European Financial Management 2018 Archive

January 2018, VOL 24:1

European Financial Management, VOL 24:1, January 2018

Investment Beliefs of University Endowments

Andrew Ang, Adnres Ayala and William N. Goetzmann

American university and college endowments now hold close to one-third of their portfolios in private equity and hedge funds. We estimate that at the end of 2012, the typical endowment believes that its private equity investments will outperform a portfolio of conventional assets by 3.9% per year and that hedge funds will outperform by 0.7% per year, and these out-performance beliefs have increased over time. Private universities, universities with larger endowments and higher spending rates, and those that rely more on the endowment to meet operational budgets tend to believe that alternatives deliver higher alphas.

Keywords: Hedge funds, private equity, alternative assets, portfolio choice, asset allocation

JEL Classification: G11, G14, G23

Consistent Valuation of Project Finance and LBO's using the Flows-to-equity Method

Ian Cooper and Nyborg Kjell

The flows-to-equity method is used to value transactions where debt amortises according to a fixed schedule, requiring a formula that links the changing leverage with a time-varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.

Keywords: valuation, flows-to-equity, equity cash flow, cost of equity, project finance, LBO, cost of debt

JEL Classification: G12, G24, G31, G32, G33, G34

Maximum Diversification Strategies Along Commodity Risk Factors

Simone Bernardi, Markus Leippold, and Harald Lohre

Pursuing risk-based allocation across a universe of commodity assets, we nd diversi ed risk parity (DRP) strategies to provide convincing results. DRP strives for maximum diversi cation along uncorrelated risk sources. A straightforward way to derive uncorrelated risk sources relies on principal components analysis (PCA). While the ensuing statistical factors can be associated with commodity sector bets, the corresponding DRP strategy entails excessive turnover because of the instability of the PCA factors. We suggest an alternative design of the DRP strategy relative to common commodity risk factors that implicitly allows for a uniform exposure to commodity risk premia.

Keywords: Commodity Strategies, Risk-Based Portfolio Construction, Risk Parity, Diversi - cation

JEL Classification: G11, D81

Market-based Estimates of Implicit Government Guarantees in European Financial Institutions

Lei Zhao

I exploit the price differential of credit default swap (CDS) contracts written on debts with different levels of seniority to measure the implicit government guarantees enjoyed by European financial institutions from 2005 to 2013. I determine that the aggregate guarantee increases substantially during the recent financial crises and peaks at an average of 89 bps in 2011. My analysis suggests that the extent of implicit support depends on the type of financial institutions and there exists a Eurozone effect. Further investigation of feedback relationship shows that the guarantee implicitly offered by a government positively “Granger causes” the sovereign’s default risk.

Keywords: Credit default swap, financial crisis, financial institutions, implicit government guarantees, too-big-to-fail

JEL Classification: G01, G21, G28

Optimal Ownership Structure in Private Equity

Bo Liu, Yang Liu, and Jinqiang Yang

We develop a tractable model to analyse the valuation of a general partner (GP) and the ownership allocation in a private equity (PE) fund. Our results indicate that holding ownership will increase GP's value. We further explore the influential factors that affect GP's optimal ownership decision. Our model predicts that GP's managerial skill has positive effects on GP's shareholding choice. Factors such as leverage, unspanned risks, GP's compensation have negative impacts on GP's ownership decision. The fund's maturity has a non-monotonic and concave influence. Moreover, the widely used performance measures implied by our model are consistent with empirical findings.

Keywords: private equity, illiquidity, incomplete market, ownership structure, managerial compensation

JEL Classification: G11, G23, G24

Exchange Traded Funds and Asset Return Correlations

Zhi Da and Sophie Shive

We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via ETF arbitrage. Using a large sample of U.S. equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the “discontinuity” between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF-driven return comovement may be excessive.

Keywords: exchange-traded-fund, correlation, arbitrage

JEL Classification: G23, G12