Valuating and Calculating Returns on Alternative Investments

Hedge Funds

Valuating and calculating returns for hedge funds include issues such as the difference between fund performance and investor performance (net-of-fees, redemption issues). The use of high leverage in hedge funds can amplify gains and losses. Investors must, therefore, be careful when assessing the risk-reward of a fund. Other issues include the effect of redemptions on fund performance.

A valuation can be difficult if many assets are not openly traded, but most funds use “average quotes” to value the portfolio.

Private Equity Funds

For private equity funds, valuation is typically done at the portfolio company (acquired firm) level. Discount cash flow models (DCF) are common. This notwithstanding, some investors will also look at comparables (market approach) or the asset approach (assets – debt = equity).

Calculating returns are highly dependent on the exit strategy and the cash flow generated by the portfolio company.  Often the bulk of the returns come at the exit stage. Nevertheless, some LBOs are cash-generating for the investors.

Real Estate

Real estate valuation can be tricky. For this reason, professional appraisers often price assets based on three main approaches: comparable sales, the income approach (income/expected return = asset value), or replacement cost. Cap rates are the expected returns for a given asset and are usually known in a given market and asset class. Assessment of returns from real estate typically involves looking at rental rates, cap rates, vacancy rates, and specific factors relevant to the properties (legacy issues, quality of construction).

Valuing REITs means determining the net asset value (NAV) or a discount model of income and expenses.

Commodities

Commodities valuation and returns vary depending on the type of securities used. Futures are priced according to the following model: futures price = spot price (1 + r) + storage costs – convenience yield. Convenience yield refers to the benefit of holding an asset for sale and taking advantage of volatility in the market (sell high), and using it on demand if necessary.

Many commodities are openly traded in public markets, but valuation depends on quality, quantity, grade, location of delivery, time of delivery, and many other factors. In addition, storage costs are often significant, and depending on the specific market for a commodity, the convenience yield may be larger or smaller than the storage costs for a given period.

Infrastructure

Infrastructure valuation relies on knowledge of regulatory risk, construction risk, reliability of cash flows (tolls, utilities prices). Returns are often reliable, but heavy regulation on profits and service quality can hurt.

Question

Which of the following statements is inaccurate?

1. Alternative investments track markets with a high degree of correlation.
2. Real estate valuation relies on three factors: cost, market, and income.
3. Discount cash flow modelling is a common valuation tool for private equity investors.

Solution

The correct answer is A.

Alternative investments typically do not track the movements of the markets.  They offer hedging opportunities for investors.

Options B and C are accurate statements.

Reading 50 LOS 50e:

describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure