CAIA - 11 - Private Equity Investment Process and Portfolio Management Set

Question 1

___ ___ ___, which was pioneered by the economist Harry Markowitz, maintains that assets that are less than perfectly correlated can be combined to maximize return for a given level of risk.

Answer 1

Modern portfolio theory, which was pioneered by the economist Harry Markowitz, maintains that assets that are less than perfectly correlated can be combined to maximize return for a given level of risk.

Question 2

Applying MPT to PE is challenging primarily due to the lack of ___ ___ ___. Thus, instead of optimal decision-making, portfolio management in PE typically involves “___,” which is a term coined by the economist Herbert Simon, that is a heuristic that entails searching through available alternatives until an acceptable solution is found.

Answer 2

Applying MPT to PE is challenging primarily due to the lack of quality PE data. Thus, instead of optimal decision-making, portfolio management in PE typically involves “satisficing,” which is a term coined by the economist Herbert Simon, that is a heuristic that entails searching through available alternatives until an acceptable solution is found.

Question 3

Private equity has 3 key performance drivers:

1. ___ ___ consistent with targeted ___ and ___profile
2. Fund manager ___ and ___
3. ___ management

Answer 3

Private equity has 3 key performance drivers:

1. Portfolio design consistent with targeted risk and return profile
2. Fund manager selection and monitoring
3. Liquidity management

Question 4

Distinguishing between ___ and ___can be useful for managing a PE investment program. While ___relates to being able to determine the probability of an event, ___relates to not being able to objectively determine the probability of an event.

Answer 4

Distinguishing between risk and uncertainty can be useful for managing a PE investment program. While risk relates to being able to determine the probability of an event, uncertainty relates to not being able to objectively determine the probability of an event.

Question 5

Under modern portfolio theory, ___ and ___are the same since return distributions are assumed to be known. In contrast, investors in private markets are exposed to different degrees of ___.

Answer 5

Under modern portfolio theory, risk and uncertainty are the same since return distributions are assumed to be known. In contrast, investors in private markets are exposed to different degrees of uncertainty.

Question 6

The first step of the private equity investment process is for the investor to establish and approve the ___.

Answer 6

The first step of the private equity investment process is for the investor to establish and approve the objectives.

Question 7

___ ___is considered the main performance driver of well-diversified portfolios.

Answer 7

Asset allocation is considered the main performance driver of well-diversified portfolios.

Question 8

The appropriate allocation to PE cannot be determined using standard risk-return optimization for several reasons:

1. Estimating ___ ___and ___is challenging
2. Analyzing ___requires adjustments
3. PE is ___, and desired investments may be unavailable

Answer 8

The appropriate allocation to PE cannot be determined using standard risk-return optimization for several reasons:

1. Estimating risk premium and correlations is challenging
2. Analyzing correlations requires adjustments
3. PE is lumpy, and desired investments may be unavailable

Question 9

Some approaches of the endowment model are consistent with a ___ diversification approach.

Answer 9

Some approaches of the endowment model are consistent with a naive diversification approach.

Question 10

Under the endowment model, the portfolio (is/is not) regularly rebalanced back to the original asset class weightings.

Answer 10

Under the endowment model, the portfolio is regularly rebalanced back to the original asset class weightings.

Question 11

Under the ___ ___, rebalancing involves selling PE positions in the secondary market when prices have risen and buying when prices have declined.

Answer 11

Under the endowment model, rebalancing involves selling PE positions in the secondary market when prices have risen and buying when prices have declined.

Question 12

The naive private equity allocation is estimated by analyzing four factors:

1. ___ size
2. ___ size to overall portfolio
3. Composition of ___ ___ portfolio
4. ___ needs

Answer 12

The naive private equity allocation is estimated by analyzing four factors:

1. Absolute size
2. Relative size to overall portfolio
3. Composition of existing PE portfolio
4. Liquidity needs

Question 13

Monitoring PE investments involves six activities:

1. Tracking ___ vs ___strategy
2. Review ___, ___, and ___information
3. Analyzing the effect of relevant ___ ___
4. Assessing ___investment and overall ___ ___
5. ___/___performance
6. Verifying ___and ___compliance

Answer 13

Monitoring PE investments involves six activities:

1. Tracking planned vs implemented strategy
2. Review investment, divestment, and valuation information
3. Analyzing the effect of relevant market trends
4. Assessing individual investment and overall portfolio risks
5. Measuring/benchmarking performance
6. Verifying legal and tax compliance

Question 14

___ ___can increase the portfolio’s transparency and provide signals of overexposure.

Answer 14

Stress tests can increase the portfolio’s transparency and provide signals of overexposure.

Question 15

In order to keep the program fully invested in the PE fund, ___-___strategies are used.

Answer 15

In order to keep the program fully invested in the PE fund, over-commitment strategies are used.

Question 16

A ___-___ portfolio construction process involves examining all investment opportunities in the targeted PE market and selecting the best fund manager.

Answer 16

A bottom-up portfolio construction process involves examining all investment opportunities in the targeted PE market and selecting the best fund manager.

Question 17

Bottom-up portfolio construction involves the following steps:

1. Investment ___
2. ___and ___ ___
3. ___and ___
4. ___

Answer 17

Bottom-up portfolio construction involves the following steps:

1. Investment identification
2. Analysis and due diligence
3. Structuring and commitment
4. Monitoring

Question 18

An issues with a bottom-up approach is that, since it strives to exploit opportunities, it can result in an ___ portfolio that is ___than intended.

Answer 18

An issues with a bottom-up approach is that, since it strives to exploit opportunities, it can result in an unbalanced portfolio that is riskier than intended.

Question 19

A ___-___ PE portfolio construction approach takes a big-picture approach that involves examining macroeconomic conditions and determining the strategic asset allocation.

Answer 19

A top-down PE portfolio construction approach takes a big-picture approach that involves examining macroeconomic conditions and determining the strategic asset allocation.

Question 20

The top-down portfolio construction approach involves the following steps:

1. General ___ ___
2. ___ asset allocation
3. ___ planning
4. ___ ___ projections

Answer 20

The top-down portfolio construction approach involves the following steps:

1. General economic analysis
2. Strategic asset allocation
3. Commitment planning
4. Cash flow projections

Question 21

The main drawback of the ___-___approach to investing in private equity is that strict allocations are not possible in practice.

Answer 21

The main drawback of the top-down approach to investing in private equity is that strict allocations are not possible in practice.

Question 22

Most investors use a ___ approach to PE portfolio construction.

Answer 22

Most investors use a mixed approach to PE portfolio construction.

Question 23

The ___- ___approach combines passive investing with active management aimed at outperforming a benchmark.

Answer 23

The core- satellite approach combines passive investing with active management aimed at outperforming a benchmark.

Question 24

The ___ portfolio relates to investors’ strategic asset allocation and consists of passive, often low-cost investments that track an asset class’s overall performance.

Answer 24

The core portfolio relates to investors’ strategic asset allocation and consists of passive, often low-cost investments that track an asset class’s overall performance.

Question 25

The ___ portfolio aims to add alpha via tactical asset allocation and consists of actively managed, higher-cost investments that require monitoring.

Answer 25

The satellite portfolio aims to add alpha via tactical asset allocation and consists of actively managed, higher-cost investments that require monitoring.

Question 26

There are a number of advantages to the core-satellite approach:

1. ___ without foregoing potential for high returns from actively-managed strategies
2. Flexibility to tailor the portfolio to ___ ___
3. Ability to target ___ ___
4. Ability to focus more effort on the ___portfolio and less on the benchmarked, lower-return ___ portfolio

Answer 26

There are a number of advantages to the core-satellite approach:

1. Diversification without foregoing potential for high returns from actively-managed strategies
2. Flexibility to tailor the portfolio to specific objectives
3. Ability to target specific risks
4. Ability to focus more effort on the satellite portfolio and less on the benchmarked, lower-return core portfolio

Question 27

In general, investors have larger satellites with:

1. ___ time horizon
2. ___resources
3. ___changes in PE market

Answer 27

In general, investors have larger satellites with:

1. Longer time horizon
2. More resources
3. More changes in PE market

Question 28

PE fund return distributions exhibit large ___ skewness

Answer 28

PE fund return distributions exhibit large positive skewness

Question 29

PE diversification has two key effects on portfolios:

1. Reduces portfolio ___ if assets are not perfectly ___
2. Makes the return distribution closer to a ___ ___

Answer 29

PE diversification has two key effects on portfolios:

1. Reduces portfolio risk if assets are not perfectly correlated
2. Makes the return distribution closer to a normal distribution

Question 30

For most assets, adequate diversification is achieved using about ___ positions.

Answer 30

For most assets, adequate diversification is achieved using about 20 positions.

Question 31

A portfolio of ___-___funds can diversify away about ___% of the standard deviation.

Answer 31

A portfolio of 20-30 funds can diversify away about 80% of the standard deviation.

Question 32

As diversification increases, ___ decreases at about the same rate as standard deviation.

Answer 32

As diversification increases, skewness decreases at about the same rate as standard deviation.

Question 33

A portfolio of ___ funds can diversify away more than ___% of kurtosis

Answer 33

A portfolio of 5 funds can diversify away more than 80% of kurtosis

Question 34

Over-diversification has considerable negative effects:

1. It reduces ___ ___and ___
2. It reduces expected fund ___ and portfolio ___ ___

Answer 34

Over-diversification has considerable negative effects:

1. It reduces positive skewness and kurtosis
2. It reduces expected fund quality and portfolio expected return

Question 35

Leveraged buyouts are ___ susceptible than venture capital funds to the loss of quality and positive skewness and kurtosis.

Answer 35

Leveraged buyouts are less susceptible than venture capital funds to the loss of quality and positive skewness and kurtosis.

Question 36

___ ___ involves composing an N-asset portfolio and allocating a weight of 1/N to each asset.

Answer 36

Naive diversification involves composing an N-asset portfolio and allocating a weight of 1/N to each asset.

Question 37

___ ___is the optimal strategy when no information is available to differentiate among assets, and has been found to produce reasonably diversified portfolios that are close to the ___ ___.

Answer 37

Naive diversification is the optimal strategy when no information is available to differentiate among assets, and has been found to produce reasonably diversified portfolios that are close to the efficient frontier.

Question 38

A diversification strategy that does not account for PE’s specific factors can be inefficient for a number of reasons:

1. Over-diversification may ___ the ___
2. Not managing the diversification of each risk dimension can ___ ___the ___
3. There are ___of ___
4. ___and ___suitable funds becomes increasingly challenging

Answer 38

A diversification strategy that does not account for PE’s specific factors can be inefficient for a number of reasons:

1. Over-diversification may cap the upside
2. Not managing the diversification of each risk dimension can adversely affect the portfolio
3. There are diseconomies of scale
4. Identifying and accessing suitable funds becomes increasingly challenging

Question 39

Vintage-year diversification is a ___-___approach and commits to the best funds regardless of the economic environment.

Answer 39

Vintage-year diversification is a cost-averaging approach and commits to the best funds regardless of the economic environment.

Question 40

The ___-___approach involves varying investment levels across vintage years with the intention of investing more in years with better prospects.

Answer 40

The market-timing approach involves varying investment levels across vintage years with the intention of investing more in years with better prospects.

Question 41

___ ___assumes that the recent past is a good indicator of the future and can be dangerous.

Answer 41

Recency bias assumes that the recent past is a good indicator of the future and can be dangerous.