1

READING 47: ALTERNATIVE INVESTMENTS

Learning outcomes

47.a. Describe types and categories of alternative investments.

47.b. Describe characteristics of direct investment, co-investment, and

fund investment methods for alternative investments.
47.c. Describe investment and compensation structures commonly used
in alternative investments.

47.d. Explain investment characteristics of hedge funds.

47.e. Explain investment characteristics of private capital.

47.f. Explain investment characteristics of natural resources.

47.g. Explain investment characteristics of real estate.

47.h. Explain investment characteristics of infracstructure.

47.i. Describe issues in performance appraisal of alternative

investments. 1

47.j. Caculate and interpret returns of alternative investments on both

before-fee and after-fee bases.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.a] Describe types and categories of alternative
investments.
1. Definition of Alternative investments

“Alternative investments” is a label for a disparate group of investments that

are distinguished from long-only, publicly traded investments in stocks, bonds,
and cash (often referred to as traditional investments)

Narrow managers specialization

Low correlation of returns with traditional investments

Less regulation and less transparency

Alternative Limited historical risk and return data

investments
characteristics Unique legal and tax considerations

Higher fees

Concentrated portfolios

Restrictions on redemptions
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.a] Describe types and categories of alternative
investments.
2. Why Investors Consider Alternative Investments

Alternative investments offer:

Potentially increased
Broader
Opportunities for income through higher
diversification
enhanced returns (by yields (particularly
(because of their
increasing the compared with
lower correlation
portfolio’s risk–return traditional investments
with traditional asset
profile). in low–interest rate
classes). (*)
periods).
Note (*): Alternative investments are not free of risk, of course, and their returns
may be correlated with those of other investments, especially in periods of
financial crisis.

The average correlation of returns from alternative

Over a long
investments with those of traditional investments may
historical period
be low.

During periods of Correlations among many assets (both alternative and

economic crisis traditional) can increase dramatically.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.a] Describe types and categories of alternative
investments.
3. Categories of Alternative Investments

Hedge funds
Invest in portfolios of securities and/or derivative
(Refer to Los
positions using a variety of strategies.
47.d)

Private equity: Generally invest in companies (start up or

established firm) that are not listed on a public exchange
Private capital or in public companies with the intent to take them
(Refer to Los
private.
47.e) Private debt: Make loans directly to companies, lend to
early stage (venture) firms, or invest in the debt of firms
that are financially distressed.

Real estate
Invest in real estate such as residential or commercial
(Refer to Los
properties, as well as real estate–backed debt.
47.g)

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.a] Describe types and categories of alternative
investments.
3. Categories of Alternative Investments

Commodities: Invest in physical commodities, businesses

engaged in the production of commodities or gain
exposure through commodity futures contracts and funds
Natural benchmarked.
resources
Farmland: Invest in agricultural land that can produce
(Refer to Los income from leasing it out for farming or from raising
47.f) crops or livestock for harvest and sale.
Timberland: Invest in forested land or trees are planted
for harvesting, which provides cash flows.
Invest in real assets intended for public use, essential
Infrastructure
services which most investment occurs indirectly through
(Refer to Los
shares in infrastructure companies, private equity funds,
47.h)
and unlisted mutual funds.

Other alternative investments may include tangible assets,

Other
such as fine wine, art, patents, litigation actions,…
5
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.1. Fund Investing

The investor contributes capital to a fund, and the fund identifies, selects,
and makes investments on the investor’s behalf.

Investor

Alternative
Investments Fund

Fund Fund Fund

Investment 1 Investment 2 Investment 3
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.1. Fund Investing

Advantages Disadvantages

Fund managers offer professional Costly management and performance

investment services and expertise fees

Lower level of investor involvement

Easier access to alternative

investments Investor must conduct thorough due
diligence when selecting the right
Valuable diversification benefits fund

Lower capital requirements

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.2. Co - Investing

The investor invests in assets indirectly through the fund but also possesses
rights (known as co-investment rights) to invest directly in the same assets.

Alternative
Investor
Investments Fund

Co -
Investment
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.2. Co - Investing

Advantages Disadvantages

Learn from the fund’s process to Reduced control over the investment
become better at direct investing selection process

Reduced management fees

May be subject to adverse selection
Allows more active management of bias
the portfolio
Requires more active involvement
Allows for a deeper relationship with compared with fund investing
the manager
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.3. Direct Investing

Occurs when an investor makes a direct investment in an asset without the

use of an intermediary.

Investor

Direct Direct Direct

Investment 1 Investment 2 Investment 3
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

1.1.3. Direct Investing

Advantages Disadvantages

Avoids paying ongoing management Requires more investment expertise

fees and financial sophistication

Less access to a fund’s ready

Greatest amount of flexibility for the diversification benefits, sourcing
investor network

Greater levels of due diligence

Highest level of control over how the
asset is managed Higher minimum capital
requirements
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.1. Fund Investing, Co-Investing and Direct Investing

Fund Investing

Investor

Direct Investing
Co - Investing

Alternative
Investments Fund

Fund Co – Direct
Investment Investment Investment
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

When investing in alternative investments, investor must consider whether

to rely on the expertise of the fund manager or to undertake the investment
selection process themselves via direct investing.

For direct investing For fund investing

• Investor has control over the • Investor pays the fund
choice of which company to additional fees for the
invest in. diversified portfolios, due
• Requires the investor to conduct diligence expertise, and the
a thorough investigation. negotiation of favorable
redemption terms. (**)

For Co - investing
• the investor will conduct direct due diligence on the portfolio company
with the support of the fund manager. 13
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

Note (**): Although funds offer due diligence on the underlying

investments, responsibility still falls to the investor for conducting due
diligence when choosing among funds to invest in.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Manager selection is a critical factor in portfolio performance. A manager

should have a verifiable track record and display a high level of expertise,
experience with the asset type.

For investors considering new investment, a proper due diligence process

should be carried out to ensure that the targeted investment is:
• In compliance with its prospectus.
• Meet their investment strategy, risk and return objectives, and
restrictions.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Fraud

The investor should be skeptical of unusually good and overly consistent

reported performance.
Third-party custody of assets and independent
verification of results can help reduce the chance of an
investor being defrauded.
Avoid
Fraud Separate accounts make theft more difficult because
the investor retains custody of the assets and
sometimes can select the prime broker or other service
providers, binding them to the client’s interest.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Typical Due Diligence Process

Organization
Portfolio management
Operations and controls

Risk management

Legal review

Fund terms

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Due Dilligence process

Experience and quality of management team,

compensation, and staffing
Analysis of prior and current funds
Organization
Track record/alignment of interests

Reputation and quality of third-party service providers

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Due Dilligence process

Investment process

Target markets/ asset/ types strategies

Sourcing of investments
Portfolio
Role of operating partners
Management
Environmental and engineering review process

Integration of asset management/ acquisition/ dispositions

Disposition process, including its initiation and execution

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Due Dilligence process

Reporting and accounting methodology

Operation Audited financial statements and other internal controls

And Controls Valuations—frequency and approach(es)

Insurance and contingency plans

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Due Dilligence process

Fund policies and limits

Risk Risk management policy

Management Portfolio risk and key risk factors

Leverage
Insuranceand
andcurrency—risks/
contingency plansconstraint /hedging

Fund structure

Legal Review Registrations

Existing/prior litigation 21

(Continue in next slide)

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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.1. Due diligence for fund investing

Due Dilligence process

Fees (management and performance) and expenses

Contractual terms
Investment period and fund term and extensions
Carried interest
Fund Terms
Distributions
Conflicts
Limited partners’ rights
“Key person” and/or other termination procedures
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.2. Due diligence for direct investing

Due diligence for direct investing requires the investor to conduct a

thorough investigation into the target asset or business, including but not
limited to the quality of its management team, the quality of its customers,
the competitive landscape, revenue generation, risks, and so on.

Investment Investors’ considerations focus on

Private equity • Quality of interactions between the business and each

of its stakeholders (via reference checks and
interviews).

Private debt • Borrowers’ ability to service the regular interest and

principal payments of debt.
• Owners and management team background.
(Continue in next slide)
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.2. Due diligence for direct investing

Investment Investors’ considerations focus on

Real estate • The building’s occupancy rate and the quality of its
structure and tenants.

Infrastructure • Quality of the assets held and operated (e.g., an

airport).
• Assets’ ability to generate future cash flows.

Note: In conducting due diligence, direct investors often supplement their

due diligence with analysis prepared by external consultants.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.b] Describe characteristics of direct investment, co-
investment, and fund investment methods for
alternative investments

1 Investment Methods

1.2. Due diligence for fund investing, direct investing, and co-investing

1.2.3. Due diligence for Co-investing

Given that direct investing is an element of co-investing, aspects of the due

diligence process apply to both. In co-investing, investors often rely heavily
on the due diligence conducted by the fund manager.

Compared to direct investing

Co-investing opportunities are

usually provided by the private
equity, real estate, or
infrastructure fund manager. Direct investing due diligence
may be more independent than
Direct investing opportunities are co-investing due diligence.
usually sourced by the direct
investment team at a large
pension or sovereign wealth fund.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] Describe investment and compensation structures
commonly used in alternative investments

1 Partnership structures

General partner Fund manager who runs the business and theoretically
(GP) bears unlimited liability for anything that goes wrong.

Outside investors who own a fractional interest in the

limited partners partnership based on the amount of their initial
(LPs) investment and the terms set out in the partnership
documentation.

Fund Manager/ Investors/

General Partner (GP) Limited Partners (LPs)
$50 m

$70 m
$70 m
$10 m

$200 million Alternative

investments Fund
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] Describe investment and compensation structures
commonly used in alternative investments

1 Partnership Structures

The partnership between the GP and LPs is governed by a limited

partnership agreement (LPA), a legal documents that:
• Outlines the rules of the partnership.
• Establishes the framework that ultimately guides the fund’s operations
throughout its life.

Note: In addition to LPAs, side letters may also be negotiated. Side letters
are side agreements created between the GP and a certain number of LPs
that exist outside the LPA.

Example of side letters:

• Potential additional reporting due to an LP’s unique circumstances, such
as regulatory or tax requirements.
• Notice requirements in the event of litigation, insolvency, and related
matters
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

1 Partnership Structures

Certain structures are commonly adopted for specific alternative

investments. For example:

Investment

Real estate • In real estate fund investing, investors may be classified as

unitholders.
• In real estate direct investing, investors usually enter into
joint venture partnerships.

Infrastructure • investors frequently enter into public–private

partnerships.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

2 Compensation Structures

Funds are generally structured with a management fee typically ranging

from 1% to 2% of:

assets under management committed capital

(e.g., for hedge funds) (e.g., for private equity funds)

The money that an investor has

Typically the net asset value of the
agreed to contribute to an
fund’s investments.
investment fund.

On top of the management fee, a performance fee (also referred to as an

incentive fee or carried interest) is applied based on excess returns.

Note: Having committed capital as the basis for management fee

calculations reduces the incentive for GPs to deploy the committed capital as
quickly as possible to grow their fee base.
 30

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

2 Compensation Structures

The hurdle rate is a minimum rate of return, that the GP must exceed in
order to earn the performance fee.

Hard hurdle rate Soft hurdle rate

Incentive fees are a percentage of

Incentive fees are based only on
the total increase in the value of
gains above the hurdle rate.
each partner’s investment.

Example:
Consider a fund with a hurdle rate of 8% that has produced returns of 12%.
We will use an incentive fee structure of 20% of gains.
• If the 8% is a soft hurdle rate, the incentive fee will be 20% of the entire
gains of 12%, or 2.4%.
• If the 8% is a hard hurdle rate, the incentive fee will be 20% of the gains
above the hurdle rate (12% – 8% = 4%), which would be 0.8%. 30
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

A catch-up clause in a partnership agreement is based on a hurdle rate and

is similar in its effect to a soft hurdle rate.

Illustration for catch-up clause

For a GP who earns a 20% performance fee, a catch-up clause allows the
GP:
• Receive 100% of the distributions above the hurdle rate until he
receives 20% of the profits generated.
• Every excess dollar is split 80/20 between the LPs and GP
Assume that the GP has earned an 18% IRR on an investment, the hurdle
rate is 8%,.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

The partnership agreement includes a catch-up clause

The LPs would receive the entirety of the first 8% profit, the GP would
receive the entirety of the next 2% = 20% x (18% - 8%) profit.
As the catch-up clause stipulates—and the remaining 8% would be split
80/20 between the LPs and the GP.
At this point, the GP’s profit increases by: 8% x 20% = 1.6%
The LP’s profit increases by: 8%x 80% = 6.4%
Total profit to the GP is: 2% + 1.6% =3.6% (or we can also calculate as 18% x
20% = 3.6%)

In the absence of a catch-up clause

The LPs would still receive the entirety of the first 8% profit; however, the
remaining 10% would be split 80/20 between the LPs and GP. The GP earn:
10% x 20% = 2%
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

GP profits with a catch-up clause

1.6%
6.4% GP earns
2% 3.6%
(18% x 20%)
8%

Entirely Entirely Remaining 8% is

for LP’s for GP’s split 80/20
 34

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

GP profits without a catch-up clause

GP earns
2%
2%
8%
(18% - 8%)
8% x 20%

Entirely Entirely Remaining 8% is

for LP’s for GP’s split 80/20
 35

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

In hedge funds, fee calculations also take into account a high-water mark,
which reflects the highest value used to calculate an incentive fee.
• A high-water mark is the highest value of the fund investment ever
achieved at a performance fee crystallization date, net of fees, by the
individual LP.

High-water mark clause: Incentive fees are only paid to the extent that the
current value of an investor’s account is above the highest net-of-fees value
previously recorded (at the end of a payment period).

Protects clients from paying twice for the same performance.

 36

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.c] describe investment and compensation structures
commonly used in alternative investments

3 Common Investment clauses, provisions, and contingencies

A waterfall represents the distribution method that defines the order in

which allocations are made to LPs and GPs.

deal-by-deal whole-of-fund
(or American) waterfalls (or European) waterfalls

Performance fees are collected on All distributions go to the LPs as

a per-deal basis, allowing the GP deals are exited and the GP does
to get paid before LPs receive both not participate in any profits until
their initial investment and their the LPs receive their initial
preferred rate of return on the investment and the hurdle rate
entire fund. has been met.

more advantageous to the GP more advantageous to the LPs

A clawback provision stipulates that if the GP accrues or receives incentive

payments on gains that are subsequently reversed as the partnership exits
deals, the LPs can recover previous (excess) incentive payments.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

1 Overview of hedge fund

1.1. Characteristic of Hedge fund

Portfolio of investments involved in one or more asset

classes that is often leveraged, generally takes both long
and short positions and quite often uses derivatives to
express a view or establish a hedge.

Goal is to generate high returns, either in an absolute

Charateristics sense or on a risk adjusted basis relative to its portfolio-
level volatility.

Set up as a private investment partnership or offshore

fund that under certain legal restrictions make the offering
open to a limited number of investors willing and able to
make a substantive initial investment.
 38

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

1 Overview of hedge fund

1.1. Characteristic of Hedge fund

Hedge funds typically have restrictions on limited partner redemptions.

The time after initial investment over which limited

lockup period partners either cannot request redemptions or incur
significant fees for redemptions.

The amount of time a fund has to fulfill a redemption

notice period
request made after the lockup period has passed.

Allow hedge fund managers:

• more flexibility in portfolio construction.
• giving them leeway to invest in situations in which time may be needed to
generate an suitable expected return for them.
 39

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

1 Overview of hedge fund

1.1. Characteristic of Hedge fund

A fund of hedge funds (fund-of-funds) is an investment company that hold

a portfolio of hedge funds.

Diversification among hedge fund strategies

Fund-of-funds
Provide expertise in selecting individual hedge funds
offer

Provide smaller investors with access to hedge funds

Fund-of-funds managers charge an additional layer of fees beyond the fees

charged by the individual hedge funds in the portfolio.

Note: fees to the fund-of-funds manager are on top of fees charged by the
individual funds, therefore they can significantly reduce investor net return.
 40

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

2 Form of investment/ Hedge Fund Strategies

2.1. Equity hedge fund strategies

Equity hedge fund strategies seek to profit from long or short positions in
publicly traded equities and derivatives with equities as their underlying assets.

Select undervalued equities to be held long and to select

Market neutral overvalued equities to be sold short on technical or
fundamental analysis. (Leverage may be used)
Fundamental Buy equities of companies that are expected to sustain high
long/short rates of capital appreciation, and short equities of companies
growth expected to have low or no revenue growth.
Buy equity shares that are believed to be undervalued based
Fundamental
on fundamental analysis and sometimes short an index or
value
companies believed to be overvalued.
Identify opportunities and invest within a sector, such as
Sector specific health care, biotech, technology, and financial services based
on manager expertise within that sector.
Take predominantly short positions in overvalued equities,
Short bias possibly with smaller long positions but with negative market
exposure overall.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

2 Form Of Investment/ Hedge Fund Strategies

2.2. Event-driven strategies

Event-driven strategies are typically based on a corporate restructuring or

acquisition that creates profit opportunities for long or short positions in
equity or debt of a specific corporation. (typically long-biased)

Merger Buy the shares of a firm being acquired and sell short the
arbitrage firm making the acquisition.

Buy the (undervalued) securities of firms in financial

Distressed/ distress when analysis that value will increase by a
restructuring successful restructuring, possibly short overvalued
securities at the same time.

Activist Buy sufficient equity shares to influence a company’s

shareholder policies, with the goal of increasing company value
Invest in the securities of firms that are issuing or
Special
repurchasing securities, spinning off divisions, selling
situations 41
assets or distributing capital.
 42

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

2 Form Of Investment/ Hedge Fund Strategies

2.3. Relative value strategies

Relative value strategies involve buying a security and selling short a related
security, with the goal of profiting when a perceived pricing discrepancy
between the two is resolved.

Convertible Exploit pricing discrepancies between convertible bonds and

arbitrage fixed the common stock of the issuing companies and options on
income the common shares.

Asset-backed Exploit pricing discrepancies among various mortgage-backed

fixed income securities (MBS) or asset-backed securities (ABS).

General fixed Exploit pricing discrepancies between fixed-income securities

income of various and types

Exploit pricing discrepancies arising from differences between

Volatility returns volatility implied by options prices and manager
expectations of future volatility.
Exploit pricing discrepancies among securities in asset classes
Multistrategy different from those previously listed and across asset classes
and markets.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

2 Form Of Investment/ Hedge Fund Strategies

2.4. Macro and CTA Strategies

Macro strategies are based on global economic trends and events and may
involve long or short positions in equities, fixed income, currencies, or
commodities.

• These strategies take a top-down view as they focus on the overall

macroeconomic environment.
• It involves taking long and short positions in broad markets that are
expected to benefit based on the manager’s view regarding overall market
direction.
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READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.d] Hedge Funds

3 Diversification benefit

Studies that have analyzed data over long periods of time suggest that there
is a less than perfect positive correlation between hedge fund returns and
equity returns.

This gives rise to diversification opportunities, which strengthen the case

for investment in hedge funds.

Note: The correlation between hedge fund returns and stock market
performance tends to increase in times of financial crisis.
 45

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital

1. Overview of private capital

Private capital refers to fundings provided to companies without issuing

securities to the public nor raising funds from traditional institutional
providers, such as a government or bank.

In the form of an equity In the form of a loan or other

investment form of debt

Private equity Private debt

The private capital space largely consists of private investment funds and
entities that invest in the equity or debt securities of companies, real
estate, or other assets that are privately held.
 46

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

• Private equity refers to investment in privately owned companies or

in public companies with the intent to take them private.
• The company the private equity fund invests in is often called a
portfolio company because it will become part of a private equity
fund portfolio.

Types of financing at each growth stage of company

Company maturity

Start-up business More established Mature Business

business
Venture capital Growth capital Leverage
(2.1.2) (2.1.3) buyouts (2.1.1)
 47

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.1. Leveraged Buyouts

Debt Public traded

LBO funds

Private establish (significant acquire companies

equity fund percentage) (target
companies)

Equity

Going-private (*)

(*) LBOs are sometimes referred to as “going-private” transactions

because after the acquisition of a publicly traded company, the target
company’s equity is substantially no longer publicly traded.
 48

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.1. Leveraged Buyouts

Two types of LBO

Management buyouts (MBOs) Management buy-ins (MBIs)

the current management team is
the current management team is being replaced and the acquiring
involved in the acquisition team will be involved in managing
the company.

LBO strategies

Improve acquired company operations: new management, management

incentives, restructuring, cost reduction, or revenue enhancement

Increase profits and cash flows

Service the debt taken on acquisition and then take profits

 49

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.2. Venture capital

• Venture capital funds invest in companies in the early stages of their

development.
• The investment often is in the form of equity but can be in convertible
preferred shares or convertible debt.

Venture capital can be provided at a variety of stages, ranging from the

inception of an idea for a company to the point when the company is about
to launch an IPO (initial public offering) or be acquired.

+ Risks/ required rate of return

a. Formative- b. Later-stage c. Mezzanine-

stage financing financing stage financing

a.1. Angel a.2. Seed-stage a.3. Early-

investing financing stage financing
 50

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.2. Venture capital (VC)

a. Formative-stage financing

Refers to investments made for a company that is still in the process of being
formed. Its steps are as follows:

a.1. Angel investing/Pre-seed capital

• Refers to investments made at the idea stage → transform the idea into a
business plan and to assess market potential
• The amount of financing at this stage is typically small and provided by
individuals (“angel”) rather than by VC funds.

a.2. Seed-stage financing/seed capital

Refers to investments made for product development, marketing, and market

research. This is the first stage at which VC funds usually invest.

a.3.Early-stage financing/start-up stage financing

Refers to investments made to fund initial commercial production and sales.

 51

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.2. Venture capital

b. Later-stage financing

• Refers to investments provided after commercial production and sales

have begun but before an IPO takes place.
• Funds may be used to support initial growth, a major expansion (such
as a physical plant upgrade), product improvements, or a major
marketing campaign

c. Mezzanine-stage financing

• Refers to investments provided to prepare the firm for an IPO.

• The term “mezzanine-stage financing” is used because this financing is
provided at the stage between being a private company and being a
public company → focus is on the timing of the financing rather than
the financing mechanism itself.
 52

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.2. Venture capital

Venture capital strategies

A venture capitalist needs to be convinced that the portfolio company’s

management team is competent and is armed with a solid business plan
and strong prospects for growth.

Decide to invest after estimating company valuations on the basis of

future prospects

Venture capital fund managers are actively involved in the development

of portfolio companies, often sitting on their boards or filling key
management roles.

Earn very high profits if the business is successful, however, the risk of
start-up companies is also great.
 53

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.3. Other Private Equity Strategies – Growth capital

• Growth capital/ Developmental capital/ minority equity investing

refers to the provision of capital for business growth or restructuring
in mature companies – which may be public or private.
• In the case of public companies, such financing is called private
investments in public equities (PIPEs)

Growth capital is usually initiated and sought by the management of the

investee company
→ realize earnings from selling a portion of its shares before the
company can go public but still seeks to retain control and participation
in the success of the company.
 54

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.1. Private equity

2.1.4. Exit strategies

Private equity firms seek to improve new or underperforming businesses and

then exit them at higher valuations, buying and holding companies for an
average of five years.

Trade sale Sell a portfolio company to a competitor or another strategic

buyer.

IPO Sell all or some shares of a portfolio company to the public.

Recapitalization The company issues debt to fund a dividend distribution to

equity holders (the fund). This is not an exit, in that the fund
still controls the company, but is often a step toward an exit.

Secondary sale Sell a portfolio company to another private equity

Write- A write-off occurs when a transaction has not gone well: The
off/liquidation private equity firm revises the value of its investment
downward or liquidates the portfolio company before
moving on to other projects.
 55

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

Private debt primarily refers to the various forms of debt provided by

investors to private entities.

Types of private debt

Direct lending (2.2.1)

Mezzanine loans (2.2.2)

Venture debt (2.2.3)

Distressed debt (2.2.4)

Other private debt strategies (2.2.5)

 56

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

2.2.1. Direct lending

• Loans made directly to a private company without an intermediary.

• As with typical bank loans, payments are usually received on a fixed
schedule, and the loan itself typically is senior and secured and has
covenants in place to protect the lender/investor.

Raised from
internal Borrowers
source (lack favorable
Private debt
Fund

establish lend alternatives to

fund
Borrowed traditional
from another bank lenders)
source

A leveraged loan - magnify fund returns on its loan portfolio

 57

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

2.2.2. Mezzanine loans

Refer to private debt that is subordinated—that is, has a lower priority of

claims than the borrower’s existing (more senior) debt
→ riskier than senior secured debt
→ demand higher interest rates and may require additional features for
equity participation such as warrants or conversion rights.

2.2.3. Venture debt

Refers to private debt financing provided to venture firms (start-up or

early stage firms that are not yet profitable).
→ High risk of default because start-up and early-stage companies often
lack substantial assets that can be pledged as collateral for the debt.
→ require higher interest rates and may carry additional features such
as granting the lender rights to purchase equity in the borrowing
company under certain circumstances.
 58

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

2.2.4. Distressed debt

Refer to private debt to purchasing the debt of mature companies with

financial difficulty: in bankruptcy, in default on existing loans, or seem
likely to default on debt.

Turnaround investors buy debt and plan to be more active in the

management and direction of the distressed companies
→ help them restructure and revive

Investors buy the company’s debt in expectation of both the company

and its debt increasing in value.
 59

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

2.2.5. Other Private Debt Strategies

Collateralized Refer to private debt investing in leveraged structured

loan vehicles that are collateralized by a portfolio of loans
obligations covering a diverse range of tranches, issuers, and
(CLOs) industries (similar to ABS with credit tranching in reading
42)

Unitranche Refer to private debt investing in a hybrid or blended

debt loan structure that combines different tranches of
secured and unsecured debt into a single loan with:
• A single, blended interest rate - fall in between the
interest rates often demanded on secured and
unsecured debt.
• Priority ranking is between senior and subordinated
debt ranking.
 60

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
2. Forms of investment

2.2. Private debt

2.2.5. Other Private Debt Strategies

Real estate Refers to private debt provided for real estate financing,
debt where a specified real estate asset or property serves as
collateral.

Infrastructure Refer to many forms of debt used to finance the

debt construction, operation, and maintenance of
infrastructure assets.

Specialty loans Refer to private debt provided for niche borrowers in

specific situations.
For example: litigation finance is the practice of a
specialist funding company providing debt to clients,
usually plaintiffs in litigation, for their legal fees and
expenses in exchange for a portion of any case winnings.
 61

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
3. Risks and returns of private capital

Private equity Private debt

Higher risk than investing in Higher risk than investing in

common stocks: illiquidity and traditional bonds: illiquidity and
leverage risks. heightened default risk.
Risk
→ vary in risk with senior
private debt carrying moderate
risk and mezzanine private debt
carrying higher risk.

Higher return opportunities Higher-yielding opportunities

relative to traditional relative to traditional bonds by
investments depending on the taking opportunistic positions
Return
ability of the fund manager to based on market inefficiencies
both select and manage fund → vary in return due to risk
investments. variation.
 62

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
3. Risks and returns of private capital

Private capital risk and return levels by category

Return

Private Equity
Co-Investments

Debt Mezzanine

Unitranche debt

Senior Direct debt

Senior Real Estate debt

Infrastructure debt

Risk
 63

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.e] Explain investment characteristics of private
capital
4. Diversification benefits of investing in Private Capital

Private capital encompasses a variety of securities, from start-up equity

to the senior debt of a mature company.
→ the range of risks across the spectrum of private capital funds is very
large
→ diversification benefit given the additional leverage, market, and
liquidity risks.

Private equity Private debt

Capital is not deployed at a Offer more options and features

single point in time but invested than bonds and public forms of
over several years. traditional fixed income

Avoid concentration risk

Diversify across different managers,

industries, and geographies
 64

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources

1. Overview of natural resources

Natural resources is a unique asset category comprising commodities

(2.1) and raw land used for farming and timber (2.2).

Commodities are considered either:

• “hard”: those that are mined, such as copper, or extracted, such as
oil.
• “soft”: those that are grown over a period of time, such as
livestock, grains, and cash crops, such as coffee.

• Timberland investment involves ownership of raw land and the

harvesting of its trees for lumber → generate an income stream and
the potential for capital gain.
• Farmland investment is a more recent phenomenon, with only a
few dedicated funds involved.

Become more attractive investments for investors due to:

• Population growth, more topical weather, and water management (for
timber and farmland)
• A wide variety of direct investments via ETFs, limited partnerships,
REITS, swaps, and futures.
 65

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

• Commodities are physical products that can be standardized on

quality, location, and delivery for the purpose of directly investing.
• Returns on commodity investments are primarily based on changes in
price rather than on income stream.

Incur transportation and storage costs if holding physical commodities

Only a smaller group of entities that are part of the physical supply chain
can join trading physical commodities.

Most commodity investors trade commodity derivatives (2.1.1) that

have a single commodity or an index of commodities as the underlying.
 66

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

2.1.1. Instruments of commodity investments

Derivatives as the majority of commodity investing

Futures, forwards, options, and swaps are all available forms of commodity
derivatives, which are traded on exchanges or over the counter (OTC).
• Futures and forwards are contractual obligations to buy or sell a
commodity at a specified price and time.
• Options convey the right, but not the obligation, to buy or sell a
commodity at aspecified price and time.
(details about future, forward, option and swap are explained in Reading 46 -
Derivatives)

Other methods of exposure to commodities

Exchange-traded ETFs may invest in commodities or commodity futures and

funds (commodity can track prices or indices.
ETFs) → Suitable for investors who are restricted to equity
shares.
 67

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

2.1.1. Instruments of commodity investments

Other methods of exposure to commodities

Managed Modern CTAs often invest in a variety of futures, including

futures funds commodities, equities, fixed income, and foreign exchange while
(CTAs) others concentrate on a specific commodity, such as grains or
livestock.
Structure of CTAs:
• Be structured as limited partnerships with fees like those of
hedge funds and restrictions on the number, net worth, and
liquidity of the investors.
• Or be structured like mutual funds with shares that are publicly
traded so that retail investors can also benefit from professional
management.

Specialized Funds that specialize in specific commodity sectors exist.

funds Be organized under any of the structures we have discussed and
focus on certain commodities, such as oil and gas, grains, precious
metals, or industrial metals.
 68

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

2.1.2. Commodity prices and valuation

a. Commodity prices

The prices of commodity derivatives are a function of the underlying

commodity prices → it is important to understand the physical supply chain
and general supply–demand dynamics of the commodity prices.

Spot prices for commodities are a function of supply and demand.

• Economic cycles
The purchases Demand • The value of the
and sales of commodity to end-users
nonhedging
investors • Storage costs and existing
(speculators) inventories
Supply
• Other factors as weather,
costs of extracting oil,…
 69

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

2.1.2. Commodity prices and valuation

b. Commodity valuation

In order to be transparent, investable, and replicable, commodity

indexes typically use the price of the futures contracts rather than the
prices of the underlying commodities.

Future price ≈ spot price × (1 + risk-free rate) + storage costs (*) −

convenience yield (**)
where convenience yield is the value of having the physical commodity
for use over the period of the futures contract.

(*) Futures contract for commodity to be delivered at a specified date in

the future can avoids storage costs future price is adjusted up for the
storage costs.
(**) However, the buyer of the futures contract has no immediate access
to the commodity → cannot benefit from it → the futures price is
adjusted for the loss of convenience, a value that varies.
 70

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.1. Commodity

2.1.2. Commodity prices and valuation

b. Commodity valuation

Futures prices > spot prices Futures prices < spot prices
(No/Low convenience yield) (High convenience yield)

commodity forward curve is commodity forward curve is

upward sloping downward sloping

Contango Backwardation
 71

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.2. Timberland and farmland

In this section, we are discussing land owned or leased for the benefit of
the returns it generates from crops and timber.

• Timberland returns drivers are biological growth, changes in

spot prices and futures prices of lumber (cut wood), and
changes in the price of the underlying land.
• Timber (trees) can be grown and easily stored by simply not
harvesting them → the flexibility production when timber
prices are up and delaying harvests when prices are down.

• Farmland returns are based on land price changes, changes in

farm commodity prices, and the quality and quantity of the
crops produced.
• Unlike timberland, farm products must be harvested when ripe,
so there is little flexibility in production.

An ESG focus on climate change will attract investors because timberland

and farmland may consume carbon.
 72

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
2. Forms of investment

2.2. Timberland and farmland

Instruments of timberland and farmland investments

Direct investments in timberland and farmland

Limitations of direct investments:

• Limited price transparency or information to guide investment
decisions without the assistance of sector specialists.
• The illiquidity of direct farm and timberland investments is also
limiting.

Use some investment vehicles instead of directly investing :

• Real estate investment trusts (REITs) in the United States (refer to LOS
47.g)
• Or administered privately through limited partnerships.
 73

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
3. Risks and returns of natural resources

Commodity (*) Timberland/Farmland

Higher risk than investing in High risk: low liquidity, high

common stocks or bonds: fixed costs of production,
Risk
mismatch of supply and variable cash flows that depend
demand → price volatility on weather, and potential
losses from natural disasters.

Lower returns than returns on Historically, farmland had

global stocks or bonds: earn higher return than timberland,
returns over short periods however, it can not be
when expectations of prices concluded that farmland is
movements are correct more attractive due to risk
Return • Commodity prices tend to potential.
move with inflation rates
→ holding commodity as
hedging of inflation risk
→ the real return over time
would be 0

(*) From studies over the periods 1990-2020

 74

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.f] Explain investment characteristics of natural
resources
4. Diversification benefits of investing in natural resources

• Historically, natural resources returns have low correlation with those

of global equities and global bonds
→ adding commodities to a traditional portfolio can provide
diversification.
• Natural resources have historically been positively correlated with
inflation
→ hedge against inflation
 75

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

1. Overview of real estate investing

Real estate investing is typically either direct or indirect ownership

(equity investing) in real estate property, such as land and buildings as
well as lending (debt investing) against real estate property.

Real estate property

Residential property—single-family homes.

Commercial property—produces income (office building)

Loans with residential or commercial property as collateral—

mortgages (“whole loans”), construction loans.
 76

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.1. Forms of real estate investments

Debt Equity

Private • Mortgages (2.1.3) • Direct investing of real estate

• Construction lending (2.1.1)
• Mezzanine debt • Indirect investing via real
estate funds (2.1.2)
• Private REITs

Public • MBS (residential and • Shares in real estate operating

commercial) and development
• Collateralized mortgage corporations
obligations (CMO) • Listed REIT shares (2.1.4)
• Mortgage REITs • Mutual funds
• ETFs that own securitized • Index funds
mortgage debt • ETFs
 77

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.1. Forms of real estate investments

2.1.1. Direct real estate investing

Direct investing involves purchasing a property and originating debt for

one’s own account → the title to the property is transferred to the
owner(s) unencumbered by any financing liens, such as from outstanding
mortgages.

2.1.2. Indirect real estate investing

Indirect investing provides access to the underlying real estate assets

through a variety of pooled investment vehicles, which can be public or
private, such as limited partnerships, mutual funds, corporate shares,
REITs, and ETFs.
 78

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.1. Forms of real estate investments

2.1.3. Mortgages

• Mortgages represent passive investments in which the lender expects

to receive a predefined stream of payments throughout the finite life
of the mortgage.
• If the borrower defaults on the loan, the lender may seek to take
possession of the property.

2.1.4. REITs

Real estate investment trusts (REITs) are the preferred investment

vehicles for owning income-producing real estate of both private and
public investors.
• Equity REITs own real estate equity
• Mortgage REITs own real estate mortgages and MBS
• Hybrid REITs own both
 79

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.1. Forms of real estate investments

2.1.5. Private Fund Investing Styles

Capital committed to or invested by:

Real estate Structured as infinite-life open-end funds - allow investors to

private contribute or redeem capital throughout the life of the fund
equity funds (like mutual funds)
• Offer exposure to core real estate (well-leased, high-quality
institutional real estate in the best markets)
→ deliver stable returns - real estate beta, primarily from
income as well as returns through better market selection,
property management, and execution.

Core-plus Offer exposure to non-core markets and sectors or

strategies properties with slightly more leasing risk:
• Large sectors with different risk profiles (hotels and
nursing homes)
• Assets in secondary and tertiary markets (student
housing, self-storage, and data centers)
→ Deliver slightly higher risks → require higher returns
 80

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.1. Forms of real estate investments

2.1.5. Private Fund Investing Styles

Capital committed to or invested by:

Finite-life • Value-add investments may require modest

closed-end redevelopment or upgrades, the leasing of vacant space,
funds or repositioning the underlying properties to earn a
higher return than core properties.
• Opportunistic investing accepts the much higher risks of
development, major redevelopment, repurposing of
assets, taking on large vacancies, and speculating on
significant improvement in market conditions.
 81

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.2. Real estate investments categories

2.2.1. Residential property

Refer to direct investment in real estate with the intent to occupy it (a

home is purchased).

Buy 100% cash up front

or Residential
Buyers
Borrow funds Buy property
Mortgage

sold and pooled

RMBS

Owner’s equity = value of property – outstanding loan amount

→ Any appreciation (depreciation) in the value of the home increases
(decreases) the owner’s equity in the home and is magnified by mortgage
leverage.
 82

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.2. Real estate investments categories

2.2.2. Commercial real estate

• Refer to direct investment in real estate generating income from rents

for institutional funds or wealth individuals with long time horizons and
limited liquidity needs.
• Homes purchased for rental income are considered investments in
commercial property.

Investors can invest in commercial property by direct equity investing or

direct debt financing.

Direct equity investing: the success of equity investment depends on

how well the property is managed, general economic and specific real
estate market conditions, and the extent and terms of any debt financing.

Direct debt financing: the investors need to conduct financial analysis to

determine the borrower’s creditworthiness → ensure the property can
generate sufficient cash flow to service the debt, to estimate the
property’s value, and to evaluate economic conditions.
 83

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.2. Real estate investments categories

2.2.3. REIT investing

• Refer to indirect investment in real estate by investing in publicly

traded shares of Real estate investment trusts (REIT).
• The risk and return characteristics of REITs depend on the type of
investment they make: equity REIT, mortgage REIT or hybrid REIT.

Business trategy for REITs investing

Mortgage REITs, which invest primarily in mortgages, are similar to

fixed-income investments.

Equity REITs are similar to direct equity investments in leveraged

real estate: Maximize property occupancy rates and rents
→ maximize income and dividends.
• Typically, 90% of income must be distributed to shareholders to
avoid taxes on this income that would have to be paid by the
REIT before distribution to shareholders.
 84

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

2. Forms of investment

2.2. Real estate investments categories

2.2.4. Mortgage-Backed Securities

MBS structuring is based on the asset-backed securitization model of:

• Transforming illiquid assets (mortgages) into liquid securities
• Transferring risk from asset owners (banks, finance companies) to
investors.

The MBS issuer assigns the incoming stream of mortgage interest income
and principal payments to individual security tranches, which will be sold
to investors.
• Each tranche is assigned a priority distribution ranking.

Details about MBS are referred to Reading 42: Asset backed securities
 85

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

3. Risks and returns of real estate

Real estate

Measured by three different types of index:

• An appraisal index, such as those prepared by the National
Council of Real Estate Investment Fiduciaries (NCREIF), is
based on periodic estimates of property values. Appraisal
index returns are smoother than those based on actual sales
and have the lowest standard deviation of returns of the
Return various index methods.
• A repeat sales index is based on price changes for properties
that have sold multiple times → suffer from a sample
selection bias because the properties that sell in each period
vary and may not be representative of the larger market.
• REIT indices are based on the actual trading prices of REIT
shares, similar to equity indices.
 86

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

3. Risks and returns of real estate

Real estate

Property values fluctuate due to:

o Global and national economic factors, local market
conditions, and interest rate levels.
o Variation in the abilities of managers to select and manage
properties and changes in regulations.
Risk o The degree of leverage used in a real estate investment
• Distressed-property investing has greater risk.
• Property development is subject to special risks: regulatory
issues, construction delays, and cost overruns.
• Financing risk: The possible inability to get long-term financing
at the appropriate time for properties initially developed with
short-term financing.
 87

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.g] Explain investment characteristics of real estate

4. Diversification benefits of investing in real estate

Historically, REIT index returns and global equity returns have had a
relatively strong correlation (on the order of 0.6) because business cycles
affect REITs and global equities similarly while the correlation between
global bond returns and REIT returns has been very low
→ diversification benefits can result from adding real estate in an
investor’s portfolio.

However, the method of index construction (e.g., appraisal or repeat

sales indices) may be a factor in the low reported correlations → actual
diversification benefits may be less than expected.
 88

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

1. Overview of infrastructure

The assets underlying infrastructure investments are real, capital-intensive,

long-lived assets. They are intended for public use and provide essential
services (i.e., airports, health care facilities, and power plants). Typically,
infrastructure assets are financed, owned, and operated by governments.

1.1. Characteristics

Highly-leveraged financial structure

investment characteristics

Strategically important
Typical infrastructure

Monopolistic and regulated

Stable long-term cash flows

Significant capital investment

Long operational lives

Defined risks
 89

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

1. Overview of infrastructure

1.2. Intention of investors when invest in infrastructure

The private sector is increasingly becoming more involved in infrastructure

investments with an intention to:

Sell newly
Lease the assets back Hold and operate the
constructed assets to
to the government. assets.
the government.

Investors are tempted to hold and operate infrastructure assets when:

(1) there is relatively inelastic demand for the assets and services.
(2) the high costs of the assets create high barriers to entry.
 90

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.1. Instruments of infrastructure investments

Economic infrastructure assets

Based on the underlying
Categories of instruments

assets (2.1.1)
Social infrastructure assets

Based on stage of Greenfield investment

development of the
underlying assets (2.1.2) Brownfield investment

Location of the underlying assets (2.1.3)

 91

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.1. Instruments of infrastructure investments

2.1.1. Based on the underlying assets

Economic infrastructure assets Social infrastructure assets

Economic infrastructure assets Social infrastructure assets are

support economic activity. directed toward human activities.

Including: Including:
Transportation assets, information Educational, health care, social
and communication technology housing, and correctional
(ICT) assets and utility and energy facilities.
assets
 92

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.1. Instruments of infrastructure investments

2.1.2. Based on underlying asset’s stage of development

Greenfield investment Brownfield investment

Investing in infrastructure assets Investing in existing infrastructure

that are to be constructed. assets.

This investment subject to more This investment provides stable

uncertainty and may provide cash flows and relatively high
relatively lower yields but offers yields but offers little potential for
greater growth potential. growth.

2.1.3. Based on location of the underlying asset

Infrastructure investments are available globally, and the geographic

location of the underlying assets will inform the political and
macroeconomic risks, particularly in light of the government’s relationship
to the assets.
 93

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.2. . Investment strategies

Infrastructure investments take two main forms of investments

Direct investments Indirect investments

Direct investments in the Indirect investments in the

underlying assets provide control underlying assets are through
and the opportunity to capture full infrastructure funds, infrastructure
value. ETFs, and company shares.
(More detail in next slide)

Investors bear the responsibility of Funds bear the responsibility of

managing and operating the managing, diversifying and
assets, resulting in concentration operating the assets, resulting in
and liquidity risks. reduction of concentration and
liquidity risks.
 94

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.2. . Investment strategies

Infrastructure investments take two main forms of investments

Indirect investments

Investors who concerned about liquidity and diversification may choose (1)
publicly traded infrastructure securities or (2) master limited partnerships.

(1) Publicly traded infrastructure securities

Publicly traded infrastructure securities provide the benefits not only of

liquidity but also of reasonable fees, transparent governance, market prices,
and the ability to diversify among underlying assets.

Note:
These securities represent a small segment of the infrastructure investment
universe and tend to be relatively concentrated in categories of assets.
 95

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

2. Forms of investment

2.2. . Investment strategies

Infrastructure investments take two main forms of investments

Indirect investments

(2) Master limited partnerships (MLPs)

Similar to real estate investment trusts (REITs), master limited partnerships

(MLPs) trade on exchanges and are pass-through entities.
• Regulations regarding MLPs tend to vary across countries.
• Most of the free cash flow is passed on to investors. However, investors
are liable for taxes on that income.
• Typically, a general partner manages the partnership, receives a fee, and
holds a small partnership interest. Limited partners own the remaining
partnership interest.
 96

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

3. Risk and return

Typical infrastructure investment risk-return profile

Early-stage Mid-stage Late-stage

investments investments investments

Investment in Investment in Investment in

greenfield projects. existing projects existing projects
(which have been (which have been
commissioned and operational for a
commenced). number of years).

Higher-risk profile, Delivering prospects Lower-risk profile but

but typically deliver for return through lower prospects for
higher prospects for capital gain & yield return through
return through (lower level than capital gain and yield.
capital gain and yield. early stage
investments).
+ Risk

Return
 97

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

3. Risk and return

Typical infrastructure risk management

Types of risks Offsetting mechanism

Demand/volume risk Take-or-pay arrangement

Performance
risks

Operational risk Incentivized maintenance contract

Construction risk Fixed-price date-certain contract

Financing/interest rate risk Interest rate swaps

Structural risks

Regulatory risk Provisions or due diligence

Political risk Insurance against debt default

Currency risk
Public-private partnerships
agreement
Tax/profit repatriation risks
 98

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.h] Explain investment characteristics of infrastructure

4. Diversification benefits

In terms of individual investors

Investing in infrastructure may enable them to:

Add a steady income

Further diversify their Gain some inflation
stream to their
portfolios. protection.
portfolios.

Infrastructure assets
exhibit low
correlation with
other investments.

In terms of institutional investors

Because these investments are placed in long-lived assets, infrastructure

may better match the longer-term liability structure of certain institutional
investors, such as pension funds, superannuation schemes, and life
insurance companies.
 99

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

1. Overview of performance appraisal for alternative investments

Alternative investments are typically exposed to some risks that unleveraged

long-only traditional investments are not, which are:
• Lack of transparency.
• Illiquidity, including restrictions on and performance impact of
redemptions.
• Complexity of positions and strategies employed.
• Use of derivatives.
• Use of securities that are marked to market.
• Use of leverage.
• Variety of manager strategies and areas of expertise.
• Cash drag from significant drawdown periods (e.g., with private equity).
 100

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

2. Common approaches to evaluate and application challenges

There are three common instruments to evaluate an alternative investment:

Sharpe ratio Sortino ratio Treynor ratio

Sharpe ratio measures Sortino ratio is quite Treynor ratio measures

excess return per unit similar to Sharpe ratio: excess return per unit
of total risk: Rp − Rf of systematic risk:
Rp − Rf Sortino ratio = Rp − Rf
σp
Sharpe ratio = Treynor ratio =
σp Where σp is downside βp
Where σp is SD of total deviation. Where βp is systematic
risk. risk.

Their limitation is that they not take into account Its limitation is that it
the diversification benefits from low correlations is based on historical
with returns to traditional investments. beta data.

A higher Sharpe, Sortino, or Treynor ratio indicates greater excess returns

per unit of risk taken.
 101

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

2. Common approaches to evaluate and application challenges

In addition to three common measures above, there are some other risk-
adjusted return measures:

Calmar ratio MAR ratio

The Calmar ratio is a comparison of The MAR ratio uses a full

the average annual compounded investment history and the average
return to a maximum drawdown drawdown.
risk (MDD), which is the maximum
observed loss from a peak to a
trough of a portfolio, before a new
peak is attained.

The higher (lower) the ratio, the better (worse) an alternative asset
performed on a risk-adjusted basis over a specified period of time.
 102

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

3. Performance evaluation for Private equity and Real estate

Both private capital and real estate investments are often characterized by
inflows, as well as outflows over an investment’s life, and by cash returned
to investors at various times over an investment’s life.

There are two common measure of investment success:

Multiple of invested
IRR
capital (money multiple)
It measures the total
It is the discount rate that
value of all distributions
equates the sum of the
and residual asset values
present values of all
Definition (assets that may still be
after-tax cash flows for a
awaiting their ultimate
project (inflows and
sale) relative to an initial
outflows) to zero.
total investment.
Reflects the timing of
Advantage Simple
cash flows
Completely ignores the
Disadvantage Complex
timing of cash flows.
 103

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

3. Performance evaluation for Private equity and Real estate

• For funds investing in private equity or real estate where initial committed
capital is drawn down over time as individual investments are made, if
returns are calculated on committed capital, there is a fee drag on
calculated returns.
• Typically, investments are made over a significant period of time and
returns are staggered over subsequent periods. This results in a pattern of
quite low returns on investment early in the fund’s life with relatively
higher returns over the final years.
• In real estate funds, significant investments in property improvements
after acquisition may amplify this pattern of returns on investment.
 104

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

4. Performance evaluation for Hedge funds

4.1. Illiquidity

In case of evaluate performance shares of retiring firm founder in order to

establish the long exposure or securities that are particularly illiquid or that
trade infrequently.

Special valuations are used for calculating performance in these situations:

Bid prices for long positions and

ask prices for short positions at
An average of the bid and the ask
which the prices of the positions
are closed

Hedge funds are generally valued by the manager internally, and these
valuations are confirmed by an outside administrator on a daily or perhaps
weekly basis; performance is reported to investors by the administrator on
a monthly or quarterly basis.
 105

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.i] Describe issues in performance appraisal of
alternative investments

4. Performance evaluation for Hedge funds

4.2. Potential redemption pressures

Redemptions may require the hedge fund manager to liquidate some

positions and potentially receive particularly disadvantageous prices when
forced to do so by redemption pressures, while also incurring transaction
costs.

To minimize the losses incurred with redemption, hedge funds use:

• Redemption fees
• Lockup periods
• Notice periods.
 106

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

Alternative asset fee structures and terms

• Calculating before-fee returns just as we calculate fees on any investment.

• Calculating after-fee returns simply requires adjustment of the cash flows
or values for the various fees involved, typically management and incentive
fees.

Some of fee structures

1. Hedge fund fees

2. Fund-of-funds

3. Waterfall structure and clawback provision

4. Negotiated fee structures

 107

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

Steps for fees calculation

Step 1: Calculate management fee

A management fee is calculated on assets under management (AUM) for

hedge fund and on committed capital for private equity funds.
For hedge fund, here are two cases of management fees calculation:
• Case 1: Management fees are calculated on assets under management at
the beginning of the year.
• Case 2: Management fees are calculated on assets under management at
the ending of the year.

Step 2: Calculate incentive fee

An incentive fee is calculated on realized profits.

There are two cases of incentive fees calculation:
• Case 1: Incentive fees are calculated on profits net of management fees.
• Case 2: Incentive fees are calculated independently of management fees.
Furthermore, there is several clauses that will affect the amount of incentive
fee, for example, hurdle rate, high watermark, clawback provisions.
 108

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

1. Hedge fund fees

Recall the Hedge fund section

Total fees Management fee Incentive fee

Incentive fee may subject to

Hurdle rate High-water mark provision

• Hard hurdle rate: means that A high-water mark refers to the
incentive fees are earned only highest value, net of fees, that the
on the return in excess of the fund has reached.
hurdle rate. → Incentive fee is only charged to
• Soft hurdle rate: means that the extent that the current value
incentive fees are earned on all is above the highest value after
profits, but only if the hurdle fee previously recorded.
rate is met.
 109

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

1. Hedge fund fees

Example:
BJI Funds is a hedge fund with a value of $110 million at initiation. BJI Funds
charges a 2% management fee based on assets under management at the
beginning of the year and a 20% incentive fee with a 5% soft hurdle rate, and
it uses a high-water mark. Incentive fees are calculated on gains net of
management fees. The year-end values before fees are as follows:
• Year 1: $100.2 million
• Year 2: $119.0 million
Calculate the total fees and the investor’s after-fee return for both years.
 110

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

1. Hedge fund fees

Remember that: In this example, management fees are calculated on assets

under management at the beginning of the year and incentive fee are
calculated on gains net of management fees.

Answer:
• Year 1:
Step 1: Calculate management fee
Management fee : 110 × 2% = $2.2 million
Step 2: Calculate incentive fee
Firstly, we need to test for hurdle rate:
Gross value end of year (given): $100.2 million
100.2 − 2.2
Return net of management fees: – 1 = –10.9% < 5% (hurdle rate).
110
Because the return after the management fee is less than the 5% hurdle rate,
there is no incentive fee.
Step 3: Calculate total fees
Total fees: $2.2 million
Step 4: Calculate after-fees return
Ending value net of fees: 100.2 – 2.2 = $98.0 million
98
→ Year 1 after-fees return: – 1 = -10.9%
110
 111

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

1. Hedge fund fees

• Year 2:
Step 1: Calculate management fee
Management fees: 98.0 × 2% = $1.96 million
Step 2: Calculate incentive fee
Firstly, we need to test for hurdle rate:
Gross value end of year (given): $119.0 million
119.0 − 1.96
Return net of management fees: – 1 = +19.4% > 5% (hurdle rate).
98
There is incentive fee existence in year 2.
Secondly, we need to test for high-water mark:
0 2

$110 $119.0 – $1.96 = $117.04 > $110

Year 2 value net of management fees, above high-water mark:
119.0 – 1.96 – 110.0 = $7.04 million
Finally, we need to test for soft hurdle rate again:
Year 2 return net of management fees, above high-water mark:
7.04
= 6.4% > 5% (soft hurdle rate)
110
Because 6.4% is greater than the soft hurdle rate, the incentive fee is calculated on
the entire gain above the high-water mark.
→ Incentive fees: 7.04 x 20% = $1.41 million
 112

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

1. Hedge fund fees

• Year 2: (cont)
Step 3: Calculate total fees
Total fees: 1.96 + 1.41 = $3.37 million
Step 4: Calculate after-fees return
Ending value net of fees: 119.0 – 3.37 = $115.63 million
115.63
→ Year 2 after-fees return: – 1 = 17.9%
98
 113

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

2. Fund-of-funds

Recall the Fund-of-funds section

There are two common fee structures for fund-of-funds:

• “1 and 10” implies a 1% management fee is charged on AUM and a 10%
incentive fee is charged on gains.
• “2 and 20” implies a 2% management fee is charged on AUM and a 20%
incentive fee is charged on gains.

Example:
An investor makes a total investment of $60 million in a fund-of-funds that
has a “1 and 10” fee structure, with management and incentive fees
calculated independently based on year-end values. $40 million of the
investment was allocated to the Alpha fund, and $20 million was allocated to
the Beta fund. One year later, the value of the Alpha fund investment is $46
million and the value of the Beta fund investment is $28 million, both net of
fund fees. Calculate the investor’s return for the year net of fees.
 114

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

2. Fund-of-funds

Remember that: In this example, management fees and incentive fees are
calculated independently based on year-end values.

Answer:
At year-end, the gross value of the investor’s investment: 46 + 28 = $74
million.
Step 1: Calculate management fee
The fund-of-funds management fee: 74 x 1% = $0.74 million.
Step 2: Calculate incentive fee
The investor’s gain for the year before fund-of-funds fees: 74 – 60 = $14
million.
The fund-of-funds incentive fee is: 14 x 10% = $1.4 million.
Step 3: Calculate total fees
Total fees: 0.74 + 1.4 = $2.14 million
Step 4: Calculate after-fees return
Ending value net of fees: 74 – 2.14 = $71.86 million.
71.86
→ Year-end after-fees return: – 1 = 19.8%.
60
 115

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

3. Waterfall structure and clawback provision

Recall the Private equity section

There are two types of waterfall structures:

American-style (deal-by-deal) European-style (whole-of-fund)

Performance fees are collected on

a per-deal basis, allowing the GP to GP does not participate in any
get paid before LPs receive both profits until the LPs receive their
their initial investment and their initial investment and the hurdle
preferred rate of return (i.e., the rate has been met.
hurdle rate) on the entire fund.
 116

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

3. Waterfall structure and clawback provision

Recall the Private equity section

A clawback provision stipulates that if the GP accrues or receives incentive

payments on gains that are subsequently reversed as the partnership exits
deals, the LPs can recover previous (excess) incentive payments.
 117

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

3. Waterfall structure and clawback provision

Example:
A private equity fund invests $100 million in a venture company that is sold
for $130 million. It also invests $100 million in an LBO that goes poorly and is
liquidated for $80 million.
1. If the carried interest incentive fee for the GP is 20% and there is no
clawback provision, what is the investor’s return after incentive fees,
assuming the investment outcomes are realized in the same year:
a. Under an American-style (deal-by-deal) waterfall structure?
b. Under a European-style (whole-of-fund) waterfall structure?
2. How would the answers be affected if the venture investment was sold in
year 1 and the LBO investment was sold in year 2?
3. How would including a clawback provision affect investor returns
calculated in question 1?
 118

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

3. Waterfall structure and clawback provision

Answer:
1. The investment outcomes are realized in the same year
a. Under an American-style (deal-by-deal) waterfall structure:
Incentive fee paid on venture investment is: (130 – 100) x 20% = $6 million.
Because there is a loss on LBO investment, no incentive fee is paid.
130 + 80 – 6
→ Investor’s after-fees return: – 1 = 2%
200
b. Under a European-style (whole-of-fund) waterfall structure:
The gain for the period is: 130 + 80 – 200 = $10 million.
Incentive fee paid on total investment is: 10 x 20% = $2 million.
130 + 80 – 2
→ Investor’s after-fees return: – 1 = 4%
200
 119

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

3. Waterfall structure and clawback provision

Answer:
2.
The European-style waterfall structure would have the same overall return as
the American-style structure, as the incentive fee for the venture investment
of $6 million would be paid in year 1 and no incentive fee would be received
on the LBO investment.
3.
With a clawback provision, after the LBO investment is sold, the incentive fee
of $6 million paid on the venture investment is more than 20% of the return
on the total investment. It is 60% of the total (net) gain of $10 million. The
investor could “claw back” $4 million of the $6 million paid as an incentive
fee on the venture investment so that the total incentive fee is reduced to
20% of the $10 million gain.
 120

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

4. Negotiated fee structures

In addition to “2 and 20” and “1 and 10” fee structures for hedge funds and fund-
of-funds, there are many variations exist:

Fees based on
liquidity terms and Founders’ shares “Either/or” fees
asset size

Hedge funds may As a way to entice Managers agree either

charge different rates early participation in to charge a 1%
depending on the start-up and emerging management fee or to
liquidity terms that an hedge funds, receive a 30%
investor is willing to managers have incentive fee above a
accept and may increasingly offered mutually agreed-on
discount the fees for incentives known as annual hurdle,
certain investors. founders’ class shares. whichever is greater.
Example: Founders’
shares entitle investors
to a lower fee
structure, such as 1.5
and 10 rather than 2
and 20.
 121

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

5. Comparison of returns

Comparison of returns: Investment directly into a Hedge fund or through a

Fund-of-fund

Example:
An investor is contemplating investing €100 million in either a Hedge Fund
(HF) or a Fund of Funds (FOF). FOF has a “1 and 10” fee structure and invests
10% of its AUM in HF. HF has a standard “2 and 20” fee structure with no
hurdle rate. Management fees are calculated on an annual basis on AUM at
the beginning of the year. For simplicity, assume that management fees and
incentive fees are calculated independently. HF has a 20% return for the year
before management and incentive fees.
1. Calculate the return to the investor from investing directly in HF.
2. Calculate the return to the investor from investing in FOF. Assume that the
other investments in the FOF portfolio generate the same return before
management fees as those of HF and that FOF has the same fee structure as
HF.
 122

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

5. Comparison of returns

Answer:
1. Investment directly into HF: “2 and 20” fee structure
Step 1: Calculate management fee
Management fees: 100 × 2% = $2 million
Step 2: Calculate incentive fee
The investor’s gain before fees: 100 x 20% = $20 million
Incentive fees: 20 x 20% = $4 million.
Step 3: Calculate total fees
Total fees: 2 + 4 = $6 million
Step 4: Calculate after-fees return
20 – 6
Investor’s after-fees return: = 14%
100
 123

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

5. Comparison of returns

Answer:
2. Investment through FOF: “1 and 10” fee structure
Step 1: Calculate management fee
Management fees: 100 x 1% = $1 million
Step 2: Calculate incentive fee
FOF earns a 14% return on €100 million invested with hedge funds (as
calculate in Answer 1), so the investor’s gain for the year after HF fees:
100 x 14% = $14 million
Incentive fees: 14 x 10% = $1.4 million
Step 3: Calculate total fees
Total fees: 1 + 1.4 = $2.4 million
Step 4: Calculate after-fees return
14 – 2.4
Investor’s after-fees return: = 11.6%
100

Discussion:
Comparing with return of investment into a Hedge fund, return of
investment through a Fund-of-funds is lower.
 124

READING 47: ALTERNATIVE INVESTMENTS

[LOS 47.j] Calculate and interpret returns of alternative
investments on both before-fee and alter-fee bases

5. Comparison of returns

Conclusion:
Comparing with investment into a Hedge fund, investment through a Fund-
of-funds is charged given the effect of the “double fee”, resulting in lower
after-fees return.

However, this disadvantage may be balanced by positive features, such as

access to a diversified portfolio and to hedge funds that may otherwise be
closed to direct investments, as well as expertise in due diligence in hedge
fund selection.
→ There is both added cost and added value.