Portfolio Management Process Logic Planning Step: 1) 2) 3) 4) Determination of investors objectives and constraints Creating the investment policy

statement Forming capital market expectations Setting strategic asset allocation

Execution Step: 1) Portfolio selection 2) Portfolio implementation Feedback Step: 1) Monitoring and rebalancing 2) Performance evaluation Investment Objectives and Constraints Objectives: 1) Risk a. Ability (required spending needs, financial strength, long-term wealth targets) b. Willingness (behavioral factors) 2) Return (want vs need, measurement) Constraints: 1) 2) 3) 4) 5) Liquidity Time Horizon Tax Concerns Legal and Regulatory Factors Unique Circumstances

Investment Policy Statement should be transportable, foster discipline, and discourage short-term strategy shifts 1) Brief client description 2) Purpose of establishing policies and guidelines 3) Duties and investment responsibilities of parties involved, particularly those relating to fiduciary duties, communication, operational efficiency, and accountability. Parties involved include the client any investment committee, the investment manager, and the bank custodian. 4) Statement of investment goals, objectives, and constraints 5) Schedule for review of investment performance as well as the IPS itself 6) Performance measures and benchmarks to be used in performance evaluation 7) Any considerations to be taken into account in developing the strategic asset allocation

8) Investment strategies and investment style(s) 9) Guidelines for rebalancing the portfolio based on feedback

Impediments to Capital Mobility: 1) 2) 3) 4) 5) 6) Psychological barriers Legal restrictions Transaction costs Discriminatory taxation Political risks Foreign currency risks

Forms of Integration: 1) Statutory merger 2) Subsidiary merger 3) consolidation Types of Mergers: 1) horizontal merger 2) vertical merger 3) conglomerate merger Motivations for M&A: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) Synergies Achieving more capital growth Increased market power Gain access to unique capabilities Diversification Bootstrapping EPS Personal benefits for managers Tax benefits Unlocking hidden value Achieving international business goals a. Take advantage of market inefficiencies b. Working around disadvantageous government policies c. Use technology in new markets d. Product differentiation e. Provide support to existing multinational clients

Pre-Offer Takeover Defense Mechanisms: 1) Poison Pill (flip-in or flip-over and dead-hand provision)

2) 3) 4) 5) 6) 7) 8)

Poison Put Incorporation in a state with restrictive takeover laws Staggered Board of Directors Restricted voting rights Supermajority voting provisions Fair price amendments Golden Parachutes

Post-Offer Takeover Defense Mechanisms: 1) 2) 3) 4) 5) 6) 7) 8) Just say no defense Litigation Greenmail Share Repurchase (LBO) Leveraged Recapitalization Crown Jewel defense White Knight defense (winners curse) White Squire defense

Hostile Mergers: 1) Bear hug 2) Tender offer 3) Proxy fight Industry analysis model: 1) Industry classification a. Life cycle position b. Business cycle 2) External factors a. Technology (pioneer vs mature firm) b. Government (regulation,taxes,subsidies) c. Social changes (fashion,lifestyle) d. Demographic (difficult to forecast effects) e. Foreign influences (comparative advantage, increasing prosperity) 3) Demand Analysis a. End users b. Real and nominal growth c. Trends and cyclical variation around trends 4) Supply Analysis a. Degree of concentration b. Ease of entry c. Industry capacity 5) Profitability a. Supply/demand analysis b. Cost factors c. Pricing flexibility

6) International competition and markets Life Cycle Phases: 1) 2) 3) 4) Pioneer Growth Mature Decline

Business Cycle Behavior: 1) Growth 2) Defensive 3) Cyclical Factors affecting industry pricing: 1) 2) 3) 4) Product segmentation Industry concentration Ease of industry entry Supply input price

Factors that shape strategy: 1) 2) 3) 4) Industry growth rate Technology and innovation Government Complementary Products and Services

Forces that shape competition: 1) Threat of entry a. Supply-side economies of scale b. Demand-side benefits of scale c. Customer switching costs d. Capital requirements e. Incumbency advantages independent of size f. Unequal access to distribution channels g. Restrictive government policy h. Expected retaliation 2) Power of suppliers a. Supplier concentration b. Importance of volume to supplier c. Switching costs in changing suppliers d. Differentiated products from suppliers e. Presence of substitute inputs f. Threat of forward integration

3) Power of buyers a. Few or volume buyers b. Undifferentiated products c. Few switching costs d. Threat of backward integration e. Buyer group price sensitivity 4) Threat of substitutes a. Price-performance trade-off b. Buyer propensity to substitute c. Switching costs 5) Rivalry among existing competitors a. Number of competitors equal in size and power b. Industry growth c. Exit barriers d. Commitment to business e. Degree of operating or financial leverage f. Product differences g. Product shelf-life h. Complexity, diverse approaches and goals Six steps in using forces in an industry analysis: 1) 2) 3) 4) 5) 6) Define the industry (examine products/services in separate regions and classes) Identify participants (competitors, buyers, suppliers, potential entrants, substitutes) Determine strength/weakness of each force, what drives it, why Determine industry structure, causes, pricing, determinants of profitability Assess current and potential shifts in each force Decide which forces could be altered

Suitability DDM 1) Company is dividend paying with a dividend record 2) Board of directors has established a dividend policy with a consistent relationship to profitability 3) Investor takes noncontrol perspective FCFE (and FCFF) 1) 2) 3) 4) Company is not dividend paying Company is dividend paying but dividends significantly exceed or fall short of FCFE Companys FCF align with companys profitability within a forecast horizon Investor takes a control perspective a. (FCFE for stable capital structure) b. (FCFF for a levered company with negative FCFE or levered company with changing capital structure)

Residual income model 1) Company is not paying dividends, as an alternative to FCF model 2) Companys expected FCF are negative within a forecast horizon

Reasons for divestitures 1) 2) 3) 4) Divestitures 1) 2) 3) 4) Equity carve out equity to outsiders, parent keeps rest of shares Spin-off shares to old shareholders, no cash inflow to parent Split-off some shareholders are given shares in new entity in exchange for parents shares Liquidation bankruptcy Change in strategic focus Poor fit Reverse synergy Financial or cash flow needs

Core attributes of an effective corporate governance system: 1) 2) 3) 4) 5) Delineation of rights of shareholders and other stakeholders Clearly defined manager and director governance responsibilities to the stakeholders Identifiable and measurable accountabilities for performance of responsibilities Fairness and equitable treatment in all dealings between mangers, directors, and shareholders Complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position

Board of Directors should: 1) 2) 3) 4) Be composed of at least a majority of independent members Have appropriate experience and expertise Have authority to hire outside counsel Have access to complete and accurate information about financial position and underlying value drivers

Audit Committee should: 1) 2) 3) 4) Consist only of independent directors Have expertise in financial and accounting matters (at least two members) Internal audit staff should report directly to audit committee meet with external auditors at least once annually without management present

Nominating Committee should: 1) establish criteria for evaluating candidates for the board

2) 3) 4) 5) 6) 7)

identify candidates for the board and all committees review qualifications of nominees to board and committees establish criteria for evaluating nominees to senior management positions identify candidates for management positions review qualifications of nominees for management positions document reasons for selection of candidates recommended to the board

Objectives of a corporate governance system: 1) Eliminate or mitigate conflicts of interest among stakeholders, esp. managers-shareholders 2) Ensure that assets of the company are used efficiently and productively in the interest of investors and other stakeholders Sources of conflict in agency relationships: 1) Manager-shareholder 2) Director-shareholder Responsibilities of board members: 1) Establish corporate values and governance structures to ensure that business is conducted in an ethical, competent, fair, and professional manner 2) Ensure that all legal and regulatory requirements are met and complied with fully in a timly fashion 3) Establish long-term strategic objectives ensuring that best interest of shareholders come first and company fulfills all obligations to others in a timely fashion 4) Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of companys operations 5) Hire CEO, determine compensation, and evaluate officers performance 6) Ensure management supplied the board with sufficient information to be fully informed and prepared to make decisions and to be able to monitor and oversee management 7) Meet regularly to perform duties and in extraordinary session as required 8) Acquire adequate training so they can perform duties Analyst must assess: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) Board composition and independence Independence of chairman Qualifications of directors Whether board is elected annually or on a staggered basis Board self-assessment practices Frequency of separate sessions of independent directors Audit committee and audit oversight Nominating committee Compensation committee and rewards to management Use (or not) of independent legal and expert counsel

Statement of governance Policies: 1) Code of ethics 2) Statements of oversight, monitoring, and review responsibilities of directors, including internal control, risk management, audit and accounting and disclosure policy, compliance assessment, nominations, compensation awards, and other responsibilities 3) Statements of managements responsibilities to provide complete and timely information to the board prior to board meetings, and to provide directors with free and unfettered access to control and compliance functions within the company 4) Reports of directors examinations, evaluations, and findings in their oversight and review function 5) Board and committee performance self-assessments 6) Management performance assessments 7) Training provided to directors prior to joining the board and periodically thereafter

ESG risks (environmental, social, governance factors) 1) 2) 3) 4) 5) Legislature and regulatory Legal Reputational risk Operating risk Financial risk

Risks to value of investments 1) 2) 3) 4) Accounting risk (incomplete, misleading, misstated)/financial disclosure risk Asset risk Liability risk Strategic policy risk

Residual Income Model Strengths 1) 2) 3) 4) 5) Weakness 1) Relies on accounting data which is often manipulated 2) Requires many adjustments to accounting data 3) Assumes clean surplus account Adjustments needed Terminal values doesnt dominate value estimate like DDM and FCF Uses easy to find accounting data Good for companies with no dividend or positive FCF Good when CF are volatile Focus on economic profitability

1) Adjust BV of common equity for off-balance-sheet items 2) Net income to obtain comprehensive income (all changes in equity other than contributions, distributions to owners) 3) BS adjustments inventory, deferred tax assets and liabilities, operating leases, specialpurpose entities, reserves and allowances (bad debts), intangible assets 4) Nonrecurring items unusual items, extraordinary items, restructuring charges, discontinued operations, accounting changes Justify Active Portfolio Management 1) Efficient market draws money to passive portfolios, then prices deviate causing active portfolio management to gain attractiveness 2) Fund managers outperform empirical 3) Theory is needed for mean-variance theory for forecasts, rebalancing, etc. Step 1: develop E(R) and stdev for passively managed market index portfolio, M Step 2: find mispriced securities, large +/- alphas ; alpha = forecast Ri CAPM Step 3: determine weights for mispriced securities to form actively managed portfolio Small weights for small alpha and high unsystematic risk Large weights for large alpha and low unsystematic risk Positive weight for positive alpha, negative for negative alpha Step 4: create optimal portfolio using Sharpe between active and passive Step 5: allocate between RF and Portfolio using CAL Common Capital Budgeting Pitfalls 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) Failing to incorporate economic responses into analysis (ex. Low barriers to entry) Misusing standardized templates Pet projects of senior management Basing investment decisions on EPS, net income, or ROE Using IRR for project decisions Poor CF estimation Misestimation of overhead costs Using incorrect discount rate Politics involved with spending the whole budget Failure to generate alternative investment ideas Proper handling of sunk and opportunity costs

Real options change value of capital budgeting decisions made today 1) 2) 3) 4) 5) Timing options Abandonment options (allow exit if PV of exit CF > PV of continuing) Expansion options Flexibility options (price setting, production flexibility) Fundamental options (depends on underlying asset)

Alternative valuation methods project evaluation:

1) 2) 3) 4)

Economic income and accounting income Economic profit valuation Residual income valuation Claims valuation

Types of Business Combinations: 1) 2) 3) 4) Merger Acquisition Consolidation Special Purpose Entities

Estimating MV of real estate investments 1) Direct capitalization approach derive cap rate a. Market-extraction method b. Band-of-investment method c. Built-up method 2) Gross income multiplier technique Potential advantages of private equity firms over public counterparts 1) Ability to re-engineer the private firm to generate superior returns 2) Ability to access credit markets on favorable terms a. Debt repackaged to CLOs then sold to funds creating CDOs b. M-M and Jensen c. Liquidation of excess cash removes mgmts discretionary use of cash 3) Better alignment of interests between private equity firm owners and the managers a. Results-driven mgmt. pay packages b. Tag-along, drag-along rights provision in share purchase agreement ensuring any future acquirer has to extend an acquisition offer to all shareholders, including mgmt. c. Mgmt finds it easier to pursue long-term projects, not being short-sighted d. Effective structuring of investment terms term sheet i. Corporate board seats-ensures equity control ii. Noncompete clause iii. Preferred dividends and liquidation preference-#1 in line and sometimes guaranteed multiple before others iv. Reserved matters-some major decisions subject to approval v. Earn-outs (mostly in VC)-acquisition price paid and financial performance link (2-3 years) Private equity Exit Routes 1) 2) 3) 4) IPO Secondary market to other financial investor or strategic investor Management Buyout Liquidation

Private Equity Fund Economic Terms: 1) 2) 3) 4) 5) 6) 7) 8) Management fees Transaction fees fees for GPs i-banking services Carried interest Ratchet specifies equity allocation b/w LPs and mgmt. and when GP may receive carried interest Hurdle rate before GP gets carried interest Target fund size Vintage year year launched Term of the fund typically 10 years

Private Equity Fund Corporate Governance Terms: 1) 2) 3) 4) 5) 6) 7) 8) 9) Key man clause Disclosure and confidentiality Clawback provision requires GP to return capital to LPs in excess of agreed profit split Distribution waterfall deal-by-deal or total return waterfall Tag-along, drag along rights give mgmt. right to buy equity stake upon sale by PE owners No-fault divorce GP removed without cause Removal for cause Investment restrictions Co-investment GP and affiliated parties typically restricted in their co-investments

Private Equity Fund Risks of Investing in Private Equity: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) Illiquidity of investments Unquoted investments Competition for attractive investment opportunities Reliance on the management of investee companies (agency risk) Loss of capital Government regulations Taxation risk Valuation of investments Lack of investment capital Lack of diversification Market risk

Private Equity Fund Costs associated with investing in Private Equity: 1) 2) 3) 4) 5) 6) 7) Transactions fees due diligence, bank financing, legal, sale transactions Investment vehicle fund setup costs Administrative costs custodian, transfer agent, accounting Audit costs Management and performance fees 2x20 Dilution stock option plans granted and additional rounds of financing Placement fees fundraising fees up front or trailer fee

Private Equity Fund valuation policies: 1) At cost with significant adjustments for subsequent financing events or deterioration 2) At lower of cost or market value 3) By a revaluation of a portfolio company whenever a new financing round involving new investors takes place 4) At cost with no interim adjustment until the exit 5) With a discount for restricted securities 6) More rarely, marked to market by reference to a peer group of public comparables and apply illiquidity discounts Traditional credit analysis: 1) 2) 3) 4) Capacity Collateral Covenants Character

Factors analyzed by Moodys: 1) 2) 3) 4) 5) 6) 7) Industry trends Regulatory environment Basic operating and competitive position Financial position and sources of liquidity Company structure (including structural subordination and priority of claim) Parent company support agreements Special event risk

Factors considered by rating agencies in rating asset-backed securities: 1) 2) 3) 4) Collateral credit quality and concentration risk Seller/servicer quality (true securitization or hybrid) Cash flow stress and payment structure Legal structure (securitizing firm uses a SPV to separate collateralized assets)

Tax-backed debt: 1) 2) 3) 4) Issuers debt structure Budgetary policy Local and intergovernmental revenue availability Issues socioeconomic environment

Revenue bonds: 1) Limits of the basic security 2) Flow of funds structure (debt service is second after operating expenses) 3) Rate, or user, charge, covenants (how price will be set on product, improves bonds quality)

4) Priority-of-revenue claims can other entities redirect revenue? 5) Additional-bonds test Deriving sovereign risk ratings: Economic risk: 1) 2) 3) 4) 5) 6) 7) Economic and income structure Prospects for economic growth Degree of fiscal flexibility Public debt burden Monetary policy and price stability Balance of payments flexibility External debt and liquidity