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Level II

Alternative Investments - Summary

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Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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Private Real Estate Investments

Summary

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Real Estate Investment

Equity Debt

Direct investments in real estate. This can be Mortgages.

Private through sole ownership, joint ventures, real
estate limited partnerships, or other forms of
commingled funds.

Publicly Shares of real estate operating companies and Mortgage-backed securities (residential and
Traded shares of REITs. commercial).

Characteristics
Residential (single family; multi-family) and non-
• Heterogeneity and fixed locations
residential (commercial property other than multi-
• High unit value family properties, farmland and timber)
• Management intensive
• High transaction costs
Commercial real estate properties are categorized by
• Depreciation end use: office, industrial and warehouse, retail,
• Need for debt capital hospitality, multi-family, farmland and timberland
• Illiquidity
• Price determination
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Private Market Real Estate Equity Investments

Motivations: current Income, price appreciation, inflation In terms of risk/return characteristics, private real
hedge, diversification, tax benefits. estate investments fall between stocks and bonds.

Office: The demand for office properties depends heavily on employment growth— Risk Factors
especially in those industries that use large amounts of office space, such as finance
• Business conditions
and insurance. The average length of an office building lease varies globally. An
important consideration in office leases is whether the owner or tenant incurs the • Long lead time for new
risk of operating expenses, such as utilities, increasing in the future. developments
• Cost and availability of capital
Industrial and Warehouse: The demand for industrial and warehouse space is heavily
dependent on the overall strength of the economy and economic growth. • Unexpected inflation
• Demographics
Retail: The demand for retail space depends heavily on trends in consumer spending. • Lack of liquidity
Consumer spending, in turn, depends on the health of the economy, job growth,
population growth, and savings rates. A unique aspect of many retail leases is the • Environmental
requirement that the tenants pay additional rent once their sales reach a certain • Availability of information
level. This type of lease is referred to as a “percentage lease.” • Management (asset management
and property management)
Multi-Family: The demand for multi-family space depends on population growth,
especially for the age segment most likely to rent apartments. • Leverage (loan-to-value ratio)
• Other risk factors
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Valuation of Commercial Real Estate

Commercial real estate does not trade frequently; hence estimates of value (appraisals) are needed.

Definitions of value: market value, investment value (particular investor), value in use (particular user),
mortgage lending value. The highest and best use of a vacant site is the use that would result in the
highest value for the land.
Three major approaches to estimate value: income approach, cost approach and sales comparison approach.
The income approach focuses on net operating income generated from a property.

NOI is roughly analogous to EBITDA

Rental income at full occupancy

+ other income
= Potential gross income
- Vacancy and collection loss
= Effective gross income
- Operating expenses
= Net operating income

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Income Approaches
Estimate value by capitalizing NOI Discounted Cash Flow Methods

Value = NOI / Cap rate NOI = 100,000 for 5 years

Year 6 NOI = 120,000 and grows at 2%
Cap rate = Discount rate - Growth rate Property value also increases at 2%
Discount rate = 12%
Can also estimate cap rate from comparables
Reversion: estimated value obtained by selling
property in the future
The term ARY stands for all risk yield and is used in
the UK: Terminal capitalization rate
ARY = NOI / recent sales price of comparable
V5 = NOI6 / (r – g) = 120 / 0.1 = 1200
Stabilized NOI is the NOI assuming property is not
being renovated. CF0 = 0; C01 = 100, F01 = 4, C02 = 1300, I = 12

Gross Income Multiplier = Value / Gross Income Compute NPV: 1,041 (this is the value at t = 0)

Implied going in rate = 100,000/1,041,000 = 9.6%

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The Cost Approach to Valuation

Cost Approach

Used for unusual properties or properties for specialized use (comparable data not
available)

Land + replacement cost

Adjust for depreciation

Physical deterioration (curable and incurable)
Functional obsolescence
Locational obsolescence
Economic Obsolescence

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The Sales Comparison Approach

Subject property and comparables

use comparables price as starting point and then make

adjustments

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Advantages and Disadvantages of the Income Approach

• Advantage: captures cash flows investors care about

• Disadvantage: forecasts are prone to error

Advantages and Disadvantages of the Cost and Sales Comparison Approaches

• Cost approach is more reliable for new properties and less reliable for old properties

• Cost approach is most reliable for new properties with relatively modern design in a stable
market

• Sales comparison approach relies on reasonable number of comparable sales

• Problematic if comparable data is limited

• Assumes prices paid are representative of market values

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Due Diligence: Verify facts and conditions which might affect value of property:
Review leases of major tenants
Study past operating expenses
Environmental inspection
Physical/engineering inspection
…

Indices: There are many real estate indices. We (investors) should be aware of how the indices are created and
inherent limitations. Seemingly low correlations between real estate and other asset classes might be explained by
limitations of how the index is created

Appraisal Based Indices: Indices often rely on appraisals because transaction data is not available. Appraisal lag 
smoothing effect  understated volatility

Two types transaction-based indices: Repeat Sales Index and Hedonic Index. Transaction-based indices can be ‘noisy’.

Investors using debt financing will expect relatively higher returns because they are taking more risk.
Lenders will be concerned with:
• Loan to value ratio (low is safer; hence lenders will want the ratio lower than a certain number)
• Debt service coverage ratio (high is safer; hence lenders will want the ratio above a certain level)

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Publicly Traded Real Estate Securities

Summary

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Types of Publicly Traded Real Estate Securities

Public Private
REITs are tax-advantaged entities that
typically own, operate, and – to a limited
Equity REITS Private REITs extent – develop income producing real
Equity estate.
REOCs Private REOCs
REOCs are ordinary taxable corporations;
generally operate in countries that do not
have tax-advantaged REIT regime. Most
Debt Mortgage REITs Mortgage advantages and disadvantages similar to
REITs. REOCs face similar operating and
CMBS Private Debt financial risk as private real estate
investments.
RMBS Bank Debt
Equity markets generally show preference to
REITs.

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Publically Traded Equity REITs

Investment Characteristics of REITs
• Exemptions from income taxes at the corporate/trust level
• High income distributions
• Relatively low volatility of reported income
• More frequent secondary equity offerings compared with industrial companies

Advantages of Publically Traded Equity Real Estate Advantages of REITS over REOCs:
Securities • Taxation
• Earnings predictability
The following apply to REITS and REOCs: • High income payout ratios and yields
• Greater liquidity
• Lower investment requirements Advantage of REOCs over REITs
• Access to superior quality and range of properties • Operating flexibility
• Active professional management
• Diversification

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Disadvantages of Publically Traded Equity Assess specific investment characteristics,

Real Estate Securities opportunities and risks

• Taxation (can not use tax losses as • Remaining lease terms

deductions from taxable income)
• Inflation protection
• Lack of control • Market rent analysis
• Stock market determined pricing and • Costs of re-leasing space
returns • Tenant concentration
• Relatively moderate income growth • Availability of new competitive supply
potential • Balance sheet/leverage analysis
• Management

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Equity REITs: Property Subtypes

Most REITs are specialized

Factors impacting economic value of different property types

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Valuation: Net Asset Value Approach

Valuation approaches: Asset Value Based, Price Multiple Comparison, Discounted Cash Flow
Shares can trade at a discount or premium relative to NAVPS. NAVPS is the largest component of intrinsic value.

NAVPS
calculation NAV is used by different kinds of investors

NAV reflects value of REIT assets to a private market buyer

Public equity investors have a forward-looking perspective

NAV is based on value of static pool of assets

Estimates problematic if transaction data is limited

REIT investors have liquidity; private investors do not

REITs likely to have above average management teams

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Valuation: Relative Value (Price Multiple) Approach
Major multiples: P/FFO, P/AFFO, EV/EBITDA
FFO is accounting net earnings excluding:
1. Depreciation charges on real estate
2. Deferred tax charges (deferred portion of tax
expenses)
3. Gains/losses from sale of property and debt
restructuring
AFFO is a refinement to FFO
AFFO = FFO - straight line adjustment – recurring
maintenance type capital expenditures and leasing
commissions
AFFO is the better measure of economic return to
shareholders.
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Valuation: Discounted Cash Flow Approach
Dividend discount model works for REIT valuation
Two or three step DDM
Four key considerations when forecasting long term growth rates:
1. Internal growth potential
2. Investment activities
3. Capital structure
4. Retaining and reinvesting portion of cash flow
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Three main drivers behind these multiples:
1. Expectations for growth in FFO
2. Risk associated with underlying real estate
3. Risk associated with capital structure and
access to capital
Advantages and drawbacks of P/FFO AND P/AFFO
multiples
• Widely accepted
• PMs can put REIT valuations into context with other
investment alternatives
• FFO estimates are readily available
• Can be used in conjunction with growth rates and
leverage levels for relative value analysis
• Does not capture intrinsic value of all real estate
assets
• P/FFO does not adjust for recurring capital
expenditures
• One time gains/losses create issues with this model
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Private Equity Valuation

Summary

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How Is Value Created in Private Equity

• Reengineer firm and generate superior returns

• Access credit markets on favorable terms

• Align economic interests of private equity owners and mangers

of portfolio companies
• Longer term perspective
• Effective structuring of investment terms (“term sheet”)
• Tag-along, drag-along rights
• Corporate board seats
• Non-compete clause
• Preferred dividend and liquidation preference
• Reserved matters
• Earn-outs

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Contrasting Valuation in VC and Buyout Settings

Buyout Investments Venture Capital Investments

Major dimensions:

Predictability

Asset Base

Leverage

Risk

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Valuation Issues in Buyout Transactions

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Valuation Issues in Venture Capital Transactions

PRE: Agreed value of a company prior to a round of financing or investment (I)

POST: Value of a company after the financing or investing round

POST = PRE + I

Proportionate ownership of the venture capital investor = I/POST

Example 1: A venture capital firm invests £1 million on a £1.5 million pre-money valuation and the VC
firm obtains 40 percent of shares. In this case, PRE is £1.5 million, POST is £2.5 million, and the
proportion financed by venture capital is £1 million/£2.5 million. The parties agreed that the VC firm
would retain 40 percent of the shares and have that proportion of the rights of shareholders should
dividends be paid or the firm sold.

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VC Exit Routes: Returning Cash to Investors

Initial Public Offering (IPO):
 Highest exit value relative to other methods
 High liquidity, access to capital, and attracts good management
 Less flexible, more costly, and complex
 Use when company has strong growth prospects, operating history, size
 Timing of IPO is an important consideration

Secondary Market: sale to other financial investors or strategic investors

Management Buyout: firm sold to management

Liquidation: Sale of firm’s assets

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Understanding Private Equity Fund Structures

General Partner (GP) vs. Limited Partner (LP)

Two core functions of a PE firm: 1) raise funds and 2) manage investments

Investors commit a certain amount that

is subsequently drawn by the fund

J curve effect: Low or negative returns

initially followed by increased returns

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Economic Terms (Most Testable)

• Management fees represent a percentage of committed capital paid annually to the GP

• Carried interest represents the general partner’s share of profits generated by a private equity fund.

• Hurdle rate is the internal rate of return that a private equity fund must achieve before the GP
receives any carried interest.

• Vintage year is the year the private equity fund was launched. Reference to vintage year allows
performance comparison of funds of the same stage and industry focus.

• Term of the fund is typically 10 years, extendable for additional shorter periods (by agreement with
the investors).

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Corporate Governance Terms

• Key man clause
• Disclosure and confidentiality
• Distribution waterfall Total Return Waterfall Alternative 1:
 Total return waterfall GP receives carried interest after
entire committed amount is returned
 Deal-by-deal waterfall
• Clawback provision Total Return Waterfall Alternative 2:
GP receives carried interest if value of
 Due on termination investment portfolio exceeds a
 Annual reconciliation (true-up) threshold over invested capital
• Tag-along, drag along rights
• No-fault divorce
• Removal for “cause”
• Investment restrictions
• Co-investment
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Example 2: Calculation of Carried Interest

Suppose that a LBO fund has committed capital of US$100 million,
carried interest of 20 percent, and a hurdle rate of 8 percent. The
fund called 75 percent of its commitments from investors at the
beginning of year 1, which was invested at the beginning of year 1 in
target company A for $40 million and target company B for $35
million. Suppose that at the end of year 2, a profit of $5 million has
been realized by the GP upon exit of the investment in company A,
and the value of the investment in company B has remained
unchanged. Suppose also that the GP is entitled to carried interest on
a deal-by-deal basis, i.e., the IRR used to calculate carried interest is
calculated for each investment upon exit. A theoretical carried
interest of $1 million (20 percent of $5 million) could be granted to
the GP, but the IRR upon exit of investment in company A is only 6.1
percent. Until the IRR exceeds the hurdle rate, no carried interest
may be paid to the GP.

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Example 3: Distribution Waterfalls

Suppose a private equity fund has a committed capital totaling £300 million and a
carried interest of 20 percent. After a first investment of £30 million, the fund exits
the investment 9 months later with a £15 million profit. Under the deal-by-deal
method, the GP would be entitled to 20 percent of the deal profit, i.e., £3 million.

In the first alternative of the total return method, the entire proceeds of the sale,
i.e., £45 million, are entitled to the LPs and nothing (yet) to the GP.

In the second alternative, the exit value of £45 million exceeds by more than 20
percent the invested value of £30 million. The GP would thus be entitled to £3
million.

Continuing the above example with a clawback provision with an annual true-up,
suppose that the deal-by-deal method applies and that a second investment of £25
million is concluded with a loss of £5 million 1 year later. Therefore, at the annual
true-up, the GP would have to pay back £1 million to LPs. In practice, an escrow
account is used to regulate these fluctuations until termination of the fund.

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3.2 Risks and Costs of Investing in Private Equity

Risks Costs

• Illiquidity of investments Costs associated with private equity

investing are substantially more relative
• Unquoted investments to public market investing. Costs include:

• Transaction fees
• Valuation of investments
• Investment vehicle fund setup costs
• Competition for attractive investment
opportunities • Management and performance fees

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Due Diligence by Potential Investors

Due diligence is important because:

• Private equity funds tend to exhibit a strong persistence of returns over time. This means that top
performing funds tend to continue to outperform and poor performing funds also tend to continue
to perform poorly or disappear.

• The performance range between funds is extremely large. For example, the difference between top
quartile and third quartile fund IRRs can be about 20 percentage points.

• Liquidity in private equity is typically very limited and thus LPs are locked for the long term. On the
other hand, when private equity funds exit an investment, they return the cash to the investors
immediately. Therefore, the “duration” of an investment in private equity is typically shorter than
the maximum life of the fund.

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Private Equity Fund Valuation

The value of a fund is based on NAV. The fund’s assets are valued by GPs in the
following ways:
1. at cost with significant adjustments for subsequent financing events or
deterioration
2. at lower of cost or market value
3. by a revaluation of a portfolio company whenever a new financing round involving
new investors takes place
4. at cost with no interim adjustment until the exit
5. with a discount for restricted securities
6. more rarely, marked to market by reference to a peer group of public comparables
and applying illiquidity discounts

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Evaluating Fund Performance

• Gross IRRs are estimated by calculating the internal rate of return between the following cash flows:
called down capital at the beginning of period and the previous year’s operating results

• Net IRRs are calculated by removing management fees and carried interest from gross IRR

• PIC (paid in capital): the ratio of paid in capital to date divided by committed capital.

• DPI (distributed to paid in): cumulative distributions paid out to LPs as a proportion of the cumulative
invested capital. DPI is presented net of management fees and carried interest.

• RVPI (residual value to paid in): value of LPs’ shareholding held with the private equity fund as a
proportion of the cumulative invested capital. RVPI is presented net of management fees and carried
interest.

• TVPI (total value to paid in): the portfolio companies’ distributed and undistributed value as a proportion
of the cumulative invested capital. TVPI is the sum of DPI and RVPI. TVPI is presented net of management
fees and carried interest.

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Concept in Action: Evaluating a PE Fund

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The Basic Venture Capital Method

Amount of investment = $3 million Terminal value (at the end of 4 years) = $25 million
r = 50% (using a high discount rate is one way of accounting for risk)
Number of existing (owned by entrepreneurs) = 1 million

General Case/Formula Calculation

1. Post-Money Valuation POST = V/(1 + r)t 25,000,000 / 1.54 = 4,938,272

2. Pre-Money Valuation PRE = POST I 4,938,272 – 3,000,000 = 1,938,272

3. Ownership Fraction F = I/POST 3,000,000/4,938,272 = 0.6075

4. Number of Shares y = x [ F / (1 F) ] 1,000,000 x 0.6075 / (1 – 0.6075) = 1,547,771

5. Price of Shares P1 = I/y 3,000,000 / 1,547,771 = 1.94

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Venture Capital Method in terms of IRR

Step
Step 1: Determine the future wealth that
Vulture Ventures needs to obtain in
order to achieve their desired IRR.
Step 2: Determine the fraction of shares
that Vulture Ventures needs to hold in
order to achieve the desired IRR.
Step 3: Determine the number of shares
that VV needs.
Data
VV is asking for a 50% IRR
SpiffyCalc needs an
investment of 3 million
Final value is estimated at
25 million
Owners of SpiffyCalc issued
themselves 1 million shares
Calculation
$3 million × (1.5)4 = $15,187,500
$15,187,500/$25 million = 0.6075
y = 1,000,000 [0.6075/(1 0.6075)]
= 1,547,771

Step 4: Determine the price of shares. VV invests 3 million. $3 million/1,547,771 = $1.94

Step 5: Determine post-money valuation. Investment of $3 million POST = $3 million/0.6075 =

buys 60.75% $4,938,272

Step 6: Determine pre-money valuation. PRE = $4,938,272 $3 million =

$1,938,272

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Level II – Alternative Investments

Commodities and Commodity Derivatives: An Introduction

Summary

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Characteristics of Commodity Sectors

Description Storage/Transport Supply Demand

Energy Crude oil, refined Natural storage, pipes, Political events, new Economic growth
products, natural gas ships technologies
Grains Corn, wheat, rice, soy; Easy Weather, disease, Humans, animal
seasons pests feed, fuel
Industrial Copper, aluminum, Storage easy, transport Not impacted by Industrial growth
Metals nickel, zinc, lead, tin, iron can be expensive weather
Livestock Poultry, sheep, cattle, Linked to grain costs Grain costs, weather, Emerging markets
hogs disease
Precious Gold, silver, platinum Easy Not impacted by Inflation, technology,
Metals weather jewelry
Softs (Cash Cotton, coffee, sugar, Freshness is important Weather Wealth, emerging
Crops) cocoa markets

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Life Cycle for Energy and Metals

Commodity Steps Seasons Considerations Contracts
Crude oil Input-output production life Extracted year Refineries and Futures contracts
cycle: extraction, round; seasonal pipelines are very and indexes which
transportation, storage, demand based on expensive to build follow local grades
trading, refining, weather but these costs are and origins
transportation and trading much lower than the
Natural gas Straight-through cost of exploration
consumption: extraction,
transportation, storage,
trading
Copper Input-output production life Extracted year round Economies of scale; Futures contracts
cycle: extract, grind, difficult to reduce come due every
concentrate, roast, smelt, supply when month of the year
convert, refine, store and demand is low
transport

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Life Cycle for Livestock, Grains, Softs

Commodity Steps Seasons Considerations Contracts
Livestock Time to maturity Growth is year- Historically US Ranchers and
increases with size round; weight gain is livestock exports low slaughterhouses
Cattle: birth, feeder influenced by because of high risk of trade futures to
cattle, live cattle, weather and spoilage; now this risk hedge exposure.
slaughter. pastures. is lower because of
advances in
cryogenics.
Grains Planting, growth, Well defined seasons Stored in silos and Farmers and
pod/ear/head formation, and growth cycles. warehouses. consumers trade
harvest. Demand is year- futures to hedge
round. exposure.
Coffee Harvested somewhere year-round. Cycle: Plant, Two major varieties: Two futures
three to four years to bear fruit (cherry), robusta and arabica. contracts: robusta in
harvesting is done by hand in multiple sweeps, Brazil produces both. London and arabica
two to three weeks to dry, hulled, sorted and in New York.
bagged for final market. Local buyer roasts and
ships to retail location.

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Valuation of Commodities
• Stocks and bonds are financial assets which represent a claim on the profits of
business
 Valuation is based on the present value of future cash flows

• Commodities do not generate cash

 Valuation can’t be based on future cash flows
 Valuation is based on expected price in the future
 Driven by expected supply and demand
 Expected price needs to be discounted back; discount rate should factor volatility

• Futures contracts are based on spot prices and…

 Storage and transportation costs
 Physical delivery versus cash settlement
 Hedgers

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Futures Market Participants

• Commodity Traders and Investors
 Commodity producers and consumers
 Speculators (liquidity providers)
 Arbitrageurs

• Exchanges

• Analysts

• Regulators

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Spot and Futures Pricing

• Spot price: current price to deliver physical commodity; location specific

• Futures price: an agreed price to buy/sell a defined quantity (and often quality) of a commodity at a
future date
 Futures prices can be global, regional or national
 Futures contracts are standardized to promote liquidity
 Reference for forward contracts; provide data for market participants and governments

• Basis = spot price – futures price

• Backwardation (positive basis) and Contango (negative basis)

 Relationship between spot and futures prices; or between two
futures contracts of the same commodity
 Calendar spread

• Cash settled versus physical delivery

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Theories Explaining Futures Returns

Theory Futures prices are impacted by:

Insurance commodity producers who are long the physical good

Theory are motived to sell the commodity for future delivery
to hedge their production price risk exposure.

The Hedging producers along with consumers seek to protect

Pressure themselves from commodity market price volatility
Hypothesis by entering into price hedges to stabilize their
projected profits and cash flow.

The Theory of supply and demand dynamics of commodity

Storage inventories, including the concept of “convenience
yield.” Convenience yield is inversely related to
general available of the commodity.

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Components of Futures Returns

• Price Return (Spot Yield)

• Roll Return (Yield)

• Collateral Return (Yield)

S&P GSCI Return Total Return Spot Return Roll Return Collateral Return
Return 8.1% 3.2% –0.7% 5.5%
Risk 19.9% 19.9% 4.7% 1.0%

Roll return can be significant for a single period but is a small percentage of total return over multiple periods
Roll return is sector dependent

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Commodity Swaps
A commodity swap is a legal contract involving the exchange of payments over multiple dates as
determined by specified reference prices or indexes relating to commodities. Example: an oil refiner may
want to hedge oil price exposure over time without entering into multiple futures contracts. Swaps allow
participants to customize contracts (not possible with futures contracts).

Types of swaps:

• Excess return: party pays a premium and receives excess return over a strike price

• Total return: party receives total return on a commodity or index

• Basis: payments are based on two related commodity reference prices

• Variance: variance buyer benefits if actual variance is higher than stated variance (direction matters)

• Volatility: similar to variance swap except based on volatility and direction does not matter

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Commodity Indexes - Key Characteristics

• Breadth
• Weighting method (production, fixed, liquidity)
 Liquidity can be a screening factor and weighting factor
 Can have caps/floors on the size of sectors or individual commodities
 In an upward trending market production value weighted indexes will outperform
• Rolling methodology (own front contracts, maximize roll yield)
 Maximizing roll yield involves making active decisions
• Rebalancing frequency (monthly or annual)
 Rebalancing return
 Greater opportunity to earn positive rebalancing return when constituents are mean reverting
 Frequent mean reversion favors monthly rebalance indexes
• Governance

Commodity indexes and futures exchanges have high correlation with each other and low
correlation with traditional assets

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Practice, Practice, Practice

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