Industry info - Aluminium

Aluminium

The most commercially mined aluminium ore is bauxite, as it has the highest content of the base metal. The primary aluminium production process consists of three stages. First is mining of bauxite, followed by refining of bauxite to alumina and finally smelting of alumina to aluminium. India has the fifth largest bauxite reserves with deposits of about 3 bn tonnes or 5% of world deposits. India’s share in world aluminium capacity rests at about 3%. Production of 1 tonne of aluminium requires 2 tonnes of alumina while production of 1 tonne of alumina requires 2 to 3 tonnes of bauxite.

The aluminium production process can be categorised into upstream and downstream activities. The upstream process involves mining and refining while the downstream process involves smelting and casting & fabricating. Downstream-fabricated products consist of rods, sheets, extrusions and foils.

Power is amongst the largest cost component in manufacturing of aluminium, as the production involves electrolysis. Consequently, manufacturers are located near cheap and abundant sources of electricity such as hydroelectric power plants. Alternatively, they could set up captive power plants, which is the pattern in India. Indian manufacturers are the lowest cost producers of the base metal due to access to captive power, cheap labour and proximity to abundant supply of raw material, i.e., bauxite.

The Indian aluminium sector is characterised by large integrated players like Hindalco and National Aluminium Company (Nalco). The other producers of primary aluminium include Indian Aluminium (Indal), now merged with Hindalco, Bharat Aluminium (Balco) and Madras Aluminium (Malco) the erstwhile PSUs, which have been acquired by Sterlite Industries. Consequently, there are only three main primary metal producers in the sector.

The per capita consumption of aluminium in India continues to remain abysmally low at under 1 kg as against nearly 25 to 30 kgs in the US and Europe, 15 kgs in Japan, 10 kgs in Taiwan and 3 kgs in China. The key consumer industries in India are power, transportation, consumer durables, packaging and construction. Of this, power is the biggest consumer (about 44% of total) followed by infrastructure (17%) and transportation (about 10% to 12%). However, internationally, the pattern of consumption is in favour of transportation, primarily due to large-scale aluminium consumption by the aviation industry.

The metal has a long working life due to its propensity for recycling. Recycled metal requires significantly less amounts of energy for manufacturing of primary aluminium. Just to put things in perspective, the recycling of aluminium scrap requires 5% of the energy required for primary smelting, which is astoundingly lower, considering that power is such a high cost component.

Key Points
Supply Supply of aluminum is in excess and any deficit can be imported at low rates of duty. Currently, domestic production comfortably meets domestic requirements.

Demand Demand for aluminium is estimated to grow at 6%-8% per annum in view of the low per capita consumption in India. Also, demand for the metal is expected to pick up as the scenario improves for user industries, like power, infrastructure and transportation.

Barriers to entry Large economies of scale. Consequently, high capital costs.

Bargaining power of suppliers Most domestic players operate integrated plants. Bargaining power is limited in case of power purchase, as Government is the only supplier. However, increasing usage of captive power plants (CPP) will help to rationalise power costs to a certain extent in the long-term.

Bargaining power of customers Being a commodity, customers enjoy relatively high bargaining power, as prices are determined on demand and supply.

Competition Competition is primarily on quality and price, as being a commodity, differentiation is difficult. However, the recent spate of consolidation has reduced the competitive pressure in the industry. Further, increasing value addition to aluminium products has helped some companies protect themselves from the high volatilities witnessed in this industry.

Financial Year '07
Global production of primary aluminum rose from 30 million tons (MT) in 2004 to 32 MT in 2005, a jump of 6.9%. In 2006, it further increased to 34 MT, an increase of 6.3% YoY. North America, Western Europe and China together accounted for approximately 56% production, with China alone accounting for 26% of global primary aluminum production. Asia, once again showed the largest annual increases in consumption of primary aluminum, driven largely by increased industrial consumption in China, which has emerged as the largest aluminum consuming nation, accounting for 25% of global primary aluminum consumption in 2006. As far as global consumption is concerned, it increased by 5.6% in 2005 and touched 32 MT. In 2006, the corresponding figures were 8.2% and 34.7 MT.

The Indian aluminium industry grew by only 7% YoY during FY07, in quite contrast to the 20% YoY growth witnessed during FY06. This was mainly on account of subdued demand from the power sector, which grew by 7% as opposed to 23% growth in FY06. However, consumption of the metal continued to be strong in the transportation and construction sectors with growth rates in the region of 16% and 15% YoY respectively. As far as prices are concerned, they rose significantly in FY07, jumping by as much as 31% YoY. However, they are likely to soften going forward, on the backdrop of slowing global growth. Alumina prices corrected downwards because of surge in Chinese output. Rupee appreciation against the US dollar also had an impact on the realisations of domestic companies.

Prospects
Globally, newer packaging applications and increased usage in automobiles is expected to keep the demand growth for aluminium over 5% in the long-term. Asia will continue to be the high consumption growth area led by China, which has been and is expected to continue to register double-digit growth rates in aluminium consumption in the medium-term.

With key consuming industries forming part of the domestic core sector, the aluminium industry is sensitive to fluctuations in performance of the economy. Power, infrastructure and transportation account for almost 3/4th of domestic aluminium consumption. With the government focusing towards attaining GDP growth rates above 8%, the key consuming industries are likely to lead the way, which could positively impact aluminium consumption. Domestic demand growth is estimated to average in the region of over 8% over the longer-term.

Lowering of duties reduces the net tariff protection for domestic aluminium producers. Aluminum imports are currently subject to a customs duty of 5% and an additional surcharge of 3% of the customs duty. The customs duty has been reduced in a series of steps from 15% in 2003 to 5% in January 2007. With reduction in import duties, domestic realisation of aluminium majors, namely Hindalco and Nalco, is likely to be under pressure, as the buffer on international prices is reduced. Moreover, with greater linkage to international prices, volatility in financials could increase. However, producers are moving downstream to negate the higher volatility.


source: www.equitymaster.com

Theories of and Gains from Mergers

THEORIES of MERGERS
The theories of mergers can be summarized into three major explanations.
The first category is synergy or efficiency, in which total value from the combination is greater than the sum of the values of the component firms operating independently.

• Gains to Target Positive
• Gains to Acquirer Positive
• Total value Positive

Hubris (the second category) is the result of the winner’s curse, causing bidders to overpay; it postulates that value is unchanged. Of course, in a synergistic merger, it would be possible for the bidder to overpay as well.

• Gains to Target Positive
• Gains to Acquirer Negative
• Total value NIL

The third class of mergers comprises those in which total value is decreased as a result of mistakes or managers who put their own preferences above the well-being of the firm, the agency problem.

• Gains to Target Positive
• Gains to Acquirer Negative
• Total value Negative

So as we see, gains to targets are always positive. The acquired firm is usually paid a premium, so there are pluses under each type of takeover theory.
Next, we consider gains to acquirers; In case of synergy or efficiency, total value can be increased sufficiently to provide gains to acquirers. With hubris, by definition, total value is not increased, so acquirers lose. With mistakes or agency problems, total value is decreased, so that the gains to targets imply severe loses in value for acquirers.

Sources of Gains in M&As

A. Strategy
1. Develop a new strategic vision
2. Achieve long-run strategic goals
3. Acquire capabilities in new industry
4. Obtain talent for fast-moving industries
5. Add capabilities to expand role in a technologically advancing industry
6. Quickly move into new products, markets
7. Apply a broad range of capabilities and managerial skills in new areas

B. Economies of scale
1. Cut production costs due to large volume
2. Combine R&D operations
3. Increased R&D at controlled risk
4. Increased sales force
5. Cut overhead costs
6. Strengthen distributions systems

C. Economies of scope
1. Broaden product line
2. Provide one-stop shopping for all services
3. Obtain complementary products

D. Extend advantages in differentiated products

E. Advantages of size
1. Large size can afford high-tech equipment
2. Spread the investments in the use of expensive equipment over more units
3. Ability to get quantity discounts
4. Better terms in deals

F. Best practices
1. Operating efficiencies (improve management of receivables, inventories,
fixed assets, etc.)
2. Faster tactical implementation
3. Incentives for workers—rewards
4. Better utilization of resources

G. Market expansion
1. Increased market shares
2. Obtain access to new markets

H. New capabilities, managerial skills
1. Apply a broad range of capabilities and managerial skills in new areas
2. Acquire capabilities in new industry
3. Obtain talent for fast-moving industries

I. Competition
1. Achieve critical mass early before rivals
2. Preempt acquisitions by competitor
3. Compete on EBIT growth for high valuations

J. Customers
1. Develop new key customer relationships
2. Follow clients
3. Combined company can meet customers’ demand for a wide range of
services

K. Technology
1. Enter technologically dynamic industries
2. Seize opportunities in industries with developing technologies
3. Exploit technological advantage
4. Add new R&D capabilities
5. Add key complementary technological capabilities
6. Add key technological capabilities
7. Add new key patent or technology
8. Acquire technology for lagging areas

L. Shift in industry organization
1. Adjust to deregulation—relaxing of government barriers to geographic and
product market extensions
2. Change in strategic scientific industry segment

M. Adjust to industry consolidation activities
1. Eliminate industry excess capacity
2. Need to cut costs

N. Shift in product strategy
1. Shift from overcapacity area to area with more favorable sales capacity
2. Exit a product area that has become commoditized to area of specialty

O. Industry roll-ups—taking fragmented industries, and because of improvements
in communication and transportation, rolling up many individual firms into
larger firms, obtaining the benefits of strong and experienced management
teams over a large number of smaller units

P. Globalization
1. International competition—to establish presence in foreign markets and to
strengthen position in domestic market
2. Size and economies of scale required for effective global competition
3. Growth opportunities outside domestic market
4. Diversification
a. Product line
b. Geographically—enlarge market
c. Reduce systematic risk
d. Reduce dependence on exports
5. Favorable product inputs
a. Obtain assured sources of supply—sources of raw materials
b. Labor (inexpensive, well-trained, etc.)
c. Need for local manufacturing
6. Improve distribution in other countries
7. Political/regulatory policies
a. Circumvent protective tariffs, etc.
b. Political/economic stability
c. Government policy
d. Invest in a safe, predictable environment
e. Take advantage of common markets
8. Relative exchange rate conditions

Q. Investment – acquire company, improve it, sell it

R. Prevent competitor from acquiring target company

S. Create antitrust problem to deter potential acquirers of our firm

Source: Mergers & Acquisitions by J. FRED WESTON and SAMUEL C. WEAVER, Mc Graw Hill Publications

ARBITRAGE in a MERGER TRANSACTION

ARBITRAGE in a MERGER TRANSACTION
When a merger or takeover is announced, arbitrageurs sell short the stock of the acquiring company, and take a long position (buy) in the stock of the target company. Because of the risk that the transaction may not be completed, the price of the target stock may not immediately rise to the full offer price. So arbitrageurs may gain as the price of the target stock rises toward the offer price.
Indeed, the target may resist, driving its price even above the initial offer price. Another possibility is that another firm may make a competing bid at a richer price.

An example will illustrate the arbitrage operation. When a tender is announced, the price will rise toward the offer price. For example, bidder B selling at Rs. 100 may offer Rs.60 for target T, now selling at Rs.40 (a 50 percent premium). After the offer is announced, the arbitrage firm (A) may short B and go long in T. The position of the hedge depends on price levels after the announcement. Suppose B goes to Rs.90 and T to Rs.55. If the arbitrage firm (A) shorts B and goes long on T, the outcome depends on a number of alter-natives. If the tender succeeds at Rs.60, the value of B may not change or may fall further, but the value of T will rise to Rs.60, resulting in a profit of at least Rs.5 per share of T for A. If the tender fails, T may fall in price but not much if other bids are made for T; the price of B may fall because it has “wasted” its search and bid-ding costs to acquire T. Thus, A may gain whether or not the bid succeeds. If the competition of other bidders causes B to raise its offer further, A will gain even more, because T will rise more and B will fall. (Remember that A is short on B and long on T.)


Arbitrageurs perform another role in the merger process. Since they go long in the stock of the target and short the stock of the bidder, they are in a hedged position. A change in the price relationship between bidder and target is not a risk because they can cover their short position with their stock ownership in the target. The big risk to the arbitrageur is that the deal does not go through and the price relationship has shifted. When arbitrageurs have accumulated large positions in a target stock, they become a force pushing the deal to its completion.

Source: Mergers & Acquisitions by J. FRED WESTON and SAMUEL C. WEAVER; THE McGRAW-HILL EXECUTIVE MBA SERIES

LEVERAGED BUY-OUT

LEVERAGED BUY-OUT

Leveraged buy-out is a corporate finance method under which a company is acquired by a person or entity using the value of the company's assets to finance its acquisition; this allows for the acquirer to minimize its outlay of cash in making the purchase.
A leveraged buyout may also be referred to as a hostile takeover, a highly-leveraged transaction, or a bootstrap transaction.

In other words a LBO is a company acquisition method by which a business can seek to takeover another company or at least gain a controlling interest in that company. Special about leveraged buy-outs is that the corporation that is buying the other business borrows a significant amount of money to pay for (the majority of) the purchase price (usually over 70% or more of the total purchase price).
Furthermore, the debt which has been incurred is secured against the assets of the business being purchased along with the acquiring company. Interest payments on the loan will be paid from the future cash-flow of the acquired company or the ‘joint’ company.

Leveraged buy-outs became very popular in the 1980s, as public debt markets grew rapidly and opened up to borrowers that would not previously have been able to raise loans worth millions of dollars to pursue what was often an unwilling target. The persons or company doing such a "takeover" often used very little of its own money and borrowed the rest, often by issuing extremely risky, but high interest, "junk" bonds. These bonds, since they were high-risk, paid a high interest rate, because little or nothing backed them up. No surprise some of these LBO's in the 1980s ended disastrous, with the borrowers going bankrupt.

Typical advantages of the leveraged buy-out method include:
· Low capital or cash requirement for the acquiring entity
· Synergy gains, by expanding operations outside own industry or business,
· Efficiency gains by eliminating the value-destroying effects of excessive diversification,
· Improved Leadership and Management. Sometimes managers run companies in ways that improve their authority (control and compensation) at the expense of the companies’ owners, shareholders, and long-term strength. Takeovers weed out or discipline such managers. Large interest and principal payments can force management to improve performance and operating efficiency. This “discipline of debt” can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be postponed or rejected outright. In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior.
· Leveraging: as the debt ratio increases, the equity portion of the acquisition financing shrinks to a level at which a private equity firm can acquire a company by putting up anywhere from 20-40% of the total purchase price.
· Critics of Leveraged buy-outs indicated that bidding firms successfully squeezed additional cash flow out of the target’s operations by expropriating the wealth from third parties, for example the federal government. Takeover targets pay less taxes because interest payments on debt are tax-deductible while dividend payments to shareholders are not. Furthermore, the obvious risk associated with a leveraged buyout is that of financial distress, and unforeseen events such as recession, litigation, or changes in the regulatory environment can lead to difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weak management at the target company or misalignment of incentives between management and shareholders can also pose threats to the ultimate success of an Leveraged buy-out.

Firms of all sizes and industries may be the targets of a leveraged buyout, but because of the importance of debt and the ability of the acquired firm to make regular loan payments after the completion of a leveraged buyout, some features of potential target firms make for more attractive leverage buyout candidates, including:
· Low existing debt loads
· A multi-year history of consistent and reliable cash flows
· Hard assets (property, equipment, real-estate, inventory) that may be used as collateral for new debt
· The potential for new management to make operational or other improvements to the firm to boost cash flows
· Temporary market conditions that are depressing current valuation or stock price



Source: http://www.valuebasedmanagement.net/
Source: http://www.wikipedia.com/

Case Study –
TATASTEEL AND CORUS

About Tata Steel

Established in 1907, Tata Steel is Asia’s first and India’s largest integrated private sector steel company with 2005/06 revenues of US$5 billion and crude steel production of 5.3 million tonnes across India and South-East Asia. It is a vertically integrated manufacturer and is one of the world’s most profitable and value creating steel companies. In 2005, Tata Steel acquired 100% equity interest in NatSteelAsia in Singapore and in 2006 acquired majority control of Millennium Steel in Thailand, now Tata Steel Thailand.

About Corus

Corus is Europe’s second largest steel producer with revenues in 2005 of £9.2 billion (US$18 billion and crude steel production of 18.2 milliontonnes, primarily in the UK and the Netherlands. Corus provides innovative solutions to the construction, automotive, packaging, mechanical engineering and other markets worldwide. Corus has 41,100 employees in over 40 countries and sales offices and service centres worldwide. Combining international expertise with local customer service, the Corus brand represents quality and strength.

Acquisition of Corus and its Financing
a) Corus Acquisition Process
On 20th October 2006, the Boards of Tata Steel, Tata Steel UK (100% subsidiary of Tata Steel) and Corus reached an agreement on the terms of a recommended acquisition of the entire issued and to be issued share capital of Corus, at a price of 455p in cash for each Corus share. This was to be implemented by means of a Scheme of Arrangement under Section 425 of the UK Companies Act, 1985, and the relevant scheme document was sent to the Corus shareholders on 10th November, 2006.
Subsequently, a competitive situation emerged when a Brazilian steel company - Companhia Siderurgica Nacional(CSN) subsequently approached Corus with a proposal to make a cash offer. While Tata Steel revised its offer to 500p per share, CSN made a binding offer at 515p per share in December 2006. The Board of Corus recommended CNS’s offer to the shareholders.
As the process got extended, the Panel on Takeovers and Mergers in the UK (the Panel) set a deadline of 30th January, 2007 as the final date by which Tata Steel and CSN could revise their offers for Corus Group plc. The Panel subsequently announced in January 2007 that in order to provide an orderly resolution to this competitive situation, an auction process would be held on 30th January, 2007 to establish final bids from both Tata Steel and CSN. This auction process began in the evening of 30th January (Indian time) and ended in the early hours of 31st January, 2007 (Indian time) when the Panel announced that Tata Steel has won the auction to acquire Corus at a price of 608p per share.
The Board of Corus subsequently recommended the Tata Steel offer to its shareholders who voted to approve Tata Steel’s Scheme of Arrangement, at an Extra-Ordinary General Meeting held on 7th March, 2007. Corus’ shares were subsequently suspended from trading on each of the London, New York and Amsterdam Stock Exchanges and the Scheme became effective on 2nd April, 2007.

b) Corus Financing Structure
The financing structure of the Corus transaction as on date is given below:
The above financing structure is being re-organised to achieve fiscal unity in Netherlands and consequent tax efficiencies.

c) Corus Financing
On 2nd April, 2007, Tata Steel completed its acquisition of Corus Group plc (Corus) at a price of 608p per ordinary share in cash. The net funding requirement for the acquisition of Corus was Rs. 56,150 crores (USD 12.90 billion). The acquisition was initially funded by a cash contribution by Tata Steel of Rs. 11,750 crores (USD 2.7 billion) (funded by a mixture of its own cash resources and syndicate loans) to Tata Steel Asia Holdings Pte. Ltd. (TSAH). TSAH raised bridge loans of Rs. 10,900 crores (USD 2.5 billion) and Tulip UK Holdings raised a mezzanine loan of Rs. 2,600 crores (USD 0.6 billion) which was invested by way of equity in Tata Steel UK Ltd. To finance the balance ofthe consideration due under the acquisition, Tata Steel UK Ltd. (through its wholly owned subsidiary, Tulip Finance Netherlands BV) raised senior debts of Rs. 17,400 crores (USD 4.0 billion) and Mezzanine bridge of Rs. 13,500 cores (USD 3.1 billion). These loans were raised without recourse to Tata Steel.
At the Board Meeting held on 17th April, 2007, Tata Steel’s Board approved the long term funding arrangement for the acquisition of Corus as per details given below:

Equity Capital from Tata Steel Ltd. Rs. 17,850 Crore (US$ 4.10 bn)
Quasi - Equity / long term funding Rs. 11,570 Crore (US$ 2.66 bn)
Total Equity and Quasi-Equity contribution (a) Rs. 29,420 Crore (US$ 6.76 bn)
Non-recourse long-term debt at Corus (b) Rs. 26,730 Crore (US$ 6.14 bn)
Total (a+b) Rs. 56,150 Crore (US$ 12.90 bn)

The Company proposes to infuse USD 4.1 billion as equity to part finance the transaction. The equity will comprise of USD 700 million from internal generation, USD 500 million of external commercial borrowings, USD 640 million from the preferential issues of equity shares to Tata Sons Ltd. in 2006- 07 and 2007-08, USD 862 million from a rights issue of equity shares to the shareholders, USD 1000 million from a rights issue of convertible preference shares and about USD 500 million from a foreign issue of equity-related instrument.

Source:http://www.tatasteel.com/investorrelations/tatasteelAR2006-7/html/discussion4.html

Valuation of Corus Group plc
The Enterprise Value (EV) of the Corus acquisition was around Rs. 59,850 crores (USD 13.75 billion), which includes its continuing debt of Rs. 3,700 crores (USD 0.85 billion). The Enterprise Value/tonne of the Corus acquisition works out to around Rs. 32,700/tonne (USD 751/tonne) based on Corus’ actual crude steel production of 18.3 million tonnes in 2006 and Rs. 28,250/ tonne (USD 649/tonne) based on its crude steel capacity.
Source: Tata steel 0607 Annual Report

Tata Steel Growth Strategy

In 2005, the Company made long term plans of becoming a 50 million tonne steel producer by 2015 having multi-locational manufacturing facilities with strong regional presence focusing mainly on auto, packaging and construction sectors across the global markets. The long term growth plans of Tata Steel are focused on the following levers:

Price/sales ratio

Price/sales ratio
Price-to-sales ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company's market cap by the company's revenue in the most recent fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-share revenue.
The metric can be used to determine the value of a stock relative to its past performance. It may also be used to determine relative valuation of a sector or the market as a whole.
PSRs vary greatly from sector to sector, so they are most useful in comparing similar stocks within a sector or sub-sector. Also, since sales are less easy to manipulate as compared to earnings, price-sales ratios are more indicative of performance as compared to price-earnings ratios.

Capital Asset Pricing Model (CAPM)

Capital asset pricing model

The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return.
An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data.
The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe received the Nobel Memorial Prize in Economics (jointly with Harry Markowitz and Merton Miller) for this contribution to the field of financial economics.
The formula

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual security perspective, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

Individual security’s Risk to Reward ratio / beta = Market’s securities (portfolio) Reward-to-risk ratio.

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).
Re = Rf + (Rm - Rf) * b

Where:
Re = is the expected return on the capital asset
Rf = is the risk-free rate of interest
b = (the beta coefficient) the sensitivity of the asset returns to market returns, or also ,
Rm = is the expected return of the market
(Rm - Rf) = is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return). Note 1: the expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio (i.e. S&P 500). Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return.
For the full derivation see Modern portfolio theory.

Asset pricing
Once the expected return, E(Ri), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate (E(Ri)), to establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued (and undervalued when the observed price is below the CAPM valuation).
Alternatively, one can "solve for the discount rate" for the observed price given a particular valuation model and compare that discount rate with the CAPM rate. If the discount rate in the model is lower than the CAPM rate then the asset is overvalued (and undervalued for a too high discount rate).

Asset-specific required return
The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market.

Risk and diversification
The risk of a portfolio comprises systematic risk and unsystematic risk which is also known as idiosyncratic risk. Systematic risk refers to the risk common to all securities - i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio. (specific risks "average out"); systematic risk (within one market) cannot. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US (more in case of developing markets because of higher asset volatilities) will render the portfolio sufficiently diversified to limit exposure to systemic risk only.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor.

The efficient frontier

The (Markowitz) efficient frontier

The CAPM assumes that the risk-return profile of a portfolio can be optimized - an optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.
Because the unsystemic risk is diversifiable, the total risk of a portfolio can be viewed as beta.

The market portfolio
An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the remainder in cash - earning interest at the risk free rate (or indeed may borrow money to fund his or her purchase of risky assets in which case there is a negative cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall return - this relationship is clearly linear. It is thus possible to achieve a particular return in one of two ways:
1. By investing all of one's wealth in a risky portfolio,
2. or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or invested).
For a given level of return, however, only one of these portfolios will be optimal (in the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2 will generally have the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio.

Assumptions of CAPM
· All investors have rational expectations.
· There are no arbitrage opportunities.
· Returns are distributed normally.
· Fixed quantity of assets.
· Perfectly efficient capital markets.
· Investors are solely concerned with level and uncertainty of future wealth
· Separation of financial and production sectors.
· Thus, production plans are fixed.
· Risk-free rates exist with limitless borrowing capacity and universal access.
· The Risk-free borrowing and lending rates are equal.
· No inflation and no change in the level of interest rate exists.
· Perfect information, hence all investors have the same expectations about security returns for any given time period.

Shortcomings of CAPM
· The model assumes that asset returns are (jointly) normally distributed random variables. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect.
· The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately.
· The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient markets hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).
· The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.
· The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets. (Homogeneous expectations assumption)
· The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.
· The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.
· The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. Theories such as the Arbitrage Pricing Theory (APT) have since been formulated to circumvent this problem.
· Because CAPM prices a stock in terms of all stocks and bonds, it is really an arbitrage pricing model which throws no light on how a firm's beta gets determined.

Price to Book Value ratio

P/B ratio
The Price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to its current market price. Book value is an accounting term denoting the portion of the company held by the shareholders; in other words, the company's total assets less its total liabilities. The calculation can be performed in two ways but the result should be the same each way. In the first way, the company's market capitalization can be divided by the company's total book value from its balance sheet. The second way, using per-share values, is to divide the company's current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).
As with most ratios, be aware this varies a fair amount by industry. Industries that require higher infrastructure capital (for each dollar of profit) will usually trade at P/B much lower than the P/B of (e.g.) consulting firms. P/B ratios are commonly used for comparison of banks, because most assets and liabilities of banks are constantly valued at market values. P/B ratios do not, however, directly provide any information on the ability of the firm to generate profits or cash for shareholders.
This ratio also gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. For companies in distress the book value is usually calculated without the intangible assets that would have no resale value. In such cases P/B should also be calculated on a 'diluted' basis, because stock options may well vest on sale of the company or change of control or firing of management.

This ratio compares the market's valuation of a company to the value of that company as indicated on its financial statements. The higher the ratio, the higher the premium the market is willing to pay for the company above its hard assets. A low ratio may signal a good investment opportunity, but the ratio is less meaningful for some types of companies, such as those in technology sectors. This is because such companies have hidden assets such as intellectual property which are of great value, but not reflected in the book value. In general, price to book ratio is of more interest to value investors than growth investors.
Also known as the "Price / Equity Ratio" (which should not be confused with P/E or price/earnings ratio); or the market cap divided by shareholders' equity.

All about P/E Ratio

P/E Ratio
The P/E ratio (price-to-earnings ratio) of a stock (also called its "earnings multiple", or simply "multiple", "P/E", or "PE") is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios. The reciprocal of the P/E ratio is known as the earnings yield.

P/E Ratio = Price per Share / Earnings per Share

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. The earnings per share (EPS) used can also be the "diluted EPS" or the "comprehensive EPS".
For example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of stock A is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or "N/A"); sometimes, however, a negative P/E ratio may be shown.
By relating price and earnings per share for a company, one can analyze the market's stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, countries, and time periods may be misleading.
Determining share prices
Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:
· The company's future and recent performance, including potential growth;
· Perceived risk, including risk due to high leverage;
· Prospects for companies of this type, the "market sector".
By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings move up in line with share prices (or vice versa) the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.
The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a trailing P/E, because it involves taking earnings from the last four quarters; the 'forward P/E' (or current price compared to estimated earnings going forward twelve months) is also used.

Interpretation
The average U.S. equity P/E ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean is used to average), meaning it takes about 14 years for a company you purchase to earn back your full purchase price for you.
Normally, stocks with high earning growth are traded at higher P/E values. For example, stock A may be expected to earn $6 per share the next year. Then the forward P/E ratio is $24/6 = 4. So, you are paying $4 for every one dollar of earnings, which makes the stock more attractive than it was the previous year.
The P/E ratio implicitly incorporates the perceived riskiness of a given company's future earnings. For a stock purchaser, this risk includes the possibility of bankruptcy. For companies with high leverage (that is, high levels of debt), the risk of bankruptcy will be higher than for other companies. Assuming the effect of leverage is positive, the earnings for a highly-leveraged company will also be higher. In principle, the P/E ratio incorporates this information, and different P/E ratios may reflect the structure of the balance sheet.
Variations on the standard trailing and forward P/E ratios are common. Generally, alternative P/E measures substitute different measures of earnings, such as rolling averages over longer periods of time (to "smooth" volatile earnings, for example), or "corrected" earnings figures that exclude certain extraordinary events or one-off gains or losses. The definitions may not be standardized.
Various interpretations of a particular P/E ratio are possible, and the historical table below is just indicative and cannot be a guide, as current P/E ratios should be compared to current real interest rates:

N/A

A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be mathematically determined.

0-10

Either the stock is undervalued or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends.

10-17

For many companies a P/E ratio in this range may be considered fair value.

17-25

Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.

25+

A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

It is usually not enough to look at the P/E ratio of one company and determine its status. Usually, an analyst will look at a company's P/E ratio compared to the industry the company is in, the sector the company is in, as well as the overall market (usually the S&P 500). Sites such as Reuters offer these comparisons in one table. Example of RHAT Often, comparisons will also be made between quarterly and annual data. Only after a comparison with the industry, sector, and market can an analyst determine whether a P/E ratio is high or low with the above mentioned distinctions (i.e., undervaluation, over valuation, fair valuation, etc).

The Market P/E

To calculate the P/E ratio of a market index such as the S&P 500, it is not accurate to take the "simple average" of the P/Es of all stock constituents. The preferred and accurate method is to calculate the weighted average. In this case, each stock's underlying market cap (price multiplied by number of shares in issue) is summed to give the total value in terms of market capitalization for the whole market index. The same method is computed for each stock's underlying net earnings (earnings per share multiplied by number of shares in issue). In this case, the total of all net earnings is computed and this gives the total earnings for the whole market index. The final stage is to divide the total market capitalization by the total earnings to give the market P/E ratio. The reason for using the weighted average method rather than 'simple' average can best be described by the fact that the smaller constituents have less of an impact on the overall market index. For example, if a market index is composed of companies X and Y, both of which have the same P/E ratio (which causes the market index to have the same ratio as well) but X has a 9 times greater market cap than Y, then a percentage drop in earnings per share in Y should yield a much smaller affect in the market index than the same percentage drop in earnings per share in X.

An example
An easy and perhaps intuitive way to understand the concept is with an analogy:
Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's P/E ratio is 20 and my P/E ratio is 0.5.
Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, that is, only 6 months.
If a stock has a relatively high P/E ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high P/E ratio are:
· The market expects the earnings to rise rapidly in the future. For example a gold mining company which has just begun to mine may not have made any money yet but next quarter it will most likely find the gold and make a lot of money. The same applies to pharmaceutical companies — often a large amount of their revenue comes from their best few patented products, so when a promising new product is approved, investors may buy up the stock.
· The company was previously making a lot of money, but in the last year or quarter it had a special one time expense (called a "charge"), which lowered the earnings significantly. Stockholders, understanding (possibly incorrectly) that this was a one time issue, will still buy stock at the same price as before, and only sell it at least at that same price.
· Hype for the stock has caused people to buy the stock for a higher price than they normally would. This is called a bubble. One of the most important uses for the P/E metric is to decide whether a stock is undergoing a bubble or an anti-bubble by comparing its P/E to other similar companies. Historically, bubbles have been followed by crashes. As such, prudent investors try to stay out of them.
· The company has some sort of business advantage which seems to ensure that it will continue making money for a long time with very little risk. Thus investors are willing to buy the stock even at a high price for the peace of mind that they will not lose their money.
· A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same time period. Since there are only a limited amount of stocks to buy, supply and demand dictate that the prices of stocks must go up. This factor can make comparing P/E ratios over time difficult.
· Likewise, a specific stock may have a temporarily high price when, for whatever reason, there has been high demand for it. This demand may have nothing to do with the company itself, but may rather relate to, for example, an institutional investor trying to diversify out risk.

Inputs
Accuracy and context
In practice, decisions must be made as how to exactly specify the inputs used in the calculations.
· Does the current market price accurately value the organization?
· How is income to be calculated and for what periods? How do we calculate total capitalization?
· Can these values be trusted?
· What are the revenue and earnings growth prospects over the time frame one is investing in?
· Was there special one time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored?
· Were these charges truly one-time, or is the company trying to manipulate us into thinking so?
· What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?

Historical vs. Projected Earnings
A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.
On the other hand, just because a stock is trading at a low fundamental P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock. Thus, one way to get a fair comparison between stocks is to use their primary P/E. This primary P/E is based on the earnings projections made for the next years to which a discount calculation is applied.

A Forward PE Ratio refers to PE Ratio using earnings estimates for the next four quarters while a Trailing PE Ratio refers to the PE Ratio using EPS of the last four quarters

Trailing PE Ratio = Current Market Price per share / EPS of the last four quarters.

Leading PE Ratio = Current Market Price per share / (EPS of the last four quarters x (1+Growth rate))


The P/E Concept in Business Culture
The P/E ratio of a company is a significant focus for management in many companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. As mentioned earlier, a higher P/E ratio is the result of a sustainable advantage that allows a company to grow earnings over time (i.e., investors are paying for their peace of mind). Efforts by management to convince investors that their companies do have a sustainable advantage have had profound effects on business:
· The primary motivation for building conglomerates is to diversify earnings so that they go up steadily over time.
· The choice of businesses which are enhanced or closed down or sold within these conglomerates is often made based on their perceived volatility, regardless of the absolute level of profits or profit margins.
· One of the main genres of financial fraud, "slush fund accounting" (hiding excess earnings in good years to cover for losses in lean years), is designed to create the image that the company always slowly but steadily increases profits, with the goal to increase the P/E ratio.
These and many other actions used by companies to structure themselves to be perceived as commanding a higher P/E ratio can seem counterintuitive to some, because while they may decrease the absolute level of profits they are designed to increase the stock price. Thus, in this situation, maximizing the stock price acts as a perverse incentive.

Dividend Yield
Publicly traded companies often make periodic quarterly or yearly cash payments to their owners, the shareholders, in direct proportion to the number of shares held. According to US law, such payments can only be made out of current earnings or out of reserves (earnings retained from previous years). The company decides on the total payment and this is divided by the number of shares. The resulting dividend is an amount of cash per share. The dividend yield is the dividend paid in the last accounting year divided by the current share price.
If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.
Historically, at severely high P/E ratios (such as over 100x), a stock has NO (0.0%) or negligible dividend yield. With a P/E ratio over 100x, and supposing a portion of earnings is paid as dividend, it would take over a century to earn back the purchase price. Such stocks are extremely overvalued, unless a huge growth of earnings in the next years is expected.

Earnings yield
The reverse (or reciprocal) of the P/E is the E/P, also known as the earnings yield. The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market's valuation relative to bonds.
The earnings yield is also the cost to a publicly traded company of raising expansion capital through the issuance of stock.

PEG Ratio

PEG ratio
The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected future growth.

PEG = (P/E Ratio) / (Growth Rate)

A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that gets close to 2 or higher is generally believed to be expensive, that is, the price paid appears to be too high relative to the estimated future growth in earnings.
It is generally accepted that a PEG ratio of 1 represents a reasonable trade-off between cost (as expressed by the P/E ratio) and growth: the stock is reasonable valued given the expected growth. If a company is growing at 30% a year, for example, then the stock's P/E could be as high as approximately 30. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values.
The PEG ratio is commonly used and provided by various sources of financial and stock information. The PEG ratio is only a rule of thumb despite its wide use, and has no accepted underlying mathematical basis; the PEG ratio's validity at extremes in particular (when used, for example, with low-growth companies) is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market).
When the PEG is quoted in public sources it may not be clear whether the earnings used in calculating the PEG is the past year's EPS or the expected future year's EPS; it is considered preferable to use the expected future growth rate.

Advantages
Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.

Disadvantages
The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.
A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, and hype of investors.
The convention that (PEG=1) is appropriate is somewhat arbitrary and considered a rule of thumb metric. Mathematically, growth faster than growth of the economy cannot be infinite (or the company would eventually become larger than the economy), and the PEG ratio does not correct for the period of time that faster-than-normal growth will continue. Hence, the PEG ratio lacks a coherent conceptual framework, and is used solely as an indication of the extent of the growth/price trade-off.
At extremes, and particularly for low-growth companies, the PEG ratio implies valuations that may appear to be nonsensical. For example, the PEG ratio "rule of thumb" implies that a company with 1% growth in earnings per annum should have a P/E ratio between 1 and 2, a level that would appear to be extremely low.

Hedge Funds

A hedge fund is
An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

· Private fund,
· Largely unregulated
· Pool of capital
· require a very large initial minimum investment
· Illiquid investments as they often require investors keep their money in the fund for at least one year.
· Managers can buy or sell any assets,
· Bet on falling as well as rising assets and
· Participate substantially in profits from money invested.
· Charges both Performance Fees and Management Fees
· Typically open only to qualified investors
· Dominate certain specialty markets such as trading within derivatives with high-yield ratings, and distressed debt.
Fees
Charges both a performance fee and a management fee (also known as Incentive Fees)
Generally referred as “2 and 20” implying 2% Management Fees on NAV and 20% Performance Fees on Increases in NAV.
Fees are payable by the fund to the investment manager. They are therefore taken directly from the assets that the investor holds in the fund.
Management fees are usually calculated annually and paid monthly, but can also be paid weekly.

A high water mark (also known as a loss carryforward provision) is often applied to a performance fee calculation.[8] This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved. For example, if a fund were launched at an NAV per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the $13 return from $130 to $143 rather than on the full return from $120 to $143.
This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors.
The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund's value will often close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made good. This depends on the manager being able to persuade investors to trust it with their money in the new fund.
Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.
Managers who specify a "soft" hurdle rate charge a performance fee based on the entire annualized return once the hurdle rate has been achieved. Managers who use a "hard" hurdle rate only charge a performance fee on returns above the hurdle rate.
Some managers charge investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period of time has elapsed since the money was invested. The purpose is to encourage long-term investment in the fund: as a fund's investments need to be liquidated to raise cash for withdrawals, the fee allows the fund manager to reduce the turnover of its own investments and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance.

Alfred W. Jones is credited with inventing hedge funds in 1949

While there is no legal definition for "hedge fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in more complex and riskier investments than a public fund might.

As a hedge fund's investment activities are therefore limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.
As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling.

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment.
The term "hedge fund" has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase risk, and therefore return, rather than reduce it.

Hedge fund risk
Investing in certain types of hedge fund can be (but is not necessarily) a riskier proposition than investing in a regulated fund, despite a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk in hedge funds as an industry, though by no means all hedge funds have all of these characteristics, and some have none:
Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment.
Short selling - Where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of regulation - hedge funds are not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are, in most countries, required to be sophisticated investors who will be aware of the risk implications of these factors. They are willing to take these risks because of the corresponding rewards: leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.

Legal structure
A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management.
It may be in a form of Partnership, a corporate entity, a trust or a fund.

Open-ended nature
Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (“NAV”) per interest/share. To realize the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded among investors, and which distributes its profits.

Listed funds
Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there.
A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a "hedge-fund IPO", the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.

Regulatory Issues
In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act. The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed.

Comparison to private equity funds
Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.

Comparison to U.S. mutual funds
Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:
Mutual funds are regulated by the SEC, while hedge funds are not
A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
Mutual funds must price and be liquid on a daily basis
For most hedge funds, there is no method of ascertaining pricing on a regular basis.
Mutual funds must have a prospectus available to anyone that requests one and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.
Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.
Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund subject to certain restrictions and conditions.

Offshore regulation
Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.[27]
Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.
Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.

Hedge Fund Indices
There are a number of indices that track the hedge fund industry.
These indices come in two types, Investable and Non-investable, both with substantial problems. Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included.
Non-investable benchmarks are indicative in nature, and aim to represent the performance of the universe of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. There are diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different databases.
Transparency
As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy.
Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). This can lead to conflicts of interest, and in extreme cases can assist fraud.

Investigations of illegal conduct
In the U.S., the SEC is focusing more resources on investigating violations and illegal conduct on the part of hedge funds in the public securities markets.

Performance measurement
The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are autocorrelated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series.
Innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003),
Omega by Keating and Shadwick (2002),
Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and
Kappa by Kaplan and Knowles (2004).

However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry.

Notable hedge fund management companies
Sometimes also known as alternative investment management companies.
• Amaranth Advisors
• Bridgewater Associates
• Centaurus Energy
• Citadel Investment Group
• D. E. Shaw & Co.
• Fortress Investment Group
• Goldman Sachs Asset Management
• Harbert Management Corporation
• Long Term Capital Management
• Man Group
• Marshall Wace
• Pirate Capital LLC
• Renaissance Technologies
• SAC Capital Advisors
• Soros Fund Management
• The Children's Investment Fund

Takeovers & Substantial acquisition FAQ

What is meant by Takeovers & Substantial acquisition of shares?
When an “acquirer” takes over the control of the “target company”, it is termed as takeover. When an acquirer acquires “substantial quantity of shares or voting rights” of the Target Company, it results into substantial acquisition of shares. The term “Substantial” which is used in this context has been clarified subsequently.

What is a Target Company?
A Target Company is a company whose shares are listed on any stock exchange and whose shares or voting rights are acquired/being acquired or whose control is taken over/being taken over by an acquirer.

Who is an Acquirer?
An acquirer means any individual/company/any other legal entity which intends to acquire or acquires substantial quantity of shares or voting rights of target company or acquires or agrees to acquire control over the target company. It includes persons acting in concert (PAC) with the acquirer.

What is meant by the term “Persons Acting in Concert (PACs)”?
PACs are individual(s)/company(ies)/ any other legal entity(ies) who are acting together for a common objective or for a purpose of substantial acquisition of shares or voting rights or gaining control over the target company pursuant to an agreement or understanding whether formal or informal. Acting in concert would imply co-operation, co-ordination for acquisition of voting rights or control, either direct or indirect.
The concept of PAC assumes significance in the context of substantial acquisition of shares since it is possible for an acquirer to acquire shares or voting rights in a company “in concert” with any other person in such a manner that the acquisition made by them may remain individually below the threshold limit but collectively may exceed the threshold limit. Unless the contrary is established certain entities are deemed to be persons acting in concert like companies with its holding company or subsidiary company, mutual funds with its sponsor / trustee / asset management company, etc.

How substantial quantity of shares or voting rights is defined?
The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 has defined substantial quantity of shares or voting rights distinctly for two different purposes:
(I) Threshold of disclosure to be made by acquirer(s):
1) 5% or more but less than 15% shares or voting rights: A person who, alongwith PAC, if any, (collectively referred to as “Acquirer” hereinafter) acquires shares or voting rights (which when taken together with his existing holding) would entitle him to exercise 5% or 10% or 14% shares or voting rights of target company, is required to disclose the aggregate of his shareholding to the target company within 2 days of acquisition or within 2 days of receipt of intimation of allotment of shares.
2) More than 15% shares or voting rights: (a) Any person who holds more than 15% shares but less than 75% or voting rights of target company, and who purchases or sells shares aggregating to 2% or more shall disclose such purchase/sale along with the aggregate of his shareholding to the target company and the stock exchanges within 2 working days. (b) Any person who holds more than 15% shares or voting rights of target company or every person having control over the Target Company within 21 days from the financial year ending March 31 as well as the record date fixed for the purpose of dividend declaration, disclose every year his aggregate shareholding to the target company. The target company, in turn, is required to inform all the stock exchanges where the shares of target company are listed, every year within 30 days from the financial year ending March 31 as well as the record date fixed for the purpose of dividend declaration.
(II) Trigger point for making an open offer by an acquirer
1) 15% shares or voting rights: An acquirer who intends to acquire shares which alongwith his existing shareholding would entitle him to exercise 15% or more voting rights, can acquire such additional shares only after making a public announcement (PA) to acquire atleast additional 20% of the voting capital of Target Company from the shareholders through an open offer. 2) Creeping acquisition limit: An acquirer who is having 15% or more but less than 75% of shares or voting rights of a target company, can acquire such additional shares as would entitle him to exercise more than 5% of the voting rights in any financial year only after making a public announcement to acquire atleast 20% shares of target company from the shareholders through an open offer. 3) Consolidation of holding: An acquirer, who is having 75% shares or voting rights of a target company, can acquire further shares or voting rights only through an open offer from the\ shareholders of the target company.

What is the meaning of “control”?
Control includes the right to appoint directly or indirectly or by virtue of agreements or in any other manner majority of directors on the Board of the target company or to control management or policy decisions affecting the target company.

What is a Public Announcement (PA)?
A public announcement is an announcement made in the newspapers by the acquirer primarily disclosing his intention to acquire shares of the target company from existing shareholders by means of an open offer.

What information do I get in the Public Announcement?
The disclosures in the announcement include the offer price, number of shares to be acquired from the public, identity of acquirer, purpose of acquisition, future plans of acquirer, if any, regarding the target company, change in control over the target company, if any, the procedure to be followed by acquirer in accepting the shares tendered by the shareholders and the period within which all the formalities pertaining to the offer would be completed.

What is the objective of Public Announcement?
The Public Announcement is made to ensure that the shareholders of the target company are aware of an exit opportunity available to them through ensuing open offer.

Who is required to make a Public Announcement and when is the Public Announcement required to be made?
The Acquirer is required to make PA through the Merchant Banker (MB) within four working days of the entering into an agreement to acquire shares or deciding to acquire shares/voting rights of target company or after any such change or changes as would result in change in control over the target company. Incase of indirect acquisition or change in control, acquier can make public announcement within three months of consumnation of acquisition or change in control or restructuring of the parent or the Company holding shares of or control over the target Company in India.

What is a letter of offer?
A letter of offer is a document addressed to the shareholders of the target company containing disclosures of the acquirer/PACs, target company, their financials, justification of the offer price, the offer price, number of shares to be acquired from the public, purpose of acquisition, future plans of acquirer, if any, regarding the target company, change in control over the target company, if any, the procedure to be followed by acquirer in accepting the shares tendered by the shareholders and the period within which all the formalities to the offer would be completed.

Does SEBI “approve” the draft letter of offer?
No. SEBI does not clear, vet or approve the Letter of Offer. While the acquirer is primarily responsible for the correctness, adequacy and disclosure of information in the Letter of Offer, the Merchant Banker is expected to exercise due diligence to ensure that the Acquirer duly discharges its responsibility.

When can I, as a shareholder of Target Company, expect to get the letter of offer?
The MB will send the letter of offer within 45 days from the date of PA alongwith the blank acceptance form, to all the shareholders whose names appear in the register of the company on the specified date.

Within what period I can accept the offer?
The offer remains open 30 days. You are required to send your share certificate(s) / related documents to registrar or MB as specified in PA and letter of offer so as to ensure delivery/credit latest within the last date. You are advised to send such documents under registered post.
Under no circumstances such documents should be sent to the acquirer.

Within what period would I be paid for shares accepted in the offer?
The acquirer is required to pay consideration to all those shareholders whose shares are accepted under the offer, within 30 days from the closure of offer.

How is the price determined in an open offer?
SEBI does not decide or approve the offer price. The acquirer/Merchant Banker is required to ensure that all the relevant parameters are taken in to consideration for fixing the offer price and that justification for the same is disclosed in the letter of offer. The relevant parameters are:
a. negotiated price under the agreement which triggered the open offer.
b. highest price paid by acquirer or persons acting in concert with him for any acquisitions, including by way of allotment in public or rights or preferential issue during the 26 week period prior to the date of the PA.
c. average of weekly high and low of the closing prices of shares as quoted on the stock exchanges, where shares of the target company are most frequently traded during 26 weeks or average of the daily high and low prices of shares during the 2 weeks prior to the date of the Public Announcement. In case the shares of Target Company are not frequently traded then instead of point (c) above, parameters based on the fundamentals of the company such as return on net worth of the company, book value per share, EPS etc. are required to be considered and disclosed. Any amount paid in excess of 25% of the offer price towards noncompete agreement, shall be added to the offer price.

What are the criteria for determining whether the shares of the Target Company are frequently or infrequently traded?
The shares of the target company will be deemed to be infrequently traded if the annualised trading turnover in that share during the preceding 6 calendar months prior to the month in which the PA is made is less than 5% (by number of shares) of the listed shares. If the
said turnover is 5% or more, the shares will be deemed to be frequently traded.

Are only those shareholders whose names appear in the register of Target Company on a specified date, eligible to tender their shares in the open offer?
No. Any shareholder who holds the shares on or before the date of closure of the offer is eligible to participate in the offer.

What is a competitive bid?
Competitive bid is an offer made by a person, other than the acquirer who has made the first public announcement.

In case of a competitive offer, can I switch my acceptance to a better offer after I have availed the first offer at a lower price?
Yes, switching of acceptances between different offers is possible. The shareholder has the option to withdraw acceptance tendered by him up to three working days prior to the date of closure of the offer. To enable the shareholders to be in a better position to decide as to which of the subsisting offers is better and also not to cause last minute decisions / confusions, the offer price and size are effectively frozen for the last 7 working days prior to the closing date of the offers. You may wait till the commencement of that period to be aware of upward revisions in the offer price and size of the offers, if any.

Can an acquirer withdraw the offer once made?
No, the offer once made can not be withdrawn except in the following circumstances:
_ statutory approval(s) required have been refused;
_ the sole acquirer being a natural person has died;
_ such circumstances as in the opinion of the Board merits withdrawal.

How can I avail the offer if I have not received the letter of offer?
The PA contains procedure for such cases i.e. where the shareholders do not receive the letter of offer or do not receive the letter of offer in time. The shareholders are usually advised to send their consent to registrar to offer, if any or to MB on plain paper stating the name, address, number of shares held, distinctive folio no., number of shares offered and bank details alongwith the documents mentioned in the PA, before closure of the offer. The PA and the letter of offer along with the form of acceptance
is available on the SEBI website at www.sebi.gov.in.

Am I compulsorily required to accept the offer?
No. The decision to accept or forgo the offer lies exclusively with you.
How do I decide as to whether I should hold the shares or accept the offer or sell the shares in the share market?
The decision as to whether you should hold your shares or accept the offer or should sell the shares in the share market lies with you. However, you should read the letter of offer and take a decision in this regard after considering various factors such as the price of the offer, number of shares likely to be accepted under the offer, etc.

Will be compensated for delay in getting payment under the offer?
Acquires are required to complete the payment of consideration to shareholders who have accepted the offer within 30 days from the date of closure of the offer. In case the delay in payment is an account of non receipt of statutory approvals and if the same is not due to wilful default or neglect on part of the acquire, the acquires would be liable to pay interest to the shareholders for the delayed period in accordance with Regulations.
If the delay in payment of consideration is not due to the above reasons, it would be treated as a violation of the Regulations and therefore, also liable for other action in terms of the Regulations.

Is the acquirer required to accept all my shares under the open offer?
No, if the shares received by the acquirer under the offer are more than the shares agreed to be acquired by him, the acceptance would be on a proportionate basis.

What are the safeguards incorporated in the takeover process so as to ensure that I get my payment under the offer / receive back my share certificates?
Before making the PA, the acquirer has to open an escrow account in the form of cash deposited with a scheduled commercial bank or bank guarantee in favour of the MB or deposit of acceptable securities with appropriate margin with the MB. The MB is also required to confirm that firm financial arrangements are in place for fulfilling the offer obligations. In case, the acquirer fails to make the payment, MB has a right to forfeit the escrow account and distribute the proceeds equally amongst the target company, regional SEs (for credit to investor protection fund) and the shareholders who have accepted the offer. The MB is required to ensure that the rejected documents which are kept in the custody of the Registrar / MB are sent back to the shareholder through Registered Post.

Whether all types of acquisitions of shares or voting rights over and above the specified limits necessarily require an acquirer to make a public announcement followed up by an open offer?
No. Certain types of acquisitions are specifically exempted from the open offer process subject to the acquirer complying with the requirements/conditions, as may be applicable, for such acquisitions. Such exemptions include acquisitions arising out of firm allotment in public issues, right issues, inter-se transfer amongst group companies, relatives, promoters, etc.

What happens if the acquire/Target Company/Merchant Banker violates the provisions of the Regulations?
The Regulations have laid down the general obligations of acquirer, target company and the MB. For failure to carry out these obligations as well as for failure/non compliance of other provisions of the Regulations, the Regulations have laid down the penalties for noncompliance.

Do mergers and amalgamations of companies also fall under the regulatory purview of SEBI?
No, only takeovers and substantial acquisition of shares of a listed company fall within the regulatory purview of SEBI. Mergers and Amalgamations are outside the purview of SEBI and they are a subject
matter of the Companies Act, 1956.

Whom can I approach for Grievance Redressal/further information?
You should approach the concerned MB in this regard. If you do not get satisfactory response thereto, you may write to SEBI at Mittal Court, B Wing, First Floor, Nariman Point, Mumbai - 400021. You may also refer to SEBI website at www.sebi.gov.in