Professional Documents
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Unit - 6
Unit - 6
Deemed to be University
CDS
J curve
In private equity, the J Curve represents the tendency of private equity funds to post
negative returns in the initial years and then post increasing returns in later years when
the investments mature.
Historically, the J curve effect has been more pronounced in the US, where private equity
firms tend to carry their investments at the lower of market value or investment cost and
have been more aggressive in writing down investments than in writing up investments.
J curve diagram
TIME – The time it takes for a private equity manager to improve a business can
greatly affect the shape of the J-Curve, which is especially true given that the IRR
metric, used commonly as the vertical axis in PE performance charts, is a discounted
cash flow methodology which takes into account the time value of money.
The longer it takes for a private equity manager to improve companies and drive
profitability the longer and deeper the downward shape of the J-Curve.
If the improvements to the financials of the companies occur quickly the downward
shape of the J-Curve can be shallow and short with a steep upward line as the tail of
the “J”.
● MARKET CONDITIONS & PRIVATE MARKET "BETA" – During the life of a private
equity fund, the private companies owned by the fund are typically evaluated
quarterly. There are three primary inputs when evaluating a Private Company:
Discounted Cash Flow valuation which is valuing the companies based on cash flow
valuation metrics.
MANAGER SKILL – The skill of the manager can also affect the shape of the J-Curve. If
the manager can source companies where they have identified immediate value to
unlock, the J-Curve can be altered significantly.
For example, if a private company also owns a lot of its own real estate, a sale
leaseback, shortly after acquisition, of some or all of the company’s real estate
portfolio could greatly shorten the J-Curve
● COMMIT EARLY – Private Equity Funds often give fee discounts or fee holidays to investors
who commit to a Fund’s initial closing.
CDO
Example of LBO
● David owns an investment firm. He would like to purchase Store Co, a retail chain. He intends to reform
the company into a more cost-effective operation then sell it.
● They agree to a purchase price of $100 million. To conduct a leveraged buyout, David first commits $10
million of his firm's money. He then finds a bank to extend a loan for the remaining $90 million.
● David's firm is negotiating this loan, but it will soon own Store Co. So, the loan is structured such that
Store Co will assume this debt. The bank will secure its $90 million with Store Co's assets. This means
that Store Co will be responsible for making all payments on the debt that David used to buy it, and that if
Store Co defaults on these obligations the bank will seize its land, inventory and other assets in lieu of
payment.
Let's say you want to buy a small pizzeria in your hometown. The pizza shop earns $200,000 per
year in operating income, and the owners will sell it to you for $1 million. You don't have $1 million
laying around to invest, so you find a senior lender who will finance $600,000 of the purchase price
at a rate of 8% per year.
● With this in mind, we can calculate the return on your investment. We know the business
produces $200,000 in operating income per year. We need to subtract the $48,000 in interest
payable to the senior lender, thus arriving at pretax profits of $152,000. We'll assume that the
profits are taxed at 35%, so the after-tax profit is $98,800.
● Thus, your return on your $400,000 equity investment is $98,800 annually, or 24.7% per year
● But what if you could reduce your equity investment? What if another lender could come in
behind the senior lender and add more leverage? Suppose you could find mezzanine lender
who will provide $200,000 of financing at a rate of 15% per year.
● The new capital structure would look like this:
The senior lender contributes $600,000 of debt financing at 8% per year.
The mezzanine lender contributes $200,000 of debt financing at 15% per year.
7 alternative investments:
These types of investments can vary wildly in their accessibility and structure, but they share a few key
characteristics:
• They're unregulated by the US Securities and Exchange Commission (SEC)
• They're illiquid, meaning they can’t be easily sold or otherwise converted to cash
• They have a low correlation to standard asset classes, meaning they don’t necessarily move in the same
direction as other assets when market conditions change
● While alternative investments share these key traits, they're also a diverse asset class. Here are seven
types of alternative investments everyone should know, what makes them unique, and how to think about
them as investment opportunities.
Private Equity:
Private equity is a broad category that refers to capital investment made into private companies, or those not
listed on a public exchange, such as the New York Stock Exchange. There are several subsets of private equity,
including:
• Venture capital, which focuses on startup and early-stage ventures
• Growth capital, which helps more mature companies expand or restructure
• Buyouts, when a company or one of its divisions is purchased outright.
• An important part of private equity is the relationship between the investing firm and the company
receiving capital. Private equity companies often provide more than capital to the firms they invest in;
they also provide benefits like industry expertise, talent sourcing assistance, and mentorship to founders.
Private Debt:
Private debt refers to investments that are not financed by banks (i.e., a bank loan) or traded on an open
market. The “private” part of the term is important—it refers to the investment instrument itself, rather than
the borrower of the debt, as both public and private companies can borrow via private debt.
● Private debt is leveraged when companies need additional capital to grow their businesses. The companies
that issue the capital are called private debt funds, and they typically make money in two ways: through
interest payments and the repayment of the initial loan.
Hedge Funds:
Hedge funds are investment funds that trade relatively liquid assets and employ various investing strategies
with the goal of earning a high return on their investment. Hedge fund managers can specialize in a variety of
skills to execute their strategies, such as long-short equity, market neutral, volatility arbitrage, and
quantitative strategies.
● Hedge funds are exclusive, available only to institutional investors, such as endowments, pension funds,
and mutual funds, and high-net-worth individuals.
Real Estate:
There are many types of real assets. For example, land, timberland, and farmland are all real assets, as is intellectual
property like artwork. But real estate is the most common type and the world’s biggest asset class.
● In addition to its size, real estate is an interesting category because it has characteristics similar to bonds—because
property owners receive current cash flow from tenants paying rent—and equity, because the goal is to increase the
long-term value of the asset, which is called capital appreciation.
● Like with other real assets, valuation is a challenge in real estate investing. Real estate valuation methods include
income capitalization, discounted cash flow, and sales comparable, with each having both benefits and shortcomings.
To become a successful real estate investor, it’s crucial to develop strong valuation skills and understand when and
how to use various methods.
Commodities:
Commodities are also real assets and mostly natural resources, such as agricultural products, oil, natural gas,
and precious and industrial metals. Commodities are considered a hedge against inflation, as they're not
sensitive to public equity markets. Additionally, the value of commodities rises and falls with supply and
demand—higher demand for commodities results in higher prices and, therefore, investor profit.
● Commodities are hardly new to the investing scene and have been traded for thousands of years.
Amsterdam, Netherlands, and Osaka, Japan may lay claim to the title of the earliest formal commodities
exchange, in the 16th and 17th centuries, respectively. In the mid-19th century, the Chicago Board of Trade
started commodity futures trading.
Collectibles:
Collectibles include a wide range of items, from rare wines to vintage cars to baseball cards. Investing in
collectibles means purchasing and maintaining physical items with the hope the value of the assets will
appreciate over time.
● These investments may sound more fun and interesting than other types, but can be risky due to the high
costs of acquisition, a lack of dividends or other income until they're sold, and potential destruction of the
assets if not stored or cared for properly. The key skill required in collectibles investment is experience;
you have to be a true expert to expect any return on your investment.
Structured products :
It usually involve fixed income markets—those that pay investors dividend payments like government or corporate
bonds—and derivatives, or securities whose value comes from an underlying asset or group of assets like stocks, bonds,
or market indices. Examples of structured products include credit default swaps (CDS) and collateralized debt obligations
(CDO).
● Structured products can be complex and sometimes risky investment products, but offer investors a customized
product mix to meet their individual needs. They're most commonly created by investment banks and offered to
hedge funds, organizations, or retail investors.
● Structured products are relatively new to the investing landscape, but you’ve probably heard of them due to the
2007-2008 financial crisis. Structured products like CDO and mortgage-backed securities (MBS) became popular as
the housing market boomed before the crisis. When housing prices declined, those who had invested in these
products suffered extreme losses.
CLO
Collateralized loan obligations (CLO) are securities that are backed by a pool of loans. In
other words, collateralized loan obligations are repackaged loans that are sold to
investors.
For example, mortgage-backed securities (MBS) are comprised of mortgage loans, and
asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt.
CDOs are called "collateralized" because the promised repayments of the underlying
assets are the collateral that gives the CDOs their value
Synthetic CDO
A synthetic CDO is a form of collateralized debt obligation that invests in credit default
swaps or other noncash assets to gain exposure to fixed income.
• Cash flow CDOs pay interest and principal to tranche holders using the cash flows
produced by the CDO's assets. Cash flow CDOs focus primarily on managing the
credit quality of the underlying portfolio.
• Market value CDOs attempt to enhance investor returns through the more frequent
trading and profitable sale of collateral assets. The CDO asset manager seeks to
realize capital gains on the assets in the CDO's portfolio. There is greater focus on the
changes in market value of the CDO's assets. Market value CDOs are
longer-established, but less common than cash flow CDOs.
• Arbitrage transactions (cash flow and market value) attempt to capture for equity
investors the spread between the relatively high yielding assets and the lower yielding
liabilities represented by the rated bonds. The majority, 86%, of CDOs are
arbitrage-motivated.
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds or
mortgaged backed assets. Ownership of the assets is transferred to the legal entity
(known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the
assets is divided among tranches in reverse order of seniority.
Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs
gain credit exposure to a portfolio of fixed income assets without owning those assets
through the use of CDS, a derivatives instrument. (Under such a swap, the credit
protection seller, the Synthetic CDO, receives periodic cash payments, called premiums,
in exchange for agreeing to assume the risk of loss on a specific asset in the event that
asset experiences a default or other credit event.
Hybrid CDOs have a portfolio including both cash assets—like cash CDOs—and swaps
that give the CDO credit exposure to additional assets—like a synthetic CDO. A portion of
the proceeds from the funded tranches is invested in cash assets and the remainder is
held in reserve to cover payments that may be required under the credit default swaps.
The CDO receives payments from three sources: the return from the cash assets, the
GIC or reserve account investments, and the CDO premiums.
Single tranche CDO: The flexibility of credit default swaps is used to construct Single
Tranche CDOs (bespoke tranche CDOs) where the entire CDO is structured specifically
for a single or small group of investors, and the remaining tranches are never sold but
held by the dealer based on valuations from internal models.