8.1 Alternative Investment Features, Methods, and Structures

Question 1

Alternative investments can be defined as

Answer 1

anything beyond traditional asset classes

Question 2

Investors are attracted to alternative investments because

Answer 2

they offer diversification benefits and/or higher expected returns

Markets for these assets tend to be less efficient markets than those for traditional assets, which provides managers opportunities to earn illiquidity premiums and profit from mispricing.

Question 3

traditional asset classes

Answer 3

defined as long-only positions in publicly traded stocks, bonds, and cash

Question 4

While there are several categories of alternative investments, they generally share the following characteristics:

Answer 4

Specialized managers focused on valuing unique cash flows and risks

Low correlation with traditional asset classes

Large capital outlays

Long investment horizons

Illiquidity concerns due to underlying assets and/or restrictions on redemptions

Investment vehicles designed to overcome the challenges of investing directly

Incentive-based compensation arrangements designed to overcome information asymmetry between managers and investors

Performance appraisal challenges

Question 5

There are three broad categories of alternative investments:

Answer 5

Private capital

Real assets

Hedge funds

Question 6

Private Capital

Answer 6

an umbrella term that is used to describe debt or equity investments that are not structured as purchases of publicly traded securities

While investors who trade debt and equity securities in public markets base their decisions largely on mandatory disclosures (e.g., annual reports), private capital investors generally have access to more information and greater influence over the companies in their portfolios.

Question 7

private equity investing

Answer 7

provide equity capital to private companies

Question 8

leveraged buyouts

Answer 8

executed by purchasing the shares of a (typically mature) public company with the intention of reorganizing it and improving its profitability over a multi-year horizon as a privately held firm.

Investors believe that operating under private ownership will allow the company to make decisions that may be unpopular in the short-term (e.g., selling assets, closing business lines) but are deemed necessary to increase long-term shareholder value.

Question 9

Venture capital (VC) investing

Answer 9

involves providing equity capital to early-stage companies with limited operations that may not yet have begun generating sales

The targets of venture capital investments may be companies with little more than a business plan and intellectual property.

Founders are willing to sell some of their equity ownership in order to raise the capital needed to help their companies achieve their potential.

VC investments are high-risk, high-reward propositions.

The vast majority end in failure, but the relatively small number of successful investments generated very high rates of return.

Question 10

Private debt investors

Answer 10

lend to private companies, either through direct loans or by purchasing private bonds

Question 11

Venture debt

Answer 11

a relatively small segment of the private debt market because few early-stage companies typically burn through equity capital and are relatively able to generate the cash flows needed to service debt obligations

Question 12

Distressed debt investments

Answer 12

loans made to companies that are currently in (or close to) bankruptcy protection but are believed to be able to return to profitability after restructuring their finances.

Question 13

Real Assets

Answer 13

represent real tangible or intangible assets

Question 14

The three main types of real assets

Answer 14

real estate

infrastructure

natural resources.

Question 15

Real estate investments

Answer 15

can take the form of direct ownership of commercial or residential properties, or they may be done indirectly through vehicles such as mortgage-backed securities (MBS) or equity issued by Real Estate Investment Trusts (REITs).

Question 16

Infrastructure investments

Answer 16

capital-intensive, long-lived real assets that are intended for public use and provide an essential public service.

Infrastructure projects are increasingly structured as public-private partnerships (PPPs), with investors financing the construction of assets and covering maintenance costs over a defined period during which they receive the cash flows that the asset generates

At the end of the contractual term, ownership of the asset is transferred to the government

Question 17

Natural resources

Answer 17

may include undeveloped lands with potential economic value and commodities that can be harvested, extracted, and/or refined.

Examples of undeveloped lands include farmland, timberland, and lands containing mineral deposits

Question 18

Farmland

Answer 18

agricultural land that is cultivated to produce grains or livestock.

Income streams to investors may take the form of lease payments from farmers or revenues from sales of crops or livestock

Question 19

Timberland investments

Answer 19

require a longer investment cycle than investments in agricultural land due to the time needed for trees to grow to a size at which they can be harvested.

Carbon offset credits represent an additional source of income from timberland investments.

Question 20

Commodities investments

Answer 20

may take the form of physical ownership of standardized, naturally occurring products such as grains, metals, or crude oil.

More often, investors trade derivatives based on these assets or purchase shares of companies involved in their production

This asset class has historically generated returns that have low correlations with traditional assets. Investors value commodities for their diversification benefits and ability to hedge against unexpected inflation.

Question 21

collectibles

Answer 21

art, wine, or antique furniture.

Question 22

Intangible digital assets

Answer 22

emerging source of investments

This is a broad term covering assets that can be created, stored, and transmitted electronically.

The two main categories of digital assets are cryptocurrencies and tokens

Question 23

Hedge Funds

Answer 23

run by managers who may pursue various strategies and hold various positions in a range of assets, such as publicly traded equities and debt, private capital, and real assets.

Even if traditional assets are held, these are considered alternative investments because of the high degree of managerial skill needed to execute specialist strategies and greater use of leverage, derivates, and short positions compared to vehicles such as mutual funds.

Question 24

Hedge funds of funds (HFOFs)

Answer 24

are funds that invest in multiple hedge funds.

Question 25

Fund investing

Answer 25

a method that relatively inexperienced investors often used to gain exposure to various categories of alternative investments

Investors entrust their capital to a fund manager who is responsible for identifying attractive opportunities.

This is an indirect form of investment because investors have little or no input in the manager’s decisions about which opportunities to pursue.

The manager charges fees based on the amount of assets being managed as well as an incentive fee based on the fund’s performance.

Question 26

Advantages of fund investing

Answer 26

Fund managers offer investment services and expertise

Lower level of investor involvement required

Lower minimum capital requirements

Access to a diverse range of alternative investments without possessing specialized knowledge

Question 27

Disadvantages of fund investing

Answer 27

Costly management and performance fees

Investors still need to conduct due diligence when selecting the right fund

Lockups and other restrictions limit investors’ ability to access to their funds

Question 28

Co-investing

Answer 28

a hybrid between direct investing and indirect investing

Investments are made through a fund, but the investors possess co-investment rights that allow them to make complementary direct investments in any opportunities that the fund manager identifies.

Although investors using this method need to conduct due diligence on their direct investments, they often rely heavily on the due diligence performed by the fund manager.

Question 29

Advantages of Co-investing

Answer 29

Provides learning opportunities for investors seeking adopt the direct investing model

Reduced management fees

Allows for more active management compared to fund investing

Opportunity to develop a deeper relationship with the manager

Question 30

disadvantages of Co-investing

Answer 30

Lower level of control over the investment selection process compared to direct investing

Exposure to the risk that managers will make less attractive investment opportunities available to co-investors

Investors are required to be more actively involved in evaluating opportunities

Question 31

Direct investing

Answer 31

done by investors who are sufficiently knowledgeable in identifying alternative investment opportunities without relying on a fund manager

A complex and thorough due diligence process must be undertaken when evaluating all investment opportunities

By allocating their capital directly, investors retain control over asset selection decisions and financing methods.

This model is most commonly used for private equity and real estate investments, but it has also been adopted by larger institutions (e.g., pension plans, sovereign wealth funds) for investments in the infrastructure and natural resources sectors.

Question 32

Advantages of direct-investing

Answer 32

No fees are paid to external managers

Flexibility to pursue different investment opportunities

Control over asset management decisions

Question 33

disadvantages of direct-investing

Answer 33

In-house expertise is expensive to develop and maintain

The lack of diversification benefits compared to fund investing increases concentration risk

Investors must evaluate opportunities without the benefit of managers and their sourcing networks

Higher minimum capital requirements

Question 34

Ownership Structures

Answer 34

Alternative asset funds are often structured as partnerships with investors as limited partners (LPs) and the fund manager acting as a general partner (GP) who is responsible for the fund’s operations and retains unlimited liability if anything goes wrong.

This structure can be used for fund investing and co-investing, while direct investing does not require a partnership.

Question 35

limited partners (LPs)

Answer 35

own a fractional interest in the partnership based on their share of committed capital and their exposure to losses is limited to the amount of their investment

Often, the amount that limited partners initially invest represents only a fraction of their total commitment, which the GP can call upon as opportunities are identified over the course of the fund’s life.

LPs must meet the requirements (e.g., minimum net worth) to be considered accredited investors.

Question 36

general partner (GP)

Answer 36

GPs put their own capital into the fund, but their investment is typically lower than the contributions from LPs.

is responsible for the fund’s operations and retains unlimited liability if anything goes wrong

Question 37

limited partnership agreement (LPA)

Answer 37

governs the relationships between GPs and LPs

a legal document that set out the parties’ rights and responsibilities

An LPA defines the partnership’s rules as well as the framework for the fund’s operations

Question 38

Limited partners may also negotiate separate side letters with the GP

what are these side letters?

Answer 38

These supplementary agreements may include clauses on additional reporting, first right of refusal for co-investments, notice requirements for redemptions, and the right to benefit from any fee reductions that are offered to other LPs.

Question 39

Structures commonly adopted for specific alternative investments include:

Answer 39

Joint ventures for direct real estate investing

Unitholder arrangements for indirect real estate investment vehicles (e.g., REITs)

Master limited partnerships (MLPs) for indirect investments in real assets (e.g., timberland funds)

Special purpose entities to provide capital for public-private partnerships (PPPs) on infrastructure projects

Question 40

Compensation Structures

Hedge funds

Answer 40

Hedge fund managers generally charge a management fee ranging from 1% to 2% of assets under management (AUM)

On top of the management fee, a performance fee, also known as an incentive fee or carried interest, is charged as a percentage of the fund’s returns over a given period (e.g., annually). \

–> A common fee structure is “2 and 20,” which is 2% of AUM (or committed capital) plus a 20% performance fee.

Question 41

Compensation Structures

Private equity funds

Answer 41

the management fee is a percentage of committed capital , which increases the incentive for GPs to be selective about which opportunities to invest in rather than choosing opportunities that deploy committed capital as quickly as possible.

Question 42

hurdle rate

Answer 42

In order to limit compensation for low returns, investors typically make the payment of performance fees contingent on generating returns that meet a minimum hurdle rate

Question 43

If a soft hurdle rate is used

Answer 43

the manager’s performance fee is zero if the hurdle rate is not met, or the product of the performance fee percentage (p) and the fund’s return over the period (r)

Question 44

For a hard hurdle rate

Answer 44

the performance fee percentage is applied only to the portion of the fund’s return in excess of that rate:

Performance fee = max [0, p * (r - Hurde rate)]

Question 45

catch-up clause

Answer 45

An example of accelerated compensation

allows a GP to receive an immediate “catch-up” return and a proportionate share of incremental returns

With a catch-up clause in effect, investors receive 100% of returns up to the hard hurdle rate, the GP receives 100% of the next Catch-up returns, and any returns in excess of this are split proportionately based on the performance fee percentage.

Question 46

The performance fee earned by a manager with a hard hurdle rate and a catch-up clause is calculated as follows:

Answer 46

Performance fee = max [0, Catch-up return + p * (r - Hurdle rate - Catch-up return)]

Question 47

A high-water mark clause

Answer 47

ensures that investors do not pay twice for the same performance gains

For example, if a fund’s value is initially 100 and rises to 120 in Year 1, incentive fees will be paid on that gain and 120 will be established as the high-water mark. If the fund’s value falls back to 100 in Year 2 and rises to 120 again in Year 3, the high-water mark provision will ensure that the manager does not receive incentive fees for Year 3 returns that simply get investors back to where they were at the end of Year 1.

Question 48

A clawback provision

Answer 48

allows the LPs to reclaim any incentive fees that have been improperly paid to the GP

LPs typically enforce such a provision in circumstances where a GP has exited, and been compensated for, one successful deal but incurs losses on subsequent deals

Clawback provisions are most relevant in the early years of private equity and real estate partnerships, which invest in relatively illiquid assets and have longer-term holding periods

Question 49

A waterfall

Answer 49

the method used by partnerships to allocate an investment’s profits between the GP and the LPs.

Waterfalls can be structured in different ways that are more or less advantageous for investors:

–> deal-by-deal (American) waterfall

–> whole-of-fund (European) waterfall

Question 50

deal-by-deal (American) waterfall

Answer 50

the GP collects performance fees on a per-deal basis

The GP collects their performance fee percentage on each profitable deal, even if investors have not earned their hurdle rate or even had their original investment returned

However, the GP must reimburse LPs a proportionate share of losses on any deals as they are realized.

Question 51

whole-of-fund (European) waterfall

Answer 51

no performance fee is calculated until after all investments have been exited.

At that time, the GP will earn a performance fee on the aggregate cash flows from all deals remaining after LPs have had their initial investment returned and the hurdle rate has been met.

This arrangement is more beneficial to LPs, who are not at risk of paying performance fees that must be returned if losses are later incurred.