Alternative Invesmtents

Question 1

Recapitalization

Answer 1

not a true exit strategy as the private equity firm typically maintains control.

Question 2

Mortgage REITs make loans

Answer 2

secured by real estate but generally do not own or operate real estate

Question 3

Master limited partnerships

Answer 3

are similar to REITs but they trade on exchanges rather than over-the-counter

Question 4

Real estate investment includes two major sectors

Answer 4

Two main sectors are residential and commercial.

Question 5

commercial real estate investment was traditionally seen as an appropriate investment

Answer 5

for institutional funds and high net worth investors with long time horizons and limited liquidity needs

Question 6

commodity prices

Answer 6

correlate positively w inflation

Question 7

contango market

Answer 7

future prices are higher than the cash price

Question 8

Futures price

Answer 8

= Spot price (1+r) + Storage costs – Convenience yield

Question 9

Commodities

Answer 9

> Returns are based on price changes rather than income streams
Most trading of commodities is via derivatives
Have historically behaved differently to stocks and bonds during the business cycle. > This offers diversification benefits

Question 10

Market neutral and short bias can both make use of

Answer 10

technical and fundamental analysis

Question 11

Digital assets derive their price

Answer 11

from an anticipated asset appreciation from a perceived scarcity value (due to limitations on the total supply of currency) and the potential ability to transfer value in the future (due to unique features in the underlying algorithms that may facilitate certain types of financial transactions).

Question 12

stablecoin

Answer 12

An altcoin designed to maintain a stable value by linking their value to another asset and are collateralized by a basket of assets

Question 13

enterprise value of a company

Answer 13

Market capitalisation + market value of debt - cash

Question 14

In a two-tier structure

Answer 14

> management board run the company but are supervised by the supervisory board.
supervisory board is mainly comprised of non-executive directors whilst the management board is composed of executive directors.

Question 15

The audit function is designed

Answer 15

> to mitigate instances of fraud as well as misstatements of accounting and financial information
external auditors are usually recommended by the Audit Committee and typically conduct annual audits

Question 16

nominations committees

Answer 16

> Recruiting new Board members with appropriate qualities and experience in light of the company’s business needs, and preparing for the succession of executive management and the Board
responsible for creating nominations policies and procedures and regularly examining the performance, independence, skills and expertise of existing board members to determine whether they meet both present and future company needs

Question 17

Introduction to Alternative Investments

Answer 17

Introduction to 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)
* Features that may distinguish alternative investments include the following:
- The requirement for specialised knowledge to value cash flows and risks
- Typically low correlation of returns with more traditional asset classes
- Illiquidity, long investment time horizons, and large capital outlays
* The above features lead to the following alternative investment characteristics:
- Different investment structures due to the challenges of direct investment
- Incentive-based fees to address/minimise information asymmetry between managers
and investors
- Performance appraisal challenges

Question 18

Private capital

Answer 18

• Private equity firms invest in companies that are not listed on a public exchange
• LBO/Venture capital

Question 18

Natural resources

Answer 18

• Commodities
• Agricultural land and timberland

Question 18

Hedge funds

Answer 18

• Private investment vehicle
• May employ long and short positions
• Often highly leveraged
• Often aim to deliver an absolute return

Question 19

Real estate

Answer 19

• Direct or indirect

Question 20

Infrastructure

Answer 20

• Capital intensive, long lived, real assets, e.g. roads, bridges
• Increasingly the private sector is investing in infrastructure assets

Question 21

Others

Answer 21

• Investing in tangible assets, e.g. fine wine, art
• Investing in intangible assets, e.g. patents
• Digital assets e.g. cryptocurrencies and tokens

Question 22

Fund investing
Advantages
Disadvantages

Answer 22

Advantages
> Fund managers offer investment services and expertise
> Lower level of investor involvement compared with direct and co-investing methods
> Access to alternatives investments without possessing a high degree of investment expertise
> Potentially valuable diversification benefits
> Lower minimum capital requirements

Disadvantages
> Costly management and performance fees
> Investor must conduct due diligence when selecting the right fund because of the wide dispersion of fund manager
returns

Question 23

Investment Methods
Co-investing
Advantages
Disadvantages

Answer 23

Advantages
> Investor can learn from the fund’s process to become better at direct investing
> Reduced management fees
> Allows more active management of the portfolio compared with fund investing and allows a deeper relationship with the manager

Disadvantages
> Reduced control over the investment selection process compared with direct investing
> May be subject to adverse selection bias
> Requires more active involvement compared with fund investing which can be challenging if resources and due
diligence experience are limited

Question 24

Investment Methods
Direct investing
Advantages
Disadvantages

Answer 24

Advantages
> Avoids paying ongoing management fees to an external manager
> Greatest amount of flexibility for the investor
> Highest level of control over how the asset is managed

Disadvantages
> Requires more investment experience and a higher level of financial sophistication compared with the other methods resulting in higher internal investment costs
> Less access to a fund’s ready diversification benefits or the fund manager’s sourcing network
> Requires greater levels of due diligence because of the absence of a fund manager
> Higher minimum capital requirements

Question 25

Investment and Compensation Structures

Answer 25

• In the world of alternative investments, partnership structures are common
• The GP runs the business and, in theory, bears unlimited liability and may run many funds at the same time
• The LPs are passive investors and are generally accredited investors
• LPs commit to future investments and the upfront cash outflow might only be a small portion of their total commitment to the fund

Question 26

Investment and Compensation Structures
Investment structures

Answer 26

• The partnership between the GP and LPs is governed by a limited partnership agreement (LPA)
• A legal document that outlines the rules of the partnership
• LPAs vary in length and complexity and may contain provisions and clauses
• In addition to LPAs there may be side letters, which are side agreements created between the GP and a certain number of LPs, that exist outside the LPA
• A side letter may include some of these clauses or details:
• Potential additional reporting due to an LP’s unique circumstances
• First right of refusal and other similar clauses that apply to selected LPs
• Notice requirements in the event of litigation, solvency, and related matters
• Most favoured nation clauses, such as agreeing that if similar LPs pay lower fees they will be offered to the LP
• Certain structures are commonly adopted for specific alternative investments
• For example, infrastructure investors often enter into public-private partnerships

Question 27

Investment and Compensation Structures
Compensation structures

Answer 27

• Funds generally have a management fee
• Typically 1–2% based on assets under management for hedge funds or committed capital for private equity funds
• Private equity funds charge the management fee based on committed capital NOT invested capital
• The committed capital is often fully invested after between three and five years
• Additionally they have a performance/incentive fee (hedge funds) or carried interest (private equity funds) which is based on excess returns
• The partnership agreement will generally state that the performance fee is subject to a hurdle rate, typically 8%, which might be a hard or soft hurdle
• Hurdle rates are less common with hedge funds
• In addition to the above fees, LBO firms in private equity might charge consulting and monitoring fees

Question 28

Investment and Compensation Structures
Common investment clauses, provisions, and contingencies
High water mark
Waterfall
Clawback

Answer 28

• High water mark
• Highest value a fund has achieved net of fees
• Common with hedge funds
• Requires the hedge fund manager to recoup losses before further incentive fees are paid
• An issue around this is that investors enter the fund at different times
• If you buy in a dip then you might be subject to an incentive fee when other investors are not because your high watermark might be very different
• Waterfall
• A waterfall is the distribution method that defines the order in which allocations are made to LPs and GPs
• GP returns are proportionately higher relative to their initial investment which incentivizes them to maximize profitability
• Deal-by-deal (or American) waterfall – GPs receive performance fees deal-by-deal which means they get paid before LPs have received their investment back plus their hurdle rate on their full investment
• Whole-of-funds (or European) waterfall – all distributions go to LPs as deals are exited and the GP does not participate until the LPs have received all of their original investment plus the hurdle rate on the full investment
• Clawback
• A clawback provision reflects the right of LPs to reclaim part of the GP’s performance fee
• Clawback provisions are usually activated when a GP exits successful deals early on but incurs losses on deals later in the fund’s life

Question 29

Alternative Investment Performance
Comparability with Traditional Asset Classes

Answer 29

• Alternative investments are customised with distinctive features which complicate performance appraisal between investments and across asset classes. These include:
• The timing of cash inflows and outflows for specific investments
• The use of borrowed funds
• The valuation of individual portfolio positions over specific phases of the investment life cycle, and
• More complex fee structures and tax and accounting treatment

Question 30

Alternative Investment Performance
Performance Appraisal and Alternative Investment Features

Answer 30

• When appraising alternative investments, four areas to focus on include:
  1. Life cycle phase of the investment
  2. Use of borrowed funds to maintain the market position
  3. Valuation of the assets
  4. Fee structure of the fund

Question 31

Alternative Investment Performance
1. Investment Life Cycle

Answer 31

Alternative Investment Performance
1. Investment Life Cycle
* Alternative investments usually involve a longer investment life cycle with distinct phases characterized by net cash outflows and inflows that complicate periodic return comparisons.
* Life cycle phases and timing vary across alternative investment types but generally fall into three distinct periods:
- Capital commitment:
* Identify and select appropriate investments with either an immediate or a delayed commitment of capital (known as a capital call).
* Returns are usually negative over this phase because fees and expenses are immediately incurred prior to capital deployment and assets may generate little or no income during this first phase
- Capital deployment:
* Managers deploy funds to stimulate initiate the value creation process
* Cash outflows typically exceed inflows, with management fees further reducing returns
- Capital distribution:
* If the investments are successful, the underlying assets appreciate in price and/or generate income in excess of costs, causing fund returns to accelerate.
* The fund may realize substantial capital gains from liquidating or exiting its investments, which may involve an initial public offering (IPO) for venture capital

• The so-called J-curve effect (because it resembles the letter J) shown below:
• There is an initial negative return in the capital commitment phase followed by an acceleration of returns through the capital deployment phase
• Returns often level off as capital is distributed to investors, investments are sold, and the fund is closed
• As a general rule, the best way to start evaluating such investments is with the IRR
• The IRR will take into account the respective cash flows into an investment and the timing thereof, versus the magnitude and the timing of the cash flows returned
  by the investment (inclusive of tax benefits)
• The use of the IRR would be relevant for an independent, fixed-life private equity fund, where the decisions to raise money, take money in the form of capital calls, and distribute proceeds are all at the discretion of the private equity manager
• Assumptions regarding the opportunity cost of outgoing cash flows and the reinvestment rate for incoming cash flows will affect the results
• Because of this complexity, a shortcut methodology often used by both private equity and real estate managers involves simply citing a multiple of invested capital (MOIC), or money multiple, on total invested capital (which is paid-in
  capital less management fees and fund expenses)

MOIC = (Realized value of investment + Unrealized value of investment) / Total amount of invested capital

Question 32

2. Use of Borrowed Funds

Answer 32

• AIs may use borrowed funds to increase investment returns. This form of financial leverage has the effect of magnifying both gains and losses by allowing investors
  to take a market position that is larger than the capital committed

Return on a Leveraged Portfolio = Rp + Vb/Ve(Rp-rd)

• Hedge funds leverage their portfolios by using derivatives or borrowing capital from prime brokers
• The prime broker essentially lends the hedge fund the shares, bonds, or derivatives, and the hedge fund deposits cash or other collateral into a margin account with the prime broker based on certain fractions of the investment
  positions
• The margin account represents the hedge fund’s net equity in its positions

Question 33

Alternative Investment Performance
3. Valuation

Answer 33

• Alternative assets are often illiquid, which makes performance appraisal over time challenging and periodic comparison with common asset classes problematic
• Accounting rules require investments are to be recorded at their fair value (FV) for financial reporting purposes
• FV is market-based measure based on observable or derived assumptions to determine a price that market participants would use to exchange an asset or
  liability (often referred to as the exit price for a seller) in an orderly transaction at a specific time

Level 1 - Quoted prices in active markets - Exchange-traded public equity securities
Level 2 - Inputs other than quoted market prices in Level 1 that are directly or indirectly observable - Over-the-counter interest rate derivatives (pricing model using quoted market prices)
Level 3 - Private equity or real estate investments (cash flow projection models with reasonably available market participant assumptions)

Question 34

Alternative Investment Performance
4. Fees

Answer 34

• AI fees vary from those for common asset classes, which typically involve a flat management fee
• Alternative investments often levy additional performance fees based on a percentage of periodic fund returns. Performance appraisal for these investments can be difficult to generalize, because results may vary significantly based on which investor has invested when in a particular vehicle.
• For example, an investor may face much lower incentive fees if they invest more capital in a fund at an earlier phase or is willing to accept greater restrictions on redemptions

Question 35

Calculating Fees and Returns
Custom fee arrangements

Answer 35

• Although “2 and 20” and “1 and 10” are common fee structures there are variations
• Fees based on liquidity terms and asset sizes
• Longer lockups generally mean lower fees
• Larger clients might have discounted fees
• Terms are negotiated for individual investors using side letters
• Founders’ shares
• Often the first to contribute (usually the first $100m in assets) are subject to lower fees
• Alternatively, fees for founders are reduced once a certain amount of funds is raised or performance targets are met
• Either/or fees
• Managers agree to either receive a 1% management fee during down years (to cover expenses) or a 30% incentive fee above a mutually agreed annual hurdle rate in up
  years whichever is greater

Question 36

Private capital

Answer 36

• Private capital is the broad term used to describe funding provided to companies that is not sourced from public markets nor from traditional institutional providers
  such as banks
• If the funding is an equity investment it is known as private equity
• If capital is extended to companies in a similar way via a loan it is referred to as private debt
• Although many private investment firms have private equity and private debt arms they are often known as private equity firms
• Typically, the equity and debt arms do not invest in the same assets or businesses to avoid overexposure to a single investment and to avoid the conflict of interest that arises from sitting on either side of the creditors’ table
• Private equity generally relates to investing in privately owned companies or in public companies with the intent of making them private

Question 37

Leveraged buyouts (LBOs)

Answer 37

• LBO fund established by a private equity firm acquires established private companies or public companies (‘going private’ as the target’s share no longer trade publicly) with a significant amount of the purchase price financed through
  debt
• The company’s assets are used as collateral for the debt and the target company’s cash flows service the debt
• Management buyout (MBO) – current management team is involved in the acquisition
• Management buy-in (MBI) – current management team is being replaced and the acquiring team will be involved in managing the company

Question 38

Stages of venture capital investing

Answer 38

Financed via ordinary or convertible preference
shares to the VC Fund
Management retains control

Formative stage financing:
Angel Investing Idea stage
– no VC involvement
Seed-stage
Development and marketing
First stage of VC investment
Early Stage Financing
Initiate manufacturing

Financed via equity and debt (for security to VC fund)
Management sells control to the VC investor

Later Stage Financing
Initial expansion followed by major expansion such as PPE expansion
Mezzanine or ‘bridge’ Pre-IPO preparation
Initial Public Offering (IPO)

Question 39

Other private equity strategies

Answer 39

Other private equity strategies
* Some PE funds specialize in growth capital, also known as growth equity or minority equity investing
- The PE firms takes less than a controlling interest in more mature, private companies that are looking for capital
- Minority investing is often initiated and sought by the management of the investee company who want to maintain control of the company before taking it public
- This is common for private companies but public companies can seek private equity capital through PIPEs (private investments in public equities)
* Other private equity strategies secure returns by investing in specific industries

Question 40

Types of liquidation/divestment

Answer 40

• Exit strategies are critical for venture capital investing
• Types:
• Trade sale
• Initial public offering (IPO)
• Recapitalization
• Secondary sales
• Write-offs, i.e. voluntary liquidations

Question 41

Types of private debt

Answer 41

• Private debt refers to the various forms of debt provided by investors to private entities
• This has grown a lot since the credit crunch because opportunities to borrow from traditional lenders have reduced
• Types:
• Direct lending
• Mezzanine debt
• Venture debt
• Distressed debt

Question 42

Other private debt strategies

Answer 42

• Other ways of lending include
• Issuing CLOs
• Unitranche debt
• Real estate/Infrastructure debt
• Specialty loans

Question 43

Risk and return of private capital

Answer 43

• Investors in private equity expect a higher return for accepting higher risk, including illiquidity and leverage risks
• Private equity return indexes are subject to self-reporting as well as survivorship and other biases
• Investors in private debt should earn a higher return than from investing in traditional bonds due to higher risks including illiquidity risk and default risk

Question 44

Diversification benefits of investing in private capital

Answer 44

• Investment in private capital funds can add a moderate diversification benefit to a portfolio of publicly traded stocks and bonds and can potentially earn excess
  returns due to the excess risk

Question 45

Real Estate Investment Categories
Residential property
Commercial real estate

Answer 45

Residential property
* Individuals and families directly invest into property with the intent to occupy the property
* Mortgages are provided through financial institutions who carry out due diligence when deciding to lend to the borrower
* Securitization provides indirect, debt investment opportunities via residential mortgage-backed securities (RMBS), to other investors

Commercial real estate
* Appropriate direct investment for institutional funds or high-net-worth individuals
* Direct ownership requires active and experienced and professional management
* Indirect investment via REITs

Question 46

Real Estate
Unique properties of real estate:

Answer 46

• Initial investment is typically large
• No two properties are identical
• There are multiple types of real estate investment alternatives available e.g. direct and indirect investment
• Diversification across all different types of real estate investment alternatives may be difficult to attain.
• Private market indexes replicating the performance of real estate are not directly investable
  Also, the price discovery process in the private real estate markets is opaque, for multiple reasons:
• Historical prices may not reflect prevailing market conditions
• Transaction costs are typically high
• Transaction activity may be limited

Question 47

Basic forms of real estate investments
Private: Debt / Equity
Public: Debt / Equity

Answer 47

Private: Debt
* Mortgages
* Construction lending
* Mezzanine debt
Private: Equity
* Direct ownership
- Sole ownership
- Joint ventures
- RELPs
* Indirect ownership via real estate funds
* Private REITs

Public: Debt
Mortgage-backed securities (residential
and commercial)
* Collateralized mortgage obligations
* Mortgage REITs
* ETFs that own securitized mortgage debt
Public: Equity
Shares in real estate operating and
development corporations
* Listed REITs
* Mutual funds
* Index funds
* ETFs

Question 48

Direct Real Estate Investment
Advantages
Disadvantages

Answer 48

Direct Real Estate Investment
Advantages
* Control.
* Tax benefits
* Diversification.
Disadvantages
* Complexity
* Need for specialized knowledge
* Significant capital needs
* Concentration risk
* Lack of liquidity

Question 49

Indirect Real Estate Investment
REIT investing
Mortgage-backed securities (MBS)

Answer 49

Indirect Real Estate Investment
REIT investing
* Mortgage REITs invest in mortgages and are similar to fixed income investments.
* Equity REITs primarily invest into commercial or residential properties and employ leverage. Under regulation equity REITs are required to distribute their majority of
income to shareholders to retain their regulatory tax-advantaged status.
* Hybrid REITs invest in both of the above
* REITs can avoid corporate income taxation by distributing dividends equal to 90%–100% of taxable net rental income
Mortgage-backed securities (MBS)
* Based on a securitization model of buying a pool of assets (mortgages in this case) and assigning the interest and principal returns into individual equity
tranches.
* MBS may be issued publicly or privately.

Question 50

Indirect Real Estate Investment Strategies
* Core
* Core-Plus
* Value-add
* Opportunistic

Answer 50

• Core
• Well-leased, high-quality commercial and residential real estate in the best markets
• Stable returns, primarily from income from the property
• Usually structured as infinite-life, open-end funds and allow investors to contribute or redeem capital throughout the life of the fund e.g. Diversified Public REIT Investing
• Core-Plus
• Investors seeking higher returns may also accept additional risks from development, redevelopment, repositioning, and leasing e.g. Tenant Repositioning
• Usually via the use of finite-life, closed-end funds
• Value-add
• Investments that require modest redevelopment or upgrades to lease any vacant space together with possible alternative use of the underlying properties.
• Opportunistic
• In order to seek even higher returns, investors may engage in value-add real estate strategies, such as larger-scale redevelopment and repositioning of existing assets
• This often includes major redevelopment, repurposing of assets, taking on large vacancies, or speculating on significant improvement in market conditions

Question 51

Primarily Private Strategies

Answer 51

Core
Core-Plus
Value-Add
Opportunistic (highest risk return)

Question 52

Available Through Public Vehicles

Answer 52

Senior Debt
bond-like returns

Question 53

Infrastructure
Categories of infrastructure investment
* Economic infrastructure
* Social infrastructure

Answer 53

• Economic infrastructure – investment into assets supporting economic activities:
• Transportation assets e.g. roads, bridges, tunnels, airports, seaports, and heavy and light/urban railway systems. Income will usually be linked to demand based on traffic, airport and seaport charges, tolls, and rail fares and hence is deemed to carry market risk.
• ICT assets include infrastructure that stores, broadcasts, and transmits information or data, such as telecommunication towers and data centers.
• Utility and energy assets generate power and produce potable water; transmit, store, and distribute gas, water, and electricity; and treat solid waste.
• Social infrastructure - investment directed toward human activities and include such assets as educational, health care, social housing, and correctional facilities, with the focus on providing, operating, and maintaining the asset infrastructure

Question 54

Forms of infrastructure investments
* Directly
* Indirectly
* Master Limited Partnerships (MLPs)

Answer 54

Forms of infrastructure investments
* Directly
- Provides control over the asset
- Able to capture the full value of the asset
- Least common method given the large investment needed, significant active management and the concentration and liquidity risk involved
* Indirectly
- Public traded infrastructure securities e.g. Infrastructure ETFs or holding equity in publicly traded infrastructure providers
* Liquid, lower cost, transparent governance, market prices, diversification
* However, these securities represent a small segment of the infrastructure investment universe
* Master Limited Partnerships (MLPs)
- Exchange traded pass-through entities similar to REITs
- Regulation varies across countries and the income is allocated to investor for taxation
- Most free cash flow generated is distributed to investors

Question 55

Stages of infrastructure development
* Greenfield
* Brownfield investment
* Secondary-stage investments

Answer 55

• Greenfield
• Investing into infrastructure yet to be constructed
• Investors typically invest alongside strategic investors or developers that specialize in developing the underlying assets.
• Brownfield investment
• Investing into existing infrastructure assets e.g. government wanting to privatise, lease out, or to sell and lease back an asset
• Secondary-stage investments
• Invest in existing infrastructure facilities or fully operational assets that do not require further investment or development over the investment horizon
• Generate immediate cash flow and returns expected over the investment period

Question 56

Risks and returns overview

Answer 56

Risks and returns overview
* Higher risk
- Greenfield projects without guarantees of demand upon completion e.g. variable electricity prices, uncertain traffic on roads and through ports
* Medium risk
- Mostly brownfield assets (with some capital expenditure requirements) and some greenfield assets (with limited construction and demand risk
* Low Risk
- Brownfield assets with mitigated risks e.g., fully constructed with contracted/regulated revenues
- Secondary stage assets that already exist
* Most institutional investors consider infrastructure investments to balance public equity holdings because infrastructure has proven to be relatively resilient to
swings in the equity markets.

Question 57

Overview of natural resources

Answer 57

• This is a unique category comprising commodities and raw land used for farming and timber
• Commodities are considered either hard or soft
• Hard commodities are those that are mined, such as copper, or extracted, such as oil
• Soft commodities are grown over time and include livestock, grains and cash crops, such as coffee
• Timberland investment involves ownership of raw land and the harvesting of its trees for lumber
• It generates an income stream and an opportunity for capital gains
• Investment in timberland by large institutional portfolios is well established
• Farmland as an investment is more recent with only a few dedicated funds involved

Question 58

Commodities

Answer 58

• Commodities are physical products, e.g., oil, natural gas, precious metals
• Returns are based on changes in price rather than an income stream via dividends or coupons
• Portfolio diversification is possible on the observation that commodities have historically behaved differently to stock and bonds during the business cycle
• Offers a hedge against inflation
• Indices on commodities generally use the price of futures
• Indices also vary in the terms of composition and weighting methods used
• Most trading of commodities occurs through derivatives rather than direct investment
• Funds that specialize in specific commodity sectors exist

Question 59

Pricing of commodity futures contracts

Answer 59

Most investments in commodities are by way of future contracts

Futures price ≈ Spot price (1 + Risk-free rate) + Storage costs - Convenience Yield

• Contango
• Future price > Spot price
• Backwardation
• Future price < Spot price

Question 60

Timberland

Answer 60

Timberland
* Offers income stream based on the sale of timber products
* Return is not highly correlated with other asset classes
* Acts as a warehouse and factory
- Can be easily grown and stored by not harvesting
* Three primary drivers of return: Biological growth, commodity price change and
land price changes

Question 61

Farmland

Answer 61

• Perceived as a hedge against inflation
• Consists of two main property types:
• Row crops planted and harvested annually
• Permanent crops that grow on trees or vines
• Little flexibility (in comparison to timberland) in harvesting and must be harvested when ripe
• Can be used as pastureland for livestock
• Three primary drivers of return: Harvest quantities, commodity prices, land price
  changes

Question 62

Hedge Funds
Typical hedge fund characteristics

Answer 62

• Aggressively managed portfolio across asset classes: leveraged, takes long and
  short positions, and/or uses derivatives
• Sometimes invest across different geographic areas
• Hedge funds are subject to less regulation than mutual funds which allows for
  more flexibility
• Often very few restrictions with a view to generate absolute returns
• Large initial investment involving a limited number of private investors
• Often impose redemption restrictions:
• Lockup period
• Notice period (typically 30–90 days)
• Investors may be charged a fee which is payable to the fund not the manager
• Soft lockup – where investors redeem during a lockup period but must pay a fee to exit

Question 63

Hedge Funds
Funds of funds

Answer 63

• Funds that hold a portfolio of hedge funds making hedge funds accessible to
  smaller investors
• Allows the investor to be diversified to some extent in hedge funds
• Have expertise in conducting due diligence on hedge funds
• May provide access to hedge funds that may otherwise be closed to direct
  investment
• May have more favourable redemption terms (shorter lockup period and/or notice
  period)
• However, the multi-layered fee structure of funds of funds has the effect of diluting
  returns to the investor
• The fee structure is often 1% management fee and 10% incentive fee (1 and 10)
• Incentive fee typically charged on profits net of the management fee

Question 64

Hedge Funds
Survivorship bias

Answer 64

• Hedge fund indexes suffer from self-reporting and survivorship bias
• Survivorship bias relates to the inclusion of only current investment funds in a
  database
• The return on funds no longer available are not included in the database

Question 65

Hedge Funds
* Four broad categories of hedge fund strategies have been identified:

Answer 65

Event-driven
Relative value
Macro
Equity hedge

Question 66

Hedge Funds
Event-driven strategies

Answer 66

• Seek to profit from short-term events, usually involving corporate events such as
  restructuring or acquisition
• Considered a ‘bottom up’ strategy
• Sub-divisions of this category include:

Merger arbitrage: Long the stock being acquired, short the stock of the acquiring company upon announcement of the acquisition.

Distressed/ restructuring: Focus on companies either in, or close to, bankruptcy.

Activist shareholder (or ‘Activist’): Purchase of equity to a level that can influence a company’s policies or directions.

Special situations: Focus on opportunities in the equity of companies involved in
restructuring other than M+A and bankruptcy, e.g. activities in secondary issues/repurchases and asset sales/spin-offs.

Question 67

Hedge Funds
Relative value strategies

Answer 67

• Seek to profit from a pricing discrepancy between related securities
• Typically involves buying and selling the related securities
• Sub-divisions of this category include:
• Fixed Income Convertible Arbitrage
• Fixed Income Asset Backed
• Fixed Income General
• Volatility
• Multi-Strategy

Question 68

Hedge Funds
Macro strategies

Answer 68

• Use a ‘top down’ approach to identify economic trends, from which trades are
  then based
• Trade opportunistically in a range of asset classes, using long and short positions
  to profit from an overall market direction implied by identified macroeconomic
  events

Question 69

Hedge Funds
Equity hedge strategies

Answer 69

• Long and short positions in equity and equity derivatives
• Examples of equity hedge strategies include:
• Market Neutral
• Use of quantitative and fundamental analysis to identify undervalued stocks and overvalued stocks
  with an aim to remain market neutral
• Fundamental Growth
• Fundamental Value
• Quantitative Directional
• Use of technical analysis to identify under- and overvalued stocks
• Not necessarily market neutral
• Short Bias
• Sector Specific

Question 70

Hedge Fund Investment Forms
* Direct Hedge Fund Investment Forms
* Indirect Hedge Fund Investment Forms

Answer 70

• Direct Hedge Fund Investment Forms
• A common hedge fund form is a master feeder structure
• The master feeder structure is set up for optimum tax efficiency and consists of an
  offshore feeder fund and an onshore feeder fund—both feeding into a master fund that
  invests the capital based on its contractual partnership agreements
• For larger investors, the hedge fund structure could be a fund of one or a separately
  managed account (SMA)
• An SMA structure allows for a customisable portfolio, with investor-specific investment mandates, better transparency, efficient capital allocation, and higher liquidity, over
  which the investor can exercise enhanced control while keeping the fees lower
• Indirect Hedge Fund Investment Forms
• Fund-of-hedge-funds approach (seen before)

Question 71

Hedge Fund Investment Risk and Return

Answer 71

• Hedge funds attempt to limit market exposure and returns from beta and to then
  focus on generating idiosyncratic returns by identifying sources of unique return,
  or alpha
• Primary source of hedge fund excess return is market inefficiencies (which may
  be short lived) and the skill of the manager in leveraging them
• The performance of hedge funds can be attributed to three distinct sources:
• Market beta - the broad market beta that can be realized using market index–based
  funds/ETFS
• Strategy beta - the beta attributed to the investment strategy of the hedge fund applied across the broad market
• Alpha - the manager-specific returns, due to the selection of specific positions

Question 72

Hedge Fund Investment and Diversification

Answer 72

• While hedge fund strategies vary widely, market-neutral, relative value, and
  event-driven strategies tend to outperform equity markets during market
  downturns and when individual stock correlations fall and tend to have weaker
  performance when correlations are high (reducing relative value opportunities)
  and equities move uniformly higher
• Typically, hedge fund performance has a very low correlation with that of
  traditional asset classes, such as investment bonds and currencies/cash

Question 73

Distributed Ledger Technology
Introduction

Answer 73

• Distributed ledger technology (DLT) based on a distributed ledger represents a
  technological development and offers potential improvements to delivering
  financing services and financial record keeping
• Potential benefits of using this technology include:
• Greater accuracy, transparency, and security in record keeping;
• Faster transfer of ownership; and P2P interactions
• Potential downsides:
• The technology is not fully secure, and breaches in privacy and data protection are
  possible
• Additionally, the computational processes underlying DLT generally require massive
  amounts of energy to verify transaction activity

Question 74

Distributed Ledger Technology
Distributed Ledger

Answer 74

• A type of database that can be shared among potentially infinite numbers of
  entities in a network:
• Entries are recorded, stored, and distributed across a network of participants so that
  each participating entity has a matching copy of the digital database
• Basic elements of a DLT network include:
• Digital ledger e.g. Blockchain
• Consensus mechanism used to confirm new entries
• Process by which the computer entities (or nodes) in a network agree on a common state of the ledger
• Enables the creation of records that are, for the most part, considered immutable, or
  unchangeable, yet they are transparent and accessible to network participants on a near-real-time basis
• Participant network

Question 75

Distributed Ledger Technology
Proof of Work vs. Proof of Stake

Answer 75

• When transactions enter into a node of the blockchain, they are bundled into
  “blocks” and cryptographically “chained” together to facilitate verification of the
  prior history
• Consensus protocol determines how blocks are chained together is determined
  and represent a set of rules governing how blocks can join the chain and become
  the immutable “truth”. There are two main types of protocol:
• Proof of Work (PoW) Protocol
• Involves a cryptographic problem that must be solved by some computers on the network (known
  as miners) each time a transaction takes place
• The “proof of work” consensus process to update the blockchain requires substantial computing power, making it very difficult and extremely expensive for an individual third party to manipulate
  historical data
• Proof of Stake (PoS) Protocol
• Requires selected participants on the networks, the validators, to pledge capital to vouch for the block’s validity
• This capital (stake) signals to the network that a validator is available to verify the veracity of a transaction and propose a block
• Validators benefit from both proposing and attesting to the validity of blocks that have been proposed by other participants in a similar staking process

Question 76

Distributed Ledger Technology
Permissioned and Permissionless Networks

Answer 76

• Permissionless networks e.g. Bitcoin
• Open to any user who wishes to make a transaction, and all users within the network can
  see all transactions that exist on the blockchain.
• Any network participant can perform all network functions
• Main benefit is that it does not depend on a centralised authority to confirm or deny the validity of transactions given this occurs through the consensus mechanism i.e. no single
  point of failure
• Permissioned networks
• Network members might be restricted from participating in certain network activities
• Controls, or permissions, can be used to allow varying levels of access to the ledger:
• Participant – able to add transactions
• Regulator – view transactions only

Question 77

Permissioned vs. Permissionless Networks
Speed
Cost
Decentralisation
Access
Governance

Answer 77

Permissioned blockchain
> Faster given only a limited number of members participate or are authorised to validate transactions
> Cost-effective as few members are required to validate each transaction
> Partially decentralised as there are a limited number of members in the chain
> Membership is limited
> The governance is determined by a centralised organisation.

Permissionless blockchain
> Slower as a large number of members have to reach consensus, which decreases
network speed and scalability
> Not cost-effective as many members are required to validate each transaction
> Decentralised as all members can access the network
> Membership is unlimited
> The governance is decentralised and is maintained by the members

Question 78

Types of Digital Asset
* Cryptocurrencies
* Tokenisation

Answer 78

• Cryptocurrencies e.g. Bitcoin, altcoins (other cryptocurrencies, stable coins,
  meme coins), central bank digital currencies.
• Units used to transfer or store value, which allow near-real-time transactions between parties without the need for an intermediary
• Don’t have the benefit from the backing of a central bank or a monetary authority
• Very little regulation
• Tokenisation e.g. Non-fungible tokens (NFTs), security tokens, utility tokens,
  governance tokens
• The process of representing ownership rights to physical assets on a blockchain or
  distributed ledger e.g. verification for ownership of luxury items and property
• Non-fungible token (NFT) – links digital assets to certificates of authenticity using
  blockchain technology.
• NFTs differ from “fungible” tokens, such as cryptocurrencies, because each token and the authenticated object it represents is unique
• Security tokens digitize the ownership rights associated with publicly traded securities.
• The custody of these security tokens can be stored on a blockchain, which increases the efficiency of post-trade processing, settlement, record keeping, and custody
• Initial coin offering (ICO) – an unregulated process whereby companies sell their crypto-tokens to investors in exchange for money or for another agreed upon cryptocurrency. Typically structured to issue digital tokens to investors that can be used to purchase future products or services being developed by the issuer:
• ICOs provide an alternative to traditional, regulated capital-raising processes, such as IPOs.
  Compared to the regulated IPO market, ICOs might have lower associated issuance costs and
  shorter capital-raising time frames.
• However, most ICOs do not typically have attached voting rights

Utility tokens – provide services within a network, such as pay for services and network fees
* While security tokens may pay out dividends, utility tokens only compensate for activities on the
network.
- Governance tokens – serve as votes to determine how particular networks are run
* For instance, when there is a technical problem on a permissionless blockchain network, it is the owners of governance tokens who can vote on a solution or any major changes to maintain the stability and integrity of the network

Question 79

Digital Assets vs. Traditional Financial Assets
Inherent value
Transaction validation
Uses as a medium of exchange
Legal and regulatory protection

Answer 79

Inherent value:
* No fundamental value or future cash flow generation
* Price driven by certain features on the blockchain
Transaction validation:
Usually recorded on decentralized digital ledgers using cryptography and
algorithms for permissionless blockchain networks
Uses as a medium of exchange:
Very few digital assets are used as a direct medium of exchange, mainly
targeting large-scale commercially viable acceptance
Legal and regulatory protection:
* Ambiguous, often contradictory, evolving framework; generally unregulated, with
minimal legal protections
* Use can be illegal or criminal in some countries

Question 80

Digital Assets vs. Traditional Financial Assets
Inherent value
Transaction validation
Uses as a medium of exchange
Legal and regulatory protection

Answer 80

Inherent value:
* Value determined by future cash flow generated from the assets
Transaction validation:
* Recorded in private ledgers maintained by central intermediaries
Uses as a medium of exchange:
* Not used directly as a medium of exchange but can be readily transacted
and exchanged into traditional fiat currencies that are widely used in the
real world
Legal and regulatory protection:
Well-established, tested, and proven legal, regulatory, and commercial
standards that are clear, predictable, and well defined across all jurisdictions

Question 81

Investible Digital Assets

Answer 81

• Altcoins
• Ether
• Ether involves the added feature of a programmable blockchain that allows users to construct applications using the blockchain to validate or secure transactions or payments for markets or other uses
• Ether and other programmable coins therefore have the possibility to be more widely used than simply as a store of value
• Such programmable altcoins are also called smart coins or smart contracts, a self-executing contract with the salient terms of the contract directly written into the lines of code, which allows for execution of the contract using the blockchain network.
• Stablecoins
• Designed to maintain a stable value by linking their value to another asset and are collateralized
  by a basket of assets, typically legal tender, precious metals, or other cryptocurrencies
• The reserve basket protects the holders from price volatility and minimizes the risk to the holders of the stablecoin should the cryptocurrency face transaction problems, including failure
• Meme coins
• Cryptocurrencies often inspired by a joke and are generally launched for entertainment purposes as they gain popularity in a short period of time, which allows early purchasers to sell their holdings at an often considerable profit.

Question 82

Cryptocurrency Exchanges

Answer 82

• Centralised exchanges
• Most popular type of exchange
• Privately held exchanges provide trading platforms for cryptocurrencies and offer
  volume, liquidity, and price transparency
• Trading is electronic and direct, without any intermediating broker or dealer, and is
  hosted on private servers, exposing the centralised exchanges and their clients to
  security vulnerabilities
• Some exchanges are regulated, and depending on jurisdiction, these exchanges may be regulated as financial exchanges or other types of financial intermediaries.
• Decentralised exchanges
• Emulate blockchain’s decentralised protocol and lack a centralised control mechanism and operate on a distributed platform without central coordination or control
• As a result attacking decentralised exchanges is substantially more difficult
• Difficult to regulate because no single individual, organisation, or group controls the
  system. As a result participants are free to transact without any regulatory scrutiny,
  allowing for potentially illegal activity

Question 83

Direct Digital Asset Investment Forms

Answer 83

• Direct investments in digital assets are made on various digital exchanges where
  the transaction is recorded on the blockchain
• Most cryptocurrency exchanges are always open and available, which allows for
  continuous trading
• Many of the smaller cryptocurrencies may be held primarily by a small number of
  holders, sometimes referred to as “whales”. Possiblt large enough to have the
  ability to manipulate the price

Question 84

Indirect Digital Asset Investment Forms

Answer 84

• Cryptocurrency coin trusts
• Investors trade shares in trusts holding large pools of a cryptocurrency and that trade over the counter (OTC) and behave like closed-end funds
• Cryptocurrency futures contracts
• Represent agreements to buy or sell a specific quantity of Bitcoin or other cryptocurrency at a specified price on a particular future date e.g. Bitcoin futures on the Chicago
  Mercantile Exchange (CME)
• Typically cash settled and inherently leveraged
• Less developed and potentially less liquid and more volatile than more established
  futures markets
• Cryptocurrency ETFs
• typically do not directly invest in cryptocurrencies and gain exposure via derivatives
• Cryptocurrency stocks
• Provide indirect exposure due to their activity and relationship to digital assets
• Hedge funds investing in cryptocurrencie

Question 85

Digital Forms of Investment for Non-Digital Assets

Answer 85

• Represent similar digital forms of investment with an underlying non-digital asset
  from which the investment derives its value
• For example, asset-backed tokens
• Represent digital claims on physical assets, financial assets, or financial instruments that are collateralized by the underlying asset and derive their value directly from the
  underlying asset
• Asset-backed tokens are a digital representation of the ownership
• Tokenized assets include gold, crude oil, real estate, and equities
• Potential to increase liquidity by allowing for fractional ownership of high-priced
  assets, such as houses and art
• Allows for an immutable record of ownership information and ownership transfer,
  which increases the transparency of these transactions and reduces transaction,
  intermediation, and record-keeping costs

Question 86

Digital Asset Investment Risk, Return, and Diversification

Answer 86

• Because cryptocurrencies are a relatively new innovation, their market is subject
  to rapid price swings, changes, and uncertainty, with most investors considering
  them alternative investments
• Given that regulation of cryptocurrencies is evolving, there still is no clear legal
  protection for using them as a medium of exchange
• Although purely speculative in nature, considered by some to have value drivers
  distinct from common equity and debt markets, cryptocurrencies have exhibited
  low correlations with traditional asset class returns

Question 87

private equity funds
hedge funds

Answer 87

based on committed capital
based on assets under management

Question 88

In a public–private partnership (PPP),

Answer 88

both governments and private investors are involved in funding and completing long-lived fixed assets intended for public use and/or to provide essential services.

Question 89

mutual fund: the fee structure for mutual funds usually includes only a management fee, not an incentive fee

Answer 89

includes only a management fee, not an incentive fee.

Question 90

rL (return of leveraged portfolio)

Answer 90

rL = [r × (Vb+Vc) – (Vb × rb)]/Vc

b- borrowed

Question 91

A common problem for the “mark-to-model” valuation of private equity funds is most likely:

Answer 91

an understatement of portfolio risk.

Question 92

fees with a hard hurdle rate calculated net of management fees
from gains from postive return first subtract the hard rate*original value and then caluclate incentive fees

Answer 92

RGP(Net with Hurdle) = (P1 × rm) + max{0, [P1(1 – rm) – P0×(1+hurdle)] × p}

p - performance fee
rm - manageent fee

Question 93

a high-water mark (PHWM) computed net of fees

Answer 93

RGP(High-Water Mark) = (P2 × rm) + max[0, (P2 – PHWM) × p]

p - performance fee
rm - manageent fee

Question 94

ri = (P1 – P0 – RGP)/P0

Answer 94

ri = (P1 – P0 – RGP)/P0

Question 95

performance fee is calculated net of
management fees

Answer 95

RGP(Net) = (P1 × rm) + max{0, [P1(1 – rm) – P0] × p}

Question 96

GP performance
fee (p) that is a percentage of total return

Answer 96

RGP = (P1 × rm) + max[0, (P1 – P0) × p].

Question 97

When evaluating hedge fund positions, internal valuation models are most likely used for:

Answer 97

Level 3

Question 98

Internal valuation

Answer 98

Level 1 assets have an exchange-traded, publicly traded price available that is mandated to be used for valuation purposes.

Level 2 asset values use outside quotes from brokers when publicly traded (Level 1) prices are not available.

Level 3 asset values are computed using only internal models when outsider broker (Level 2) quotes are not available or not reliable.

Question 99

With a soft hurdle rate,

Answer 99

the incentive fee is earned on all of the return as long as the hurdle rate is exceeded.

Question 100

catch-up

Answer 100

catch-up clause allows a general partner to accelerate performance fees once a fund exceeds a specified soft hurdle rate.