Alterative Assets are a major theme in the investing world, so CFAI expects candidates to have general knowledge about assets classes that are beyond the traditional categories of equity/stock and debt/fixed income.  The Level 2 exam covers three alternative asset classes: real estate, private equity, and hedge funds.

One item set (six questions) on alternative assets is a reasonable exam expectation.  It is unlikely that the entire item set will be dedicated to a single alternative asset, so candidates may see a six question combination covering two or three of the asset classes presented.

While this is a small part of the test, Alternative Assets can also be grounds for easy points.  Formulas are short in number and not terribly complex.  However, candidates do not want to over invest in Alternative Assets at the expense of more critical subjects.  Candidates should have some general understanding of all three alternative asset categories, but avoid getting too slowed down in the details.

This tutorial aligns with Study Session 13 material in the Level 2 CFA Program Curriculum ©.

Material:

In this tutorial, we will cover the following material:

I.          Real Estate

II.        Private Equity

III.       Hedge Funds

CFA Level 2: Alternative Assets – Introduction

Offering potential diversification benefits to a stock and bond only portfolio, real estate is an important alternative asset class.

Real estate presents investors with the opportunity to employ financial leverage, obtain tax benefits, and help hedge against inflation.

Property Types (6) and Characteristics

1. Vacant Land
<ul>
	<li>Investors: Short term speculators, long term developers, investors seeking a potential long term inflation hedge.</li>
	<li>Investment Traits: Passive approach, illiquid asset, wait for asset appreciation, nothing to depreciate for tax purposes.</li>
	<li>Influences on Returns:Increase in demand for land, strategic location, favorable zoning policy.</li>
	<li>Risks: Land does not increase in value, opportunity cost of having capital tied up.</li>
</ul>
2. Apartment Buildings
<ul>
	<li>Investors: High net worth investors with significant capital on hand.</li>
	<li>Investment Traits: Significant leverage, greater liquidity than other real estate types, income generating, potential appreciation in value, rent increases can move with inflation, and depreciation tax shield.</li>
	<li>Influences on Returns: Regional demographics.</li>
	<li>Risks: Requires managerial oversight, competition from other segments of the housing market, and can be challenging to start up.</li>
</ul>
3. Office Buildings
<ul>
	<li>Investors: High net worth investors with significant capital on hand, public and private organizations.</li>
	<li>Investment Traits: Medium liquidity compared to other real estate types, income generating, potential appreciation in value, and depreciation tax shield.</li>
	<li>Influences on Returns: Regional economic growth and tenant optimization.</li>
	<li>Risks: Requires managerial oversight, competition from other properties, building can become technologically outdated.</li>
</ul>
4. Hotels and Motels
<ul>
	<li>Investors: High net worth investors with significant capital on hand, real estate investment trusts (REITS).</li>
	<li>Investment Traits: Moderate leverage and liquidity compared to other real estate types, and depreciation tax shield.</li>
	<li>Influences on Returns: Strategic location, number of tourist events and conferences.</li>
	<li>Risks: Requires managerial oversight, competition from other hotels, staff turnover, and maintaining utilization.</li>
</ul>
5. Shopping Malls
<ul>
	<li>Investors: High net worth investors with significant capital on hand.</li>
	<li>Investment Traits: Moderate leverage but low liquidity compared to other real estate types, requires strategic location.</li>
	<li>Influences on Returns: Regional demographics, regional economic growth, strong lease management, possession of a marquee tenant.</li>
	<li>Risks: Requires managerial oversight with high service, vacant units, and competing malls.</li>
</ul>
6. Warehouses 
<ul>
	<li>Investors: Investors wanting cash flow with limited managerial oversight requirements.</li>
	<li>Investment Traits: Passive approach, with medium leverage and liquidity compared to other real estate types, income generating, low leasing costs, and depreciation tax shield.</li>
	<li>Influences on Returns: Regional commercial activity and strategic location.</li>
	<li>Risks: Competition from other storage type properties, outdated facility technology.</li>
</ul>

Real Estate: Types of Properties

NPV and IRR analysis can be applied to real estate valuation.

The standard decision rules apply, in that an NPV greater than zero or an IRR above the required rate of return indicates that the real estate investment should be undertaken.

IRR Challenges for Real Estate Valuation:
<ul>
	<li>IRR cannot properly value real estate investments where cash flows begin positive and become negative for a period.</li>
</ul>
<ul>
	<li>IRR may not properly rank mutually exclusive projects, when the size and timing of the cash flows are materially different.</li>
</ul>
After Tax Cash Flows (ATCF)

In order to perform a discounted cash flow valuation, analysts need to know a real estate investment’s after tax cash flows (ATCF) and after tax equity reversion (ATER).
<div class="formula1">ATCF = Net Operating Income – Mortgage Payment – Income Taxes</div>
ATCF must be used in conjunction with a property’s After Tax Equity Reversion (ATER), which is realized upon sale of the property at the end of the investment time horizon.

ATER is conceptually similar to the terminal value in stock valuation.

After Tax Equity Reversion (ATER)

ATER: The non-operating cash flow generated by property sale at the end of the investment horizon.
<div class="formula1">ATER = Net Sales Price – Capital Gains Tax – Mortgage Balance.</div>
ATCF and ATER are used to perform an <a title="Net Present Value of a Project" href="https://financetrain.com/net-present-value-of-a-project/">NPV or IRR analysis</a> and this can be done on a <a title="CFA Calculator: Financial Calculator for CFA Exam" href="https://financetrain.com/cfa-calculator-financial-calculator-for-cfa-exam/">CFAI approved calculator (HP 12C or TI BA2+)</a>.

Real Estate Valuation: NPV & IRR Analysis

The income-based perspective is appropriate for valuing investment properties, rather than residential real estate.

Real Estate Capitalization Rate is the required rate of return minus the growth rate; it can be used in conjunction with NOI to value income generating real estate.

<div class="formula1">Capitalization Rate = R0 = r – g</div>
<ul>
	<li>r = required return on investment</li>
	<li>g = growth of Net Operating Income or appreciation/depreciation rate</li>
<li> It is not unheard of for “g” to be negative when valuing real estate; this reflects a recapture premium required of the investment.</li>
	<li>NOTE: a discount rate represents the overall required rate of return on an investment, while the capitalization rate (also called the “going-in” rate) is the required return, net of the underlying asset’s growth.</li>
</ul>
<h2>Direct Income Capitalization Approach</h2>

The direct income capitalization approach can be used to estimate the market value of income producing real estate, by dividing the net operating income by the capitalization rate.

<div class="formula1">Market Value: MV0 = NOI / R0</div>

With accurate data, the direct income capitalization approach allows investors to estimate market value in a single step.  The challenge is how to determine an accurate capitalization rate.

<h2>Determining the Capitalization Rate</h2>

Market Extraction Method: As the title indicates, this method allows the analyst to use market data to derive the capitalization rate.
<ul>
	<li>If the analyst can obtain reliable market data on income and market values, then he/she can back into the cap rate.</li>
	<li>R0 = Net Operating Inc. / Market Value of Comparable Property0</li>
	<li>NOTE: the analyst might not just use data from one comparable property, but calculate several cap rates based on data from several properties and apply an average cap rate to the real estate investment in question.</li>
</ul>
Built-up Method: In this approach, an analyst will decompose the cap rate into its components and build-up a cap rate for the property under consideration.
<ul>
	<li>Interest rate: The risk free rate, net of any real estate tax shield.</li>
	<li>Illiquidity premium: Adjustment to account for the inability to quickly sell real estate.</li>
	<li>Recapture premium: Adjustment for appreciation/depreciation.</li>
	<li>Risk premium: Property specific risk.</li>
	<li>Under the built-up method, the cap rate equals the sum of these items.</li>
</ul>
Band of Investment Method: Allows the capitalization rate to reflect a weighted average cost of capital for instances where both debt and equity financing are used.
<ul>
	<li>Mortgage Constant: This is an adjusted interest rate to capture the sinking fund factor in a mortgage; the mortgage constant will be used as the cost of debt rate in the WACC calculation.</li>
	<li>Mortgage Constant = Interest Rate + Sinking Fund Factor</li>
	<li>The analyst will apply the weights employed to a mortgage constant and a required return on equity capital to determine a WACC that will be used as the capitalization rate in valuation.</li>
</ul>
<h2>Capitalization Rate Challenges</h2>

It can be challenging to determine the “correct” capitalization rate.  The rate should reflect expected behavior of investors.

It can be difficult to obtain accurate data around net operating income.

The capitalization rate seeks to capture many fluid considerations, such as: income appreciation, capital appreciation, the financing environment, property liquidity, the need to employ managerial oversight, and the characteristics of cash flows.

Income Property Valuation Using Capitalization Rate

The GIM can be used to compare properties or can be averaged across properties to determine a market GIM rate, which can then be applied to a property under investment consideration.

<div class="formula1">GIM = Purchase Price / Gross Annual Income</div>

Because sale of income generating properties can be infrequent, it may be difficult to employ the GIM approach when performing a valuation. Further, truly comparable properties may not exist. Gross rental income is not necessarily better than net operating income, when valuing properties.

Gross Income Multiplier (GIM) for Real Estate Comps

Private equity is a special asset class form of equity ownership, as these investments are not exchange traded.

The exam should focus on two forms of private equity: venture capital (VC) and leveraged buyouts (LBO).

Private equity typically requires investors to have a long investment time horizon; therefore institution investors, such as pension funds and endowments, are key players in this asset class.

<h2>Sources of Value</h2>

The following list represents sources of value from private equity:
<ul>
	<li>Ability to turn companies around (primarily an LBO driver).</li>
	<li>Ability to obtain better borrowing terms (primarily an LBO driver).  Private equity firms with established track records may be able to borrow on better terms than the target company.</li>
	<li>Alignment of interests between the private equity firm and the target company’s management.</li>
<ul>
	<li>The term sheet states the duties and rights of the private equity firm and the company’s management.</li>
	<li>Term sheet clauses include:</li>
	<li>Tag along, drag along rights.</li>
	<li>Results driven pay packages.</li>
	<li>Earn outs.</li>
	<li>Reserved matters.</li>
	<li>Non-compete agreements.</li>
	<li>Board seats.</li>
</ul>
</ul>
<h2>Venture Capital (VC) vs. Leveraged Buyouts (LBO)</h2>

While both falling under the broad category of “private equity” there are some notable differences between VC and LBO.

Venture Capital (VC) 

This private equity approach is associated with providing funding to new companies with high growth potential, often in new and/or high tech industries.

Some VC investment characteristics:
<ul>
	<li>Unpredictable cash flows.</li>
	<li>Low company asset base.</li>
	<li>Low leverage, primarily equity financed.</li>
	<li>Products and market are often new and not yet established.</li>
	<li>High working capital needs.</li>
	<li>Unseasoned management team.</li>
	<li>Focus on revenue growth.</li>
	<li>The risk/reward tradeoff can be difficult to assess, but a private equity fund typically generates most of its returns from a small number of big successes.</li>
	<li>The general partner typically gets carried interest.</li>
	<li>The exit timing can be difficult to know.</li>
</ul>
Leveraged Buyouts (LBO)

This private equity approach is associated with the use of high levels of debt financing to obtain a controlling share in an existing publicly traded company.  The acquirer would have strong reasons to believe that it can unlock value trapped in the target firm.

Some LBO investment characteristics:
<ul>
	<li>Consistent cash flows.</li>
	<li>Large company asset base.</li>
	<li>Heavily leveraged.</li>
	<li>Products and markets are usually well established.</li>
	<li>Low working capital needs.</li>
	<li>Veteran management team.</li>
	<li>Focus on profit growth.</li>
	<li>Restructure to reduce costs.</li>
	<li>The risk/reward tradeoff is more easily measured than VC.</li>
	<li>The general partner will receive carried interest, transaction fees, and monitoring fees.</li>
</ul>
<h2>Exit Strategies</h2>

The exit is the manner in which investors recover their capital and returns.  It is critical in private equity as the exit value estimate plays heavily into setting investor return expectations.

Private equity exit mechanisms that allow investors to realize value:
<ul>
	<li>Initial public offering.</li>
	<li>Sale of private equity stake to another investor on the secondary market.</li>
	<li>Management buyout of company.</li>
	<li>Liquidation of the company’s assets.</li>
</ul>

Private Equity: Venture Capital, Leveraged Buyouts and Exit Strategies

Typically, a private equity fund has a life of 10-12 years.

Return on investment in a private equity fund commonly exhibits a “J-curve” shape, where returns are low in negative early in the life of the fund with high returns coming late in the life of the fund as companies owned by the fund are exited.

<img class="aligncenter size-full wp-image-6422" title="j-curve" src="https://financetrain.com/wp-content/uploads/j-curve.png" alt="" />

Legal Forms

Two common legal forms for private equity funds are:
<ul>
	<li>Limited Partnership: A general partner will manage the fund and will be legally exposed for liability of fund debts.  The fund’s investors are limited partners, whose liability is limited to the loss of capital provided.</li>
	<li>Company Limited by Shares: Similar to limited partnership, but this structure may offer better legal protection to the partners, depending on the jurisdiction.</li>
	<li>NOTE: Under either legal form, private equity funds are frequently closed-end, which places restrictions on exit of current investors and entry of new investors.</li>
</ul>
Economic Terms of a Private Equity Fund
<ul>
	<li>Term: Ten years is a standard, but variations certainly exist</li>
	<li>Vintage Year: Year that the fund was started; performance is often compared to funds with the same vintage year.</li>
	<li>Target Fund Size</li>
	<li>Management Fees: Commonly 1.5-2.5% of some measure of fund assets paid each year to the general partner</li>
	<li>Transaction Fees: Fees for the general partner and potentially shared with the limited partners, for investment banking services.</li>
	<li>Carried Interest: Percentage of profits paid to general partner; 20% is something of a standard.</li>
	<li>Hurdle Rate: Threshold rate of return that the fund must generate before the carried interest is paid to the general partner.</li>
</ul>
Governance Terms of a Private Equity Fund
<ul>
	<li>Key man clause: Provides a policy framework for issues around succession of critical executives involved in the fund’s companies.</li>
	<li>Tag-along, drag-along rights: Offers protection to minority fund investors by allowing participation, in the event that an acquisition offer is made to the general partner.</li>
	<li>Removal of general partner for cause: Limited partners can vote out the fund’s general partner; possibly requires a super-majority of 75%.</li>
	<li>No-fault divorce: Allows for fund termination or general partner removal for cause.</li>
	<li>Co-investment: Gives limited partners the first right to invest with the general partner.</li>
	<li>Investment restrictions: Guidance for fund investments.</li>
	<li>Clawback provision: Returns capital to the limited partners from the general partner that exceeds the profit split agreement.</li>
	<li>Distribution waterfall: Limited partners receive payout prior to the general partner receiving carried interest.  This can be done on a per deal basis or based on total returns.</li>
	<li>Disclosure and confidentiality</li>
</ul>

Private Equity Fund Structures

<h2>Venture Capital Method of Valuation with a Single Round of Financing</h2>

The Venture Capital Method provides potential investors with a simple NPV or IRR view of a prospective VC fund investment.

The following calculations are employed by the Venture Capital Method:

<div class="formula1">Post Money Valuation (POST) = Estimated Terminal Fund Value / (1 + discount rate) # of years to exit

Pre Money Valuation (PRE) = POST – amount of VC investment

Ownership Fraction (F) = amount of VC investment / POST

Required Shares = # of fund shares * (F / (1-F))

Share Price = amount of VC investment / Required Shares</div>

Discount Rate and Risk: VC investors commonly apply a high discount rate when valuing a fund (30 – 40% for example); this must be done to account for the high degree of risk and uncertainty surrounding venture capital investments.

<h2>Leveraged Buyout Valuation</h2>

LBOs are commonly valued from an enterprise value perspective.

Performing a NPV or IRR analysis on an LBO investment is somewhat consistent with standard valuation approaches discussed in the equity sections.

The analyst must forecast earnings and cash flows, create a terminal value (the terminal value is commonly based on a multiple), then discount the terminal value.

Special LBO valuation considerations:
<ul>
	<li>Cash sweep: Depending on the nature of the debt arrangements, the company may be required to retire debt with excess cash flows.  Debt may be required to be paid off before any capital can be returned to equity investors.  Cash sweep requirements must be accounted for in analyst forecasts.</li>
	<li>Exit Strategy: Much of the investor value will be realized at a single exit point, when the company is sold.  This can be in the form of an initial public offering, a private sale, or another leveraged buyout.</li>
</ul>
Two methods for valuing an LBO from an investor standpoint are the: Target IRR method and the Equity Cost Flow method.

Venture Capital and Leveraged Buyout Valuation

Hedge funds are privately organized investment entities that commonly take both long and short positions in securities and derivatives contracts and employ the use of financial leverage.



Hedge funds are usually organized as limited partnerships or limited liability companies and have strict minimum investment and net worth requirements.



Equity Hedge Funds: Common strategies are market neutral (zero beta portfolios), net short, and long/short.



Fixed Income Hedge Funds: May use leverage to generate returns on yield spread relationships.



<h2>Performance Measurement Challenges</h2>



Historically, hedge funds are thought of as investments designed to generate positive returns in both bull and bear markets.



Because of their unique characteristics, it is difficult to measure hedge fund performance with traditional benchmarks and risk-adjusted return measures.&nbsp; Some of these unique characteristics include:



<ul><li>In the large universe of hedge funds, there are many styles and sub-styles.</li><li>Limited public disclosure requirements for funds.</li><li>High portfolio turnover.</li><li>Large and/or changing degrees of leverage.</li><li>Style drift.</li></ul>



<h2>Hedge Fund Benchmarks</h2>



<ul><li>Hedge Fund Indexes: CSFB/Tremont offers several style based hedge fund benchmark indexes.
<ul>
<li>Hedge Fund Index pitfalls: Voluntary fund listing, potential exclusion of large funds, no way to validate data.</li>
<li>Pitfall sources: Turnover of index funds, short histories for some funds, survivorship bias, autocorrelation causing misestimates of volatility, and closure of some funds to new investors.</li>
</ul>
</li><li>Market Indexes: some market indexes can be useful in assessing hedge fund returns, while others not so much.&nbsp; The Merrill Lynch High Yield Index may work well for assessing returns on some fixed income hedge funds and the Russell 3000 Index may work well for assessing returns on some equity hedge funds.&nbsp; With this in mind, market indexes generally cannot be used to explain hedge fund returns.</li><li>Positive Risk Free Rate: Given the expectations of hedge funds to generate positive returns in any market, the risk free rate plus some additional margin is sometimes used as a benchmark.&nbsp; Funds may be benchmarked against an absolute return or an index return plus a margin.&nbsp; A positive risk free rate of return may be technically appropriate for only market neutral funds.</li></ul>



<h2>Hedge Fund Risks</h2>



Hedge fund risks include:



<ul><li>Fraud (remember Bernie Madoff?)</li><li>Operational risks: breakdown in operations related to insufficient employee supervision, infrastructure weakness, technology shortfalls, or counterparty risk have lead to the demise of some hedge funds over the years.</li><li>Investment strategy risk: different hedge funds expose their investors to the risks of the strategies pursued (imagine being invested in a short bias equity fund when a bull market suddenly takes off).</li></ul>



Reviewing <a href="https://financetrain.com/overview-of-operational-risk/">Operational Risk</a>



Investors should take care to monitor hedge funds for the following red flags: high personnel turnover, changes in lifestyle or behavior of key fund managers, controlled asset pricing, and absence of third party audits on the fund’s financial statements.



Reviewing Investment Risk



In order to monitor investment risk associated with hedge funds, investors should be alert for a high degree of investment concentration (either in a sector or single investment) and increases in the amount of leverage.



<h2>Measuring Downside Risk</h2>



<ul><li>Hedge fund investors are commonly focused on loss avoidance (this is “left tail” risk, on a distribution of returns), so downside measures of risk are appropriate when evaluating funds.</li><li>Maximum Drawdown: This is a fund’s largest percentage loss over a specified period of returns.  While this provides some insight about risk in a historical context to investors, maximum drawdown does not give any indication of probability for a comparable loss in the future.</li><li><a href="https://financetrain.com/value-at-risk-var/" class="rank-math-link">Value at Risk (VaR)</a>: This measure attempts to incorporate probability into the left tail risk assessment by informing investors how much the fund could lose if a significant event transpired. <ul><li>Example: A hedge fund has assets of $100 million.  The probability of losing $20 million or more over the next month is 5%. VaR in minimum loss terms: the fund has a 5% probability of losing at least $20 million. VaR in maximum loss terms: there is a 95% probability that the fund will not lose more than $20 million.</li><li>VaR can be flawed in that: past data may not be indicative of future return patterns; changes to a fund’s strategy reduces the insightfulness of VaR; it can be easy to inaccurately account for overlapping risks when performing a VaR calculation; and VaR assumes a normal distribution of returns but many hedge funds employ derivatives strategies that do not have symmetrical returns. </li></ul></li><li>Loss <a href="https://financetrain.com/mean-variance-standard-deviation-and-correlation/">Standard Deviation</a>: This is a modification of a fund’s standard deviation of returns, calculated from only loss making periods.</li><li>Downside Deviation: Another variation on standard deviation, downside deviation begins with an investor’s minimum acceptable return and then calculates a standard deviation based on the periods where a fund’s return was below the investor’s minimum acceptable return.</li><li><a href="https://financetrain.com/sortino-ratio/">Sortino Ratio</a>: This is a modified version of the Sharpe Ratio, where fund excess returns above the minimum acceptable return are divided by the downside deviation.</li></ul>

About Hedge Funds: What You Need to Know

Alternative Assets

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Alternative Assets

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