Last Revised: 08/08/2022

2023 Level 2 - Alternative Investments

Readings Page

Overview of Types of Real Estate Investment 2

Investments in Real Estate through Private Vehicles 12

Investments in Real Estate Through Publicly Traded Securities 16

Private Equity Investments 23

Introduction to Commodities and Commodity Derivatives 41

Review 59

UI.D122845772

This document should be used in conjunction with the corresponding readings in the 2023 Level 2 CFA® Program curriculum.
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with permission from CFA Institute. All rights reserved.

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 Last Revised: 08/08/2022

Overview of Types of Real Estate Investment

a. compare the characteristics, classifications, principal risks, and basic forms of

public and private real estate investments

b. explain portfolio roles and economic value determinants of real estate investments

c. discuss commercial property types, including their distinctive investment

characteristics

d. explain the due diligence process for both private and public equity real estate
investments

e. discuss real estate investment indexes, including their construction and potential
biases

UI.D122845772

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Real Estate Investments

Page 1/
➞ Basic Forms/ owner occupied
single family rental
Residential urban
multi-family* rental
suburban
high rise garden or
low-rise
townhouse
Non-residential Office*
Industrial/Warehouse*- light/heavy manufacturing
Shopping Centers*- covered malls/strip malls
Multi-use (combinations of commercial types)

Farmland each produce a saleable commodity

Timberland + price appreciation

* Core property types

- core real estate investment style ➞ investing in high-quality,
well leased core property types with low leverage (< 30% of
in the largest markets with strong diversified asset value)
economies

Page 2
➞ Basic Forms/ LOS a
non-core properties - hotels, senior housing, hospitals, - compare UI.D122845772

MHC (manufactured home communities), cell towers,

data centers, etc…

Public Private
shares of REOCs direct investment higher required
Equity shares of REITs, ETFs, as a LP to an rate of return
index funds investment fund income + price
private REITs/REOCs appreciation

mREITS mortgages interest plus

Debt MBS private debt principal
unsecured REIT debt band debt

divisibility & diversification requires management expertise

liquidity longer investment horizons

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Page 3
➞ Characteristics/ LOS a
a) unique asset & fixed location - compare
- no 2 properties are the same
(use, age, size, location, type of construction, quality of tenant
and leasing arrangement)
b) high unit value - indivisibility

c) management intensive - maintaining the property

- negotiating leases
creates additional
costs - collecting rents

d) high transaction costs - appraisers, lawyers, agents/brokers

e) Depreciation - or appreciation

f) Need for debt capital - ability to access funds, cost of funds

- values are sensitive to the cost and
availability of funds
(high rates + low credit availability = low property values)

Page 4
➞ Characteristics/ LOS a
g) Illiquidity - compare
UI.D122845772

h) price determination - often requires estimates or appraisals

➞ Risk Factors/ 1. Valuation/

a) Business conditions - affects both current income and property
values
b) Demographics - size and age dist. of population, new
household formation

c) Excess supply - tight markets ➞ rising rents

- encourages supply
- new development requires long lead times
- supply usually comes to market late in the
business cycle
- a contraction will create significant oversupply

d) Cost and availability of capital

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Page 5
➞ Risk Factors/ LOS a
e) Availability of Information - improving - compare

f) Lack of Liquidity

g) Rising Interest rates - raises costs of financing

2. Property Operations/
a) Management - property + asset management
(day-to-day ops.) (monitoring performance)

b) Lease provisions - rent reviews, step-ups/escalators

- more important for longer-term leases

c) Leverage - affects returns but not the value of the property

- loan-to-loan ratio (LTV: higher = more leverage)

d) Environmental - contaminants of previous owner or adjacent

property

Page 6
➞ Risk Factors/ LOS a
2. Property Operations/ - compare
e) Obsolescence - changes in tenant preferences, regulations, and
technology
UI.D122845772

- may not be economically viable to upgrade

f) recent and ongoing market disruption - online shopping,

growth of data and fulfillment centers, carbon
footprint
g) Others - unobserved physical defects, natural
disasters, pandemics, acts of terrorism, unknown risks

➞ Economic drivers/ age LOS b

- explain
cash flow = f(rental income, op. exp., leverage, CAPEX)
supply inflation credit availability
demand interest rates
economy credit risk

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Page 7
➞ Economic drivers/
LOS b
GDP growth - most - explain
important single economic factor

largest driver of apartment demand

consumer discretionary
- demand ↑ as incomes ↑

Demographic trends - long-term

others listed - short to medium
term
college graduation rates

age ➞ 65+, esp. 75+

Page 8
➞ Role in an investment portfolio/ LOS b
1/ Current income - lease/rent income - explain UI.D122845772
- typically largest component of return
2/ Price appreciation - capital gain component
3/ Inflation hedge - rents and property values typically rise with inflation
4/ Diversification - low correlation with the performance of traditional
asset classes

returns

correlations
- publicly traded
RE appears to
behave more like
stocks.

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Page 9
➞ Role in an investment portfolio/ LOS b
5/ Tax Benefits - depreciation tax shield for direct - explain
investments
- elimination of corporate tax for REITs as long as
a min. amount of taxable income is paid as a div.

➞ Risk and Return/

E(R) better yield than bonds ➞ higher current income
with the possibility for income growth
non-core Equities
leasing rates, terms, renewals affected by overall
Real Estate (core)
economy, as are equities
Bonds - real estate risk thus has an equity
𝛔 characteristic

Page 10
➞ Classifications/ LOS c
1/ Office - single tenant to multi-tenant - discuss
(build-to-suit) (typically has an anchor tenant) UI.D122845772

- pre-leased buildings for development are easier to finance

- speculative development increases as the property cycle heats
- net lease - tenant pays op. exp. up.
- lease structures differ by country and property

2/ Industrial/Warehouse - wholesale/retail distribution centers

- light to heavy manufacturing
- warehouse/showroom
- net leases usually

3/ Retail - covered malls, strip malls, community shopping centers (big-box

stand-alone properties pad locations)
- office with ground floor retail common
- net leases, fixed or variable rent (base + % of sales)

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Page 11
➞ Classifications/
LOS c
4/ Hospitality - motels, small hotels, hotels at destinations - discuss
(airports, tourist resorts)

5/ Other specialty - hospitals, labs, self-storage, student housing,

cell towers, data centers, parking facilities,
restaurants

- some types are more mgmt. intensive (i.e. hotels, recreational facilities)
- often property ownership is separated from operating the
business

➞ Investment characteristics by property type/ - location is key

Types of leases:
net lease - tenant pays operating expenses of building + unit
gross lease - owner pays operating expenses
triple net lease (TN or NNN)
common area/repairs, property taxes, insurance

Page 12
➞ Investment characteristics by property type/ LOS c
Types of leases: - discuss
sale and leaseback - company sells the building to a real UI.D122845772

estate investor and agrees to a long-term net lease

- medium/long-term leases include rent escalators (rent bumps or
rent step-ups)
- low vacancy rates + rising rents
➞ owner benefits more from short-term leases
(marking-to-market effects)
a) Office: depends heavily on employment growth
lease duration ~ 3-5-10 years
- typically net leases

b) Industrial/warehouse: heavily dependent on strength of economy & growth

warehouse demand also depends on M/X activity
Industrial - long-term net leases usually

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Page 13
➞ Investment characteristics by property type/ LOS c
c) Retail: depends on trends in consumer spending - discuss
- leases vary considerably anchors ➞ 10-20 yrs. favourable rents
attract other tenants
- triple net for strip malls, community sh. centers
- percentage lease for covered malls typically

- base rent + % of sales 𝟐𝟓𝟎, 𝟎𝟎𝟎 $4.16M

=
. 𝟎𝟔
e.g. $50/ft2 5000 ft2 or 6% sales if larger
natural
d) Multi-family - depends on population growth, esp. for the age breakpoint
segment most likely to rent
- also depends on cost of renting vs. owning (HP ↑, renting ↑)
- as rates rise, mortgage costs rise + opportunity cost of
home equity rises ➞ shift towards renting

- typically 1 yr. leases (gross) + unit costs (util., phone, internet)

Page 14
➞ Considerations in due diligence/ LOS d
market review - trends, local market pop., job, and - explain

income growth, expected supply, vacancy rates, rents, etc…

UI.D122845772

lease and rent review - in-place rents vs. market rents

short leases ➞ mark-to-market potential impact
- history of payments/defaults
costs of releasing space - brokerage, leasehold improvements, grace periods,
seek underlying documentation - bills for op. exp. vacancy periods
several years of audited financial statements
environmental inspection
physical/engineering inspection
title search/property survey (easements)
service/maintenance records
verify compliance with zoning, regulations, parking ratios
verify taxes, assessments have been paid

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Page 15
➞ Considerations in due diligence/
LOS d
- for a real estate company (REIT) - explain

tenant concentration
balance sheet/leverage analysis
mgmt. ➞ backgrounds, skill sets, experience, track records
- completion and stabilization of developed properties
- unit upgrades
- financial statements + notes
- compare stock price with NAVPS
- compare cash flow multiples or div. yields with comparables

LOS e
➞ Appraisal-based indexes/
- discuss
NCREIF Property Index (NPI) - common U.S. Index

- members contribute information on the appraised value,

NOI, CAPEX, occupancy rate, etc. every quarter

Page 16
➞ Appraisal-based indexes/ LOS e
𝐍𝐎𝐈 − 𝐂𝐀𝐏𝐄𝐗 + (𝐄𝐧𝐝𝐢𝐧𝐠 𝐌𝐕 − 𝐁𝐞𝐠. 𝐌𝐕) - discuss
Return = UI.D122845772
𝐁𝐞𝐠. 𝐌𝐕
HPR Ending MV
appraisals
(a single period IRR) Beg. MV

𝐍𝐎𝐈 (𝐄𝐧𝐝𝐢𝐧𝐠 𝐌𝐕 − 𝐁𝐞𝐠. 𝐌𝐕) − 𝐂𝐀𝐏𝐄𝐗

= income return = capital return
𝐁𝐞𝐠. 𝐌𝐕 𝐁𝐞𝐠. 𝐌𝐕

𝐍𝐎𝐈 − 𝐂𝐀𝐏𝐄𝐗
= cash return
𝐁𝐞𝐠. 𝐌𝐕

- a return measure is first calculated for each reported property and then
value-weighted to get the return for all properties in the index
- allows for the comparison of real estate performance with other
asset classes
- quarterly returns help measure risk (volatility or s.d. of returns)
- index also acts as a benchmark

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Page 17
➞ Transaction-based indexes/ LOS e
- requires observations of enough transactions - discuss
- both NCREIF and MSCI

1) repeat-sales index - relies on repeat sales of the same property

change in value since last sale

every quarter ➞ observed
indicates how market conditions
sales & prices
have changed

a regression methodology allocates this

change to each time period

2) Hedonic Index - requires only one sale of the property

- uses a regression with IVs that control for age,
size, location, etc…

Page 18
➞ Advantages/Disadvantages/ LOS e
lags market prices - discuss
- appraisal lag
smooths the index - understates volatility UI.D122845772

(thus appearing to have lower correlations with other

asset classes)
also overstates Sharpe ratio

- can unsmooth returns

- can use a transaction-based index for measure of correlation for
asset allocation or for comparisons with other asset classes

- transaction-based index - leads appraisal-based index

- includes a random element (noise) due to statistical
technique used
- the more transaction, the less noisy the series

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Investments in Real Estate through Private Vehicles

a. discuss the income, cost, and sales comparison approaches to valuing real estate
properties

b. compare the direct capitalization and discounted cash flow valuation methods

c. estimate and interpret the inputs (for example, net operating income, capitalization
rate, and discount rate) to the direct capitalization and discounted cash flow valuation
methods

d. calculate the value of a property using the direct capitalization and discounted cash
flow valuation methods

e. calculate and interpret financial ratios used to analyze and evaluate private real estate
investments

UI.D122845772

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Real Estate Investments

Page 1/
➞ Valuation Approaches/

1/ Income approach - DCF to calculate the price of a

property (PV of future cash flows including
proceeds from sale)

2/ Cost approach - equivalent to replicating the property

Replacement cost:
- buy land & construct the facility with the same utility
or functionality (+/- adjustments)
- age, design, location
3/ Sales comparison approach
- what similar or comparable properties transacted for in
the current market (+/- adjustments)
- size, age, location, condition
- the most recent transactions should carry more weight

Page 2/
➞ Valuation Approaches/ UI.D122845772

- 3 approaches unlikely to result in the same value

Highest and best use: the value a vacant site would hold if used
for its highest and best use
- land value is based on its highest and best use even if
there is an existing building on the site

if the building is not consistent with highest and best

use, the value of the building would be lower, not the
land

Note: highest and best use is not the use with the highest total value
- it is the use that imputes the land with the highest value
example #15/16

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Page 3/
Income Approaches/

1/ Direct Capitalization Method:

MV = 𝐍𝐎𝐈 ➞ based on what is expected during the current (1st)

𝐫−𝐠 year of ownership
cap-rate

𝐍𝐎𝐈 going-in cap. rate, NOI in first year of ownership

∴ cap-rate =
𝐌𝐕 terminal cap. rate, NOI in first year after sale

estimate r and g
or: observe what comparable properties are selling for
𝐍𝐎𝐈 𝐨𝐟 𝐜𝐨𝐦𝐩𝐚𝐫𝐚𝐛𝐥𝐞
Cap. rate of comparables = 𝐀𝐕𝐆 > I
𝐒𝐚𝐥𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐜𝐨𝐦𝐩𝐚𝐫𝐚𝐛𝐥𝐞
𝐌𝐕 - properties with higher growth potential
= multiple
𝐍𝐎𝐈 will have higher multiples (i.e. lower cap. rate)

Page 4/
Income Approaches/

1/ Direct Capitalization Method:

e.g./ NOI = 250K comparable cap. rate = 5% UI.D122845772

Property Value = 250K/.05 = 5M

- if rents have a 2% escalator/yr., NOI will grow at 2%

𝑬:𝑹𝑷𝒆 < = cap. rate + growth rate = (r - g) + g = r

Note: for rents that escalate less frequently, cannot just add the 2 terms

- it is possible for NOI g not to equal the implicit g in the cap. rate
- depending on lease structures, some leases will escalate per
lease term, some will re-lease/re-new at market rents
- if market rent g > escalator g , then NOI g > cap. rate g

Stabilized NOI - what the NOI would be ignoring current

extraordinary conditions (renovations, temporary overbookings)
ex. #18

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Page 5/
Income Approaches/

2/ DCF Method - used when NOI is not expected

to grow at a constant rate

ValueDCF = explicit forecast period + Terminal Value

requires an estimated selling price

𝐍𝐎𝐈𝐭#𝟏 ➞ first year of new - PV of income to be received by
𝐓𝐕𝐭 =
𝐭𝐞𝐫𝐦𝐢𝐧𝐚𝐥 investor next investor
𝐜𝐚𝐩 − 𝐫𝐚𝐭𝐞
could be higher, lower, or the same as the going-in cap. rate
- if interest rates are expected to rise, r ↑ and cap. rate ↑
ex. #19 - g typically lower due to age, hence cap. rate ↑
ex. #20 - but strong economy may increase forecast of g
ex. #21

Note: Ex. 22 introduces new information in the answer that is

required to answer the question

Page 6/
➞ Private Real Estate Debt/
- the use of debt introduces leverage into the investment
- small drop in NOI or property value can result in UI.D122845772

a large decrease in equity return

- max. amount of debt usually limited loan-to-value ratio

debt service coverage ratio
(depending on which measure results in
𝐃𝐒𝐂𝐑 = 𝐍𝐎𝐈7𝐃𝐞𝐛𝐭 𝐒𝐞𝐫𝐯𝐢𝐜𝐞 (~ 1.25-1.5)
the lowest loan amount)

both interest and principal

Cash-on-cash return = first yr. ROI (measure of CF to equity)

Note: a loan may be participating ➞ lender gets some of the price

appreciation of the property in exchange for a lower interest rate

ex. #23-26

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Investments in Real Estate Through Publicly Traded Securities

a. discuss types of publicly traded real estate securities

b. justify the use of net asset value per share (NAVPS) in valuation of publicly traded
real estate securities and estimate NAVPS based on forecasted cash net operating
income

c. describe the use of funds from operations (FFO) and adjusted funds from operations
(AFFO) in REIT valuation

d. calculate and interpret the value of a REIT share using the net asset value, relative
value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches

e. explain advantages and disadvantages of investing in real estate through publicly

traded securities compared to private vehicles

UI.D122845772

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Real Estate Investments

Page 1/
➞ Types of Publicly Traded Real Estate Securities/

a) Real Estate Investment Trusts (REITs)

a) equity REIT - own, operate (maybe develop)

income-producing real estate
b) mortgage REITs - make loans, or hold mortgage securities,
backed by real estate

b) Real Estate Operating Companies (REOCs)

- taxable
- REOC structure used when a jurisdiction does not have a
tax advantaged REIT regime in place
or/ engage to a large extent in the development of properties
(with the intent to sell)
or/ if they offer other non-qualifying services ➞ brokerage, 3rd party
property management

Page 2/
➞ Types of Publicly Traded Real Estate Securities/
UI.D122845772

b) Real Estate Operating Companies (REOCs)

- primary cash flows from the sale of properties
- reinvest cash flow rather than distribute large dividends

c) Mortgage-back securities (debt) - covered in fixed income

➞ REIT structures/ corporations or trusts

- tax-advantaged, required to distribute 90%-100% of taxable
earnings
> 75% of assets in real estate
> 75% of income from rental or interest income

- may have min. number of shareholders, max. share ownership,

min. number of properties, maximum asset concentration,
maximum level of non-rental income
- most US REITs are self-managed and self-advised
- externally managed relies on property management companies

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Page 3/
➞ Advantages/

1/ greater liquidity - publicly traded

2/ transparency - share price, quarterly financials, annual audit
3/ diversification - geography, property type
4/ high-quality portfolios
5/ active professional management
6/ high, stable income - predictable, recurring, contractual revenue
7/ tax efficiency - at corporate/trust level

➞ Disadvantages/
- lack of retained earnings - more frequent secondary offerings
- constrained in the types of assets the own

- will own taxable REIT subsidiaries (TRS)

- concentrate non-qualifying revenue there

Page 4/
+ premium = potential overvaluation
➞ Net Asset Value per share
- discount = potential undervaluation
(NAVPS)
key word - over/under valuation may UI.D122845772

largest component of be justified

intrinsic value

IFRS - Investment Property - owned for the purpose of earning either

rental income or price appreciation
- valued with cost model or fair value model
- method must be disclosed all changes affect net income
cost ➞ dep. method, useful life, + FV - must be able to reliably determine
FV on a continuing basis
FV ➞ how determined, reconcile
beg. + end. FV balances

U.S. GAAP - cost model only tends to - overstate dep.

- understate carrying values

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Page 5/
NAVPS - difference between assets and liabilities all
taken at market value, divided by the number of
shares outstanding

MV assets ➞ appraised value of properties (if available)

or 𝐍𝐎𝐈M𝐜𝐚𝐩 − 𝐫𝐚𝐭𝐞 (comparables)

(- goodwill, DTA,
deferred financing exp.) + other assets
- MV liabilities
(-DTL)

# of shares outstanding

Page 6/

result of straight-lining rent

(may be pos. or neg.)
UI.D122845772

reflect a full year’s impact of

acquisitions

value of other tangible assets

$𝟐, 𝟗𝟏𝟒, 𝟏𝟗𝟖

= $𝟓𝟐. 𝟑𝟑 𝐍𝐀𝐕𝐏𝐒
𝟓𝟓, 𝟔𝟖𝟗

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Page 7/
- since comparables are from the private market,
so are cap-rates and values per square foot
- NAV reflects the value of a REITs/REOCs assets
to a private market buyer

- may or may not be the same as the value that a

REIT/REOC investor may use
- helps account for some of the discount/premium range
- NAV also does not reflect value that a mgmt. team can add
(or subtract) from NAV
- other NAV issues
NAV can become subjective in illiquid markets
undeveloped land, very large properties with few/no comparables,
specific use properties ➞ all complicate NAV
- since REITs/REOCs offer liquidity, r should be lower, ∴ should trade
at a premium (can also attract better mgmt.)

Page 8/
➞ FFO/AFFO: widely accepted and reported measure of
the operating performance of a REIT

FFO = Net Income

+ Dep. ➞ since RE often appreciates over the long-term, Dep.

UI.D122845772

does not reflect economic reality

+ Amort. ➞ leasing commissions, tenant improvements/allowances

+ losses
➞ on sale of properties - do not represent sustainable
- gains
normal income
+ impairments
+ writedowns

AFFO (FAD - funds available for distribution)

= FFO
+/- non-cash rent
- maintenance-related CAPEX and leasing commissions

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Page 9/
➞ FFO/AFFO: AFFO is superior to FFO as a measure of
economic income since it takes into consideration
the CAPEX needed to maintain the economic
income of the property
- also more reflective of dividend-paying ability ex. # 30/31

- open to more variation and error in estimation than FFO

Relative valuation measures

h versus historical multiples
versus other REITs or
𝐏7
𝐅𝐅𝐎
𝐏7 - based on net income available to equity, thus
𝐀𝐅𝐅𝐎 represent levered income
𝐄𝐕7
𝐄𝐁𝐈𝐓𝐃𝐀 - measures income before the leveraging effects of debt
- facilitates like-for-like valuation comparisons

drivers of multiples 1/ expectations for growth of FFO/AFFO

- higher expectations, higher multiple

Page 10/
drivers of multiples
2/ risk associated with the underlying real estate
- cash flow volatility associated with asset type, UI.D122845772

quality, age, market conditions, etc…

e.g. apartments less risky CF vs. hotels

higher multiples

3/ risks associated with the company’s capital structure and access

h to capital
- as leverage ↑, multiples ↓ since r ↑ as risk ↑
- investors anticipate equity offering

+/ widely accepted P/FFO ➞ most frequently used multiple

readily available through market data providers (FF0)

-/ may not capture the intrinsic value of all real estate assets
(esp. non-income producing assets, e.g. undeveloped land)
P/FFO ignores cap. reinvestment necessary to maintain income levels
- P/AFFO does, wide variations in assumptions exist

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Page 11/
LOS n - calculate/interpret - mini case study
LOS o - explain

UI.D122845772

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Private Equity Investments

a. explain sources of value creation in private equity

b. explain how private equity firms align their interests with those of the
managers of portfolio companies

c. compare and contrast characteristics of buyout and venture capital

investments

d. interpret LBO model and VC method output

e. explain alternative exit routes in private equity and their impact on value

f. explain risks and costs of investing in private equity

g. explain private equity fund structures, terms, due diligence, and valuation in
the context of an analysis of private equity fund returns

h. interpret and compare financial performance of private equity funds from the
perspective of an investor

i. calculate management fees, carried interest, net asset value, distributed to UI.D122845772

paid in (DPI), residual value to paid in (RVPI), and total value to paid in
(TVPI) of a private equity fund

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Private Equity
Page 1
Investor
LOS a, b
Section 3 costs: risks of investing in PE - explain
PE
Section 2 main ways in which valuation is approached
target (majority of transactions occur in the
companies private market)

- focus of this reading:

Venture · seed stage pre-sales Buyout · acquisition capital
Capital · start-up stage · LBO
post-sales
· expansion stage · MBO
· replacement capital – from one
PE firm to another

Page 2
- investors in PE firms institutional LOS a, b
high net worth individuals - explain
typically expect
their money returned with high
expected profit within 10 years of committing funds

- hence PE firms are not buy & hold models, they

UI.D122845772

are buy-to-sell models

⇒ Valuation techniques used/ depend on stage of development

Note: price paid = f(negotiation, valuation)

1. Income approach expansion ➞ maturity growing or stable

(DCF)
2-step, 3-step

2. Relative value late expansion ➞ maturity - stability of CFs

(comparables)

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Page 3
⇒ Valuation techniques used/ LOS a, b
3. Real option - the right to undertake a - explain
business decision (seed or start-up)
4. Replacement Cost – estimated cost to recreate the
business as it stands (seed or start-up)
(development stage)

- other key considerations/

- the value of control (premium for control)
- impact of illiquidity (discount for both illiquidity
- country risk & marketability)

adjustments to value, not adjustments to costs

of capital

Page 4
⇒ How is value created/ LOS a, b
1. The ability to re-engineer the private firm to - explain

generate superior returns

- typically have in-house consulting capabilities
supported by seasoned industry veterans (CEOs, CFOs)

2. The ability to access credit markets on favourable UI.D122845772

terms - for private equity, leverage is measured as a

multiple of EBITDA, not equity

- ability to arrange syndication, create structured products

such as CDOs & CLOs

- locating the acquisition holding company in a favourable

tax jurisdiction
- high levels of leverage and subsequent
paydowns crowd out FCFE, reducing the ability to mgmt.
to make reinvestment mistakes that destroy value

25
 Last Revised: 08/08/2022

Page 5
⇒ How is value created/ LOS a, b
3. a better alignment of interests between - explain
private equity firm owners and the managers of
the firms they control
- results-driven mgmt. pay packages & certain
contractual clauses
e.g. tag-along – gives min. sh. the right to
have their shares bought at
the same terms as a maj. sh.
drag-along – gives maj. sh. the right to
force a min. sh. to join in the
sale of a company

- elimination of ‘short-termism’ of public markets

(having to meet quarterly targets)

Page 6
⇒ Other methods of alignment of interests/ LOS a, b
- explain
1. Corporate board seats – ensures PE control
2. Non-compete clauses – imposed on founders/mgmt. preventing
them from restarting/re-entering a similar business
for a specified period of time UI.D122845772

3. Preferred dividends/liquidation preference – PE generally uses

- may be 2x–3x participating conv. pref.
4. Reserved matters – critical decisions that must be
approved by PE firm
5. Earn-outs – seller of a business is to obtain additional
compensation/valuation in the future if the business
achieves certain financial goals

- a contingent payout – shifts some of the purchase

price to be paid into the future

26
 Last Revised: 08/08/2022

Buyout vs. Venture Capital

Page 7
- other than public-to-private, there is no direct LOS c, d
market evidence on the valuation of a target - compare
comparison companies trading - contrast
- indirect evidence multiples
recent transactions - interpret
acquisition
multiples
Buyout Venture Capital

- steady, predictable CFs - low CF predictability (unrealistic proj.)

- excellent market position - lack of market history, new or
unproven market
- significant asset base - weak asset base
- strong, experienced mgmt. team - newly formed mgmt. team but may
have strong individual records
- extensive use of leverage - primarily equity funded
- large prop. of senior debt - leverage is rare
- significant junior debt

Page 8
LOS c, d
Buyout Venture Capital
- compare
- risk is measurable - assessment of risk - contrast UI.D122845772
- interpret
difficult – new tech., markets
- predictable exit - exit difficult to anticipate
- established products - route to market non proven
- potential for restructuring - significant cash burn
& cost savings
- low wc requirement - expanding capital requirement (growth)
- deep & full DD - technological & commercial DD
- close monitoring by PE firm - monitoring of milestones
- lower variance of returns - high returns from a few investments,
from underlying investments significant number of write-offs

27
 Last Revised: 08/08/2022

Page 9
Buyout Venture Capital LOS c, d
- compare
- buyout firms are large - VC firms generally - contrast
players in capital markets are not - interpret

- most transactions are auctions - more proprietary transactions

(competing bids) (relationship-based)

- revenue typically from - revenue typically from

· carried interest · carried interest
· transaction fees
· monitoring fees (+ mgmt. fee)

Page 10a
- focus in on LBOs - using borrowed money to finance a LOS c, d
significant portion of a target’s acquisition price - compare
- contrast
- PE firms look for characteristics that make a target - interpret
firm attractive

1/ Undervalued/depressed stock - easier to pay a premium in order to UI.D122845772

secure approval by seller’s shareholders

2/ Willing mgmt. and shareholders - not into hostile takeovers/proxy fights

3/ Inefficient companies - source of return

4/ Strong and sustainable cash flows - required in order to pay the debt

5/ Low leverage - a significant amount to debt will be introduced, so

existing high levels of leverage would limit the use of debt

6/ Assets - unencumbered physical assets can be used to secure

lower cost debt

28
 Last Revised: 08/08/2022

Page 10b
⇒ Valuation Issues/ LOS c, d
A. Buyout transactions – buyer obtains from seller - compare
- contrast
obtaining MBO a controlling stake in the
LBO - interpret
control equity of a target company
takeover
DD
heavily scrutinized by strategic
LBO Model/ ➀ FCF forecasts by PE firm commercial
target mgmt. financial
exit year legal
PV = max Price
environmental
that can terminal value
be paid expected holding horizon - expected range of
of the PE firm multiples on the basis
➁ CFs discounted by the E(R) of peer group
of the providers of capital comparables (EV/EBITDA)

➂ - amount of financing available for the transaction

Page 11
⇒ Valuation Issues/ LOS c, d
A. Buyout transactions - compare
- contrast UI.D122845772

- interpret

heavily dependent on
the exit

sources of additional value

arising from operational optimal cap. structure

improvements - repayment with operational
- enhanced corporate governance CFs before the exit

29
 Last Revised: 08/08/2022

Page 12
⇒ Valuation Issues/
LOS c, d
A. Buyout transactions - compare
- contrast
- interpret

8000 – 4320
- 1600 – 2061)
× 1.6 am
ity progr IRR = 85%
. equ (8000 – 4230
– mgmt
M EP - 1600) × .95
IRR = 20%
- equity return +
50% Equity
pr. sh. return)
2400(1.12)5

reduction is
50% Debt critical in order
to deliver equity returns

Page 13a
VC Method/ DCF, multiples, and LBO model are not LOS c, d
practical due to substantial uncertainty about - compare
- contrast
future prospects
UI.D122845772

- interpret
- VC financing is done in stages (Series)

e.g./ Company A valued at $16M, needs $4M equity capital

Post money valuation = Pre-money valuation + Investment

(20M) (16M) (4M)

difficult to determine 20% VC share

∴ VC method works backwards
i.e. from ‘exit value’ to ‘pre-money value’

based on a multiple of some performance metric

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐚𝐭 𝐞𝐱𝐢𝐭
Post money valuation =
𝐑𝐎𝐈 10x - 30x
∴ Pre-money valuation = Post money valuation - new equity injection

30
 Last Revised: 08/08/2022

Page 13b
VC Method/ e.g./ Company B needs $500k LOS c, d
E (sales over IH) = $80M - compare
ROI = 20x multiple = 2x Sales - contrast
- interpret
𝟖𝟎𝐌 × 𝟐
∴ Pre-money val. = - 500k = 8M - 500k = 7.5M
𝟐𝟎
VC fractional ownership = 𝟓𝟎𝟎𝐤M𝟖𝐌 = 6.25%

(1 + IRR)t = ROI ➞ assuming a 5-yr. IH

20 = (1 + IRR)5
√𝟐𝟎 − 𝟏 = IRR ➞ IRR = 82.056%
𝟓

Option Pools/ - Company A (revisited) $16M needs $4M

- assume no option pool - assume 10M shares currently
𝟏𝟎𝐌7 = 12.5M
.𝟖
new shares 𝟐. 𝟓𝐌
= = 𝟐𝟎% Price/sh. = $𝟒𝐌M𝟐. 𝟓𝐌 = $1.60
old shares + new shares 𝟏𝟐. 𝟓𝐌

Page 13c
Option Pools/ - critical in attracting talent LOS c, d
- when options pools exist (typically), VC firms - compare UI.D122845772

- contrast
calculate per-share price on a fully-diluted basis
- interpret
∴ VC investors will be immune from the dilution effect of
option exercise, original shareholders absorb the effect

➞ Company A ➞ 10M shares + 2M option pool

𝟏𝟐𝐌7 = 15M
.𝟖

∴ 3M new shares at $𝟒𝐌M𝟑𝐌 = $1.33/share

fractional ownership = 𝟑𝐌M𝟏𝟑𝐌 = 23.08% ➞ but as options
are exercised, ownership
will be diluted to 20%

which is $𝟒𝐌M𝟐𝟎𝐌

31
 Last Revised: 08/08/2022

Page 13d
Stage Financing/ - stage financing is used to mitigate the LOS c, d
risk regarding significant uncertainty about - compare
- contrast
growth and profitability prospects
- interpret
e.g./ Company B ➞ raises $500k , post-money val. = $8M, VC ➞ 6.25% stake

Series A financing

- one year later, Series B raises $2M at 10x ROI, E(exit val.) = $300M
less risky at each new
Post-money val. = 𝟑𝟎𝟎𝐌M𝟏𝟎 = $30M
Series
Pre-money val. = $30M - $2M = $28M - convertible preferred
typically used with
𝟐
VCB fractional ownership = M𝟑𝟎 = 6.67% a stated div.
- sits higher in the
ROIB = (1 + IRR)5 ➞ (10).2 - 1 = 58.48% capital structure

VCA fractional ownership = (1 - .0667).0625 = 5.83%

𝟑𝟎𝟎𝐌 × 𝟓. 𝟖𝟑%
𝐑𝐎𝐈𝐀 = = 𝟏𝟕. 𝟒𝟗𝐌7𝟓𝟎𝟎𝐤 ~ 𝟑𝟓𝐱
𝟓𝟎𝟎𝐤

Exits Routes
Page 14
- typically considered before entering the transaction LOS e
UI.D122845772

1. IPO – highest valuation multiples - explain

- access to large amounts of capital
- attract high caliber managers
but/ costly & time consuming
- appropriate for companies with operating history or
excellent growth prospects
strategic buyer
2. Secondary market – acquisition
financial buyer – other PE/VC
firm
- advantages 1) next highest valuation besides IPO
2) new skills to the firm to help get to next
level of performance
3. MBO
4. Liquidation

32
 Last Revised: 08/08/2022

Risks & Costs

Page 15
⇒ PE investments usually restricted to qualified
LOS f
investors - explain
- general PE risk factors/
• illiquidity of investments
• unquoted investments
• competition for attractive investment opportunities – deal flow
• reliance on the mgmt. of portfolio companies (agency risk)
• loss of capital
• government regulations – affecting portfolio companies
• taxation risk
• valuation of investments – subject to significant judgement
• lack of investment capital
• lack of diversification
• market risk

Page 16
⇒ Costs/ bank financing costs LOS f
· transaction fees legal fees - explain
sale transaction fees

· investment vehicle fund setup costs – legal UI.D122845772

custodian
· administrative costs transfer agent typically a %
accounting cost of NAV
· audit costs
· mgmt. & performance fees – typically 2/20

earn-outs
· dilution
follow-on rounds of financing

· placement fees ∼ 2% fundraising fees

33
 Last Revised: 08/08/2022

Structure, Terms, Valuation, DD

fund structure Page 17

Investor - 2 main differentiating
terms LOS g
characteristics of PE - explain
valuation
PE firm due diligence
versus public equity:
1) commitment of funds followed
by drawdowns
2) J-curve effect
0 𝒕
⇒ Structure/
return
closed-end ⇒ fund does not
limited need to redeem partnership units
partners - no new funds unless specified and
at pre-determined time periods

⇒ PE firms need expertise in 2 domains

GP – PE firm
1) mgmt. of private equity investments
2) raising funds

Page 18
LOS g
- explain
UI.D122845772

T=0 T=10
4-5 yrs.

exits in this phase are typically

pre-marketing distributed
as well 1–2 yrs.

exits in this phase may be reinvested

34
 Last Revised: 08/08/2022

Page 19
⇒ Terms/ - contractually defined in a fund LOS g
prospectus available to qualified investors - explain

1) Economic Terms
a) management fee – as a % of committed capital paid
annually to the GP during the life of the fund
∼ 1.5% - 2.5%
b) transaction fees – fees paid to GPs in their advisory
capacity when they provide investment banking
services for a transaction benefiting the fund
c) carried interest – GPs share of profits generated by
the fund (∼ 20%)
d) ratchet – target company earn out
- allows mgmt. to increase its equity allocation
if certain targets are met

Page 20
1) Economic Terms LOS g
- explain
e) hurdle rate – the IRR a PE fund must
obtain before the GP receives any carried interest
(∼ 7% - 10%)
f) target fund size – signals GPs capacity to manage
UI.D122845772

a given size fund + ability to raise capital

g) vintage year – year the fund was launched
- allows performance comparisons to be made
h) term of the fund – typically 10 years, extendible
for another 1-2 yrs.

2) Corporate Governance Terms

a) key man clause – a certain # of key named executives
are expected to play an active role in fund mgmt.
- if not, fund may be blocked from making new inv.

35
 Last Revised: 08/08/2022

Page 21
2) Corporate Governance Terms LOS g
b) disclosure/confidentiality – PE firms have - explain
no obligation to disclose publicly their financial performance

c) Clawback provision – requires GP to return capital to LPs

in excess of agreed profit split
- normally due on fund termination but may be subject
to an annual reconciliation (true-up)

d) Distribution waterfall – provides for order of distribution to

LPs first before GPs receive carried interest

deal-by-deal (early dist. of CI to GPs – mostly U.S.)

total return GPs get CI only after LPs are whole
GPs get CI on any dist. if value of
inv. portfolio > 20% above invested capital

Page 22
2) Corporate Governance Terms LOS g
e) tag-along, drag-along - explain

f) no-fault divorce – GP can be removed with a

supermajority approval of LPs UI.D122845772

g) removal for cause – removal of GP or early

termination of fund (e.g. negligence, key-person event)

h) Investment restrictions – minimum level of

diversification
- geographic/sector focus
- limits on borrowing

i) Co-investment (a.k.a. sidecar deal)

- LPs have a right of co-investing along
with the fund

36
 Last Revised: 08/08/2022

Page 23
⇒ Due Diligence/ LOS g
- explain
· persistence – top performing funds tend to
continue to outperform, poor performing funds
tend to continue to underperform
· large range in performance
· limited liquidity – LPs may be locked-in
- typically lock-up periods

⇒ Valuation/ PE valuation typically associated with NAV

- assets are valued:
1) at cost – with significant adjustments for subsequent
financing events or deterioration
2) lower of cost or market

Page 24
⇒ Valuation/ LOS g
3) by a revaluation of a portfolio company - explain
whenever a new financing round involving new
investors takes place
4) at cost (no adjustments until the exit)
5) with a discount for restricted securities UI.D122845772

6) marked-to-market by reference to a peer group

of public companies (applying illiquidity discounts)
(rarely)

- industry valuation standards are increasingly being adopted by

funds
- valuation is mostly performed by GPs
- increasing number being performed by independent
valuers

37
 Last Revised: 08/08/2022

Evaluating Fund Performance

Page 25
➞ IRR – a cash flow weighted rate of return
LOS h
- deemed most appropriate measure of - interpret
PE performance by GIPS - compare

investors PE fund portfolio companies

net IRR gross IRR – a measure of the

- returns for investors PE mgmt. team’s record
in creating value

vs. peer group IRRs for similar

investment strategy & vintage year

Page 26
⇒ Multiples/ measure total return to investors LOS h
relative to the total sum investment - interpret
- compare
· PIC (paid in capital) ratio of: 𝐩𝐚𝐢𝐝 − 𝐢𝐧 − 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐭𝐨 𝐝𝐚𝐭𝐞
- the proportion of capital 𝐜𝐨𝐦𝐦𝐢𝐭𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
called by the GP
𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐝𝐢𝐬𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧𝐬 𝐭𝐨 𝐋𝐏𝐬
UI.D122845772

· DPI (distributed to paid-in)

𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
- cash-on-cash return

· RVPI (residual value to paid-in) 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐫𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐩𝐨𝐫𝐭. 𝐜𝐨𝐦𝐩𝐚𝐧𝐢𝐞𝐬

- measure of unrealized return 𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

· TVPI (total value to paid-in) 𝐃𝐏𝐈 + 𝐑𝐕𝐏𝐈

DPI/RVPI/TVPI – presented net of GPs fee & carried interest

38
 Last Revised: 08/08/2022

Page 27
LOS i
- calculate

Page 28
LOS i
- calculate
DPI
+ RVPI op. results
TVPI UI.D122845772

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2-125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2-144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

39
 Last Revised: 08/08/2022

Page 29
DPI = (25 + 45 + 75)/115 = 1.26x LOS i
- calculate
RVPI = 147.9/115 = 1.29x

TVPI = 1.26 + 1.29 = 2.55x (25 + 45 + 75 + 147.9)/115 = 2.55x

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2-125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2-144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

Page 30
25 45 55 105
LOS i
-

50 15 10 25 10 5 - calculate
5 15
1 1.3 1.5 5.8 9.0 13.5

UI.D122845772
IRRg (-50, -20, -25, 0, 35, 50, 105) IRRn = (-50, -21, -26.3, -1.5, 29.2, 41, 91.5)

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2-125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2-144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

40
 Last Revised: 08/08/2022

Introduction to Commodities and Commodity Derivatives

a. compare characteristics of commodity sectors

b. compare the life cycle of commodity sectors from production through

trading or consumption

c. contrast the valuation of commodities with the valuation of equities and

bonds

d. describe types of participants in commodity futures markets

e. analyze the relationship between spot prices and futures prices in markets in
contango and markets in backwardation

f. compare theories of commodity futures returns

g. describe, calculate, and interpret the components of total return for a fully
collateralized commodity futures contract

h. contrast roll return in markets in contango and markets in backwardation

i. describe how commodity swaps are used to obtain or modify exposure to UI.D122845772

commodities

j. describe how the construction of commodity indexes affects index returns

41
 Last Revised: 08/08/2022

Commodities

⇒ Commodity – a physical good attributable to a Page 1

LOS a
natural resource that is tradeable and supplied
- compare
without substantial differentiation by the general public
- trade in physical (spot) & futures/forward markets

- potential for diversification benefits in a Page 2

multi-asset class portfolio due to low (historically) LOS a UI.D122845772
- compare
correlation w/ bonds & stocks (some possible inflation
hedging benefits)
from use as a consumable
- derive their value
as inputs to the production process
Sectors/ as per Thompson Reuters/Core Commodity CRB Index
· Energy · Industrial (base) metals · Livestock
· Grains · Precious Metals · Softs (cash crops)

1. Energy – most economically valuable sector

1) Crude Oil – must be refined to be useful
Brent – North Sea
- different grades
WTI – US
(trade at
varied prices) Bonny Light – Nigeria
Mayan Crude – Mexico

42
 Last Revised: 08/08/2022

Page 3
1. Energy LOS a
1) Crude Oil – low in density & flows freely at - compare
room temperature ⇒ Light
- easier to process, yielding more valuable gasoline & diesel
- low in sulfur content ⇒ Sweet
- weather ➞ temporary impact (e.g. hurricane)
· as economies grow, oil demand increases (availability of
oil at affordable prices also facilitates growth)
extraction
· drivers of supply & demand technology
politics refining
business cycle usage
e.g./ shale oil – supply availability due to extraction technology
electric vehicles, solar – reduce demand for oil products
US & Canada – ban offshore drilling in Artic waters

1. Energy Page 4
LOS a
2) Natural Gas – can be used directly
- compare
(heavier compounds – NGLs – are also extracted

liquids
- categorized as either: UI.D122845772

a) associated gas – coming from an oil well (a co-product of oil)

can be: - sold in spot markets
- burned off
- re-injected into the oil field to maintain
pressure (keeps extraction costs low)
b) unassociated gas – on its own (where oil is not present)
- Storage/transportation cost high ➞ need to keep gas under
pressure
- liquified natural gas (LNG) – for transport by ships
- must be cooled to -260℉
- primary demand – electric generation
cooling
- also weather dependent
heating

43
 Last Revised: 08/08/2022

Page 5
1. Energy LOS a
3) Refined products – heating oil, gasoline, - compare
jet fuel, propane, etc…
- refined products typically have a short shelf life (availability
measured in days)
- refineries typically located on major coastlines & ports
(that is where the oil is delivered)
- planned refinery maintenance ➞ switch over from summer gas
(typically low demand periods) to winter gas

2. Grains/ · Corn · Soybean · Wheat · Rice

- can be stored season over season (sometimes multiple
seasons)
- some crops can be grown multiple times/yr.
- levels of heat & precipitation determine yields & acreage
(droughts kill, floods drown)

Page 6
3. Industrial (base) Metals/ can be stored for years
LOS a
- mined ore that is processed into
- compare
copper, aluminum, nickel, zinc, lead, tin & iron
UI.D122845772

used in production, construction, infrastructure

- supply is weather insensitive, but demand may be affected

- tied very closely with GDP growth
- political issues ➞ strikes, development approval, environmental
concerns, regulation

feeder
4. Livestock/ · hogs · cattle · sheep · poultry
live
- depends on low cost inputs (feed) i.e. grains
- high grain costs lead to short-term oversupply
as herds are slaughtered (mid-term price increases)
- tied to GDP growth (especially in emerging/developing
economies)

44
 Last Revised: 08/08/2022

Page 7
4. Livestock/ LOS a
Weather – affects health & weight - compare
- winters tough for cattle, heat & humidity tough for hogs
- limits weight gain
avian flu
- disease
mad cow disease
porcine epidemic diarrhea virus (PEDv)

fear of consumption can drive prices down

price effect uncertain
lost supply can increase prices
5. Precious Metals
- straddle monetary & industrial world
gold, silver, platinum ⇒ act as stores of value
- also used in jewelry, auto parts, electronics
(makes up about 50% of demand, other than gold)
- high storability

Page 8
6. Softs (cash crops) · cotton, coffee, sugar, LOS a
cocoa - compare
- called ‘cash crops’ since they are grown to be sold, UI.D122845772

not consumed for subsistence

- primary source – countries close to the equator

- weather is an important supply factor, global growth

is an important demand factor

45
 Last Revised: 08/08/2022

Commodity Production Life Cycle

- will reflect (and amplify) changes in storage, Page 9

LOS b
weather political/economic events that shift demand & supply
- compare
- Short life cycle ⇒ rapid adjustment
- long life cycle ⇒ limits ability of market to react
⇒ Energy/ crude futures
reflect both demand for crude

Extraction Transportation Storage Refining Transportation

50-100 days 1-10 days days to 3-5 days 5-20 days
a few
months
natural gas can be consumption of crude
consumed at this stage oil products begin
- trading in futures will reflect - futures reflect pricing
pricing just prior to this point at this point

Page 10
⇒ Energy/
LOS b
· Refineries – affect demand for crude - compare
& supply of oil products
UI.D122845772

costly to build - long lead times – built to a specific

oil grade
· Pipelines – affect supply of oil & market reach

costly to build, long lead times

· Exploration – affects supply of crude

- over 120 different grades of oil - both 1000

Brent barrels
- 2 most traded futures contracts
West Texas Intermediate
(CL)
- contracts for gasoline – RB – 42,000 gallons
nat. gas – NG – 10,000 MBTU
heating oil – HO – 42,000 gallons

46
 Last Revised: 08/08/2022

Page 11
⇒ Industrial/Precious Metals
LOS b
- ore & finished products can be stored - compare
for years (but storage costs, risks of ownership, financing
costs)
e.g./ Copper

extracting ➞ grinding ➞ concentrating ➞ roasting ➞ smelting

ore ～ 2% into metal content removes heated to 1200℃

metal content powder reaches 25% sulfur to melt calcine
- powder now - metal content
called calcine reaches 60%

➞ converting ➞ electro-refining ➞ storage/logistics

air blown into purified to typically held in a bonded

the liquid 99.99% warehouse until shipped
- 99% pure copper to end user

Page 12
⇒ Industrial/Precious Metals
LOS b
- smelting/processing relies on economies of scale - compare UI.D122845772
- large facilities with high utilization rates
∴ when supply > demand, difficult to cut production
- overproduction continues until smaller players
drop out
- long lead times + large costs to add extraction or processing
capacity
- monthly futures contracts with no seasonality (unlike energy)

⇒ Livestock/ - all year round

- good weather, high quality pasture & feed accelerate
weight gain
- timing to maturity increases with size

47
 Last Revised: 08/08/2022

⇒ Livestock/ poultry – a few weeks Page 13

hogs – a few months LOS b
- compare
cattle – a few years
HE
sow gives birth 6 mos. to get slaughter weight
after summer heat (soymeal & cornmeal)

1-2 years – feeder cattle ⇒ 6-12 months LE

(grass fed) GF (feed lot ➞ corn-based diet)
～ 1200 lbs.
⇒ Grains/
hard
northern winter
hemisphere wheat
(North Am.)

Page 14
⇒ Grains/ - demand for grains is year round
LOS b
- storage facilities supply year round
- compare
⇒ need to understand old crop vs. new crop
(inventory) (coming harvest)
for futures trading
UI.D122845772

⇒ Softs/ commodities in this sector differ significantly

e.g./ coffee

- harvested somewhere all year round (best are from

high-altitude plantations, picked in middle of harvest)

48
 Last Revised: 08/08/2022

⇒ Softs/ - newly planted trees take about Page 15

LOS b
3-4 years to produce
- compare
- once picked, laid out in sun for 2-3 weeks to dry
(dry method ～ 50%)

or/ soaked in water to remove pulp, bean then fermented

12-48 hours, then dried 24-36 hours
- then shipped – roasting done by buyer before shipping to sales
points
robusta – lower quality, less flavour
2 main varieties futures traded in London
arabica
futures traded in New York

Valuation

Page 16
estimation of
FV LOS c
future profitability
- contrast
CF CF CF TV and cash flows

PV = DCF Stocks
bonds
UI.D122845772

financial assets

no cash inflows

future possible ➞ based on

price supply & demand
-CF -CF -CF of the item
PV=
discounted
potential cash outflows
commodities - transportation
- storage
- physical assets
- tangible items with intrinsic value affects the forward
price curve

49
 Last Revised: 08/08/2022

Participants
Page 17
1) Hedgers – eliminate price risk
LOS d
- may be a registration requirement - describe
(hedgers face different margin requirements
since they make/take delivery)

2) Traders/Investors 1) informed investors

2) liquidity providers
3) arbitrageurs

3) Exchanges – standardized contracts

4) Analysts – perform research, conduct policy

5) Regulators

Spot vs. Futures Price

- spot ➞ current price for immediate delivery Page 18

LOS e
- futures ➞ price today for some future delivery
- analyze
· difference between spot & futures price called the ‘basis’ UI.D122845772

futures futures
price price
spot - price difference
between one
contract & another
is called the
calendar
spread
spot
Backwardation Contango
𝒕 𝒕
- bearish indicator - bullish indicator
- expected future spot - expected future spot price
price = lower = higher
Note: for commodities

50
 Last Revised: 08/08/2022

Page 19
Contango LOS e
$ (negative $ - analyze
spot
calendar
spread)
Backwardation
(positive
calendar spread)

spot

𝒕 𝒕
Trading strategy 1. Trading strategy 3.
Buy long-dated contract Sell long-dated contract
Sell short-dated contract Buy short-dated contract

roll over short position roll over long position

each month each month

Trading strategy 2. short long-dated Trading strategy #4 Buy

contract long-dated contract

Theories of Futures Returns

UI.D122845772

Page 20
⇒ theories to explain the shape of the futures LOS f
curve - compare
1) Insurance Theory (Keynes) – a.k.a. ‘Theory of Normal Backwardation’
- producers will use commodity futures for insurance
by locking-in prices, thereby having more predictable revenue
- this selling forward pushes down prices in the future
⇒ further, prices would have to be lower in the future to
induce a buyer to take price risk (remuneration for the
speculator)
∴ such a resulting price curve would be ‘normal’
⇒ not backed by observation however:
i.e. backwardation does not generate positive returns
contango does not generate negative returns
(statistically significant that is)

51
 Last Revised: 08/08/2022

2) Hedging Pressure Hypothesis/ Page 21

LOS f
- producers will want to sell to hedge
- compare
- end users will want to buy to hedge

- if hedging demand from producers & end users is in balance,

then a flat futures curve should develop

- if hedging demand from producers > hedging demand from end users
then futures prices would have to be lower to induce
speculators to fill the gap ⇒ Backwardation

- if hedging demand from producers < hedging demand from end users
then the futures prices will be higher ⇒ Contango
Problem: producers tend to be more persistently exposed to
price risk than end-users/consumers

Page 22
3) Theory of Storage/
LOS f
- compare
Futures price = spot price + direct storage costs – convenience yield

- high when - low when stocks - low when stocks UI.D122845772

demand > supply are low are high

- low when - high when stocks - high when stocks
supply > demand are high are low

52
 Last Revised: 08/08/2022

Components of Futures Returns

- total return with futures is different from Page 23

LOS g
total return on the physical asset
- describe
- futures price return (spot yield) - calculate
roll return (roll yield) - interpret
collateral return (collateral yield)

Price Return/ - change in price in the front month contract

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
𝐩𝐫𝐢𝐜𝐞 𝐫𝐞𝐭𝐮𝐫𝐧 =
𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

Roll/ - as investors move from contract to contract, must sell

the current contract on/near expiration and buy
the next dated contract
- likely a price difference depending on the shape of
the futures curve

Page 24
e.g./
LOS g
- 11 Jan contracts = $110 exposure - describe
10 - rolling forward to Feb, need - calculate
12 contracts = $108 exposure - interpret UI.D122845772
(opposite for contango)
9

Jan Feb
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
k m %′𝐚𝐠𝐞 𝐨𝐟 𝐭𝐡𝐞
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐑𝐨𝐥𝐥 𝐫𝐞𝐭𝐮𝐫𝐧 = × 𝐩𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐛𝐞𝐢𝐧𝐠
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐫𝐨𝐥𝐥𝐞𝐝
e.g./ 𝟏𝟎 − 𝟗
= . 𝟏 𝐨𝐫 𝟏𝟎%
𝟏𝟎

- the amount of return generated in a backwardated futures

market and profiting from the convergence towards a
higher spot price

53
 Last Revised: 08/08/2022

Page 25
3) Collateral Return/ yield from bonds/cash
LOS g
used to maintain the position - describe
- when calculating E(R), most indices will use S.t. T-Bills - calculate
- interpret
Notes/ price return on front month contracts typically different
from the price change of the physical commodity
contract–standardized (quality, delivery)
physical markets – not to the same degree

- roll at T, 𝚫spot at T, 𝚫spot at T, 𝚫spot > 𝚫futures

= 𝚫futures spot < 𝚫futures
futures

spot 𝚫𝐟𝐮𝐭𝐮𝐫𝐞𝐬
− 𝚫𝐬𝐩𝐨𝐭
= 𝐫𝐨𝐥𝐥
futures
futures spot neg. roll
no roll yield pos. roll
T T T

Roll Return – More Detail

- periods of either backwardation or contango Page 26

LOS h
do not persist indefinitely UI.D122845772
- contrast
- roll return is also not very indicative of price return
(i.e. pos. roll does not necessarily imply pos. price return)
- roll return is very sector dependent

(statistically strong neg. roll return)

longer storage periods

minimal
storage

54
 Last Revised: 08/08/2022

Commodity Swaps

- commodity swap – a legal contract involving Page 27

LOS i
the exchange of payments over multiple
- describe
dates as determined by specified reference prices or
indexes relating to commodities
often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts

2) may want a specific

grade/quality of oil
hedged

3) may want to maintain

flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months UI.D122845772

pays $25/barrel
for the 9-month period
· called an ‘excess return swap’

overall (-9)
+ 16

55
 Last Revised: 08/08/2022

Page 29
- OTC, customizable LOS i
· Total return swap – one party receives payment based - describe
on the change in the level of an index (multiplied
by some notional amount)

· Basis swap – periodic payments are exchanged based on the

values of 2 related commodity reference prices
that are not perfectly correlated
- often used between a highly liquid futures contract
as an illiquid but related material

· variance swaps – for a specific commodity

· volatility swaps – relative to the volatility of a reference

commodity

Commodity Index
used as a benchmark to evaluate Page 30
⇒ Index LOS j
broader moves in commodity pricing
- describe
for macroeconomic or forecasting purposes
the basis for an investment vehicle
UI.D122845772

- differ based on:

a) the breadth of coverage - # of commodities & sectors
b) relative weighting – assigned to each component & how
those weights are determined
c) the rolling methodology – has a direct impact on the roll return
d) methodology & frequency of rebalancing the weights
of the individual commodities, sectors & contracts - potential
for positive rebalancing return (assuming mean reversion
of prices)

56
 Last Revised: 08/08/2022

- differ based on: Page 31

LOS j
e) governance – rules-based ⇒ quantitative
- describe
methodology for a-d above
- selection-based – an index committee selects
the commodities

- the Index should be replicable to be useful – must be

investable (i.e. translated into a representation of the
asset class)
- use of exchanges vs. physical trading
- contracts/markets with liquidity
- care used in selecting long-dated contracts
⇒ S&P GSCI – based on 24 commodities
- uses only contracts with a minimum level of
trading volume

⇒ S&P GSCI/ Page 32

LOS j
- uses a world-production weighting scheme
- describe
- largest weight to the most valuable commodity
of the basis of physical trade value
(crude oil highest single weight, energy highest sector UI.D122845772

weight)
- rolling methodology ⇒ owning the front contracts
- highest liquidity
- supply/demand shocks have most impact

⇒ Bloomberg Commodity Index/ (BCOM – formerly DJ–USB)

- 22 commodities, selection-based
- 33% cap on size of sectors, 2% minimum floor
- results in very different index composition &
weights
- same rolling methodology as S&P GSCI

57
 Last Revised: 08/08/2022

Page 33
⇒ Deutsche Bank Liquid Commodity Index/
LOS j
- uses a fixed weighting scheme - describe
- rolling a bit complicated ⇒ attempts to maximize
backwardation & minimize contango

more e.g./ June contract 1% backwardated to May

active July contract 3% 3%/2 months = 1.5%/month
roll
mgmt. ∴ roll May into July
⇒ Thompson Reuters/Core Commodity CRB Index
- 19 commodities, fixed weights, selection committee
- rolling ⇒ own front or second front month

Page 34
⇒ Rogers International Commodity Index (RICI)/ LOS j
- 37 commodities, fixed weights, selection committee - describe
- not all components are denominated in USD

- Rebalancing Frequency/
- rebalancing is more important if a market is UI.D122845772

frequently mean reverting (more peaks to sell, more

valleys to buy)
- can lead to underperformance in a trending market

- TR/CC CRB & RICI – monthly rebalancing

- Other – annual
- S&P GSCI & BCOM ➞ typically have lower rebalancing costs
(production weights)

58
 Last Revised: 08/08/2022

REVIEW
UI.D122845772

59
 Last Revised: 08/08/2022

Private Equity Valuation

institutional Review - 1
- investors in PE typically 10-yr.
high net worth individuals
investment periods
⇒ Valuation Techniques used – depends on stage of development
a) Income Approach (expansion - maturity)
b) Relative Value (late expansion - maturity)
c) Real Options (seed/start-up)
d) Replacement Cost (seed/start-up)
e) Venture Capital Model (development stage)

⇒ How is value created/

1) ability to re-engineer the private firm to generate superior
2) ability to access credit markets on favourable terms returns
3) a better alignment of interests (PE vs. private mgmt.)
eliminate ‘short - tag-along – min. sh. can have their shares bought at
termism’ of public same terms as maj. sh.
markets - drag-along – maj. sh. can force min. sh. to join a sale

⇒ Aligning Interests/ Review - 2

· Corporate board seats · Non-compete clauses

· Preferred dividends/liquidation preference (convertible pref.)
· Reserved matters (must be approved by PE firm) UI.D122845772

· Earn-outs (contingent payouts)

⇒ Buyout vs. VC – key points/

Buyout VC
- mature companies, strong mgmt. - emerging/growing companies,
- use of leverage new mgmt.
- measurable risk, predictable exit - use of equity funding
- restructuring/cost-savings - risk & exit difficult to
- significant asset base assess
- low variance of returns - cash burn to fund growth
from underlying investments - weak asset base
- high returns from a few
investments, significant # of
write-offs

60
 Last Revised: 08/08/2022

Review - 2b
· desirable characteristics for LBO targets:

1/ undervalued/depressed stock price

2/ willing mgmt. and shareholders

3/ Inefficient companies

4/ Strong and sustainable cash flows

5/ Low leverage

6/ Assets - unencumbered physical assets

Review - 3
⇒ Valuation Issues/
A. Buyout transactions DD
LBO Model/ forecast FCF (done by target mgmt.) strategic
discounted by E(R) of PE firm commercial
financial
PV = max. price that can be paid
legal UI.D122845772

- sources of value: earnings growth from environmental

operational improvements, multiple expansion, debt
reduction from operational CFs before exit (pg.-12)

⇒ Exit Routes/ considered before entry

1. IPO – highest valuation, costly & time consuming
2. acquisition – strategic or financial buyer
3. MBO another VC or PE firm
4. Liquidation

61
 Last Revised: 08/08/2022

Page 12
⇒ Valuation Issues/ LOS c, d
A. Buyout transactions - distinguish
- describe

8000 – 4320
- 1600 – 2061)
× 1.6 am
ity progr IRR = 85%
. equ (8000 – 4230
– mgmt
M EP - 1600) × .95
IRR = 20%
- equity return +
50% Equity
pr. sh. return)
2400(1.12)5

reduction is
50% Debt critical in order
to deliver equity returns

Review - 3a
VC Method/ financing is done in stages on a fully diluted basis

Post money val. = Pre-money val. + Investment

arrived at by moving from exit value backwards

UI.D122845772

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐚𝐭 𝐞𝐱𝐢𝐭

Post money val. =
𝐑𝐎𝐈
Pre-money val. = Post money val. - equity injection

VC fractional ownership = 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭M𝐏𝐨𝐬𝐭 − 𝐦𝐨𝐧𝐞𝐲 𝐯𝐚𝐥. (no options)

(1 + IRR)t = ROI
(𝐞𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐬𝐡𝐚𝐫𝐞𝐬 + 𝐨𝐩𝐭𝐢𝐨𝐧𝐬)
share issued = ]𝐦𝐠𝐦𝐭. 𝐩𝐨𝐬𝐭 − 𝐦𝐨𝐧𝐞𝐲 𝐨𝐰𝐧𝐞𝐫𝐬𝐡𝐢𝐩

VC fractional ownership = (𝐧𝐞𝐰 𝐬𝐡𝐚𝐫𝐞𝐬 𝐢𝐬𝐬𝐮𝐞𝐝)7𝐞𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐬𝐡𝐚𝐫𝐞𝐬 + 𝐧𝐞𝐰 𝐬𝐡𝐚𝐫𝐞𝐬

as options are exercised,

VC fractional ownership · Series B, same process
will be reduced to

62
 Last Revised: 08/08/2022

Review - 4
⇒ Structure/ closed-end (fund does not need to redeem
partnership units)
∼ limited partners
distributions
∼ GP – PE firm drawdowns realizations
- limited duration ∼ 10 yrs.

marketing possible
𝒕 10 yrs.
extension
return J-curve effect

⇒ Terms/ 1) Economic terms (contractually defined)

· mgmt. fee ∼ 1.5% - 2.5% of committed capital, not paid-in capital
· transaction fees – paid to GP for advisory services
· carried interest – GP’s share of profits (∼ 20%)
· ratchet – target company earn outs (lowers PE return)
· hurdle rate – IRR a fund must earn before carried interest
· target fund size (∼ 7 - 10%)

Review - 5
⇒ Terms/
· vintage yr. – allows for performance comparisons
· term of the fund – typically 10 yrs., 1-2 yr. extension

2) Corporate Governance Terms

UI.D122845772

· key-man clause – named executives expected to play

an active role in fund mgmt.
· disclosure/confidentiality
· clawback provision – GPs must return capital to LPs
in excess of agreed profit split (true-up)
· distribution waterfall – order of dist. to LPs first
before GPs receive carried interest.
· deal-by-deal – LPs made whole first
· total return – GPs get CI on any dist. if
value Inv. Port. > 20% above Invested Capital
· tag along/drag along

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 Last Revised: 08/08/2022

Review - 6
2) Corporate Governance Terms
· no-fault divorce – GP can be removed ⇒ supermajority of LP
· removal for cause - or early termination
· Investment restrictions – min. level of diversification
· Co-Investment – sidecar deals

⇒ Valuation/ typically at NAV

- assets valued at
· cost (with adjustments for subsequent financing)
· lower of cost or market
· a revaluation of a portfolio company whenever a new
financing round done with new investors
· at cost (no adjustments)
· with a discount for restricted securities
· marked-to-market (reference to a peer group of public
companies)

Review - 7

⇒ Risks/ · illiquidity · unquoted investments · deal flow competition

· reliance on mgmt. of portfolio companies · loss of capital
· taxation risk · valuation of investments · lack of diversification
· market risk (PE investments usually restricted to qualified investors) UI.D122845772

⇒ Costs/ · transaction fees · fund set-up fees · admin. costs

· audit costs · mgmt./performance fees · dilution earn-outs
follow-on
· placement fees ∼ 2% fundraising fees rounds

⇒ IRR – deemed most appropriate measure of PE performance

by GIPS
investors PE fund portfolio companies
net IRR gross IRR

⇒ Multiples/ PIC (paid-in-capital) 𝐩𝐚𝐢𝐝 − 𝐢𝐧 − 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐭𝐨 𝐝𝐚𝐭𝐞

𝐜𝐨𝐦𝐦𝐢𝐭𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
DPI (distributed-to-paid-in) 𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐝𝐢𝐬𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧𝐬 𝐭𝐨 𝐋𝐏𝐬
𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

64
 Last Revised: 08/08/2022

Review - 8
⇒ Multiples/
RVPI (residual value-to-paid-in) 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐫𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐩𝐨𝐫𝐭. 𝐜𝐨𝐦𝐩.
𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
TVPI (total value to-paid-in) 𝐃𝐏𝐈 + 𝐑𝐕𝐏𝐈
(DPI/RVPI/TVPI – all presented net of fees & carried interest)
(pg. ➞ 28-30)

⇒ Venture Capital Method/

Calculate ➞ Post-money valuation
Pre-money valuation
ownership fraction (%’age)
# of shares issued
Price/sh.

⇒ Option Pool ∼ 15% of shares ⇒ to attract key employees

⇒ Alternative IRR – amt. needed on exit to achieve IRR target

⇒ Multiple Rounds of Financing

Evaluating Fund Performance

Page 28
LOS i UI.D122845772

- calculate
DPI
op. results
+ RVPI
TVPI

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2 - 125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2 - 144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

65
 Last Revised: 08/08/2022

Page 29
LOS i
DPI = (25 + 45 + 75)/115 = 1.26x
- calculate
RVPI = 147.9/115 = 1.29x

TVPI = 1.26 + 1.29 = 2.55x (25 + 45 + 75 + 147.9)/115 = 2.55x

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2 - 125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2 - 144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

Page 30
25 45 55 105
LOS i
-

50 15 10 25 10 5 - calculate
5 15
1 1.3 1.5 5.8 9.0 13.5

IRRg (-50, -20, -25, 0, 35, 50, 105) IRRn = (-50, -21, -26.3, -1.5, 29.2, 41, 91.5) UI.D122845772

01 50 50 1 -5 44 - - 44
02 15 65 1.3 -15 42.7 - - 42.7
03 10 75 1.5 25 76.2 - - 76.2
04 25 100 2.0 45 144.2 (144.2 - 125) × .2 25 115.4
3.8
05 10 110 2.2 55 178.2 (178.2 - 144.2) × .2 45 126.4
6.8
06 5 115 2.3 105 234.1 11.2 75 147.9

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Private Equity Valuation

⇒ Multiples/ Review - 8

RVPI (residual value-to-paid-in) 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐫𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐩𝐨𝐫𝐭. 𝐜𝐨𝐦𝐩.

𝐜𝐮𝐦𝐮𝐥𝐚𝐭𝐢𝐯𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
TVPI (total value to-paid-in) 𝐃𝐏𝐈 + 𝐑𝐕𝐏𝐈
(DPI/RVPI/TVPI – all presented net of fees & carried interest)
(pg. ➞ 28-30)

⇒ Venture Capital Method/

Calculate ➞ Post-money valuation
Pre-money valuation
ownership fraction (%’age)
# of shares issued
Price/sh.

⇒ Option Pool ∼ 15% of shares ⇒ to attract key employees

⇒ Alternative IRR – amt. needed on exit to achieve IRR target

⇒ Multiple Rounds of Financing

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Commodities
Review - 1
⇒ commodity – a physical good that is tradable and supplied
without substantial differentiation (spot & future/forward
markets)
- potential for diversification – low 𝐫 with stocks
and bonds
- possible inflation hedging benefits
⇒ Energy/ – most economically valuable sector
1) Crude Oil - different grades (Brent, WTI)
– low in density ⇒ Light - low sulfur content ⇒ Sweet
- drivers of supply & demand technology extraction
politics refining
usage
2) Natural Gas business cycle
· associated gas – coming from an oil well
· unassociated gas – no oil present
- storage/transportation costs high - markets tend to be
- primary demand – electric generation regional
(heating/cooling)

⇒ Energy/ Review - 2
3) Refined products – heating oil, gasoline, jet fuel etc…
- shut down for planned maintenance 2x/yr. during low UI.D122845772

demand periods
⇒ Grains/ · Corn · Soybean · Wheat · Rice - can be stored season
- heat/precipitation determine yield over season
⇒ Industrial (base) Metals/ - copper, aluminum, zinc, lead, tin, iron etc…
· demand tied very closely to GDP
feeder
⇒ Livestock/ · hogs · cattle · sheep · poultry
live
- depend on price of grains (input)
- tied to GDP growth (esp. in emerging/developing markets)
- weather – can affect health & weight
- disease
⇒ Precious Metals/ · gold · silver · platinum · palladium
- act as stores of value
- also used as an input in other items

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Review - 3
⇒ Softs/ cash crops · cotton, coffee, sugar, cocoa
- weather affects supply, GDP growth affects demand

⇒ Commodity Production Life Cycle/

Extraction Transport. Storage Refining Transport.
➀ Energy
50-100d. 1-10d. days to a 3-5d. 5-20d.
few months
nat. gas can be consumed here oil products
futures reflect
Refineries – affect demand for crude pricing here
- costly to build - long lead times
Pipelines
affect supply of oil
Exploration
➁ Industrial/Precious Metals - can be stored for yrs.
- requires storage, risks of ownership, financing costs
· smelting/processing relies of economies of scale
· long lead times + large costs to add extraction/processing
· monthly futures contracts w/ no seasonality capacity

⇒ Commodity Production Life Cycle/ Review - 4

poultry – a few weeks
4) Livestock – all yr./
hogs – a few months
cattle – a few years
5) Grains ➞ 5-6 mos. (Planting to Harvest) UI.D122845772

- demand year round, storage facilities supply yr. round

6) Softs - each commodity differs significantly
⇒ Participants/
· Hedgers – eliminate price risk · Exchanges – standardized
· Traders/Investors informed investors · Analysts contracts
liquidity providers · Regulators
arbitrageurs

⇒ Spot vs. Futures Price/ - difference between spot & futures price
negative Contango called ‘basis’
Backwardation
calendar limited by positive spot
spread arbitrage calendar
bullish
spread
spot indicator
bearish indicator
𝐭 𝐭

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⇒ Spot vs. Futures Price/ Review - 5

Contango - buy long dated contracts

sell short dated contracts

roll over short pos. each

Backwardation – opposite month

⇒ Theories of Futures Returns/

1) Insurance Theory (Keynes) (Theory of Normal Backwardation)
- produces reduce risk by selling futures, prices ↓
2) Hedging Pressure Hypothesis - producers sell to hedge
but users buy to hedge
producers = users - flat curve
producers > users - backwardation, else Contango
3) Theory of Storage
direct storage convenience
Futures price = spot price + -
costs yield
low is stocks - low when
D > S, then
low stocks
high
high

⇒ Components of Futures Returns/ Review - 6

· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

=
· change in price in the return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞 UI.D122845772

front month contract

· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergence to a convergence to a higher spot price
higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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Components of Futures Returns

e.g./ Page 24
- 11 Jan. contracts = $110 exposure LOS g
10 - rolling forward to Feb., need - describe
12 contracts = $108 exposure - calculate
- interpret
(opposite for contango)
9

Jan. Feb.

Roll return = ` 𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞

a %’age of the
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position being
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝟏𝟎 − 𝟗 rolled
e.g./ = . 𝟏 𝐨𝐫 𝟏𝟎%
𝟏𝟎
- the amount of return generated in a backwardated futures
market and profiting from the convergence towards a
higher spot price

Commodities
Review - 6
⇒ Components of Futures Returns/
· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
=
· change in price in the
UI.D122845772
return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
front month contract
· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergence to a convergence to a higher spot price
higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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Commodity Swaps

- commodity swap – a legal contract involving Page 27

the exchange of payments over multiple LOS i
- describe
dates as determined by specified reference prices or
indexes relating to commodities often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts
2) may want a specific
grade/quality of oil
hedged
3) may want to maintain
flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months
pays $25/barrel UI.D122845772

for the 9-month period called an ‘excess return swap’

overall (-9) +16

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Commodities

⇒ Commodity Index/ a benchmark Review - 7

macro forecasting purposes
investment vehicle
Differ based on:
· breadth of coverage - # of commodities/sectors
· relative weighting
· rolling methodology
· rebalancing methodology/frequency
· governance – rules based quantitative methodology
- selection based – index committee selects

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