1  

ALTERNATIVE INVESTMENT

2  

Important Concepts of Alternative Investment :

The fundamental concept of Alternative Investment is that this is the market

where the funds would be raised from high net worth individual and also

from the companies . The regulations of this market would be less stringent

due to non involvement of the common people. So Alternate Investment

market would be having the following characteristics :

• The regulation of the market would be much more liberal and less

stringent

• The players of the market would be high Net Worth Individual and

institutions of capable of taking higher risks

• Investment would be in the form of riskier assets

• The market operates under high risk- high gain principle

• The market would be approached through wealth managers and

investment banks

• Since the market is opaque there would be higher possibilities of the

money laundering . So KYC compliance would be of highest order .

• Since the sources of money are of higher amount per individual lender

, the enhanced due diligence is required before administering the

scheme

• The products would be complex products and mainly structured

products

• The chances of failure of the scheme is higher compared to other

traditional scheme.

This source can be a good sources of fund for many business when

traditional market is not able to assess the risk properly. Specially during

the slow down of the economy , the rating agencies and traditional lending

institutions behave more negative way than they should . In this process,

these traditional lenders eliminate good borrowers too. So during this time ,

these good borrowers should avail the Alternate Investment Market ( AIM) .

As of July 2013, Indian economy is going through very negative phase and

this has resulted in the dearth of fund for good borrowers too. During this

3  

time, the AIM can be a very good sources of fund. So we can build some

ground rules when to access the AIM market rather than the traditional

market :

• Part funding of promoters equity can be met through the AIM market.

In this type of product, the main lender would be the traditional

lender and the margin money for this senior loan can be brought in

the AIM market . This would work well for the companies which would

be requiring to bring in the margin money for the senior loan

• Funding riskier projects where traditional lender would not lend due

to lack of proper assessment of risks. This would be useful for second

or third level of growth of new age business. Venture Capital funding

would be falling in this category

• Funding projects where traditional lenders would not be able to lend

due to regulatory restrictions. For example, in India real estate can

not get fund from the baking system due to RBI restriction . So for

real estate funding AIM market can be explored .

Once we have built up fundamental concept of AIM now we shall discuss

about the regulatory fame work of AIM in India. In India the guiding

principle is given as below :

• A business entity can raise money in the form of loan from banks and

financial institutions

• A business entity can raise money from other entity in the form of

loan provider the number of lender is not more than 50

• A business entity can raise money in the form of bond from investors

under Private Placement route provided the number of investors are

not more than 50 only after compliance of Private Placement

regulations as stipulated by SEBI

• A business entity can raise money in the form of bond from investors

under Public Issue route provided the number of investors are more

than 50 and in such case the business entity has to comply with the

Public Issue guidelines

4  

• Same rule applies for raising fund in the form of equity by the

business entity . The general principle of public issue and private

placement is that if the number of investors are more , more stringent

norms and regulatory compliances are required.

• A business entity can raise money in the form of debt or equity from

investors or lenders having number more than 50 but without

following the public issue norms only under the Scheme of AIM

guidelines , Collective Investment Schemes .

Security Exchange Board of India ( SEBI ) has published a comprehensive

regulations called SECURITIES AND EXCHANGE BOARD OF INDIA

(ALTERNATIVE INVESTMENT FUNDS) REGULATIONS, 2012 . Under this

regulation , Alternative Investment Fund means any fund established or

incorporated in India in the form of a trust or a company or a limited

liability partnership or a body corporate which,-

(i) is a privately pooled investment vehicle which collects funds from

investors, whether Indian or foreign, for investing it in accordance with a

defined investment policy for the benefit of its investors; and

(ii) is not covered under the Securities and Exchange Board of India (Mutual

Funds) Regulations, 1996, Securities and Exchange Board of India

(Collective Investment Schemes) Regulations, 1999 or any other regulations

of the Board to regulate fund management activities.

However the following exemptions are provided as per the regulations :

1. family trusts set up for the benefit of ‗relatives‘ as defined under

Companies Act, 1956;

2. ESOP Trusts set up under the Securities and Exchange Board of

India (Employee Stock Option Scheme and Employee Stock Purchase

Scheme), Guidelines, 1999 or as permitted under Companies Act,

1956;

3. employee welfare trusts or gratuity trusts set up for the benefit of

employees;

5  

4. holding companies‘ within the meaning of Section 4 of the Companies

Act, 1956;

5. other special purpose vehicles not established by fund managers,

including securitization trusts, regulated under a specific regulatory

framework;

6. funds managed by securitisation company or reconstruction company

which is registered with the Reserve Bank of India under Section 3 of the

Securitisation and Reconstruction of Financial Assets and Enforcement of

Security Interest Act, 2002; and

7. any such pool of funds which is directly regulated by any other regulator

in India;

As per the regulations , we have got clear definitions of certain category of

funds in India. This clarity has come first time and this would help these

types of fund to show a steady growth . These are :

Private equity fund means an Alternative Investment Fund which invests

primarily in equity or equity linked instruments or partnership interests of

investee companies according to the stated objective of the fund;

SME fund means an Alternative Investment Fund which invests primarily in

unlisted securities of investee companies which are SMEs or securities of

those SMEs which are listed or proposed to be listed on a SME exchange or

SME segment of an exchange;

social venture fund means an Alternative Investment Fund which invests

primarily in securities or units of social ventures and which satisfies social

performance norms laid down by the fund and whose investors may agree to

receive restricted or muted returns;

6  

Venture capital fund means an Alternative Investment Fund which invests

primarily in unlisted securities of start-ups, emerging or early-stage venture

capital undertakings mainly involved in new products, new services,

technology or intellectual property right based activities or a new business

model;

Hedge fund means an Alternative Investment Fund which employs diverse

or complex trading strategies and invests and trades in securities having

diverse risks or complex products including listed and unlisted derivatives;

Important Provisions of the Regulations :

• Every entity has to take a registration number from SEBI. While

applying for registration , the entity has to specify the objectives of the

schemes and proposed investment details .

For existing VC , the following norms are applicable :

The funds registered as venture capital fund under Securities and Exchange

Board of India (Venture Capital Funds) Regulations, 1996 shall continue to

be regulated by the said regulations till the existing fund or scheme

managed by the fund is wound up and such funds shall not launch any new

scheme after notification of these regulations:

Provided that the existing fund or scheme shall not increase the targeted

corpus of the fund or scheme after notification of these regulations.

Provided further that venture capital funds may seek re-registration under

these regulations subject to approval of two-thirds of their investors by value

of their investment.

The registration would take place under three categories :

7  

Category I Alternate Investment Fund :

Category I Alternative Investment Fundǁ which invests in start-up or early

stage ventures or social ventures or SMEs or infrastructure or other sectors

or areas which the government or regulators consider as socially or

economically desirable and shall include venture capital funds, SME Funds,

social venture funds, infrastructure funds and such other Alternative

Investment Funds as may be specified;

Category II Alternate Investment Fund :

Category II Alternative Investment Fundǁ which does not fall in Category I

and III and which does not undertake leverage or borrowing other than to

meet day-to-day operational requirements and as permitted in these

regulations;

Category III Alternate Investment Fund :

Category III Alternative Investment Fund which employs diverse or complex

trading strategies and may employ leverage including through investment in

listed or unlisted derivatives.

Eligibility Criteria :

For the purpose of the grant of certificate to an applicant, the Board shall

consider the following conditions for eligibility, namely, —

(a) the memorandum of association in case of a company; or the Trust Deed

in case of a Trust; or the Partnership deed in case of a limited liability

partnership permits it to carry on the activity of an Alternative Investment

Fund;

(b) the applicant is prohibited by its memorandum and articles of

association or trust deed or partnership deed from making an invitation to

the public to subscribe to its securities;

8  

(c) in case the applicant is a Trust, the instrument of trust is in the form of a

deed and has been duly registered under the provisions of the Registration

Act, 1908;

(d) in case the applicant is a limited liability partnership, the partnership is

duly incorporated and the partnership deed has been duly filed with the

Registrar under the provisions of the Limited Liability Partnership Act, 2008;

(e) in case the applicant is a body corporate, it is set up or established under

the laws of the Central or State Legislature and is permitted to carry on the

activities of an Alternative Investment Fund;

(f) the applicant, Sponsor and Manager are fit and proper persons based on

the criteria specified in Schedule II of the Securities and Exchange Board of

India (Intermediaries) Regulations, 2008;

(g) the key investment team of the Manager of Alternative Investment Fund

has adequate experience, with at least one key personnel having not less

than five years experience in advising or managing pools of capital or in

fund or asset or wealth or portfolio management or in the business of

buying, selling and dealing of securities or other financial assets and has

relevant professional qualification;

(h) the Manager or Sponsor has the necessary infrastructure and manpower

to effectively discharge its activities;

(i) the applicant has clearly described at the time of registration the

investment objective, the targeted investors, proposed corpus, investment

style or strategy and proposed tenure of the fund or scheme;

(j) whether the applicant or any entity established by the Sponsor or

Manager has earlier been refused registration by the Board.

9  

Furnishing the information :

1) The Board may require the applicant to furnish any such further

information or clarification regarding the Sponsor or Manager or nature of

the fund or fund management activities or any such matter connected

thereto to consider the application for grant of a certificate or after

registration thereon.

(2) If required by the Board, the applicant or Sponsor or Manager shall

appear before the Board for personal representation.

Procedure for grant of certificate : (1) The Board may grant certificate under any specific category of Alternative

Investment Fund, if it is satisfied that the applicant fulfills the requirements

as specified in these regulations.

(2) The Board shall, on receipt of the registration fee as specified in the

Second Schedule, grant a certificate of registration in Form B.

(3) The registration may be granted with such conditions as may be deemed

appropriate by the Board.

Conditions of certificate.

(1) The certificate granted shall, inter-alia, be subject to the following

conditions:-

(a) the Alternative Investment Fund shall abide by the provisions of

the Act and these regulations;

(b) the Alternative Investment Fund shall not carry on any other

activity other than permitted activities;

10  

(c) the Alternative Investment Fund shall forthwith inform the Board

in writing, if any information or particulars previously submitted to

the Board are found to be false or misleading in any material

particular or if there is any material change in the information already

submitted.

(2) An Alternative Investment Fund which has been granted registration

under a particular category cannot change its category subsequent to

registration, except with the approval of the Board.

Procedure where registration is refused.

(1) After considering an application made under this regulation, if the Board

is of the opinion that a certificate should not be granted, it may reject the

application after giving the applicant a reasonable opportunity of being

heard.

(2) The decision of the Board to reject the application shall be communicated

to the applicant within thirty days.

(3) Where an application for a certificate is rejected by the Board, the

applicant shall cease to carry on any activity as an Alternative Investment

Fund:

Provided that nothing contained in these regulations shall affect the liability

of the applicant towards its existing investors under law or agreement.

11  

Investment conditions and restrictions:

Investment Strategy.

(1) All Alternative Investment Funds shall state investment strategy,

investment purpose and its investment methodology in its placement

memorandum to the investors.

(2) Any material alteration to the fund strategy shall be made with the

consent of at least two-thirds of unit holders by value of their investment in

the Alternative Investment Fund.

Investment in Alternative Investment Fund.

Investment in all categories of Alternative Investment Funds shall be subject

to the following conditions:-

(a) the Alternative Investment Fund may raise funds from any investor

whether Indian, foreign or non-resident Indians by way of issue of units;

(b) each scheme of the Alternative Investment Fund shall have corpus of at

least twenty crore rupees;

(c) the Alternative Investment Fund shall not accept from an investor,

an investment of value less than one crore rupees:

Provided that in case of investors who are employees or directors of the

Alternative Investment Fund or employees or directors of the Manager,

the minimum value of investment shall be twenty five lakh rupees.

(d) the Manager or Sponsor shall have a continuing interest in the

Alternative Investment Fund of not less than two and half percent of the

corpus or five crore rupees, whichever is lower, in the form of investment in

the Alternative Investment Fund and such interest shall not be through the

waiver of management fees:

12  

Provided that for Category III Alternative Investment Fund, the

continuing interest shall be not less than five percent of the corpus or

ten crore rupees, whichever is lower.

(e) the Manager or Sponsor shall disclose their investment in the Alternative

Investment Fund to the investors of the Alternative Investment Fund;

(f) no scheme of the Alternative Investment Fund shall have more than

one thousand investors;

(g) the fund shall not solicit or collect funds except by way of private

placement

Placement memorandum :

(1)Alternative Investment Fund shall raise funds through private

placement by issue of information memorandum or placement

memorandum, by whatever name called.

(2) Such information or placement memorandum as specified above shall

contain all material information about the Alternative Investment Fund and

the Manager, background of key investment team of the Manager, targeted

investors, fees and all other expenses proposed to be charged, tenure of the

Alternative Investment Fund or scheme, conditions or limits on redemption,

investment strategy, risk management tools and parameters employed, key

service providers, conflict of interest and procedures to identify and address

them, disciplinary history, the terms and conditions on which the Manager

offers investment services, its affiliations with other intermediaries, manner

of winding up of the Alternative Investment Fund or the scheme and such

other information as may be necessary for the investor to take an informed

decision on whether to invest in the Alternative Investment Fund.

13  

Schemes :

1) The Alternative Investment Fund may launch schemes subject to filing of

placement memorandum with the Board.

(2) Such placement memorandum shall be filed with the Board at least

thirty days prior to launch of scheme along with the fees as specified in

Provided that payment of scheme fees shall not apply in case of launch of

first scheme by the Alternative Investment Fund.

(3) The Board may communicate its comments, if any, to the applicant prior

to launch of the scheme and the applicant shall incorporate the comments

in placement memorandum prior to launch of scheme.

Tenure : (1) Category I Alternative Investment Fund and Category II Alternative Investment Fund shall be close ended and

(2) Category I and II Alternative Investment Fund or schemes launched by such funds shall have a minimum tenure of three years.

(3) Category III Alternative Investment Fund may be open ended or

close ended.

(4) Extension of the tenure of the close ended Alternative Investment

Fund may be permitted up to two years subject to approval of two-

thirds of the unit holders by value of their investment in the

Alternative Investment Fund.

(5) In the absence of consent of unit holders, the Alternative

Investment Fund shall fully liquidate within one year following

expiration of the fund tenure or extended tenure.

14  

Listing :

1) Units of close ended Alternative Investment Fund may be listed on stock

exchange subject to a minimum tradable lot of one crore rupees.

(2) Listing of Alternative Investment Fund units shall be permitted only after

final close of the fund or scheme.

General Investment Conditions.

(1) Investments by all categories of Alternative Investment Funds shall be

subject to the following conditions:-

(a) Alternative Investment Fund may invest in securities of

companies incorporated outside India subject to such conditions or

guidelines that may be stipulated or issued by the Reserve Bank of

India and the Board from time to time;

(b) Co-investment in an investee company by a Manager or Sponsor

shall not be on terms more favourable than those offered to the

Alternative Investment Fund;

(c) Category I and II Alternative Investment Funds shall invest

not more than twenty five percent of the corpus in one Investee

Company;

(d) Category III Alternative Investment Fund shall invest not more than ten percent of the corpus in one Investee Company

(e) Alternative Investment Fund shall not invest in associates

except with the approval of seventy five percent of investors by

value of their investment in the Alternative Investment Fund;

(f) Un-invested portion of the corpus may be invested in liquid

mutual funds or bank deposits or other liquid assets of higher

15  

quality such as Treasury bills, CBLOs, Commercial Papers,

Certificates of Deposits, etc. till deployment of funds as per the investment objective;

(g) Alternative Investment Fund may act as Nominated Investor as

specified in clause (b) of sub-regulation (1) of regulation 106N of the

Securities and Exchange Board of India (Issue of Capital and

Disclosure Requirements) Regulations, 2009.

(2) Notwithstanding the conditions as specified in above, the Board may

specify additional requirements or criteria for Alternative Investment Funds

or for a specific category thereof.

Conditions for Category I Alternate Investment Fund :

(1) The following investment conditions shall apply to all Category I

Alternative Investment Funds:-

(a) Category I Alternative Investment Fund shall invest in investee

companies or venture capital undertaking or in special purpose vehicles or

in limited liability partnerships or in units of other Alternative Investment

Funds as specified in these regulations;

(b) Fund of Category I Alternative Investment Funds may invest in units of

Category I Alternative Investment Funds of same sub-category:

Provided that they shall only invest in such units and shall not invest in

units of other Fund of Funds:

Provided further that the investment conditions as specified in sub-

regulations (2), (3), (4) or (5) shall not be applicable to investments by such

funds.

(c) Category I Alternative Investment Funds shall not borrow funds

directly or indirectly or engage in any leverage except for meeting

temporary funding requirements for not more than thirty days, on not

16  

more than four occasions in a year and not more than ten percent of

the corpus.

(2) The following investment conditions shall apply to venture capital

funds in addition to conditions laid down in sub-regulation (1):-

(a) at least two-thirds of the corpus shall be invested in unlisted equity

shares or equity linked instruments of a venture capital undertaking or

in companies listed or proposed to be listed on a SME exchange or SME

segment of an exchange;

(b) not more than one-third of the corpus shall be invested in:

(i) subscription to initial public offer of a venture capital undertaking whose

shares are proposed to be listed;

(ii) debt or debt instrument of a venture capital undertaking in which the

fund has already made an investment by way of equity or contribution

towards partnership interest;

(iii) preferential allotment, including through qualified institutional

placement, of equity shares or equity linked instruments of a listed company

subject to lock in period of one year;

(iv) the equity shares or equity linked instruments of a financially weak

company or a sick industrial company whose shares are listed.

Explanation.– For the purpose of these regulations, ―a financially weak

company means a company, which has at the end of the previous financial

year accumulated losses, which has resulted in erosion of more than fifty

percent but less than hundred percent of its net worth as at the beginning of

the previous financial year.

(v) special purpose vehicles which are created by the fund for the purpose of

facilitating or promoting investment in accordance with these regulations:

Provided that the investment conditions and restrictions stipulated in

clause (a) and clause (b) of sub-regulation (2) shall be achieved by the fund

by the end of its life cycle.

17  

(c) such funds may enter into an agreement with merchant banker to

subscribe to the unsubscribed portion of the issue or to receive or deliver

securities in the process of market making under Chapter XB of the

Securities and Exchange Board of India (Issue of Capital and Disclosure

Requirements) Regulations, 2009 and the provisions of clause (a) and clause

(b) of sub-regulation (2) shall not apply in case of acquisition or sale of

securities pursuant to such subscription or market making.

(d) such funds shall be exempt from regulation 3 and 3A of Securities and

Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992

in respect of investment in companies listed on SME Exchange or SME

segment of an exchange pursuant to due diligence of such companies

subject to the following conditions:

(i) the fund shall disclose any acquisition or dealing in securities pursuant

to such due-diligence, within two working days of such acquisition or

dealing, to the stock exchanges where the investee company is listed;

(ii) such investment shall be locked in for a period of one year from the date

of investment.

(3) The following conditions shall apply to SME Funds in addition to conditions laid down in sub-regulation (1):-

(a) at least seventy five percent of the corpus shall be invested in

unlisted securities or partnership interest of venture capital

undertakings or investee companies which are SMEs or in companies

listed or proposed to be listed on SME exchange or SME segment of an

exchange;

(b) such funds may enter into an agreement with merchant banker to

subscribe to the unsubscribed portion of the issue or to receive or deliver

securities in the process of market making under Chapter XB of the

Securities and Exchange Board of India (Issue of Capital and Disclosure

Requirements) Regulations, 2009;

18  

(c) such funds shall be exempt from regulation 3 and 3A of Securities and

Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992

in respect of investment in companies listed on SME Exchange or SME

segment of an exchange pursuant to due diligence of such companies

subject to the following conditions:

(i) the fund shall disclose any acquisition or dealing in securities pursuant

to such due-diligence, within two working days of such acquisition or

dealing, to the stock exchanges where the investee company is listed;

(ii) such investment shall be locked in for a period of one year from the date

of investment.

(4) The following conditions shall apply to social venture funds in addition to the conditions laid down in sub-regulation (1):-

(a) at least seventy five percent of the corpus shall be invested in unlisted securities or partnership interest of social ventures.

(b) such funds may accept grants, provided that such utilization of such

grants shall be restricted to clause (a).

(c) such funds may give grants to social ventures, provided that appropriate

disclosure is made in the placement memorandum.

(d) such funds may accept muted returns for their investors i.e. they

may accept returns on their investments which may be lower than prevailing returns for similar investments.

(5) The following conditions shall apply to Infrastructure Funds in

addition to conditions laid down in sub-regulation (1):-

(a) at least seventy five percent of the corpus shall be invested in

unlisted securities or units or partnership interest of venture capital

undertaking or investee companies or special purpose vehicles, which

are engaged in or formed for the purpose of operating, developing or

holding infrastructure projects;

19  

(b) notwithstanding clause (a) of sub-regulation (5), such funds may also

invest in listed securitized debt instruments or listed debt securities of

investee companies or special purpose vehicles, which are engaged in or

formed for the purpose of operating, developing or holding infrastructure

projects.

Conditions for Category II Alternative Investment Funds.

The following investment conditions shall apply to Category II Alternative

Investment Funds:-

(a) Category II Alternative Investment Funds shall invest primarily in

unlisted investee companies or in units of other Alternative Investment Funds as may be specified in the placement memorandum;

(b) Fund of Category II Alternative Investment Funds may invest in units of

Category I or Category II Alternative Investment Funds:

Provided that they shall only invest in such units and shall not invest in

units of other Fund of Funds.

(c) Category II Alternative Investment Funds may not borrow funds

directly or indirectly and shall not engage in leverage except for

meeting temporary funding requirements for not more than thirty

days, not more than four occasions in a year and not more than ten

percent of the corpus;

(d) Notwithstanding clause (c), Category II Alternative Investment Funds

may engage in hedging, subject to guidelines as specified by the Board

from time to time;

(e) Category II Alternative Investment Funds may enter into an agreement

with merchant banker to subscribe to the unsubscribed portion of the issue

20  

or to receive or deliver securities in the process of market making under

Chapter XB of the Securities and Exchange Board of India (Issue of Capital

and Disclosure Requirements) Regulations, 2009.

(f) Category II Alternative Investment Funds shall be exempt from regulation

3 and 3A of Securities and Exchange Board of India (Prohibition of Insider

Trading) Regulations, 1992 in respect of investment in companies listed on

SME Exchange or SME segment of an exchange pursuant to due diligence of

such companies subject to the following conditions:

(i) the fund shall disclose any acquisition or dealing in securities pursuant

to such due-diligence, within two working days of such acquisition or

dealing, to the stock exchanges where the investee company is listed;

(ii) such investment shall be locked in for a period of one year from the

date of investment. Conditions for Category III Alternative Investment Funds.

The following investment conditions shall apply to Category III Alternative

Investment Funds:-

(a) Category III Alternative Investment Funds may invest in securities of

listed or unlisted investee companies or derivatives or complex or structured products;

(b) Fund of Category II Alternative Investment Funds may invest in units of

Category I or Category II Alternative Investment Funds:

Provided that they invest solely in such units and shall not invest in units

of other Fund of Funds.

21  

(c) Category III Alternative Investment Funds may engage in leverage or

borrow subject to consent from the investors in the fund and subject to

a maximum limit, as may be specified by the Board:

Provided that such funds shall disclose information regarding the overall

level of leverage employed, the level of leverage arising from borrowing of

cash, the level of leverage arising from position held in derivatives or in any

complex product and the main source of leverage in their fund to the

investors and to the Board periodically, as may be specified by the Board.

(d) Category III Alternative Investment Funds shall be regulated through

issuance of directions regarding areas such as operational standards,

conduct of business rules, prudential requirements, restrictions on

redemption and conflict of interest as may be specified by the Board.

Transparency.

All Alternative Investment Funds shall ensure transparency and disclosure

of information to investors on the following:

(a) financial, risk management, operational, portfolio, and transactional

information regarding fund investments shall be disclosed periodically to the

investors;

(b) any fees ascribed to the Manager or Sponsor; and any fees charged to the

Alternative Investment Fund or any investee company by an associate of the

Manager or Sponsor shall be disclosed periodically to the investors;

(c)any inquiries/ legal actions by legal or regulatory bodies in any

jurisdiction, as and when occurred;

(d) any material liability arising during the Alternative Investment Fund‘s

tenure shall be disclosed, as and when occurred;

22  

(e) any breach of a provision of the placement memorandum or agreement

made with the investor or any other fund documents, if any, as and when

occurred;

(f) change in control of the Sponsor or Manager or Investee Company.

(g) Alternative Investment Fund shall provide at least on an annual basis,

within 180 days from the year end, reports to investors including the

following information, as may be applicable to the Alternative Investment

Fund:-

A. financial information of investee companies.

B. material risks and how they are managed which may include:

(i) concentration risk at fund level;

(ii) foreign exchange risk at fund level;

(iii)leverage risk at fund and investee company levels;

(iv) realization risk (i.e. change in exit environment) at fund and

investee company levels;

(v) strategy risk (i.e. change in or divergence from business strategy) at

investee company level;

(vi) reputation risk at investee company level;

(vii) extra-financial risks, including environmental, social and

corporate governance risks, at fund and investee company level.

(h) Category III Alternative Investment Fund shall provide quarterly

reports to investors in respect of clause (g) within 60 days of end of the

quarter;

23  

(i) any significant change in the key investment team shall be intimated to

all investors;

(j) alternative Investment Funds shall provide, when required by the Board,

information for systemic risk purposes (including the identification, analysis

and mitigation of systemic risks).

Valuation.

(1) The Alternative Investment Fund shall provide to its investors, a

description of its valuation procedure and of the methodology for valuing

assets.

(2) Category I and Category II Alternative Investment Funds shall

undertake valuation of their investments, atleast once in every six

months, by an independent valuer appointed by the Alternative Investment

Fund:

Provided that such period may be enhanced to one year on approval of

atleast seventy-five percent of the investors by value of their

investment in the Alternative Investment Fund.

(3) Category III Alternative Investment Funds shall ensure that

calculation of the net asset value (NAV) is independent from the fund

management function of the Alternative Investment Fund and such

NAV shall be disclosed to the investors at intervals not longer than a

quarter for close ended Funds and at intervals not longer than a month

for open ended funds.

24  

Real Estate Investment Trust ( REIT) and Real Estate Investment Fund

( REIF) :

Real Estate Funds are one of the most used financial instruments in the

developed world as an investment tool. They have become popular in the

developed world mainly because it does not have any correlation with the

movements in the equity markets and thus providing diversification

benefits.

With the second largest population in the world, India’s market possesses

inevitable characteristics that will relate strongly to the creation of

enormous real estate pressure and growth in this dynamic sector.

Present Real Estate Structure : The Present Reality :

The Indian economy was a closed market prior to 1991 with recognized real

estate in its infancy in India. Antiquated real estate laws have impeded the

development recently.

The Indian real estate market has traditionally considered illiquid, opaque

and conservative unlike the modern western states where organized real

estate is seen as an avenue for investment and forms a valuable cornerstone

of the economy.

But few years back this changed and the construction business was given

an industry status and some sort of finance flowed into it but not to that

extent. To that end the Indian real estate marketplace has been locked

outside the financial market and not leveraged for investment purposes.

Despite this India is poised for dizzying and rapid urbanization, which will

lead to major developments in Real Estate. However the continued demand

of quality real estate is yet to be achieved due to the shortage of space (Clear

25  

Titled Lands) and funds. Secondly developments of new towns and cities,

which are on the anvil, and which India requires drastically, are in the need

of huge amount of investment and technical expertise. This cannot be

achieved under the present practices or by the present domestic developers,

who still work in a much disorganized manner.

The Indian Government is realizing that the Real Estate sector is a key

component of the infrastructure of ant economy and factors inhibiting

growth will have a subsequent negative impact on the economy. The real

estate sector in India has an untapped potential to become a catalyst for

economic growth. This has been demonstrated by the performance of the

industry in other economies but this will only happen if the industry can be

corporatised.

The Indian government has recently allowed the much awaited foreign direct

investment (FDI) in the real estate sector, which is expected to open doors

for much needed investments in the reality sector. However, this requires a

clear understanding of the structure of the industry, its relationship with

the rest of the economy and a focused effort on the reform process. More so

ever this FDI is actually allowed in selected areas only. These investments

would be in integrated township which would include housing, commercial

premises, hotels and resorts, while the urban infrastructure would

compromise roads bridges, mass rapid transit, systems and manufacture of

building materials. The minimum acreage that can be developed is 100

acres designed keeping into consideration the local bylaws and regulations.

The minimum capitalization would be US $ 10 million for a wholly owned

subsidiary and US $ 5 million for a joint venture with an Indian partner. FDI

is however not being allowed in the retail sector.

Real Estate Fund :

26  

Real estate funds can be of four types based on the investment tools, which

they use.

Pure Equity Fund : This fund invests in shares of companies, which have

substantial interest (at least 50%) in Real estate sectors, e.g. Construction,

REITs, infrastructure development, etc. this is like any other pure equity

sectoral fund, which has a potential of high returns, accompanied by high

risk brought by a single sector concentration. Examples of such funds are

ABN AMRO Real Estate Fund and AIM Real Estate Fund. These funds invest

in securities of companies, which are in the business of real estate.

Mortgaged Backed Securities Fund : This kind of funds invests in

mortgaged backed securities of companies by investing directly in these

companies or by buying mortgage backed securities. This is very new in

India and not much used here as of now.

Hybrid Fund : This kind of fund invests in shares and mortgaged backed

debt instruments issued by companies involved in the real estate sectors or

generate a substantial part of their business from the real estate sector. This

again is nothing but a hybrid sectoral fund and has higher sector specific

risk attached to it. An example of such a fund is Gaa Blueprint Property

Fund. It is a UK based fund, which invests in real estate equity, debt

instruments issued by real estate firms, property trusts funds and

commercial property funds.

Real Estate Investment Trust ( REIT) : This kind of fund will invest in

different kinds of Real Estate properties like Retail Stores, Industrial

Properties, Commercial Properties and Residential Properties, etc. and earn

their income from rents, lease payments and possible appreciation of the

value of these properties. Examples of such funds are Norwich Property

Fund and Guardian Property Fund.

Baring the last one i.e. Real Estate Investment Trust, the first three kind of

funds cab be launched in India as per the current SEBI regulations, the only

27  

problem they might face in India is that there aren’t many company listed in

India which have substantial part of their business in Real Estate. As of now

the India laws do not allow us to form a Real Estate Investment Trust, but

the finance ministry, SEBI and RBI have taken steps and are trying to evolve

a route to introduce a Real Estate Investment Trust.

REMF Framework :

INVESTOR is the one who has an affinity towards realty investments.

Investor profile can range from Insurance Companies, Corporate Bodies to

Retail Investors. The Investors are the source of funds in the whole

framework.

REAL ESTATE MUTUAL FUND or the REMF acts as a conduit or a link

between an investor and real estate and helps manage the funds of the

investors and invest them in the real estate sector.

INVESTMENTS: REMF can invest in a developed property, and as the value

appreciates over a period of time, it can offload its investment to make

capital gains. It also has an option of developing the property on its own and

then selling it at an appropriate time to ensure adequate returns.

Furthermore, it can realize regular stream of returns through leasing,

financing to developers and mortgage backed financing. The Investment

Avenues are the users of funds in the whole framework.

The FUNCTIONS, which REMF performs, includes entering into Real Estate

Transactions on behalf of its investors, performing valuations of the

properties either internally or through external agencies. The REMF is also

responsible in maintaining liquidity in case of any redemption pressures or

to fulfil any financial obligations or to undertake trades. The REMF is also

responsible for maintaining the properties, which it has brought under its

control.

The REGULATORY BODIES involved in the working of REMF include the

Finance Ministry, the SEBI, the RBI and any other body as per the rules

formed by the concerned authority.

28  

Real Estate Investment Trust :

A Real Estate Investment Trust (REIT) is a company that invests its assets in

real estate holdings. Investors get a share of the earnings, depreciation, etc.

from the portfolio of real estate holdings that the REIT owns. Thus, investors

get many of the same benefits of being a landlord without too many of the

hassles. Investors also have a much more liquid investment than investors

do when directly investing in real estate. The downsides are that investors

have no control over when company will sell its holdings or how it will

manage them, like you would have if investors owned an apartment

building.

Advantages :

REIT is a company that buys, develops, manages and sells real estate

assets. REITs allow participants to invest in a professionally managed

portfolio of real estate properties. REIT qualify as pass through entities,

companies who are able distribute the majority of income flows to investors

without taxation at the corporate level (providing that certain conditions are

met). As pass through entities, whose main function is to pass profits on to

investors, a REITs business activities are generally restricted to generation

of property rental income. Another major advantage of REIT investment is

its liquidity (ease of liquidation of assets into cash), as compared to

traditional private real estate ownership which are not very easy to liquidate.

One reason for the liquid nature of REIT investments is the its shares are

primarily traded on major exchanges, making it easier to buy and sell REIT

assets/shares than to buy and sell properties in private markets.

Essentially, REITs are the same as stocks, only the business they are

engaged in is different than what is commonly referred to as “stocks” by

most folks. Common stocks are ownership shares generally in

manufacturing or service businesses. REITs shares on the other hand are

the same, just engaged in the holding of an asset for rental, rather than

producing a manufactured product. In both cases, though the shareholder

29  

is paid what is left over after business expenses, interest/principal, and

preferred shareholders dividends are paid. Common stockholders are always

last in line, and their earnings are highly variable because of this. Also,

because their returns are so unpredictable, common shareholders demand a

higher expected rate of return than lenders (bondholders). This is why equity

financing is the highest cost form of financing for any corporation.

An interesting thing about REITs is that they are probably the best inflation

hedge around. However, they almost always lack the potential for

tremendous price appreciation (and depreciation) that you get with most

common stocks. There are exceptions, of course, but they are few and far

between.

Investors should pick several REITs instead of one. They are subject to

ineptitude on the part of management just like any company’s stock, so

diversification is important. However, they are rather conservative

investment, with long term returns lower than common stocks of other

industries. This is because rental revenues do not usually vary as much as

revenues at a mfg. or service firm.

Types of REITs :

REITs fall into three broad categories:

EQUITY REITs

Equity REITs invest in and own properties (thus responsible for the equity or

value of their real estate assets). Their revenues come principally from their

properties rents.

Mortgage REITs:

30  

Mortgage REITs deal in investment and ownership of property mortgages.

These REITs loan money for mortgages to owners of real estate, or invest in

(purchase) existing mortgages or mortgage backed securities. Their revenues

are generated primarily by the interest that they earn on the mortgage loans.

Hybrid REITs :

Hybrid REITs combine the investment strategies of Equity REITs and

Mortgage REITs by investing in both properties and mortgages.

Individual REITs are able to distinguish themselves by specialization. REITs

may focus their investments geographically (by region, or metropolitan area),

or in property types (such as retail properties, industrial facilities, office

buildings, apartments or healthcare facilities). Certain REITs choose a

broader focus, investing in a variety of types of property and mortgage

assets across a wider location and different categories of assets and thus

ensuring proper diversification. This would help investors to reduce the

risks.

REITs are dividend paying stocks that focus on real estate. If investors seek

income, investors would consider them along with high yield bond funds

and dividend paying stocks. Investors can see that stable dividends combine

with price volatility to create a total return which is often promising, but

volatile nonetheless.

Introducing REITs to the Indian market place requires a favourable legal,

regulatory, accounting and tax system and environment. Presently, the

introduction and facilitation of the REIT concept is still in the planning

stages with the securities exchange bureau of India (SEBI), Reserve Bank of

India (RBI) and the Finance Ministry evolving a blue print for customizing

REITs for the Indian marketplace and formulating the changes in

regulations required to enable this structure. With that in mind the

association of mutual funds of India (AMFI) formed a Sub-Committee. The

31  

mandate of this committee called the ‘Satwalekar Committee’ was to

formulate a working plan for real estate investment schemes based on their

findings and to propose recommendations for change to the government.

SATWALEKAR COMMITTEE:

The Satwalekar Committee conducted a detailed study and has prepared an

exhaustive report on the above subject and formulated a working plan for

launching Real Estate Investment Schemes (REIS) based on the Committee

recommendations.

The Structure :

The Sub-committee deliberated on the appropriate structure to be

recommended for the introduction of the real estate funds in the country.

the deliberations focused on two different models:

Real Estate Investment Trust of USA, which have been in operation since

1962 and The Mutual Fund Structure prevalent in UK.

The favoured model for India being that prevalent in the UK the pooled

managed vehicle (PMV) a Mutual Fund Structure. In the United Kingdom,

real estate investments are done through pooled managed vehicles. While

these are different from open ended Investment companies (OICs), they can

be in the form of trusts. The regulator for these however, have a variable

capital and are similar to open ended funds. PMVs may get tax qualify for

benefits. However, there are no tax benefits for the regular PMVs. This would

be comparable to have no tax benefits for typical OICs. The PMV has ability

to delay redemption if there is excessive pressure to exit the fund.

32  

In this context, the sub-committee has been able to suggest a solid

investment program by evaluating international experience regarding Real

Estate Funds in other countries and has a looked to the points of liquidity

and low volatility, Professional management, Conservative leverage,

Diversification of investment risk, Independent monitoring and Technology

transfer.

In the United States real estate investment is through real estate investment

trusts (REITs). The REITs are formed as companies that have an issued

share capital. Further, they have the flexibility to raise funds through

preference shares and debt. In this structure they are always close ended

and listed on the exchanges. In order to qualify as an American REIT the

following rules have to be followed:

• Be an entity that is taxable as a corporation.

• Be managed by a board of directors or trustees.

• Have shares that are fully transferable.

• Have a minimum of hundred shareholders.

• Have no more than 50% held by five or fewer individuals during the

last half of each taxable year.

• Invest at least 75% of the total assets in the real assets.

• Invest at least 75% of gross income from real property, or interest on

mortgages on real property.

• Have no more than 20% of its assets consist of stocks in taxable REIT

subsidiaries.

• Pay dividends of at least 90% of its taxable income form of

shareholder dividends.

• REITs were started without tax benefits and did not do well until the

US tax laws were amended in 1986. The new laws provided them with

tax benefits under the condition that they conform to certain

requirements that have been laid down. REITs are very popular now in

United States. as per the data available, there are approximately 300

REITs operating in the country with assets in excess of US$300

33  

billion. The company structure followed in the USA (REITs), which

allows the flexibility to raise funds by leveraging the balance sheet,

was deemed inappropriate by the sub-committee for pooling of small

savings in the area of Real Estate Investment.

The PMVs in UK are in the form of trusts and similar to the open ended

Mutual Funds/Collective Investment Schemes. Which are regulated by

SEBI. The sub-committee has therefore recommended the trust structure

as appropriate for Real Estate Investments.

It should be noted that REITs in the US became popular structure for

investing in Real estate only after the US Congress granted them tax

benefits. After comparison of the features and suitability of the collective

investment scheme structure versus the mutual fund structure for real

estate investments, the securities and exchange board of India

determined that the (Collective Investment Scheme (CIS) Regulations, of

1999 (CIS Regulations) would have to be modified to include real estate

as an investment objective and to enable and launch Indianized REITs of

REMFs.

Recommended Changes in the CIS Regulations :

Some of the problems with the CIS regulations in India are as follows:

The CIS regulations do not have a concept of a sponsor. Thus any

company having a net worth of Rs 5 crores and the appropriate main

objectives in its articles of association can set up a collective investment

scheme. This needs to be rectified and only companies with a sound

financial background should be allowed to set up collective investment

schemes based REIT. Due the lack of a sponsor for the business, the CIS

Regulations do not seem to be emphasize the concept of arms length

relationships between group companies. this concept is very important

for investor safeguard and should specify the upper limit for the exposure

34  

that the REIT can take on group companies projects and projects of its

majority shareholders.

The CIS regulations appear to be made keeping a specific project in mind.

The regulations prescribe a maximum subscription level and recommend

proportionate allotment of units. It may be noted that real estate funds

are not project specific and therefore do not have predetermined size of

subscription. So keeping a maximum limit on subscription would

disadvantage small investors desirous of taking exposure to the real

estate sector.

Being fundamentally based on a specific project rationale, CIS

regulations do not have any investment restrictions. Extensive

investment restrictions were recommended by the ‘Deepak Satwalekar

Committee’ to avoid over exposure to certain projects, groups or

geographic locations. Investment restrictions are vital for ensuring safety

of the investor’s monies. It should also noted that the existing MF

regulations contain investment restrictions similar to the ones

recommended by the Satwalekar Committee.

Another issue with the CIS regulations is the concept of an appraising

agency. This is again appropriate for a specific project that would need to

be appraised, as a measure of abundant caution. The appraisal concept

is misplaced in a situation where multiple properties are being invested

in. Also, the appraising concept reduces the flexibility of the managers of

the scheme and may impair the possibility of better returns.

Another important aspect of CIS is that the CIS Regulations do not

necessitate the calculation of NAV. Thus, there is no underlying value of

the investments or the units that can be calculated on an on going basis.

Thus, Real Estate investments done under the CIS Regulations would not

35  

provide a fair and transparent underlying NAV, against which the market

price could be benchmarked. It should be noted that in the case of

pooled managed vehicles in the UK, valuation of properties is done on a

quarterly basis and NAV is reported on a daily basis. Thus, even the

international experience suggests NAV calculation as a central concept of

Real Estate Investment.

Finally, tax benefits available to mutual funds are a vital determinant of

the success of the domestic mutual fund industry. If we recall the

experience of the USA where REITs gained popularity after receiving tax

benefits.

The need of appropriately structured Real Estate investments can be

hardly overemphasized. It may be noted that the Deepak Satwalekar

Committee went into great detail on the benefits of Real Estate Funds,

including channeling small savings into the housing sector, which

currently faces a huge shortage, as well as providing investors with

another investment alternative, hitherto unavailable.

It is suggested that the mutual fund structure for introducing Real Estate

investments in India is preferable. Post the issuing of comprehensive

guidelines by SEBI, the mutual fund structure is now well understood

and trusted. Selling of real estate investments through the mutual fund

route would therefore be easier and energies can be directed towards

selling the product rather than the structure. There are many different

structures, which can be used to form a real estate fund, one such

structure, which can be very successful, is the Interval Mutual Fund

structure. An example of an Interval structure is given below:

Be close ended for a minimum period of 3 years.

Open at the end of every quarter for sale of fresh units based on the

quarterly NAV calculation and remain open for a minimum period of 15

days. This will enable the fund to grow by soliciting fresh inflows from

investors, while giving potential investors a chance to participate in the

scheme after its Initial Offer.

36  

Offer redemption / repurchase to the investors at the end of 3 years in a

staggered manner. For example, at the end of 3 years, 20% of the

investment can be redeemed at NAV; at the end of 5th year, balance 30%

can be redeemed to the investor at NAV.

Be an interval fund, and offers redemption at the end of 3 years, the

scheme may be listed on any stock exchange to provide the liquidity to

the investors.

Calculate the NAV on quarterly basis as per the valuation of the

underlying investments. Operate within the regulations of Mutual Funds

as amended from time to time and comply with all the requirements of

the SEBI (Mutual Fund) Regulations.

Tax benefits :Being part of a Mutual Fund, Real Estate Investment

Schemes would be eligible for all tax benefits applicable to Mutual Funds

in general. This would enhance the attractiveness of these schemes to

investors.

The scheme will not be allowed to borrow funds from the market and

thus use leverage so as to enhance the risk – return paradigm.

No matter what the structure of the real estate scheme is but it is

expected that the investment avenues will be restricted to the list given

below:

Equity Shares / Bonds / Debentures of the listed companies which deal

in properties along with property development. however, at present, in

India there are very few such companies, which are listed.

Mortgage-backed securities i.e. the securitisation of housing loans.

At present, these are not yet available. Direct estate project finance,

construction finance, purchase / option to purchase of buildings under

37  

construction with a view to sell it again; investment in the debt securities

issued by development and construction companies (placed privately).

Investments in money markets and call markets so as to maintain the

required liquidity.

Launching REITs in India :

Before launching a REMF, all Real Estate Investment Schemes would

need the approval of SEBI and will also have to file the Offer Document

as per the existing SEBI (Mutual Fund) Regulations. An asset

Management company could launch these Schemes if it has the

appropriate investment management skills and if not then it can use the

services of an advisor.

There are certain risks associated with investing in Real Estate as an

asset class. Some of these risks are given below:

• Liquidity Risk

• Risk because of high maintenance burden.

• Risk due to high government controls

• Risk due to real estate cycles

• Risk due to legal hurdles and complexity

• Risk due to high transaction cost and thus forming barriers to

entry and exit.

• Risk due to lack of information

Some of these risks are natural and inevitable but a lot of these risks can

be controlled to some extent. A Real estate mutual fund should work in

38  

such a way that the over all risk is optimized and matched to the

investors needs.

Risk Management :

Amendment in SEBI – As recommended by the Satwalekar Committee, an

amendment in SEBI regulations is suggested enabling the SEBI to

regulate the establishment and functioning of the real estate mutual

funds schemes with all the existing regulations applicable to such

mutual funds pertaining to net worth of AMC; existing free structure;

initial launch expenses restricted at 6%; maximum limit of expenses; etc.

as already provided in the Mutual Fund regulations.

Investment Restriction – That present Regulations have restriction on

investment where any investment in one corporate should be restricted

up to 10% of the corpus and similarly, any investment in the properties

owned and managed by sponsor should be restricted upto 25% of the

corpus.

Restriction based on project, Promoter Group and Geographical area –

The Satwalekar Committee has recommended Investment Restrictions

based on a project, a promoter group and a geographical area. With these

restrictions appropriate ti mitigate the concentration risk of the

investment portfolio of the real estate investment scheme. Details of the

investment restrictions proposed in the report of the Satwalekar

Committee can be found on page 24 of that report

Valuation – At present, we have “Registered Valuers” as proved by

Government of India / Income tax Departments / Insurance Regulatory

Development Authority. Thus it becomes imperative for SEBI to use them

and approve these registered valuers for the purpose of valuing properties

held by Real Estate Investment Schemes.

Legal Aspects that need change :

39  

Along with the regulatory issues, there are some legal issues that are

caused by our antiquated laws and which will hamper the smooth and

profitable functioning of the Real Estate Mutual Funds. thus these laws

need to be reformed since they also increase the risk level of a Real

Estate Investment. Some of these laws and proposed changes are given

below:

Stamp Duty – This is a state subject and unless the Central Government

decides to make it uniform, it will be difficult and time consuming to

expect any changes in the stamp duty framework. It is recommended

that either there should be no stamp duty for a SEBI registered REMF or

even if a minor stamp duty is imposed it should take the form of value

added stamp duty structure and thus double stamp duty will be avoided

in case of frequent transfer of the properties.

Property Taxes – this is a State/City subject. It recommended that the

relevant authorities provide exemption from annual property taxes to real

estate investment schemes. This would help real estate investment

schemes to provide better returns to investors.

Records – A significant issue in dealing with properties is the custody if

title and paper form of transaction. It would be very helpful to the REMF

if all the property records are computerized and the properties be

transacted in a dematerialized format, exactly how the securities are

traded right now.

Rent Control Act – The provisions of the Rent Control Act have been

amended in some of the states. since, several states continue with the

ancient Rent Control provisions and it is believed that the Rent Control

Act is one of the main reasons why people are not very enthusiastic in

building a house and giving it on rent.

Urban Land Ceilings and Regulations Act – This act lays a ceiling

(generally around 500 to 2000 square meter) on the land which a person

40  

can hold in an urban area, the excess land is either to be handed over to

a competent authority or is to be developed by the owner for a specified

purposes only. Here a person stands for an individual, corporation, firm,

family, association or body of individuals etc. Thus if the REIT has to

come to any meaningful existence this law has to be scrapped.

It can be concluded that there is a tremendous potential for a Real Estate

Hedge Fund to be introduced in India. The proposed fund will mainly

follow the structure already being followed in UK, which is that of a

Mutual Fund with some changes. Though the demand for such a fund is

huge there are a lot of concerns, which are still to be answered in terms

of the antiquated laws, which govern the real estate business, the

existing laws of SEBI and regulatory mechanisms to be used. If these

concerns are taken care off by the government then the proposed real

estate funds are poised to have exponential growth in India and thereby

lead to greater economic growth and overall progress of the country.

Hedge Fund :

A hedge fund is a limited-partnership fund that invests private capital

speculatively to maximize capital appreciation. They invest in a diverse

range of markets, investment instruments, and strategies. Though they

are privately owned and operated, hedge funds are subject to the

regulatory restrictions of their respective countries. U.S. regulations, for

example, limit hedge fund participation to certain classes of accredited

investors. Hedge fund sources fund from High Net-worth Individual ( HNI)

as well as from Institutions. These funds operate with a lean operating

structure and uses different strategies to maximize the income. The fund

is not risk averse in nature. However the hedge fund strategy and under

lying operations have shifted to great extent post 2008 crisis which we

shall discuss in the detail later on.

41  

A hedge fund typically pays its investment manager an annual 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 1st Quarter 2013, total assets under management for the

hedge fund industry was $1865.5 billion, and the managed futures (CTA)

industry was $337.2 billion.[ Source www.barclayhedge.com]. Detail sector

wise break up of hedge fund assets are given below :

Hedge Fund Industry - Assets Under Management

Assets Under

Management

1st Qtr 13† 4th Qtr 12† 3rd Qtr 12†

Hedge Funds * $1865.5B $1798.7B $1827.3B

Funds of

Funds

$485.5B $501.4B $515.1B

Sectors Convertible

Arbitrage

$38.6B $38.9B $39.9B

Distressed

Securities

$142.6B $124.4B $120.7B

Emerging

Markets

$232.5B $211.6B $211.8B

Equity Long

Bias

$163.8B $149.9B $151.0B

Equity $176.9B $170.2B $176.0B

42  

Long/Short

Equity Long-

Only

$59.5B $53.5B $87.2B

Equity Market

Neutral

$20.2B $23.2B $28.8B

Event Driven $174.4B $164.8B $168.7B

Fixed Income $287.5B $280.6B $263.0B

Macro $167.6B $172.9B $171.5B

Merger

Arbitrage

$24.0B $24.2B $24.5B

Multi-Strategy $241.6B $239.7B $242.1B

Other ** $30.3B $33.3B $29.8B

Sector Specific

***

$106.2B $111.6B $112.3B

†Industry-wide estimated in USDBillions

*Excludes Fund of Funds assets

**Other: Include funds categorized as Regulation D, Equity ShortBias,

Option Strategies, Mutual Fund Timing, Statistical Arbitrage, Closed-End

Funds, Balanced, Equity Dedicated Short and without a category.

***Sector Specific: Includes sector funds categorized as Technology, Energy,

Bio-Tech, Finance, Real Estate, Metals & Mining and Miscellaneous

oriented.

[ Sources : www.barclayhedge.com]

43  

Once we have discussed about the different categories of asset class within

the Hedge fund , now we shall see how Hedge Fund contributes to the

overall Alternate Investment Market :

 

 

 

(*Includes CTAs and Hedge Funds)

Source : www.barclayhedge.com

The above data shows that the Hedge fund and CTA as a percentage of the

Alternative Investment Industry has started declining 2000 and then it

reached its nadir in the year 2007. However after that it started showing

going up with a slight drop in 2012. This is due to the reason that post

subprime crisis the overall Alternative Investment Industry suffered due to

the liquidity crisis and Hedge fund also suffered. However , Hedge Fund as a

44  

percentage of the total investment has gone up due to lack of other avenues

of the Alternative Investment Industry and better regulations of the Hedge

Fund Industry.

During the US bull market of the 1920s, there were numerous private

investment vehicles available to wealthy investors. One of the most popular

funds during that time is the Graham-Newman Partnership founded

by Benjamin Graham and Jerry Newman . This is considered one of the

early hedge funds.

Financial journalist Alfred W. Jones is credited with coining the phrase

"hedged fund" and is wrongly quoted as the creator of the first hedge fund

structure in 1949. Jones referred to his fund as "hedged", a term then

commonly used on Wall Street, to describe the management of investment

risk due to changes in the financial markets. However this is not the true

spirit of the Hedge Fund what we hear today. In 1968 there were almost 200

hedge funds, and the first fund of funds that utilized hedge funds were

created in 1969 in Geneva .In the 1970s hedge funds specialized in a single

strategy, and most fund managers followed the long/short equity model.

As happened in the past , due to recession and adverse economic situation

many hedge funds closed, for example : many hedge funds closed during

the recession of 1969–70 and the 1973–1974 stock market. They received

renewed attention in the late 1980s. During the 1990s the number of hedge

funds increased significantly, funded with wealth created during the 1990s

stock market rise. It shows that immediately after wealth creation , hedge

fund industry boomed. The increased interest was due to the aligned-

interest compensation structure (i.e. common financial interests) and the

promise of above high returns. Over the next decade hedge fund started

using multiple strategies with the use of computers and other sophisticated

modelling techniques . These strategies expanded to include: credit

arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. US

institutional investors such as pension and endowment funds began

allocating greater portions of their portfolios to hedge funds . The main

45  

interest of these entities were to generate higher amount of return from their

investment .

During the first decade of the 21st century, hedge funds gained popularity

worldwide and by 2008, the worldwide hedge fund industry held

US$1.93 trillion in assets under management (AUM).However, the 2008

financial crisis caused many hedge funds to restrict investor withdrawals

and their popularity and AUM totals declined. AUM totals rebounded and in

April 2011 were estimated at almost $2 trillion. Now since 2008 crisis ,

hedge fund investors profile has undergone change with more and more

institutional investors investing in the hedge fund. As of February 2011,

61% of worldwide investment in hedge funds comes from institutional

sources. In June 2011, the hedge funds with the

greatest AUM was Bridgewater Associates (US$58.9 billion), Man

Group (US$39.2 billion), Paulson & Co. (US$35.1 billion), Brevan Howard

(US$31 billion), and Och- Ziff (US$29.4 billion). Bridgewater Associates,

had $70 billion under management as of 1 March 2012. At the end of that

year, the 241 largest hedge fund firms in the United States collectively held

$1.335 trillion. In April 2012, the hedge fund industry reached a record high

of US$2.13 trillion total assets under management.

Strategies :

Hedge fund employs lot of strategies to increase the return. However

classifying them is difficult due to rapid change in the same over time.

Broadly we can segregate the Hedge Fund Strategies into four categories :

Global

Hedge

sizable

global m

return.

analysis

for inve

global m

to use

markets

order t

categor

Global

approac

who i

on math

Glob

Macro Str

funds

positions

macroecon

Global m

s based on

estment th

macro stra

leverage t

s, the tim

o generat

rized as a d

macro str

ches. Disc

dentify a

hematical

bal Macro

rategies :

utilizing

in share,

nomic ev

macro fun

n global m

hat would

ategies hav

to take la

ming of the

e attractiv

directional

rategies c

cretionary

and selec

models a

Dire

a glob

bond or

vents in o

d manage

market eve

d profit fro

ve a large

arge positi

e implemen

ve, risk-ad

l investme

an be div

trading i

ct invest

and execu

HedgTra

Stra

ectional

46

al macr

r currency

order to

ers use m

ents and tr

om anticip

amount o

ions in div

ntation of

djusted re

ent strateg

vided into

is carried

tments; sy

uted by s

ge Fund ading ategies

Event

o invest

y markets

generat

macroecon

rends to i

pated pric

of flexibilit

verse inve

f the strate

eturns. Gl

gy.

discretion

out by in

ystematic

software w

t Driven

ting stra

s in antic

te a ris

nomic ("bi

dentify op

ce moveme

ty due to t

estments i

egies is im

lobal mac

nary and

nvestment

trading

with limite

Relativ( Arbi

ategy tak

cipation o

sk-adjuste

ig picture

pportunitie

ents. Whil

their abilit

in multipl

mportant i

cro is ofte

systemati

t manager

is base

ed huma

ve Value itrage)

ke

of

ed

e")

es

le

ty

le

in

en

ic

rs

ed

an

47  

involvement beyond the programming and updating of the software. These

strategies can also be divided into trend or counter-trend approaches

depending on whether the fund attempts to profit from following trends (long

or short-term) or attempts to anticipate and profit from reversals in trends.

Within global macro strategies, there are further sub-strategies including

"systematic diversified", in which the fund trades in diversified markets, or

"systematic currency", in which the fund trades in currency markets. Other

sub-strategies include those employed by Commodity Trading Advisors

(CTA), where the fund trades in futures (or options) in commodity markets

or in swaps. This is also known as a managed future fund. CTAs trade in

commodities (such as gold) and financial instruments, including stock

indices. In addition they take both long and short positions, allowing them

to make profit in both market upswings and downswings.

Directional

Directional investment strategies utilize market movements, trends, or

inconsistencies when picking stocks across a variety of markets. Computer

models can be used, or fund managers will identify and select investments.

These types of strategies have a greater exposure to the fluctuations of the

overall market than do market neutral strategies. Directional hedge fund

strategies include US and international long/short equity hedge funds,

where long equity positions are hedged with short sales of equities or

equity index options.

For example , hedge fund manager may think that the equity of a particular

stock would go up. It would take a long position on the equity and it would

hedge the same with the short position with the futures.

Long and Short Equity :

48  

This strategy involves investments, long or short, in equities. Traditional

equity value and growth hedge funds purchase stocks which they perceive to

be undervalued and sell stocks which they perceive to be overvalued. The

research-intensive efforts employed in identifying promising stocks to hold

long in a portfolio may also provide short-sale opportunities, and for this

reason many directional equity funds often maintain both long and short

portfolios. While the long side generally outweighs the short side in most

directional equity funds, there is also a small group of short-biased funds in

which the short side as a general matter exceeds the long side, sometimes

by a significant margin.

Within directional strategies, there are a number of sub-strategies.

"Emerging markets" funds focus on emerging markets such as China and

India, whereas "sector funds" specialize in specific areas including

technology, healthcare, biotechnology, pharmaceuticals, energy and basic

materials. Funds using a "fundamental growth" strategy invest in companies

with more earnings growth than the overall stock market or relevant sector,

while funds using a "fundamental value" strategy invest in undervalued

companies. Funds that use quantitative techniques for equity trading are

described as using a "quantitative directional" strategy. Funds using a

"short bias" strategy take advantage of declining equity prices using short

positions.

There are many difficulties with managing long/short funds. These include

the difficulties of estimating and hedging the risks to which a portfolio is

exposed, and the requirement to manage unsuccessful short positions in an

active manner. Short positions that are losing money grow to become an

increasingly large part of the portfolio, and their price can increase without

limit.

However, the major difficulty is that to make money the hedge fund must

successfully predict which stocks will perform better. Most investors grossly

underestimate the difficulty of this task. It requires making intelligent use of

49  

the available information, but this is not enough -- it also requires making

better use of the available information than large numbers of capable

investors.

Event-driven

Event-driven strategies concern situations in which the underlying

investment opportunity and risk are associated with an event. An event-

driven investment strategy finds investment opportunities in corporate

transactional events such as consolidations, acquisitions, recapitalizations,

bankruptcies, and liquidations. Managers employing such a strategy

capitalize on valuation inconsistencies in the market before or after such

events, and take a position based on the predicted movement of the

security or securities in question. Large institutional investors such as

hedge funds are more likely to pursue event-driven investing strategies than

traditional equity investors because they have the expertise and resources to

analyze corporate transactional events for investment opportunities.

Corporate transactional events generally fit into three categories:

1. distressed securities,

2. risk arbitrage and

3. special situations.

Distressed securities : It includes such events as restructurings,

recapitalizations, and bankruptcies. Distressed securities are securities of

companies or a nation's central bank that are either already in default,

under bankruptcy protection, or in distress and heading toward such a

condition. When it comes to fixed income, these types of securities are below

investment grade, and can include corporate credit as well as emerging

market government fixed income. The most common distressed securities

are bonds and bank debt. While there is no precise definition, fixed income

instruments with a Yield to Maturity in excess of 1000 basis points over the

risk-free rate of return (e.g. Treasuries) are commonly thought of as being

50  

distressed. A related category is stressed debt yielding between 600-800

basis points over Treasuries.

Historically, distressed securities have traded at deep discounts to a rational

assessment of their risk-adjusted value for a number of reasons. For

example, banks or institutional investors often have constraints that prevent

them from investing in such risky securities. This has led to above average

returns (adjusted for risk) from investors in this asset class. In recent years,

the amount of capital devoted to the distressed securities sector has

increased.

A distressed securities investment strategy involves investing in the bonds

or loans of companies facing bankruptcy or severe financial distress, when

these bonds or loans are being traded at a discount to their value. Hedge

fund managers pursuing the distressed debt investment strategy aim to

capitalize on depressed bond prices. Hedge funds purchasing distressed

debt may prevent those companies from going bankrupt, as such an

acquisition deters foreclosure by banks. While event-driven investing in

general tends to thrive during a bull market, distressed investing works best

during a bear market.

Risk arbitrage or merger arbitrage : It includes such events as mergers,

acquisitions, liquidations, and hostile takeovers. Risk arbitrage typically

involves buying and selling the stocks of two or more merging companies to

take advantage of market discrepancies between acquisition price and stock

price. The risk element arises from the possibility that the merger or

acquisition will not go ahead as planned; hedge fund managers will use

research and analysis to determine if the event will take place. Special

situations are events that impact the value of a company's stock, including

the restructuring of a company or corporate transactions including spin-

offs, share-buy-backs, security issuance/repurchase, asset sales, or other

catalyst-oriented situations. To take advantage of special situations the

hedge fund manager must identify an upcoming event that will increase or

decrease the value of the company's equity and equity-related instruments.

51  

Other event-driven strategies include: credit arbitrage strategies, which

focus on corporate fixed income securities; an activist strategy, where the

fund takes large positions in companies and uses the ownership to

participate in the management; a strategy based on predicting the final

approval of new pharmaceutical drugs; and legal catalyst strategy, which

specializes in companies involved in major lawsuits.

Relative value

Relative value arbitrage strategies take advantage of relative discrepancies in

price between securities. The price discrepancy can occur due to mispricing

of securities compared to related securities, the underlying security or the

market overall. Hedge fund managers can use various types of analysis to

identify price discrepancies in securities, including

mathematical, technical or fundamental techniques. Relative value is often

used as a synonym for market neutral, as strategies in this category

typically have very little or no directional market exposure to the market as

a whole. Other relative value sub-strategies include:

• Fixed income arbitrage: exploit pricing inefficiencies between related fixed

income securities :

• Fixed Income Arbitrage (FIA) is the name given to a family of trading

strategies that, to various extents, use spread trades on debt

instruments to take advantage of pricing inefficiencies independent of

overall market direction. A spread trade is the simultaneous purchase

and shorting of related securities (and their derivatives) in the hope of

profiting from the widening or narrowing of the spread (i.e. the prices)

between the two securities. FIA typically deal with large quantities of

highly liquid debt instruments, such as government and corporate

bonds, asset-backed securities, and debt-related derivatives like

swaps, futures, and options. Positions are usually leveraged from 5 to

15 times the asset base’s value, although there is no hard and fast

rule concerning this.

52  

• Because FIA spreads contain long and short legs, they tend to cancel

out systematic market risks, such as changes to the yield curve.

Managers are free to hedge away specific risk exposures, including

risks due to changes in interest rates, creditworthiness, foreign

exchange risks, and default, though the extent of hedging employed

varies greatly among hedge fund managers. Managers are also free to

take directional positions instead of relying solely on pure neutral

hedges.

• Spreads available to FIA traders are typically small, which is why

leverage is widely employed. Leverage is gained through the use of

borrowing, repurchase agreements (repos), and derivatives. It is not

unusual to put on an FIA trade for a $100 million notional amount

requiring less than $1 million of posted collateral. Usually, the more

basic types of FIA trades use higher levels of leverage than do more

complicated trades (such as mortgage-backed security trades) that

expose positions to particular risks.

• FIA returns are made up of spread profits, due to systematic risk

premia and/or price inefficiencies, and carry, which is the excess of

positive cash flow over negative cash flow. A simple example of carry

would be a long position that earned 5.25% interest paired to a short

position paying out 5.05%; a 20 basis point carry profit can be

achieved by this spread.

• Returns from FIA trades can result from sudden market dislocations,

demand or supply shocks, changes in investor preferences,

restrictions on particular instruments or markets, credit rating

changes, execution of options embedded within debt securities, and

any event that changes a bond’s anticipated cash flow. Price

inefficiencies can arise from a number of factors:

1) Agency bias: the tendency of fiduciaries to purchase

securities based on past results

53  

2) Structural impediments: the trading of securities for non-

economic reasons relating to tax, regulatory, and accounting

issues

3) Market segmentation: the preference for a particular range

of maturities can become pronounced enough to cause price

dislocations between different securities

Systematic risk premia can result from several causes. For instance, a

hedged spread may feature long and short positions that differ in

liquidity or credit quality. In this case, a premium is earned by holding

lower quality or less liquid positions and shorting higher quality/more

liquid positions. Other systematic risks can arise from, among others,

cross-currency trades, and spreads between Treasury and agency debt.

In general, FIA traders earn their premia by taking positions that profit

when “the sky doesn’t fall”. This is similar to selling a disaster put – the

buyer would profit only in the case of catastrophe, in which case the buyer

can put securities to the seller at a pre-catastrophe price. This is a form of

insurance; you might recall credit default swaps, which served a similar

purpose. Normally, it works, and the put seller pockets the put’s premium

when it expires without intervening economic disaster.

FIA trades behave much like the short put strategy. When turmoil occurs,

there is a flight to quality that causes bond spreads to widen and liquidity to

dry up, all of which cause FIA traders to realize losses. As a crisis unfolds,

market participants all exit at the same time, and leveraged positions

collapse. Bankruptcy and financial ruin can easily follow. The collapse of

Long Term Capital Management in 1999 is a famous object lesson in this

regard.

Equity market neutral: exploits differences in stock prices by

being long and short in stocks within the same sector, industry, market

54  

capitalization, country, which also creates a hedge against broader market

factors.

Convertible arbitrage: It exploits pricing inefficiencies between convertible

securities and the corresponding stocks. This strategy primarily involves

taking long positions in convertible bonds or warrants, hedged with a short

position, typically in the underlying stock. Convertible bonds and warrants

(as derivatives) are priced as a function of the price of the underlying stock,

expected future volatility of returns, risk-free interest rates and the issuer-

specific corporate Treasury yield spread. However, in many cases,

convertible bonds and warrants are not accurately priced due to illiquidity

in the convertible debt and warrant markets as compared to the markets in

the underlying common stocks, uncertainty concerning the call or

redemption features of convertible securities and lesser market focus on

these derivatives as opposed to the equities into which they are convertible

or exercisable. These mispricings may give rise to significant profit

opportunities, as positions are acquired in anticipation of the market price

eventually reflecting true value.

Delta hedging is the process of setting or keeping the delta of

a portfolio of financial instruments zero, or as close to zero as possible -

where delta is the sensitivity of the value of a derivative to changes in the

price of its underlying instrument; see Hedge (finance). Mathematically,

delta is the partial derivative of the portfolio's fair value with respect to the

price of the underlying security; Being delta neutral (or, instantaneously

delta-hedged) means that the instantaneous change in value of the portfolio

for an infinitesimal change in the value of the underlying is zero.

As with most successful arbitrage strategies, convertible arbitrage has

attracted a large number of market participants, creating intense

competition and reducing the effectiveness of the strategy. For example,

many convertible arbitrageurs suffered losses in early 2005 when the credit

of General Motors was downgraded at the same time Kirk Kerkorian was

making an offer for GM's stock. Since most arbitrageurs were long GM debt

55  

and short the equity, they were hurt on both sides. Going back a lot further,

many such "arbs" sustained big losses in the so-called "crash of '87". In

theory, when a stock declines, the associated convertible bond will decline

less, because it is protected by its value as a fixed-income instrument: it

pays interest periodically. In the 1987 stock market crash, however, many

convertible bonds declined more than the stocks into which they were

convertible, apparently for liquidity reasons (the market for the stocks being

much more liquid than the relatively small market for the bonds).

Arbitrageurs who relied on the traditional relationship between stock and

bond gained less from their short stock positions than they lost on their long

bond positions.

• Asset-backed securities (Fixed-Income asset-backed): fixed income

arbitrage strategy using asset-backed securities.

• Credit long / short: the same as long / short equity but in credit

markets instead of equity markets.

• Statistical arbitrage: identifying pricing inefficiencies between securities

through mathematical modeling techniques

• Volatility arbitrage: exploit the change in implied volatility instead of the

change in price.

• Yield alternatives: non-fixed income arbitrage strategies based on the

yield instead of the price.

• Regulatory arbitrage: the practice of taking advantage of regulatory

differences between two or more markets.

• Risk arbitrage: exploiting market discrepancies between acquisition price

and stock price

56  

Risk Return relationship with Hedge Fund :

One of the most interesting issues related to Hedge fund is the risk return

relationship of the fund. So a discussion from the practical point of view is

of importance so that proper benchmarking is possible with the fund

performance .

Hedge fund investment strategies tend to be quite different from the

strategies followed by traditional money managers. In principle every fund

follows its own proprietary strategy, which means that hedge funds are an

extremely heterogeneous group. It is common practice, however, to classify

hedge funds depending on the main type of strategy that funds claim to

follow and the different strategies have already been discussed in the

previous parts of this study material.

Given the above classification, the question arises whether funds classified

as following the same type of strategy indeed generate similar returns. We

can easily investigate this by calculating the correlation between the returns

of funds within each strategy group. Actual data shows the average

correlations between individual hedge funds belonging to the same strategy

group are quite low. This makes it clear that although funds may be

classified in the same strategy group, this does in no way mean that they

will produce similar returns. The correlation coefficients between funds

belonging to different strategy groups are low as well. The fact that the

average correlation between funds of the same type and between different

types of funds is of a similar order of magnitude is an interesting finding. It

suggests that it may not make too much difference whether an investor

diversifies within a given strategy group or between strategy groups.

The true risk of hedge funds tend to be seriously underestimated

Marking-to-market problems tend to create lags in the evolution of hedge

funds’ netasset values, which statistically shows up as autocorrelation in

57  

hedge funds’ returns. This autocorrelation causes estimates of the standard

deviation of hedge fund returns to exhibit a systematic downward bias.

The results show that the problem is especially acute for convertible

arbitrage and distressed securities funds, which makes sense as these

funds’ assets will typically be the most difficult to value.

A second reason why many investors think hedge funds are less risky than

they really are results from the use of the standard deviation as the sole

measure of risk. Generally speaking, risk is one word, but not one number.

The returns on portfolios of stocks and bonds risk are more or less normally

distributed. Because normal distributions are fully described by their mean

and standard deviation, the risk of such portfolios can indeed be measured

with one number. Confronted with non-normal distributions, however, it is

no longer appropriate to use the standard deviation as the sole measure of

risk. In that case investors should also look at the degree of symmetry

of the distribution, as measured by its so-called ‘skewness’, and the

probability of extreme positive or negative outcomes, as measured by the

distribution’s ‘kurtosis’. A symmetrical distribution will have a skewness

equal to zero, while a distribution that implies a relatively high

probability of a large loss (gain) is said to exhibit negative (positive)

skewness. A normal distribution has a kurtosis of 3, while a kurtosis

higher than 3 indicates a relatively high probability of a large loss or

gain. Since most investors are in it for the longer run, they strongly rely on

compounding effects. This means that negative skewness and high kurtosis

are extremely undesirable features as one big loss may destroy years of

careful compounding shows the average skewness and kurtosis found in the

returns of individual hedge funds from various strategy groups. From the

actual data , it is clear that hedge fund returns tend to be far from normally

distributed and exhibit significant negative skewness as well as substantial

kurtosis. Put another way, hedge fund returns may exhibit relatively low

standard deviations but they also tend to provide skewness and kurtosis

attributes that are exactly opposite to what investors desire. It is this whole

package that constitutes hedge fund risk, not just the standard deviation.

58  

Sharp Ratio and Alpha of hedge fund is highly misleading :

To evaluate hedge fund performance many investors use the so-called

Sharpe ratio, which is calculated as the ratio of the average excess return

and the return standard deviation of the fund being evaluated. When

applied to raw hedge fund return data, the relatively high means and low

standard deviations offered by hedge funds lead to Sharpe ratios that are

considerably higher than those of the relevant benchmark indices.

Whilst this type of analysis is widely used, it is again not without problems.

First, survivorship bias and autocorrelation will cause investors to

overestimate the mean and underestimate the standard deviation. Second,

the Sharpe ratio does not take account of the negative skewness and excess

kurtosis observed in hedge fund returns. This means that the Sharpe ratio

will tend to systematically overstate true hedge fund performance.

In this context it is important to note that there tends to be a clear

relationship between a fund’s Sharpe ratio and the skewness and kurtosis of

that fund’s return distribution.

High Sharpe ratios tend to go together with negative skewness and high

kurtosis. This means that the relatively high mean and low standard

deviation offered by hedge funds is not coming free. Investors simply pay for

a more attractive Sharpe ratio in the form of more negative skewness and

higher kurtosis.

Another performance measure often used is ‘alpha’. The idea behind alpha is

to first construct a portfolio that replicates the sensitivities of a fund to the

relevant return generating factors and then compare the fund return with

the return on that portfolio.

If the fund produces a higher average return, this can be interpreted as

superior performance since both share the same return generating factors.

The main problem with this approach lies in the choice of return generating

factors. We have little idea what factors really generate hedge fund returns.

As a result, investors that calculate hedge funds’ alphas are likely to leave

59  

out one or more relevant risk factors. This will produce excess return where

in reality there is none.

Good examples of often forgotten but extremely important risks are credit

and liquidity risk. So far, no study of hedge fund performance has explicitly

figured in credit or liquidity risk as a source of return, despite the fact that

some hedge funds virtually live off it.

Providing liquidity to a market, can be expected to be compensated by a

higher average return. However, when this is not taken into account, we will

find alpha where there is in fact none.

The above makes it very clear that when it comes to hedge funds, traditional

performance evaluation methods like the Sharpe ratio and alpha can be

extremely misleading. A high Sharpe ratio or alpha should therefore not be

interpreted as an indication of superior manager skill, but first and foremost

as an indication that further research is required. One can only speak of

superior performance if such research shows that the manager in question

generates the observed excess return without taking any unusual and/or

catastrophic risks. Unfortunately, simply studying a manager’s past returns

will not be enough. Apart from the fact that most hedge fund managers do

not have much of a track record to study, extreme events only occur

infrequently so that it is hard if not impossible to identify the presence of

catastrophic risk from a relatively small sample of returns. Consider the

following example. A substantial portion of the outstanding supply of

catastrophe-linked bonds are held by hedge funds. These bonds pay an

exceptionally high coupon in return for the bondholder putting (part of) his

principal at risk. Since the world has not seen a major catastrophe for some

time now, these bonds have performed very well and the available return

series show little skewness. However, this does not give an accurate

indication of the actual degree of skewness as when a catastrophe does

eventually occur, these bonds will produce very large losses.

Investment Ideas of Investment Guru’s :

60  

Benjamin Graham : Graham was an investor and investing mentor who is

generally considered to be the father of security analysis and value

investing. His ideas and methods on investing are well documented in his

books Security Analysis (1934) and The Intelligent Investor (1949), which

are two of the most famous investing books. These texts are often considered

to be requisite reading material for any investor, but they aren’t easy reads.

Here, we’ll condense Graham’s main investing principles and give you a

head start on understanding his winning philosophy.

Principle No. 1: Always Invest With a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount

to its intrinsic value, which is thought to not only provide high-return

opportunities but also to minimize the downside risk of an investment. In

simple terms, Graham’s goal was to buy assets worth Rs 100 for Rs 50/-

To Graham, these business assets may have been valuable because of their

stable earning power or simply because of their liquid cash value. It wasn’t

uncommon, for example, for Graham to invest in stocks in which the liquid

assets on the balance sheet (net of all debt) were worth more than the total

market cap of the company (also known as “net nets” to Graham followers).

This means that Graham was effectively buying businesses for nothing. This

concept is very important for investors to note, as value investing can

provide substantial profits once the market inevitably re-evaluates the stock

and raises its price to fair value. It also provides protection on the downside

if things don’t work out as planned and the business falters. The safety net

of buying an underlying business for much less than it is worth was the

central theme of Graham’s success. When stocks are chosen carefully,

Graham found that a further decline in these undervalued equities occurred

infrequently.

While many of Graham’s students succeeded using their own strategies,

they all shared the main idea of the “margin of safety.”

Principle No. 2: Expect Volatility and Profit From It:

61  

Investing in stocks means dealing with volatility. Instead of running for the

exits during times of market stress, the smart investor greets downturns as

chances to find great investments. Graham illustrated this with the analogy

of “Mr. Market,” the imaginary business partner of each and every investor.

Mr. Market offers investors a daily price quote at which he would either buy

an investor out or sell his share of the business. Sometimes, he will be

excited about the prospects for the business and quote a high price. Other

times, he will be depressed about the business’s prospects and will quote a

low price.

Because the stock market has these same emotions, the lesson here is that

you shouldn’t let Mr. Market’s views dictate your own emotions or, worse,

lead you in your investment decisions. Instead, you should form your own

estimates of the business’s value based on a sound and rational

examination of the facts. Furthermore, you should only buy when the price

offered makes sense and sell when the price becomes too high. Put another

way, the marketwill fluctuate–sometimes wildly–but rather than fearing

volatility, use it to your advantage to get bargains in the market or to sell

out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative

effects of market volatility:

–Dollar-cost averaging: Achieved by buying equal dollar amounts of

investments at regular intervals. It takes advantage of dips in the price and

means that an investor doesn’t have to be concerned about buying his or

her entire position at the top of the market. Dollar-cost averaging is ideal for

passive investors and alleviates them of the responsibility of choosing when

and at what price to buy their positions.

–Investing in stocks and bonds: Graham recommended distributing one’s

portfolio evenly between stocks and bonds as a way to preserve capital in

market downturns while still achieving growth of capital through bond

income. Remember, Graham’s philosophy was, first and foremost, to

62  

preserve capital, and then to try to make it grow. He suggested having 25%

to 75% of your investments in bonds, and varying this based on market

conditions. This strategy had the added advantage of keeping investors from

boredom, which leads to the temptation to participate in unprofitable

trading (i.e., speculating).

Principle No. 3: Know What Kind of Investor You Are

Graham said investors should know their investment selves. To illustrate

this, he made clear distinctions among various groups operating in the stock

market.

Active vs. passive: Graham referred to active and passive investors as

“enterprising investors” and “defensive investors.”

You only have two real choices: The first is to make a serious commitment in

time and energy to become a good investor who equates the quality and

amount of hands-on research with the expected return. If this isn’t your cup

of tea, then be content to get a passive, and possibly lower, return but with

much less time and work. Graham turned the academic notion of “risk =

return” on its head. For him, “work = return.” The more work you put into

your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on

your investments, then investing in an index is a good alternative. Graham

said that the defensive investor could get an average return by simply

buying the 30 stocks of the Dow Jones industrial average in equal amounts.

Both Graham and Buffett said getting even an average return–for example,

equalling the return of the S&P 500–is more of an accomplishment than it

might seem.

The fallacy that many people buy into, according to Graham, is that if it’s so

easy to get an average return with little or no work (through indexing), then

just a little more work should yield a slightly higher return. The reality is

that most people who try this end up doing much worse than average.

63  

In modern terms, the defensive investor would be an investor in index funds

of both stocks and bonds. In essence, they own the entire market, benefiting

from the areas that perform the best without trying to predict those areas

ahead of time. In doing so, an investor is virtually guaranteed the market’s

return and avoids doing worse than average by just letting the stock

market’s overall results dictate long-term returns. According to Graham,

beating the market is much easier said than done, and many investors still

find they don’t beat the market.

Speculator vs. investor: Not all people in the stock market are investors.

Graham believed that it was critical for people to determine whether they

were investors or speculators. The difference is simple: An investor looks at

a stock as part of a business and the stockholder as the owner of the

business, while the speculator views himself as playing with expensive

pieces of paper with no intrinsic value. For the speculator, value is only

determined by what someone will pay for the asset. To paraphrase Graham,

there is intelligent speculating as well as intelligent investing–just be sure

you understand which you are good at.

Buffett's Philosophy

Warren Buffett descends from the Benjamin Graham school of value

investing. Value investors look for securities with prices that are

unjustifiably low based on their intrinsic worth. When discussing stocks,

determining intrinsic value can be a bit tricky as there is no universally

accepted way to obtain this figure. Most often intrinsic worth is estimated by

analyzing a company's fundamentals. Like bargain hunters, value investors

seek products that are beneficial and of high quality but underpriced. In

other words, the value investor searches for stocks that he or she believes

are undervalued by the market. Like the bargain hunter, the value investor

tries to find those items that are valuable but not recognized as such by the

majority of other buyers.

64  

Warren Buffett takes this value investing approach to another level. Many

value investors aren't supporters of the efficient market hypothesis, but they

do trust that the market will eventually start to favor those quality stocks

that were, for a time, undervalued. Buffett, however, doesn't think in these

terms. He isn't concerned with the supply and demand intricacies of the

stock market. In fact, he's not really concerned with the activities of the

stock market at all. This is the implication this paraphrase of his famous

quote : "In the short term the market is a popularity contest; in the long

term it is a weighing machine

He chooses stocks solely on the basis of their overall potential as a company

- he looks at each as a whole. Holding these stocks as a long-term play,

Buffett seeks not capital gain but ownership in quality companies extremely

capable of generating earnings. When Buffett invests in a company, he isn't

concerned with whether the market will eventually recognize its worth; he is

concerned with how well that company can make money as a business.

Buffett's Methodology

Here we look at how Buffett finds low-priced value by asking himself some

questions when he evaluates the relationship between a stock's level of

excellence and its price. Keep in mind that these are not the only things he

analyzes but rather a brief summary of what Buffett looks for:

1. Has the company consistently performed well?

Sometimes return on equity (ROE) is referred to as "stockholder's return on

investment". It reveals the rate at which shareholders are earning income on

their shares. Buffett always looks at ROE to see whether or not a company

65  

has consistently performed well in comparison to other companies in the

same industry. ROE is calculated as follows:

= Net Income / Shareholder\'s Equity

Looking at the ROE in just the last year isn't enough. The investor should

view the ROE from the past five to 10 years to get a good idea of historical

performance.

2. Has the company avoided excess debt?

The debt/equity ratio is another key characteristic Buffett considers

carefully. Buffett prefers to see a small amount of debt so that earnings

growth is being generated from shareholders' equity as opposed to borrowed

money. The debt/equity ratio is calculated as follows:

= Total Liabilities / Shareholders\' Equity

This ratio shows the proportion of equity and debt the company is using to

finance its assets, and the higher the ratio, the more debt - rather than

equity - is financing the company. A high level of debt compared to equity

can result in volatile earnings and large interest expenses. For a more

stringent test, investors sometimes use only long-term debt instead of

total liabilities in the calculation above.

3. Are profit margins high? Are they increasing?

The profitability of a company depends not only on having a good profit

margin but also on consistently increasing this profit margin. This margin is

calculated by dividing net income by net sales. To get a good indication of

66  

historical profit margins, investors should look back at least five years. A

high profit margin indicates the company is executing its business well, but

increasing margins means management has been extremely efficient and

successful at controlling expenses.

4. How long has the company been public?

Buffett typically considers only companies that have been around for at least

10 years. As a result, most of the technology companies that have had

their initial public offerings (IPOs) in the past decade wouldn't get on

Buffett's radar (not to mention the fact that Buffett will invest only in a

business that he fully understands, and he admittedly does not understand

what a lot of today's technology companies actually do). It makes sense that

one of Buffet's criteria is longevity: value investing means looking at

companies that have stood the test of time but are currently undervalued.

Never underestimate the value of historical performance, which

demonstrates the company's ability (or inability) to increase shareholder

value. Do keep in mind, however, that the past performance of a stock does

not guarantee future performance - the job of the value investor is to

determine how well the company can perform as well as it did in the past.

Determining this is inherently tricky, but evidently Buffett is very good at it.

5. Do the company's products rely on a commodity?

Initially you might think of this question as a radical approach to narrowing

down a company. Buffett, however, sees this question as an important one.

He tends to shy away (but not always) from companies whose products are

indistinguishable from those of competitors, and those that rely solely on

a commodity such as oil and gas. If the company does not offer anything

different than another firm within the same industry, Buffett sees little that

sets the company apart. Any characteristic that is hard to replicate is what

67  

Buffett calls a company's economic moat, or competitive advantage. The

wider the moat, the tougher it is for a competitor to gain market share.

6. Is the stock selling at a 25% discount to its real value?

This is the kicker. Finding companies that meet the other five criteria is one

thing, but determining whether they are undervalued is the most difficult

part of value investing, and Buffett's most important skill. To check this, an

investor must determine the intrinsic value of a company by analyzing a

number of business fundamentals, including earnings, revenues and assets.

And a company's intrinsic value is usually higher (and more complicated)

than its liquidation value - what a company would be worth if it were broken

up and sold today. The liquidation value doesn't include intangibles such as

the value of a brand name, which is not directly stated on the financial

statements.

Once Buffett determines the intrinsic value of the company as a whole, he

compares it to its current market capitalization - the current total worth

(price). If his measurement of intrinsic value is at least 25% higher than the

company's market capitalization, Buffett sees the company as one that has

value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on

his unmatched skill in accurately determining this intrinsic value. While we

can outline some of his criteria, we have no way of knowing exactly how he

gained such precise mastery of calculating value.

George Soros' Philosophy:

George Soros is a short-term speculator. He makes massive, highly-

leveraged bets on the direction of the financial markets. His famous hedge

fund is known for its global macro strategy, a philosophy centered around

making massive, one-way bets on the movements of currency rates,

68  

commodity prices, stocks, bonds, derivatives and other assets based on

macroeconomic analysis.

Simply put, Soros bets that the value of these investments will either rise or

fall. This is "seat of the pants" trading, based on research and executed on

instinct. Soros studies his targets, letting the movements of the various

financial markets and their participants dictate his trades. He refers to the

philosophy behind his trading strategy as reflexivity. The theory eschews

traditional ideas of an equilibrium-based market environment where all

information is known to all market participants and thereby factored into

prices. Instead, Soros believes that market participants themselves directly

influence market fundamentals, and that their irrational behavior leads to

booms and busts that present investment opportunities.

Housing prices provide an interesting example of his theory in action. When

lenders make it easy to get loans, more people borrow money. With money in

hand, these people buy homes, which results in a rise in demand for homes.

Rising demand results in rising prices. Higher prices encourage lenders to

lend more money. More money in the hands of borrowers results in rising

demand for homes, and an upward spiralling cycle that results in housing

prices that have been bid up way past where economic fundamentals would

suggest is reasonable. The actions of the lenders and buyers have had a

direct influence on the price of the commodity.

An investment based on the idea that the housing market will crash would

reflect a classic Soros bet. Short-selling the shares of luxury home builders

or shorting the shares of major housing lenders would be two potential

investments seeking to profit when the housing boom goes bust.

Major Trades

69  

George Soros will always be remembered as "the man who broke the Bank of

England." A well-known currency speculator, Soros does not limit his efforts

to a particular geographic area, instead considering the entire world when

seeking opportunities. In September of 1992, he borrowed billions of dollars

worth of British pounds and converted them to German marks.

When the pound crashed, Soros repaid his lenders based on the new, lower

value of the pound, pocketing in excess of $1 billion in the difference

between the value of the pound and the value of the mark during a single

day's trading. He made nearly $2 billion in total after unwinding his

position.

He made a similar move with Asian currencies during the 1997 Asian

Financial Crisis, participating in a speculative frenzy that resulted in the

collapse of the baht (Thailand's currency). These trades were so effective

because the national currencies the speculators bet against were pegged to

other currencies, meaning that agreements were in place to "prop up" the

currencies in order to make sure that they traded in a specific ratio against

the currency to which they were pegged.

When the speculators placed their bets, the currency issuers were forced to

attempt to maintain the ratios by buying their currencies on the open

market. When the governments ran out of money and were forced to

abandon that effort, the currency values plummeted.

Governments lived in fear that Soros would take an interest in their

currencies. When he did, other speculators joined the fray in what's been

described as a pack of wolves descending on a herd of elk. The massive

amounts of money the speculators could borrow and leverage made it

impossible for the governments to withstand the assault.

70  

Despite his masterful successes, not every bet George Soros made worked in

his favor. In 1987, he predicted that the U.S. markets would continue to

rise. His fund lost $300 million during the crash, although it still delivered

low double-digit returns for the year.

He also took a $2 billion hit during the Russian debt crisis in 1998 and lost

$700 million in 1999 during the tech bubble when he bet on a decline.

Stung by the loss, he bought big in anticipation of a rise. He lost nearly $3

billion when the market finally crashed.

His public stance and spectacular success put Soros largely in a class by

himself. Over the course of more than three decades, he made the right

moves nearly every time, generating legions of fans among traders and

investors, and legions of detractors among those on the losing end of his

speculative activities.

71  

Part A

MCQ

1. If an economy is moving from developing economy to developed

economy, the scope of Alternate Investment Management would :

a. Go up due to higher risk in the economy associated with the

developed economy

b. Go up due to higher risk taking capability of more High Net-

worth Individual created out of higher economic growth

c. Go down due to higher regulations by regulators

d. Both a and c

2. Alternative Investment Management is ................... than normal

investment and accordingly common people’s money should

..................................... this investment class:

a. Safer ; flow into

b. Riskier ; not go to

c. Safer ; not go to

d. Riskier; flow into

3. In India hedge fund belongs to .................................. Alternate

Investment Management class :

a. Category I

b. Category II

c. Category III

d. None of the above

4. Alternate Investment Fund would invest preferably in to :

a. Listed Debt

b. Listed Equity

c. Unlisted Equity

d. Unlisted Debt

5. Hedge fund works on ........................ ............................... strategy

a. High Risk ; High Return

b. Low Risk ; Low Return

72  

c. High Risk ; Low Return

d. Low Risk; High Return

6. If the age of an Investor is 30 and the investment surplus is Rs 10000

/- , then the investment in equity as per Benjamin Graham would be :

a. Rs 7000/-

b. Rs 4000/-

c. Rs 3000/-

d. None of the above

7. Which of the following stock would be taken in the portfolio as per

Warren Buffet Strategy :

a) Tata Steel

b) Tata Motors

c) Flipcart

d) Both a and b

8. Mark to Market valuation would be .................. frequent for

investment of Alternate Fund in India :

a. Category III

b. Category II

c. Category I

d. Both a and c

9. Which of the following should not be an investor in an Alternate

Investment Fund ?

a. Investment Bank

b. Commercial Banks

c. Insurance companies

d. Both b and c

10. Which of the following should not be a performance measure of

Alternate Investment Fund ?

a. CAPM

b. APT

c. Both a and b

d. None of the above

73  

 

Short Questions

1. As a Chief Financial Officer of a SME company, at what stage would

you approach an Alternate Investment Management firm . Please give

reason for your answers .

Alternate investment management is a source of fund which can take

high risk and high return. So when an SME is in the growth phase

and it requires more fund , it may approach a bank for the funding .

The bank may insist that the SME should bring in more equity. Since

there is a limit up to which promoter can bring in the equity , the

company can approach the Alternate Investment Fund for equity

infusion. The risk of the investment is higher but at the same time

the return is also higher. Since investor of this fund belongs to High

Net Worth Individual , the higher riskiness matches with the risk

profile of the investor. Now once the SME grows to higher end or mid

corporate , the riskiness of the borrower would come down and then

the firm can be listed in the market and accordingly retail investor

would be able to participate. So as a CFO , you would approach the

AIM when the SME is into the growth phase and you think that listing

in the main exchange is about three to four years away .

2. State three differences between Category I and Category III fund as

prescribed in the SEBI AIM guidelines ;

Investment Objectives : The investment objective Category I is to

provide equity to the growth oriented sector like SME , Infrastructure ,

Social Sector. Where as the investment objectives of Category III fund

is to make profit from speculative activities

Use of Leverage : There should not be use of leverage by Category I

fund as it increases the risk of the fund . There should be use of

leverage by Category III find as its main aim is to generate higher

return from higher risk category

74  

Valuation Norms : The Valuation norms for Category I fund is relaxed.

More Category I fund, the valuation norms is half yearly where as the

valuation norms for Category III fund is quarterly. This is due to the

fact that investment in Category III fund is mainly in traded securities

where Mark To Market valuation is possible.

3. Why traditional risk return matrix would not evaluate Hedge Fund

Performance ?

From the actual data , it is clear that hedge fund returns tend to be far from

normally distributed and also it exhibits significant negative skewness as

well as substantial kurtosis. Hedge fund returns may exhibit relatively low

standard deviations but they also tend to provide skewness and kurtosis

attributes that are exactly opposite to what investors desire. Accordingly

traditional measures like Sharpe ratio does not take account of the negative

skewness and excess kurtosis observed in hedge fund returns. This means

that the Sharpe ratio will tend to systematically overstate true hedge fund

performance.

4. What are the advantages and disadvantages of Geroge Soros

Investment philosophy ?

George Soros investment strategy has speculative component. Under this

strategy, the investor would speculate about the price of the targeted

security. While speculating the investor would take the help of supports

available and the investor would take a call on the directional movement in

the price of the security. If the prediction turns out to be correct, the

investor would make large profit. In case it does not make the correct

prediction , it would incur the loss. In case of this investment strategy, the

investor can incur loss some times and some times he can make profit. So

this strategy of investment is riskier and the investor should have higher Net

Worth to pursue this strategy .

5. If REIT is coming under Alternate Investment Fund ? What are the

differences between REIT and Real Estate Investment Fund ?

75  

REIT is not coming under Alternate Investment Fund . REIT is governed by a

separate regulations . SEBI has made the investment in REIT is much easier

with the minimum investment amount is made Rs 2 lacs. Besides the REIT

has got lot of restriction from the investment side where as the Real Estate

Investment Fund under AIM has lot of flexibility for investment . So Real

Estate Investment Trust is less riskier investment compared to Real Estate

Investment fund under AIM. Riskier real estate project would be funded by

the Real Estate Investment Fund under AIM whereas the less riskier real

estate project would be funded by REIT.

76  

Case Study on Hedge Fund Failure : Long Term Capital Management (

LTCM ) Case :

 

Taken from Sungard, Bancware Erisk. Link to Sungard. Spring 2006.

Summary

In 1994, John Meriwether, the famed Salomon Brothers bond trader,

founded a hedge fund called Long-Term Capital Management. Meriwether

assembled an all-star team of traders and academics in an attempt to create

a fund that would profit from the combination of the academics' quantitative

models and the traders' market judgement and execution capabilities.

Sophisticated investors, including many large investment banks, flocked to

the fund, investing $1.3 billion at inception. But four years later, at the end

of September 1998, the fund had lost substantial amounts of the investors'

equity capital and was teetering on the brink of default. To avoid the threat

of a systemic crisis in the world financial system, the Federal Reserve

orchestrated a $3.5 billion rescue package from leading U.S. investment and

commercial banks. In exchange the participants received 90% of LTCM's

equity.

The lessons to be learned from this crisis are:

• Market values matter for leveraged portfolios;

• Liquidity itself is a risk factor;

• Models must be stress-tested and combined with judgement; and

• Financial institutions should aggregate exposures to common risk

factors.

77  

Overview

LTCM seemed destined for success. After all, it had John Meriwether, the

famed bond trader from Salomon Brothers, at its helm. Also on board were

Nobel-prize winning economists Myron Scholes and Robert Merton, as well

as David Mullins, a former vice-chairman of the Federal Reserve Board who

had quit his job to become a partner at LTCM. These credentials convinced

80 founding investors to pony up the minimum investment of $10 million

apiece, including Bear Sterns President James Cayne and his deputy.

Merrill Lynch purchased a significant share to sell to its wealthy clients,

including a number of its executives and its own CEO, David Komansky. A

similar strategy was employed by the Union Bank of Switzerland (The

Washington Post, 9/27/98).

LTCM's main strategy was to make convergence trades. These trades

involved finding securities that were mispriced relative to one another,

taking long positions in the cheap ones and short positions in the rich ones.

There were four main types of trade:

• Convergence among U.S., Japan, and European sovereign bonds;

• Convergence among European sovereign bonds;

• Convergence between on-the-run and off-the-run U.S. government

bonds;

• Long positions in emerging markets sovereigns, hedged back to

dollars.

Because these differences in values were tiny, the fund needed to take large

and highly-leveraged positions in order to make a significant profit. At the

beginning of 1998, the fund had equity of $5 billion and had borrowed over

$125 billion — a leverage factor of roughly thirty to one. LTCM's partners

believed, on the basis of their complex computer models, that the long and

short positions were highly correlated and so the net risk was small.

78  

Events

1994: Long-Term Capital Management is founded by John Meriwether and

accepts investments from 80 investors who put up a minimum of $10

million each. The initial equity capitalisation of the firm is $1.3 billion. (The

Washington Post, 27 September 1998)

End of 1997: After two years of returns running close to 40%, the fund has

some $7 billion under management and is achieving only a 27% return —

comparable with the return on US equities that year.

Meriwether returns about $2.7 billion of the fund's capital back to investors

because "investment opportunities were not large and attractive enough"

(The Washington Post, 27 September 1998).

Early 1998: The portfolio under LTCM's control amounts to well over $100

billion, while net asset value stands at some $4 billion; its swaps position is

valued at some $1.25 trillion notional, equal to 5% of the entire global

market. It had become a major supplier of index volatility to investment

banks, was active in mortgage-backed securities and was dabbling in

emerging markets such as Russia (Risk, October 1998)

17 August 1998: Russia devalues the rouble and declares a moratorium on

281 billion roubles ($13.5 billion) of its Treasury debt. The result is a

massive "flight to quality", with investors flooding out of any remotely risky

market and into the most secure instruments within the already "risk-free"

government bond market. Ultimately, this results in a liquidity crisis of

enormous proportions, dealing a severe blow to LTCM's portfolio.

1 September 1998: LTCM's equity has dropped to $2.3 billion. John

Meriwether circulates a letter which discloses the massive loss and offers

the chance to invest in the fund "on special terms". Existing investors are

79  

told that they will not be allowed to withdraw more than 12% of their

investment, and not until December.

22 September 1998: LTCM's equity has dropped to $600 million. The

portfolio has not shrunk significantly, and so its leverage is even higher.

Banks begin to doubt the fund's ability to meet its margin calls but cannot

move to liquidate for fear that it will precipitate a crisis that will cause huge

losses among the fund's counterparties and potentially lead to a systemic

crisis.

23 September 98: Goldman Sachs, AIG and Warren Buffett offer to buy out

LTCM's partners for $250 million, to inject $4 billion into the ailing fund and

run it as part of Goldman's proprietary trading operation. The offer is not

accepted. That afternoon, the Federal Reserve Bank of New York, acting to

prevent a potential systemic meltdown, organises a rescue package under

which a consortium of leading investment and commercial banks, including

LTCM's major creditors, inject $3.5-billion into the fund and take over its

management, in exchange for 90% of LTCM's equity.

Fourth quarter 1998: The damage from LTCM's near-demise was

widespread. Many banks take a substantial write-off as a result of losses on

their investments. UBS takes a third-quarter charge of $700 million,

Dresdner Bank AG a $145 million charge, and Credit Suisse $55 million.

Additionally, UBS chairman Mathis Cabiallavetta and three top executives

resign in the wake of the bank's losses (The Wall Street Journal Europe, 5

October 1998). Merrill Lynch's global head of risk and credit management

likewise leaves the firm.

80  

April 1999: President Clinton publishes a study of the LTCM crisis and its

implications for systemic risk in financial markets, entitled the President's

Working Group on Financial Markets (Governance and Risk Control-

Regulatory guidelines-president's working group)

Analysis:

The Proximate Cause: Russian Sovereign Default

The proximate cause for LTCM's debacle was Russia's default on its

government obligations (GKOs). LTCM believed it had somewhat hedged its

GKO position by selling rubles. In theory, if Russia defaulted on its bonds,

then the value of its currency would collapse and a profit could be made in

the foreign exchange market that would offset the loss on the bonds.

Unfortunately, the banks guaranteeing the ruble hedge shut down when the

Russian ruble collapsed, and the Russian government prevented further

trading in its currency. (The Financial Post, 9/26/98). While this caused

significant losses for LTCM, these losses were not even close to being large

enough to bring the hedge fund down. Rather, the ultimate cause of its

demise was the ensuing flight to liquidity described in the following section.

The Ultimate Cause: Flight to Liquidity

The ultimate cause of the LTCM debacle was the "flight to liquidity" across

the global fixed income markets. As Russia's troubles became deeper and

deeper, fixed-income portfolio managers began to shift their assets to more

liquid assets. In particular, many investors shifted their investments into

the U.S. Treasury market. In fact, so great was the panic that investors

81  

moved money not just into Treasury, but into the most liquid part of the

U.S. Treasury market -- the most recently issued, or "on-the-run"

Treasuries. While the U.S. Treasury market is relatively liquid in normal

market conditions, this global flight to liquidity hit the on-the-run

Treasuries like a freight train. The spread between the yields on on-the-run

Treasuries and off-the-run Treasuries widened dramatically: even though

the off-the-run bonds were theoretically cheap relative to the on-the-run

bonds, they got much cheaper still (on a relative basis).

What LTCM had failed to account for is that a substantial portion of its

balance sheet was exposed to a general change in the "price" of liquidity. If

liquidity became more valuable (as it did following the crisis) its short

positions would increase in price relative to its long positions. This was

essentially a massive, un-hedged exposure to a single risk factor.

As an aside, this situation was made worse by the fact that the size of the

new issuance of U.S. Treasury bonds has declined over the past several

years. This has effectively reduced the liquidity of the Treasury market,

making it more likely that a flight to liquidity could dislocate this market.

Systemic Risk: The Domino Effect

The preceding analysis explains why LTCM almost failed. However, it does

not explain why this near-failure should threaten the stability of the global

financial markets. The reason was that virtually all of the leveraged Treasury

bond investors had similar positions: Salomon Brothers, Merrill Lynch, the

III Fund (a fixed-income hedge fund that also failed as a result of the crisis)

and likely others.

There were two reasons for the lack of diversity of opinion in the market. The

first is that virtually all of the sophisticated models being run by the

leveraged players said the same thing: that off-the-run Treasuries were

significantly cheap compared with the on-the-run Treasuries. The second is

that many of the investment banks obtained order flow information through

82  

their dealings with LTCM. They therefore would have known many of the

actual positions and would have taken up similar positions alongside their

client.

Indeed, one industry participant suggested that the Russian crisis was the

crowning blow on a domino effect that had started months before. In early

1998, Sandy Weill, as co-head of Citigroup, decided to shut down the

famous Salomon Brothers Treasury bond arbitrage desk. Salomon, one of

the largest players in the on-the-run/off-the-run trade, had to begin

liquidating its positions. As it did so, these trades became cheaper and

cheaper, putting pressure on all of the other leveraged players.

Lessons to be learned:

Market values matter

LTCM was perhaps the biggest disaster of its kind, but it was not the first. It

had been preceded by a number of other cases of highly-leveraged

quantitative firms that went under in similar circumstances.

One of the earliest was Franklin Savings and Loan, a hedge fund dressed

down as a savings & loan. Franklin's management had figured out that

many of the riskier pieces of mortgage derivatives were undervalued because

a) the market could not understand the risk on the risky pieces; and b) the

market overvalued those pieces with well-behaved accounting results.

Franklin decided it was willing to suffer volatile accounting results in

exchange for good economics.

More recently, the Granite funds, which specialised in mortgage-backed

securities trading, suffered as the result of similar trading strategies. The

funds took advantage of the fact that "toxic waste" (risky tranches) from the

mortgage derivatives market were good economic value. However, when the

83  

Fed raised interest rates in February 1994, Wall Street firms rushed to

liquidate mortgage-backed securities, often at huge discounts.

Both of these firms claimed to have been hedged, but both went under when

they were "margin-called". In Franklin's case, the caller was the Office of

Thrift Supervision; in the Granite Fund's, the margin lenders. What is the

common theme among Franklin, the Granite Funds and LTCM? All three

depended on exploiting deviations in market value from fair value. And all

three depended on "patient capital" -- shareholders and lenders who

believed that what mattered was fair value and not market value. That is,

these fund managers convinced their stakeholders that because the fair

values were hedged, it didn't matter what happened to market values in the

short run — they would converge to fair value over time. That was the

reason for the "Long Term" part of LTCM's name.

The problem with this logic is that capital is only as patient as its least

patient provider. The fact is that lenders generally lose their patience

precisely when the funds need them to keep it — in times of market crisis.

As all three cases demonstrate, the lenders are the first to get nervous when

an external shock hits. At that point, they begin to ask the fund manager for

market valuations, not models-based fair valuations. This starts the fund

along the downward spiral: illiquid securities are marked-to-market; margin

calls are made; the illiquid securities must be sold; more margin calls are

made, and so on. In general, shareholders may provide patient capital; but

debt-holders do not.

The lesson learned from these case studies spoils some of the supposed "free

lunch" features of taking liquidity risk. These plays can indeed generate

excellent risk-adjusted returns, but only if held for a long time.

Unfortunately the only real source of capital that is patient enough to take

fluctuations in market values, especially through crises, is equity capital.

84  

In other words, you can take liquidity bets, but you cannot leverage them

much.

Liquidity risk is itself a factor :

As pointed out in the analysis section of this article, LTCM fell victim to a

flight to liquidity. This phenomenon is common enough in capital markets

crises that it should be built into risk models, either by introducing a new

risk factor — liquidity — or by including a flight to liquidity in the stress

testing (see the following section for more detail on this). This could be

accomplished crudely by classifying securities as either liquid or illiquid.

Liquid securities are assigned a positive exposure to the liquidity factor;

illiquid securities are assigned a negative exposure to the liquidity factor.

The size of the factor movement (measured in terms of the movement of the

spread between liquid and illiquid securities) can be estimated either

statistically or heuristically (perhaps using the LTCM crisis as a "worst case"

scenario).

Using this approach, LTCM might have classified most of its long positions

as illiquid and most of its short positions as liquid, thus having a notional

exposure to the liquidity factor equal to twice its total balance sheet. A more

refined model would account for a spectrum of possible liquidity across

securities; at a minimum, however, the general concept of exposure to a

liquidity risk factor should be incorporated in to any leveraged portfolio.

Models must be stress-tested and combined with judgement:

Another key lesson to be learnt from the LTCM debacle is that even (or

especially) the most sophisticated financial models are subject to model risk

and parameter risk, and should therefore be stress-tested and tempered

with judgement. While we are clearly privileged in exercising 20/20

hindsight, we can nonetheless think through the way in which judgement

and stress-testing could have been used to mitigate, if not avoid, this

disaster.

85  

According to the complex mathematical models used by LTCM, the positions

were low risk. Judgement tells us that the key assumption that the models

depended on was the high correlation between the long and short positions.

Certainly, recent history suggested that correlations between corporate

bonds of different credit quality would move together (a correlation of

between 90-95% over a 2-year horizon). During LTCM's crisis, however, this

correlation dropped to 80%. Stress-testing against this lower correlation

might have led LTCM to assume less leverage in taking this bet.

However, if LTCM had thought to stress test this correlation, given that it

was such an important assumption, it would not even have had to make up

a stress scenario. This correlation had dropped to 75% as recently as 1992

(Jorion, 1999). Simply including this stress scenario in the risk management

of the fund might have led LTCM to assume less leverage in taking this bet.

Financial institutions must aggregate exposures to common risk factors :

One of the other lessons to be learned by other financial institutions is that

it is important to aggregate risk exposures across businesses. Many of the

large dealer banks exposed to a Russian crisis across many different

businesses only became aware of the commonality of these exposures after

the LTCM crisis. For example, these banks owned Russian GKOs on their

arbitrage desks, made commercial loans to Russian corporates in their

lending businesses, and had indirect exposure to a Russian crisis through

their prime brokerage lending to LTCM. A systematic risk management

process should have discovered these common linkages ex ante and

reported or reduced the risk concentration.

86