Alternative Investments Management: 2013

Dow Jones-AIG Commodity Index

According to Raab (2007), the Dow JonesAIG Commodity Index (DJ-AIGCI) uses two-thirds of a dollar-weighted liquidity measure combined with one-third of a dollar-weighted world-production measure to determine which commodities to include in the index. Any commodity that falls below a 0.5% threshold is eliminated from consideration.

Also, the DJ-AIGCI limits weightings for each commodity sector to 33% and rebalances annually. The sector weighting limits are in contrast to the S&P GSCI, which was weighted 70% in energies, as of the spring of 2007.

Like the GSCI, the DJ-AIGCI consists of the same five commodity sectors: energy, industrial metals, agriculture, livestock, and precious metals. The DJ-AIGCI consists of 19 individual commodities while the GSCI includes 24 commodities.

The DJ-AIGCI was launched in 1998. Akey (2007) notes that the unique benefits of the DJ-AIGCI are its emphasis on liquidity for weighting and its diversification rules. As of the end of 2006, there was an estimated US$30 billion tracking the DJ-AIGCI.

Down Capture Ratio

The down capture ratio is a measure of a manager’s sensitivity to an index when the index has negative returns. It is calculated by dividing the manager’s annualized performance return for the intervals of time during the measurement period when the index was negative by the index’s negative returns over the same intervals.

For example, if the S&P 500 was down 100 basis points and a manager was down 35 basis points over the exact same period of time, the down capture ratio would equal 35%. A down capture ratio that is greater than 100% indicates a manager lost more than the index when the index had negative returns.

Likewise, a down capture ratio that is less than 100% indicates a manager lost less than the index when the index had negative returns. Lastly, a down capture ratio that is negative indicates a manager had positive returns when the index had negative returns.

Since the down capture ratio measures how much of the negative index returns a manager captured, the less it is the better. However, the down capture ratio (and all risk measures) should be evaluated in conjunction with other investment metrics to best assess the manager’s performance and risk profile.

Down Round

A down round is private equity or venture capital financing for a company where the valuation is lower than that in the prior round of fundraising. This is especially common in venture capital, a subset of the private equity industry that focuses on high risk, high growth opportunities.

Venture capital firms use staged capital where they provide a limited amount of capital to an entrepreneurial company, typically investing enough to help it advance to an important milestone thereby demonstrating that the overall investment risk has been reduced. If the entrepreneurial company performs as expected, as per the business plan, then the next stage (or round) of funding is typically done at a higher evaluation.

However, should the company perform below expectations or have a material adverse event—for example, if the key drug of a pharmaceutical firm performed poorly in an FDA trial—then the valuation of the company would fall, resulting in a down round.

While down rounds are usually the result of performance issues in the portfolio company, they can also be the result of a poor external fundraising environment. An example of this situation was when the Internet bubble collapsed in 2001; this created a major shortage of risk capital, thereby putting companies needing to raise money in a weak bargaining position.

Drag-Along Right

This contractual right, most commonly contained in the company’s shareholders’ agreement, enables the majority shareholder (usually holding more than 75% in nominal value) to “drag” the minority shareholders into a specific action, such as selling their shares to the same purchaser.

The majority shareholder must give the minority shareholders who are being dragged into the deal the same price, terms, and conditions as any other seller. The right is intended to be a protection of the majority shareholding venture capitalists.

Some purchasers may be exclusively seeking to gain complete ownership of a company, in which case the drag-along right helps the venture capitalist to realize the deal by eliminating the minority shareholders and sell 100% of the shares to the purchaser.

As a result, founding partners or entrepreneurs could lose their companies. At the same time, the right ensures that the minority shareholders get the offer under the same conditions.

The drag-along right, along with other stringent investor rights, has gained more importance after the era of poor deal structuring in 1999 to 2000 and is now a common prerequisite to concluding any new investment. Not many venture capitalists today will be willing to forgo the drag along right in their contracts.

Due Diligence

Due diligence is quantitative and qualitative investigation and verification into the business practice, operations, financial statements, and legal details of a prospective business client or associate.

This process is generally done prior to a business relationship being established; however, routine investigations of existing relationships can also be beneficial in uncovering pertinent information.

A due diligence investigation reduces risk associated with conducting business with other individuals or companies by ensuring their credibility and accurate portrayal.

These examinations may expose disparaging details that could ultimately hinder a business affiliation. Failure to conduct proper due diligence can lead to false representation of a party involved in a relationship, potential monetary loss, as well as litigation.

Due diligence is of great importance in the hedge fund space with the lack of transparency and regulation. A major characteristic of these private investment vehicles is that they have an aversion to divulging information on investment processes and market positions. Proper due diligence may mitigate some of these information asymmetries as well as protect an investment.

This process has numerous components and can include (but not limited to):

Credibility assessment of the particular company and executives
On-site visitation and verification of internal control systems
Independent research for any publicly printed information about the company and officers
Research and overview of third-party service providers
Check of past, pending, or current litigations
Overview of financial statements

Dutch Auction

In a Dutch auction, the auctioneer begins with a high asking price and gradually lowers the price until a buyer accepts the current price. Thus, in contrast with the English or ascending price auction, where multiple bids can be observed, for a Dutch auction the first bid is the only bid.

A common example of this kind of auction is the Dutch wholesale flower auctions and treasury auctions by the United States Department of Treasury for all T-bills, notes, and bonds.

Bidding behavior in a Dutch auction depends on the reserve utility of the first bidder and his/her information about the probability of other bids. Reserve utility is his/her subjective valuation of the good being auctioned.

If he/she bids as soon as the price falls to his/her reserve utility, he/she maximizes the probability of winning the item, but minimizes his/her surplus, that is, the difference between the winning bid and his/ her reserve utility.

If he/she waits longer for prices to fall further, he/she increases his/ her surplus but reduces his/her probability of winning the item. Accordingly, other bidders will behave based on their expectation about the first bidder’s behavior.

Noble Laureate economist William Vickrey has shown that under a set of assumptions both the progressive price English auction and the regressive price Dutch auction results in the same average expected price and gains for the buyers and the sellers.

The variance of the price, however, is smaller for the Dutch auction by a factor of (N − 1)/2N than the English auction where N is the number of bidders. The variance of the gain by the winning bidder is smaller by a factor of 1/N² in case of a Dutch auction. Hence, for risk-averse buyers and sellers, Dutch auction is slightly better than the English auction because of the smaller variance of gains.

Vickrey further argues that where bidders are fairly sophisticated and homogeneous, that is, they have similar information and bidding strategies, the Dutch auction may produce results that are close to Paretooptimal case of English auction.

The term “Pareto-optimal” suggests that an alternative allocation (than the existing one) where one bidder is better off without making at least one bidder worse off is not possible for the good being auctioned.

Where the bidders have different set of information or are less sophisticated, Dutch auction may produce higher price and lower average surplus for the buyers relative to the Paretooptimal English auction and can be relatively inefficient from the bidders’ point of view. Similarly, there are other extremes where Dutch auction produces lower price and may be inefficient from seller’s perspective.

Despite the complexity of the Dutch auction process and the optimization problem faced by the bidders due to the tradeoff between maximizing the surplus or gain from winning and the probability of winning the auction item, Vickrey argued and Milgrom further elaborated that the task of a bidder in a Dutch auction is similar to that of abidder in a sealed bid auction. In a sealed bid auction, the seller sells the goods to the highest bidder at his/her own bid.

Milgrom argues that in both cases the bidder’s choice is to determine the price at which he/she is willing to obtain the good. In case of a Dutch auction, the bidder starts with the highest price he/she is willing to bid. When price drops to that level, the bidder has the option to bid or to wait.

If he/she chooses to wait, he/she updates the highest price he/ she is willing to bid at that point based on the latest information. This process is repeated and can be summarized into a single price that the bidder is willing to pay. Hence, the Dutch auction and sealed bid auction should result in the same selling price.

In laboratory experiments where stakes are low, the above prediction does not hold. In these experiments, winning bidders in a Dutch auction on average pay a lower price than the sealed bid auction.

He postulates that the design of a Dutch auction discourages the bidders from advance planning and hence results in lower price. Other alternatives suggested by him are

the bidders in these experiments are not maximizing utility, and
the lower stakes in the experiments encourage bidders to wait longer before bidding.

The term “Dutch auction” used in connection with share repurchase or Initial Public Offering (IPO) share allocation has a different mechanism. Bagwell describes the Dutch auction method for share repurchase.

The buying firm in such auction specifies a range of prices at which shareholders can offer to sell their shares. Selling shareholders indicate the reserve price or the minimum selling price he/she is willing to accept and the quantity available at that price.

The buyer aggregates the supply quantity and constructs the supply curve. The lowest price at which the demand of the repurchasing firm is fulfilled is paid to all sellers who are willing to sell at this price or below.

Share repurchase with a Dutch auction pays lower premium (relative to the open market price) than a fixed price repurchase but the number of shares demanded is also lower in the former case. They also find that Dutch auctions are preferred by large firms that are transparent in terms of information.

Early Redemption Policy

The early redemption policy refers to a charge levied to an investor that redeems units of a fund before a specified date. Early redemption penalties aim to discourage short-term trading in a fund. There is generally a lockup period that may last several years until the first redemption.

The units issued by a fund that follows an early redemption policy are thus illiquid for some laps of time after being issued. After the lockup period, there is a predefined schedule of redemptions dates with their corresponding penalties.

Some hedge funds also retain the right to suspend redemptions under exceptional circumstances. By lengthening the lockup period, hedge funds obviously seek more stable financing facilities and want to protect themselves from sudden withdrawals by investors.

To illustrate this point, we examine the prospectus of managed futures notes issued by the Business Development Bank of Canada (BDC) on March 27, 2003 and which mature on February 28, 2011. There is a lock-up period lasting until June 30, 2005.

Thereafter, the redemption fees follow a step function. Redemption is allowed every year on June 30 and on December 30 and the fees decrease from 4 to 2% until December 31, 2007. Thereafter, they are nil until the expiration of the notes.

Obviously, BDC wants to discourage withdrawals from 2005 to 2007 and the imposed penalty is higher, the nearer the redemption is from the date of issuance of the notes.

Early Stage Finance

Early stage finance encompasses any financing transaction or support operation (not exclusively financial) undertaken to benefit companies in the seed and start-up phases.

At a global level, early stage financing is considered a key to innovation. However, it must also be stressed that several problems arise in implementing solutions.

Specifically, financial players are unanimous in asserting that early stage projects are usually too expensive to investigate and too risky. At the same time, entrepreneurs in general are badly trained to appreciate the teamwork and leadership as well as sales competence required.

Corporate development can be summarized in four phases:

Preparation—excogitating a business idea, running feasibility studies, presenting the idea to the team of “colleagues”
Start-up—creating the company, team building, setting up production activities, marketing, selling
Growth—defining the organizational structure of the company, creating various supply/sales channels, growing the team, internationalizing, penetrating new markets
Exit—liquidating partially or totally the work of the original promoters

Again, ideally speaking, various financial needs may be associated with these phases;
specifically, early stage financing addresses two of them:

Preparation—pre-seed or seed. Normally the financial needs that arise here are negligible. In fact, the promoters of the initiative are the ones who take on these expenses personally, or in some instances together with their families or friends. In recent years, an increase in specialized public funds for this kind of venture has been seen, along with the appearance of specialized financial intermediaries, often “spin-offs” of venture capitalists attracted by the chance to finance these companies/ projects during later phases.
Start-up—development financing. Here more substantial capital is required which is invested directly in the company’s operations. In this phase, in addition to financial requirements, the need for competencies and skills must also be satisfied which help the entrepreneurial initiative along its development path.

Economically Deliverable Supply

The economically deliverable supply is that fraction of the deliverable supply of a commodity that is in position for delivery against a future contract, and is not otherwise unavailable for delivery.

For example, oil that is held by a country for resources for crises is not considered part of the economically deliverable supply of oil futures contract. Another example is grain of a farmer.

Assume that a portion of the grain is held by the farmer for his own cattle. This portion is not economically deliverable because it is captive and so unavailable for delivery as a part of a futures contract.

The deliverable supply consists of the captive portion and of the portion that is part of the futures contract. Therefore, the economically deliverable supply is always equal or less than the deliverable supply.

The economically deliverable supply can explain in comparison with the deliverable supply futures price reactions. When it is significantly less than the amount needed to fulfill the short position of a contract, the futures price may increase.

That is the reason why futures contracts are closed nearby the delivery month. For example, the holder of a long position can close his position with a counter-trade and realize profits because of the risen price.

EDHEC Alternative Indexes

Alternative investment strategies are often referred to as “absolute return” strategies. One could consequently argue that developing hedge fund indexes does not make sense.

However, recent research has highlighted that the exposure of hedge funds to multiple risk sources (volatility, default, etc.) and the dynamic character of their management make monoand multilinear factor models inadequate for evaluating their performance.

A pragmatic alternative to developing factor models involves comparing the return of a given fund to that of a portfolio of funds following the same strategy (peer benchmarking), or to that of a representative index (index benchmarking).

The difficulties related to the development of indexes, which are already evident in the traditional universe, are exacerbated in the alternative investment world. Finding a benchmark that is representative of a particular management universe is not a trivial problem.

In response to the needs of investors, the EDHEC Risk and Asset Management Research Center has proposed an original solution by constructing an “index of indexes,” the EDHEC Alternative Indexes.

The aim of the methodology used to construct this index of indexes (see Amenc and Martellini, 2002) was to construct a benchmark which is more representative and stable than the indexes provided by Altvest, CSFB/Tremont, EACM, Hennessee, HF Net, HFR, MAR, Van Hedge, Zurich, etc. (the competing indexes). As a noncommercial initiative and in order to facilitate access. EDHEC has received support from Alteram for the promotion of its alternative indexes.

Alternative Investments Management