1. Economics 489 Alternative Assets – Part I August 27, 2008 Alternative Assets Economics 489 Senior Seminar Hedge Funds Private Equity Funds Real Estate Funds

2. Economics 489 Alternative Assets – Part I August 27, 2008 What does “Alternative” Mean? Traditional (as opposed to “alternative”) –Stocks –Bonds Alternatives –Everything Else: –In particular Hedge Funds Private Equity Funds Real Estate Funds Other (commodities, infrastructure, etc…..no end)

3. Economics 489 Alternative Assets – Part I August 27, 2008 How Does Traditional Work? Mostly….what we call “separate account management” Sometimes “commingled” fund

4. Economics 489 Alternative Assets – Part I August 27, 2008 Characteristics of Traditional Long only Asset based fees (as opposed to “performance” based fees Subject to the Investment Company Act of 1940 (which means the SEC regulates the managers

5. Economics 489 Alternative Assets – Part I August 27, 2008 Types of Traditional EquityFixed Income US DomesticLehman Aggregate Foreign (non-US)Core Emerging MarketCore Plus GlobalNon-US Global The above table is not exhaustive

6. Economics 489 Alternative Assets – Part I August 27, 2008 Alternative Assets Everything that is “not” traditional

7. Economics 489 Alternative Assets – Part I August 27, 2008 What are the “characteristics” of alternative? LLC (limited liability company) or Partnership structure Money manager is GP and investors are LP

8. Economics 489 Alternative Assets – Part I August 27, 2008 What are the “characteristics” of alternative? Fee Structure –Commitment Fee: usually 2 % –Performance Fee: 20 % of profits Strategy Defined by LLC or Partnership Agreement Not regulated by SEC –Hedge funds required to register in 2006 –More regulation on the way Favorable tax treatment for GP (LT Capital Gains as opposed to ordinary income for the performance fee)

9. Economics 489 Alternative Assets – Part I August 27, 2008 So, What are the (major) Alternatives? Real Estate Funds Private Equity Funds Hedge Funds

10. Economics 489 Alternative Assets – Part I August 27, 2008 Real Estate Funds Lockup: 7 to 10 years Capital calls Performance fees on each investment separately Hurdle rates

11. Economics 489 Alternative Assets – Part I August 27, 2008 Investment Strategies Commercial real estate (office buildings) Multi-family residential Hotel Shopping Centers

12. Economics 489 Alternative Assets – Part I August 27, 2008 Observations Returns vary with the “real estate cycle” Investors expect the return of their investment in less than 10 years Thus, these are not long term investments in real estate, but shorter term “trading” opportunities

13. Economics 489 Alternative Assets – Part I August 27, 2008 Private Equity Buying “equity” in companies (private companies, normally) –“Buy out” funds: tend to buy whole companies outright…sometimes called LBO funds (for Leveraged Buyout funds)….targets are often “public” companies…. –Others might buy minority stakes in companies and assist management with ideas or execution of strategies –Might specialize in particular industries: high tech, health care, industrials, natural resources, etc.

14. Economics 489 Alternative Assets – Part I August 27, 2008 Private Equity Large buyout funds often have $ 20 billion in available investor money in the fund: Blackstone, Carlyle…. Small buyout funds would be those under $ 5 billion in available investor money Middle market buyout funds do not buy large companies…tend to buy smaller, private companies and get involved in management. ($ 1 to $ 5 billion in investor money is typical)

15. Economics 489 Alternative Assets – Part I August 27, 2008 Private Equity Typical “deal” (investment) is highly levered….often 5 to 1, debt to equity. Exit strategies: –Take company public –Sell to existing public (occasionally private) company –Recapitalization

16. Economics 489 Alternative Assets – Part I August 27, 2008 Observations Returns should approximate returns from levered equity If public markets are rising, it is hard not to win owning levered public stocks

17. Economics 489 Alternative Assets – Part I August 27, 2008 Hedge Funds Dramatic Growth since 1995 –$ 40 billion in 1991 –$ 100 billion in 1995 –$ 1 Trillion in 2001 –$ 2 Trillion today Originally, mostly a “global macro” business –Tiger, Soros, Steinhardt Berkowitz –All went bust in late 90s

18. Economics 489 Alternative Assets – Part I August 27, 2008 Dominant Hedge Fund Strategy is Long/Short Market neutral –Idea is relative gains exceed relative losses –But, what is neutral? Long bias (70 % long) –$ 100 million long –$ 30 million short

19. Economics 489 Alternative Assets – Part I August 27, 2008 How does long short work? Buy $ 100,000 worth of GM Sell (short) $ 100,000 worth of F Market goes up, market goes down So long as GM does relatively better than F, the strategy makes money No money up (or very little)

20. Economics 489 Alternative Assets – Part I August 27, 2008 130/30…..an aside Long $ 130 million, short $ 30 million using $ 100 million of investor capital This is not a hedge fund, but is instead a “traditional” equity manager extending his long only expertise to short selling Fees much lower: 75 basis points plus 5 percent of profits is typical Will probably force fees to fall for hedge funds

21. Economics 489 Alternative Assets – Part I August 27, 2008 Who does the operations end of a long short hedge fund? What operations? –Buying and selling stock –Borrowing stock to facilitate short sales** Plus leverage –Loaning money to hedge funds so that they can add leverage

22. Economics 489 Alternative Assets – Part I August 27, 2008 Who does the operations end of a long short hedge fund? Answer: Prime Brokers –Goldman Sachs, Morgan Stanley, etc. –Most profitable are of brokerage business –Only risk is hedge fund goes belly-up and owes them money Partner up with……Cap Intro –Short for Capital Introductions –They help hedge funds raise money

23. Economics 489 Alternative Assets – Part I August 27, 2008 Topics for Research Fund of funds –Types –Growth –Pros and Cons Multi-Strategy Funds Single Strategy funds –Long Short –Market Neutral –Risk Arbitrage –Distressed Debt –High Yield –Structured Products –Macro –Commodity Funds