Alternative Investments (8%) Flashcards
Identify which of the following choices is most likely an alternative investment:
A.An investment in a hedge fund focused on traditional assets
B.Shares in a manufacturing firm traded on the Bursa Malaysia exchange
C.A euro foreign exchange future purchased on the Chicago Mercantile exchange
The correct answer is A. An investment in a hedge fund, even one that purchases traditional exchange-traded assets, is considered an alternative investment.
Alternative investments:
definition
investments other than ownership of traditional asset classes (public equity and fixed-income instruments and cash) and include private capital, real assets, and hedge funds.
Alternative investments:
purpose
Investors often consider alternative investments in pursuit of greater portfolio diversification and/or increased expected returns.
In doing so, they usually face
Alternative investments:
downside
longer investment periods
reduced liquidity, and
less efficient markets than for more traditional assets.
Private Capital
a broad term for funding provided to companies that is sourced from neither the public equity nor the public debt markets.
Capital that is provided in the form of equity investments is called private equity, whereas capital that is provided as a loan or other form of debt is called private debt.
Private Equity:
Target Firms
private equity is used in the mature life cycle stage or for firms in decline, with leveraged buyouts being a key approach.
Venture Capital:
Definition
a specialized form of private equity whereby ownership capital is used for non-public companies in the early life cycle or startup phase, where often an idea or business plan exists with a limited operation or customer base.
private debt:
venture debt
venture debt is extended to early-stage firms with little or no cash flow
private debt:
distressed debt
involves public or private debt of corporate issuers believed to be close to or in bankruptcy that could benefit from investors with capital restructuring skills.
real assets
Generally, these are tangible physical assets, such as real estate, infrastructure, and natural resources, but they also include such intangibles as patents, intellectual property, and goodwill. Real assets generate current or expected future cash flows and/or are considered a store of value.
real estate
Includes borrowed or ownership capital in buildings or land. Developed land includes commercial and industrial real estate, residential real estate, and infrastructure.
Infrastructure
A type of real asset that is intended for public use and provides essential services. These assets are typically long-lived fixed assets, such as bridges and toll roads.
public–private partnership (PPP)
An agreement between the public sector and the private sector to finance, build, and operate public infrastructure, such as hospitals and toll roads.
concession agreement
A legal agreement in infrastructure investing that governs the investor’s obligations to construct and maintain infrastructure as well as the exclusive right to operate and earn fees for a pre-determined period.
Natural resources
These include commodities (hard and soft), agricultural land (farmland), and timberland.
commodities
product or service from a firm that is indistinguishable from products or services of competing firms, usually conforming to a common standard or grade imposed by convention or regulation.
digital assets
The umbrella term covering assets that can be created, stored, and transmitted electronically and have associated ownership or use rights. Digital assets include a variety of assets, such as cryptocurrencies, tokens (security and utility), and digital collectables.
hedge funds
Private investment vehicles that may invest in public equities or publicly traded fixed-income assets, private capital, and/or real assets, but they are distinguished by their investment approach rather than by the investments themselves.
Fund of Funds
Funds that hold a portfolio of hedge funds; also called funds of hedge funds.
Three methods for accessing alternative investments
Investors can access alternative investments through three main methods:
Fund Investment
Co-Investment
Direct Investment
Fund Investment:
Definition
Investors contribute capital to a fund, which identifies, selects, and manages investments.
Fund Investment:
Structure
The fund charges a management fee and a performance fee for superior results.
Fund Investment:
Advantages
Suitable for investors with limited resources or experience. Provides exposure to a diversified portfolio managed by professionals.
Fund Investment:
Disadvantages
Limited control over specific investments and potentially higher fees.
Coinvestment:
Definition
Investors invest alongside a fund in specific deals, gaining direct exposure to the assets.
Coinvestment:
Advantages
Lower fees compared to fund-only investments and greater control over investment decisions. Investors can expand their knowledge and skills.
Coinvestment:
Disadvantages
Requires more involvement and oversight from the investor.
Direct Investment:
Definition
Investors directly invest in companies or projects without using an intermediary fund.
Direct Investment:
Advantages
Maximum flexibility and control over investment choices, financing methods, and timing. Suitable for sophisticated investors with specialized knowledge.
Direct Investment:
Disadvantages
Requires significant resources, expertise, and oversight capabilities. Typically undertaken by large institutions like sovereign wealth funds or pension funds.
Alternate Investments:
Ownership Structures
Typically involve partnerships, especially limited partnerships, with at least one general partner (GP) managing the fund and outside investors as limited partners (LPs). LPs have limited liability and are passive investors, while GPs have unlimited liability and manage the fund’s operations.
Alternate Investments:
Compensation Structures
Use a combination of management fees and performance fees.
limited partnership agreement (LPA):
Definition
A legal document that outlines the rules of the partnership and establishes the framework that ultimately guides the fund’s operations throughout its life.
Limited partnership agreement (LPA):
Key Feature
Key features of an LPA include the distribution of profits and losses (covered in detail below); manager roles and responsibilities, such as investment criteria and restrictions; and terms governing transfers, withdrawals, and dissolution of the agreement.
Limited partnership agreement (LPA):
Side Letter
A side agreement created between the GP and specific LPs. These agreements exist outside the LPA. These agreements provide additional terms and conditions related to the investment agreement.
master limited partnership (MLP):
definition
Has similar features to limited partnerships but is usually a more liquid investment that is often publicly traded
master limited partnership (MLP):
uses
Real estate or natural resource fund
performance fee
Fee paid to the general partner from the limited partner(s) based on realized net profits.
carried interest
A performance fee (also referred to as an incentive fee, or carry) that is applied based on excess returns above a hurdle rate.
committed capital
The amount that the limited partners have agreed to provide to the private equity fund.
PE management fee
management fee is typically based on committed capital, not invested capital; the committed-capital basis for management fees is an important distinction from hedge funds, whose management fees are based on assets under management (AUM).
Using committed capital as the basis for management fee calculations reduces the incentive for GPs to deploy the committed capital as quickly as possible (in order to increase near-term management fees). This allows the GPs to be selective about deploying capital into investment opportunities.
hurdle rate
Also called “preferred return.” The minimum rate of return on investment that a fund must reach before a GP receives carried interest.
hard hurdle rate
Hurdle rate where the manager earns fees on annual returns in excess of the hurdle rate
soft hurdle rate
Hurdle rate where the fee is calculated on the entire return when the hurdle is exceeded. With a soft hurdle, GPs are able to catch up performance fees once the hurdle threshold is exceeded.
With a soft hurdle, GPs are able to catch up performance fees once the hurdle threshold is exceeded.
catch-up clause
The acceleration of performance fees once a fund exceeds the soft hurdle rate.
A clause in an agreement that favors the GP. For a GP who earns a 20% performance fee, a catch-up clause allows the GP to receive 100% of the distributions above the hurdle rate until she receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP.
high-water mark:
definition
The highest value, net of fees, that a fund has reached in history. It reflects the highest cumulative return used to calculate an incentive fee.
High-water mark:
penalization
If the fund’s value subsequently declines below the high-water mark, the hedge fund manager may not charge performance fees until the fund value exceeds the previous high-water mark. The use of high-water marks seeks to reward managers for sustained performance and protect LPs from paying twice for the same returns.
clawback provision
A requirement that the general partner return any funds distributed as incentive fees until the limited partners have received their initial investment and a percentage of the total profit.
waterfall types:
deal-by-deal
Deal-by-deal waterfalls are more advantageous to the GP because performance fees are collected on a per-deal basis, allowing the GP to get paid before LPs receive both their initial investment and their preferred rate of return (i.e., the hurdle rate) on the entire fund.
waterfall types:
whole-of-fund
In whole-of-fund waterfalls, all distributions go to the LPs as deals are exited and the GP does not participate in any profits until the LPs receive their initial investment and the hurdle rate has been met. In contrast to deal-by-deal waterfalls, whole-of-fund waterfalls occur at the aggregate fund level and are more advantageous to the LPs
Identify the following statement as true or false: Limited partners (LPs) are involved in the management of the alternative investment fund in which they invest; they assist the general partner (GP) in the operations and decisions of the fund.
True
False
False. LPs play passive roles and are not involved in the management of the fund (although co-investment rights allow LPs to make additional direct investments in the portfolio companies); the operations and decisions of the fund are controlled solely by the GP.
Calculate the general partner’s performance fee earned based on the following terms:
rGP=max[0, p(r – rh)]
rGP = max[0, 18%(20% – 10%)]
rGP = 1.8%.
In which part of the investment life cycle of a private equity investment should investors generally expect a positive cash flow?
A. Capital commitment
B. Capital deployment
C. Capital distribution
C is correct. In the initial capital commitment phase, fees and expenses are immediately incurred prior to capital deployment, and assets may generate little or no income during this first phase. In the capital deployment phase, cash outflows typically exceed inflows as funds are deployed. Only in the capital distribution phase can excess income be generated from the invested properties and substantial capital gains be realized upon the sale of assets.
preferred measure for alternative investment returns
Internal rate of return (IRR)
Why is IRR preferred for performance measurement for alternative investments?
A. IRR is commonly used for other asset classes.
B.IRR is easy and intuitive to calculate.
C.IRR takes into account the timing of cash flows in long-lived alternative investments.
C is correct. IRR is seldom used to measure investment performance of other asset classes with publicly quoted market prices. Although IRR is complicated to calculate and involves assumptions on opportunity costs and reinvestment rates, it is the best metric to evaluate long-lived alternative investments because it takes into account the unique timing of cash flows in the investment life cycle of alternative investments.
Which of the following statements regarding hedge fund fee structure is correct?
A.The periodic returns of all investors in the same fund must be identical.
B.Hedge funds usually charge a performance fee based on a percentage of periodic return above a certain threshold.
C.The management and performance fee rates are always the same for all investors in the same fund.
B is correct. A hedge fund usually charges both a flat management fee and an additional performance fee based on a percentage of periodic fund returns. Periodic performance results may vary based on which investor has invested and when the investor invested into the fund. Besides, a particular investor may face significantly lower incentive fees if she invests more capital in a fund at an earlier phase or is willing to accept greater restrictions on redemption
A $100 million hedge fund charges all its investors a 2% management fee and a 20% performance fee if the periodic return, net of management fee, exceeds a 5% hard hurdle rate. All fees are deducted based on the end-of-year value. If the fund makes a gross return (before fees) of 8% for the year, what is the investor’s return, net of fees, closest to (ignoring any high-water mark provisions)?
A. 4.67%
B. 5.67%
C. 5.84%
B is correct. If the hedge fund makes 8% gross return for the year, its net asset value has grown to $108 million before any fees are deducted.
Management fee = $108 × 2% = $2.16 million.
Performance fee = [($108 – $2.16) – ($100 × $1.05%)] × 20% = $0.168 million.
Net asset value after fee deduction = $108 – $2.16 – $0.168 = $105.672 million.
Net investor return = ($105.672 – $100)/$100 ≈ 5.67%.
Alternative Investment Phases:
Capital Commitment
Alternative managers identify and select appropriate investments with either an immediate or a delayed commitment of capital (known as a capital call) that may be in an early-stage company in the case of venture capital, a more mature firm for private equity, or one or more properties in the case of real estate. 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.
Alternative Investment Phases:
Capital deployment
Over this second phase, alternative managers deploy funds to engage in construction or make property improvements in the case of real estate or infrastructure, incur expenses in the turnaround phase of a mature company in the case of private equity, or initiate operations for a startup using venture capital. Cash outflows typically exceed inflows, with management fees further reducing returns.
Alternative Investment Phases:
Capital distribution
When the turnaround strategy, startup phase, or property improvements are completed and if the investment is 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 or the sale of properties in the case of real estate.
J-Curve Effect
Represents the initial negative return in the capital commitment phase followed by an acceleration of returns through the capital deployment phase.
multiple of invested capital (MOIC)
A simplified calculation that measures the total value of all distributions and residual asset values relative to an initial total investment; also known as a money multiple.
Himitsu, a private equity firm, makes an initial investment of JPY3.8 billion into ZZZ company in Year 0. Eight years later, it sells its stake in ZZZ for JPY8.5 billion. Additional capital investments were made in Year 2 and in Year 3 for JPY1.2 billion and JPY200 million, respectively.
Calculate the MOIC.
MOIC = 8.5/(3.8 + 1.2 + 0.2) = 1.63
primer brokers
A broker that provides services that commonly include custody, administration, lending, short borrowing, and trading.
margin financing
broker lends shares, bonds, or derivatives and the hedge fund (or investment manager) deposits cash or other collateral into a margin account at the prime broker based on certain fractions of the investment positions.
Which of the following is not a factor that makes comparison of performance between alternative investments and public securities difficult?
A. Alternative investments charge higher fees.
B. The use of leverage in alternative investments magnifies their risk and return measures.
C.The fair value of portfolio positions in alternative investments may not be readily available.
A is correct. Although an alternative investment may charge a higher fee, it is not the absolute fee level but the complexity of the fee arrangement that makes alternative investment appraisal unique compared to other common asset classes.
Alternative investments often involve the use the of explicit leverage, which has the effect of magnified gains and losses. Alternative assets are often characterized by illiquidity with unobservable market prices, making performance appraisal over time and periodic comparison with common asset classes challenging.
Describe the J-curve effect in alternative investments.
The J-curve effect in alternative investments describes the 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.
A private equity closes a fund with a capital commitment of €750 million. It has a capital call of €500 million initially and another €250 million at the end of Year 1. The management fee is 2% per annum. At the end of Year 5, a total of €1.0 billion is distributed to its investors, and the fund is left with €500 million in asset value. The multiple of invested capital (MOIC) after five years is closest to:
A) 1.3×
B) 2.0×
C) 2.2×
C is Correct.
Total paid-in capital = 500 + 250 = 750.
Total management fee for 5 years = 750 × 0.02 × 5 = 75.
Total invested capital = 750 – 75 = 675.
MOIC = (1,000 + 500)/675 ≈ 2.2×.
redemption fee
A fee charged to discourage redemptions and to offset the transaction costs for remaining investors in the fund.
notice period
The length of time (typically 30–90 days) in advance that investors may be required to notify a fund of their intent to redeem some or all of their investment. This allows a fund manager to liquidate a position in an orderly fashion without magnifying losses.
lockup period
The minimum holding period before investors are allowed to make withdrawals or redeem shares from a fund. Its purpose is to allow the hedge fund manager the required time to implement and potentially realize a strategy’s expected results.
gate
A provision that when implemented limits or restricts redemptions for a period of time.
Custom Fee Arrangements:
Fees based on liquidity terms and asset size
Limited partnerships may charge different rates depending on the liquidity terms that an investor is willing to accept (longer lockups resulting in lower fees), and managers may discount their fees for larger investors or for placement agents who introduced these investors. Different investors in the same fund may face different fee structures.
Founders shares
A way to entice early participation in startup funds whereby managers offer incentives that entitle investors to a lower fee structure and/or other favorable terms.
Either/or fees
A custom fee arrangement whereby major investors are offered a structure where managers agree to charge either a lower management fee or a higher incentive fee, whichever is greater.
survivorship bias
The exclusion of failed funds from a given benchmark is a form of selection bias that can lead investors to overly optimistic return expectations
backfill bias
The subsequent inclusion or “backfilling” of prior performance data on a selective basis serves to increase average reported returns
Hedge Fund Indexes
A common problem with hedge fund indexes is the upward bias due to:
A.backfill bias only.
B.survivorship bias only.
C.both backfill and survivorship bias.
C is correct. Both backfill bias and survivorship bias are common in hedge fund indexes.
At the conclusion of a public company’s leveraged buyout, the amount of its market-traded stock is substantially:
A. reduced.
B. increased.
C. unaffected.
A is correct. After the transaction, the target company becomes or remains a privately owned company.
Leveraged buyouts are sometimes called “going-private” transactions because after the acquisition of a publicly traded company, the target company’s equity is substantially no longer publicly traded.
Which of the following financing tools would most likely be used at the later stage of venture capital investment?
A. Common stock
B. Preferred stock
C. Convertible debt
B is correct. Preferred stock can be deployed as late into a company’s maturity as later-stage venture capital, when preferred stock can offer more protection to venture investors as a company transitions toward an IPO. A and C are incorrect because these instruments are more typically used in the earlier pre-seed and seed stages.
Which of the following transaction features is associated with mezzanine debt?
A. Warrants
B. Lines of credit
C. Fixed payment schedules
A is correct. Mezzanine debt often comes with additional features, such as warrants or conversion rights.
In using private debt for a syndicated leveraged mortgage portfolio, the financial ratio of loan to value (LTV) is important at:
A. origination and to the real estate fund sponsor.
B.syndication and to the private debt fund lender.
C.both transaction phases and to each of the parties.
C is correct. LTV plays a significant role in both legs of this transaction.
Vintage diversification is an advisable policy for implementation by private capital:
A. funds.
B. investors.
C. users, such as company managers.
B is correct. The vintage year, the time when fund deployment begins, is important for comparing PE and VC investments with other funds in the same year. Because of changing business and valuation environments, funds of a certain vintage have a relative advantage based on their start-up timing. That is why investors are encouraged to pursue vintage diversification by investing in multiple vintage years.
The potential diversification benefits from private capital investment are most likely related to its:
A. wide range of exit strategies.
B. various types of fee structures.
C. lower correlation with public asset returns.
C. lower correlation with public asset returns.
private capital
Funding provided to companies that is not sourced from the public markets.
private equity
Equity investment capital raised from sources other than public markets and traditional institutions.
private debt
Capital extended to companies through a loan or other form of debt.
leveraged buyout
Transactions whereby the target company’s management team converts the target to a privately held company by using heavy borrowing to finance the purchase of the target company’s outstanding shares.
management buyout
A type of leveraged buyout where the current management team participates in the acquisition.
management buy-in
A type of leveraged buyout where the current management team is replaced with the acquiring team involved in managing the company.
Private Equity:
Types of Investments
- Leveraged Buyout
- Venture Capital
- Growth Capital
Growth Capital
Providing capital to more mature companies for expansion or restructuring, often without taking a controlling interest.
Private Equity:
Exit Strategies:
Trade Sale
Selling the company or a part of it to a strategic buyer.
Private Equity:
Exit Strategies:
Public Listing
IPO, direct listing, or SPAC
Private Equity:
Exit Strategies:
Recapitalization
Increasing leverage and paying a dividend without exiting.
Private Equity:
Exit Strategies:
Secondary Sale
Selling the company to another private equity firm.
Private Equity:
Exit Strategies:
Write-off/Liquidation
Revising the value downward or liquidating the company if the investment loses value.
True or False:
Both public and private equity represent direct ownership and control of the corporation. Additionally, all owners have a direct and proportional claim to residual cash flow rights in the form of dividends.
True
Describe a funding situation to which a PIPE transaction is well suited
A PIPE transaction is well suited for a company needing to quickly raise capital with fewer disclosures and lower transaction costs than traditional public offerings. This is often used in situations like work-out or rescue scenarios where the company faces immediate financial needs, such as during the early stages of the COVID-19 pandemic when travel companies like Expedia needed rapid capital infusion.
Mezzanine-stage financing
Mezzanine venture capital that prepares a company to go public as it continues to expand capacity and enhance its growth trajectory. It represents the bridge financing needed to fund a private firm until it can execute an IPO or be sold.
PIPE (private investment in public equity)
a private offering to select investors with fewer disclosures and lower transaction costs that allows the issuer to raise capital more quickly and cost effectively than with other means that may be more regulated, expensive, and lengthy. In a traditional PIPE transaction, either newly issued common stock or shares sold by existing stockholders—or a combination of both—in an already-publicly traded company are made available to certain investors. These investors, typically investment firms, mutual funds, or other institutional investors, enter into a definitive purchase agreement with the issuer and commit to purchase securities at a fixed price.
Pre-seed capital, or angel investing
capital provided at the idea stage. Funds may be used to develop a business plan and to assess market potential. The amount of financing here is typically small and sourced from individuals, often friends and family, rather than by VC funds.
Seed-stage financing, or seed capital
generally supports product development and marketing efforts, including market research. This is the first stage at which VC funds usually invest.
Early-stage financing
start-up stage financing, goes to companies moving toward operation but prior to commercial production or sales, in both of which early-stage financing may be injected to initiate.
Later-stage financing
comes after commercial production and sales have begun but before an IPO. Funds may be used to support initial growth, a major expansion (such as a physical plant upgrade), product improvements, or a major marketing campaign.
Private Debt: Direct Lending
Loans provided directly to operating companies by private debt firms or funds.
Private Debt: Mezzanine Loans
Subordinated to senior debt but senior to equity, often used in LBOs, recapitalizations, and acquisitions. It offers higher returns due to higher risk and may include equity participation options.
Private Debt: Venture Debt
Provides funding to start-ups or early-stage companies with little or negative cash flow, often without diluting shareholder ownership.
venture debt may carry additional features that compensate the investor/lender for the increased risk of default or for the start-up and early-stage companies that lack substantial assets for debt collateral.
Private Debt: Distressed Debt
Involves buying debt of companies in financial distress, with the goal of restructuring and reviving them.
Private Debt: Unitranche Debt
Unitranche debt combines different tranches of secured and unsecured debt into a single loan with a single, blended interest rate. The interest rate typically falls between the rates demanded on secured and unsecured debt, providing a middle ground in terms of cost.
leveraged loan
Where private debt investor firms borrow money to make a direct loan to a borrower.
Factors Making
Performance/Risk Comparisons with Public Debt and Equity Inappropriate:
Phase of Life Cycle
The performance of private capital investments greatly depends on the specific phase of a company’s life cycle. For example, investing in a start-up carries greater risk than investing in a well-established firm.
Factors Making
Performance/Risk Comparisons with Public Debt and Equity Inappropriate:
Vintage Year
The vintage year affects the performance of private equity and venture capital investments due to the economic conditions at the time of initial investment.
Life Cycle Segments of a Private Equity Fund:
Investment Period
Typically the first five years, during which the fund sources capital from limited partners and invests in various companies.
Life Cycle Segments of a Private Equity Fund:
Harvesting Period
The remaining years when the fund exits existing investments and returns capital to limited partners.
Vintage Year
The year in which a private capital fund makes its first investment.
Ranking Asset By Risk:
1. Infrastructure Debt
2. Sr. Real Estate Debt
3. Unitranche Debt
4. Mezzanine Debt
5. Private-Equity Co Investments
The two categories of real property are:
A.residential and commercial.
B.privately held and publicly traded.
C.individual market and institutional market.
A.residential and commercial.
The preferred investment vehicles for public investors to own income-producing real estate are:
A. real estate funds.
B. mortgage-backed securities.
C. real estate investment trusts.
The correct answer is C. Real estate investment trusts (REITs) are the preferred investment vehicles for owning income-producing real estate for both private and public investors.
Which of the following entails the least risk?
A. Value-add real estate
B. Investment-grade commercial mortgage-backed securities
C.Residential real estate with long-term leases and many lessors
The correct answer is B. Of these three, investment-grade commercial mortgage-backed securities (CMBS) entail the least risk, and value-add real estate investments entail the most.
