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CFA2: Alternatives

Real Estate

Real property investment Value determinants Principal characteristics Risk Typical investor
Raw Land Supply/demand, location, planning & zoning Passive, illiquid, low leverage, return from value appreciation, no tax depreciation, capital gains tax exposure, capitalized expenses Cost of carry, unstable appreciation Speculators/developers, estates and long-term horizon portfolios
Apartments Population growth, income growth, location Moderately active, medium liquidity, high leverage, return from income plus appreciation, tax depreciation, ordinary & capital gains tax exposure, inflation hedge Start up for new construction, hiring effective management for large investments High income in need of tax shelter, anyone with sufficient initial equity requirement
Office Buildings Economic expansion, location, tenant mix, favorable status Active, medium liquidity, moderate leverage, return from income plus appreciation, tax depreciation, ordinary & capital gains tax exposure New construction, good management, competition, obsolescence, business activity location shifts High income in need of tax shelter, anyone with sufficient initial equity requirement (typically need to employ professional management)
Warehouses Commercial/industrial activity, location, designed to accommodate changing material handling processes Passive, medium liquidity, medium leverage, periodic income, tax depreciation, ordinary income tax exposure Oversupply, obsolescence if material handling procedures change Retirees with desire for high cash flow, anyone in need of tax shelter with sufficient initial equity requirement
Shopping Centers Community growth, population & income, location, adequate parking, suitable tenant mix, lease terms Principal Characteristics: Moderately active, low liquidity, medium leverage, return from income plus appreciation, tax depreciation, ordinary & capital gains tax exposure Proper tenant mix, good management needed, high vacancy rate, competition, obsolescence High wealth to make large equity outlay, anyone in need of tax shelter
Hotels/Motels Location, demand by business and tourists, facility & service mix Active, medium/low liquidity, medium/low leverage, return from income plus appreciation, tax depreciation, ordinary and capital gains tax exposure Sufficient size, competent management, competition Anyone in need of tax shelter with sufficient initial equity requirement, owner/managers for smaller properties

Cash Flows After Taxes (CFAT) for each year and Equity Reversion After Taxes need to be calculated in order for NPP&IRR evaluation

  1. Taxes = (NOI - depreciation - interest) × tax rate
  2. Cash flow after taxes (CFAT): CFAT = NOI - debt service - taxes payable
  3. Equity reversion after taxes (ERAT):
ERAT = selling price - selling costs - mortgage balance - taxes on sale

Recaptured depreciation represents depreciation taken in anticipation of a decline in the value of an asset which ultimately did not materialize

  • If the asset actually appreciates in value -> all depreciation must be recaptured and appreciation in the asset’s value is taxed as a capital gain
  • If the asset has declined in value but by less than the total depreciation taken -> recaptured depreciation equals net selling price less book value.

Potential problems in using IRR as a measurement tool in real estate investments

  • Multiple IRRs: When the cash flows from a project change signs during the life of the investment, the IRR calculation may result in multiple solutions. This is common when an investment requires a large expense, such as a major repair or renovation, at some point during its useful life
  • Ranking Conflicts: When ranking mutually exclusive projects there is a relatively large difference in the size of the projects being evaluated and/or 2) the pattern or timing of the cash flows for the projects is significantly different. When there is conflict, accept the project with the highest NPV.

Income Property Analysis and Appraisal

Capitalization rate calculation

  • Market extraction method: Assuming that comparable properties can be found, this technique is relatively simple to use because all that is required is the NOI and selling price for each comparable property
R0(ME) = net operating income/market value
  • Band-of-investment method (BOI): BOI utilizes a weighted average cost of capital as an estimate of the market capitalization rate. It is appropriate for properties that utilize both debt and equity financing.
R0(BOI) = (mortgage weight × mortgage cost) + (equity weight × equity cost)

Built-up method: This technique starts with an adjusted risk-free rate and adds premiums:

R0(BU) = pure interest rate + liquidity premium + recapture premium + risk premium

Limitations of the direct capitalization approach:

  • Difficult to select the appropriate capitalization rate. It is difficult to estimate a capitalization rate that accurately reflects investors’ behavior, particularly when market data are unavailable or lacking in quality.
  • Only applies to income-producing property. Income capitalization is only applicable to properties that generate monetary income, not owner-occupied properties that provide other benefits or amenities.

Limitations of the gross income multiplier approach:

  • Discontinuous pricing. Sales of some types of income-generating properties occur infrequently, which may result in the need to estimate the income multiplier with limited (or non-current) information.
  • Lack of information. Rental income may not be available.
  • Gross rent versus NOI. The use of gross rents may distort multipliers and, consequently, appraised values. This is because gross rent, versus NOI, does not account for differences in building-to-land ratios, or differences in the ages of buildings among otherwise comparable properties.
  • Distorted selling prices. Sales prices may be impacted by poor maintenance, zoning, or high taxes, while rents may not be as affected. This will render the gross income multiplier inaccurate unless comparables are exposed to these same factors.
  • Unique or non-income producing properties. The income multiplier approach is not useful for unique properties or properties that produce benefits in lieu of monetary income

Private Equity

Sources of value creation

  1. ability to reengineer the firm
  2. ability to obtain debt financing on more favorable terms
  3. superior alignment of interests between management and private equity ownership
    • Compensation: managers receive compensation according to firm's performance.
    • Tag-along, drag-along clauses: promote manager’s loyalty by giving stock option
    • Board representation: The private equity firm is ensured control if the firm experiences a major event
    • Noncompete clauses: Company founders must sign these clauses that are valid within a prespecified period of time.
    • Priority in claims: Private equity firms receive their distributions before other owners and have priority on the firm’s assets if the portfolio company is liquidated.
    • Required approvals: Changes of strategic importance must be approved by the private equity firm.
    • Earn-outs: These tie the acquisition price paid by the private equity firm to the portfolio company’s future performance
  • tax savings from the use of debt is thought to benefit private equity firms
  • required interest payments force portfolio companies to use free cash flow more efficiently
  • due to high risks, available to only "qualified" investors, usually defined as institutions and wealthy individuals.
  • higher costs than publicly traded securities: transactions costs, investment vehicle fund setup costs, administrative costs, audit costs, management and performance fee costs, dilution costs, and placement fees
  • Due diligence needed due to the persistence in returns in private equity fund returns, the return discrepancies between outperformers and underperformers, and their illiquidity

Venture Capital Buyout
Primary form of financing Equity Debt
Asset valuation Discounted cash flow
Key drivers of equiy return Pre-money valuation
Subsequent equity dilution
Earnings growth
Debt reduction

Leveraged Buyout (LBO)

  • Components of performance: earnings growth, increase in multiple upon exit, debt reduction

Exit routes - strongly influenced by means and timing

  1. Initial Public Offering(IPO): highest exit value due to increased liquidity, greater access to capital, and the potential to hire better quality managers.
  2. Secondary market sales to other investors or firms
  3. Management Buyout(MBO): sold to management, who utilize a large amount of leverage
  4. Liquidation: pursued when deemed no longer viable and results in a low exit value
  • Common forms of ownership
    • Limited partnership: funding provision and limitied liability
    • General partner manages the investment fund
  • Economic terms
    • management fees
    • transaction fees;
    • carried interest;
    • ratchet;
    • hurdle rate;
    • target fund size;
    • vintage year
    • term of the fund.
  • Corporate governance terms in the prospectus
    • key man clause;
    • performance disclosure and confidentiality;
    • clawback;
    • distribution waterfall;
    • tag-along, drag-along clauses;
    • removal for cause;
    • no-fault divorce;
    • investment restrictions
    • co-investment.

PE fund performance evaluation

  • paid-in capital = cumulative sum of the capital called down
  • management fees = percentage fee multiplied by the paid-in capital
  • carried interest = %carried interest x increase in the NAV before distributions
  • DPI multiple = cumulative distributions / paid-in capital
  • RVPI multiple = NAV after distributions / paid-in capital
  • TVPI multiple = DPI + RVPI

NPV venture capital method
1. Discount FV of company at exit back to the present to obtain the post-money (POST) valuation

POST = FV / (1 + r)N

2. Determine the pre-money (PRE) valuation by netting the investment (INV) from the post-money (POST) valuation


3. Determine the required fractional ownership (f) for the private equity firm

f = INV / POST

4. Determine the number of shares the private equity firm (Spe) needs to obtain their fractional ownership

Spe = Se * f/(1-f)

5. Determine the stock price per share (P)

P = INV / Spe

IRR venture capital method
1. Using the IRR, compound the investment out to the exit to obtain the investor’s expected future wealth (W)

W = INV× (1 + r)N

2. Determine the required fractional ownership (f) for the private equity firm which is the investor’s wealth divided by the terminal, future value (FV) of the firm

f = W / FV

3. Determine the number of shares the private equity firm (Spe) needs to obtain their fractional ownership, where Se is the entrepreneur’s shares

Spe = Se * f/(1-f)

4. Determine the stock price per share (P)

P = INV / Spe

5. Divide the investment by the fractional ownership to obtain the post-money (POST) valuation

POST = INV / f

6. Determine the pre-money (PRE) valuation by netting the investment (INV) from the post-money (POST) valuation


Risk adjustment to venture capital valuation

  • Discount rate is adjusted to reflect the risk that the company may fail in any given year
VentureCapital riskadj.gif
  • Scenario analysis, reflecting different values under different assumptions.

CashFlow in an LBO = NI + non-cash depreciation expenditures + amortization of deferred charges - increases in NWC - capital expenditures

  • Cash sweep: excess cash flow from an LBO used to pay down debt
  • Liquidation of an LBO investment can occur through: an IPO, a private sale, or a recapitalization where a new LBO is formed. It is usually assumed that the LBO will be cashed out in five years.

Target IRR method to determine the enterprise value in an LBO

PV of an equity investment = terminal equity value / (1+target IRR)N


Commodity futures

  • Contango (futures price > spot price): gold and other precious metals have limited contango
  • Backwardation: futures price < spot price: oil often have natural backwardation due to storage cost
  • If demand for investment in long futures increases, this is likely to reduce the prevalence of backwardation and increase the prevalence of contango

Roll yield: gain or loss when a commodity futures position matures and must be re-established

  • positive during periods of backwardation, but negative under contango

Arguments against commodity futures as an asset class:

  1. Commodity prices have tended to decline in the long run.
  2. Roll yield is not guaranteed (and may be eliminated).
  3. Rolling costs will reduce returns.
  4. Rebalancing, rather than any change in the asset price, drives return premiums.
  5. Commodity futures do not produce cash flows.

  • An actively managed commodity futures portfolio can have positive returns during periods when the underlying commodities have zero returns, if the rebalancing framework leads the portfolio manager to sell high and buy low.
  • Commodity prices tend to be inversely correlated with stock returns over the economic cycle and inversely correlated with inflation over the long term.

Hedge Funds

Changes in performance measurements

  • Changes in Leverage: hedge funds often use leverge with fixed income funds; affects fund performance but not accounted for evalution
  • Changes in Hedging Techniques
    • Market neutral fund - typically strives to hedge long positions with short positions so that it has a zero beta position
    • If market index increases, put option provides a more advantageous position because it expires worthless and allows the investor to participate in the higher market return
    • If the market decreases, the put increases in value according to the option delta. This change in value may not fully protect the fund’s position, especially in the case of deep out-of-the-money puts. In contrast, the short stock position does not require a premium to be paid and can better protect the fund’s position.
  • Style Drift: hedge fund manager can change her style over time to exploit perceived mispricing in various sectors
  • Portfolio Turnover: At down economy, hedge fund managers often trade frequently to exploit the volatility, which could result in inappropriate risk exposures for the investor

Hedge fund performance evaluation metrics

  • Broad Market Indexes: hedge funds experience high turnover and are not transparent; broad-based market indexes are applied to measure performance evey though may be inappropriate(Russell 3000 for equity, Merrill Lynch for fixed income)
  • Hedge Fund Indexes: best used as methods for detecting unusual performance; can be misleading if used as the only basis for performance evaluation
    • susceptible to data problems
    1. Managers voluntarily report performance to hedge fund index providers, and it is more likely managers *#will not report the results from poorly performing funds.
    2. Indexes may omit the returns of some large funds.
    3. Self-reported hedge fund data is not confirmed by index providers.
    4. Problems with questionable statistics include:
    • inconsistency because constituent funds change over time:
    1. Funds are subject to survivorship and backfill bias.
    2. Some constituent hedge funds are closed to new investors.
    3. Serial correlation in hedge fund data results in artificially low standard deviations.
    4. The historical record of hedge fund data is limited.
  • Risk-Free Rate - investors desire a positive return, that arbitrage strategies are risk-free, and that the interest earned on short positions is often tied to it. If a spread is added to the risk-free rate, it should reflect management costs and an expected excess return from active management.

Investment risks for hedge funds.

  • Fraud risk: misrepresentation of fund manager's background, qualifications, track record, or assets under management. The capital raised from investors is then used for the manager’s personal welfare or other purpose. For these reasons, investors should conduct a background check on potential managers. The scrutiny of the manager’s record should include a check of employment history, references, and court records.
  • Operational risk: deficiencies in procedures, infrastructure, technology, resources, supervision, or trade data
  • Counterparty risk: problem when securities are traded off an exchange; e.g. when one party defaults, the counterparty experiences a loss

Risk measurement tools

  • Drawdown: percentage decrease in investment value from its peak to its valley; measures left tail risk
    • Maximum drawdown: largest drawdown that has ever occurred for a fund within a specified time period
    • does not provide the probability of a large loss.
  • Value at Risk (VaR) provides both the amount of an expected largest loss as well as its probability
    • not indicative of future risk when a fund changes its investment strategy over time
    • calculated under the assumption that the returns are normally distributed, but hedge fund returns are rarely normally distributed
    • computed assuming that component risks are additive, when in fact they are often multiplicative