Session 1: What is an alternative investment? ▪ Different angles to answer the question: ▪ By exclusion ▪ By inclusion ▪ By their structure ▪ By their returns Alternative investments by exclusion ▪ Alternative investments are sometimes viewed as including any investment that is not simply a long position in traditional investments ▪ Traditional investments include publicly traded equities, fixed-income securities, and cash ▪ This definition is overly broad and we will instead focus only on alternative investments that are viable investments for institutional investors Alternative investments by inclusion ▪ Generally alternative investments are categorized as follows: ▪ REAL ASSETS (including natural resources, commodities, real estate, infrastructure, and intellectual property) ▪ HEDGE FUNDS (including managed futures) ▪ PRIVATE EQUITY (including mezzanine and distressed debt) ▪ STRUCTURED PRODUCTS (including credit derivatives) Real assets ▪ Real assets are investments in which the underlying assets involve direct ownership of nonfinancial assets ▪ Real assets vary in the extent to which ownership involves operational aspects, such as day-to-day management ▪ Examples, in growing order of operational complexity, include: ▪ Natural resources (such as mineral and energy rights or reserves) ▪ Commodities (natural resources having been extracted or produced) ▪ Real estate ▪ Land (undeveloped land, timberland, and farmland) ▪ Infrastructure (claims on the income of toll roads, regulated utilities, ports, airports, and other real assets that are traditionally held and controlled by the public sector) ▪ Intellectual property (e.g., patents, copyrights, and trademarks, as well as music, film, and publishing royalties) Hedge funds ▪ Most visible category of alternative investments ▪ Can be defined as privately organized investment vehicles that use their less regulated nature to generate distinct investment opportunities ▪ Hedge funds represent a wide-ranging set of vehicles that are differentiated primarily by the investment strategy or strategies implemented ▪ Macro hedge funds and managed futures ▪ Event-driven hedge funds ▪ Relative value hedge funds ▪ Equity hedge funds ▪ Funds of hedge funds Private equity ▪ The term private equity includes both equity and debt positions that, among other things, are not publicly traded ▪ The distinction between equity and debt is sometimes blurred because debt positions may contain so much risk from cash flow uncertainty that their short-term return behavior is similar to that of equity positions ▪ Main types of private equity include: ▪ Venture capital: funding new ventures ▪ Equity in leveraged buyouts (LBOs) of existing companies ▪ Mezzanine debt in LBOs of existing companies ▪ Distressed debt Structured products ▪ Instruments that generate unique cash flows as a result of partitioning the cash flows from a traditional investment or linking the returns of the structured product to one or more market values ▪ Examples include ▪ Collateralized debt obligations (CDOs) ▪ Mortgage backed securities (MBS) ▪ Credit derivatives (e.g., Credit default swaps, CDS) ▪ Structured products will be discussed in the advanced course in alternative investments Alternative investment structures ▪ Alternative investments can be distinguished from traditional investments because of their structures ▪ Regulatory structures ▪ Securities structures ▪ Trading structures ▪ Compensation structures ▪ Institutional structures ▪ Structures determine if an underlying real asset end up in a traditional or alternative investment Regulatory structure ▪ Role of government: ▪ regulation ▪ Taxation ▪ Key structure for hedge funds that are: ▪ less regulated than mutual funds ▪ built to avoid higher levels of taxation and regulation ▪ More recently liquid alternatives arose as an alternative asset class thanks to favorable regulation (discussed later) Securities structure ▪ Structuring of cash flows through leverage and securitization. ▪ Securitization: transforming asset ownership into tradable units, partitioning cash flows across different types of financial claims with different levels of risk or other characteristics ▪ This is the key structure for structured securities (CDOs, CMOs, etc.) Trading structure ▪ Role of an investment vehicle's investment managers in developing and implementing trading strategies ▪ buy-and-hold management strategy will replicate the returns of the underlying asset ▪ an aggressive, complex, fast-paced trading strategy can cause the ultimate cash flows from a fund to differ markedly from the cash flows of the underlying assets. ▪ The trading strategy embedded in an alternative asset such as a fixed-income arbitrage hedge fund is often the most important structure in determining the investment's characteristics. Compensation structure ▪ How organizational issues, especially compensation schemes, influence particular investments ▪ Compensation structures in alternative investments can be much more complex than for traditional investments ▪ The compensation structure affects the risk and returns of investment managers and hence influences their actions ▪ Compensation structures are particularly important for hedge fund and private equity funds The environment of alternatives investment: Before getting into the details of each type of alternative investments, it is worth giving a description of the actors: ▪ On the buy side ▪ On the sell side ▪ Providing outside services Buy-side: Who are the institutional investors that buy alterative investments: ▪ Plan sponsors (e.g., companies with healthcare or retirement plans) ▪ Foundations and endowments ▪ Family offices ▪ Sovereign wealth funds ▪ Limited partnerships (see next slide) ▪ Pooled investments ▪ Separately managed accounts (SMA) ▪ Mutual funds (e.g., for liquid alternatives) Limited partnership: Sell side: ▪ Large dealer banks provide several services including: ▪ Prime brokerage for hedge funds (see later) ▪ OTC trading of derivatives ▪ Repurchase agreements ▪ Securities lending ▪ Proprietary trading ▪ Brokers execute orders on different exchanges or privately to other traders Service Providers: ▪ Prime brokers: clearing and financing of trades, provides research, produces portfolio accounting (allow a fund to trade with multiple broker/dealers keeping all cash in one place) ▪ Fund administrator: independently providing bookkeeping and valuation ▪ Custodians: hold cash and securities ▪ Accountants, auditors, lawyers and consultants ▪ Service providers play a key role in the due diligence process Some common issues: Cash waterfalls ▪ Security and compensation structure determine the “cash waterfall” of an alternative investment, i.e., how the return is distributed among fund mangers and (different categories of) investors ▪ This is a common feature of alternative investments that has a specific terminology that deserves to be explored Benchmarking: A benchmarking is a reference point against which you evaluate the performance of a portfolio ▪ The benchmark will depend on the mandate and should have some properties (e.g., investibility) ▪ In general, the benchmark should have a “comparable” risk profile as the mandate ▪ The notion of comparability requires a theoretical model for risk ▪ The simplest way to model risk is the CAPM, which assumes the risk of a well-diversified portfolio is captured by its beta What about alternatives ▪ Benchmarking is a particularly tricky exercise for alternatives ▪ There are at least three good reasons why, for instance, the CAPM (and hence Sharpe ratio) is a poor choice to assess the performance of an alternative investment portfolio ▪ Multi-period vs. single-period ▪ Non-normal vs. normal distribution ▪ Illiquid vs. liquid assets Multi-period ▪ CAPM is a single-period model ▪ When multi-periodicity is introduced, risk factors other than beta can emerge (e.g., risk factors that affect how risk changes between periods) ▪ This issue is more relevant for alternative than for traditional investments because of: ▪ Their dynamic nature ▪ Their exposure to non-traditional sources of risk Non normality ▪ Returns of alternative investments are not normal and tend to be skewed and leptokurtic ▪ Skewness and kurtosis tend to get even more pronounced when we look at longer time intervals ▪ These higher moments are not captured by CAPM ▪ Although models to include higher moments of the distribution exist, estimating these higher moments and their evolution over time can be challenging Illiquidity ▪ Some alternative investments tend to be pretty illiquid ▪ Illiquidity is a risk factor that is not considered by CAPM (which is a single-period model) ▪ Illiquidity also means that alternative investments are more difficult to rebalance, and hence achieving full diversification in the portfolio may not be possible at all times, exposing the portfolio to otherwise idiosyncratic risk Session 2: Natural Ressource: Land ▪ Untransformed natural resources: ▪ Energy production: oil, natural gas, coal… ▪ Mineral ore ▪ Often land ownership include mineral rights (except for split estate) ▪ Land owner can sell or lease the mineral rights Natural Resources VS commodities: Natural resources are Different from commodities, which are “natural resources ready for consumption” ▪ Gold: ▪ A gold mine is natural resource investment ▪ A gold futures contract is a commodity investment ▪ The fundamental characteristic of natural resources is hence in the development ▪ One can see natural resources as exchange options Exchange Option: ▪ An exchange option is an option in which a predefined quantity of risk asset A can be exchanged with a predefined quantity of risky asset B ▪ Main difference with standard options is that the “strike price” is not known in advance and will depend on the stochastic process of risky asset B Why are natural resources an exchange option: ▪ One can see development of natural resources as an option in which uncertain development cost is exchanged with uncertain value of the underlying resource ▪ Risky asset A → development cost ▪ Risky asset B → value of natural resource ▪ Hence the value of the option will depend on its moneyness and the joint volatility Volatility of the exchange option ▪ The value of the option is, other things equal, increasing with the volatility of the “spread” between the two stochastic processes, which depends upon: ▪ The volatility of the two processes ▪ the correlation between the two processes ▪ Put differently a valuable option will be one in which development costs and the value of the natural resources are highly uncertain and not very correlated (but see next slide) ▪ Technology also plays a role by affecting the cost of development and making some natural resource properties profitable (see e.g., cost of fracking) Volatility of the spread ▪ Assume ▪ At is the (normally distributed) value of the underlying asset A at time t ▪ Bt is the (normally distributed) value of the development cost B at time t ▪ Then the Spread St has a volatility of: 𝜎𝑆𝑡 2 = 𝜎𝐴𝑡 2 + 𝜎𝐵𝑡 2 − 2𝜌𝜎𝐴𝑡 𝜎𝐵𝑡 ▪ Note that the volatility of the spread is not monotone in the volatility of B (see example on the right in which sigma A is 10%) Value determinant ▪ Development will start once the option is enough in the money (Point A) ▪ Value of immediate exercise > Value on deferred basis ▪ The value determinants change with moneyness: ▪ in-the-money options: value of the underlying resources ▪ Out-of the money options: uncertainty Land: Land banking: Land that is not generating any revenue (otherwise, we will discuss next time about real estate) ▪ Acquisition of undeveloped land is made in anticipation of possible commercial or residential development ▪ Because of this, it can be interpreted in a real option framework Types of land acquistion ▪ Paper lots: sites that are vacant, approved for development, but not infrastructure (streets, sewage, etc) not built yet ▪ Blue top lots: interim stage of lot completion. Infrastructure construction underway, home builder can start getting a building permit ▪ Finished lots: ready for home construction and occupancy. All infrastructure work done ▪ Institutional investors are key providers of blue top and finished lots to home builders Return from investing in land ▪ Return from investing in land come almost exclusively from development ▪ Land that remains undeveloped is like an option that does not get exercised ▪ Studies show that return of investment in undeveloped land is poor, but they tend to exclude land that does get developed → negative selection/survival bias Selection bias ▪ Selection (or survival) bias is a type of statistical bias that results from a sample not being representative of the target population ▪ A negative (positive) selection bias is a selection bias that, because of the way the sample is constructed, results in a negative (positive) bias in the estimated parameter ▪ Population: all land investment (including plots that get developed and plots that remain undeveloped) ▪ Sample: only undeveloped plots ▪ Bias: negative, because return is downward biased ▪ We will encounter selection bias other times in this course, but it will more often lead to an positive rather than negative selection bias Timberland and farmland: Timberland ▪ Investment in existing forestland for long-term harvesting of wood ▪ Most (>80%) timberland is public owned worldwide , with the exception of the US, where public ownership is approximately 40% A short history of timberland and TIMOs ▪ Historically timberland was integrated in paper manufacturers but LBOs in the 1970s and 1980s broke down the integrated companies selling timberland investment and focusing on core business ▪ Timberland investment management organizations (TIMOs) were created to provide management services to ensure sustainable harvesting and management of privately owned timberland ▪ Institutional investors buy timberland and TIMO manages it for them, collecting an annual fee and share of harvest Pros and Cons of Timberland Investment Pros -Timber can be an inflation hedge. -Timber has had modest correlation to stocks and bonds. -Timber is also an investment in land. -Timber is a perpetually renewable resource. -The harvest schedule for timber is very flexible. -Trees continue to grow until harvesting. Cons -Timber values are tied to cyclical industries. -As a renewable resource, timber supply is not fixed. -Electronic media and recycling limit demand for paper. -Timber is at risk to natural disasters. Cyclicality vs flexibility ▪ Note that timber prices depend on cyclical industries (e.g., construction which, especially in the US, is heavily based on timber) ▪ However, if prices are low, harvesting can be delayed ▪ This flexibility is harvesting is an advantage of timberland over other real investments like agriculture and cattle ▪ Also, timber is input to different markets (firewood, pulpwood, home building etc), giving additional flexibility Risk of long rotation ▪ Rotation: length growth cycle from the start of the timber (typically the planting) until the harvest of the timber ▪ Pine: 45 to 60 years (can be shortened to 25-35 with intensive management) ▪ Hardwoods: 60 to 80 ▪ Long-term investment subject to risk: ▪ Natural: fire, drought, and other natural disasters ▪ Regulatory: government restrictions on ownership rights ▪ Innovation: wood being supplanted by other materials How do you own timberland? ▪ Direct ownership is the most common means of exposure to timberland ▪ Timber ETFs exist but have not managed to track the returns of timberland investment ▪ A few timberland real estate investment trusts (REITS) also exist Timberland vs. land ▪ Note that there is a very substantial difference between land and timber investment ▪ Land investment is a bet on development ▪ Timberland investment is substantially more conservative, providing regular income ▪ This does not mean that timberland investment bears no risk (see later) Farmland ▪ Investment in land that generates agricultural products ▪ Similar to timberland in that it is a land investment that generates regular cash flows Main differences with timberland ▪ Farmland has much shorter cycles (often annual or shorter) ▪ However less flexibility: most agricultural produce cannot be stored or not stored for long ▪ Political risk is also more pronounced for agricultural investment because of the importance of subsidies and tariffs (e.g., US vs China on garlic) ▪ Farmland is also becoming increasingly more about producing oil-alternatives such as ethanol, opening different sources of revenue Harvard’s investment in alternatives ▪ Harvard has a $39 billion endowment ▪ >50% is in alternative investments ▪ 6% is in “natural resources” which includes all real assets we’re discussing here (and excluding real estate) ▪ After 2007 a large portion of this 6% was invested in timberland and agricultural properties, including developing countries ▪ Teak forests in Latin America ▪ Cotton farms in Australia ▪ Eucalyptus in Uruguay ▪ Timberland in Romania ▪ Timberland and agricultural development in Brazil The Brazil bet ▪ Harvard’s investment in Brazil is a cautionary tale ▪ 1 million acres (5 times the size of Grand Paris) of timberland, in the Northeast of Brazil for agricultural development producing sugarcane, sugar, ethanol, tomatoes etc. ▪ TIMO is Gordian BioEnergy, a private equity Issues ▪ Investment made when Brazil economy was booming, which is no longer the case ▪ Legal issues with ownership documents ▪ Agricultural development costs higher than expected ▪ Dispute over fees with TIMO ▪ Result: ▪ >70 institutional investors contacted to buy land were not interested ▪ $200 million write down ▪ 2,000+ pages of court records ▪ Bad press because agricultural development could have contributed to fires A side note on the Harvard example ▪ Another interesting takeaway from this example is that whereas here we try to categorize alternative investments in silos, reality is often more nuanced ▪ The Brazil investment was at the same time: ▪ Land (because of substantial development) ▪ Timberland (because of forest harvesting) ▪ Agriculture (because of farming development) Are timberland and farmland sustainable? ▪ If properly managed, timberland investment can be sustainable and could contribute to slowing down deforestation ▪ This means adapting harvesting schedule to natural rotation rhythm, putting in place risk-containment etc. ▪ Agricultural development of forests can contribute to deforestation if not properly conducted ▪ Sustainable agroforestry methods exist (e.g., sustainable cattle ranching using native species) and are starting to be used (see also this documentary) ▪ Role of independent watchdog key in ensuring respect of rules Return analysis of timberland and farmland ▪ Timberland and farmland are illiquid and their value is generally not observable from trading, like for listed stocks and bonds ▪ Often the value of these assets is appraised or based on the rare observed transactions ▪ Both methods have their own issues: ▪ Appraisal → smoothing of returns ▪ Transactions → selection bias ▪ Econometric techniques exist to reduce the extent to these issues Appraisal and return smoothing ▪ Regular appraisals of an asset tend to be “updates” over previous appraisals rather than independent evaluations ▪ The result is that the appraised value is “anchored” to the previous value (a behavioral bias known as “anchoring”) ▪ Information used for appraisals are also not known in real time or are known with a time lag ▪ Result: returns calculated with appraisals tend to be “smoothed” compared to theoretical “real” returns ▪ Mean return is not biased, ▪ Standard deviation is underestimated ▪ Correlation with other asset classes also tends to be underestimated ▪ Smoothed returns also tend to be serially correlated ▪ We will discuss (later on) how to unsmooth a smoothed time series of returns Smoothing of returns, example: 100-period simulated returns (mean 1%, std. dev. 5%) ▪ Appraised value is a 1-period AR: 𝐴𝑡 = 𝛼𝐴𝑡−1 + 𝑅𝑡 , where ▪ A is the appraised value ▪ R is the “real” value ▪ Alpha is the smoothing parameter (0.5 here) Transactions ▪ An alternative would be to base the valuation on transactions ▪ Look at what timberland and agricultural properties were sold during the period and calculate their return since the initial investment ▪ Then take out the appreciation due to previous periods and attribute the rest to the current period ▪ Problem: ▪ Properties sold in each period are few and could not be enough to draw inference on the population ▪ Even if they were numerous enough, properties that are sold may not be representative of the population, causing a selection bias that is difficult to control Quaterly returns of timber and farmland Multivariate Beta: Commodities: ▪ Commodities are a very important category of alternative investment ▪ The most common way to get exposure to commodities are futures contracts, which hence play an important role in the story ▪ Other courses in the MSc in Finance talk about commodities and futures, so I will only gloss over the topic here What commodities ▪ Commodities can be classified in: ▪ Hard: all those that need to be extracted or mined (e.g., oil, gold, copper) ▪ Soft: agricultural (e.g., crops) and livestock (e.g., cattle) ▪ Another common distinction is between: ▪ Energy (e.g., oil, ethanol) ▪ Mineral (e.g., gold, copper) ▪ Agricultural (e.g., crops and cattle) Why commodities ▪ Investment in commodities typically aims at: ▪ Diversification ▪ Hedging against unexpected inflation ▪ Return enhancement Why diversification? 1. Commodities are priced based on forecast demand and supply rather than expected future cash flows → return determinants are partly different 2. Commodity returns tend to follow different cyclicality than stocks and bonds (the latter anticipate the market) 3. They are “real” assets whose value is positively linked to inflation → diversification wrt to stocks and especially bonds 4. Commodities are often a “cost” for industrial produces, causing short term negative correlation between commodities price and stock and bond return How do you invest in commodities ▪ Most of the times the most convenient and cheap way to invest in commodities is futures contracts ▪ Other means of investment include: ▪ Investing in physical commodities ▪ Investing in commodity-related equities ▪ ETFs ▪ Commodity-linked notes Physical ownership: Physical ownership requires some knowledge about financing, transportation, and storage of the commodity ▪ Relatively more common for some commodities (like gold) for which specialized intermediaries exist (e.g., UK Royal Mint) ▪ Physical ownership has also in rare circumstances been used by hedge funds or speculative investors trying to corner the market, often with disastrous results Investing in commodity-related equities ▪ Investing in commodity-related equities is relatively costeffective but does not result in acceptable exposure to commodities ▪ Returns to equities are determined by a lot of non-commodity factors ▪ Equity returns do not have many of the diversification properties of commodities themselves ▪ Some companies (e.g., airline companies) may hedge away commodity risk, at least in the short term ETFs ▪ Exchange traded funds (ETFs) are a relatively costeffective way of achieving commodity exposure for individual investors ▪ Available on a number of different commodities are reasonably liquid ▪ Institutional investors can still get better terms (in terms of cost and flexiblity) by investing in commodity futures CLN ▪ Commodity linked notes (CLNs) are bonds whose value at maturity is a function of commodity prices ▪ Often issues by commodity producers to fund investments ▪ Advantage over futures: ▪ longer term exposure without need to roll over the futures ▪ Admissible investment for investors whose mandate excludes trading in derivatives ▪ Some CLN are principal-protected, which means the value at maturity will not go below par → call option on commodity The S&P GPCI index ▪ In order to assess the return of commodity investment we will use the S&P GPCI index ▪ An investable index ▪ Comprising a large basked of commodities ▪ Rebalanced quarterly ▪ Different categories of commodity have markedly different return characteristics, which would require a more thorough analysis (discussed in the commodities course or in the advanced course in alternative investments) Quaterly commodities returns: Multivariates Betas: Operationally intensive real assets ▪ Category of investment in real assets that require very significant operational activity ▪ Infrastructure investment ▪ Intellectual property ▪ Other examples include: ▪ Litigation funds ▪ Social impact investment Infrastructure investment ▪ Investment in infrastructure (e.g., motorway, hydroelectric plant) development, typically with build-operate-transfer (BOT) agreement in a Private-PublicPartnership (PPP) agreement ▪ In order to be “investable” infrastructure needs to satisfy the following requirements: 1. Public use: associated economic serves general welfare of a society 2. Monopolistic power: provider can set prices relatively free from competition. 3. Government related: underlying assets are typically created by, owned by, managed by, or heavily regulated by government. 4. Price inelastic: the demand for the goods or services tends to be stable and inflationprotected. 5. Direct cash-flow generation: assets that directly generate cash, such as toll roads, rather than similar assets that are supported by general tax revenues (e.g., regular roads). 6. Underlying assets and systems relatively conducive to privatization of managerial control. 7. Capital intensive, with underlying assets that are long-term in nature Type of investable infrastructure: Institutional structure ▪ Financial markets and financial institutions related to a particular investment ▪ Some of the most important aspects are if an investment is: ▪ Publicly traded or not ▪ Regulated as a financial security or not The importance of structures ▪ An investment in hotels (the real asset) can be a: ▪ traditional investment (e.g., a listed hotel chain), ▪ private equity investment (e.g., the LBO of a hotel chain), ▪ real estate investment (e.g., investment in a commercial REIT focused on hotels) ▪ Investment in structured product (e.g., a CMO whose pool of mortgages are backed by hotels) ▪ The underlying real asset is the same but the structures determine the type of traditional or alternative investments Structures for Real Asset ▪ Relatively fewer influences from structures: ▪ Commodities are primarily driven by their securities structure, (futures contracts) ▪ Land and real estate has the institutional structure of being privately held and traded. The use of securities in the structuring of cash flows and securitization has also been important in driving the nature of real estate investments. ▪ Infrastructure often includes heavy regulatory structures, ▪ Intellectual property often includes issues related to compensation structures. Structures for hedge funds ▪ Trading structure: the use of active, complex, and proprietary trading strategies. ▪ Regulatory structures (e.g., the use of offshore structures due to tax regulations) ▪ Compensation structures, including the use of performance-based investment management fees. Structures for private equity ▪ Defined by their institutional structure: not publicly traded. ▪ Compensation, securities, and trading structures also play nontrivial roles in shaping the nature of private equity. Structures for structured products ▪ Clearly distinguished by the securities structure. ▪ However, structured products are also typically moderately influenced by institutional, regulatory, and compensation structures Returns of alternative investments ▪ Alternative investments tend to have a specific role in an institutional investor’s portfolio ▪ Diversification ▪ Illiquidity ▪ Inefficiency ▪ Non-normality Diversification ▪ Institutional investors often look for alternative investments when they seek diversification ▪ In principle a diversifier is an investment that has low correlation with other investments in the (market) portfolio ▪ These investments typically aim at obtaining an absolute return ▪ Note that a large number of alternative investments (e.g., private equity) actually have very high correlation with the stock market Illiquidity ▪ One reason to invest in alternative investments is that investors may seek to get an illiquidity premium ▪ Illiquid assets are assets that cannot be bought/sold cheaply and rapidly ▪ They can be bought/sold rapidly at a strong premium/discount ▪ They can be bought/sold cheaply only if sufficient time is allowed ▪ Most (although not all) alternative investments carry some degree of illiquidity Inefficiency ▪ Another raison-d’être of alternative investments is that they try to obtain absolute return from exploiting market inefficiencies ▪ To this extent alternative investments may work best when they focus on markets that are inefficient ▪ This is especially the case for some types of hedge funds, but the general idea of buying los and selling high (which is another way of saying exploiting inefficiencies) is quite common among alternative investments Non-normality ▪ Alternative investment returns tend to be highly non-normal ▪ Even if the returns of the underlying real asset were normal, structures (trading, compensation, securities) can massively alter the return distribution ▪ Most alternative investments tend to have returns with very fat tails (leptokurtosis) ▪ Some alternative investments tend to exhibit returns that are smoothed as result of thin trading of the underlying, and that appear to be more “normal” than they actually are ▪ Non-normal and smoothed returns mean that some common measures of performance (e.g., Sharpe ratio) can be misleading when applied to alternative investments Session 3 : Real Estate Characteristics of real estate ▪ Compared to traditional investments the salient features of real estate properties are: ▪ Uniqueness: no two properties that are the same ▪ Indivisibility: large entry ticked unless pooled investment ▪ Management intensity: require maintenance, rent collection, lease negotiation ▪ Transaction costs: appraisals, notaries, lawyers… ▪ Depreciation: real estate depreciates and needs constant maintenance ▪ Illiquidity: real estate market relatively illiquid, especially for large properties ▪ Leverage: real estate investment is very often leveraged because of: ▪ Large investment amounts ▪ Relatively predictable cash flows ▪ Easily pledgeable asset backing mortgages Type of claim and vehicule Several dimensions to categorize real estate investment: ▪ What claims the investor has over the asset (equity vs fixed income) ▪ What investment vehicle is used to gain exposure, and most importantly if the vehicle is listed or not Difference: ▪ This classification is important because the quadrants differ substantially, and each has developed its own set of investment products ▪ Private investments typically: ▪ Require larger minimum investments because of indivisibility ▪ Involve more day to day operational management of property ▪ Are less liquid ▪ Equity investments typically: ▪ Are riskier ▪ Give ownership and control over the property (although control is delegated in the case of REIT) ▪ Debt investments are typically mortgages backed by the property Residential Vs non residential real estate Residential: single family vs multi-family, low-rise vs high rise, urban vs suburban Nonresidential: office, hospitality, retail, industrial and warehouse Differences among property types: ▪ Day-to-day management: ▪ High for hospitality and retail ▪ Moderate to low for residential ▪ Low for office and industrial ▪ Return characteristics (see later) ▪ Exposure to risk factors (see later) Return Characteristic: ▪ Why investment in real estate? ▪ Current income from letting, leasing or renting the property ▪ Appreciation of property (capital gain) ▪ Inflation hedge: both income and price of properties could rise with unexpected inflation ▪ Diversification: expectation of relatively low correlation with stock and bond returns (see next slide) Tax advantages: In several countries real estate investment has tax advantages over other types of investment ▪ Same pre-tax return could translate in better after-tax return ▪ Example: ▪ Tarry Macklowe, an 81-year-old New York City developer who collected $600+ million worth has not paid any income tax since… the 1980s ▪ How? ▪ Accelerated depreciation (see also this) ▪ Possibility to write off losses on the whole value of the property (including the debt part) Depreciation and taxes ▪ One of the sources of tax advantage for real estate is depreciation ▪ We will show how depreciation works with an example: ▪ Real estate property that cost $100 million and will be sold after three years. ▪ Ignore inflation and assume that the true value of the property will decline by 10% each year due to wear and aging ▪ Cash flows generated by the property each year are equal to the sum of: ▪ 10% of the property's value at the end of the previous year ▪ plus the amount by which the property declined in value. ▪ Thanks to these ad-hoc assumptions, IRR is exactly 10% Bottom line of depreciations taxes: ▪ When accounting depreciation equals economic depreciation, the investor is taxed fairly ▪ Accelerated depreciation allows for deferral of income tax  lower taxation ▪ Take into account that any depreciation is “accelerated” if applied to a building whose value is actually increasing! ▪ Quoting Donald Trump: “Depreciation is a wonderful charge, I love depreciation!” ▪ Real estate also benefits from other perks such as deferral of capital gain taxes and possibility to claim write off on the whole value of property (not only the equity part) Risk Factors: ▪ Demographic conditions ▪ Economic conditions ▪ Development time and cost ▪ Cost of debt ▪ Lack of liquidity Offices: ▪ Main driver blue-collar employment growth, which depends on economic conditions in services industries (insurance, finance…) ▪ Average space per employee is another key driver (long term trend towards reduction) ▪ Lease time varies across countries (US: 3-5 years; UK: 10 years; France: 9 years, unilateral termination possible after 3 and 6 years) ▪ Lease can be net or gross of operating expenses ▪ Net lease -> tenant pays for operating expenses ▪ Gross lease -> owners pays (and takes risk of increased) operating expenses ▪ Inflation risk can be borne by tenant or owner depending on how rent set: : ▪ Indexed rent (e.g., with inflation): inflation risk on tenant ▪ Fixed: inflation risk on owner Warehouses: ▪ Main driver is economic conditions in manufacturing ▪ Other driver is import/export activity ▪ Industrial leases are generally net-leases ▪ You can get an idea about the size of real estate investment by endowments here Retail: ▪ Main determinant is consumer spending, which depends on: ▪ health of the economy ▪ job growth ▪ population growth ▪ savings rates ▪ Length of lease is generally short for small shops and long for “anchor tenants” (which get favorable rent conditions) ▪ Rent can be calculated as minimum + percent of sales above “natural breakpoint”) ▪ E.g., rent of $30 per sq. foot + 10% of sales above $300 per sq. foot ($300 per sq. foot is the “natural breakpoint”) ▪ Owner gets essentially a call option on sales with a lower bound ▪ Additional revenue (e.g., parking) is also relevant source of income for retail Residential: ▪ Main macro driver is population growth ▪ Additional driver is quality of location ▪ Target is people who rent: ▪ young people (25-35 is mean in the US) ▪ people living temporarily in a place (students, diplomats, engineers for special projects) ▪ Ratio of rent to cost of ownership is a determinant of choice to rent or buy ▪ Regulatory risk: some cities (e.g., Paris, Berlin, San Francisco) set rent controls, which often hurt owners in the short term and often cause house shortage in the long-term: ▪ in the mid-1990s Cambridge, Massachusetts, scrapped its rent controls, while San Francisco made its regime even stricter ▪ Cambridge: apartments freed from rent control saw a spurt of property improvements ▪ San Francisco: converting rental properties so that they could be sold -> 15% reduction in supply Style of real estate investment: ▪ Core real estate: high percentage of returns from income and low volatility (Office, Retail, Industrial, Multi-Family, and Hotels) ▪ Value-added real estate: assets that have (1) substantial portion returns from appreciation in value, or (2) moderate volatility, or (3) less financially reliable than core (e.g., hotels, resorts, assisted-care living facilities, low-income housing,outlet malls, hospitals) ▪ Opportunistic real estate: most or all of returns from property appreciation and may exhibit substantial volatility in value and returns. (development risk, substantial leasing risk, or high leverage) Valuation of Real estate: Appraisal: ▪ Real estate properties do not trade differently and are unique ▪ Their market value is hence often appraised, which may lead to issues in return smoothing as discussed in the last module ▪ Market value: most probable sale price of a property ▪ Different from investment value, which is the value to a particular investor based on its existing portfolio, tax circumstances etc. ▪ Different from mortgage lending value, prudent estimate of sale price during a market downturn (used by some mortgage lenders) ▪ Appraisal is conducted on the “highest and best use” of a property Highest and best use: ▪ Suppose you are appraising the value of a plot of land which hosts a warehouse worth $500,000 ▪ The plot can be used to build an apartment complex, an office space, or a retail property ▪ Cost of construction (including demolition of warehouse) and value after construction are: ▪ Based on its highest-and-best-use (and ignoring option value of land), the implied value of the land is $1 million 3 approaches: ▪ We will discuss three approaches to valuation (appraisal) of real estate: ▪ Income approach  based on expected income ▪ Cost approach  based on replacement cost of building ▪ Sales comparison approach  based on recent sales ▪ Use of approaches varies across countries as well as characteristics of leases, as summarized in the next slide Income Approach: ▪ Real estate produces regular income, and its market value should equal the present value of the expected income in the future ▪ And of course we’re referring to income produced under highest and best use, rather than income produced under current use ▪ We will first show a simple income approach, the direct capitalization method, and then move to a more refined income valuation method, the DCF method Net Operating income (NOI): ▪ One of the key inputs for the income method is the net operating income (NOI) ▪ NOI is a measure of the income from the property after deducting: ▪ operating expenses ▪ property taxes ▪ insurance ▪ maintenance of common and leased spaces ▪ utilities ▪ Note that: ▪ NOI is calculated before deducting any costs associated with financing (like unlevered free-cash flow in capital budgeting) ▪ If some costs (e.g., utilities and ordinary maintenance of leased spaces) are at paid by the tenant they should not be subtracted (or should be added as additional income) ▪ Vacancy also needs to be taken into account Calculation Cap Rate: ▪ The second key element of the direct capitalization method is the cap rate ▪ For a property that produces an NOI that is expected to grow at a constant pace, the cap rate can be calculated as: Cap rate = Risk-adjusted discount rate – Expected growth rate of NOI ▪ Alternatively the NOI can be calculated as: NOIt+1 = Cap rate * Valuet Two ways to calculate it: ▪ The two definitions of cap rate in the previous slide are consistent because they are linked by the value equation ▪ If NOI grows at constant rate g, the free-cash flows from the property (approximated by NOI) are a growing perpetuity discounted at rate r: Cap rate and return: ▪ Note that the cap rate is not the internal rate of return (IRR) an investor may expect from the investment which is instead: ▪ Cap rate -> income received (similar to a dividend yield) ▪ Growth rate -> appreciation of property (similar to capital gain) ▪ Often the cap rate is calculated from that of comparable properties Stabilized NOI: ▪ Sometimes the investor is buying a property that currently has an NOI that is below its potential (e.g., because of renovation, or exceptional vacancy) ▪ In this case using the current NOI as a starting point of the calculation would lead to an underestimation of the value ▪ A stabilized NOI can then be used, in which the NOI in normal circumstances is used in the calculation, giving us an upper bound of the value of the property The DCF Method: ▪ The cash flow assumptions behind the direct capitalization method are very simplistic (constant growth) and we could get a more precise value estimate if we had better cash flow projections ▪ Often valuation period is split in two parts: ▪ An estimation part in which NOI is explicitly estimated until year T ▪ A terminal value that captures the value of the property at time T based on the residual NOIs after T ▪ The direct capitalization method is normally used to estimate the terminal value Terminal Cap rate: ▪ Note that the terminal value is based on a cap rate at time T, which needs not be the same as the going-in cap rate (i.e., the cap rate now) ▪ The terminal cap rate is generally a bit less than the current cap rate because of a lower projected long-term growth (the property aged) Advanced DCF: ▪ DCF method allows us to make much more precise estimates because we can in principle split the property and estimate income from each tenant separately ▪ A single property could also have different types of tenants (residential, commercial, etc), each with their own cash flows in the estimation period, risk, expected NOI growth and cap rate Valuation of Real Estate : Cost Approach ▪ The cost approach estimates the value of an existing property as: ▪ Value of land ▪ Plus: replacement cost of the building  built today using current construction costs and standards ▪ Minus: adjustments due to obsolescence ▪ Several sources of obsolescence: ▪ Physical deterioration ▪ Functional ▪ Locational ▪ Economic Physical obsolescence: ▪ Physical deterioration related to the age of the property because ▪ Two types: ▪ Curable: fixing the problem will add value that is at least as great as the cost of the cure ▪ Incurable: cost of fixing the problem exceeds increase in value (e.g., gradual loss of structural integrity) ▪ Deduction of value for curable deterioration -> subtract cost to fix it ▪ Deduction of value for incurable deterioration -> depreciate property proportionally to its expected useful life compared to its effective age Functional obsolescence: ▪ Functional obsolescence refers to poor design compared to current standards: ▪ Change in design standards ▪ Bad design to begin with ▪ E.g., for office space: design (size, distribution) of office space has changed dramatically over the past 20 years ▪ Functional obsolescence leads to reduction in NOI -> discount on replacement value Locational obsolescence: ▪ Locational obsolescence is linked to the fact that the placement of the property might no longer reflect its highest and best use ▪ Example: ▪ warehouse located in an area that has become residential ▪ luxury apartment in an area that has become industrial ▪ Part of the locational obsolescence is captured by the reduced value of land Economic obsolescence: ▪ Refers to the fact that NOI could be below the breakeven point for a new building to be built in the first place ▪ Hence even a fully functional new building would be worth less than its construction cost Valuation of real estate: Sales comparison approach: Sales comparison: ▪ Determine value of a property based on price of recently transacted “similar” properties ▪ Because of property uniqueness, no identical property can be found and adjustments will have to be made ▪ Procedure is generally to: ▪ Identify comparable properties ▪ Calculate price per square foot (or square meter) for each comparable property ▪ Adjust price psf to reflect the characteristics of the focal property ▪ Calculate adjusted average price psf Adjustment: ▪ Adjustments include: ▪ Age: newer properties are worth more ▪ Condition: better condition  higher price psm ▪ Location: prime location better than secondary location ▪ Date of sales: in a trending market prices need to be adjusted if they refer to previous months Illustration: Issues with this method: ▪ Adjustments need to be estimated from hedonic regression, which requires large and reliable historical data ▪ Need to have significant number of comparable recent sales ▪ Properties that are sold are not necessarily representative of the property being assessed (see: sample selection) Publicly traded real estate: ▪ Investment vehicles that: ▪ Equity: own and operate income-producing real estate property ▪ Mortgage: own pools of mortgage loans to income-producing real estate ▪ Types of publicly traded real estate: ▪ Real estate investment trusts (REITs): tax-advantaged entities that can be either equity or debt ▪ Real estate operating companies (REOCs): trusts that do not have the tax advantages of REITs, in countries or circumstances in which REITs are not possible ▪ Mortgage-backed securities (MBS): pools of mortgages backed by commercial (CMBS) or residential (RMBS) real estate ▪ Hybrid REITs that do both equity and mortgage real estate History of REITS: ▪ Origin mid-1800s in the US ▪ Several boom and busts over the decades, including substantial use as means to get property out of balance sheets ▪ Latest wave formed in, and has grown massively since, the 1990s ▪ Introduced in the mid-2000 in other jurisdictions including Japan, Singapore, Europe, Dubai… ▪ China and India lagging behind Taxes advantages of REITs: ▪ REITs are typically exempt from income taxation at the corporate (or trust) level if: ▪ a specified majority (75% or more, depending on country) of their income and assets relate to income- producing property ▪ all or virtually all their potentially taxable income is distributed to shareholders (or unit holders). ▪ Funds that mostly do property development generally do not qualify to tax exemption and are set up as REOC ▪ Because they can retain earnings and can invest in any real estate, REOCs have better operating flexibility than REITs Main Characteristic ▪ Tax efficiency ▪ Because no retained earnings: ▪ High income distribution ▪ Relatively frequent follow-on equity offerings ▪ Relatively low volatility of income ▪ Compared to private real estate: ▪ Liquidity ▪ Lower investment requirement ▪ Access to superior quality ▪ Professional management ▪ Diversification ▪ However, taxation is often more favorable for direct ownership than REITs (cannot pass-on losses or defer taxable gains) Valuation of REITs: ▪ Three main approaches to value an equity REIT ▪ Asst value estimates ▪ Price multiples ▪ Discounted cash flow valuation Asset Value estimates: ▪ Objective is to compare the current price of a REIT to the net asset value per share (NAVPS), which is calculated based on ▪ value of real estate assets ▪ Minus all liabilities ▪ Value of real estate assets could be calculated using any of the methods seen previously (illustration in next slide uses cap rate) Notes on NAVPS: ▪ NAVPS value implicitly assumes that the REIT is a static pool of assets ▪ REITs can buy, sell and transform property in ways that can create (or destroy) value above (below) the value of the current pool Price multiples: ▪ Another method to value a REIT is through multiples ▪ Two multiples are used that divide price by: ▪ Funds from operations (FFO) ▪ Adjusted FFO Calculation the FFO and AFFO ▪ FFO is calculated as: ▪ net income (computed in accordance with IFRS or US GAAP) ▪ Plus: gains and losses from sales of properties ▪ Plus: depreciation and amortization ▪ Illustration: AFFO: ▪ More precise estimate than FFO, recognizing ▪ Non-cash rents: rent in FFO is straight-line rent, which is the average rent during the lease period; the actual rent can be higher or lower in any given period for each property ▪ Recurring maintenance-type capex: maintenance expenditures necessary to maintain income generation but not recognized in income statement ▪ Compared to FFO: ▪ Harder to estimate (bigger error) ▪ Harder to obtain consistent data (lacks unique definition) ▪ Illustration: Using Multiples: Advantages ▪ Widely accepted in evaluating shares across global stock markets and industries ▪ Portfolio managers can put the valuation of REITs and REOCs into context with other investment alternatives. ▪ FFO estimates are readily available through market data providers ▪ Multiples can be used in conjunction with such items as expected growth and leverage levels to deepen the relative analysis among REITs and REOCs. Drawback: ▪ Applying a multiple to FFO or AFFO may not capture non-income-generating property ▪ P/FFO does not adjust for the impact of recurring capital expenditures and non-cash rent ▪ P/AFFO should do so but there’s no unique accepted way to do so ▪ Accounting standards differ across country and over time, and one-time items can be relevant, making these multiples less useful Using DCF: Using DCF valuation to a REIT or on individual properties within a REIT can give much more precise estimate of NAV ▪ This valuation method however, requires a great deal of information about the real estate portfolio of a REIT ▪ Alternatively, dividend discount model (DDM) could also be used to value REITS, which pay out regular and relatively predictable dividends REITs, REOCs and… what else? Other ways to obtain exposure to real estate include: ▪ Private real-estate funds (similar to private equity) ▪ Commingled real estate investment funds (CREIF), similar to private real-estate funds but easier to trade ▪ Joint venture (often between institutional investor and real estate developer) ▪ Options and futures on real-estate indices ▪ ETFs tracking real-estate indices Mortages: Leverage in RE ▪ Leverage is extremely substantial in income-producing real estate ▪ Capital intensive investment ▪ Cash flows are relatively predictable ▪ Asset is tangible and makes for good collateral ▪ Leverage for real estate comes in the form of mortgages Mortgages: ▪ Mortgage is a loan secured by property ▪ If borrower defaults on payments, the lender can take possession of property ▪ Mortgages can generally be prepaid, sometimes with a prepayment penalty (penalty is illegal in some countries for residential mortgages) ▪ Mortgages can be: ▪ Fixed-rate vs. Variable-rate ▪ Residential vs. commercial Fully Ammortize fixed-rate mortgage: ▪ n equal monthly payments (MP) calculated from mortgage balance (MB) and monthly interest rate (i) using the annuity formula as follows: Interest only mortgage: ▪ An interest-only mortgage has an initial period in which only interest is paid, followed by a period in which it is fully amortized ▪ The two most common interest-only mortgages are: ▪ 10/20 -> 10 years interest only followed by 20 years of full amortization ▪ 15/15 -> 15 years interest only followed by 15 years of full amortization Variable-rate mortgage: ▪ Interest is periodically adjusted following a pre- determined index rate + spread (margin rate) ▪ Each period the payment is calculated using the same formula used before ▪ Interest rate can be capped Residential mortgages and default risk: ▪ In some countries (notably the US) prime mortgages are backed by government agencies ▪ This, in conjunction with the underlying property, makes default risk for residential prime mortgages relatively unimportant ▪ Residential mortgages that are too risky to be insured are known as subprime ▪ An important source of risk for residential mortgages is instead pre-payment risk (see later) LTV: ▪ Leverage is often measured in terms of Loan-to-value (LTV) ratio: ratio between loan and property value ▪ For residential mortgages normally LTV is capped at 80% but it can go up to 95% for prime mortgages ▪ In some countries LTV of 100% (or above) is also possible in exceptional circumstances Commercial mortgage and default risk: ▪ Default is a more important risk factor for commercial mortgages ▪ Besides LTV, mortgages are normally made not to go below a given threshold of debt-service coverage ratio (DSCR) ▪ DSCR is defined as the ratio between net income and debt service (interest + principal repayment) ▪ DSCR should in general be above 1.2 or 1.3 Mortgage Back securities: ▪ We will briefly discuss residential pass-through mortgage backed securities (MBS) ▪ Pool of mortgages (residential or commercial) ▪ No securities structure (i.e., all cash flows from the pool as passed-through investors pari-passu) ▪ More complex arrangements than pass-through MBS are possible, but will not be discussed in this course Prepayment risk: ▪ RMBS is dominated by insured (prime) mortgages, for which default risk is minimum ▪ A substantial source of risk is prepayment risk ▪ A borrower can reimburse his/her mortgage in part or completely before the end ▪ This is particularly common if the mortgage is fixed-rate and rates have declined since inception ▪ The borrower can reimburse the mortgage and refinance in better terms ▪ This is bad news for the lender who gets the reimbursement when rates have declined but remains locked-in a low- interest mortgage if rates increase Mortgage as callable bonds: ▪ Mortgages can be seen as callable bonds, in which the borrower (i.e., the issuer) owns a call option that can be exercised to reimburse (i.e., buy) the loan (i.e., the bond) ▪ The lender is short the same call option on the mortgage Prepayment risk in RMBS: ▪ Hundreds of mortgages are aggregated in an RMBS, and all their cash flows (interest + scheduled repayment + unscheduled repayment) are aggregated and paid out to the investors in the RMBS ▪ Unscheduled repayments mean that investors could be paid earlier then expected, and this tends to happen when rates are low, i.e. investment opportunities offer lower returns ▪ Prepayments may also: ▪ occur for other, idiosyncratic, reasons E.g., Owners selling their property to buy a new one for personal (e.g., divorce) or professional (e.g., job opportunity elsewhere) circumstances. ▪ not occur even when rates decline for borrower who face difficulty in refinancing Conditional prepayment risk (CPR): ▪ Prepayment can be measured by the monthly CPR ▪ annualized prepayment of a mortgage based on the amount that has been prepaid in a particular month ▪ Intuitively, if 1% of a mortgage is reimbursed in a given month, CPR will be about 12% ▪ The actual amount is 11.4% because of compounding with a declining balance, but this is not important here ▪ The Public Securities Association (PSA) publishes a benchmark of CPR ▪ The exhibit on the right shows PSA’s benchmark CPR for a 30-year mortgage Forecasting prepayment risk: ▪ Investors willing to create alpha out of RMBS need to estimate prepayment risk vs the benchmark rate with high precision ▪ This requires sophisticated models about: ▪ Evolution of interest rates ▪ Behavior of borrowers ▪ Real estate market dynamics ▪ Job market dynamics Session 4: Private Equity ▪ In this module we discuss Private Equity, defined as the investment in equity or quasi-equity securities of non- listed companies ▪ The definition can be confusing: ▪ private equity does not mean necessarily investing in the equity of non-listed companies, quasi-equity (e.g., mezzanine or distressed debt) also qualify as private equity ▪ In some context private equity is actually used to refer only to a subset of late-stage deals deals (buyouts, LBOs, etc) and is contrasted to venture capital Types of PE ▪ Three broad classes: ▪ Venture capital -> investment in young companies with high growth potential ▪ Buyout -> investment in more mature companies, often in a“juncture phase” ▪ Debt types of private equity Venture Capital • Seed stage: research business ideas, develop prototype products, or conduct market research • Start- up stage: recently created companies with well articulated business and marketing plans. • Expansion stage: expand production capacity, product development, or provide working capital. • Replacement capital: purchase shares from other existing venture capital investors or to reduce financial leverage. Venture and startup finance Buyout: • Acquisition capital: Financing in the form of debt, equity, or quasi- equity provided to a company to acquire another company. • Leverage buyout: Financing provided by an LBO firm to acquire a company using significant leverage. • Management buyout: Financing provided to the management to acquire a company, specific product line, or division (carve- out). Type of buyout: 1) Efficiency buyouts: LBOs that improve operating efficiency. E.g., large public companies with widespread equity ownership, management compensated based on revenue growth, leading to excessive expansion and operating inefficiencies 2) Entrepreneurship stimulators: LBOs allow management to concentrate on innovations, often focuses on an unwanted or neglected operating division within a larger firm 3) The overstuffed corporation: value created by splitting conglomerates or focusing on core business. Conglomerates can drain profits from profitable divisions to prop up failing divisions; an LBO can dismantle inefficient conglomerates, shut down or sell inefficient operations, and allow profitable divisions to reinvest and meet their growth potential 4) Buy-and-build strategy: synergistic combination of several operating companies or divisions through additional buyouts. Opposite of stripping a conglomerate down to its most profitable divisions, this strategy pursues an assembling approach. This type of strategy is also known as a leveraged buildup or roll up. 5) Turnaround strategy: approach used by LBO funds that look for underperforming companies with excessive leverage or poor management. The targets for turnaround LBO specialists come from two primary sources: (1) ailing companies on the brink of bankruptcy, and (2) underperforming companies in another LBO fund's portfolio. Debt type private equity: • Mezzanine finance: Financing generally provided in the form of subordinated debt and an equity kicker (warrants, equity, etc.) frequently in the context of LBO transactions. • Distressed securities: Financing of companies in need of restructuring or facing financial distress. The Buy to sell model: LPs and GPs: ▪ Private equity is often structured in a limited partnership ▪ General partners (GPs): govern the fund and take all operating decisions ▪ Limited partners (LPs): have limited liability but no say over the operation of the fund (selection, exit etc.) ▪ Limited partnerships or similar structures exist in most countries that have a thriving PE industry ▪ PE limited partnerships tend to be: ▪ Closed-end -> not open to the entry of additional investors ▪ Limited duration -> capital returned to investors within 10 years (with possible extensions) Capital drawdowns: • Private equity funds do not draw down (or call in) all capital at once • Investors agree to a committed capital that will be called in during the first years of life of the fund • The committed capital that is not called in yet is also known as “dry powder” • An investor who defaults on a capital call can be penalized (e.g., by having its share reduced) Fees in PE:  A typical private equity fee would have: • Management fee of 2% on the called-in capital • Carried interest of 20% on the return to investors  This 2/20 fee has been used traditionally but is now getting more and more under pressure  Fee rebates can also be negotiated with specific investors  Fees (and especially management fees) are the number 1 concern of LPs when it comes to interest alignment with GPs Other PE clauses: • Key man clause: a certain number of key named executives are expected to play an active role in the management of the fund, otherwise no further investment can be made • Tag- along, drag along rights: any potential future acquirer of a portfolio company may not acquire control without extending an acquisition offer to all shareholders, including the management of the company. • No- fault divorce. A GP may be removed without cause, provided that a super • majority (generally above 75 percent) of LPs approve that removal. • Removal for “cause”: removal of the GP or earlier termination of the fund for “cause” (negligence, key person event, bankruptcy of the GP, material breach of the fund prospectus) • Investment restrictions: minimum level of diversification (geographic and/or sector focus), or limits on borrowing • Co- investment. LPs could have first right of co-investing along with the GP. GPs are limited in their possibility to co-invest (e.g., with later fund) Staging: • Private equity investors often “stage” their investment in • target companies, especially so in venture capital deals • Only part of the capital needed to fund the growth/restructuring of the company is investment in the first round • Later rounds (series A, B, C etc.) are unlocked as the company reaches milestones • Staging should allow private equity stops investing in unsuccessful companies as soon as possible, avoiding to throw “good money after bad” • Especially important in early stage where majority of deals are unsuccessful Risk and cost investing in PE • Illiquidity of investments: PE shares are generally not traded in secondary markets • Unquoted investments: PE portfolio companies are not listed  less liquid, less transparent, less regulated, lower accounting standards etc. • Competition for attractive investment opportunities: PE funds compete to invest in the best private companies (see Gompers, Lerner, 2000: fund inflows boost valuations) • Reliance on GPs and management of investee companies • Lack of diversification: a PE fund will only invest in a handful of companies • Market risk: PE is not a great diversification of an equity portfolio (see later) Valuation of PE deals: o Interesting to discuss how target companies are valued by PE investors o Gain better understanding of: • Differences among PE funds • Drivers of value creation in PE investment o We can give a first look at how different valuation techniques are used in PE: • DCF approach • Multiples • Real options • Replacement cost DCF approach in PE: • Value is obtained by discounting expected future cash flows at an appropriate cost of capital • Used across a broad spectrum of company stages • Most applicable from expansion up to the maturity phase when expected cash flows easier to forecast (e.g., sufficient operating history) • Discounts for lack of control and liquidity are often applied Multiples in PE: o Application of an earnings multiple to the earnings of a portfolio company o Earnings multiple frequently obtained from the average of a group of public companies operating in a similar business and of comparable size • Price/Earnings (P/E) • Enterprise Value/EBITDA • Enterprise Value/Sales o If comparables are public companies  Discounts for lack of control and liquidity Real option approach in PE: • Consider key business decisions as call or put options • Applies mostly in startup phase when company has significant flexibility in making radically different strategic decisions (i.e., option to undertake or abandon a high risk, high return project) • Requires judgmental assumptions about key option nature and parameters Replacement cost: • Estimated cost to recreate the business as it stands as of the valuation date (see: cost method in real estate) • Generally applies to early (seed and start- up) stage companies or companies operating at the development stage and generating negative cash flows (for which DCF is hard) The LBO model:  The LBO model has three main input parameters: • the cash flow forecasts of the target company • the expected return from the providers of financing (equity, senior debt, high yield bonds, mezzanine) • the amount of financing available for the transaction  Exit value estimated based on multiples Other aspect of the LBO models:  Scenarios for both cash flows and exit (timing and multiples) are developed (often using Monte Carlo) to estimate distribution of IRR  The LBO model needs a much more complex analysis because of: • Convertible securities • Additional rounds of debt financing • Staging of equity financing • Clauses of bonds and loans The “Venture Capital” model • Main differences: o The value here comes entirely from expected valuation at exit (no debt involved) o VC will only get a fraction of the shares (whereas a buyout takes the totality) o Cash investment needed to fund the growth of the company o Investment often staged • Five steps: o Post-money value o Pre-money value o Share acquired o Number of shares o Share price Simple case without staging V = terminal value (at time of exit) = $25 million (in four years) if successful exit t = time to exit event = 4 years I = amount of required investment = $3 million r = discount return used by investors = 50 percent x = number of existing shares (owned by the entrepreneurs) = 1 million Step 1: Step 2: Step 3: Step 4: Step 5: Bottom line of this example: With a discount rate of 50% and investment of $3 million in the startup, and given an expected exit in 4 years at $25 million, the VC needs to subscribe approximately 1.55 million shares at $1.94 per share ▪ The importance of the different parameters is shown in the next slide: ▪ Variation 1: Exit value down by 10% ▪ Variation 2: discount rate up 10 percentage points ▪ Variation 3: investment up by 10% ▪ Variation 4: time to exit up by 10% Required return vs discount rate Valuation of private equity funds ▪ In this section we focus on how an investor can assess the performance of a private equity fund ▪ Note that these funds are closed, hence an investor generally cannot invest in a well-performing fund after its initial constitution ▪However: ▪It is important for an investor to assess the performance of a fund it has invested in ▪ Often investors assess the performance of other funds managed by the same GPs as indication of future performance (persistence of performance) ▪ Although rarely, some secondary transaction among LPs may exist Valuation of fund’s asset: ▪ Each PE fund holds investments in private companies that are hard to appraise ▪ The fund’s net asset value (NAV) can be calculated: ▪ At cost without any adjustment ▪ At cost, with adjustments for subsequent financing events and deterioration ▪ At the lower of cost and appraised value ▪ At post-money value, updated at each round ▪ Based on a peer-group of public companies and applying illiquidity discount ▪ IPEV (an industry workgroup) publishes best practices for valuation in private equity Conflict of interest in valuation: ▪ At the end of the life of the fund, the value that has been paid out to investors, and the money the investors put in are known ▪ However, the timing of the overall performance may affect the amount of fees paid by LPs (especially if the fund has a hurdle rate and no clawback) ▪ Because fees are based on NAV, GPs and LPs have a potential conflict of interest and it is best practice that the valuation of the fund’s holdings be made by an independent entity, rather then by the GPs Gross and net IRR: One way to assess the performance of a fund is to calculate its gross and net IRR ▪ Gross IRR is based on the flows between portfolio companies and the fund ▪ Net IRR is based on the flows between the fund and the investors ▪ Gross and net IRR differ mainly because of management fees and carried interest ▪ IRR can be compared with a peer group of funds: ▪ Within the same strategy and geography (similar risk profile) ▪ In the same vintage (similar investment opportunities) ▪ Limitations of IRR analysis: ▪ IRR has some shortcomings that are discussed in capital budgeting and apply here too ▪ Calculating IRR requires in-depth information about funds, which might be hard to come by systematically Ratios: Ratios commonly used to describe a private equity fund ▪ PIC (paid in capital) -> ratio of paid-in to committed capital ▪ DPI (distributed to paid-in) -> ratio of cumulative amount distributed to investors to total amount paid-in ▪ RVTPI (residual value to paid-in) -> ratio of current value of holdings (net of all fees) to cumulative paid-in capital ▪ TVTPI (total value to paid-in) -> ratio of all distributions plus current holdings to cumulative paid-in capital ▪ Called-down: committed capital called-down by the fund ▪ Realized results: gains/losses from exits ▪ Unrealized results: gains/losses from revaluations ▪ Distribution: amount distributed to investors Ratios over the life of the fund Performance of buyout and VC Multavariate Beta Recent trend in PE: • Attempts to create a secondary market for LP shares  • better liquidity for LPs but not necessarily good for GPs • Private investment in public equity (PIPE)  private placements in seasoned offerings of public companies • Hedge funds growingly acting as, and competing with, private equity • Mega funds, such as the $100 bn SoftBank vision fund, and sovereign wealth funds investing in late stages of the VC cycle, delaying or replacing IPOs Debt type of PE Two main types: • Mezzanine debt • Distressed debt Debt and contigent claims: • The contingent-claim view of a company sees its securities (equity and debt) as bundles of option on the underlying assets • Equity can be seen as: o A long call on assets o A leveraged long position on assets, and a long put on the assets • Similarly debt can be seen as: o a long position on assets, and short call on assets o A risk free security, and a short put on the assets Mezzanine debt and contingent claims: • Mezzanine debt tends to be associated with an equity kicker • Equity kicker is a warrant or option on firm’s equity given to • the lender • Note that because debt can be considered as assets – a call option on the assets, and equity kicker is an option on equity (which is in turn an option on the assets), mezzanine debt can be structured to approximate an unlevered position on the underlying assets of the firms • Mezzanine is different from other types of debt like: o Leveraged loans: loans to companies that already have high leverage o High-yield bonds: bonds issued by issuers below investment grade o PIK toggle: • A PIK (payment-in-kind) toggle refers to the fact that the company can pay coupons in cash OR in kind • The payment in kind can be done by issuing additional mezzanine debt Uses Mezzanine finance • The following are common uses of mezzanine finance o for a management buyout o for growth and expansion o for an acquisition o to recapitalize a company o in commercial real estate o in a leveraged buyout o as bridge financing • In general mezzanine finance caters to mid-sized companies and is rarely above $400 mln Some characteristic: • Because they are considered quasi-equity, mezzanine lenders may require board seats • Mezzanine debt may include clauses to prevent companies from issuing more debt without renegotiating the terms of mezzanine financing • Mezzanine debt may have covenants that impose an acceleration on reimbursement of mezzanine debt Distressed debt: • What is distressed debt? • Distressed debt is often defined as debt that has deteriorated in quality since issued and: o has a market price less than half its principal value o yields 1,000 or more basis points over the riskless rate o or has a credit rating of CCC (Caa) or lower • Interest is in the capital appreciation that can be achieved in various situations, rather than in coupon payments, debt service, and repayment schedules • Distress debt is as close to vulture investors as you can get Difference for mezzanine • Mezzanine debt is made equity-like primarily through equity kickers -> when asset value goes up, mezzanine becomes equity • Distressed debt becomes equity-like through potential default risk -> company defaults and debt is converted into equity • In the contingent claim view, distressed debt is so out of the money that is essentially behaves like a long position in assets without any need for equity kickers Approach to distressed investment: • Active approach with intent to obtain control of the company. Get blocking position in the bankruptcy process and convert debt into the equity of the reorganized company. Often, these investors purchase fulcrum securities (the more junior debt securities that are most likely to be converted into the equity of the reorganized company) • Active approach without intent to obtain control of the company. Objective is to participate in the bankruptcy process, and convert position into other debt securities (possibly with equity kickers) • Passive or opportunistic investors. Buy debt securities that no one else is eager to buy and free-ride on bankruptcy process Hard times for distressed debt: • Current situation of distressed debt funds not great o Expectation for downturn resulted in all times high fundraising o All times high dry powder and no signal of significant slowdown of economy o Availability of capital deteriorates ability of distressed debt to buy cheaply and impose covenants during bankruptcy o Interest rates are very low, making it easier for poorly- performing companies to “limp on” for longer