2.2 The Environment of Alternative Investments

Question 1

Describe the role of limited liability in passive investments

Answer 1

Limited liability restricts the potential loss to a fixed sum, such as the amount invested in an asset. Passive investors do not exert substantial control over the investment. Limited liability in passive investments encourage widespread investment so that more will diversify broadly.

Question 2

Explain the role of entities (i.e., limited liability companies, corporations), and their purposes in alternative investing

Answer 2

1. Corporation: shareholders receive distribution on pro rata or pari pass basis
2. LLC: protects investors from losses, does not required distribution to be made proportionate to each member’s contribution
3. Bankruptcy-Remote Entities: SPV that protects against potential bankruptcy proceedings
4. Master Feeder Funds: allow on/offshore investors to invest in the same strategy but with tax-neutral vehicles.

Question 3

Describe limited partnership structures

Answer 3

1. GP organises the fund and manages asset
2. LPs contribute capital

IRL: GP likely formed an LLC (let’s call it the “parent LLC”) that in turn formed an LLC to serve as the general partner and another LLC to serve as the investment adviser to the partnership. The personnel involved in three LLCs may be overlapping or even identical, with the primary functions being preserving liability and providing clarity with regard to control.

Question 4

Identify bankruptcy remote entities (e.g., special purpose vehicles, special purpose entities), and explain their differences

Answer 4

A bankruptcy-remote entity is designed to provide protection from bankruptcy of the entities placing assets in the vehicle.

Question 5

Recognize the structures of various entities (e.g., master-feeder funds, master trusts) that facilitate investor taxation differences

Answer 5

1. Master-feeder funds, which are designed to provide efficient access to investors who are subject to different taxation but wish to invest in the same portfolio.
2. master trust is the legal structure (typically offshore) used to invest the assets.
3. Feeder Fund

Question 6

What are the four key components of partnership documents?

Answer 6

1. Private Placement Memoranda
2. Partnership Agreement
3. Subscription Agreement
4. Management Company Operating Agreement

Question 7

Explain the two components of Limited Partnership Agreement:
1. I___ P___ Clause
2. E___ T___ Clause

Answer 7

1. Investor Protection: strategy, restrictions, provisions, termination etc.
2. Economic: Distribution Waterfall defines how returns are split between LP and GP, how fees are calculated etc.

Aims to align interest of fund managers with investors

Question 8

Moral Hazard and Adverse Selections takes place when there is asymmetrical information between two parties. Explain the two terms.

Answer 8

1. Moral Hazard: Changes in behaviour as a result of incentives that come into play once a contract is in effect.
2. Adverse Selection: Before transaction is complete, when the decisions made by one party cause less desirable parties to be attracted to the transaction.

Question 9

SICAVs and SICAFS are European fund structures, often domiciled in ___. SICAV are publicly traded ___ end funds, and SICAF are publicly traded ___end funds.

Many of these vehicles are organised under the ___ framework which includes restrictions on leverage, liquidity and concentration of assets.

Other alternatives are ICAV in Ireland and Cayman funds.

Answer 9

• Luxembourg
• Open
• Closed
• UCITS

Question 10

Define third, fourth, and private markets and describe their roles in alternative investments

Answer 10

1. Third markets are regional exchanges where stocks listed in primary secondary markets can also be traded, e.g. NASDAQ Intermarket. It represents a segment of the OTC market.
2. Fourth markets are electronic exchanges that allows traders to buy and sell exchange listed stocks quickly. Exists as an alternative to physical exchanges. Private financial markets which are non-regulated markets that are neither exchanges nor OTC. High-frequency training takes place in fourth market. Advantages include lower cost, ease of completion, speed.

Question 11

What are the five forms of hedge fund regulation?

Answer 11

1. Establishing
2. On advisor/manager
3. Distribution
4. Operations
5. Ongoing reporting

Question 12

What are liquid alternatives?

Answer 12

Investment vehicles that offer alternative strategies in a form that provides investors with liquidity through opportunities to sell their positions in a market

Question 13

What are the five liquid alt types?
1. U__ clone
2. C__ clone
3. ___-based replication products
4. ___-based replication procucts
5. A___ R___ or D___ products

Answer 13

1. Unconstrained clones: same strategy
2. Constrained clones: similar strategy a but are limited in risk exposure
3. Liquidity-based replication products: mimic by using liquid securities as proxies
4. Skill-based replication products: mimic highly skilled strategy by using a simplified and more mechanical strategy
5. Absolute return or diversified products: absolute/diversified returns not directly related to opportunities historically available; potentially inconsistent with alternative strategies as typically deployed.

Question 14

What are the three constraints that liquid alt products face?

Answer 14

1. Leverage: 300% asset coverage rule that requires a mutual fund to have assets totaling at least three times the total borrowings of the fund, thus limiting borrowing to 33% of assets. UCITS restrictions are even tighter.
2. Concentration
3. Illiquidity: No more than 15% of ‘40Act fund or 10% for UCITs can be invested in illiquid assets

Question 15

What are the four factors that determine performance of liquid alts compared to private placement?

Answer 15

1. Permissible investment strategy differ
2. Higher liquidity premium
3. Fee
4. Managerial skills differ

Question 16

What is short selling?

Answer 16

1. borrow security
2. sell at market
3. buy at market to return loan

Question 17

Describe the mechanics of short selling:

Answer 17

1. borrower posts collateral = price of asset + margin/haircut (usually 2%)
2. lender earns interest but typically offers rebate (little less than current short term market interest rate)
3. substitute dividend from borrower to lender is not an economic cost to short seller as stock paying dividend falls in price equals to dividend.

Question 18

What is a short squeeze?

Answer 18

Where holders of short positions are compelled to purchase shares at increasing prices to cover their positions due to limited liquidity.

Question 19

List several advantages of Separately Managed Accounts (SMAs) relative to funds.

Answer 19

• A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record.
• A fund invests for the common purposes of multiple investors, while an SMA may have objectives tailored to suit the specific needs of the investor, such as tax efficiency.
• A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investor.
• Fund investors may suffer adverse consequences from redemptions (withdrawals) and subscriptions (deposits) by other investors, but an SMA provides protection from these liquidity issues for its only investor.