there is a second round of financing:  first calculate the proportion of the firm (f2) purchased for the second round of financing f2 = INV2 / POST2  second calculate the fractional ownership from the first round of financing as f1 = INV1 / POST1 where POST1 = PRE2 / (1+r1)n1  finally compute number of shares issued and price per share in each round as: SharesVc1 = Shares Founders (f1/(1-f1)) Price1 = INV1/(SharesVc1) SharesVc2 = Shares Founders (f2/(1-f2)) Price2 = INV2/(SharesVc2) Study Session 13, Reading 40
  72. 72. Interest Alignment Between Private Equity Firms and Managers of Portfolio Companies Incentives Incentives that motivate managers to "behave like owners“: Manager's compensation tied to the company's performance. Priority in claims. Earn-outs. Study Session 13, Reading 40
  73. 73. Interest Alignment Between Private Equity Firms and Managers of Portfolio Companies (cont.) Contractual Structuring Effective contractual structuring is achieved by: Board representation by private equity firm. Tag-along, drag-along clauses Non-compete clauses required for company founders. Required approval by PE firm for changes of strategic importance. Study Session 13, Reading 40
  74. 74. Alternative Exit Routes in Private Equity 1. Initial Public Offering (IPO) - shares of the company are offered to the public 2. Secondary market - the company is sold to other investors 3. Management Buyout (MBO) - buyers are managers of the company 4. Liquidation of the company Study Session 13, Reading 40
  75. 75. DPI, RVPI and TVPI Fee and Asset Value DPI(Distribution to Paid-In Ratio) - measures the ratio of distributions to the limited partners compared to the amount of capital contributed by the limited partners RVPI(Residual Value to Paid-In Ratio) - measures the net asset value of the funds (unrealized gains), compared to the amount of capital contributed by the limited partners. Realization Ratios TVPI(Total Value to Paid-In Ratio) - DPI and RVPI added together Study Session 13, Reading 40
  76. 76. Post Money Value and Ownership Fraction The post-money value of the company is calculated by discounting the estimated exit value for the company to its present value (exit value), as of the time the investment is made. Ownership Fraction The required current ownership percentage given expected dilution is calculated as follows: Required Current Ownership = Required Final Ownership / Retention Ratio Study Session 13, Reading 41
  77. 77. Alternative Methods to Account for Risk in Venture Capital Two Approaches for Accounting for Risk The discount rate is adjusted to reflect the risk that the company may fail in any given year. Scenario analysis is used to calculate an expected terminal value, reflecting different values under different assumptions. General Private Equity Risk Factors liquidity risk unquoted investments risk competitive environment risk agency risk capital risk regulatory risk tax risk valuation risk diversification risk market risk Study Session 13, Reading 41
  78. 78. Two Methods to Assess the Risk of Investment 1. The discount rate is adjusted to reflect the risk that the company may fail in any given year: r*= {(1+r)/(1-q)} -1 where: r* =discount rate adjusted for probability of failure r = discount rate unadjusted for probability of failure q = probability of failure in a year 2. Scenario analysis is used to calculate an expected terminal value, reflecting different values under different assumptions. Study Session 13, Reading 47
  79. 79. Hedge Funds and Mutual Funds Hedge funds typically use more leverage and derivatives than mutual funds Disclosure requirements of hedge funds are not as strict as typical mutual funds Hedge funds typically have longer lock up periods for investors Hedge funds typically have more performance focused fee structures Study Session 13, Reading 47
  80. 80. Use of Leverage Hedge funds often use leverage. Fixed income funds often use more leverage than equity funds. The amount of leverage used often varies within a month with leverage amounts usually changing more dramatically for fixed income funds. Study Session 13, Reading 47
  81. 81. Disclosure Requirements for Hedge Funds Mutual funds are required to report to the U.S. Securities and Exchange Commission (SEC). By choosing to not market their investments to the public and restricting fund investments to certain types of high-net-worth investors, hedge funds are exempt from disclosure requirements. Hedge fund managers must still follow other laws determined by securities regulators Study Session 13, Reading 47
  82. 82. Lockup Periods for Hedge Funds 1. A “hard lockup” states that no provisions exist for the redemption of hedge fund investments for a stated period of time. 2. A “soft lockup” period suggests a minimum investment period, but investors have the ability to sell their shares before the expiration of the lockup period by paying a redemption fee, which is often in the range of 1–3%. Popular lockup periods for hedge funds are one and two years, although three-year lockups are becoming more common. Study Session 13, Reading 47
  83. 83. Fee Structures for Hedge Funds Hedge funds can earn both management fees and incentive fees.  A typical management fee is 1–2% annually, based on the assets under management.  Incentive fees (also called performance fees) are calculated as a set percentage of the profits on the underlying pool of assets. A hedge fund manager might earn 15–25% of profits in addition to the management fee. Few mutual funds charge performance fees because U.S. regulators require the fees to be symmetrical, meaning the investment manager must share equally in both gains and losses. Study Session 13, Reading 47
  84. 84. Types of Hedge Fund Strategies Arbitrage-based funds - are short volatility exposures that lead to gains in quiet markets and losses in turbulent markets. Convertible bond arbitrage strategies - purchase a portfolio of convertible bonds and take short positions in the related equity security. Equity market neutral funds - seek to take a zero beta exposure to equity markets. Event driven funds - focused on a single strategy, such as distressed investments or risk arbitrage.  Distressed funds typically invest in debt securities of issuers currently in default or expected to default soon.  Risk arbitrage, or merger arbitrage, funds seek to predict the outcome of announced corporate merger transactions. Study Session 13, Reading 47
  85. 85. Types of Hedge Fund Strategies (cont.) Fixed-income arbitrage - invests with a positive income orientation that benefits from declining credit spreads. Medium volatility hedge fund strategies - take both long and short positions, but these positions are not always designed as hedges. Global macro funds - focus on long and short investments in broad markets, such as equity indices, currencies, commodities, and interest rate markets. Long–short equity funds - very similar to that of equity market neutral hedge funds, except that long– short funds do not target a zero beta exposure to underlying equity markets. Study Session 13, Reading 47
  86. 86. Types of Hedge Fund Strategies (cont.) Managed futures funds - managers are also called commodity trading advisers (CTAs), use a strategy dominated by systematic trend following that seeks to profit through the quantitative prediction of market trends. Directional hedge fund strategies - the most volatile of all because little to no hedging activity is used. Dedicated short bias funds - invest exclusively in the short sale of equity securities. Study Session 13, Reading 47
  87. 87. Reported Hedge Fund Performance Hedge fund reporting suffers from biases such as survivorship bias and selection bias Regression analysis can be used to assess hedge fund performance Normality assumptions which are often the backbone of financial models, are often violated in the case of hedge funds Since normality assumptions are violated, traditional models should be applied with care Study Session 13, Reading 47
  88. 88. Possible Biases in Performance Reports of Hedge Funds Differences in fund weighting methodology Lack of reporting leads to selection bias or self-reporting bias Selection bias is closely related to backfill bias Analysis which doesn’t consider the track records of non surviving funds Study Session 13, Reading 47
  89. 89. Factor Models for Hedge Fund Returns A regression is performed to determine the portion of risk derived from the market and the value added by the hedge fund manager. The typical regression is: Hedge fund return = Alpha + Risk free rate+ ∑ Betai * Factori Alpha in this model is the total return of the hedge fund in excess of the risk free rate and the included factor or market exposures. Most models use a multitude of traditional market factors, such as local and global stock and bond indices, currency, and commodity market returns. Study Session 13, Reading 47
  90. 90. Non-normality in Hedge Fund Returns Implicit assumption that investment returns are normally distributed and linearly related to asset class returns. Unfortunately, many of these assumptions are violated when investing in hedge funds Investors prefer a large mean and positive skewness of returns Study Session 13, Reading 47
  91. 91. Use of Indexes Market indexes, hedge fund indexes, and positive risk-free rates can be used as guidelines for hedge fund performance, but should not be used for the final assessment of manager performance. If a manager performs outside of these benchmarks, the investor should investigate whether the manager has shifted her strategy, taken more risk, and/or is just lucky. Study Session 13, Reading 47
  92. 92. Theoretical Basis for Hedge Fund Replication Hedge fund replication is based on the factor models and the concept of alpha–beta separation. If traditional stock and bond market indices can explain the majority of hedge fund return variance, then investors may be able to replicate hedge fund returns by using index funds and swaps. Study Session 13, Reading 47
  93. 93. Types of Hedge Fund Replication Strategies Static weights Long–short equity, emerging market, short selling, and distressed strategies Neutral, risk arbitrage, fixed-income arbitrage, convertible bond arbitrage, global macro, and managed futures strategies. Hedge fund replication using factor models and liquid index products Study Session 13, Reading 47
  94. 94. Difficulties in modelling hedge funds as part of portfolios For hedge funds given the survivor, selection, stale pricing, and backfill biases inherent in hedge fund databases. Hedge fund performance can be quite dynamic, with correlation, volatility, and beta exposures that can change significantly over time. Hedge funds have asymmetrical beta exposures Study Session 13, Reading 47
  95. 95. Caveats in analysing hedge funds as part of portfolios Some hedge fund styles are known to smooth returns, as well as experience negative skewness and excess kurtosis. Investors need to determine whether the trading strategy is a short volatility, convergence related, or event- risk-laden strategy in which future risks could potentially be larger than historical risk. If mean–variance optimization is to be used to add hedge funds to traditional investment portfolios, constraints on the deterioration of skewness and kurtosis risks should be added to the optimization equation. Study Session 13, Reading 47
  96. 96. Advantages of Fund of Funds over Single Manager Hedge Funds Funds of funds can reduce the standard deviation of a hedge fund portfolio. Access a fund of funds portfolio with a minimum investment as low as $100,000. May appreciate the due diligence performed by funds-offunds managers. Study Session 13, Reading 47
  97. 97. Disadvantages of Fund of Funds over Single Manager Hedge Funds Double layer of fees presents a high hurdle for funds of funds Fund of funds tend to have average performance. Fund of funds with proven alpha tend to have longer lives and larger asset inflows Study Session 13, Reading 47
  98. 98. Types of Risks in Hedge Fund Investments Beyond investment risks, hedge fund investors need to understand and manage a number of other risks. These include event risk, operational risk, leverage, and counterparty risks. Given many of these risks tend to magnify investment risks, a global view of risk is very important for hedge fund investors and fund-of-funds managers. Study Session 13, Reading 47
  99. 99. Measures of Risks in Hedge Fund Investments Because hedge fund returns are often not normally distributed, investors should evaluate a downside measure of risk.  Maximum drawdown provides an estimate of the magnitude of the largest percentage loss (preferred measure of risk)  Value at Risk (VAR) provides both the amount of an expected largest loss as well as its probability. VAR is not preferred due to the following reasons:  VAR is usually estimated using historical data, which is not indicative of future risk when a fund changes its investment strategy over time.  The interpretation of VAR is meaningful only when the return distribution is normal. Hedge fund returns are rarely normally distributed.  VAR is often computed assuming that component risks are additive, when in fact they can be multiplicative. The Sortino ratio (similar to the Sharpe Ratio) uses the downside deviation and the minimum acceptable return in place of the risk-free rate. Study Session 13, Reading 47
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