Alternative Investments: Private Equity and Hedge Funds

1. Alternative Investments: Private Equity and Hedge Funds Chapter 21 Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.com St. Petersburg State University of Economics and Finance

2. Objectives Explain the different types of private equity/venture capital funds available for investing Explain how alternative investments can help diversify a portfolio and enhance the risk/return trade-off Understand the private equity process, from fundraising through the distribution of profits, including the time horizon for the entire process to be complete Describe the relationship between general partners and limited partners, and discuss how the two share returns Understand the different hedge fund strategies and how they generate returns and lower risk 21-2

3. Who invests in Private Equity and Hedge Funds? Pension Funds Endowment Funds Other Large/Long-term focused portfolios Why? Many of these investments require large amounts of capital to participate The investments are often illiquid; capital may be “locked up” for several years Managers desire a core-satellite strategy

4. Core and Satellite Portfolios 21-4

5. Core and Satellite Portfolios 21-5 Core Portfolio Traditional liquid portfolio of stocks and bonds Satellite Portfolios Consists of alternative investments Uncorrelated with the core portfolio Reduces the standard deviation of the overall portfolio and may increase return

6. Private Equity: Definition 21-6 • All equity investments in nonpublic companies • Common Categories: • Venture Capital • Leveraged Buyouts • Mezzanine Debt • Special Situations

7. Private Equity: Venture Capital 21-7 Raise money for investment in early/mid/late stage companies Firms invest after a company has a proven track record of performance – post seed capital or angel investment Firms usually specialize in a specific industry or point in the firm’s life cycle

8. Private Equity: Venture Capital 21-8 • Early-Stage • Highly risky - Fail often; succeed rarely • Successes tend to be very large • Benefits from diversification • Middle-Stage – Expansion Companies • Four to five years from IPO • Need capital to meet demand for products • Late-Stage • Two to three years from IPO • Financing needed to dress up balance sheet for IPO

9. Private Equity: Buyout Funds 21-9 • Purchase existing public companies or divisions of large, publicly traded companies • Target companies/divisions are often distressed • Bad/ineffective management • Not enough capital to compete efficiently • Transactions are highly levered • Company’s free cash flow is used to pay interest on debt • Buyout fund is able to restructure the firm and take it public after a few years • Levered return from IPO can be very high

10. Private Equity: Raising Capital 21-10 Who invests in a private equity fund? • Must be a qualified investor • Income – Greater than $250,000 over past 3 years • Investable Assets – Greater than $1 million • Popular with pension and endowment funds • Investable assets are much greater than $1 million

11. Private Equity: Raising Capital 21-11 The Funding process – four to five years • A fund solicits commitments from investors • Fund managers have not identified investments • Investors rely on reputation and track record of managers when making commitment • A fund reaches a target level of commitments • Begins accepting proposals from companies seeking investment • Makes “capital calls” on commitments as it identifies and executes investments • Time between commitment and funding can be several years

12. Private Equity: Corporate Venture Capital 21-12 • Large public companies investing in small nonpublic companies • Advantages for the large public company: • New products/ideas may be incorporated into existing product line • Form of outsourcing R&D • Advantages for the small private company: • Provide resources for marketing and testing: clinical trials, etc. • Lend general industry expertise and guidance

13. Private Equity: Exiting Venture Capital Deals 21-13 How do investors get their money back? • Two options to generate a payout to investors: • Take the individual companies public in an IPO, or • Sell the companies to strategic buyers • In either case, money raised from the sale is used to pay investors and fees • IPO market conditions can effect timing and price received for sale • May take several years to liquidate a fund

14. Private Equity: Returns 21-14 Are a private equity fund’s fee adjusted returns greater than that of the stock market? • General partner (fund manager) fee • 20% of profits • Also referred to as carried interest • Limited Partners (investors) receive 80% • Fund may have a Hurdle Rate • Hurdle Rate: a minimum rate of return, usually 8-10%, limited partners receive before general partners take their 20% carried interest

15. Private Equity: Returns 21-15 Largest predictor of success: Track Record • Funds in the top quartile of returns earn nearly twice the median return of all funds • Follow-on funds of successful funds tend to have the highest returns • Difficulty is in accessing these funds after they have become successful • Follow-on funds may be only offered to existing investors • Successful managers may charge higher fees

16. Private Equity: Returns 21-16 • Fund returns can be difficult to measure during the life of a fund • Vintage Year: The year the fund made its first investment • Returns can be uneven: • Some investments may have been liquidated • Some are being prepared to be sold • Illiquid nature of the investments makes them difficult to price while being held in the fund

17. Private Equity: Correlations 21-17 Low or negative correlation to other assets

18. Private Equity: Correlations 21-18 • Low / negative correlations to other assets: • Reduces the overall risk of the portfolio • Increases portfolio return per unit of risk • Very attractive to managers of large, long-term focused portfolios

19. Hedge Funds 21-19 • Private Limited Partnerships • Unregulated by the SEC • Term “hedge funds” is misleading • Activities are not restricted to reducing risk • Generic term for funds who engage in a wide range of activities that attempt to generate superior returns

20. Hedge Funds 21-20 • Fees • 1-2% of assets under management • 20% of profits • Often referred to as “2 and 20” • Fund will often have a hurdle rate similar to private equity funds (8-10% or an index return) • Investor qualifications are the same for hedge funds as for private equity funds • High net worth individuals • Pensions and other institutional investors

21. Hedge Funds: Strategies 21-21 • Many strategies exist • The most popular: • Long/Short Equity • Market Neutral or No-Bias • Short-Bias Funds • Event-Driven Funds • Distressed Funds • Merger Arbitrage • Convertible Arbitrage • Funds tend to be very secretive about strategy

22. Hedge Fund Strategies:Long/Short Equity 21-22 • Short sell equities the manager believes are over valued • Use proceeds to buy equities the manager believes are undervalued • Portfolio manager waits for the positions to converge • In the event of a broad market fall in prices, the short positions offset the long positions • Dependent on the portfolio bias

23. Hedge Fund Strategies: Long/Short Equity 21-23 • The portfolio can have a long or short bias • Long bias- Portfolio has more long positions than short • Short bias- Portfolio has more short positions than long • Market neutral- long/short positions balance • Many managers attempt to achieve a higher beta in rising markets and low beta in falling • Use futures and options to adjust the beta • Actively manage risk with derivatives

24. Hedge Fund Strategies: Event-Driven Funds 21-24 • Benefit from many types of events that can cause a change in value • Events are uncertain - Funds must consider the probability of the event occurring • Event Examples: • Litigation outcomes, corporate spinoffs, LBOs, M&A, Bankruptcy announcements • Event-driven funds allocate capital to profit when specific events occur (if they occur)

25. Hedge Fund Strategies: Distressed Funds 21-25 • Buy up the stock or debt of a company who is in bankruptcy proceedings • Most strategies involve the debt, as equity holders are usually wiped out in Chapter 11 • Fund managers believe underlying value in the distressed security is not being priced accurately by the market • The fund may realize underlying value in security after other liabilities are paid • Managers may take an active role in the restructuring process and may exchange debt for equity in new firm

26. Hedge Fund Strategies: Merger Arbitrage Funds 21-26 • Speculate on the completion or failure of a merger between two firms • Occurs post-merger announcement • Target firm will often trade at a discount to offer price • Why price discount? - Probability of completion • Could be rejected on antitrust grounds • Internal board politics of either firm • Could be rejected for other regulatory reasons

27. Hedge Fund Strategies: Merger Arbitrage 21-27 • At completion: • Target firm’s shares rise to the offer price • Acquiring firm’s shares often fall • Common Strategy: • Short the acquirer • Use the proceeds to purchase shares of the target • If equity swap: at completion, shares received are used to cover the short position • If cash purchase: cash is used to buy back acquirers shares in the market • Alternatively, a fund manager can short the target and buy the acquirer if she believes a deal will fail

28. Hedge Fund Strategies: Merger Arbitrage 21-28 • The long/short transaction is highly levered • Often the fund only has to use its own capital as margin in the short position • This could be 10-20% of the entire deal • The fund is able to realize a high ROI because of the leverage • Losses are sudden and significant if managers are wrong

29. Hedge Fund Strategies: Convertible Arbitrage 21-29 • Centers on convertible preferred stock and convertible bonds (see chapter 13) • Common strategy: • Buy convertible security • Receive interest income • Short the common stock of the company • Invest proceeds from short sale into interest paying account and earn income • Issuing companies tend to be near distress and do not pay dividends • Covering dividends of short position restricts cash flow

30. Hedge Fund Strategies: Convertible Arbitrage 21-30 • Stock price rises: • Gains on the conversion value of the bond • Loses on the short equity position • Gains on the interest income • Uses the conversion to cover the short position • Manager must maintain a proper hedge ratio • Stock price falls: • Convertible bond reaches a floor at its pure bond value • Gains on the short equity position • Gains on the interest income

31. Hedge Fund Strategies: Other Types of Funds 21-31 • Many other types of strategies exist: • Currencies • Commodities • Global macro • Fixed-income arbitrage • Managed futures • Multi-strategy • All strategies involve selling one asset short and buying a similar asset, e.g., Short USD and Buy EUR • Positions may have long, short, or neutral market bias

32. Hedge Funds: Performance 21-32

33. Hedge Funds: Performance 21-33 • Long-term returns are more significant • Represent performance during market cycles • Short bias funds have negative long-term returns • Because the broad market has a general upward trend • Can be very profitable if entered at the right time • Risk/return profile is favorable compared to S&P 500

34. Hedge Funds: Correlations 21-34 Most important: Hedge Fund returns are not highly correlated to other asset classes

35. Hedge Funds: Correlations 21-35 • Low correlations • A pension or endowment will be able to reduce long-term volatility of the overall portfolio • Able to maximize overall wealth while minimizing risk • Institutional investors continue to allocate parts of their portfolio into hedge funds for this reason