L2 flash cards alternative investments - SS 13

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

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

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


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


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


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


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.


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)


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

Benefits of Equity Real Estate
Investments
Current income
Price appreciation (capital appreciation)
Inflation hedge
Diversification
Tax benefits


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


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


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.

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


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


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.


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.


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.

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


Recaptured Depreciation
- Represents depreciation that was taken in anticipation of a
decline in the value of an asset that ultimately did not
materialize.


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.


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.

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

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


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)


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.


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

adequate data.

Only applicable for income-generating properties.


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.

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


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)


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.

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.


Real Estate Investment Trust (REIT)
Shares
Economic Value Determinants
 GDP growth
 job creation
 retail sales growth
 population growth
 new space supply and demand


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.


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


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

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.


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

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.


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.


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.


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

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.


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.


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.

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.


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.


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.


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.


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


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


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


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.


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.


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)


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

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.

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.

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.

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).


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.

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.

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

qualitative terms
Measuring performance is easier, comparing it is harder


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.

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.


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.


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.


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

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


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)

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)

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.


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.


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


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

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


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

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.


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


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.


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


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.

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.

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.

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.

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.


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


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


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.

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


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.


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.


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


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


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.

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.


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


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.


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.

L2 flash cards alternative investments - SS 13

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