Commodity Linked Notes
The last way an investor can gain exposure to the commodity markets is through a commodity-linked note. This is where financial engineering and the commodities markets intersect. In its simplest form, a commodity-linked note is an intermediate term debt instrument whose value at maturity will be a function of the value of an underlying commodity futures contract or basket of commodity futures contracts. Commodity-linked notes are not a new invention. In 1863, the Confederacy of the South issued...
Distressed Debt CDOs
A recent development in the CDO market is a distressed debt CDO. As its name implies, the primary collateral component is distressed debt. Distressed debt included both securities for which the issuer is in default of the bond payments, and non-defaulted securities that trade in distressed ranges in anticipation of a future default by the issuing entity. Distressed debt securities are generally defined as those loans or subordinated debt that trade at a coupon rate 10 or greater compared to a...
Distressed Debt and Bankruptcy
Distressed debt investing and the bankruptcy process are inextricably intertwined. Many distressed debt investors purchase the debt while the borrowing company is currently in the throes of bankruptcy. Other investors purchase the debt before a company enters into bankruptcy proceedings with the expectation of gaining con 11 See Riva D. Atlas, Company in Trouble They're Waiting, The New York Times (January 21, 2001). trol of the company. In either case a brief summary of Chapter 11 Bankruptcy...
Transparency Risk
We alluded to transparency risk as an ancillary issue associated with process risk. Transparency is a consistent issue with hedge fund managers because of their unregulated nature. Mutual fund managers, for example, are required under the Investment Company Act of 1940 to present annually a full financial disclosure including a list of their securities holdings. Commodity pool operators and Commodity trading advisors are required under the Commodity Exchange Act to make similar disclosures....
Synthetic Balance Sheet CDO
Synthetic balance sheet CDOs differ from the cash funded variety in several important ways. First, cash funded CDOs are constructed with an actual sale and transfer of the loans or assets to the CDO trust. Ownership of the assets is transferred from the bank's balance sheet to that of the CDO trust. In a synthetic CDO, however, the sponsoring bank or other institution transfers the total return profile of a designated basket of loans or other assets via a credit derivative transaction, usually...
Requirements of Rule 23c3
Rule 23c-3 is known as a safe harbor under the securities laws. This means that if a regulated entity fulfills the requirements of the rule it will be exempted from certain provisions of the securities laws. The key exemption under Rule 23c-3 is that if a mutual fund follows all of the requirements of the rule, it shall not be deemed by the SEC to be a mutual fund that issues redeemable securities. This is important because it means that the fund will be classified as a closed-end fund and...
Profiting from an Arbitrage CDO Trust
We have mentioned several times that the motivation for an arbitrage CDO trust is to earn a profit. We provide an example of how this is done. Assume a money manager establishes an arbitrage CBO to invest in high-yield bonds. The trust will have a life of three years and raises 900 million by selling three tranches of securities. The security tranches issued by the trust are divided by credit rating. In tranche A, debt with the highest priority is issued against the highest credit quality bonds...
Distressed Debt Arbitrage
If there is any way to skin an arbitrage, hedge fund managers will think of it. While this is not a private equity form of investing, it is a form of equity arbitrage best suited for hedge fund managers. The arbitrage is constructed as follows. A hedge fund manager purchases distressed debt which she believes is undervalued. At the same time, she shorts the company's underlying stock. The idea is that if the bonds are going to decline in value, the company's stock price will decline even more...
LBOs that Improve Operating Efficiency
A company may be bought out because it is shackled with a non-competitive operating structure. For large public companies with widespread equity ownership, the separation of ownership and management can create agency problems with ineffective control mechanisms. Management may have little incentive to create value because it has a small stake in the company, and monitoring of management's actions by a diverse shareholder base is likely to be just as minimal. Under these circumstances,...
Equity Lines of Credit
A variation on a PIPE transaction is an Equity Line of Credit (ELC). With an ELC, a company receives an established line of financing that it repays by issuing stock. Consider the recent example of Igen International (ticker IGEN), a biotechnology company. Igen was short on cash, and was involved in an expensive lawsuit with another pharmaceutical company. Furthermore, with a depressed market for biotechnology stocks, a secondary public offering was not a favorable option. Instead, Igen turned...
Exhibit 14 CBO Trust Annual Cash Flows
Income from high-yield bonds, 9 on 800 million Income from Treasury note, 6 on 100 million Income from Cash Reserve, 5 on 48.5 million Coupon on Tranche A, 7.5 on 100 million Coupon on Tranche B, 8.25 on 600 million Coupon on Tranche C, 8.75 on 200 million Annual management fee S7,500,000 49,500,000 17,500,000 4,500,000 9 See David Graubard, CDO Roundup GMAC is Testing the Waters with CMBS-Backed Deal, Asset Securitization Report (February 19, 2001). This is a balance sheet CDO. The G-Force CDO...
Specialization within the Venture Capital Industry
Like any industry that grows and matures, expansion and maturity lead to specialization. The trend towards specialization in the venture capital industry exists on several levels, by industry, geography, stage of financing, and special situations. Specialization is the natural by-product of two factors. First, the enormous amount of capital flowing into venture capital funds has encouraged venture capitalists to distinguish themselves from other funds by narrowing their investment focus....
Open End and Closed End Mutual Funds
The retail mutual fund industry is regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 (the Company Act). Under the Company Act, mutual funds are referred to as investment companies and are classified into two broad groups open-end companies and closed-end companies. Both types of companies offer their shares to retail investors through a public offering that must be registered with the SEC. However, there are numerous differences. An open-end...
Introduction to Hedge Funds
The term hedge fund is a term of art. It is not defined in the Securities Act of 1933 or the Securities Exchange Act of 1934. Additionally, hedge fund is not defined by the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Commodity Exchange Act, or, finally, the Bank Holding Company Act. So what is this investment vehicle that every investor seems to know about but for which there is scant regulatory guidance As a starting point, we turn to the American Heritage...
Business Plans
The most important document upon which a venture capitalist will base her decision to invest in a start-up company is the business plan. The business plan must be comprehensive, coherent, and internally consistent. It must clearly state the business strategy, identify the niche that the new company will fill, and describe the resources needed to fill that niche. The business plan also reflects the start-up management team's ability to develop and present an intelligent and strategic plan of...
The Empirical Evidence Supporting Commodity Futures As An Asset Class
While commodities within an investment portfolio are considered to be a new phenomenon, the fact is that organized commodity trading has been in existence far longer than stock and bond trading. The first commodity exchange was the Osaka rice exchange that began trading in Japan in the 1400s. By contrast, the New York Stock Exchange did not begin trading until the early 1800s. Nonetheless, commodity futures investing is relatively new compared to stock and bond investing. In his seminal paper...
Using Distressed Debt for a Takeover
As a good example of how a corporation can use distressed debt to take control of another company, consider the merger of Federated Department Stores and R.H. Macy amp Co. Federated was able to gain control of Macy's with an initial investment in distressed debt of only 109 million. Federated itself was a victim of the leveraged fallouts of the late 1980s and early 1990s. Federated was taken private in an LBO by Robert Campeau in 1988, the same gentleman that took Allied Department Stores...
Exhibit 8 Calculation of the Roll Yield for Crude Oil Futures
In July 2000 the futures term structure is slightly above the June crude oil term structure that existed in June, reflecting an increase in crude oil spot prices of about 0.50. The increase in spot prices shifted the whole term structure upwards. In addition to the price appreciation, the owner of a long crude oil can earn the roll yield. Exhibit 8 calculates the roll yield associated with each futures contract over the one month holding period of June to July 2000. As a futures contract...
Agency Costs and Firm Management
The objectives of senior management may be very different from that of a corporation's equity owners. For instance, management may be concerned with keeping their jobs, and presiding over a large empire. Conversely, shareholders want value creation. As we previously noted, in a large company, equity ownership may be so widely dispersed that the owners of the company cannot make their objectives known to management, or even control management's natural tendencies. This raises the issue of agency...
The Growth of the Distressed Debt Market
Exhibit 4 presents the face value of all distressed portfolios over the time period of 1990-1999. As can be seen, the distressed market has nearly doubled between 1998 and 1999. Several factors influenced this growth. First, many more types of commercial loans are available for resale. In addition to the traditional industrial loans that are routinely bought and sold, there are many new types of charge off loan portfolios that include auto deficiencies credit card paper medical and healthcare...
History Of Managed Futures
Organized futures trading began in the United States in the 1800s with the founding of the Chicago Board of Trade CBOT in 1848. It was founded by 82 grain merchants and the first exchange floor was above a flour store. Originally, it was a cash market where grain traders came to buy and sell supplies of flour, timothy seed, and hay. In 1851, the earliest futures contract in the United States was recorded for the forward delivery of 3,000 bushels of corn, and two years later, the CBOT...
Hedge Funds that Exhibit Credit Risk
The second general category of hedge funds lines up along the credit risk axis in Exhibit 2. We have merger arbitrage at the bottom of the credit risk axis and relative value arbitrage at the top end of the credit risk axis. 6-W 4.001 3.00 2.00 1.00 1.00 300 3.00 4.00 5,00 6.00 TOO BOO 6-W 4.001 3.00 2.00 1.00 1.00 300 3.00 4.00 5,00 6.00 TOO BOO The investment strategies of these funds involve taking only a little market exposure hence their label as arbitrage funds. However, these hedge funds...
The History Of Lbos
Although LBOs began after the Second World War, it was not until the 1970s that the investment value of LBOs became apparent. In 1976 a new investment firm was created on Wall Street, Kohlberg Kravis Roberts amp Co. KKR .1 The founders of KKR had previously worked at Bear Stearns and Company, and they helped to pioneer the LBO transaction as early as 1968. No firm has had a greater impact on the leveraged buyout market than KKR. Indeed, many of the transactions discussed in this chapter were...
Mezzanine Financing to Bridge a Gap in Time
Mezzanine financing has three general purposes. First, it can be financing used to bridge a gap in time. This might be a round of financing to get a private company 1 See Still Looking Flush with Cash, Buyout Firms Hope for a Deal Rebound, The Investment Dealer's Digest April 9, 2001 . to the IPO stage. In this case, mezzanine financing can either be subordinated debt convertible into equity, or preferred shares, convertible into common equity upon the completion of a successful IPO. Examples...
Merchant Banking
As a final discussion we take a moment to briefly describe merchant banking. Merchant banking is a first cousin of leveraged buyouts. Sometimes, it is difficult to distinguish between the two. Merchant banking is the practice of buying non-financial companies by financial institutions. Most investment banking companies and large money-center banks have merchant banking units. These units buy and sell non-financial companies for the profits that they can generate for the shareholders of the...
The Overstuffed Corporation
One of the mainstream targets of many LBO firms are conglomerates. Conglomerate corporations consist of many different operating divisions or subsidiaries, often in completely different industries. Wall Street analysts are often reluctant to follow or cover conglomerates because they do not fit neatly into any one industrial category. As a result, these companies can be misunderstood by the investing public, and therefore, undervalued. Consider the following case history. In yet another KKR...
Exhibit 10 Downside Risk Protection Monthly Returns 19902000
55 35 10 Stocks Bonds CTA Agriculture 55 35 10 Stocks Bonds CTA Financial amp Metals In each case, a portfolio with a 10 allocation to managed futures provided a higher Sharpe ratio than that for the 60 40 stock bond portfolio. This highlights the concept that managed futures products cannot be analyzed on a stand-alone basis. However, when considered within a portfolio context, some benefit from managed futures products can be achieved. However, in only one case, managed energy futures...
Data Risk
Much of the desire to invest in hedge funds stems from the academic research regarding the performance of this asset class. The empirical studies with respect 7 In fact, the individual VAR calculations would be additive only if the returns to each hedge fund were perfectly correlated. to hedge funds demonstrate convincingly that hedge funds are a valuable addition to a diversified portfolio. In summary, these studies demonstrate that an allocation to hedge funds can increase the overall return...
Market Neutral
Our last two categories are different from the previous hedge fund strategies in that they employ little or no leverage and maintain little or no market exposure. In fact, the very nature of their programs is to limit or eliminate market exposure altogether. We start with market neutral hedge funds. Market neutral hedge funds also go long and short the market. The difference is that they maintain integrated portfolios which are designed to neutralize market risk. This means being neutral to the...
Do Hedge Funds Undermine The Financial Markets
Hedge funds have often been made scapegoats for whatever ails the financial markets. This can be traced back to George Soros' currency attack on the British Pound Sterling. In 1992, George Soros bet heavily and correctly that the British government would not be able to support the pound and that the pound would devalue. In 1997, Soros was once again blamed for a currency crisis by the Malaysian Prime Minister Mahathir bin Mohammad. The Prime Minister attributed the crash in the Malaysian...
Intellectual Property Rights
Most start-ups in the technology and other growth sectors base their business opportunity on the claim to proprietary technology. It is very important that a start-up's claim and rights to that intellectual property be absolute. Any intellectual property owned by the company must be clearly and unequivocally assigned to the company by third parties usually the entrepreneur and management team . A structure where the entrepreneur still owns the intellectual property but licenses it to the...
Performance Measurement Risk
The Sharpe ratio is the statistic most often used to compare the performance of two investment managers. It is a measure of risk-adjusted returns. It divides the performance of an investment manager in excess of the risk-free rate by the standard deviation of that manager's performance results. Its purpose is to provide a basis to compare the performance of different managers that may invest in different financial assets. However, there are some practical difficulties with using a Sharpe ratio...
Regulation D
Under the 1933 Act, Congress has provided issuers with ready-made safe harbors from the registration requirements. The most often-used are The Rules Governing the Limited Offer and Sale of Securities Without Registration under the Securities Act of 1933. These rules are universally known as Regulation D. Under Regulation D, a hedge fund must file a Notice of Sale with the SEC within 15 days of the first sale made of hedge fund units. Additionally, there are two important rules that must be...
Hedge Funds that Exhibit Market Risk
We use Exhibits 4 and 5 for comparison as we examine the distributions associated with hedge fund returns. We begin with those hedge funds that take more market risk than credit risk. These include global macro hedge funds, short selling hedge funds, and equity long short hedge funds. This type of investing focuses on stock selection. This is the source of what many hedge fund mangers claim is skill-based investing. Rather than mimic an equity benchmark, these managers focus their skill on a...
Chase Physical Commodity Index
The Chase Physical Commodity Index CPCI was created in 1993. It is a total return commodity index that measures the reinvested daily returns of a portfolio of commodity futures and the daily interest associated with fully collateralized futures investments. The index contains 19 different commodity futures contracts representing five major commodity groups grains wheat, corn, soybeans, soybean meal, and soybean oil , metals gold, silver, and copper , energy crude oil, heating oil, unleaded...
Prior Empirical Research
There are two key questions with respect to managed futures 1 Will an investment in managed futures improve the performance of an investment portfolio and 2 Can managed futures products produce consistent returns The case for managed futures products as a viable investment is mixed. Elton, Gruber, and Rentzler, in three separate studies examine the returns to pub lic commodity pools.2 In their first study, they conclude that publicly offered commodity funds are not attractive either as...
Due Diligence for Hedge Fund Managers
In our prior chapters we addressed the questions of what What are hedge funds , why Why should hedge funds be included in an investment portfolio , and how How should a hedge fund manager be selected . We now turn to the question of who. Who should be selected as your hedge fund manager will depend on due diligence. Due diligence starts the initial process of building a relationship with a hedge fund manager. It is an unavoidable task that investors must follow in order to choose a manager. Due...
The Relationship Between Futures Prices And Spot Prices
As we noted above, the easiest way to gain exposure to commodities is through commodity futures contracts. These contracts are transparent, are denominated in standard units, are exchange traded, have daily liquidity, and depend upon the spot prices of the underlying commodity. The last point, the relationship between spot and futures prices, must be developed to understand the dynamics of the commodity futures markets. A futures contract obligates the seller of the futures contract to deliver...
Outside Service Providers
The investor must document who is the hedge fund manager's outside auditors, prime broker, and legal counsel. Each of these service providers must be contacted. First, the investor should receive the hedge fund manager's last annual audited financial statement as well as the most current statement. Any questions regarding the financial statements should be directed to the CFO and the outside auditors. Any opinion from the auditors other than an unqualified opinion must be explained by the...
MLM Index
Mount Lucas Management introduced the MLM Index MLMI in 1988.23 It was the first passive index of returns to futures investing. The MLMI differs significantly from the previous futures indices in three ways. First, the MLMI is designed to be a trend following index. The MLMI uses a 12-month look back window for calculating the moving average unit asset value for each futures market in which it invests. Once a month, on the day prior to the last trading day, the algorithm examines the current...
Exhibit 1 Correlation with Inflation
3 If the futures margin is deposited in cash, then the futures broker may pay a higher interest rate on that deposit. Alternatively, if the futures margin is deposited in Treasury bills, as the T-bills mature, newer, higher yielding T-bills may be used to replace them. 4 We use the Goldman Sachs Commodity Index as our proxy for commodity prices. There are, in fact, several commodity indices that we will discuss later in the chapter. Data for the GSCI was provided by Heather Shemilt at Goldman...
The Investment Company Act Of 1940
The Investment Company Act of 1940 the Company Act was designed to regulate investment pools. Today, this act primarily regulates the mutual fund industry. Mutual funds are investment companies for purposes of the Company Act and the SEC. Under Section 3 a of the Company Act, an investment company Means any issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. While this definition...
General Classification For Hedge Funds
Recall that in Chapter 4 we provided a graphical comparison between hedge funds and traditional long-only managers. Long-only managers typically invest in either the equity or bond market, but do not leverage their investment bets. Therefore, their investment programs have considerable market risk exposure, but very little leverage or credit risk exposure. We present again Exhibit 1 where we plot market risk versus credit risk for several styles of long-only managers. Again, we use a relative...
Economics Of The Commodity Markets Normal Backwardation Versus Contango
With this pricing framework in place, we turn to the economics of commodity consumption, production, and hedging. Commodity futures contracts exhibit a term structure similar to that of interest rates. This curve can be downward sloping or upward sloping. The reasons for the different curves will be determined by the actions of hedgers and speculators. Consider a petroleum producer such as ExxonMobil. Through its exploration, developing, refining, and marketing operations, this company is...
The Securities Act Of 1933
The Securities Act of 1933 the 1933 Act was born out of the Great Depression. With the collapse of the stock market in 1929 and the economic depression that followed, Congress sought to make the financial markets a safer place for investors. The 1933 Act was enacted to regulate the initial sale of securities to investors. Prior to the 1933 Act, the initial sale of securities to investors was unregulated. Legitimate corporations and partnerships as well as scam artists could produce an offering...
The Commodity Exchange
The Commodity Exchange Act the CEA was promulgated by Congress in 1974. The CEA accomplished two major goals. First, it established the Commodity Futures Trading Commission as the regulatory authority for the futures industry including the futures exchanges. Second, it established disclosure, record keeping, and reporting rules for commodity pool operators CPOs , commodity trading advisors CTAs , futures commission merchants FCMs , and introducing brokers. It is the rules that regulate CPOs...
Merger Arbitrage
Merger arbitrage is perhaps the best-known arbitrage among investors and hedge fund managers. Merger arbitrage generally entails buying the stock of the firm that is to be acquired and selling the stock of the firm that is the acquirer. Merger arbitrage managers seek to capture the price spread between the current market prices of the merger partners and the value of those companies upon the successful completion of the merger. The stock of the target company will usually trade at a discount to...
Should Hedge Funds Be Part Of An Investment Program
Before considering hedged funds as part of a strategic investment program, we must first ask the question Are they worth it Initially, we must consider the return potential of hedge funds. Second, we must determine whether hedge funds have a place within a diversified portfolio that includes stocks and bonds. Goldman, Sachs amp Co. and Financial Risk Management Ltd. in two reports study the returns to hedge funds over two time periods, 1993-1997 and 1994-1998.2 Over the first time period, they...
Opportunistic Hedge Fund Investing
The term hedge fund can be misleading. Hedge funds do not necessarily have to hedge an investment portfolio. Rather, they can be used to expand the investment opportunity set. This is the opportunistic nature of hedge funds they can provide an investor with new investment opportunities that she cannot otherwise obtain through traditional long only investments. There are several ways hedge funds can be opportunistic. First, many hedge fund managers can add value to an existing investment...
Graphical Presentation Of The Hedge Fund Industry
It should be no surprise to most investors that hedge funds operate differently from traditional long-only investment managers. Long-only managers typically invest in either the equity or bond market, but do not leverage their investment bets. Therefore, their investment programs have considerable market risk exposure, but very little leverage or credit risk exposure.1 Consider Exhibit 1. This exhibit plots market risk versus credit risk for several styles of long-only managers. We use a...
Due Diligence Checklist
Chief Executive Officer_ Chief Operating Officer_ Chief Investment Officer Chief Financial Officer__ Head of Trading_ Attach biographies of key principals include education, work experience, and professional degrees this may be taken from the offering memorandum . Regulatory Registrations please check If any of the above were checked, please indicate the regulatory authority with whom the hedge fund manager is registered, and the date of the registration. Hedge Fund Style e.g., Market Neutral,...
Investment Process
Most investors prefer a well-defined investment process that describes how an investment manager makes its investments. The articulation and documentation of the process can be just as important as the investment results generated by the process. Consider the following language from another hedge fund disclosure document The manager makes extensive use of computer technology in both the formulation and execution of many investment decisions. Buy and sell decisions will, in many cases, be made...
Fund Organization
The hedge fund manager may invest the hedge fund's assets through an off-shore master trust account or fund. An off-shore master trust account is often used to take into account the various tax domiciles of the hedge fund's investors. Often, a hedge fund manager will set up two hedge funds, one on-shore U.S.-based and one off-shore. Master trusts are typically established in tax neutral sites such as Bermuda or the Cayman Islands. The purpose of the master trust is to invest the assets of the...
Is Hedge Fund Performance Persistent
This is the age-old question with respect to all asset managers, not just hedge funds Can the manager repeat her good performance This issue, though, is par 13 See Brown, Goetzmann, and Ibbotson, Offshore Hedge Funds Survival and Performance, 1989-1995, and Schneeweis and Spurgin, Multifactor Analysis of Hedge Fund, Managed Futures, and Mutual Fund Return and Risk Characteristics. 14 See Goldman, Sachs amp Co. and Financial Risk Management Ltd., The Hedge Fund Industry and Absolute Return Funds...
Relative Value Arbitrage
Relative value arbitrage might be better named the smorgasbord of arbitrage. This is because relative value hedge fund managers are catholic in their investment strategies they invest across the universe of arbitrage strategies. The best known of these managers was Long Term Capital Management LTCM . Once the story of LTCM unfolded, it was clear that their trading strategies involved merger arbitrage, fixed income arbitrage, volatility arbitrage, stub trading, and convertible arbitrage. In...
Fixed Income Arbitrage
Fixed income arbitrage involves purchasing one fixed income security and simultaneously selling a similar fixed income security. The sale of the second security is done to hedge the underlying market risk contained in the first security. Typi 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 cally, the two securities are related either mathematically or economically such that they move similarly with respect to market developments. Generally, the difference in pricing between the two...
Convertible Bond Arbitrage
Hedge fund managers tend to use the term arbitrage somewhat loosely. Arbitrage is defined simply as riskless profits. It is the purchase of a security for cash at one price and the immediate resale for cash of the same security at a higher price. Alternatively, it may be defined as the simultaneous purchase of security A for cash at one price and the selling of identical security B for cash at a higher price. In both cases, the arbitrageur has no risk. There is no market risk because the...
Strategic versus Tactical Allocations
Alternative assets should be used in a tactical rather than strategic allocation. Strategic allocation of resources is applied to fundamental asset classes such as 7 See Harry Markowitz, Portfolio Selection New Haven, CT Cowles Foundation, Yale University Press, 1959 . 8 See Jeffery Horvitz, Asset Classes and Asset Allocation Problems of Classification, The Journal of Private Portfolio Management Spring 2000 . equity, fixed income, cash, and real estate. These are the basic asset classes that...
