Investment Funds: Portfolio Construction and Regulation
Portfolio Management and Investment Strategies
A portfolio is the collective assets owned by the fund, managed by the fund manager.
Investment Mandate
An investment mandate is a set of instructions that the fund manager dictates to form the pool of assets. This includes rules, guidelines, and goals.
Fundamental Analysis
Fundamental analysis involves several key components:
- Financial statement analysis: Assessing a company’s financial health (e.g., Can Pepsi repay its debts?).
- Company analysis: Evaluating the company’s management and operations (e.g., Who is the CEO?).
- Competitive analysis: Comparing the company to its competitors (e.g., Is Coca-Cola better?).
- Industry analysis: Determining the attractiveness of the industry (e.g., Is investing in beverages profitable?).
This is often called bottom-up analysis, starting from specific details and moving to broader aspects. However, a top-down approach, from broad to specific, can be more logical. Financial statement analysis is crucial as it provides insights into the current condition, ratio analysis, future prospects, and factors affecting the company.
If the intrinsic value is lower than the established value, only the fundamentals (financial situation) are analyzed:
- If expected return > market value = BUY/HOLD
- If expected return < market value = SELL/HOLD
Portfolio Construction
Strong Portfolio
A strong portfolio is diversified to reduce volatility.
Ongoing Monitoring
Ongoing monitoring involves watching the portfolio’s performance to decide whether to buy more, hold, or sell assets.
Analyst Workflow
Fund managers often have analysts who perform:
- Quantitative screening
- Fundamental analysis
- Portfolio construction
Job of an Analyst
Analysts follow the goals, rules, risk tolerance, and asset allocation defined in the investment mandate.
Types of Investors
Investors can be categorized as:
- Conservative (less risk)
- Moderate
- Aggressive (more risk)
Types of Funds
Different types of funds include:
- Money market: Short-term fixed income
- Fixed income: Bonds
- Mixed bond: 30-70% stocks
- Equity fund: Stocks, risky, aggressive
- Global: Investment mandate trusts the fund manager
- Funds of funds: Funds that invest in other funds
- Index funds: Conservative investors
- Absolute return
Regulatory Framework and Investor Protection
The Comisión Nacional del Mercado de Valores (CNMV) regulates funds to protect investors from mismanagement, not from market losses.
Functions of the CNMV
The CNMV ensures:
- Transparency within Spanish securities markets
- Protection of investors
- Supervision of firms providing investment services
- Compliance with legal requirements for public disclosures
- Compliance with custody obligations, asset registration, and custodian oversight
Protecting Investors
Investor protection involves:
- Supervision: By the CNMV
- Regulation: Specific regulations for Collective Investment Structures (CIS)
- Custodian: Responsible for safekeeping assets
Specific Functions of the CNMV
The CNMV’s specific functions include:
- Approving and registering funds
- Scrutinizing the proposed fund and its management team before public offering
- Ensuring a well-functioning internal control framework
- Monitoring the fund’s reporting requirements
Reporting Requirements for Fund Managers
Asset Management Companies must submit:
- Prospectus
- Management Regulation
- Key Investor Information Document (KIID)
- Incorporation Agreement
- Evidence of honorability, professional repute, and experience of directors and managers
- Additional information necessary for authorization and registration
The CNMV oversees custodians’ compliance with custody obligations, asset registration, and supervision of management companies. Custodians submit a biannual report to the CNMV, including:
- Incidences related to Net Asset Value (NAV) discrepancies
- Discrepancies between assets held and accounting records
- Risk ratios and other legally or contractually limited measures
Private Investment Funds
Private investment funds differ from mutual funds in that they are:
- Not open to the general public
- Require significant capital commitment for several years, limiting access to high-net-worth individuals
Characteristics of private investment funds include:
- Limited life cycle (10-12 years)
- No daily NAV
- No redemptions from the fund’s value
- Restricted transfer of ownership
Investing in Private Funds
Manager selection is crucial. Data shows a 20% annual performance difference between the best and worst private equity performers, compared to 3% for public equity managers. Limited Partners (LPs) commit to a team without knowing the future portfolio. This is known as blind-pool investing, where LPs cannot replace poorly performing teams and must honor capital commitments.
Private Equity Real Estate Funds (PERE)
Private Equity Real Estate (PERE) funds exemplify diversification benefits. They invest directly in real estate and are managed by experienced teams. PERE funds can build diversified portfolios across various property types and geographic areas. The investment goal is capital appreciation, with cash flow being important for less risky strategies.
PERE firms engage in:
- Capital raising
- Screening investment opportunities
- Acquisition and development of properties
- Property management
- Property selling
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are publicly traded and available to retail investors. They are more regulated than PERE funds and own income-producing real estate. REITs must distribute at least 90% of taxable income as dividends, making them a current-income strategy.
Private Equity
Private Equity (PE) provides funding to companies that prefer not to access public markets. PE funds can specialize by stage (venture capital, growth capital, buy-outs) or by sector and geography.
What Does a PE Firm Do?
PE firms buy companies, overhaul them, and sell them for a profit. Capital comes from LPs and is often supplemented by debt. Earlier-stage companies may use pure equity or hybrid instruments. PE firms can replace management, restructure the company, provide network advantages, and inject capital to create competitive advantages.
Private Equity Fund Lifecycle
The lifecycle of a PE fund includes:
- Capital raise: Seeking investor commitments
- Deal sourcing: Identifying potential deals
- Analysis and execution: Due diligence, negotiation, and deal structuring
- Post-acquisition improvement: Enhancing operations and strategic partnerships
- Exit: IPO, trade sale, refinancing, or secondary buyout
- Final settlement: Closing all fund-related business
Analyst Point of View (POV)
As a PE analyst, you must:
- Understand and model financial statements in Excel
- Perform sensitivity analysis on returns, pricing, and deal structure
- Participate in due diligence and negotiation processes
- Review legal documentation
How Does a PE Firm Decide Which Deals to Do?
PE firms typically target:
- Internal Rate of Return (IRR) of 25%+ (gross)
- Multiple of Invested Capital (MOIC) >2.5x over 5 years
Smaller firms may have higher targets. Out of 100 opportunities, only about 5 investments are made, progressing from initial opportunities to deep dives, signed agreements, and finally, closed deals.
Private Equity Deal Structure and Financial Engineering
Most PE investments involve debt financing, which can enhance returns but also increases risk. The financial structure must be sustainable, even if performance is worse than expected. Cash flow analysis, often using EBITDA, is crucial for determining debt load.
The Role of Debt Financing
Debt can make a company more competitive or saddle it with unsustainable debt. Too much leverage in a downturn can be dangerous, but zero debt is not optimal either. EBITDA is a frequent pricing metric for determining debt capacity.