McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Alternative Investments: Private Equity and Hedge Funds Chapter 21 Prof. Hagen Sinodoru, MBA Banking and Finance St. Petersburg State University of Economics and Finance

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

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 21-3

Core and Satellite Portfolios 21-4

Core and Satellite Portfolios 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 21-5

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

Private Equity: Venture Capital  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 21-7

Private Equity: Venture Capital  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 21-8

Private Equity: Buyout Funds  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 21-9

Private Equity: Raising Capital 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 21-10

Private Equity: Raising Capital 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 21-11

Private Equity: Corporate Venture Capital  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 21-12

Private Equity: Exiting Venture Capital Deals 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 21-13

Private Equity: Returns 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 21-14

Private Equity: Returns 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 21-15

Private Equity: Returns  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 21-16

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

Private Equity: Correlations  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 21-18

Hedge Funds  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 21-19

Hedge Funds  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 21-20

Hedge Funds: Strategies  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 21-21

Hedge Fund Strategies: Long/Short Equity  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 21-22

Hedge Fund Strategies: Long/Short Equity  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 21-23

Hedge Fund Strategies: Event-Driven Funds  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) 21-24

Hedge Fund Strategies: Distressed Funds  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 21-25

Hedge Fund Strategies: Merger Arbitrage Funds  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 21-26

Hedge Fund Strategies: Merger Arbitrage  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 21-27

Hedge Fund Strategies: Merger Arbitrage  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 21-28

Hedge Fund Strategies: Convertible Arbitrage  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 21-29

Hedge Fund Strategies: Convertible Arbitrage  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 21-30

Hedge Fund Strategies: Other Types of Funds  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 21-31

Hedge Funds: Performance 21-32

Hedge Funds: Performance  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

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

Hedge Funds: Correlations  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 21-35