The Fundamentals of Alternative Investments by Laney Sanders, CFA

Report
The Fundamentals of
Alternative Investments
Laney Sanders, CFA
Assistant Chief Investment Officer
LASERS
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Topics
1.
2.
3.
4.
5.
6.
Alternative vs Traditional Investments
Types of Alternative Investments
More On: Alternative Investments
Fund of Funds vs Direct Funds
Alternative Manager Selection
Goals of Alternative Investing
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Alternative Assets vs Traditional Assets
What is a traditional asset?
Include long positions in cash, bonds, and stocks. These are the most well
known and widely used by investors.
What is an alternative asset?
A “non-traditional” asset. Encompass many different categories including:
1. Real Assets
2. Hedge Funds
3. Commodities
4. Private Equity
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Types of Alternative Assets: Real Assets
Real assets are investments that directly control nonfinancial assets and
represent actual rights to consumption rather than indirect financial
claims on cash flows generated by the tangible assets of a firm
• A typical “financial asset” such as a bond, is a claim on a set of cash flows
of a firm
• Whereas a real asset is the investment in an actual physical asset such as:
• Real Estate: land and permanent improvements to the land
• Timberland: trees (underlying land is not always part of the
investment)
• Infrastructure: toll roads, utility companies, etc. Claim on the cash
flow generated by these assets.
• Intellectual Property: copyrights, patents, trademarks, royalties, etc.
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Types of Alternative Assets: Hedge Funds
Hedge Funds are private investment vehicles that capitalize on various
investment opportunities. Funds often use derivatives, leverage, short
positions, and other strategies.
• Classifications of hedge funds include:
• Futures Funds: Macro and managed
• Event Driven: Activist, Merger Arbitrage, Distressed, Event Driven
Multi Strategy
• Relative Value Hedge Funds: Convertible, Volatility, Fixed Income,
Event Driven
• Equity Hedge Funds: Long-Short, Market Neutral, Short Selling,
130/30
• Fund of Funds: Hedge fund manager chooses and invests in
underlying hedge funds
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Types of Alternative Assets: Commodities
Commodities are standardized goods (metals, agriculture products,
energy products, and building materials) delivered to markets by many
producers in large quantities
• Commodity investments can take the form of:
• Ownership of the physical commodity
• Forward or futures contracts
• Securities of commodity producing firms
• Exchange traded funds (ETFs) – these provide passive commodity
price exposure
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Types of Alternative Assets: Private Equity
Private Equity includes debt and equity securities that are not publically
traded
• Greater risk than public counterparts – more likely to achieve greater
returns
• Willing to accept long term investment horizons and conduct extensive due
diligence
• 5 types:
• Venture capital
• Leveraged buyouts (LBOs)
• Mezzanine financing
• Distressed debt investing
• Special situations/opportunistic
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Return Characteristics of Alternatives
Diversification
• Many alternative products have low correlation to traditional assets
• Allow reduced risk without significantly lowering return expectations
Illiquidity
• Illiquidity refers to securities with infrequent trading and/or low volume
trading
• Difficult to observe price and returns through trades
• “Lumpy assets” are difficult to divide and can only be traded in certain
quantities
• Illiquidity premium
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Return Characteristics of Alternatives
Market Inefficiency
• Efficiency in markets means all available information is incorporated into
asset prices
•
Efficient market prices reflect highly competitive bidding process
• Inefficiency indicates that prices are different than those expected from an
efficient market
•
•
Fewer participants, lower competition
Excess returns can be generated due to market inefficiency
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More on: Hedge Funds
Primary Elements of Hedge Funds
Regulatory Structure
• Privately organized and generally unlisted
• Not heavily regulated – exempt from Investment Company Act of 1940 – do
not adhere to same filing and disclosure requirements and record keeping
as mutual funds
• Must meet certain standards to invest such as “qualified purchaser” – net
worth greater than $5 million for individuals or $25 million for institutions
Trading Structure
• Private securities, real assets, derivatives, structured products, leverage,
long/short
Industry Growth
• $500 billion in 2000 to $1.8 trillion in 2010
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More on: Hedge Funds
Compensation Structure
• Performance-based incentive fees that attract elite managers
• Management fee – collected on a quarterly, semi-annual, or annual basis
•
Collected regardless of performance (1% - 3%)
• Performance fee – collected annually but only if fund is profitable (usually
20%)
•
•
High water mark provision – incentive fee only paid if NAV is above
previous NAV
Hurdle rate – incentive fee only paid after fund exceeds a set threshold
return
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More on: Hedge Funds
Benefits of Hedge Funds
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More on: Hedge Funds
Definitions
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Long Position – owning a security
Short Position – selling a borrowed security (sell high, buy low)
Derivative – instruments which derive their value from an underlying asset
Alpha – value added or subtracted by a fund manager (above or below a
benchmark)
Beta – market driven performance
Leverage – increasing exposure to markets by borrowing and/or using derivatives
Absolute Return Fund – euphemism for a hedge fund/ these funds were supposed
to deliver “absolute returns” no matter what state the markets were in
Fund of Fund – a fund that aggregates investor money and invests in hedge funds
as opposed to stocks, bonds, and other assets
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More on: Hedge Funds
Traditional Funds vs Hedge Funds
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More on: Hedge Funds
Transparency
• Most managers do not want to share their positions
• Provides the ability to evaluate and understand the manager’s
process/strategy
• Institutions have asked for more transparency over recent years
• Information usefulness
• Many HFs now report to 3rd party risk aggregators (Measurisk and
RiskMetrics)
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More on: Hedge Funds
Liquidity
• Usually a 6 month to 1 year initial lock up unless some event occurs (key
man provision)
• Redemptions can usually occur every quarter with a 60 – 90 day notice
• Gates/Suspensions
• Side pocket investments
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More on: Hedge Funds
Leverage
• Employed by HFs to magnify gains, but magnifies losses as well
• Funds can employ different types of leverage
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•
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Financial (borrowing)
Use of derivatives
Can these exposures be quantified and monitored?
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More on: Hedge Funds
Hedge Funds
Strategies
Market
Directional
Corporate
Restructuring
Convergence
Trading
Opportunistic
Equity
Long/Short
Distressed
Securities
Fixed Income
Arbitrage
Global Macro
Emerging
Markets
Merger
Arbitrage
Convertible
Bond Arbitrage
Fund of Funds
Short Selling
Event Driven
Equity Market
Neutral
Multi-Strategy
Activist Investing
Regulation D
Fixed Income
Yield Alternative
Relative Value
Arbitrage
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More on: Hedge Funds
Equity Long/Short
• Like long-only traditional equity managers, these HFs will go long on the
stocks they like
• Also go short
•
•
•
Stocks they do not like or
An ETF (S&P 500) or
An index future
• These managers tend to maintain a net long position
• Shortcut: buy the good, sell the bad
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More on: Hedge Funds
Arbitrage and Merger Arbitrage
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Loose use of the word “arbitrage” by hedge fund managers
• “The exploitation of security mispricing in such a way that risk-free economic
profits may be earned”
• 1 security, 2 exchanges example
In HF world, this usually means the purchase and sale of similar investments (not a
risk free exercise)
Empirical evidence suggests that corporations tend to overpay for acquisitions
The stock of the company being acquired will trade at a discount to the offering
price (reflects the risk of the deal not taking place)
Merger Arbitrage managers will short the stock of the acquirer and buy the stock of
the company being targeted
Spread must be sufficient to compensate for the possibility of deal failing
Shortcut: Short the acquirer, buy the target
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More on: Hedge Funds
Global Macro
• Macro-economic approach/Global reach
• These managers invest opportunistically across currencies, commodities,
equities, fixed income, derivatives, etc. in any country or market
• Use other strategies under their umbrella (fixed income arbitrage, equity
long/short, etc.)
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More on: Hedge Funds
Multi-Strategy
• Ability to invest in different strategies
• Ability to shift capital across strategies to reflect their views on markets
• Sometimes these funds will grow based on their “bread and butter” and
then branch into other strategies
• Use other strategies under their umbrella
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More on: Hedge Funds
Fund of Funds
• Hedge fund managers that invest their capital into other hedge fund
managers
• Tactically allocate capital
• Pros:
•
•
•
Immediate hedge fund diversification
Fund of Funds (FoF) have infrastructure and expertise to conduct due diligence and
monitor underlying managers
Knowledge transfer to staff
• Cons:
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•
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Double layer of fees (investors pay underlying hedge fund fee and FoF manager fee) could
be substantial
Asset allocation in the hands of the FoF manager
Over-diversification is possible
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More on: Hedge Funds
The Good and the Bad
The Good
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Potential for non-correlated returns to traditional assets
•
Potential to reduce overall portfolio volatility
•
Access to the best
•
Rapidly evolving
•
Incentive structure
The Bad
•
Complicated
•
Lack of transparency
•
Difficult to evaluate
•
Infrequent liquidity
•
Expensive
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More on: Private Equity
What is Private Equity
• Limited Partnership Agreement (LPA) – legal framework for partnership
and terms and conditions of fund investments in companies that are not
listed on a publicly-traded exchange.
• Private markets are usually less efficient.
• Exposure to carefully selected and efficiently structured companies with
strong corporate governance and growth potential.
• A fund is managed by a General Partner (GP) who invests on behalf of the
Limited Partners (LPs)
• Ten to twelve-year limited partnership
• Commitment called over four to five years
• Distributions typically begin by year three or four
• Partnerships are terminated once all investments have been liquidated
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More on: Private Equity
Private Equity Structure
Three levels
1. Private Equity Firms (Zeus Global Management)
2. Private Equity Funds (Zeus Buyout Fund IV)
3. Private Equity Portfolio Companies (Sanders Bake Shop)
Partnership Structure
• General Partner – money management firm
• Limited Partners – institutions and wealthy individuals
• Limited Partnership Agreement (LPA) – legal framework for partnership
and terms and conditions of fund
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More on: Private Equity
Limited Partnership Agreement
PE Firm
(Zeus Global
Management)
Limited
Partner
PE Investor
(Pension)
Partnership
Interests
(distributions)
Investment
(capital calls)
General
Partner
PE Firm
Fund
(Zeus IV)
Equity
Position
Investment
Portfolio
Company
(Bakery)
Portfolio
Company
(Shoe Store)
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More on: Private Equity
Cash flow pattern of investing in private equity
– Years 1-3 returns are negative, little income is generated, management fees
are collected on committed (not invested) base, additionally there are some
early investments which fail;
– Years 3-5 returns flatten out and gradually turn positive as values are written
up to reflect transactions and some income is received;
– Years 5-10 returns spike as assets are sold and accumulated increases in value
are reflected, and income is received as businesses become profitable;
– All years combined leads to what has been termed the “J-Curve.”
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More on: Private Equity
Projected Cash Flows for a $10 Million Commitment
The “J Curve”
$15,000,000
$10,000,000
$5,000,000
$0
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Year
10
-$5,000,000
-$10,000,000
Drawdown
Distribution
Cumulative Net Cash Flow
J Curve
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More on: Private Equity
Venture Capital, Growth Equity, Buyouts
Investment
Style
Time
Horizon
to
Liquidity
IRR
Range
DPI
Multiple
Primary
Return
Drivers
Description of
Investment Strategy
Main Sector Types
Venture Capital
Investments in early stage of companies
with an innovative and or a disruptive
business idea for a proprietary product or
service. Investments are made in the early
life of the company, seed stage, early stage
and pre-revenue.
Technology
Communications
Software
Bio-tech
Healthcare
Clean Tech
8 – 12 years
10% - 15%
2.00x
Capital
Appreciation
Growth Equity
Provides expansion capital for small,
growing businesses, that are generating
cash flow and profits. Generally, these
types of investments have minimal
exposure to technology risk
Diversified
5 – 7 years
15% - 20%
2.00x
Capital
Appreciation
5 – 7 years
15% - 20%
2.00x
Current Income
and Capital
Appreciation
Buyouts
Investments in established companies that
require capital to expand and or
restructure
Business Services
Industrial
Consumer
Diversified
Business Services
Industrial
Consumer
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More on: Private Equity
Mezzanine
Investment
Style
Mezzanine
Description of
Investment Strategy
Investment strategy involving
subordinated debt, (the level of
financing senior to equity and below
senior debt).
Investments are generally shorter in
duration, loans are 3 – 5 years, returns,
generated are primarily current income
with a lesser emphasis on capital
appreciation
Capital supplied by mezzanine financing
is used for various situations such as
facilitating changes in ownership
through leveraged buyouts or
recapitalizations, financing acquisitions,
or enabling growth
Revenue and Royalty interests are a
subset of mezzanine financing that
targets intellectual property, license
agreements and other similar property
that has the ability to restrict the rights
to commercialization.
Main Sector Types
Companies in a variety of
industries that are backed by
Private Equity Managers
(Sponsored)
Or
Not backed by a Private Equity
Manager
(Sponsor-less)
Venture backed technology and
healthcare companies
Time
Horizon
to
Liquidity
IRR
Range
DPI
Multiple
Corporate
Finance
11% - 14%
1.50x
1 – 4 years
Venture
Lending
11% - 16%
1.60x
Primary
Return
Drivers
Current Income
and
Capital
Appreciation
Current Income
and
Capital
Appreciation
1 – 3 years
Current Income
Royalty and Revenue Interests
generally targets intellectual
property and pharmaceuticals
Royalty &
Revenue
Interests
1 – 4 years
12% - 16%
1.60x
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More on: Private Equity
Distressed, Secondaries
Investment
Style
Distressed
Description of
Investment Strategy
Investments in companies that have
poorly organized capital structures or
failing operations.
Distressed strategies includes trading
strategies, significant influence and
control positions.
Long and short positions are
commonly used as a technique to lock
in profit or reduce risk.
Secondaries
Private equity interests are generally
purchased at a discount from
valuation from motivated owners of
private equity interests. The interests
purchased are generally venture and
buyout interests with limited
exposure to unfunded capital
commitments.
The strategy also includes the
purchase of direct interests in
companies through the secondary
market
Main Sector Types
Trading strategies, Investment
instruments include publicly traded
debt securities, private debt, trade
claims, mortgage debt, common and
preferred stock and commercial
paper.
Time
Horizon
to
Liquidity
IRR
Range
DPI
Multiple
Primary
Return
Drivers
3 – 4 years
13% - 17%
1.65x
Capital
Appreciation
2 – 3 years
14% - 22%
1.50x
Capital
Appreciation
Significant influence and Control
strategies involve companies with
poorly organized capital structures,
turnaround situations and bankrupt
companies.
Diversified
Venture and Buyout investors’
interests with limited exposure to
unfunded capital commitments.
Direct interests in companies
through the secondary market
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More on: Private Equity
Energy, Infrastructure, Timber, Agriculture
Investment
Style
Time
Horizon to
Liquidity
IRR
Range
DPI
Multiple
Primary
Return
Drivers
Description of
Investment Strategy
Main Sector Types
Energy
Investments will include
exploration & production,
generation, storage, transmission,
distribution, renewable energy
sources, clean technologies,
energy technologies and other likekind investments
Up-Stream
Mid-Stream
Down-Stream
Power
Cleantech
Renewables
Energy efficiency
5 – 7 years
15% - 20%
2.00x
Capital
Appreciation,
some income
from production
Infrastructure
Investments in physical assets or
companies that operate assets that
provides essential services to
society and typically exhibit one or
more of the following qualities:
monopolistic or quasimonopolistic, high barriers to
entry, long term assets, regulatory
or permitting constraints
Infrastructure strategies may be
classified into four broad
categories: Transportation, Energy
and Utilities, Communications, and
Social Infrastructure
5-15 years
6% - 15%
1.75x
Current Income
and
Capital
Appreciation
Timber
Investment in producing timber
properties for forest products
Hardwoods
Softwood Plantations
Growth only
10-15 years
6%-12%
1.50x
Current Income
and Capital
Appreciation
Agriculture
Ownership of properties leased to
farm operators
Row & Field Crops
Permanent Crops
6-10 years
6%-12%
1.75x
Current Income
and Capital
Appreciation
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More on: Private Equity
The Good and the Bad
The Good
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Precedent of 20% + annual returns over long horizon
•
Diversification resulting in improved risk and volatility
characteristics
•
Imperfect correlation with other asset classes
•
Market inefficiency; transactions are negotiated
The Bad
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•
•
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High risk, particularly on an individual transaction basis
Illiquidity
Lack of transparency
Valuations somewhat judgmental
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More on: Private Equity
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More on: Private Equity
Lifecycle
Fundraising (0 to 1.5 years)
•
•
Private Equity Manager raises sufficient funds for the strategy
Investors make capital commitments to the fund
Investing (1-6 years)
•
Private Equity manager calls capital from investors to source investment
opportunities and create value
Harvesting (7-10 years)
•
•
Private Equity Manager exits investments through IPOs and Mergers and
Acquisitions
Proceeds of the exits are distributed to the fund’s investors according to provisions
in LPA
Liquidating (10-12 years)
•
Private Equity Manager exits the few remaining investments in fund
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More on: Private Equity
Projected Cash Flows for a $10 million Commitment
$15,000,000
$10,000,000
$5,000,000
$0
-$5,000,000
-$10,000,000
Yr 1
Yr 2
Drawdown
Yr 3
Yr 4
Distribution
Yr 5
Yr 6
Yr 7
Cumulative Net Cash Flow
Yr 8
Yr 9
J Curve
Yr 10
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More on: Private Equity
Management Fees
• General Partner is compensated through fees and shares of profits
• Annual fee based on committed capital
– Venture Funds: 2 - 2.5%
– Buyout Funds: 1.5 - 2%
• Profit participation
– Most often set at 20% of gains
– Usually above a preferred return of 5 - 10%
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More on: Real Assets
General Definition
• Tangible assets that have their own intrinsic worth based on utility
• Assets whose intrinsic value is less eroded by inflation compared to paper
assets – provide real returns over inflation
• Examples
Real Estate
Energy
Commodities
Timber
Infrastructure
TIPS/Inflation Linked Bonds
Natural Resource Equities
REITS
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More on: Real Assets
Commodities
Purchase the commodity outright
• Shipping and Storage costs/logistics
Commodity Linked Notes/ Exchange Traded Funds
• CLNs: Debt instrument whose value at maturity will be a function
of the value of an underlying commodity index
• ETFs: Simple, but higher fees for commodity index exposure and
added layer of complexity
Natural resource companies
• Stocks and bonds of the companies
• Do you get pure exposure to the commodity?
• Equity Market Risk
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More on: Real Assets
The Business Cycle and Stock, Bond and Commodity Prices
Equities
Falling
Bonds Rising
Commodities
Rising
Commodities
Falling
GDP
Bonds Falling
Equities Rising
Commodities
Bottom
Time
Source: CAIA Level I Text (Anson)
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Fund of Funds vs Direct Investing
• Many alternative investments are in a fund structure (hedge fund, private
equity fund, etc.)
• There are two general ways to implement an investment:
• Direct Fund
• Fund of Funds
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Fund of Funds vs Direct Investing
• A direct fund is when a pension system invests directly in an individual
fund
• Louisiana Retirement System invests in the Zeus IV Fund
• Zeus IV Fund invests in individual companies
• A fund of funds is when a pension system invests in a fund that in turn
invests the capital in a group of different underlying funds
• Louisiana Retirement invests in the Cronus I Fund
• Cronus I fund invests in the following funds:
•
•
•
•
Zeus IV Fund
Poseidon III Fund
Hades II Fund
Hestia IV Fund
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Alternative Manager Selection
Key drivers
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Strong reputation
Established firm
Stable investment team
Relevant experience
Demonstrated track record
Thorough due diligence process
Ability to accommodate client needs
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Alternative Manager Selection
Due Diligence Process
1.
2.
3.
4.
5.
6.
7.
Structure of the fund
Investment strategy review
Performance review
Risk assessment
Administrative review
Legal review
Checking references
3 fundamental questions in order to understand a fund’s investment program:
1.
2.
3.
What is the fund manager’s investment objectives?
What is the fund manager’s investment process?
What is the fund manager’s competitive advantage?
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Goals of Alternative Investing
• Higher returns
• Higher risk
• Illiquidity premium
• Diversification
• Structure program so that returns of alternatives are uncorrelated
to traditional portfolio returns
• Unique Opportunities
• Alternative investments allow strategies that are often not available
in traditional long only investments
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Questions?

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