INTERNATIONAL INSTITUTE OF PROFESSIONAL STUDIES

Investment Management

FINANCE CONCEPTS

Assigned by: Presented by: Mrs. Kalyani Parmal Ankur Pandey

MBA (MS) 5yrs.

IM-2K8-007

Contents

1. Private Equity

2. Venture Capital

3. Hedge Fund

4. Real Estate Investment Trust – REIT

5. Pension Fund

6. Securitization

7. Capping

8. Floor Planning

9. Collar

10. Bridge Financing

11. AG Mezzanine Financing

12. Algorithmic Trading

13. Leveraged portfolio

Private Equity

In finance, private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.

A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership.

Bloomberg Business Week has called private equity a rebranding of leveraged buyout firms after the 1980s. Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically venture capital firms or angel investors) invest in young or emerging companies, and rarely obtain majority control.

Private equity is also often grouped into a broader category called private capital, generally used to describe capital supporting any long-term, illiquid investment strategy.

 Strategies

1. Leveraged buyout2. Simple example3. Growth Capital4. Mezzanine Capital5. Venture Capital6. Distressed and Special situations7. Secondaries8. Other Strategies

Venture Capital

Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc. The typical venture capital investment occurs after the seed funding round as growth funding round (also referred to as Series A round) in the interest of generating a return through an eventual realization event, such as an IPO or trade sale of the company. Venture capital is a subset of private equity. Therefore, all venture capital is private equity, but not all private equity is venture capital.[1]

In addition to angel investing and other seed funding options, venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value).

Venture capital is also associated with job creation (accounting for 2% of US GDP), the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography. Every year, there are nearly 2 million businesses created in the USA, and 600–800 get venture capital funding. According to the National Venture Capital Association, 11% of private sector jobs come from venture backed companies and venture backed revenue accounts for 21% of US GDP.

It is also a way in which public and private actors can construct an institution that systematically creates networks for the new firms and industries, so that they can progress. This institution helps in identifying and combining pieces of companies, like finance, technical expertise, know-how of marketing and business models. Once integrated, these enterprises succeed by becoming nodes in the search networks for designing and building products in their domain.

Hedge Fund

A hedge fund is an investment fund that can undertake a wider range of investment and trading activities than other funds, but which is generally only open to certain types of investors specified by regulators. These investors are typically institutions, such as pension funds, university endowments and foundations, or high-net-worth individuals, who are considered to have the knowledge or resources to understand the nature of the funds. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies, and make use of techniques such as short selling and leverage.

Hedge funds are typically open-ended, meaning that investors can invest and withdraw money at regular, specified intervals. The value of an investment in a hedge fund is calculated as a share of the fund's net asset value, meaning that increases and decreases in the value of the fund's investment assets (and fund expenses) are directly reflected in the amount an investor can later withdraw.

Most hedge fund investment strategies aim to achieve a positive return on investment whether markets are rising or falling. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund.[1][2] A hedge fund typically pays its investment manager a management fee, which is a percentage of the assets of the fund, and a performance fee if the fund's net asset value increases during the year. Some hedge funds have a net asset value of several billion dollars. As of 2009, hedge funds represented 1.1% of the total funds and assets held by financial institutions. As of April 2012, the estimated size of the global hedge fund industry was US$2.13 trillion.

Because hedge funds are not sold to the public or retail investors, the funds and their managers have historically not been subject to the same restrictions that govern other funds and investment fund managers with regard to how the fund may be structured and how strategies and techniques are employed. Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate certain regulatory gaps.

Real Estate Investment Trust – REITA real estate investment trust (“REIT”), generally, is a company that owns – and typically operates – income-producing real estate or real estate-related assets.  REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership – without actually having to go out and buy commercial real estate.  The income-producing real estate assets owned by a REIT may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans.

Most REITs specialize in a single type of real estate – for example, apartment communities.  There are retail REITs, office REITs, residential REITs, healthcare REITs, and industrial REITs, to name a few.  What distinguishes REITs from other real estate companies is that a REIT must acquire and develop its real estate properties primarily to operate them as part of its own investment portfolio, as opposed to reselling those properties after they have been developed.

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.  In addition to paying out at least 90 percent of its taxable income annually in the form of shareholder dividends, a REIT must:

Be an entity that would be taxable as a corporation but for its REIT status; Be managed by a board of directors or trustees; Have shares that are fully transferable; Have a minimum of 100 shareholders after its first year as a REIT; Have no more than 50 percent of its shares held by five or fewer individuals

during the last half of the taxable year; Invest at least 75 percent of its total assets in real estate assets and cash; Derive at least 75 percent of its gross income from real estate related

sources, including rents from real property and interest on mortgages financing real property;

Derive at least 95 percent of its gross income from such real estate sources and dividends or interest from any source; and

Have no more than 25 percent of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.

REITs generally fall into three categories:  equity REITs, mortgage REITs, and hybrid REITs.  Most REITs are equity REITs.  Equity REITs typically own and operate income-producing real estate.  Mortgage REITs, on the other hand, provide money to real estate owners and operators either directly in the form of mortgages or other types of real estate loans, or indirectly through the acquisition of mortgage-backed securities.  Mortgage REITs tend to be more leveraged (that is, they use a lot of borrowed capital) than equity REITs.  In addition, many mortgage REITs manage their interest rate and credit risks through the use of derivatives and other hedging techniques.  You should understand the risks of these strategies before deciding to invest in these types of REITs.  Hybrid REITs generally are companies that use the investment strategies of both equity REITs and mortgage REITs.

Many REITs (whether equity or mortgage) are registered with the SEC and are publicly traded on a stock exchange.  These are known as publicly traded REITs.  In addition, there are REITs that are registered with the SEC, but are not publicly traded.  These are known as non-traded REITs (also known as non-exchange traded REITs).  You should understand the risks of the different types of REITs and their strategies before deciding to invest in them.

As with any investment, you should take into account your own financial situation, consult your financial adviser, and perform thorough research before making any investment decisions concerning REITs.  You can review a REIT’s disclosure filings, including annual and quarterly reports and any offering prospectus at sec.gov.  You can invest in a publicly traded REIT, which is listed on a major stock exchange, by purchasing shares through a broker (as you would other publicly traded securities).  Generally, you can purchase the common stock, preferred stock, or debt securities of a publicly traded REIT.  You can purchase shares of a non-traded REIT through a broker that has been engaged to participate in the non-traded REIT’s offering.  You can also purchase shares in a REIT mutual fund (either an index fund or actively managed fund) or REIT exchange-traded fund.

Source: http://www.sec.gov/answers/reits.htm

Pension Fund

A pension fund is any plan, fund, or scheme which provides retirement income.

Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold about $6 trillion in assets. In January 2008, The Economist reported that Morgan Stanley estimates that pension funds worldwide hold over US$20 trillion in assets, the largest for any category of investor ahead of mutual funds, insurance companies, currency reserves, sovereign wealth funds, hedge funds, or private equity. Although the (Japan) Government Pension Investment Fund (GPIF) lost 0.25 percent, in the year ended March 31, 2011 GPIF was still the world's largest public pension fund which oversees 114 trillion Yen ($1.5 trillion).

Classifications:

1. Open vs. closed pension funds

Open pension funds support at least one pension plan with no restriction on membership while closed pension funds support only pension plans that are limited to certain employees.

Closed pension funds are further sub-classified into:

Single employer pension funds Multi-employer pension funds Related member pension funds Individual pension funds

2. Public vs. private pension funds

A public pension fund is one that is regulated under public sector law while a private pension fund is regulated under private sector law. In certain countries the distinction between public or government pension funds and private pension funds may be difficult to assess. In others, the distinction is made sharply in law, with very specific requirements for administration and investment. For example, local governmental bodies in the United States are subject to laws passed by the states in which those localities exist, and these laws include provisions such as defining classes of permitted investments and a minimum municipal obligation

Securitization

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitize may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.

In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off-balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.

The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

Securitization has evolved from its tentative beginnings in the late 1970s to an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3.455 trillion in the US and $652 billion in Europe. WBS (Whole Business Securitization) arrangements first appeared in the United Kingdom in the 1990s,

and became common in various Commonwealth legal systems where senior

creditors of an insolvent business effectively gain the right to control the company.

Capping

Definition

1. The practice of selling large amounts of a commodity or security close to the options expiry date in order to prevent a rise in market price. 

2. It is an attempt to keep a stock's price low or move its price lower by putting selling pressure on it.

Investopedia explains 'Capping'

1. The investor who might practice capping is a call option writer. If practicing capping, he or she is trying to avoid having to transfer the underlying security or commodity to the option holder. The goal is to have the option expire worthless so that the premium initially received by the writer is protected.

2. This is a violation of NASD rules.

Source: http://www.investopedia.com/terms/c/capping.asp#ixzz2CZjw2Kfp

Collar

In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range.

1. Equity Collar

Structure

A collar is created by an investor being:

Long the underlying long a put option at strike price X (called the "floor") Short a call option at strike price (X+a) (called the "cap")

These latter two are a short Risk reversal position. So:

Underlying - Risk reversal = Collar

The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. If the premium of the short call is exactly equal to the cost of the put, the strategy is known as a 'zero-cost collar. [Strictly speaking the name should be 'zero-premium collar' since the cost of holding the position may be high if the price of the underlying rises above the strike level of the call.]

On expiry the value (but not the profit) of the collar will be:

X if the price of the underlying is below X positive if the price of the underlying is between X and (X + a)

The maximum value occurs for any price of the underlying above X+a.

2. Interest Rate Collar

Structure

In an interest rate collar, the investor seeks to limit exposure to changing interest rates and at the same time lower its net premium obligations. Hence, the investor goes long on the cap (floor) that will save it money for a strike of X +(-) S1 but at the same time shorts a floor (cap) for a strike of X +(-) S2 so that the premium of one at least partially offsets the premium of the other. Here S1 is the maximum tolerable unfavorable change in payable interest rate and S2 is the maximum benefit of a favorable move in interest rates.[2]

ImportanceIn times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?

If it makes more sense to hold onto the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received for selling the call is used to buy the put—one pays for the other.

Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, and that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.

Floor Planning

Definition

It is a form of financing pertaining specifically to inventory. A lender will purchase the inventory from the borrower and as the inventory sells, the borrower will repay the debt. It is essential that the creditworthiness of both parties is established and that a procedure for if the inventory does not sell is in place before the lending takes place.

Investopedia explains 'Floor Planning'

This type of financing began in the automobile industry as the purchase price for vehicles was high and standard financing was hard to obtain. Its popularity spread to home appliances and finally to large-scale home electronics such as personal computers.Source: http://www.investopedia.com/terms/f/floor-planning.asp#ixzz2CZlIzvMG

Derivatives - Interest Rate Caps and Floors

Interest Rate Cap An interest rate cap is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on the date the floating loan rate will be reset. At each interest payment date the holder decides whether to exercise or let that particular option expire. In an interest rate cap, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. Interest rate caps are used often by borrowers in order to hedge against floating rate risk.

Formula: (Current market rate - Cap Rate) x principal x (# days to maturity/360)

Interest Rate FloorFloors are similar to caps in that they consist of a series of European interest put options (called caplets) with a particular interest rate, each of which expire on the date the floating loan rate will be reset. In an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at different rates. The difference occurs in that on each date the writer pays the holder if the reference rate drops below the floor. Lenders often use this method to hedge against falling interest rates.

The cash paid to the holder is as follows:

(Floor rate - Current market rate) x principal x (# days to maturity/360)

Source: http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/interest-rate-caps-floors.asp#ixzz2CZlSmwE0

Bridge FinancingBridge financing is a method of financing, used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of cash. Bridge financing is commonly used when the cash flow from a sale of an asset is expected after the cash outlay for the purchase of an asset. For example, when selling a house, the owner may not receive the cash for 90 days, but has already purchased a new home and must pay for it in 30 days. Bridge financing covers the 60 day gap in cash flows.

Another type of bridge financing is used by companies before their initial public offering, to obtain necessary cash for the maintenance of operations. These funds are usually supplied by the investment bank underwriting the new issue. As payment, the company acquiring the bridge financing will give a number of stocks at a discount of the issue price to the underwriters that equally offset the loan. This financing is, in essence, a forwarded payment for the future sales of the new issue.

Bridge financing may also be provided by banks underwriting an offering of bonds. If the banks are unsuccessful in selling a company's bonds to qualified institutional buyers, they are typically required to buy the bonds from the issuing company themselves, on terms much less favorable than if they had been successful in finding institutional buyers and acting as pure intermediaries.

There are two types of bridging finance. Closed bridging and Open Bridging.

Closed bridging finance is where you have a date for the exit of the bridging finance and are sure that the bridging finance can be repaid on that date. This is less risky for the lender and thus the interest rates charged are lower.

Open bridging is higher risk for the lender. This is where the borrower does not have an exact date for the bridging finance exit and may be looking for a buyer of the property or land.

Mezzanine FinancingMezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.

Mezzanine capital is often a more expensive financing source for a company than secured debt or senior debt. The higher cost of capital associated with mezzanine financings is the result of it being an unsecured, subordinated (or junior) obligation in a company's capital structure (i.e., in the event of default, the mezzanine financing is only repaid after all senior obligations have been satisfied). Additionally, mezzanine financings, which are usually private placements, are often used by smaller companies and may involve greater overall leverage levels than issuers in the high-yield market; as such, they involve additional risk. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or more senior lenders.

Swiss Finance Partners AGMEZZANINE FINANCING

Mezzanine Financing Concepts

We do offer different concepts of so called Mezzanine financing which presents a way for publicly and privately held companies to attain financing without going public and potentially ceding ownership of their company.

It is a blend of traditional debt financing and equity financing, reaping some benefits of both. Like equity financing, mezzanine financing is an unsecured debt, requiring no collateral to be put up unlike traditional bank loans.

Like debt financing, mezzanine financing is very fluid and does not necessarily involve giving up an interest in the company. 

Mezzanine financing relies on very high interest rates in the 5 - 10% range to make it profitable.

Unlike a bank loan, mezzanine financing does not hold real assets of a company as collateral; instead, lenders offering mezzanine financing have the right to convert their stake to an equity or ownership in the event of a default on the loan.

Mezzanine financing is a particularly appealing form of liquidity for owners of privately held companies. It is traditionally understood that a privately held company simply cannot achieve the same sort of fluid capital flow as a publicly held company, therefore mezzanine financing offers a way to balance that situation without going public.

In addition to the fact that mezzanine financers do not retain an interest in the company except in the event of a default, there is also the important consideration that they actively do not want an interest in the company.

While traditional equity investors are often striving towards some level of control, a displeasing thought to many private owners, with mezzanine financing one can rest assured that the financiers will do what they can to ensure you pay off your debt without resorting to default.

Because of the lack of real collateral, as well as the high speed of lending, mezzanine financing is typically more difficult to receive than a traditional bank loan or equity financing.

A company must demonstrate an established track record in its industry, show a profit or at the very least post no loss, and have a strong business plan for future expansion. Because of these limitations; mezzanine financing is not for every business.

However for businesses looking for a quick injection of capital to grow their already successful business, without giving up an interest, mezzanine financing can be an ideal solution.

Source: http://swissfinpartners.com/private_equity/mezzanine_financing

Algorithmic TradingAlgorithmic trading, also called automated trading, black-box trading, or algo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the order, or in many cases initiating the order without human intervention.

Algorithmic trading is widely used by pension funds, mutual funds, and other buy-side (investor-driven) institutional traders, to divide large trades into several smaller trades to manage market impact and risk. Sell side traders, such as market makers and some hedge funds, provide liquidity to the market, generating and executing orders automatically.

A special class of algorithmic trading is "high-frequency trading" (HFT), in which computers make elaborate decisions to initiate orders based on information that is received electronically, before human traders are capable of processing the information they observe. This has resulted in a dramatic change of the market microstructure, particularly in the way liquidity is provided.

Algorithmic trading may be used in any investment strategy, including market making, inter-market spreading, arbitrage, or pure speculation (including trend following). The investment decision and implementation may be augmented at any stage with algorithmic support or may operate completely automatically.

A third of all European Union and United States stock trades in 2006 were driven by automatic programs, or algorithms, according to Boston-based financial services industry research and consulting firm Aite Group. As of 2009, HFT firms account for 73% of all US equity trading volume.

In 2006, at the London Stock Exchange, over 40% of all orders were entered by algorithmic traders, with 60% predicted for 2007. American markets and European markets generally have a higher proportion of algorithmic trades than other markets, and estimates for 2008 range as high as an 80% proportion in some markets. Foreign exchange markets also have active algorithmic trading (about 25% of orders in 2006). Futures and options markets are considered fairly easy to integrate into algorithmic trading with about 20% of options volume expected to be computer-generated by 2010. Bond markets are moving toward more access to algorithmic traders.

One of the main issues regarding HFT is the difficulty in determining how profitable it is. A report released in August 2009 by the TABB Group, a financial services industry research firm, estimated that the 300 securities firms and hedge funds that specialize in this type of trading took in roughly US$21 billion in profits in 2008.

Algorithmic and HFT have been the subject of much public debate since the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission said they contributed to some of the volatility during the 2010 Flash Crash, when the Dow Jones Industrial Average suffered its second largest intraday point swing ever to that date, though prices quickly recovered. (See List of largest daily changes in the Dow Jones Industrial Average.) A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010.

Leveraged Portfolio

It is a Portfolio that includes risky assets purchased with funds borrowed.

Definition

A portfolio that includes at least some securities that were bought with borrowed money. A leveraged portfolio is risky because the securities may result in a loss, which would leave the investor liable to repay the borrowed capital. However, if the securities result in a gain, the investor has essentially made a profit without using his/her own money.

Source: http://www.investorwords.com/16510/leveraged_portfolio.html#ixzz2CZpATlU3