McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 21Chapter 21

Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.comSt. Petersburg State University of Economics and Finance

Explain the different types of private equity/venture capital Explain the different types of private equity/venture capital funds available for investing funds available for investing

Explain how alternative investments can help diversify a Explain how alternative investments can help diversify a portfolio and enhance the risk/return trade-offportfolio and enhance the risk/return trade-off

Understand the private equity process, from fundraising Understand the private equity process, from fundraising through the distribution of profits, including the time horizon through the distribution of profits, including the time horizon for the entire process to be completefor the entire process to be complete

Describe the relationship between general partners and Describe the relationship between general partners and limited partners, and discuss how the two share returnslimited partners, and discuss how the two share returns

Understand the different hedge fund strategies and how they Understand the different hedge fund strategies and how they generate returns and lower risk generate returns and lower risk

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Pension Funds Pension Funds Endowment FundsEndowment Funds Other Large/Long-term focused portfolios Other Large/Long-term focused portfolios

Why? Why? Many of these investments require large Many of these investments require large

amounts of capital to participateamounts of capital to participate The investments are often illiquid; capital may The investments are often illiquid; capital may

be “locked up” for several years be “locked up” for several years Managers desire a core-satellite strategy Managers desire a core-satellite strategy

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Core Portfolio Core Portfolio Traditional liquid portfolio of stocks and Traditional liquid portfolio of stocks and

bonds bonds

Satellite Portfolios Satellite Portfolios Consists of alternative investments Consists of alternative investments Uncorrelated with the core portfolio Uncorrelated with the core portfolio Reduces the standard deviation of the Reduces the standard deviation of the

overall portfolio and may increase return overall portfolio and may increase return

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All equity investments in nonpublic companies All equity investments in nonpublic companies

Common Categories:Common Categories:◦ Venture Capital Venture Capital ◦ Leveraged Buyouts Leveraged Buyouts ◦ Mezzanine Debt Mezzanine Debt ◦ Special Situations Special Situations

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Raise money for investment in early/mid/late Raise money for investment in early/mid/late stage companiesstage companies

Firms invest after a company has a proven track Firms invest after a company has a proven track record of performance – post seed capital or record of performance – post seed capital or angel investment angel investment

Firms usually specialize in a specific industry or Firms usually specialize in a specific industry or point in the firm’s life cycle point in the firm’s life cycle

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Early-Stage Early-Stage ◦Highly risky - Fail often; succeed rarely Highly risky - Fail often; succeed rarely ◦Successes tend to be very largeSuccesses tend to be very large◦Benefits from diversification Benefits from diversification

Middle-Stage – Expansion Companies Middle-Stage – Expansion Companies ◦Four to five years from IPO Four to five years from IPO ◦Need capital to meet demand for productsNeed capital to meet demand for products

Late-Stage Late-Stage ◦Two to three years from IPO Two to three years from IPO ◦Financing needed to dress up balance sheet for Financing needed to dress up balance sheet for

IPOIPO

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Purchase existing public companies or divisions of large, Purchase existing public companies or divisions of large, publicly traded companies publicly traded companies

Target companies/divisions are often distressed Target companies/divisions are often distressed ◦ Bad/ineffective management Bad/ineffective management ◦ Not enough capital to compete efficientlyNot enough capital to compete efficiently

Transactions are highly levered Transactions are highly levered ◦ Company’s free cash flow is used to pay interest on debt Company’s free cash flow is used to pay interest on debt ◦ Buyout fund is able to restructure the firm and take it public Buyout fund is able to restructure the firm and take it public

after a few yearsafter a few years◦ Levered return from IPO can be very high Levered return from IPO can be very high

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Who invests in a private equity fund?Who invests in a private equity fund? Must be a Must be a qualified investorqualified investor

◦ Income – Greater than $250,000 over past 3 yearsIncome – Greater than $250,000 over past 3 years◦ Investable Assets – Greater than $1 millionInvestable Assets – Greater than $1 million

Popular with pension and endowment funds Popular with pension and endowment funds ◦ Investable assets are much greater than $1 millionInvestable assets are much greater than $1 million

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The Funding process – four to five yearsThe Funding process – four to five years A fund solicits commitments from investorsA fund solicits commitments from investors

◦ Fund managers have not identified investmentsFund managers have not identified investments◦ Investors rely on reputation and track record of managers Investors rely on reputation and track record of managers

when making commitment when making commitment A fund reaches a target level of commitments A fund reaches a target level of commitments

◦ Begins accepting proposals from companies seeking Begins accepting proposals from companies seeking investment investment

◦ Makes “capital calls” on commitments as it identifies and Makes “capital calls” on commitments as it identifies and executes investments executes investments

◦ Time between commitment and funding can be several years Time between commitment and funding can be several years

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Large public companies investing in small Large public companies investing in small nonpublic companies nonpublic companies

Advantages for the large public company:Advantages for the large public company:◦ New products/ideas may be incorporated into existing New products/ideas may be incorporated into existing

product line product line ◦ Form of outsourcing R&D Form of outsourcing R&D

Advantages for the small private company:Advantages for the small private company:◦ Provide resources for marketing and testing: clinical Provide resources for marketing and testing: clinical

trials, etc. trials, etc. ◦ Lend general industry expertise and guidanceLend general industry expertise and guidance

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How do investors get their money back?How do investors get their money back? Two options to generate a payout to investors:Two options to generate a payout to investors:

◦ Take the individual companies public in an IPO, orTake the individual companies public in an IPO, or◦ Sell the companies to strategic buyers Sell the companies to strategic buyers ◦ In either case, money raised from the sale is used to In either case, money raised from the sale is used to

pay investors and feespay investors and fees IPO market conditions can effect timing and price IPO market conditions can effect timing and price

received for sale received for sale May take several years to liquidate a fund May take several years to liquidate a fund

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Are a private equity fund’s fee adjusted returns Are a private equity fund’s fee adjusted returns greater than that of the stock market?greater than that of the stock market?

General partner (fund manager) fee General partner (fund manager) fee ◦ 20% of profits20% of profits◦ Also referred to as carried interest Also referred to as carried interest

Limited Partners (investors) receive 80%Limited Partners (investors) receive 80% Fund may have a Hurdle Rate Fund may have a Hurdle Rate

◦ Hurdle Rate:Hurdle Rate: a minimum rate of return, usually 8-10%, a minimum rate of return, usually 8-10%, limited partners receive before general partners take limited partners receive before general partners take their 20% carried interest their 20% carried interest

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Largest predictor of success: Track Record Largest predictor of success: Track Record Funds in the top quartile of returns earn nearly Funds in the top quartile of returns earn nearly

twice the median return of all fundstwice the median return of all funds Follow-on funds of successful funds tend to have Follow-on funds of successful funds tend to have

the highest returns the highest returns Difficulty is in accessing these funds after they Difficulty is in accessing these funds after they

have become successfulhave become successful◦ Follow-on funds may be only offered to existing Follow-on funds may be only offered to existing

investorsinvestors◦ Successful managers may charge higher feesSuccessful managers may charge higher fees

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Fund returns can be difficult to measure during Fund returns can be difficult to measure during the life of a fund the life of a fund

Vintage Year:Vintage Year: The year the fund made its first The year the fund made its first investmentinvestment

Returns can be uneven:Returns can be uneven:◦ Some investments may have been liquidated Some investments may have been liquidated ◦ Some are being prepared to be soldSome are being prepared to be sold

Illiquid nature of the investments makes them Illiquid nature of the investments makes them difficult to price while being held in the funddifficult to price while being held in the fund

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Low or negative correlation to other assetsLow or negative correlation to other assets

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Low / negative correlations to other assets:Low / negative correlations to other assets:◦ Reduces the overall risk of the portfolio Reduces the overall risk of the portfolio ◦ Increases portfolio return per unit of risk Increases portfolio return per unit of risk

Very attractive to managers of large, long-Very attractive to managers of large, long-term focused portfolios term focused portfolios

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Private Limited Partnerships Private Limited Partnerships Unregulated by the SEC Unregulated by the SEC Term “hedge funds” is misleading Term “hedge funds” is misleading

◦ Activities are not restricted to reducing riskActivities are not restricted to reducing risk◦ Generic term for funds who engage in a wide range of Generic term for funds who engage in a wide range of

activities that attempt to generate superior returns activities that attempt to generate superior returns

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FeesFees◦ 1-2% of assets under management 1-2% of assets under management ◦ 20% of profits 20% of profits ◦ Often referred to as “2 and 20” Often referred to as “2 and 20” ◦ Fund will often have a hurdle rate similar to private Fund will often have a hurdle rate similar to private

equity funds (8-10% or an index return)equity funds (8-10% or an index return) Investor qualifications are the same for hedge Investor qualifications are the same for hedge

funds as for private equity funds funds as for private equity funds ◦ High net worth individualsHigh net worth individuals◦ Pensions and other institutional investors Pensions and other institutional investors

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Many strategies exist Many strategies exist The most popular:The most popular:

◦ Long/Short EquityLong/Short Equity◦ Market Neutral or No-BiasMarket Neutral or No-Bias◦ Short-Bias FundsShort-Bias Funds◦ Event-Driven FundsEvent-Driven Funds◦ Distressed FundsDistressed Funds◦ Merger ArbitrageMerger Arbitrage◦ Convertible Arbitrage Convertible Arbitrage

Funds tend to be very secretive about strategyFunds tend to be very secretive about strategy

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Short sell equities the manager believes are over Short sell equities the manager believes are over valued valued

Use proceeds to buy equities the manager Use proceeds to buy equities the manager believes are undervalued believes are undervalued

Portfolio manager waits for the positions to Portfolio manager waits for the positions to convergeconverge

In the event of a broad market fall in prices, the In the event of a broad market fall in prices, the short positions offset the long positionsshort positions offset the long positions◦ Dependent on the portfolio bias Dependent on the portfolio bias

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The portfolio can have a long or short biasThe portfolio can have a long or short bias◦ Long bias- Portfolio has more long positions than short Long bias- Portfolio has more long positions than short ◦ Short bias- Portfolio has more short positions than long Short bias- Portfolio has more short positions than long ◦ Market neutral- long/short positions balanceMarket neutral- long/short positions balance

Many managers attempt to achieve a higher beta Many managers attempt to achieve a higher beta in rising markets and low beta in fallingin rising markets and low beta in falling◦ Use futures and options to adjust the beta Use futures and options to adjust the beta ◦ Actively manage risk with derivativesActively manage risk with derivatives

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Benefit from many types of events that can Benefit from many types of events that can cause a change in valuecause a change in value

Events are uncertain - Funds must consider the Events are uncertain - Funds must consider the probability of the event occurring probability of the event occurring

Event Examples:Event Examples:◦ Litigation outcomes, corporate spinoffs, LBOs, M&A, Litigation outcomes, corporate spinoffs, LBOs, M&A,

Bankruptcy announcements Bankruptcy announcements Event-driven funds allocate capital to profit when Event-driven funds allocate capital to profit when

specific events occur (if they occur)specific events occur (if they occur)

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Buy up the stock or debt of a company who is in Buy up the stock or debt of a company who is in bankruptcy proceedings bankruptcy proceedings ◦ Most strategies involve the debt, as equity holders are Most strategies involve the debt, as equity holders are

usually wiped out in Chapter 11usually wiped out in Chapter 11 Fund managers believe underlying value in the distressed Fund managers believe underlying value in the distressed

security is not being priced accurately by the market security is not being priced accurately by the market The fund may realize underlying value in security after The fund may realize underlying value in security after

other liabilities are paid other liabilities are paid Managers may take an active role in the restructuring Managers may take an active role in the restructuring

process and may exchange debt for equity in new firm process and may exchange debt for equity in new firm

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Speculate on the completion or failure of a Speculate on the completion or failure of a merger between two firmsmerger between two firms

Occurs post-merger announcement Occurs post-merger announcement Target firm will often trade at a discount to offer Target firm will often trade at a discount to offer

priceprice Why price discount? - Probability of completionWhy price discount? - Probability of completion

◦ Could be rejected on antitrust groundsCould be rejected on antitrust grounds◦ Internal board politics of either firmInternal board politics of either firm◦ Could be rejected for other regulatory reasonsCould be rejected for other regulatory reasons

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At completion:At completion:◦ Target firm’s shares rise to the offer price Target firm’s shares rise to the offer price ◦ Acquiring firm’s shares often fallAcquiring firm’s shares often fall

Common Strategy: Common Strategy: ◦ Short the acquirer Short the acquirer ◦ Use the proceeds to purchase shares of the targetUse the proceeds to purchase shares of the target◦ If equity swap: at completion, shares received are used to cover the If equity swap: at completion, shares received are used to cover the

short position short position ◦ If cash purchase: cash is used to buy back acquirers shares in the If cash purchase: cash is used to buy back acquirers shares in the

marketmarket Alternatively, a fund manager can short the target and Alternatively, a fund manager can short the target and

buy the acquirer if she believes a deal will fail buy the acquirer if she believes a deal will fail

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The long/short transaction is highly leveredThe long/short transaction is highly levered◦ Often the fund only has to use its own capital as margin Often the fund only has to use its own capital as margin

in the short position in the short position ◦ This could be 10-20% of the entire deal This could be 10-20% of the entire deal

The fund is able to realize a high ROI because of The fund is able to realize a high ROI because of the leverage the leverage

Losses are sudden and significant if managers Losses are sudden and significant if managers are wrongare wrong

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Centers on convertible preferred stock and Centers on convertible preferred stock and convertible bonds (see chapter 13)convertible bonds (see chapter 13)

Common strategy: Common strategy: ◦ Buy convertible securityBuy convertible security

Receive interest income Receive interest income ◦ Short the common stock of the companyShort the common stock of the company

Invest proceeds from short sale into interest paying account Invest proceeds from short sale into interest paying account and earn incomeand earn income

Issuing companies tend to be near distress and do not pay Issuing companies tend to be near distress and do not pay dividends dividends

Covering dividends of short position restricts cash flow Covering dividends of short position restricts cash flow

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Stock price rises: Stock price rises: ◦ Gains on the conversion value of the bond Gains on the conversion value of the bond ◦ Loses on the short equity position Loses on the short equity position ◦ Gains on the interest incomeGains on the interest income◦ Uses the conversion to cover the short positionUses the conversion to cover the short position◦ Manager must maintain a proper hedge ratioManager must maintain a proper hedge ratio

Stock price falls: Stock price falls: ◦ Convertible bond reaches a floor at its pure bond valueConvertible bond reaches a floor at its pure bond value◦ Gains on the short equity positionGains on the short equity position◦ Gains on the interest income Gains on the interest income

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Many other types of strategies exist: Many other types of strategies exist: ◦ CurrenciesCurrencies◦ Commodities Commodities ◦ Global macroGlobal macro◦ Fixed-income arbitrage Fixed-income arbitrage ◦ Managed futures Managed futures ◦ Multi-strategy Multi-strategy

All strategies involve selling one asset short and buying a All strategies involve selling one asset short and buying a similar asset, e.g., Short USD and Buy EUR similar asset, e.g., Short USD and Buy EUR

Positions may have long, short, or neutral market biasPositions may have long, short, or neutral market bias

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Long-term returns are more significant Long-term returns are more significant ◦Represent performance during market cycles Represent performance during market cycles

Short bias funds have negative long-term returnsShort bias funds have negative long-term returns◦Because the broad market has a general upward Because the broad market has a general upward

trendtrend◦Can be very profitable if entered at the right time Can be very profitable if entered at the right time

Risk/return profile is favorable compared to S&P Risk/return profile is favorable compared to S&P 500500

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Most important: Hedge Fund returns are not highly Most important: Hedge Fund returns are not highly correlated to other asset classes correlated to other asset classes

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Low correlationsLow correlations◦ A pension or endowment will be able to reduce long-A pension or endowment will be able to reduce long-

term volatility of the overall portfolioterm volatility of the overall portfolio◦ Able to maximize overall wealth while minimizing risk Able to maximize overall wealth while minimizing risk

Institutional investors continue to allocate parts Institutional investors continue to allocate parts of their portfolio into hedge funds for this reason of their portfolio into hedge funds for this reason

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