1. Alternative Assets – Part I Economics 489 University of Virginia September 5, 2007

2. Economics 489 History and Background of AA September 5, 2007 Background & History

3. Economics 489 History and Background of AA September 5, 2007 What Assets Are Not “Alternative Assets?” Stocks Bonds These are now called “traditional assets”

4. Economics 489 History and Background of AA September 5, 2007 “Old Fashioned” Asset Allocation Two assets –Diversified stocks (think index) –Diversified bonds Now pick a percentage: –For example: 50 % stocks; 50 % bonds –More commonly 60 % stocks; 40 % bonds Decide: –How much actively managed –How much passively managed That’s it

5. Economics 489 History and Background of AA September 5, 2007 Theory Behind This “The Capital Asset Pricing Model” CAPM Mean Standard Deviation

6. Economics 489 History and Background of AA September 5, 2007 But That Wasn’t Really CAPM This Is CAPM Mean Standard Deviation Risk Free Rate

7. Economics 489 History and Background of AA September 5, 2007 Anyway The Language of CAPM is the language of the “traditional” asset allocation: –Mean –Standard Deviation –Correlation –Sharpe Ratios –Efficiency and Information Ratios Basically the idea of: –Diversification –Choosing a combination of mean, standard dev –Using correlation coefficients to describe “improvements in diversification”

8. Economics 489 History and Background of AA September 5, 2007 In the mid 1980s Pension funds and endowments began to invest in “real estate” either directly (state of Texas, state of Ohio) or through “funds” (state of Virginia) Rich people began to invest in “hedge funds” and “private equity” funds –These are called “high net worth” investors –Or, if rich enough, “family offices” These activities were the earliest modern form of “alternative assets”

9. Economics 489 History and Background of AA September 5, 2007 The 1990s The growth of private equity –Endowments and foundations invest in private equity and a few, very few, pension funds Hedge fund takes off in the late 1990s, funded by endowments and high net worth Real estate faltered in the early 1990s because of a real estate collapse in 1989-91

10. What are the major categories of alternatives? Real Estate Partnerships (not just real estate, but “real estate partnerships”) Private Equity Hedge Funds

11. What are the “vehicles” or investing in “alternative assets” Partnership or Limited Liability Corporations (LLCs) –GP (general partner or managing member) –LPs (limited partners – these are the investors) Very recently, some have gone public –Fortress –Blackstone –Lehman Private Equity

12. Why “partnership” or “LLC” structure? Avoids regulation –Its not a public company Not required to file an S-1 or S-11 or whatever Not required to file 10-Qs or 10-Ks –But….may only deal with “qualified” or “sophisticated” investors Institutions (endowments, foundations, pensions) Rich people Biggest advantage – fee structure

13. Economics 489 Fee Structures September 5, 2007 Basis Points – an aside Definition: 100 basis points is one percent or 1 % If an investment manager charges 50 basis points for Managing $ 100 for a customer, then the annual fee Will be $ 500,000 per year For Example:

14. Economics 489 Fee Structures September 5, 2007 “Capital Calls” – another aside Applies mainly to private equity and real estate LLCs or partnerships –Investor agrees to invest $ 100 million –No money is sent until the partnership actually makes an investment –Then, a “capital call” is issued and the investor sends in money This does not apply to hedge funds, who receive the entire $ 100 million at the time the investor has formally committed to becoming an LP

15. Economics 489 Fee Structures September 5, 2007 Investment Management Fees in General Lowest are index funds (Vanguard, Fidelity) –Equity: 6 -10 basis points per year –Debt: 12 basis points per year Exchange traded funds (index funds that can be purchased as if they were common stocks) –Equity: 6 – 60 basis points per year –Debt: 12 to 100 basis points per year Professional money management for institutions –Equity: 20 to 50 basis points per year –Debt: 6 to 25 basis points per year Mutual funds (actively managed) –Equity: 150 to 200 basis points –Debt: 100 to 150 basis points

16. Economics 489 Fee Structures September 5, 2007 Alternative Asset Fee Structure “two and twenty” –Annual “commitment fee” is 2 percent or 200 basis points (regardless of how well the assets are managed) For private equity or real estate, the commitment fee is to be paid even if no investments are ever undertaken and no “capital calls” are ever made Typically paid quarterly (50 basis points per quarter) –The “twenty” is the “carried interest” or known more simply as “the carry” Typically paid quarterly with –High water marks –Sometimes a “hurdle rate” (this is common in private equity and real estate – but uncommon in hedge funds) Other fees –Fees never discussed but are permitted by the partnership or LLC agreement Often cover –Chartered air flights for fund manager –Office expense for manager –Etc Almost all agreements permit this –Most investors are not aware of this –Investors don’t read the agreements

17. Economics 489 Fee Structures September 5, 2007 Examples Give private equity firm $ 100 million –Suppose they make no investments over four years –Every year you will pay them $ 2 million –Except for your payment of $ 2 million, nothing else ever happens – you give them no more money because they made no “capital calls” Give a hedge fund $ 100 million with a “2 and 20” fee structure –End of year one: fund makes 20 percent gross return –Fees: $ 2 million commitment fee 20 % of $ 20 million gross return = $ 4 million “carry” fee Total fees: $ 6 million Investors make 14 % net: $ 20 million minus $ 6 million –The following year fund loses $ 12 million –Fees: 2 % of $ 114 million equals$ 2.28 million Investors lose 14+ %: $ 2.28 million in fees and $ 12 million in gross loses No “carry” Investor now as $ 99.72 million; Fees over two years amount to $ 8.28 Million

18. Economics 489 Fee Structures September 5, 2007 Example Suppose you raise a $ 100 million fund Management fee will be $ 2 million first year regardless of how well the fund performs Make 20 percent in first year (market might be up 30 percent) Performance fee with be 20 percent of $ 18 million, or $ 3.6 million Clients make 14.4 percent net of fees Net Fee Earned – 560 basis points (which means 5.6%)

19. Economics 489 Fee Structures September 5, 2007 Start with $ 100 million Make $ 20 million gross first year $ 114.4 million Then lose $ 20 million $ 92.112 million left Fee is $ 2.288 million Gross returns are zero for the two years, but fees amount to $ 7.888 million Fee is $ 5.6 million

20. Economics 489 Fee Structures September 5, 2007 $ 100 million Lose $ 50 million First year Fee is $ 2 million $ 48 million Make $ 50 million fee is $ 11.6 million $ 86.4 million Total fees $ 13.6 million Gross return is zero in two years

21. Economics 489 Fee Structures September 5, 2007 High Water Mark At year end (or quarter end depending on fund rules), performance fee is limited to 20 percent of (end of period value less previous highest end of period value)

22. Economics 489 Fee Structures September 5, 2007 Example No performance fee Performance fee only on this difference

23. Economics 489 Fee Structures September 5, 2007 Better Example No performance fee here Performance fee here

24. Economics 489 Fee Structures September 5, 2007 The “Clawback” Sometimes this refers only to the “high water mark” But, in some cases, it calls for a return of performance fees earned in prior periods

25. Other Terms of LLCs Lock-up –Restricts the ability of an investor to withdraw their money PE or RE lock-ups are typically 7 – 10 years Hedge funds usually do not have “lockups” “Liquidity” –Daily liquidity –Quarterly liquidity –Restrictions on “liquidity”

26. Who are the Investors Originally rich people –High net worth investors (“sophisticated”) –Family offices Institutions up to 2000 –Real estate 1980s, then bust in late 80s –Private equity – boomed in the 90s –Hedge funds – substantial growth second half of the 1990s

27. 2000-2003 1981 780 12,000 Mch 2000 8,000 Nov 2003 Today 13,300 This drop created the the stampede for hedge funds by institutions

28. Economics 489 The Investors September 5, 2007 Post 2003 An explosion in demand for real estate funds, private equity funds, hedge funds (Hedge funds went from $ 40 billion in 1981 to $ 800 billion in 2001 to $ 1.7 trillion in 2007) However returns were a different picture –Stocks and bonds had an explosive rally from 2003 to the present –Hedge funds have performed poorly (compared to stocks) –Real estate and private equity funds have been the very top performer of all asset classes If you use five year return comparisons from 2001-2006, then funds with alternatives look good because of hedge funds. If you look only at 2005-07, then hedge funds are a drag on performance but private equity and real estate are a boon to performance

29. More Next Week