10th Global Conference on Business & Economics
ISBN : 978-0-9830452-1-2
Edoardo Catelani
University of Florence
Giovanni Sequi
Luxgest S.A., Luxenbourg
Alternative investment funds: the case of hedge funds, private equity
funds and real estate funds in the Italian context1
1
Paragraphs 1, 6, 7, 8 were written by Edoardo Catelani ; paragraphs 2, 3, 4, 5 were written by Giovanni Sequi.
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1. Presentation and range of paper
Up until 2007, the vigorous growth of financial markets and associated activities which
reached their peak in the United States pulled the performance of alternative investment funds along
in their wake, and these succeeded in getting far superior results to other types of fund. The
financial crisis followed by the economic recession have caused those results to decrease and capital
to be reduced. Nonetheless, alternative investments continue to perform better than investment
trusts.
The present paper deals with the principal alternative investment funds - hedge funds, private
equity and real estate funds - for which we analyse some indicators over recent years, with
particular reference to the Italian context. More precisely, we make a short analysis of available
data to verify the market trend of each type of fund, over the period 2006-2009.
It has been decided to study only three out of the various types of alternative funds, as these
form the major part of alternative funds in Italy.
This paper is mainly descriptive - its chief aim is to document the performance of these funds
on the financial markets, as well as raising some considerations on strategies and discussing the
future of these funds. Data used was collected from official sources and analysed with QDA
methodology used in the social sciences. It is hoped that this paper may be a good starting point for
future research in the field of non-traditional investment funds.
2. Regulations applying
Hedge funds (or alternative investments) are a particular type of managed savings product,
distinguished by their high risk content and their client base, limited to "expert" investors with
considerable available capital and a suitable risk-return profile.
These products can use open-ended or closed-ended investment in a wider range of financial
instruments than are available to investment trusts. They are also exempt from many restrictions in
how they are run and regarding asset allocation. This greater freedom allows hedge funds often to
obtain above-average results, with their non-uniform trend compared with market trends.
In Italy hedge funds are regulated by art.16 of Ministerial Decree 228/1999 ("Standards for
determining general criteria applicable to investment funds"), As an exception to the Bank of Italy's
prudential discipline for dividing and limiting risk, their capital can be invested in assets other than
those stipulated in art.4, comma 2 of the same decree.
Hedge funds have the following distinguishing features:
- they have a minimum initial investment of not less than 500,000 Euro;
- they cannot solicit clients to invest.
Decree Law 29 November 2008/185 and the Bank of Italy's regulations implementing it,
annulled the former maximum limit of 200 participants in a hedge fund. And to safeguard investors,
Italy also adopted the rule allowing the use of side pockets in "exceptional circumstances", when
some of the assets held by the fund have become illiquid.
Following the financial crisis and the systemic risks stemming partly from the lack of control
mechanisms for alternative investment, it was generally agreed that the European Union should
bring in new discipline. On 30th April 2009, the EC published a draft directive on hedge funds,
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which aimed to create a European reference frame. This draft focuses on regulating managers of
alternative investment funds, meaning all collective investment institutions that are not included in
the UCITS directive, or in other words, that cannot be defined as harmonised investment funds.
The proposed directive appears to rest on two key concepts. One is monitoring and risk
limitation through obligatory shared information, restrictions on leverage and on delegation. The
other is the creation of a sort of European passport for AIFM operating under the directive's terms
and offering their products to professional investors. In order to be more flexible and taking into
account the requirements of the various European nations, the proposal appears to suggest that the
new rules be certainly applied to AIFM selling their products cross-border inside the EU to
professional investors. The single member states would maintain the faculty of allowing the sale of
alternative investments in their own country, even if they do not respect the directive's formula, but
do conform to national legislation. They might also allow the sale of alternative investment
products to small investors, probably placing more severe restrictions on the fund or its manager.
Private equity and real estate funds both belong to the closed-end category, a type of
investment appearing under a 1994 law, which was repealed and substituted by new legislation
included in the 1998 Consolidated Financial Act. While open-ended funds can be bought into or
redeemed at any moment during the life of the fund, closed-end ones can only be bought into at the
start of their existence and redeemed when the fund is dissolved, i.e. when the duration established
by regulations comes to an end. This restriction obviously penalises anyone who finds himself in
need of disinvesting just a few years from the beginning of the fund. These two types of fund,
therefore, are suitable for those able to invest their resources for a fairly long time, certainly more
than five years.
Even though he cannot redeem his investment, however, the investor can always sell it. In this
case its value is determined by the market. A common characteristic of the closed-end fund sector is
low liquidity - trading is rare and sellers often find it hard to find a purchaser for the shares on sale.
All investment funds, including closed-end ones, have what is called separate capital assets:
although the fund is managed by a specially set up company, should this company be in compulsory
liquidation (equivalent of bankruptcy for other types of company), the creditors cannot touch the
fund. Closed-end funds are managed by companies described under the law as investment
management companies (IMC for short), whose only object is to manage investment funds.
These companies must obtain the authorisation of the Bank of Italy to carry out their
activities. They must satisfy two kinds of requirements: some objective ones laid down by law and
others which must be evaluated by CONSOB (Italian commission for regulating the securities
market).
The objective requirements include: company set-up - must be a joint-stock company with
registered office in Italy; minimum paid-up capital of 1 million Euro, or 120 thousand Euro for
IMCs involving universities, research centres, public authority bodies or foundations; partners with
over 5 per cent voting rights or who are part of company management must possess certain
requirements proving sound reputation, as laid down in the ministerial decree.
The second group of requirements includes: evaluating the group's corporate structure to judge
whether obstacles exist for banking supervision; verifying action plans and 3-year budget forecasts;
submitting a report on organisation structure drawn up in specific format.
For the category of closed-ended funds, the amount must be decided when the fund is set up,
unlike with open-ended funds. The opening and closing dates for subscribing must be fixed, as must
the duration of the fund, which by law cannot be more than thirty years.
Art.39 of the above-mentioned Consolidated Financial Act states that funds must have their
own regulations establishing, among other things, "in which type of assets, financial instruments or
other stock the fund's capital may be invested" (comma 2, letter d). This fact allows the fund to
predetermine, to some extent, its strategies and to limit - and this is the intent of the law - the
investment possibilities of its capital, thus further safeguarding the investors. In the case of closedOctober 15-16, 2010
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ended funds, however, these rules usually allow more wide-ranging investments, with consequently
increased risk for investors. The result is that, usually, the amount necessary to purchase shares in
closed-ended funds is considerably higher that that for open-ended ones - and so not all savers can
afford to do so.
3. Italian hedge funds after the 2008 crisis
2
At the end of 2008, assets under management amounted to 1500 billion dollars, 30% down
from the 2007 peak of 2200 billion dollars. Also, at the end of 2008, the hedge fund industry
employed about 150,000 professionals, over 10,000 funds. Half of the hedge funds were offshore
funds and the most popular locations were the Cayman Islands (67%), followed by the British
Virgin Islands (11%) and Bermuda (7%). The single most important location for on-shore funds
was the United States (66%).
Hedge funds are mainly managed in on-shore locations. In 2008, 42% of the industry's global
assets were managed in New York, followed by London with 12%. The latter city is the European
capital for the industry, accounting for four-fifths of the 300 billion dollars of alternative
investments managed in Europe.
The hedge fund industry that has come through the 2008 crisis is more compact. At the end of
2008, the 100 largest hedge funds accounted for 75% of the industry's assets, a sharp increase over
2003, when they counted for around 54%. Today Bridgewater Associates is the largest hedge fund,
with 38 billion dollars of assets, followed by JP Morgan (US$ 32.9 billion) and Paulson & Co (US$
Marko Maslakovic, Hedge Fund 2009, IFSL Research , April 2009.
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29 billion). In 2008, institutional investors overtook high net worth individuals as hedge funds
primary source of investment. Pension funds represent a third of investment flow from institutional
investors towards hedge funds.
4. Hedge fund performance
If we analyse the long-term performance (January 1990-June 2008) of the HFRI Fund of
Funds Composite Index, one of the most commonly used industry benchmarks, we note that
annualized return is around 9.5%. As the diagram shows, this is a higher return than that from
traditional asset classes (equities, bonds and cash). The overall performance of hedge funds in the
first decade of the new millennium has not been exceptional. Nonetheless, if we consider the 20002002 Bear Market and compare the performance of the HFRI Fund of Funds with other classes of
traditional investment, we note clear outperformance by the alternative funds (particularly against
the equities, as the long-only funds during that period lost about 50% of their value). This overall
outperformance marked the definitive entry by institutional investors into hedge funds.
Diversified hedge fund portfolios constantly performed well during those years when equities
fell into negative territory.
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3
The only exception was in 2008, when both asset classes ended the financial year in negative
territory.
As already mentioned, in 2008 a combination of events, including the Lehman Brothers
bankruptcy, the implementation of the short sale ban, huge government intervention and the Madoff
Investment Securities LLC fraud, pushed volatility to record levels and made part of the market
illiquid. Despite this, 21% of hedge funds performed positively and 14% of these, in double
figures. Considering hedge fund performances 12 months from the end of the biggest stock market
crisis of the last twenty years, it may be imagined that the year 2009 might close with a strong
upturn in profitability on the part of the majority of hedge strategies.
HEDGE FUND PERFORMANCE FOLLOWING MARKET CRISES
Period
C/S Tremont L/S Equity
C/S Tremont Distressed
C/S Tremont Event Driven
C/S Tremont Risk Arb
C/S Tremont Glob Macro
C/S Tremont Man Futures
C/S Tremont Convert Arb
C/S Tremont Fix Inc Arb
12 months after
12 months after
12 months after
12 months after
Hi-Tech crisis
Russian crisis
1994 bear market
Asian tigers crisis
Apr 03 - Mar 04
Oct 98 - Sept 99
Jan 95 - Dec 95
Nov 97 - Oct 98
21,78%
23,51%
19,61%
12,77%
18,44%
15,33%
9,35%
6,83%
29,59%
25,18%
21,84%
16,94%
-18,91%
0,47%
10,06%
4,93%
23,03%
26,12%
18,34%
11,90%
30,67%
-7,10%
16,57%
12,50%
Average performance
6,34%
-4,05%
-6,01%
5,07%
3,54%
22,04%
-6,49%
-10,01%
20,19%
17,69%
13,45%
11,67%
8,44%
7,69%
7,37%
3,54%
Source:Hedge Invest Financial Advisors on CS/Tremont data
Note: the table indicates cumulative performance of various strategies in the twelve months following market shock.
Average performance is obtained as a straight average of the total of four perfomances under consideration.
Statistics from the first semester of 2009 once again confirm the fact that hedge funds perform
positively in stable or "normalising" markets and are excellent instruments, offering decorrelation
(diversification) from the main traditional classes of investment.
The HFRI FoF index closed 2008 at -21.37% while MSCI World closed at -42.08%.
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5. Strategies
If we consider the fund manager's investment style and the market exposure of the strategy,
we can distinguish three different types of investment:
4
- Relative Value strategies (Convertible Bond Arbitrage, Fixed Income Arbitrage, Equity
Market Neutral, MBS Arbitrage). These are arbitrage strategies whose return derives from the
spread between two shares, rather than from market direction.
- Event Driven strategies (Distressed Securities, Merger Arbitrage): the performance of
these strategies does not depend on the market, but on opportunities deriving from notable or
See K.B Connolly, Pricing Convertible Bonds, John Wiley & Sons, 1998 and K.B Calamons N.P., Convertible
Arbitrage, Insight and techniques for successful hedging, John Wiley & Sons, 2003.
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extraordinary changes in the securities of companies undergoing structural modifications such as
mergers, acquisitions, divestures, restructuring, buyback or hostile takeovers. These so-called
special situations depend on catalyzing events and returns are based on certain events taking place
to cause an increase in the value of the investment. Fund managers use a bottom-up approach,
basing their decisions on inherent merit and knowledge of industrial sectors.
-Directional/Opportunistic strategies: These aim to exploit the overall market trends rather
than concentrating on analysing individual securities (Long Short Equity, Global Macro, Short
Sellers, Managed Futures).
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6. Private equity funds
Closed-end investment funds are those investing in securities representing part of a company's
capital or debt.
Of these, private equity funds typically invest risk capital in unquoted companies, i.e.
participate in businesses that do not use the credit market. These funds aim to grow the business
bought into until they cash in their shares in a medium-to-long timeframe, with the objective of high
returns. An alternative, or complementary definition for private equity funds would be investment
in securities through a negotiated process with the company in order to reach predefined objectives.
Venture capital, on the other hand, is a specific segment of the private equity market and
normally involves financing a company during the early phases of its life cycle.
In extreme synthesis, the following phases of private equity operation may be identified:
1. fund raising
2. deal origination
3. due diligence and deal closing
4. Drawdown
5. Investment agreement
6. Share purchase agreement
7. definition of the exit strategy
Due diligence includes various steps taken by the investor, in this case by the fund, to evaluate a
company's potential. This takes into account the risks of possible failure of the operation that, in the
case of unquoted expanding businesses chosen for private equity investing, are very high. Portfolio
management requires constant monitoring of investments and risk evaluation of underlying business
activities, in order to disinvest at the right moment.
Owing to the nature of their investments, private equity funds show negative returns in the
early years, starting to grow around their fourth year (see chart below).
Figure 1
Source: Bank of Italy
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This fact is due not only to the investment's life cycle, but also to start of activity preceding
closing or drawdown.
2009 was a very difficult year for private equity in many senses.
In Italy there was a huge drop in new investments: only 50 units as against 125 in 2008, a
reduction of 60%. This raises even more concern for the sector if one considers that the biggest drop
occurred in the last months of the year, between October and December, thus getting 2010 off to a
poor start.
In Europe, buyouts alone, which traditionally represent the majority of private equity activity,
registered a fall of 68% in share turnover, to 23 billion. Compared with 2007, which was a record
year for private equity (187 billion), turnover of operations fell by 88%.
Business in this sector has dropped worldwide. It totalled 246 billion Euro, divided among the
approximately 500 funds throughout the world, showing a drop of 60% over the previous year. Here
too, the biggest fall occurred in the last quarter, with 35 billion for 75 funds.
The crisis in the private equity sector is evident if one looks at investment capital in Italy from
2005 to the first semester of 2009 (latest available figures): there is a tendency to growth up to
2007 and then a decrease that becomes severe in 2009.
Capitali raccolti dal private equity in Italia
1600
1400
1200
1000
800
Serie1
600
400
200
0
I sem. 2005
I sem. 2006
I sem. 2007
I sem. 2008
I sem. 2009
Figure 2: Capital raised by private equity in Italy
Source: PriceWaterhouseCooper, The Private Equity Market and Venture Capital in the first
semester of 2009, slides available on www.aifi.it, page 7 (data in millions of Euro)
The situation is unchanged - rather it worsens, if one considers the evolution of annual capital
raised (figure 3)
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Capitali raccolti dal private equity sul mercato in
Italia
1200
1000
800
600
Serie1
400
200
0
I sem. 2005 I sem. 2006 I sem. 2007 I sem. 2008 I sem. 2009
Figure 3: Capital raised by private equity on the Italian market
Source: PriceWaterhouseCooper, The Private Equity Market and Venture Capital in the first
semester of 2009, slides available on www.aifi.it, page 10 (data in millions of Euro)
In the first semester of 2009, capital raised on the Italian market more than doubled compared
with 2007, a pointer to the capital market crisis: no more overseas surplus liquidity was being
produced for investment in Italy (figure 4)
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Origine geografica dei capitali raccolti sul mercato in
Italia
120%
100%
80%
Italia
60%
Estero
40%
20%
0%
2007
2008
I sem. 2009
Figure 4: Geographical origin of capital raised on the Italian market
Source: PriceWaterhouseCooper, The Private Equity Market and Venture Capital in the first
semester of 2009, slides available on www.aifi.it, page 11 (data in millions of Euro)
In the light of these figures, disinvestment by private equity funds remained high. In fact
disinvestments during the first half of 2009 almost equalled those of the whole of 2008 (figure 5).
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Attività di disinvestimento dei fondi di private equity
in Italia
3000
2500
2000
1500
Serie1
1000
500
0
2004
2005
2006
2007
2008
I sem.
2009
Figure 5: Disinvestment by private equity funds in Italy
Source: PriceWaterhouseCooper, The Private Equity Market and Venture Capital in the first
semester of 2009, slides available on www.aifi.it, page 44 (data in millions of Euro)
7. Real estate funds
Real estate funds invest primarily or exclusively in property. By law, they can only be closed
or semi-closed. The latter, introduced in 2003, allows raising of investment capital through
successive share issues, though this must be within a precise time limit and also paying out in
advance.
Their purpose is to exploit the fund's property in order to make a profit at time of sale. This
occurs through increase in value and exploitation of their capital value, e.g. through rental, in order
to derive a fairly constant income from them over the period. Frequently, because of their highly
specific nature, these funds are reserved for institutional investors like, for example, banks, real
estate companies (brokerage companies) and bank foundations. This possibility is provided for
under law, which specifies "private funds, special funds, guaranteed funds, hedge funds"
(Ministerial Decree 24 May 1999, no.228, modified by Min. Decree Treasury 31/1/2003 no. 47).
The chief function of real estate funds is to transform investments in property, which
obviously has longer times of sale than an investment in securities, into financial activities (that is
to say, into shares). The investor can thereby enjoy ownership of property without directly
purchasing it.
In Italy a considerable number of real estate funds have grown up between 2000 and the first
half of 2009 (last available data). Their managers felt that this new product would not only attract
numerous investors, but also achieve higher performance that that of stock markets which at the
time were in crisis, following the bursting of the new economy bubble. Their calculations were
right, because real estate funds performed particularly well: the capital of Italian real estate funds as
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of 30th June 2009 was 20,445.6 million Euro, an increase of 1.4% over December 2008 and more
than 50% compared with the three previous years.
This continuous increase in the value of real estate funds also demonstrates that the Italian real
estate market, despite a lull in recent years, has weathered the crisis well and that investment in the
sector, medium to long term, has proven profitable. The increase in the number of real estate funds
during the first six months of 2009 (on 30th June of last year there were 143) is a sign that operators
continue to believe in profit margins in the Italian real estate market.
Nonetheless, the sector has revealed some critical areas that, if not quickly tackled, might have
serious consequences.
The first of these problematic issues is NAV. The Italian real estate securities market is highly
illiquid and discount on NAV can sometimes reach over 40% of nominal value. To encourage
expansion of these funds, the banks should create a more liquid market for securities.
5
The second issue is that the real estate companies who head the funds have been, in the
majority of cases, in debt since 2000. Real estate funds can be managed better and more
dynamically by making use of leverage of up to "60% of value of property, property rights and
shares in real estate companies and 20% of other assets". By using this instrument, the manager can
take actions to get a better return from the fund: e.g. buying other properties, with similar
characteristics to those already in the fund, or restructuring existing properties in order to obtain
higher rents, or any other improvements that will increase the property's value. Real estate funds'
debts are paid off from the fund itself, through income deriving from rentals and sales of properties
in the fund.
6
This secondary law is ambiguous and does not clearly define those "other assets" accounting
for 20 per cent extra debt over and above the predefined 60 per cent. This has led some IMCs who
manage real estate funds to increase their use of leverage over time, encouraged both by the sector's
high performance and by the low interest rates they were paying up to 2005 on debt.
From 2007 onwards, however, the Italian real estate market has slowed down, although
statistics on assets indicate an increase in value despite this (see above). Real estate funds have
therefore run - and are still running - the risk that leverage begins to have the opposite effect and
that, instead of multiplying profits, they find themselves multiplying debts. Another tangible risk in
this scenario is that the banks are no longer giving credit to real estate funds. Instead, they are
calling in the credit given, so the funds' profit margins are reduced.
During 2009, 81% of real estate funds made use of leverage, increasing their ratio of effective
debt to potential debt from 71.8% at the end of 2008 to 72.5% in the first semester of 2009.
Art. 14-bis of the Bank of Italy's Regulations dated 14th April 2005.
For example, in 2006, managers of real estate funds were indebted for 12 billion Euro, 94 per cent up on 2005 - see
Real Estate Scenarios, Real Estate Funds in Italy and Abroad. 2007 Report, page 109.
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Figura 6: Capital, activity and use of leverage
Source: Italian Real Estate Funds 6-monthly report on Italian real estate funds, first
semester 2009, available on www.assogestioni.it, page 1
At 30th June 2009, Italian real estate funds had invested their capital as follows:
• Offices: 42 funds (10,865.6 million Euro of capital
• Mixed: 33 funds (3,682.5 million Euro)
• Commercial: 16 funds (2,220.7 million Euro)
• Residential: 15 funds (694.4 million Euro)
• Industrial: 7 funds (844.9 million Euro)
• Tourism/Leisure: 7 funds (597.1million Euro)
• Other: 9 funds (1,080.5 million Euro)
7
• Logistics: 2 funds (73.8 million Euro).
It can be seen that the majority of real estate funds invest in office or commercial property,
which is a very specific sector and different from that of the small or medium apartments normally
purchased by private individuals.
Finally, it is worth noting that the "Nakheel" real estate fund controlled by Dubai World, the
company managing U.A.E. government investments, closed the first semester of 2009 in the red, to
the tune of 3.65 billion dollars - a negative performance that reflects fundamental problems on a
worldwide scale.
8. Previsions for the future of alternative funds
The present economic situation is particularly unfavourable for Europe and, consequently, for
Italy. Although our country has been less in danger than others from the economic crisis, this in no
way means that it is impervious, as indicators that we are about to mention demonstrate.
Statistics from Real estate funds, op.cit., page 3.
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In 2009 GPD fell overall by 5%, a statistic negatively influenced by the worst drop in
investments (-12.1%) since the end of the war. Exports plummeted (-19.1%) and were only partially
compensated by a drop in imports (-14.5%). In March 2009, industrial production was 25% down
on the previous year. Since then, it has shown some, albeit weak upturn. In reality, the entire Italian
economy is weak. In 2010 the GDP is forecast to grow by 1% and the Italian government has
brought in considerable incentives to consumer spending. When the effects of the incentives cease,
consumption drops. Family spending has however remained stationary in the fourth quarter of 2009
compared with the previous one. In real terms, family incomes have decreased.
With similar numbers, it is unlikely that there will be any exceptional economic upturn in the
next few years. This fact will obviously affect the performance of non-traditional funds examined
here, albeit to a different extent.
Hedge funds, because of their speculative nature, will seek out new investment possibilities,
probably in emerging countries, avoiding the older industrialised economies. If the Euro continues
to be weak internationally, foreign exchange will be worthwhile - the longer the Euro remains
weak, the better the profit margins will be. Limitations on financial engineering - a direct
consequence of the financial crisis - will restrict investment possibilities.
Future performance of real estate funds is obviously tied to the recovery of the real estate
market. As of now (May 2010), the sector is stationary. Unlike the United States, Italy has not
experienced a major drop in house prices. But transactions have decreased, also due to a reduction
in home purchase mortgages from banks and the market is to all extents frozen. Real estate funds
cannot help being influenced by this negative situation.
The future of private equity funds is also tied to economic recovery. Private funds invest in
growing companies, usually with high business risk. The fund manager naturally has to try to
identify the more innovative sectors or even those that will grow, despite the recession.
Alternative investment funds might be one way to get capital to businesses. Due to the
recession, banks are giving less credit than formerly. For alternative funds this would therefore be
an opportunity, while for businesses it would be a possible way of finding credit during a difficult
period.
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10th Global Conference on Business & Economics
ISBN : 978-0-9830452-1-2
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