2017 Level II SS 15 Alternative Investments (Lecture)

CFA 2017 Level II
Alternative Investments
Study Session 15
Readings 43, 44, 45, 46
Created and developed by Michael Cao

No distribution/copying without permission
About Study Session 15

• 5‐10% of level II exam = 1‐2 item sets
• Core topics
– Real estate valuation methods
– Private equity performance measurement
– Buyout and venture capital valuation
– Commodity futures
• Exam focus
– Understanding of concepts and application of key formulas
– Understanding of risks in various alternative investments
– Awareness of assumptions in valuation methods
Reading 43
Private Real Estate Investments

No distribution/copying without permission 1
Forms of Real Estate Investments
• Public vs. private markets
– Public investments more liquid and easier to diversify
• Debt vs. equity investments
– Debt: interest & principal payments
– Equity: rental income & value appreciation
– Equity investments more risky
• Typical investment vehicles
Private investment Public investment
Debt Mortgages Mortgage‐backed securities
Equity Direct investments REITs and REOCs
LOS 43.a 3
Investing in Real Estate

• Motivations for investing in real estate:
– Current income
– Capital appreciation
– Hedge against inflation
– Diversification benefits
– Tax benefits (e.g. REITs)
• Role of real estate in a portfolio
– Both bond‐like and equity‐like characteristics
– Risk‐return profile in between stocks and bonds
LOS 43.c/l 4
Risks in Real Estate Investment

• Risk factors:
– Changing economic and business conditions
– Long lead time for new properties (uncertainty)
– Availability and cost of capital (e.g. interest rates)
– Local market population and demographics
– Potential illiquidity discount in sale price
– Damage to quality of property or environment
– Lack of relevant information for valuation
– Financial risk resulting from use of leverage
• Risks hedged using insurance or shifted to tenants
LOS 43.c/l 5

Commercial Properties
• Location: key to valuation of property
• Types of commercial properties:
Factors for demand Typical lease methods
Office Job growth Gross or net
Industrial Overall economy Net
Retail Consumer spending Percentage
Population growth
Multi‐family Gross or net
Cost of buying vs. renting
– Gross (net) lease: expenses paid by owner (tenant)

– Percentage lease: additional rent once sales reaches a level
LOS 43.d 6
Real Estate Valuation

• Definitions of value:
– Market value: sales price investor most likely willing to pay
– Value in use: from a particular user’s perspective
– Assessed value: value used by taxing authority
– Mortgage lending value: for valuing collateral
• Valuation approaches:
1. Income approach
a. Direct capitalization method
b. Discounted cash flow (DCF) method
2. Cost approach
3. Sales comparison approach
LOS 43.e 7
(1.a) Direct Capitalization Approach

• Net operating income (NOI) =
Rental income if fully occupied Potential
gross Effective
+ other income income gross
income
– vacancy and collection loss
– operating expense
• NOI gross of financing costs and income taxes
• Capitalization (cap) rate = discount rate – growth rate
– Discount rate: required rate of return
– Growth rate: expected constant rate of growth
– Cap rate derived from
LOS 43.f/g 8

(1.a) Direct Capitalization Approach
• Value =
• If NOI1 temporarily low, use stabilized NOI
– Stabilized NOI calculated as if temporary period is over
– Short‐term loss in value subtracted in arriving at final value
• Gross‐income‐based valuation
– Gross income multiplier =
– Value = gross income × gross income multiplier
– Drawback: vacancy rates and operating expenses ignored
LOS 43.f/g 9
Direct Capitalization: Example

• Renovations (all paid for by seller) begin on a house
with first‐year NOI forecast at $38k; NOI would have
been $50k without renovations
– After renovations, NOI expected to grow 3% per year
• Value the house, assuming 10% required return
stabilized NOI
$
• After renovations, value = = $714.29k
. .
$ $
• Temporary loss in value = = $10.91k
.
• Total house value = $714.29k – $10.91k = $703.38k
LOS 43.f/g 10
(1.b) DCF Approach

• Terminal/resale value (at the end of holding period):
– Found by direct capitalization approach
– Terminal cap rate dependent on
• Expected future interest rates
• Projected future growth rate
• Uncertainty about future NOI
• Assumptions in DCF approach:
– Future operating expenses and capital expenditures
– Vacancy assumptions
– Estimated resale price
– Estimated discount rate – level of risk embedded
LOS 43.f/g 11

DCF: Example
• Annual NOI of an office tower expected to be $4m
over five years and grow at 5% annually thereafter
• Value the property, assuming
– Property to be sold in five years
– 13% required return
$ .
• Terminal value = = $52.5m
. .
• Present value:
– N = 5, I/Y = 13, PMT = $4m, FV = $52.5m  PV = $42.56m
LOS 43.f/g 12
(2) Cost Approach

• Often considered an upper limit on property value
• Particularly useful if property unusual or lacking
comparable transactions
• Physical deterioration:
– Curable: benefit of fixing problem ≥ cost to cure
– Incurable : benefit of fixing problem < cost to cure
– Depreciation deducted from property value =
effective age property
cost of fixing
replacement
total economic life curable items
cost
• Total economic life estimated
LOS 43.i 13
(2) Cost Approach

• Steps:
– Estimate market value of land
– Estimate replacement cost of property
• Replacement cost: cost of the same property but with new design
• Contrast with reproduction cost – cost of exact same property
– Deduct depreciation
• Physical deterioration: normal wear and tear
• Functional obsolescence: bad design that impairs efficiency
• Locational obsolescence: disadvantaged location/proximity
• Economic obsolescence: infeasibility in new economic conditions
LOS 43.i 14

Cost Approach: Example
• 15,000‐square‐meter building, in need of upgraded
exterior at a $750k cost, to raise value by $1m
– 20‐year effective age, and 50‐year total economic life
– Floor plans outdated, decreasing rents by $210k per year
– Grocery store next door replaced by luxury car dealership,
impacting the rents downward by $140k per year
– Higher vacancy rates, reducing value by $825k
– Cost to replace building estimated to be $3.2k per square
meter, plus constructer’s profit of $3.6m
– Market value of land estimated at $15m
– Appropriate cap rate of 7%
LOS 43.i 15
Cost Approach: Example

• Market value of land = $15,000k
• Replacement cost after curable deterioration =
$3.2k × 15,000 + $3,600k – $750k = $50,850k
• Deducting incurable items of $26,165k, composed of
– Physical deterioration: $50,850k × 20/50 = $20,340k
• Calculated after curable items
– Functional obsolescence: $210k / 0.07 = $3,000k
– Locational obsolescence: $140k / 0.07 = $2,000k
– Economic obsolescence: $825k
• Value = $15,000k + $50,850k – $26,165k = $39,685k
LOS 43.i 16
(3) Sales Comparison Approach

• Most useful if some similar properties sold recently
• Assumption: parties in prior transactions rational
• Possible differences from comparable properties:
– Age
– Location
– Size
– Property condition
– Market economic condition
LOS 43.i 17

Sales Comparison: Example
Subject Comparable #1 Comparable #2 Comparable #3
Square footage 2,800 1,700 4,500 3,200
Sale price (P) $1,300,000 $8,400,000 $4,900,000
Sale date (months ago) 0 4 2 7
Age (years) 11 36 15 9
Physical condition Average Poor Good Average
Location Average Average Average Prime
– Linear depreciation of 3% per year

– Good condition: +4% value; poor condition: –6% value
– Average location = prime location minus 25%
– Inflation: sale price appreciating at 1.3% per month
LOS 43.i 18

Square footage 2,800 1,700 4,500 3,200
Sale price (P) $1,300,000 $8,400,000 $4,900,000
Sale date (months ago) + 4 × 0.013 × P + 2 × 0.013 × P + 7 × 0.013 × P
Age (years) + 25 × 0.03 × P + 4 × 0.03 × P – 2 × 0.03 × P
Physical condition + 0.06 × P – 0.04 × P –
Location – – – 0.25 × P
– Depreciation: + (age – subject age) × 3% × sale price

– Good (poor) condition: – 4% (+ 6%) × sale price
– Average location: – 25% × (prime location) sale price
– Inflation: + number of months × 1.3% × sale price
LOS 43.i 19

Square footage 2,800 1,700 4,500 3,200
Sale price (P) $1,300,000 $8,400,000 $4,900,000
Sale date (months ago) +$67,600 +$218,400 +445,900
Age (years) +$975,000 +$1,008,000 –$294,000
Physical condition +$78,000 –$336,000 –
Location – – –$1,225,000
Adjusted sale price $2,420,600 $9,290,400 $3,826,900
Average per square foot $1,423.88 $2,064.53 $1,195.91
– Average adjusted sale price per square foot = $1,561.44

– Estimated subject value = $1,561.44 × 2,800 = $4,372,033
LOS 43.i 20

Financial Ratios
• Primary purpose: to determine loan amount ceiling
• Debt service coverage ratio:
NOI in first year
DSC ratio
principal payment interest payment
• Loan‐to‐value ratio:
loan amount
LTV ratio
appraisal value
• Equity dividend rate (for equity investors):
cash flow in first year
EDR
equity value
LOS 43.m 21
Loan Ceiling: Example

• Calculate loan ceiling of interest‐only loan at 8%
interest to be issued on property appraised at $2m
with $198k NOI, provided DSC ratio > 1.6 and LTV
ratio < 75%; at maximum leverage, calculate EDR
• Loan amount ceiling
– Based on LTV ratio: $2m × 75% = $1.5m
$
.
– Based on DSC ratio: = $1.547m
.
– Ceiling = $1.5m, the lower of the two
$ $ . .
• At this loan amount, EDR = = 15.6%
$ $ .
LOS 43.m 22
Reading 44
Publicly Traded Real Estate

Securities
23

NAVPS for REITs
• Net asset value per share (NAVPS):
– Most appropriate measure of fundamental value
– Using market values rather than book values,
NAVPS = (assets – liabilities) / shares
– Compared to market price to determine mis‐valuation
• Estimation of NAVPS based on forecast cash NOI:
– Determine cap rate using recent comparable transactions
– Property value estimated via direct capitalization method
– NAV = property value + other tangible assets – liabilities
LOS 44.e 24
NAVPS for REITs: Example

• For a REIT with the following data:
– Estimated next‐year NOI = $12m
– Non‐cash rent = $1m
– Cash and equivalents = $1.4m
– Accounts receivable = $2m
– Debt & liabilities = $26m
– Land & half‐developed properties = $3.3m
– Cap rate based on comparable transactions = 9%
– Shares outstanding = 16m
• Calculate NAVPS
LOS 44.e 25
NAVPS for REITs: Example

• NAV calculation:
– Estimated next‐year cash NOI
= $12m – $1m = $11m
– Estimated property value (using direct capitalization)
$
= = $122.22m
.
– Gross asset value
= $122.22m + $1.4m + $2m + $3.3m = $128.92m
– Net asset value
= $128.92m – $26m = $102.92m
$ .
• NAVPS = = $6.43/share
LOS 44.e 26

FFO & AFFO for REITs
• Adjusted funds from operations (AFFO) =
Net profit
+ depreciation (often overstated) Funds from
operations
+ deferred tax expenses (likely not paid for years) (FFO)
– gains from sale of property and debt restructuring
– non‐cash rent adjustment
– recurring maintenance‐type capital expenditures (capex)
• AFFO more subjective, but considers
– Capital expenditures – must be incurred to maintain value
– Contractually increasing rental rates
LOS 44.f 27
Reading 45
Private Equity Valuation
28
Private Equity (PE)

• PE fund structure:
PE Investment PE Investment Portfolio
investor Return fund/firm Shares company
• Sources of value creation:

– Re‐engineering the portfolio company (in‐house expertise)
– Obtaining favourable debt financing
– Aligning portfolio company managers’ interest with PE firm
• Ownership and management by same individuals
• Ability to focus on long‐term performance given private nature
• Control mechanisms outlined in term sheet, e.g. manager
compensation, clauses, board representation
LOS 45.a/b 29

PE Exit Strategies
• Initial public offering (IPO)
– Highest exit value
– Less flexible, more costly
– Timing important
• Secondary market sale – sold to another investor
– Second highest exit value
• Management buyout (MBO) – sold to management
– High leverage, impacting management’s flexibility
• Liquidation
– Deemed no longer viable, resulting in low value
LOS 45.e 30
PE Terminology
• Committed capital: amount promised by investors
• Paid‐in capital: amount received from investors so far
• Management fees: percentage of committed capital
• Performance fees (carried interest): general partner’s
share of fund profits after management fees
• Ratchet: investor‐manager allocation of total equity
• Hurdle rate: minimum IRR to trigger carried interest
• Vintage: year fund started
• Term: life of PE firm
LOS 45.f 31
Risks of Investing in PE
• Liquidity – difficult to liquidate private investment
• Unquoted investments – no publicly quote price
• Agency – interest alignment of managers vs. PE firm
• Capital – possible withdrawal of invested capital
• Regulatory – company affected by regulation
• Valuation – subjective judgment used
• Market – interest rates, exchange rates, etc.
LOS 45.g 32

Costs of Investing in PE
• Transaction – due diligence, legal fees, etc.
• Fund setup – legal and other costs of setting up fund
• Administrative – custodian, transfer agent, etc.
• Management and performance – paid to PE firm
• Dilution – additional rounds of financing
LOS 45.g 33
PE Corporate Governance
• Clawback: if fund underperforms, earlier profit paid
to PE general partner paid back to investors
• Distribution waterfall – how profit flows to investors
– Deal‐by‐deal method: carried interest distributed after
each deal (even if losses made on other deals)
– Total return method: carried interest paid on entire fund
• Version #1: paid only after entire committed capital returned
• Version #2: paid when fund exceeds invested capital + an amount
LOS 45.f 34
Evaluating PE Fund Performance

• IRR – immediate reinvestment assumed, but illiquid
– Gross IRR (gross of fees) – PE fund performance of
investing in portfolio companies
– Net IRR (net of fees) – return realized by PE fund investors
• Multiples – time value of money ignored
– Paid‐in capital (PIC) =
– Distributed to paid‐in capital (DPI) =

.
– Residual value to paid‐in capital (RVPI) =

.
– Total value to paid‐in capital (TVPI) = DPI + RVPI
LOS 45.h/i 35

PE Fund Performance: Example
• PE fund with 2% management fee on paid‐in capital
and carried interest of 20%, paid only when entire
committed capital, $32m, is returned to investor
– Calculate management fees, carried interest, NAV
before/after distributions, and year‐4 DPI, RVPI and TVPI
Capital
$m called Profit Dist.
down
Year 1 13 –1.9
Year 2 8 6.3
Year 3 9 3.9 5
Year 4 2 10.7 15
LOS 45.h/i 36

• Paid‐in capital = cumulative capital called down
– In year 3, paid‐in capital = 13 + 8 + 9 = 30
• Management fees = paid‐in capital × 2%
– In year 2, mgmt. fees = 21 × 0.02 = 0.42
Capital
Paid‐in Mgmt.
$m called Profit Dist.
capital fees
down
Year 1 13 –1.9 13 0.26
Year 2 8 6.3 21 0.42
Year 3 9 3.9 5 30 0.60
Year 4 7
2 10.7 15 37
32 0.64
LOS 45.h/i 37

• NAV before distributions =
NAV after capital mgmt.
profit
distributions called down fees
– In year 1, NAV before dist. = 0 + 13 – 0.26 + (–1.9) = 10.84
– In year 4, NAV before dist. = 31.02 + 2 – 0.64 + 10.7 = 43.08
Capital NAV NAV

Paid‐in Mgmt. Carried
$m called Profit Dist. before after
capital fees interest
down dist. dist.
Year 1 13 –1.9 13 0.26 10.84 10.84
Year 2 8 6.3 21 0.42 24.72 24.72
Year 3 9 3.9 5 30 0.60 37.02 1.00 31.02
Year 4 2 10.7 15 32 0.64 43.08 1.21 26.87
LOS 45.h/i 38

• Carried interest not paid until NAV before dist. (i.e.
realized + unrealized) tops committed capital ($32)
– In year 3, carried interest = 0.20 × (37.02 – 32) = 1.00
– In year 4, carried interest = 0.20 × (43.08 – 37.02) = 1.21
Capital NAV NAV

down dist. dist.
Year 1 13 –1.9 13 0.26 10.84 10.84
Year 2 8 6.3 21 0.42 24.72 24.72
Year 3 9 3.9 5 30 0.60 37.02 1.00 31.02
Year 4 2 10.7 15 32 0.64 43.08 1.21 26.87
LOS 45.h/i 39

• NAV after distributions =
NAV before carried
distributions
distributions interest
– In year 4, NAV after dist. = 43.08 – 15 – 1.21 = 26.87
Capital NAV NAV

down dist. dist.
Year 1 13 –1.9 13 0.26 10.84 10.84
Year 2 8 6.3 21 0.42 24.72 24.72
Year 3 9 3.9 5 30 0.60 37.02 1.00 31.02
Year 4 2 10.7 15 32 0.64 43.08 1.21 26.87
LOS 45.h/i 40

• Multiples for year 4:
– DPI = = 0.625
.
– RVPI = = 0.962
– TVPI = 0.625 + 0.962 = 1.59
Capital NAV NAV
down dist. dist.
Year 1 13 –1.9 13 0.26 10.84 10.84
Year 2 8 6.3 21 0.42 24.72 24.72
Year 3 9 3.9 5 30 0.60 37.02 1.00 31.02
Year 4 2 10.7 15 32 0.64 43.08 1.21 26.87
LOS 45.h/i 41

Venture Capital vs. Buyout
Venture Capital Buyout
Characteristic
(VC) (BO)
Firm maturity Usually less mature Usually more mature
Business focus Revenue growth EBIT or EBITDA growth
Cash flows Less predictable Stable and predictable
Financial leverage Lower Higher
Asset base Limited Large (collateral use)
Management New to business Experienced
Exit timing/strategy Hard to predict More foreseeable
Subsequent funding Limited access Higher potential
LOS 45.c 42
PE Valuation Issues
• Cash flows difficult to forecast
– Large variability in valuation by different investors
• PE valuation methodologies:
– Discounted cash flow (DCF) analysis
• Most appropriate for companies with significant operating history
– Relative value approach
• Reliant on predictable cash flows and significant history
– Real option analysis
• Applicable to immature companies
– Replacement cost approach
– Most appropriate: leveraged BO method and VC method
LOS 45.d 43
Buyout (BO) Valuation

• Leverage buyout (LBO) model
– Objective: set maximum price for PE firm in negotiation
(not to value target company)
– Three main inputs:
• Projected cash flows of target company
• Expected returns to providers of financing
• Total amount of financing
• Exit value =
investment earnings increase in decrease
cost growth price multiple in debt
(last three terms: sources of BO return generation)
LOS 45.d 44

BO Valuation: Example
• An LBO transaction estimated at $12m with
projected exit in six years at 2.1× initial purchase cost
– Financed with 75% debt and 25% equity
– Components of equity investment:
• 30% in common equity by PE firm
• 60% in preference shares by PE firm – guaranteed a 11% annually
compounded return payable at exit
• 10% in common equity held by management equity participation
• Upon exit, only half of total debt left to be paid off
– PE firm promised 85% of residual value (15% for managers)
• Calculate payoff, payoff multiple, and IRR
LOS 45.d 45
• Initial invested capital:
– Debt = $12m × 0.75 = $9m
– Equity = $12m × 0.25 = $3m
• Forecast exit value = $12m × 2.1 = $25.2m
• Payoff to each provider of financing:
– Creditor: $9m / 2 = $4.5m
– Preference shares: $3m × 0.60 × (1+0.11)6 = $3.37m
– PE firm: 0.85 × ($25.2m – $4.5m – $3.37m) = $14.73m
– Managers: 0.15 × ($25.2m – $4.5m – $3.37m) = $2.60m
LOS 45.d 46
• Payoff multiples:
$ . $ .
– PE firm payoff multiple = = 6.70
$ . .
$ .
– Management payoff multiple = = 8.67
$ .
• IRRs:
– PE firm IRR = 6.70 1 = 0.3730 = 37.30%
– Management IRR = 8.67 1 = 0.4332 = 43.32%
LOS 45.d 47

Venture Capital (VC) Valuation
• Difficult to apply DCF and relative value approaches,
as cash flows hard to predict and no comparables
• Single‐period VC method (extendable to two‐period):
– Post‐money valuation: POST = PV(exit value)
– Pre‐money valuation: PRE = POST – INV
• INV: investment made by VC investor
– Proportion of VC investor ownership: f = =
– Number of shares: sharesVC = sharesfounders ×
– Purchase price: price =
LOS 45.d/j 48
VC Method: Example
• Ben, the startup founder with 1m shares, needs $2m
capital and estimates his company can be sold for
$14m in 4 years; VC firm arrives at 30% discount rate
$
– Post‐money valuation = = $4.90m
.
– Pre‐money valuation = $4.90m – $2m =$2.90m
$
– VC investor ownership = = 40.8%
$ .
.
– Shares owned by VC = 1m × = 0.689m
.
$
– Purchase price = = $2.90 / share
.
LOS 45.d/j 49
Risk in Venture Capital

• Adjusting the discount rate (r):
1
1
1
– where q = probability of failure in a given year
• Adjusting the terminal value (via scenario analysis):
– Expected terminal value across various scenarios
• Usually, terminal value = future earnings × industry multiple
• Probability weighting terminal value in each scenario
• In general, bounds placed on company value before
negotiations begin between investee and VC firm
– Difficult to ascertain exact value of company
LOS 45.k 50

Reading 46
Commodities and Commodity

Derivatives: An Introduction
51
Commodity Basics
• Commodity sectors:
– Crude oil – in natural form (not yet refined)
– Natural gas – liquefied
– Metals – demand related to business cycles
– Grains and softs – supply related to weather
– Livestock – supply related to price of grains
• Commodity valuation:
– Difficult given no cash flows (unlike equities and bonds)
– Spot price = present value of future selling price
• Selling price dependent upon supply vs. demand
LOS 46.a/c 52
Futures Market Participants

• Hedgers
– Taking an offsetting position against existing exposure
• Commodity producers: intrinsic long position
• Commodity consumers: intrinsic short position
• Speculators
– No offsetting position in underlying commodity
– Providing liquidity to hedgers, thus demanding a premium
• Arbitrageurs
– Keeping prices “right”
– Up to relevant frictions
LOS 46.d 53

Backwardation & Contango
Backwardation Contango
Definition Futures price < spot price Futures price > spot price
Slope of term structure Negative Positive
Storage cost of Zero or positive
Most common cause
commodity asset convenience yield
Futures market
Sellers Buyers
dominated by
– Futures price = FV(spot price) – FV(costs) + FV(benefits)

– Term structure: Contango
Backwardation
Maturity
0
LOS 46.e 54

• Contango: futures price > St
• Backwardation: futures price < St
– If benefits of holding the underlying are sufficiently large
• Normal contango: futures price > E[ST]
– Most hedgers on long side in futures
– Compensation required by sellers to accept risk
• Normal backwardation: futures price < E[ST]
– Most hedgers on short side in futures
– Compensation required by buyers to accept risk
LOS 46.e 55

• Supply and demand theory:
– Futures market dominated by sellers  backwardation
– Futures market dominated by buyers  contango
• Theory of storage:
– Less storable commodities (e.g. oil)  backwardation
– More storable commodities (e.g. gold)  contango
• Convenience yield theory:
– Demand/supply shocks  expected future availability of
commodity  changes in convenience yield 
backwardation or contango
LOS 46.e 56

Commodity Futures Returns
• Insurance theory: long parties providing liquidity (i.e.
opportunity to lock in a price) to producers
– Backwardation more prevalent (compensation), as a result
• Hedging pressure theory: similar to insurance theory,
but recognizing hedgers can be either long or short
• Theory of storage: futures price = spot price adjusted
by costs (storage) and benefits (convenience yield)
LOS 46.g 57
Commodity Futures Return

• Total return on commodity futures =
spot roll collateral rebalancing
return return return return
• Spot return: change in commodity’s spot price
– Global supply and demand
– Unexpected inflation
– Global economic development
– Seasonal factors
– Political factors
LOS 46.g 58

• Collateral return: income on cash investment
– Small up‐front margin payment
– Invested in short‐term government securities
– Represented by difference between a total return
commodity index and corresponding excess return index
• Excess return index: uncollateralized futures investment
• Rebalancing return (diversification return): generated
from trading to match commodity index weights
– Only relevant when managing a portfolio of futures
LOS 46.g 59

• Roll return (roll yield): income resulting from
replacing maturing futures contracts with new ones
– Profit/loss from convergence of futures price towards spot
price as futures contracts mature
, , ,
– Roll return
,
• , : futures price at time t–1 of contract maturing at time t
• , : futures price at time t of contract maturing at time T
• : spot price at time t (= , , maturing futures contract)
– Positive (negative) if in backwardation (contango)
• , ( , ) if in backwardation (contango)
LOS 46.g/h 60
Commodity Swaps
• Total return swap:
– Variable leg based on underlying commodity price
• Excess return swap:
– Payment based on difference between underlying
commodity and a benchmark
• Basis swap:
– Variable leg based on difference between prices of two
underlying commodities
• Volatility swap:
– Payment based on volatility of underlying commodity price
LOS 46.i 61


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CFA 2017 Level II

Created and developed by Michael Cao

About Study Session 15

Private Real Estate Investments

Created and developed by Michael Cao

Investing in Real Estate

Risks in Real Estate Investment

Created and developed by Michael Cao

– Gross (net) lease: expenses paid by owner (tenant)

Real Estate Valuation

(1.a) Direct Capitalization Approach

Created and developed by Michael Cao

Direct Capitalization: Example

(1.b) DCF Approach

Created and developed by Michael Cao

(2) Cost Approach

(2) Cost Approach

Created and developed by Michael Cao

Cost Approach: Example

(3) Sales Comparison Approach

Created and developed by Michael Cao

– Linear depreciation of 3% per year

Sales Comparison: Example

– Depreciation: + (age – subject age) × 3% × sale price

Sales Comparison: Example

– Average adjusted sale price per square foot = $1,561.44

Created and developed by Michael Cao

Loan Ceiling: Example

Publicly Traded Real Estate

Created and developed by Michael Cao

NAVPS for REITs: Example

NAVPS for REITs: Example

Created and developed by Michael Cao

Private Equity Valuation

Private Equity (PE)

• Sources of value creation:

Created and developed by Michael Cao

Created and developed by Michael Cao

Evaluating PE Fund Performance

– Distributed to paid‐in capital (DPI) =

– Residual value to paid‐in capital (RVPI) =

Created and developed by Michael Cao

PE Fund Performance: Example

PE Fund Performance: Example

Capital NAV NAV

Created and developed by Michael Cao

Capital NAV NAV

PE Fund Performance: Example

Capital NAV NAV

PE Fund Performance: Example

Created and developed by Michael Cao

Buyout (BO) Valuation

Created and developed by Michael Cao

Created and developed by Michael Cao

– Proportion of VC investor ownership: f = =

– Number of shares: sharesVC = sharesfounders ×

– Purchase price: price =

Risk in Venture Capital

Created and developed by Michael Cao

Commodities and Commodity

Futures Market Participants

Created and developed by Michael Cao

– Futures price = FV(spot price) – FV(costs) + FV(benefits)