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ALTERNATIVE INVESTMENT

FEATURES, METHODS, AND STRUCTURES

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LOS     76.a:   Describe       features        and     categories    of alternative investments.	available online.

MODULE 76.1: ALTERNATIVE

Alternative investments comprise various types of investments that do not fall under the heading of traditional      investments, which refers to long-only investments in cash or publicly traded stocks and bonds.

Types of alternative investment structures include hedge funds, private equity funds, and various types of real estate investments. Alternative investments typically are actively managed and may include investments in commodities, infrastructure, and illiquid securities.

The perceived bene its of including alternative investments in portfolios are risk reduction from diversi ication (due to low correlations of alternative investments with traditional investments) and possible higher returns from holding illiquid securities, and from markets for some alternative investments possibly being less ef icient than those for traditional investments.

Compared with traditional investments, alternative investments typically exhibit the following features:

More specialized knowledge required of investment managers

Relatively low correlations with returns of traditional investments

Less liquidity of assets held

Longer time horizons for investors

Larger size of investment commitments

As a result of these unique features, alternative investments exhibit the following characteristics:

   Investment structures that facilitate direct investment by managers

 Information asymmetry between fund managers and investors, which funds typically address by means of incentive-based fee structures

 Dif iculty in appraising performance, such as more problematic and less available historical returns and volatility data

Although correlations of returns on alternative investments with returns on traditional investments may be low on average, these correlations may increase signi icantly during periods of economic stress.

We will examine several types of alternative investments in detail in separate readings in this topic area. We may classify alternative investments into three broad categories of private capital, real assets, and hedge funds.

1.  Private     capital includes private equity and private debt:

–   As the name suggests, private        equity funds invest in the equity of companies that are not publicly traded, or in the equity of publicly traded irms that the funds intend to take private. These irms are often in the mature or decline stages of their industry life cycle. Leveraged            buyout (LBO) funds use borrowed money to purchase equity in established companies and comprise most private equity investment funds. Venture   capital funds invest in young, unproven companies at the start-up or early stages in their life cycles.

–   Private    debt funds may make loans directly to companies, lend to early-stage irms (venture debt), or invest in the debt of irms that are struggling to make their debt payments or have entered bankruptcy (distressed   debt).

2.  Real          assets include real estate, infrastructure, natural resources, and other assets such as digital assets:

–   Real          estate investments include residential or commercial properties, as well as real estate– backed debt. These investments are held in various structures, including full or leveraged ownership of individual properties, individual real estate–backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.

–   Natural   resources include commodities, farmland, and timberland. To gain exposure to commodities, investors can own physical commodities, commodity derivatives, or the equity of commodity-producing irms. Some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts (futures) that are expected to track a speci ic commodity index. Farmland can produce income from leasing the land out for farming or from raising crops or livestock for harvest and sale. Timberland investment involves purchasing forested land and harvesting trees to generate cash lows.

–   Infrastructure refers to long-lived assets that provide public services. These include economic infrastructure assets (e.g., roads, airports, and utility grids) and social infrastructure assets (e.g., schools and hospitals). While often inanced and constructed by government entities, infrastructure investments have more recently been undertaken by public-private       partnerships, with each holding a signi icant stake in the infrastructure assets. Various deal structures are employed, and the asset may revert to public ownership at some future date.

–   Other types of real assets include collectibles such as art, intangible assets such as patents, anddigital   assets such as cryptocurrencies.

3.  Hedge      funds are investment companies typically open only to quali ied investors. These funds may use leverage, hold long and short positions, use derivatives, and invest in illiquid assets. Managers of hedge funds use many different strategies in attempting to generate investment gains. They do not necessarily hedge risk, as the name might imply.

LOS   76.b:  Compare      direct investment, co-investment,       and     fund   investment methods      for      alternative   investments.

Fund investing refers to investing in a pool of assets alongside other investors, using a fund manager who selects and manages a pool of investments using an agreed-upon strategy. In this case, the individual investors do not control the selection of assets for investment or their subsequent management and sale. The manager typically receives a percentage of the investable funds (management fee) as well as a percentage of the investment gains (incentive fee).

Compared to funds that invest in traditional asset classes, alternative investment funds typically require investors to commit larger amounts of capital for longer periods, provide less information on positions held and returns earned, and charge higher management fees. A fund’s term sheet describes its investment policy, fee structure, and requirements for investors to participate.

With co-investing, an investor contributes to a pool of investment funds (as with fund investing) but also has the right to invest, directly alongside the fund manager, in some of the assets in which the manager invests. Compared to fund investing, co-investing can reduce overall fees while bene iting from the manager’s expertise. Co-investing also can provide an investor with an opportunity to gain the skills and experience to pursue direct investing. For a fund manager, permitting co-investment may increase the availability of investment funds and expand the scope and diversi ication of the fund’s investments.

Direct           investing refers to an investor that purchases assets itself, rather than pooling its funds with others or using a specialized outside manager. Larger, more knowledgeable investors may purchase private companies or real estate directly. For example, a sovereign wealth fund may have its own specialized managers to invest in real estate, agricultural land, or companies in the venture stage.

Direct investing has advantages in that there are no fees to outside managers, and the investor has more control over investment choices. Disadvantages include the possibility of less diversi ication across investments, higher minimum investment amounts, and greater investor expertise required to evaluate deals and perform their own due diligence.

LOS   76.c:   Describe       investment  ownership   and     compensation         structures commonly  used   in        alternative   investments.

Alternative investments are often structured as limited    partnerships. In a limited partnership, the general partner         (GP) is the fund manager and makes all the investment decisions. The limited     partners       (LPs) are the investors, who own a partnership share proportional to their investment amounts. The LPs typically have no say in how the fund is managed and no liability beyond their investment in the partnership. The GP takes on the liabilities of the partnership, including the repayment of any partnership debt. Partnerships typically set a maximum number of LPs that may participate.

LPs commit to an investment amount, and in some cases, they only contribute a portion of that initially, providing the remaining funds over time as required by the GP (as fund investments are made). General partnerships are less regulated than publicly traded companies, and limited partnership shares are typically only available to accredited investors—those with suf icient wealth to bear signi icant risk and enough investment sophistication to understand the risks.

The rules and operational details that govern a partnership are contained in the limited partnership           agreement. Special terms that apply to one limited partner but not to others can be stated in side        letters. For example, an LP might negotiate an excusal right to withhold a capital contribution that the GP would otherwise require. Some limited partners may require that special terms offered to other LPs also be offered to them. This is known as a most-favored-nation      clause in a side letter.

While most alternative investment limited partnership holdings are illiquid, a fund may be structured as a master    limited          partnership (MLP) that can be publicly traded. Master limited partnerships are most common in funds that specialize in natural resources or real estate.

Fee Structures

The total fees paid by investors in alternative investment funds often consist of a management          fee, typically between 1% and 2% of the fund’s assets, and a performance         fee or incentive      fee (sometimes referred to as carried  interest).

The fund manager earns the management fee, regardless of investment performance. For hedge funds, the management fees are calculated as a percentage of assets under management (AUM), typically the net asset value of the fund’s investments. For private equity funds, the management fee is calculated as a percentage of committed        capital, not invested capital. Committed capital is typically not all invested immediately; rather, it is “drawn down” (invested) as securities are identi ied and added to the portfolio. Committed capital is usually drawn down over three to ive years, but the drawdown period is at the discretion of the fund manager. Committed capital that has not yet been drawn down is referred to as dry powder. The reason for basing management fees on committed capital is that otherwise, the fund manager would have an incentive to invest capital quickly instead of selectively.

Performance fees (also referred to as incentive fees) are a portion of pro its on fund investments. Most often, the partnership agreement will specify a hurdle        rate (or preferred   return) that must be met or exceeded before any performance fees are paid. Hurdle rates can be de ined in two ways: either “hard” or “soft.” If a soft          hurdle           rate is met, performance fees are a percentage of the total increase in the value of each partner’s investment. With a hard hurdle           rate, performance fees are based only on gains above the hurdle rate.

For example, consider a fund with a hurdle rate of 8% that has produced a return of 12% for the year. We will use a performance fee structure of 20% of gains. If the 8% is a soft hurdle rate, the performance fee will be 20% of the entire 12%, or 2.4%. If the 8% is a hard hurdle rate, the performance fee will be 20% of the gains above the hurdle rate (12% – 8% = 4%), which would be 0.8%.

Typically, performance fees are paid at the end of each year based on the increase in the value of fund investments, after management fees and other charges, which may include consulting and monitoring fees that are charged to individual portfolio companies.

A catch-up  clause in a partnership agreement is based on a hurdle rate and is similar in its effect to a soft hurdle rate. Consider a fund with returns of 14%, a hurdle rate of 8%, and a 20% performance fee. A catch-up clause would result in the irst 8% of gains going to the LPs and the next 2% going to the GP, allowing the GP to “catch up” to receiving 20% of the irst 10% of gains. After the catchup, further gains are split 80/20 between the LPs and the GP.

Another feature that is often included is a high-water        mark, which means no performance fee is paid on gains that only offset prior losses. Thus, performance fees are only paid to the extent that the current value of an investor’s account is above the highest net-of-fees value previously recorded (at the end of a payment period). This feature ensures that investors will not be charged performance fees twice on the same gains in their portfolio values. Because investors invest in a fund at different times, they each may have a different high-water mark value.

A partnership’s waterfall refers to the way in which payments are allocated to the GP and the LPs as pro its and losses are realized on deals. With a deal-by-deal        waterfall (or American    waterfall), pro its are distributed as each fund investment is sold and shared according to the partnership agreement. This favors the GP because performance fees are paid before 100% of the LPs’ original investment plus the hurdle rate is returned to them. With a whole-of-fund      waterfall (or European   waterfall), the LPs receive all distributions until they have received 100% of their initial investment plus the hurdle rate (typically after all fund investments have been sold).

A clawback provision stipulates that if the GP accrues or receives incentive payments on gains that are subsequently reversed as the partnership exits deals, the LPs can recover previous (excess) incentive payments. With a deal-by-deal waterfall, successful deals might be exited initially, while losses are realized later. A clawback provision would allow the LPs to recover these performance fees to the extent that the subsequent losses negate prior gains on which performance fees had been paid.

        MODULE QUIZ 76.1

1.  Compared with alternative investments, traditional investments tend to:

A.  be less liquid.

B.  have lower fees.

C.  require more specialized knowledge.

2.  An investor who wants to gain exposure to alternative investments but does not have the in-house expertise to perform due diligence on individual deals is most likely to engage in:

A.  co-investing.

B.  fund investing.

C.  direct investing.

3.  Management fees for a private capital fund are determined as a percentage of:

A.  invested capital.

B.  committed capital.

C.  assets under management.

4.  For an investor in a private equity fund, the least advantageous of the following limited partnership terms is a(n):

A.  clawback provision.

B.  European-style waterfall provision.

C.  American-style waterfall provision.

KEY CONCEPTS

LOS 76.a

Alternative investments comprise various types of investments that do not fall under the heading of traditional investments. Categories of alternative investments include the following:

Hedge funds

Private capital (private equity and private debt)

Real assets (real estate, natural resources, and infrastructure)

Alternative investments have relatively low correlations with returns of traditional investments. Compared with traditional investments, alternative investments typically require more specialized knowledge of investment managers. Assets held tend to be less liquid, making alternative investments appropriate for investors who have long time horizons and can commit large amounts of capital.

LOS 76.b

Fund investing refers to pooling assets along with other investors, using a fund manager that selects and manages investments according to an agreed-upon strategy.

Co-investing refers to fund investing that includes the right to invest additional capital directly alongside the fund manager.

Direct investing refers to purchasing assets independently, rather than pooling funds with others or using a specialized outside manager.

LOS 76.c

Many alternative investments are structured as limited partnerships, in which the GP is the fund manager and the LPs are the investors. They are less regulated than publicly traded companies and are typically only available to accredited investors. LPs may commit to an investment amount and, in some cases, contribute only a portion of that initially, providing the remaining funds over time as required by the GP.

Fees in alternative investment funds often consist of a management fee and a performance fee. For hedge funds, management fees are a percentage of assets under management. For private capital, management fees are a percentage of committed capital rather than capital invested.

Performance fees are a portion of pro its on fund investments. Typically, a hurdle rate must be exceeded before performance fees are paid. With a soft hurdle rate, performance fees are based on the total increase in the value of each partner’s investment. With a hard hurdle rate, performance fees are based only on gains above the hurdle rate. A high-water mark is a provision that no performance fees are paid on gains that only offset prior losses.

A waterfall refers to the way payments are allocated to the GP and the LPs. With a dealby-deal or American waterfall, pro its are distributed as each fund investment is sold. With a whole-of-fund or European waterfall, the LPs receive all distributions until they have received 100% of their initial investment plus the hurdle rate.

With a clawback provision, if the GP receives incentive payments on gains that are subsequently reversed, the LPs can recover excess incentive payments.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 76.1

1.  B    Traditional investments typically have lower fees, require less specialized knowledge by investment managers, and are more liquid than alternative investments. (LOS 76.a)

2.  B    With fund investing, due diligence on the fund’s portfolio investments is a responsibility of the fund manager rather than the fund investors. Direct investing and co-investing require greater due diligence of individual deals on the part of the investor. (LOS 76.b)

3.  B    For a private capital fund, management fees are a percentage of committed capital rather than invested capital. For a hedge fund, management fees are a percentage of assets under management. (LOS 76.c)

4.  C    An American-style waterfall structure has a deal-by-deal calculation of incentive fees to the GP. In this case, a successful deal where incentive fees are paid, followed by the sale of a holding that has losses in the same year, can result in incentive fees greater than those calculated using a European-style (whole-offund) waterfall. A clawback provision bene its the limited partners by allowing them to recover performance fees paid earlier if the fund realizes losses later. A clawback provision, coupled with an American-style waterfall, will result in the same overall performance fees as a European-style waterfall if the transactions occur in subsequent years. (LOS 76.c)

READING 77

ALTERNATIVE INVESTMENT PERFORMANCE AND RETURNS

AND RETURN CALCULATIONS	Video covering this content is
LOS     77.a:   Describe       the      performance           appraisal      of alternative investments.	available online.

MODULE 77.1: PERFORMANCE APPRAISAL

Alternative investments are typically exposed to greater risks than unleveraged longonly traditional investments. These additional risks arise from the following:

Timing of cash lows over an investment’s life cycle

Use of leverage by fund managers

Valuation of investments that may or may not have observable market prices Complexity of fees, taxes, and accounting

Ideally, returns on alternative investments should be adjusted for these risks, although that may be dif icult in practice. It is clear, however, that evaluating alternative investment returns (or expected returns) without considering these additional risks would be naıv̈e and possibly misleading.

Timing of Cash Flows

Alternative investments often have a life cycle that exhibits three phases:

1.  In the capital      commitment           phase, a fund’s managers are identifying investments and making capital       calls from the partners. Recall that limited partners commit a stated amount of capital that they will invest, but they do not necessarily deliver the entire amount immediately in cash. Managers make capital calls as they identify investments for which they require cash. Because of these cash out lows and the long-term nature of the typical investments, returns tend to be negative during the capital commitment phase.

2.  During the capital         deployment phase, the managers fund, and often involve themselves directly in, the irms or projects in which they invest. Returns typically remain negative in this phase, especially if the investments are in start-up companies or troubled irms that the managers are attempting to turn around.

3.  If the fund’s investments succeed and begin to generate income and cash lows, the fund enters a capital  distribution             phase during which its returns turn positive and accelerate.

A J-curve     effect (illustrated in Figure 77.1) re lects the norm of negative returns in the capital commitment phase, followed by increasing returns in the capital deployment phase and maximum returns in the capital distribution phase. Returns may reach a plateau toward the end of a fund’s life as the managers exit any remaining investments.

Figure 77.1: J-Curve Example

Given the variability of cash lows over a fund’s life and the importance of management decisions in the timing and magnitude of after-tax cash lows, an IRR over the life of a fund is the most appropriate measure of after-tax investment performance. (Recall from Quantitative Methods that a money-weighted rate of return, which is an IRR, is appropriate when a manager controls the timing of cash in lows and out lows.) A drawback to using IRRs is that they rest on assumptions about the cost of capital for cash out lows and the reinvestment rate for cash in lows.

A simpler measure of investment success is the multiple  of        invested        capital (or money         multiple)—the ratio of total capital returned plus the value of any remaining assets, to the total capital paid in over the life of the investment. Because this measure does not consider the timing of cash in lows and out lows, which can affect annual returns on invested capital signi icantly, it can be considered somewhat naıv̈e.

Use of Leverage

Some alternative investments, particularly hedge funds, use borrowing to magnify their gains (at the risk of magnifying losses). Hedge funds may arrange margin inancing with prime           brokers or employ leverage by means of derivatives.

To state the effect of leverage on returns, consider a fund that can invest the amount V₀ without leverage, and earn the rate of return r. The fund’s unleveraged portfolio return (as a money amount) is simply this: r × V₀. Now, let’s say this fund can borrow the amount V_B at an interest rate of r_B, and earn r by investing the proceeds. The fund’s leveraged portfolio return (again, as a money amount), after subtracting the interest cost, then becomes:

Thus, stated as a rate of return on the initial portfolio value of V₀, the leveraged rate of return is as follows:

One of the reasons that funds use leverage is that some strategies attempt to exploit relatively small pricing anomalies that might not produce meaningful results without leverage. A risk from using leverage is that a lender may issue margin calls if a fund’s equity position decreases below a certain level. These can result in a fund having to realize losses by closing positions or liquidating investments at unfavorable prices. If the fund must sell a large position in a security, doing so may depress its price further. Another important risk of funds that depends on leverage is that lenders may limit their access to additional borrowing.

Valuation of Investments

As we have discussed, many alternative investments involve illiquid assets that do not trade frequently in transparent markets. While funds must recognize investments at fair value to comply with accounting standards, fair value might rest on assumptions of which an investor in a fund should be aware. A fair          value  hierarchy groups these assumptions into the following three levels:

   Level         1. The assets trade in active markets and have quoted prices readily available, such as exchange-traded securities.

   Level         2. The assets do not have readily available quoted prices, but they can be valued based on directly or indirectly observable inputs, such as many derivatives that can be priced using models.

   Level         3. The assets require unobservable inputs to establish a fair value, such as real estate or private equity investments, for which there have been few or no market transactions.

Particularly for Level 3 investments, the absence of market activity can result in valuations that remain near their initial cost for long periods. As a result, these values might not re lect the actual exit costs of the investments. Importantly, this relative lack of change in fair values can make reported returns for alternative investments appear higher, less risky, and less correlated with traditional investments than they really are.

Fee Structures

In the next LOS, we will examine some of the effects on investors’ returns of different fee speci ications, such as high-water marks, hard or soft hurdle rates, and waterfall structures. Keep in mind that fee structures are subject to negotiation (e.g., a limited partner might agree to a higher management fee in exchange for fewer restrictions on redemptions) and may differ depending on how early in a fund’s life cycle an investor commits capital. Thus, different investors in the same fund might realize signi icantly different returns.

LOS   77.b:  Calculate      and     interpret      alternative   investment  returns         both           before           and after      fees.

We have seen how margin calls may require a leveraged fund to exit investments at unfavorable prices and unintended times. A similar risk arises from investor redemptions. The more negative a fund’s returns, the more likely investors are to ask the manager to redeem their positions. For this reason, and because of the J-curve effect of negative returns in the early years, alternative investment funds (particularly hedge funds) typically take measures to restrict early redemptions.

A lockup      period is the time after initial investment over which limited partners either cannot request redemptions or incur signi icant fees for redemptions. A notice          period (typically between 30 and 90 days) is the amount of time a fund has to ful ill a redemption request. Notice periods allow time for managers to reduce positions in an orderly manner. Fund managers often incur signi icant transactions costs when they redeem shares. Redemption           fees can offset these costs. Managers may also have the discretion to implement a gate that restricts redemptions for a temporary period.

Investors should be aware that other investors may receive terms that differ from those stated in the partnership agreement. Customized fee structures are contained in side letters with individual investors detailing how their terms differ from those in the standard offering documents.

Although “2 and 20” and “1 and 10” were, at one time, fairly standard fee structures for fund and fund-of-funds investments, these fee structures continue to be under competitive pressure. Investors making larger commitments can negotiate lower fees. There can also be a tradeoff between liquidity provisions and fees. Investors can negotiate for lower fees or better liquidity (shorter lockups and notice periods). Hurdle rates, hard versus soft hurdles, and catch-up provisions may also be subject to negotiation.

Early investors in a fund may also receive lower fees or better liquidity terms as an incentive to invest at the fund’s inception. The investment interests of early investors who receive such relatively better terms are called founders    class   shares.

Annual investor fees can also be either-or     fees, the maximum of the management fee or the incentive fee. Under such a structure, with a 1% management fee and a 30% incentive fee, investor fees each year would simply be the management fee unless the calculated incentive fee is higher. Such a structure may also stipulate that the 1% management fee be subtracted from the incentive fee in a subsequent year.

Biases in Alternative Investment Returns

Numerous alternative investment indexes exist to measure historical performance. However, they may not provide much meaningful information on the asset class because each fund’s structure is unique, and the funds that exist at any given time can be in widely different phases of their life cycles. One way around this latter issue is to compare funds that originated in the same vintage         year.

The effect of survivorship          bias is greater for a hedge fund database than for other asset classes because by some estimates, more than 25% of hedge funds fail in the irst three years of their existence. An index that does not include failed funds will overstate the returns and understate the risk of hedge funds as an asset class. These effects may be magni ied by back ill          bias, which occurs when managers only select their successful funds for inclusion in indexes.

Return Calculations for Alternative Investments

Before-fee returns on alternative investments are calculated the same way we calculate returns on any investment. The calculation of holding period returns and periodic rates of return, both with and without interim cash distributions, is described in Quantitative Methods and expanded on by application in other topic areas.

Calculating after-fee returns simply requires adjustment of the cash lows or values for the various fees involved, typically management and performance fees. For a simple case in which management fees are a ixed percentage of end-of-period assets and performance fees are a ixed percentage of total return with no hurdle rate, we can state the general partner’s total fees in money terms as follows:

This is the rate of return for an investor after fees:

Fee structure provisions, such as hurdle rates and high-water marks, make calculating total fees more complex than this simple formula. Other provisions may state whether the performance fee is net of the management fee or independent of it, or whether the management fee is based on beginning-of-period assets or end-of-period assets.

 PROFESSOR’S NOTE

Because none of these provisions are standard across alternative investment funds, exam questions that require calculations will have to specify all of those that apply. Do not assume any provision applies unless it is stated in the question.

Some examples will illustrate the application of various fees and the relevant terminology.

EXAMPLE:           Hedge            fund   fees

BJI Funds is a hedge fund with a value of $110 million at initiation. BJI Funds charges a 2% management fee based on assets under management at the beginning of the year and a 20% performance fee with a 5% soft hurdle rate, and uses a high-water

 

mark. Performance fees are calculated on gains net of management fees. The yearend values before fees are as follows: Year 1: $100.2 million Year 2: $119.0 million Calculate the total fees and the investor’s after-fee return for both years. Answer: Year 1: Management fee: 110.0 million × 2% = $2.2 million Return net of management fees: There is no performance fee because the return after the management fee is less than the 5% hurdle rate. Total fees: $2.2 million Ending value net of fees: 100.2 million – $2.2 million = $98.0 million Year 1 after-fees return: Year 2: Management fee: 98.0 million × 2% = $1.96 million Year-end value net of management fee: $119.0 – $1.96 = $117.04 million The high-water mark is $110 million. Year 2 value net of management fee, above high-water mark: 117.04 million – 110.0 million = $7.04 million Year 2 return net of management fee, above high-water mark: Due to the high-water mark, the performance fee is calculated based on gains in value above $110 million. The performance fee is calculated on the entire gain above the high-water mark because 6.4% is greater than the soft hurdle rate. If the 5% was a hard hurdle rate,

the performance fee would be calculated only on the gains more than 5% above the high-water mark. Performance fee: 7.04 × 0.20 = $1.41 million Total fees: $1.96 million + $1.41 million = $3.37 million Year 2 year-end value after fees: 119.0 – 3.37 = $115.63 million Year 2 after-fee return:

EXAMPLE:    Fund-of-funds An investor makes a total investment of $60 million in a fund-of-funds that has a “1 and 10” fee structure, with management and performance fees calculated independently based on year-end values. Of the $60 million investment, $40 million is allocated to the Alpha fund and $20 million is allocated to the Beta fund. One year later, the value of the Alpha fund investment is $45 million, and the value of the Beta fund investment is $28 million, both net of fund fees. Calculate the investor’s return for the year net of fees. Answer: At year-end, the gross value of the investor’s investment is $45 + $28 = $73 million. The fund-of-funds management fee is 1% of $73 million, which is $0.73 million. The investor’s gain for the year before fund-of-funds fees is $73 – $60 = $13 million. The fund-of-funds manager’s performance fee is 10% of $13 million, which is $1.3 million. The year-end value of the investor’s fund-of-funds investment is $73 – $0.73 – $1.3 = $70.97 million.

EXAMPLE:           Waterfall      structure      and     clawback      provision

A private equity fund invests $100 million in a venture company that is sold for $130 million. The fund also invests $100 million in an LBO that goes poorly and is liquidated for $80 million.

1.  If the carried interest performance fee for the GP is 20% and there is no clawback provision, calculate the investor’s return after performance fees, assuming the investment outcomes are realized in the same year under the following: a. An American-style (deal-by-deal) waterfall structure b. A European-style (whole-of-fund) waterfall structure 2.  How would the answers be affected if the venture investment was sold in Year 1 and the LBO investment was sold in Year 2? 3.  How would including a clawback provision affect investor returns calculated in Question 1? Answer: 1.  Under an American-style (deal-by-deal) waterfall structure, a performance fee of 20% × ($130 – $100) = $6 million would be paid on the venture investment. Because there is a loss on the LBO investment, no performance fee is paid. Under a European-style (whole-of-fund) waterfall structure, the gain for the period is 130 + 80 – 200 = $10 million, and the performance fee is 20% × 10 = $2 million. 2.  The European-style waterfall structure would have the same overall return as the American-style structure, as the performance fee for the venture investment of $6 million would be paid in Year 1 and no performance fee would be received on the LBO investment. 3.  With a clawback provision, after the LBO investment is sold, the performance fee of $6 million paid on the venture investment is more than 20% of the return on the total investment. The fee is 60% of the total (net) gain of $10 million. The investor could “claw back” $4 million of the $6 million paid as a performance fee on the venture investment, which would reduce the total performance fee to 20% of the $10 million gain.

        MODULE QUIZ 77.1

1.  Returns to investors in an alternative investment fund are most likely to be positive during its phase of capital:

A.  distribution.

B.  deployment.

C.  commitment.

2.  A hedge fund has a return of 30% before fees in its first year. The fund has a management fee of 1.5% on end-of-year fund value and a 15% incentive fee, with an 8% hard hurdle rate on gains net of the management fee. The return after fees for an investor in this fund is closest to:

A.  20.5%.

B.  21.5%.

C.  25.0%.

3.  A private equity fund has a “2 and 20” fee structure with the performance fee independent of management fees. The fund will sell a holding for a profit of 9%. The hurdle rate is specified as 8%. The provision that would result in an incentive fee of 1% is a:

A.  hard hurdle rate.

B.  soft hurdle rate.

C.  catch-up provision.

KEY CONCEPTS

LOS 77.a

Alternative investments are typically exposed to risks that traditional investments are not, including timing of cash lows, use of leverage, valuation assumptions for illiquid investments, and complex fee structures and taxation.

Alternative investment returns typically exhibit a J-curve effect: negative during the capital commitment phase, less negative during the capital deployment phase, and positive during the capital distribution phase.

Because managers control cash in lows and out lows, an IRR is appropriate for measuring returns. The multiple of invested capital is a simpler measure that does not depend on the timing of cash lows:

Assumptions underlying the fair value of assets can be described by a three-level hierarchy:

Level 1. Quoted prices readily available.

Level 2. Can be valued based on observable inputs.

Level 3. Require unobservable inputs to establish a fair value.

Fair values of Level 3 assets might be updated infrequently due to a lack of market activity. This can bias return measures upward and risk measures downward.

LOS 77.b

Before-fee returns on alternative investments are calculated the same way we calculate fees on any investment. Calculating after-fee returns requires us to adjust the cash lows or values for the various fees involved (typically management and performance fees), and for speci ications such as hurdle rates and high-water marks.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 77.1

1.  A    A successful fund is most likely to generate positive returns in its capital distribution phase. (LOS 77.a)

2.  C    This is easiest to see using an initial investment amount of 100.

Year-end gross value = 100 × 1.30 = 130

Management fee = 1.5% × 130 = 1.95

Gains net of management fee = 30 – 1.95 = 28.05

Hurdle gains = 8% × 100 = 8

Incentive fee = 15% × (30 – 1.95 – 8) = 3.0075 Total fees = 1.95 + 3.0075 = 4.9575

Ending value after fees = 130 – 4.9575 = 125.0425

Return after fees = 125.0425 / 100 – 1 = 25.0425% (LOS 77.b)

3.  C    With a catch-up provision, the limited partners receive the irst 8% of gross return, and the general partner gets all returns above that to a maximum of 2%. Gains above that are shared 80% to the limited partners and 20% to the general partner.

With a soft hurdle rate of 8%, the performance fee would be 20% of 9%, or 1.8%.

With a hard hurdle rate of 8%, the performance fee would be 20% of (9% – 8%), or 0.2%. (LOS 77.b)

READING 78

INVESTMENTS IN PRIVATE CAPITAL: EQUITY AND DEBT

LOS     78.a:   Explain          features        of        private          equity and     its       investment characteristics.	Video covering this content is available online.

MODULE 78.1: PRIVATE CAPITAL

Private         capital is the funding provided to companies that is not raised from the public markets. Private capital includes private equity and private debt.

Private         equity is equity capital raised from sources other than the public markets. Private equity funds usually invest in private companies or public companies that they plan to take private (leveraged buyout funds) or in early in companies’ lives (venture capital funds). The companies in which a private equity fund invests are called its portfolio          companies.

Private Equity Investment Categories

A popular type of private equity fund is the leveraged       buyout          (LBO) fund, which acquires public companies with a large percentage of the purchase price inanced by debt. LBOs are a way for a company to “go private” because after the transaction, the target company’s stock is no longer publicly traded.

In an LBO, the private equity irm seeks to add value by improving or restructuring the portfolio company’s operations to increase its sales, pro its, and cash lows. The cash lows can then be used to service and pay down the debt taken to fund the acquisition.

Two of the various types of LBOs are management             buyouts        (MBOs), in which the portfolio company’s existing management team participates in the purchase, and management         buy-ins          (MBIs), in which the private equity manager replaces the portfolio company’s current management team with a new team.

Venture       capital           (VC) funds provide inancing to companies in the early stages of their development. VC funds typically receive common equity interest in the portfolio companies, but they may also get convertible debt or convertible preferred stock. Convertible securities help to align the interests of the VC investors and the start-up irm, in that both want to increase the value of the irm, but give the VC investors a higher priority of claims in the event of liquidation.

VC investment involves a high level of risk, but the returns can be substantial. VC investors are actively involved in developing their portfolio companies, often sitting on the boards or illing key management roles.

We can classify VC investments by the portfolio company’s stage of development:

1.  The formative   stage refers to investments made during a irm’s earliest period and comprises three different phases:

–   Pre-seed                 capital or angel                investing is the capital provided at the idea stage. The investment funds are used for business plans and assessing market potential. The amount of inancing is usually small, coming from individuals (“angels”) rather than VC funds.

–   Seed-stage             inancing or seed              capital generally supports product development, marketing, and market research. This is the irst stage at which VC funds usually invest.

–   Early-stage           inancing or start-up      stage     inancing refers to investments made to fund operations in the lead-up to production and sales.

2.  Later-stage         inancing or expansion     venture         capital comes after production and sales have begun. Investment funds provided at this stage are used to support initial growth, expansion, product improvement, or marketing. In this stage, the owners (typically the founders and managers of the company) often sell control of the company to VC investors.

3.  Mezzanine-stage          inancing refers to capital provided to prepare the irm for an initial public offering (IPO). The term mezzanine stage is used to indicate the timing of the inancing rather than the method. A similar term, mezzanine          inancing, refers to hybrids of equity and debt, such as convertible securities. Mezzanine-stage inancing can use these, but more often, it consists of equity or short-term debt.

A private equity irm that engages in minority           equity            investing buys a less-thancontrolling interest in public companies that are looking for capital with which to expand. One way it can make such investments is through a private         investment  in public          equity            (PIPE), a private offering to institutional investors that allows a publicly traded irm to raise capital more quickly and cost effectively than a public offering, with fewer disclosures and lower transaction costs.

Private Equity Exit Strategies

Private equity irms typically add value to young companies, then sell them, with an average holding period of ive years. Funds have several methods of exiting an investment in a portfolio company:

1.  Trade       sale. Sell a portion of the private company to a strategic buyer via direct sale or auction. An advantage of a trade sale is that the strategic investor typically pays a premium to realize synergies with an existing business. Advantages compared with an IPO include faster execution and lower transaction costs. Disadvantages of a trade sale include potential resistance from the portfolio company’s management and employees, as well as a limited universe of potential buyers.

2.  Public       listing. Listing on a stock exchange can take place through an IPO, a direct listing, or a special purpose acquisition company:

–   IPOs are the most common method of public listing, using investment banks to underwrite theoffering. Compared to other methods, IPOs typically realize a higher price for the portfolio company. They may also improve its visibility to investors and the public, which can be positive for the value of shares that the private equity fund retains. However, IPOs involve high transaction and compliance costs and might not always be received favorably by the investing public. Portfolio companies best suited for exit via IPO are large irms in growing industries that have stable inances and clear strategies.

–   A less frequently used alternative to an IPO is a direct        listing, in which the stock of the company is loated on the public market directly without underwriters. This decreases the cost of the transaction, but does not raise new capital for the portfolio company.

–   A special                purpose               acquisition         company            (SPAC) is an entity (sometimes referred to as a blank check company) set up solely to raise capital that it will use to acquire an unspeci ied private company within a stated time period; otherwise, it must return the capital to investors. This method can be more lexible than an IPO and reduce the uncertainty about the valuation of the portfolio company, as well as provide access to investors who transact regularly with the sponsors. However, SPACs have numerous disadvantages, including dilutive effects from SPAC shares and warrants, a spread between the value of the SPAC and the value of the acquired company, deal risk in the acquisition, and stockholder        overhang from SPAC shareholders selling shares after the acquisition is announced. Scrutiny from securities regulators is also increasing.

3.  Recapitalization. The company issues debt to fund a dividend distribution to equity holders. This is not an exit, in that the fund still controls the company, but a recapitalization allows the private equity fund to extract money from the company to pay its investors.

4.  Secondary          sale. Sell a portfolio company to another private equity irm or a group of investors.

5.  Write-off/liquidation. Reassess and take losses from an unsuccessful investment in a portfolio company.

Risk and Return From Private Equity Investments

Empirical evidence shows that returns on private equity funds have been higher on average than overall stock returns. However, the standard deviation of private equity returns has been higher than the standard deviation of equity index returns, suggesting higher risk, including illiquidity and leverage risks. Furthermore, private equity indexes typically rely on self-reporting and are subject to survivorship and back ill biases, both of which lead to overstated returns. Because portfolio companies are revalued infrequently, measures of volatility and correlation with other investments may be biased downward.

LOS   78.b:  Explain          features        of        private          debt   and     its       investment           characteristics.

Private         debt refers to various forms of debt provided by investors directly to private entities. Categories of private debt include the following:

1.  Direct       lending refers to loans made directly to a private company without an intermediary. The debt is typically senior and secured, with covenants to protect the lender. A leveraged        loan is a loan made by a private debt fund using money borrowed from other sources. That is, the fund’s portfolio of loans is leveraged to magnify returns.

2.  Venture   debt is funding that provides VC backing to start-up or early-stage irms that are not yet pro itable. Venture debt is often convertible to stock or combined with warrants. Managers of young companies may favor venture debt because it allows them to maintain ownership and control.

3.  Mezzanine          debt is private debt that is subordinated to senior secured debt. Mezzanine debt may have special features, such as conversion rights or warrants, to compensate investors for additional risk.

4.  Distressed          debt is the debt of mature companies in inancial trouble, such as bankruptcy or default. In many cases, the fund becomes active in restructuring the existing debt or making other changes that increase the value of the acquired debt. Some distressed debt investors specialize in identifying otherwise good companies with temporary cash low problems, anticipating that the value of the company and its debt will recover. Others focus on turnaround situations, acquiring a company’s debt with an intent to be active in managing and restructuring the company.

5.  Unitranche         debt combines different classes of debt (secured and unsecured) into a single loan with an interest rate that re lects the blend of debt classes. The resulting debt typically ranks between senior and subordinated debt.

Private debt investments typically provide a higher rate of return relative to traditional bonds to compensate investors for higher risk and a lack of liquidity. Investors may also bene it from increased portfolio diversi ication because private debt returns have relatively low correlations with other traditional investments.

The interest rate of private debt is usually set relative to a reference rate, such as the Secured Overnight Financing Rate (SOFR). Therefore, the rate changes when the reference rate luctuates due to changes to the interest rate environment.

The potential for higher returns of private debt is associated with higher risk, including illiquidity and default risk. Private debt investing requires specialized knowledge about the structure of the debt, the borrower’s life cycle phase, and the features of the underlying assets for secured lending. Senior private debt has less risk and steadier yields than private mezzanine debt, but mezzanine debt offers greater upside potential.

LOS   78.c:   Describe       the      diversi ication        bene its         that    private          capital           can     provide.

Private capital investments can provide some diversi ication bene it to a portfolio of traditional investments. Empirical evidence indicates that correlations of private capital fund index returns with public market index returns range from 0.63 to 0.83.¹

Each private equity fund has a vintage            year, which is the year the fund made its irst investment. The performance of a fund is greatly in luenced by its vintage year and the phase of the business cycle in that year. Funds that begin investing during a business cycle expansion are likely to earn higher rates of return if they specialize in early-stage companies. Funds that begin investing during business cycle contractions are likely to earn higher rates of return if they specialize in distressed companies. Investors in private capital should diversify across vintage years.

Risk and return pro iles vary among categories of private capital. Private equity has the highest risk and return, followed by mezzanine debt, unitranche debt, senior direct lending, senior real estate debt, and infrastructure debt.

        MODULE QUIZ 78.1

1.  In which stage of a firm’s development is a venture capital fund most likely to make its initial investment?

A.  Start-up.

B.  Seed capital.

C.  Angel investing.

2.  In a secondary sale, a private capital firm sells one of its portfolio companies to:

A.  the public.

B.  a competitor in its industry.

C.  another private capital fund.

3.  Unitranche debt is best described as:

A.  combining different classes of debt into a single loan.

B.  having special features, such as conversion rights or warrants.

C.  a loan made by a private debt fund using money borrowed from other sources.

4.  Which type of private capital fund is most likely to earn excess returns over its life if its vintage year took place during an economic contraction?

A.  Venture capital fund. B. Distressed debt fund.

C. Leveraged buyout fund.

KEY CONCEPTS

LOS 78.a

Private equity funds usually invest in the equity of private companies or companies wanting to become private, often inancing their assets with high levels of debt:

   Venture capital funds provide capital to companies early in their development. Stages of venture capital investing include the formative stage (composed of the angel investing, seed, and early stages), the later stage (expansion), and the mezzanine stage (prepare for IPO).

   Leveraged buyouts include management buyouts, in which the existing management team is involved in the purchase, and management buy-ins, in which an external management team replaces the existing management.

 Developmental capital or minority equity investing refers to providing capital for business growth or restructuring. The irms inanced may be public or private. In the case of public companies, such inancing is referred to as a private investment in public equity.

Methods for exiting investments in portfolio companies include trade sale (sell to a competitor or another strategic buyer), IPO (sell some or all shares to investors), recapitalization (issue portfolio company debt), secondary sale (sell to another private equity irm or other investors), or write-off/liquidation.

LOS 78.b

Private debt refers to lending to private entities. Private debt investments include direct lending, venture debt, mezzanine loans, distressed debt, and unitranche debt. Private debt investing requires specialized knowledge about the structure of the debt, the borrower’s life cycle phase, and the features of the underlying assets.

LOS 78.c

Private capital investments can provide some diversi ication bene it to a portfolio of traditional investments because their correlations of returns with traditional investments are relatively low.

Investors in private capital should diversify across vintage years. Funds that begin investing during a business cycle expansion are likely to earn higher rates of return if they specialize in early-stage companies. Funds that begin investing during business cycle contractions are likely to earn higher rates of return if they specialize in distressed companies.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 78.1

1.  B    VC funds typically make their initial investments during a irm’s seed stage for product development, marketing, and market research. At the angel investing stage, the funding source is usually individuals rather than VC funds. The start-up stage or early stage follows the seed stage and refers to investments made to fund initial commercial production and sales. (LOS 78.a)

2.  C    In a secondary sale, a private capital irm sells one of its portfolio companies to another private capital fund or group of private investors. Selling a portfolio company to a competitor in its industry is known as a trade sale. Selling a portfolio company to the public requires an IPO. (LOS 78.a)

3.  A    Unitranche debt refers to combining different classes of debt into a single loan with an interest rate that re lects the blend of debt classes. (LOS 78.b)

4.  B    Funds with vintage years during contractions are likely to earn higher rates of return if they specialize in distressed companies. Funds with vintage years during expansions are likely to earn higher rates of return if they specialize in earlystage companies. (LOS 78.c)

¹ Preqin, annualized quarterly return of Private Capital Quarterly Index rebased to December 31, 2007.