2019 CFA level 3 finquiz curriculum note, study session 15, reading 30

4ETFs, mutual funds and traded closed-end investment companies allow investors to obtain a professionally managed diversified portfolio of real estate securities with a relatively small

Reading 30 Alternative Investments Portfolio Management

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Investors of alternative investments:

• Defined-benefit pension funds

• Endowments

• Foundations

• High-net worth individuals

Rationale for Alternative Investments:

Risk Diversification benefits i.e

• Returns over time are not highly correlated with

traditional asset classes

• Broaden fund’s investment “opportunity set”

Ability to add value: Provides greater ability to investors

to add value because Alternative asset classes are less

“efficient”

Return Enhancement: They can enhance total fund

return and reduce risk (volatility) over time when combined with traditional assets

Role of Alternative Investments:

• To meet return objectives

• To control risk Six groups of Alternative Investments:

Common features of alternative investments include:

1) Illiquidity: Relative illiquidity results in return premium

demanded by investors

• For investors with short investment horizons,

illiquidity leads to small allocation to alternative

investments

• Long-term investors (e.g endowments and

defined-benefit pension funds) can make large

allocations and earn illiquidity premiums

2) Diversification benefits: Low correlations with

traditional investments

3) High due diligence costs for the following reasons:

a)Complex investment structures and strategies

b)Uniqueness: Investment evaluation significantly

depends on asset class, business specific or other

expertise

c)Lack of transparency in reporting

4) Difficulty in establishing valid benchmark and

performance appraisal

5) Longer time horizons

6) Informationally less efficient relative to equity and

bonds market

7) Offer greater opportunity to add value through skill

and superior information

NOTE: In both alternative and traditional investments, management fees, trading or operational expenses need to be justified and managed

Traditional Alternative Investments:

1) Real Estate: It refers to ownership interests in land or structures attached to land

2) Private Equity: It refers to ownership interests in publicly traded companies

non-3) Commodities: It refers to agricultural goods, metals, petroleum

Modern Alternative Investments: These investments indicate investment and trading strategies (ways to invest/style of investing)

1) Hedge Funds 2) Managed Futures 3) Distressed Securities

NOTE: Alternative investment can be placed in more than one category e.g distressed securities investing can be classified:

• Within private equity if debt is considered to be private equity;

• As a subcategory of event-driven strategies under hedge funds;

• As a separate alternative investment strategy

Three groups of Alternative Investments:

1) Investments that provide exposure to unique risk

factors (not provided by traditional investments) e.g real

estate provides exposure to demographics and

(long-only) commodities provide exposure to inflation

2) Investments that provide exposure to specialized

investment strategies e.g hedge funds and managed

futures

3) Investments that have combined features of

exposure to unique risk factors and investment strategies

e.g private equity funds and distressed securities

Due Diligence process in Alternative Investments

involve the following steps:

1) Market Opportunity: It involves identifying investment

opportunities in the market, their causes and their

chances of persistence It is done by analyzing capital

markets and types of managers operating within those

markets

2) Investment process: It involves evaluating managers’

comparative advantage etc

3) Organization: It involves valuating stability of the firm

and how well it is organized i.e Consistent investment

philosophy, less management (staff) turnover, fair

compensation, succession plans etc

4) People: It involves analyzing experience, intelligence,

integrity of the people in the firm

5) Terms and Structure: It refers to time and amount of

investment and requires evaluating fair terms, alignment

of interests, properly structured account etc

6) Service Providers: These refer to firms supporting from outside e.g lawyers, auditors, prime brokers, lenders etc 7) Documents: It involves reading prospectus,

memorandum, audits etc

8) Write-up: It involves formally documenting the entire selection process and producing formal

recommendation of manager

Following are the Issues that are more acute or unique

to private wealth clients than to institutional investors: Tax issues: Alternative investments frequently involve partnerships and other structures that have distinct and peculiar tax issues

Determining suitability: Determining suitability of investment is more complex in case of an individual client or family than for an institutional investor because of:

• Uncertain time horizons of individual clients

• Emotional or financial needs of a client

Communication with client: Individuals are nonprofessional investors and have less knowledge, therefore, it is difficult for an advisor to communicate and discuss suitability of investment in the portfolio with them

Decision risk: It refers to irrational trading/changing strategies at the point of maximum loss Decision risk increases due to the strategies with following characteristics:

• Strategy that involves negatively skewed returns

• Strategies that involve high kurtosis

Note: investors prefer positive skewness and moderate or low kurtosis

Concentrated equity position of the client in a closely held company: It is necessary to take into account the effect of investment on the client’s risk and liquidity position when ownership in a closely held company represents a substantial part of wealth of the client NOTE: In core-satellite investing, alternative investments

usually are included in the satellite ring for most investors

Real estate plays an important role in both institutional

and individual investor portfolios

Note: The focus of this reading is only Equity investments

in real estate

Rationale for investment in Real Estate by institutional investors

i To diversify their portfolios

ii To hedge against inflation

3.1.1) Types of Real Estate Investments

A.Direct ownership includes:

B Indirect investment (also known as financial

ownership) includes investing in:

1 Companies engaged in real estate ownership,

development or management i.e homebuilders

and real estate operating companies

2 Real estate investment trusts (REITs) are publicly

traded equities representing pools of money

invested in real estate properties and/or real

estate debt

3 Commingled real estate funds (CREFs) are

privately traded equities representing significant

commingled (i.e pooled) investment in real

estate properties

4 Separately managed accounts managed by real

estate advisors like in case of CREFs

5 Infrastructure funds are private investment in

public infrastructure projects i.e roads, schools,

bridges, airports etc with rights to receive

specified revenue streams over a contracted

period

Types of REITs:

1.Equity REITs: Own and operate income-producing

real estate i.e office buildings, apartment buildings and

shopping centers

• Shareholders receive rental income and income

from capital appreciation if the property is sold for

a gain

2.Mortgage REITs: Mortgage REITs deal in the

investment and ownership of property mortgages;

• They loan money for mortgages to owners and

operators of real estate or

• Invest in (purchase) existing mortgages or

mortgage-backed securities

• Shareholders receive interest income on

mortgage loans and capital appreciation income

from improvement in the prices of loans

3.Hybrid REITs: Hybrid REITs invest in both mortgages

and properties, combining the investment strategies of

Equity REITs and Mortgage REITs

Advantages of REITs:

1)REITs securitize illiquid real estate assets

2)REITs are highly liquid as their shares trade on major exchanges

3)REITs allow smaller investors to get real estate exposure

4)ETFs, mutual funds and traded closed-end investment companies allow investors to obtain a professionally managed diversified portfolio of real estate securities with a relatively small outlay Disadvantages:

1)REIT returns are more volatile than real estate returns (due to public trading)

2)REITs have relatively higher correlation with equities than real estate prices

Risk Hedging properties:

• Hold property and want to sell it in future, short REITs index to hedge risk

• Want to buy property, long REITs index

• In contrast to open-end funds, closed-end funds are usually leveraged and have higher return objectives (due to high risk);

3.1.2) Size of the Real Estate Market According to estimates, real estate represents one-third

to one-half of the world’s wealth

3.2 Benchmarks and Historical Performance

3.2.1) Benchmarks

NCREIF Index: The principal benchmark used to measure the performance of direct real estate investment is the National Council of Real Estate Investment Fiduciaries Property Index

Characteristics:

• It is issued quarterly

• It covers a sample of commercial properties

owned by large institutions

• Value-weighted index

• Includes sub-indices grouped by real estate sector (apartment, industrial, office and retail) and geographical region

• Values are determined by property appraisals and conducted infrequently

• Ownership change is infrequent

• Smoothing effect due to appraised values: The

use of appraised values tends to

o Smooth the returns

o Underestimate volatility in underlying values

o Understate correlations with other assets

o Overstate benefits of real estate in the portfolio

• It is not an investable index (for performance

appraisal)

• NCREIF Index represents non-leveraged

investment only

• NCREIF Index most accurately represents the

performance of private real estate funds

Important Note: Using unsmoothed NCREIF Index more

accurately reflects the benefits of real estate investment

NAREIT Index: The principal benchmark used to

represent indirect investment in real estate is the NAREIT

Index

• It is a real time market (cap) weighted index of all

REITs actively traded on the exchange

• It computes a monthly index based on

month-end share prices of REITs that own and manage

real estate assets or equity REITs

• REITs provide a levered exposure to real estate (>

50% of capital structure is represented by debt)

Therefore, they have higher risk (higher S.D)

relative to unsmoothed NCREIF Index

Hedged REITs: Long REITs + Short Futures

• The hedged NAREIT Index is a more realistic

representation of the underlying real estate

market and has high correlation with the

unsmoothed NCREIF Index than without

correction (although hedging is imperfect)

• Hedged NAREIT Index is preferred because it

eliminates double counting of equity return

component in equity REITs It results in increase in

return, decrease in risk and increase in Sharpe

ratio

3.2.2) Historical Performance

• It has been observed that the real estate market

lags behind publicly traded real estate securities

• Direct and indirect real estate investments

produced better risk-adjusted performance over

1990-2004 period relative to general stocks and

commodities

Difference between performance properties of direct

and securitized real estate investment

REITs

(Indirect)

Direct (or appraisal-based) High return

High S.D

Higher Volatility

Low returns Low S.D Low volatility due to stale valuations

• Downside bias is corrected by “un-smoothing” the

NCREIF Index

• When NCREIF is unsmoothed, volatility more than doubles but return is increased by a small amount

• Securitized real estate investments are poor substitutes for direct investment because:

o Smooth NCREIF Index and Unsmooth NCREIF Index have high positive correlation (i.e 0.71)

o The correlation between unhedged NAREIT Index and NCREIF Index is 0

o The correlation between unhedged NAREIT Index and unsmoothed NCREIF Index is 0.21 Timberland and Farmland:

• Investing in timberland and farmland provides potential for substantial income and capital appreciation but bears limited liquidity

• Farmland returns rely on value of land and prices of agriculture commodities

• Timberland returns depend on land value and lumber prices The demand side of lumber depends on the housing starts and the supply side depends on the environmental conditions Investors can also invest in timber through timberland REITs

3.3 Real Estate: Investment Characteristics and Roles

Real estate represents a major portion of many individuals’ wealth However, the clients’ residences are not considered “marketable” and therefore, are not included in strategic asset allocation

3.3.1) Investment Characteristics Following are some of the investment characteristics of physical real estate market:

1)Relative Lack of liquidity 2)Large lot sizes and not divisible 3)Relatively high transaction costs 4)Heterogeneity

5)Immobility (fixed location) 6)Relatively low information transparency (seller has informational advantage relative to buyers) 7)Not easily traded due to market inefficiencies 8)Investment is long-term

Implication:

1)These characteristics provide opportunity to generate relatively high risk-adjusted returns for investors who can obtain cost-efficient and high quality information

2)Due to lack of reliable and high frequency transaction data for properties, valuations are appraisal-based

Effect of market and economic factors on real estate:

• Interest rates directly or indirectly affect demand

and supply for real estate by affecting factors i.e

business financing costs, employment levels,

savings habits and the demand and supply for

mortgage financing

• Worldwide, the returns to real estate are positively

correlated with changes in GDP

• In the long run, population growth positively

affects real estate returns

Inflation-hedging: There are mixed conclusions

regarding the inflation-hedging capabilities of real

estate investment Overall, direct real estate investment

can provide an inflation hedge to some degree

Real estate values are affected by idiosyncratic

variables i.e location This implies that:

• Complete diversification in real estate can be

achieved only by investing internationally

• Optimal diversification can be obtained by

selecting one country from each continent

Advantages of DIRECT INVESTMENT in real estate (for

both institutional and individual investors):

1)Tax benefits: Mortgage interest, property taxes and

other expenses are tax deductible which benefits

taxable owners of real estate

2)Use of high leverage: Greater financial leverage can

be used in mortgage loans compared to securities

investing

3)High control over investment: Real estate investors

have direct control over their property and are able to

expand or modernize property to increase its market

value

4)Geographical Diversification: The values of real

estate investments in different locations have low

correlations; thus, it can be used to reduce exposures to

catastrophic risks e.g floods etc

5)Low volatility: Real estate returns (on average) have

relatively low volatility compared to public equities

even after correcting for downward bias

6)Greater diversification benefits: Direct real estate has

lower correlations with U.S equities and bonds relative

to REITs’ correlations

Disadvantages:

1) Large size and indivisibility: Direct investment in real

estate is usually in large lots and is not easy to divide into

smaller pieces Consequently, these properties constitute

a major portion of an investor’s total portfolio and

investors have to deal with large idiosyncratic risks

associated with these investments

2) Illiquid relative to securitized real estate due to:

• Large transaction sizes when buying/selling

property compared to flexibility of trading small amounts in REITs on public exchanges

• The lack of availability and timeliness of information results in extensive valuation and due diligence issues

3) High cost of acquiring information because of heterogeneity of real estate

4) High transaction costs because of high commissions charged by real estate brokers relative to securities transaction fees Exchange traded REITs have low transaction costs and reallocation of funds is easy 5) High Operating costs i.e greater maintenance, operating and administrative costs and hands-on management

6) Locality Risk: Have greater exposure to neighborhood deterioration and conditions that are not under investors’ control

7) Political risks associated with tax benefits i.e income tax deductions can be discontinued in case of changes

in tax laws

3.2.2) Roles in the Portfolio Real estate is affected by many economic fundamentals and economic cycles Thus, these

investments can be used for tactical allocation purposes

by forecasting economic cycles that would positively affect these investments

Real estate has a potential to add value through active

management

Real estate also provides diversification benefits

• Historically, direct investment in real estate has shown low correlation with other assets

• Real estate investments are less affected by term economic conditions and therefore, have lower volatility than other asset classes

short-Good income enhancer: Income producing commercial real estate is considered a relatively stable investment Real Estate Performance in Portfolios:

Adding REITs to traditional portfolio of equities and bonds results in higher Sharpe ratio

It does not provide diversification benefits when added

to a portfolio consisting of stock/bond/ hedge funds and commodity

Unsmoothed NCREIF Index has negative correlation with S&P 500 and bonds; this results in increase in Sharpe ratio when unsmoothed NCREIF Index is added to stock/bond portfolio

However, Sharpe ratio is slightly increased when unsmoothed NCREIF Index is added to stock/bond

portfolio with the added exposure of hedge funds and

commodities

Conclusion: Direct real estate investment provides

diversification benefits to stocks and bonds but benefits

disappear when hedge funds and commodities are

added to the portfolio

Diversification within Real Estate Itself: Diversification

within real estate investing can be obtained through

type and geography Investments in different real estate

sectors have different risk and return profiles

Large office assets:

• Higher risk

• Higher volatility

• Lower risk-adjusted returns

• More pronounced impact of market cycles

Properties of Return Distribution of Real Estate:

1) Due to illiquid market (Direct investment), returns tend

following positive and negative following negative

Rationale for including real estate in a multi-asset portfolio:

1 Real estate has a low correlation with stocks and bonds

2 Real estate (historically) has shown a high adjusted rate of return relative to stocks and bonds

risk-3 Real estate has a positive correlation with both anticipated and unanticipated inflation and therefore provides an inflation hedge

Private equity is an ownership interest in a private

(non-publicly) company It includes start-up companies,

middle-market private companies and private

investment in public entities (PIPE)

Characteristics:

• Private equity is not registered with a regulatory

body

• These involve Private placements i.e sale offers to

either institutions or high-net-worth individuals

(accredited investors)

• Private equity plays a growth role in investment

portfolios

• Risk is controlled and evaluated through

appropriate due diligence processes

4.1.1) Types of Private Equity Investment

1) Direct Investment: It refers to purchasing claim

directly from the company that needs financing

• Structured as convertible preferred stock rather

than common stock

• Preferred stock is senior to common stocks both in terms of its profit share and liquidation value

• Shares issued in later rounds of financing are senior to previously issued preferred stocks (all else constant)

• Events i.e buyouts or acquisition of the common equity at a favorable price triggers the conversion

of preferred stocks into common stocks

2) Indirect Investment: It is primarily done through private equity funds i.e VC and buyout funds

• Structured as limited partnerships or limited liability companies (LLCs)

• Have an expected life of 7-10 years with 1-5 years extension option

• Commitment/offering period defines how committed funds will be requested over time

• Investment in private equity is mostly done via

private equity funds

Advantages of Limited Partnerships and LLCs:

Practice: Example 5, Volume 5, Reading 30

i Avoid double taxation

ii Liability of limited partners or shareholders is

limited to their amount of investment

General partner (managing director in LLCs): He is the

venture capitalist who selects and advises investments to

investors He also commits his own capital, which is

helpful in closely aligning interest of outside investors and

the fund manager

Limited partners: Refer to shareholders of LLCs or limited

partnerships

NOTE:

• Private equity funds usually do not maintain a

pool of uninvested capital

• Private equity funds of funds are also available

Private equity funds: These are pooled investment

vehicles through which many investors make indirect

investments in generally highly illiquid assets

Major forms include

a) Venture Capital (early, mid and late-stage): Private

capital used to finance a start-up (new) business or

growing private companies

Characteristics:

• Venture capital investments are private,

non-exchange-traded equity investments

• Investments are usually made through limited

partnerships

• Due to illiquidity and high risk, relatively high

returns are expected

• Private company eventually converts into publicly

owned company

• Have Capacity issues i.e limited investment

opportunities

• Requires distinct knowledge and experience

b) Buyout Funds/Buyouts: Acquisition of an established

company or an operating division via private equity

funds known as buyout funds

• Publicly owned company is converted into

private

• Buyout funds constitute a large portion of private

equity fund relative to VC funds in terms of AUM

or size of capital commitments

Types of buyout funds:

1) Mega-cap buyout funds: These funds take public

companies private

2) Middle-market buy-out funds: These funds purchase

private companies (established and/or divisions spun-off

from larger companies), which are not able to access

capital from public due to small revenues and profits

Value in these companies is added through:

• Restructuring operations and improving management

• Purchasing companies at a discount to their intrinsic value

• Creating gains by adding debt or restructuring of existing debt

These funds seek to reduce costs and increase revenues and for this purpose, they generally maintain a pool of experienced operating and financial executives to be added to companies if necessary or appropriate Value gains can be realized through:

a) Sale of the acquired company

b) IPO c) Dividend Recapitalization i.e debt is issued to finance special dividends to owners

• Advantage: Facilitate investors to recover all or

most of the investment within 2-4 years of the buyout along with the retention of ownership control

• Disadvantage: Due to high leverage involved, a

company may become weak

1) Private Investment in Public Entity (PIPE):It refers to

making a relatively large investment in a public company usually at a significant discount when the share price of a publicly traded company drops significantly

Investors of Private Equity include:

Private Equity Investments Publicly Traded Securities

Structure and Valuation

Price and deal structure are determined through private negotiation between the investor and company management

Price is determined by market

Deal structure is standardized

Securities regulators approve variations

Access to Information for Investment Selection

Investors can have access to all information (including internal projections)

Investors have access to only publicly available information

Post-Investment Activity

4.1 The Private Equity Market

The Demand for/Issuers of Venture Capital:

1 Formative-stage / start-up companies:

• Newly formed companies and/or young

companies beginning product development

• Companies just start selling a product (through

marketing an effective business plan to

potentially interested parties)

• Most Venture Capitalists are not interested in

companies at their earliest stage

• Companies preparing for an IPO

Financing stages of a private company include:

1 Early-stage Financing: It is used by Formative-stage

Companies It involves following sub-stages:

Seed: In seed stage, small amount of money is provided

to form a company or to prove commercial success of a

business idea

• Characteristics: Incorporation of business idea,

first personnel is employed, development of

prototype

• Buyers/financing: Founders, FF&Fs, angel investors,

venture capital

• Purpose of financing: To support market research

and to establish a business

Start-up: In this stage, a company has been formed and

idea has been proven but funds are needed to

commercialize the product or idea

• Characteristics: Pre-revenue stage i.e revenue

has not yet started

• Buyers/financing: Angel investors and venture

capital

• Purpose of financing: To support product

development and initial marketing

First-stage: When a company has been through seed and start-up stages and needs additional financing

• Characteristics: Operation has started and

revenue starts to initiate

• Buyers/financing: Angel investors and venture

capital

• Purpose of financing: To support initial

manufacturing and sales

2 Later-stage Financing: It is used by Expansion-stage Companies who need funds to expand sales It involves following sub-stages:

Second-stage:

• Characteristics: A company that is already

producing and selling a product and revenue starts to grow

• Buyers/financing: Venture capital, strategic

partners

• Purpose of financing: To support initial expansion

of a company

Third-stage:

• Characteristics: Revenue starts to grow

• Buyers/financing: Venture capital, strategic

partners

• Purpose of financing: To provide funds for major

expansion

Pre-IPO: It refers to mezzanine stage

• Characteristics: IPO preparation

• Buyers/financing: Venture capital, strategic

partners

• Purpose of Mezzanine (bridge) financing: To

provide funds to prepare for an IPO (mix of debt

In case of failure of venture, business can be closed without any recovery of the original investment by the equity holder

Practice: Exhibit 9,

Volume 5, Reading 30

Stage Characteristics

Stage Financing (buyers of private equity)

Founder, FF&F, angles, venture capital

Supports market research and establishment of business

Start-Up

Movement into operation, initial revenues

Angles, venture capital

Supports product development & initial marketing

manufacturing & sales Later

Stage

Second Stage

Revenue Growth

Venture capital, strategic partners

Supports initial expansion

of a company already producing & selling a product

expansion Pre-

IPO

Mezzanine Preparation

for IPO

Provides capital to prepare for the IPO-often

a mix of debt & equity

The Supply of Venture Capital: Suppliers of venture

capital include the following

1) Angel investors: The first outside investors in a

company

• Invest in seed and early-stage companies

• Invest relatively a small amount

• These investments are considered to be the

riskiest because of early stage of business

2) Venture Capital (VC): Dedicated Pools of capital

managed by specialists (venture capitalists) that provide

equity or equity-linked financing to privately held

companies An individual pool is known as venture

capital fund

• VC identifies companies with attractive business

opportunities

• Provide financial and strategic support and

expertise in related fields

3) Large Companies: Major companies invest in

promising young companies in the same or related

businesses

• This investment is known as corporate venturing

and the investors are often referred to as

“strategic partners”

• These funds are not available to the public

Compensation of the Fund Manager:

Management fee + Incentive fee

A Management fee is usually a % of committed funds(not the amount actually invested) It ranges 1.5 – 2.5% and decreases over a period of time to reflect lower work load in later years of partnership

B Incentive fee (a.k.a carried interest): It is the share of the private equity fund’s profit earned by manager after the fund has returned the outside investor’s capital (i.e

Reference: CFAI Curriculum,

profits that represent a return >hurdle rate or preferred

rate) It is expressed as % of total profits of a fund i.e 20%

C Clawback provision: It is a provision to penalize the

manager for bad performance in later years i.e

manager is required to return money to investors if at the

end of a fund’s life investors have not received back

their capital contributions and contractual share of

• When all or most of the cash flows are distributed to

investors, in the following years there is a catch up

period in which the manager receives all or most of

the profits

• Subsequent profits are then distributed to investors

according to carried interest %, for example 80% to

investors and 20% to manager

• Some of the profits of the manager can be placed

in an escrow account to meet claw-back liability, if

any

4.1.2) Size of the Private Equity Market

According to a reliable study, by 2006, around US$200

billion was invested in private equity VC and buyout

funds via approximately 1,000 private equity vehicles

4.2 Benchmarks and Historical Performance

In private equity, events through which market price can

be determined include:

• New funds raising

• Company acquisition by another company

• IPO

• Failure of the business

Benchmarks: Benchmarks include:

i Cambridge association and Thomson Venture

Economics

ii Custom benchmarks

Construction: Value depends on specific events

Benchmarks are constructed for VC and buyouts

Biases: Infrequent pricing process creates problems for

index construction as a result of stale values

Historical Performance: Private equity returns have

exhibited low correlation with publicly traded securities

which indicates that they can contribute to portfolio

value addition However, low correlation might exist

because of use of stale prices due to lack of observable

market prices for private equity

Interpretational Issues: Incorrect returns are estimated due to:

• Use of appraised values (stale data)

• Significant effect of company-specific events

• Non-standardized method of appraisals

Vintage year Effects: The effect of vintage year (closing year of a fund) on fund’s returns is known as vintage year effect Investors should take into account vintage year effects when comparing performance of different private equity funds

4.3 Investment Characteristics and Roles of Private

Equity 1) Illiquidity: Private equity investments are generally highly illiquid Convertible preferred stock investments do not trade in the secondary market

2) Long-term commitments: Private equity investment requires long-term commitments Time horizon can also

be quite uncertain for direct VC investments

3) Higher risk than seasoned public equity investment:

Return: On average, returns have higher dispersion than

public equity

Risk: Risk of complete loss of investment is higher New

and young businesses have higher failure rate

4) High expected IRR required: Investors require high target return to compensate for higher risk and illiquidity Characteristics of VC investments further include:

5) Limited information:

• Ventures operate in new markets

• Cash flows projections are based on limited information available and assumptions

6) High upside potential for successful ventures

Differences between VC funds and Buyout funds:

• Buyout funds are usually highly leveraged In contrast, VC funds do not use debt to obtain their equity interests

• Buyout funds have earlier and steadier cashflows relative to VC funds Note that Buyout funds are able to realize returns earlier due to purchase of established companies

Note: The earlier the stage in which a fund invests in companies, the greater the risk and the higher the return potential

• Buyout funds have less error in value measurement

• VC investing (relative to buyout funds) are associated with frequent losses and higher upside

potential when investments are successful

• Buyout funds investment involves less risk and

earlier returns

Treatment of nonmarketable interest:

• The discount for a minority interest reflects the lack

of control that the investor has over the business

and distributions i.e

Minority interest discount ($) = marketable

controlling interest value ($) × minority interest(%)

discount = (investor’s interest in the equity × total

equity value) × minority interest discount(%)

Marketable minority interest ($) = Marketable

controlling interest value ($) – minority interest

discount ($)

• Discount for lack of marketability (marketability

discount) reflects the lack of liquidity in the

investment and depends on factors i.e size of the

interest and level of dividends paid

Marketability discount ($) = Marketable minority interest

($) × marketability discount (%)

Non-Marketable minority interest ($) = Marketable

minority interest ($) - marketability discount ($)

• In case of valuing a controlling interest, we need to

consider only the marketability discount

• In case of valuing a majority interest, the discount

for lack of marketability reflects both the cost of

going public and a discount for owning a large

block of shares

4.3.2) Roles in the Portfolio Private equity has positive correlation with public equity

because all types of businesses are exposed to

economic and industry conditions However, correlation

is low due to high company-specific risk involved in

private equity

VC fund is expected to generate higher returns in case

of advancing public equity market values

The primary role of Private equity is return enhancement;

however, it can play a moderate role as risk diversifier

Issues involved in formulating a strategy for private

equity investment:

1) Sufficient diversification requires large number of positions: Investors with greater than $100 million portfolio value are able to invest in investments required for diversification Private equity FOFs are preferable for small investors to achieve diversification (in spite of higher fees)

2) Low Liquidity of the position: Direct private equity investments are inherently illiquid

• Capital has to be tied up for 7-10 years

• Limited secondary market exists for private equity commitments

• Investments trade at highly discounted prices 3) Provision for capital commitment:

• Investors make a commitment of capital

• Cash is requested over the commitment period (usually 5 years)

• Investors are required to provide capital when

future capital calls are made

4) Appropriate diversification strategy: Both the stand alone risk factors of an investment and its effect on the overall risk of portfolio should be taken into account Diversification may be across industry sectors (IT, biotech etc.), by stage of company development (early stage, expansion, buyout etc.) and by location (local, international etc.)

Due Diligence items for private equity:

1) Evaluation of prospects for market success: It includes

• Markets, competition and sales prospects

• Management experience and capabilities;

assessment of management is an ongoing process

• Management’s commitment: Following factors are used to assess management’s commitment:

i Percentage ownership: ownership of a large portion of the company is an indication of high commitment to the company

ii Compensation incentives: managers’ interests must be aligned with the shareholders through proper compensation arrangements

• Cash invested by managers: Greater cash invested

by managers indicates highly committed management team

• Opinion of customers: Customers’ opinion of the company’s existing product/service should be evaluated

• Identity of current investors: Presence of professional/expert investors related to company business give an indication of company’s future success

Practice: Example 8,

Volume 5, Reading 30

Practice: Example 9,

Volume 5, Reading 30

2) Operational Review: It includes

• Expert validation of technology i.e technology that

is marketed by a company is valid and represents

future advancement

• Employment Contracts i.e investors should

evaluate whether key employees have contracts to

stay with the company

• Intellectual property i.e investors should evaluate

whether the company possesses relevant patents

3) Financial/ legal review: It includes

• Potential for dilution of interest: Investors should

evaluate existence of stock options and other

means which can dilute their investment interests

• Examination of financial statements: Investors

should analyze financial statements, tax returns and conduct their own audits etc

Factors to be considered in evaluating manager’s team (Indirect investment):

• Historical returns generated in prior funds

A commodity is a homogeneous and tangible asset

Types of Commodity Investments

1 Direct Commodity Investment: Refers to cash (spot)

market purchase of physical commodities or exposure

via derivatives i.e futures

• Due to carrying and storage costs associated with

Cash market purchases, derivatives and/or indirect

commodity investments are preferred by investors

• Derivatives/futures provide good commodity

exposure

2 Indirect Commodity Investment: Refers to achieving

indirect exposures to changes in spot market values of

commodities via e.g investing in equity of companies

specializing in commodity production etc

• They do not provide effective exposure to

commodity price changes because these

companies themselves hedge commodity risk

• ETFs provide partial effective commodity exposure

The creation of investable commodity indices and

increase in preference to use derivative markets to gain

commodity exposure has facilitated small investors to

access commodity markets via mutual funds or

exchange-traded funds

5.2 Benchmarks and Historical Performance

Commodities physical markets are not centralized

Therefore, performance of commodity investment can

be evaluated through commodity indices

Benchmarks:

1 Reuter Jefferies/Commodity Research Bureau

(RJ/CRB) Index:

• Groups commodities into four sectors

• Gives unequal fixed weights to each sector according to its perceived relative importance

2 Goldman Sachs Commodity Index (GSCI):

• Includes energy, metals, grains, and soft commodities (i.e cocoa, coffee, cotton & sugar)

• Uses world production weighting system

• Weights are assigned on the basis of five year moving average of world production

• The energy sector is over weighted in the index

• Provides two versions of indices:

i Total return version: It assumes that capital is required to purchase basket of commodities is invested at the risk-free rate

ii Spot version: It tracks movements in futures prices only

• Sub-indices include agriculture, industrial, livestock, energy precious metals contracts

3 Dow Jones-AIG Commodity Index

4 S&P Commodity Index

Construction: Benchmarks are constructed using a futures-based strategy

Bias: Indices differ in composition, weighting scheme and purpose

Important Notes:

• Market cap weighting scheme cannot be used in commodity futures indices because every long futures position has a corresponding short futures position and market cap of futures contract is always zero

• Generally, return on commodity futures contract is not equal to the return on the underlying spot commodity However, Cost of carry model, ensures

that the return on a fully margined position in a