fbpixel Introduction to Alternative Investments | IFT World
IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R47 Introduction to Alternative Investments

Part 3


 

5. Private Capital

5.1 Overview of Private Capital

Private capital is a broad term for funding provided to companies that is not sourced from the public equity or debt markets.

Capital that is provided in the form of equity investments is called private equity, whereas capital that is provided as a loan or other form of debt is called private debt.

5.2 Description: Private Equity

Private equity means investing in private companies or public companies with the intent to take them private. The companies in which the private equity funds invests are called portfolio companies because they will become part of the private equity fund portfolio.

The three main categories of private equity are:

  • Leveraged buyouts: Borrowed funds are used to buy an established company.
  • Venture capital: This refers to investments in companies that have not been established yet.
  • Growth capital: It refers to minority equity investments in mature companies that require funds for growth or expansion, restructuring, entering a new territory, an acquisition, etc.

Leveraged Buyouts

Leveraged buyout is an acquisition of an established public or private company with borrowed funds. If the target company is a public company then after the acquisition, the company becomes private, i.e., the target company’s equity is no longer publicly traded.

The acquisition is significantly financed through debt, hence the name leveraged buyout. LBOs capital structure consists of equity, bank debt, and high-yield bonds. The firm (GP) puts in some money of its own, raises a certain amount from LPs, and a substantial amount of money is borrowed in the form of debt to invest in companies.

For example, assume the GP invests in a target company that requires an investment of $100 million. In this, the GP invests $20 million of its money (equity), $70 million from bank debt, and the remaining $10 million is raised by issuing high-yield bonds.

There are three changes that happen to a company as a result of a leveraged buyout:

  • An increase in financial leverage.
  • Change in management or the way the company is run.
  • If the target company is previously public, after the LBO it becomes private.

Why LBO?

  • To improve the company’s operations; to add value and eventually increase cash flows and profits.
  • Leverage will enhance potential returns once the restructuring/growth strategy is complete and the company turns profitable. Debt is central to an LBO structure. Buyouts are rarely done entirely using equity.

There are two types of LBOs:

  • Management buyouts (MBO): Current management team purchases and runs the company.
  • Management buy-ins (MBI): Current management team is replaced and the acquirer team runs the company.

Venture Capital

Venture capital firms invest in private companies (portfolio companies) with significant growth potential. The time horizon is typically long-term. The distinction between VC and LBO is that the latter invests in mature companies, whereas VC invests in growing companies with a good business plan and strong prospects for future growth.

  • Other important points related to VCs are given below:
  • Venture capitalists are actively involved in the companies they invest in.
  • The rate of return expected depends on the stage the company is in when the investment happens.
  • VC investing can take place at various stages

Formative stage: Company is still being formed.

  • Angel investing: Financing provided at the idea stage.
  • Seed stage financing: Financing provided for product development and market research.
  • Early stage: Financing for companies moving towards operation, but before commercial production and sales. Fund to initiate commercial production and sales.

Later stage financing: For expansion after commercial production and sales but before IPO.

Mezzanine stage:  Preparing to go public.

Exit Strategies

The goal of private equity is to improve new or underperforming businesses and exit them at high valuations. Typically, investments (target companies) are held for an average of 5 years. The holding period may be longer or shorter. Common exit strategies are:

  • Trade sale: Selling the company to a competitor or any strategic buyer. It can be done through auction or private negotiation. For instance, if a PE firm (GP) invested in a small generic pharma company, it may sell it to large pharma firm after a few years.
  • IPO: Company goes public, i.e., it sells all or some of its shares to public investors.
  • Recapitalization: Increases leverage or introduces it to the company and pays itself a dividend. Not a true exit strategy, but introduces leverage or re-leverages.
  • Secondary sale: Assume you are a VC firm that focuses on early stage companies. You may sell the portfolio company later to another private equity firm that focuses on later stage companies.
  • Write off/liquidation: This is a worst-case scenario when the investment has not gone as planned. The company’s prospects do not look promising, so the VC firm sells the assets or writes it off to focus on other projects.

5.3 Description: Private Debt

Private debt refers to various forms of debt provided by investors to private entities.

Key private debt strategies include:

  • Direct lending: Debt capital is provided at higher interest rates, directly to entities that require capital, but are unable to get capital from traditional bank lenders. Lenders subsequently receive interest, the original principal, and possibly other payments in exchange for their investment.
  • Mezzanine debt: Refers to private credit that is subordinated to senior secured debt but is senior to equity in the borrower’s capital structure. Because of the higher risk, investors commonly demand a higher interest rate and may also require options for equity participation.
  • Venture debt: Debt funding provided to start-up or early-stage companies that may be generating little or negative cash flow. Entrepreneurs may seek venture debt as a way to access funds without further diluting shareholder ownership in their companies. Similar to mezzanine debt, venture debt may contain additional feature that compensate investors for the increased risk.
  • Distressed debt: Refers to buying debt of mature companies with financial difficulty such a bankruptcy proceeding. Investors seek companies with a temporary cash-flow problem but a good business plan. They may also get actively involved in the management of the company and help turn it around.

5.4 Risk/Return of Private Equity

Private equity may provide higher return opportunities relative to traditional investments. Some of its benefits include the following:

  • Access to private companies.
  • Ability to actively manage and improve portfolio companies.
  • Easy to use leverage.

However, the higher return is often associated with higher illiquidity and leverage risks.

5.5 Risk/Return of Private Debt

Private debt investments can provide a higher return as compared to traditional bonds. However, this higher return if often connected to higher levels of risk.

5.6 Diversification Benefits of Investing in Private Capital

Investing in private capital can provide moderate diversification benefits because of their low correlation to stocks and bonds. Investors should identify and invest in the best performing private equity funds.

6. Natural Resources

6.1 Overview of Natural Resources

Natural resources include:

  • Commodities: Can be further classified into:
    • Hard: Commodities that are mined e.g., copper, gold, silver; and commodities that are extracted e.g., crude oil, natural gas.
    • Soft: Commodities that are grown over a period of time e.g., grains, livestock, and cash crops like coffee.
  • Agricultural land (or farmland):
    • Investments in land used for the cultivation of crops or livestock.
    • Income can be generated from the growth, harvest and sale of crops or livestock; or by leasing the land back to farmers.
  • Timberland:
    • Investments in natural forests or managed tree plantations.
    • The return comes from the sale of trees, wood, and other timber products.

Up to about 20 years ago, investors looking for exposure to natural resources invested mainly via financial instruments (stocks and bonds). Instead of investing in the physical land and the products that come from it, investors focused on the companies that produced natural resources. Nowadays, however, due to the wide variety of direct investments available (ETFs, limited partnerships, REITS, swaps, and futures), investors typically participate in these assets directly.

6.2 Characteristics of Natural Resources

Commodities

Commodities are physical products that can be standardized on quality, location, and delivery for investment purposes.

Generally, commodity investments take place through derivative instruments, because of the high storage and transportation costs incurred when holding commodities physically.

The underlying asset of a commodity derivative may be a single commodity or an index of commodities. The return on commodity investment is based mainly on price changes rather than an income stream such as dividends.

In order to be transparent, investable, and

replicable, commodity

indexes typically use the price of

the futures contracts rather than the prices of the underlying physical commodities.

Commodity sectors include:

  • Energy – oil, natural gas, coal, electricity etc.
  • Base metals – copper, aluminum, zinc etc.
  • Precious metals – gold, silver, platinum etc.
  • Agriculture – grains, livestock, coffee etc.
  • Others – carbon credits, freight, forest products etc.

How are commodity futures contracts priced?

  • The price of a futures contract can be calculated using the following formula:
    Future price ≈ Spot price (1 + r) + Storage costs – Convenience yield

where: convenience yield is the value associated with holding the physical asset;

r is the short-term risk-free interest rate

  • Future prices may be higher or lower than spot prices, based on convenience yield.
  • For no arbitrage to occur, Future price ≈ Spot price (1+r). But commodities incur storage costs. So, they must be added to the future price and we get Future price ≈ Spot price (1 + r) + storage costs. Storage and interest costs are collectively known as “cost of carry”.
  • Why subtract the convenience yield? Because the buyer does not possess the commodity as of now, until the end of the contract. Since he has given up this convenience, it must be subtracted from the future price. That’s how we arrive at Future price ≈ Spot price (1 + r) + storage costs – convenience yield
  • Futures price may be higher or lower than the spot price based on the convenience yield.

Contango: Future price > Spot price Markets tend to be in contango when there is little or no convenience yield.

Backwardation: Future price < Spot price

Markets tend to be in backwardation when the convenience yield is high

Timberland

Timberland provides an income stream through the sale of trees, wood, and other timber products. Timberland can be thought of as both a factory and a warehouse. The trees can be easily stored by simply not harvesting them. The trees can be harvested based on the price: more harvest when prices are up and delayed harvest when prices are down.

The three return drivers for timberland investments include: biological growth, change in prices of lumber (cut wood), and underlying land price change.

Additionally, since trees consume carbon as part of their life cycle, timberland considered a sustainable investment that mitigates climate-related risks.

Farmland

Farmland is perceived to provide a hedge against inflation. Two types of farm crops include row crops that are planted and harvested, and permanent crops that grow on trees. Like timberland, farmland also provides an income component related to harvest quantities and agricultural commodity prices. However, it does not provide production flexibility, as farm products must be harvested when ripe.

Similar to timber land, the return drivers for farmland are: harvested quantities, commodity prices, and land price appreciation.