CHAPTER 1: AI FEATURES, METHODS & STRUCTURES

Question 1

TRADITIONAL VS ALTERNATIVE INVESTMENTS

Answer 1

Traditional Investments refer to LONG-ONLY positions in stocks, bonds & cash.

All other investments are classified as alternative investments.

Alternative Investments are divided into 3 categories:
1. Private Capital (Pvt. Biz)
2. Real Assets (Real Estate & Gold)
3. Hedge Funds

Short Positions are Hedging & are therefore Alternative Investments

Question 2

Why Investors Consider Alternative Investments?

Answer 2

1. DIVERSIFICATION.
   AIs have low correlation with traditional asset classes
2. ENHANCED RETURNS.
   Can increase portfolio’s risk-return profile; harry markovitz’ efficient frontier & ray dahlio’s holy grail
3. HIGHER YIELDS & INCREASED INCOME.
   During low-interest rate periods, AIs can provide significantly higher yields compared to traditional investments

Question 3

Characteristics

Answer 3

1. NARROW MANAGER SPECIALIZATION

eg: VC, PE, LBO.

2. LOW CORRELATION w traditional investments; this increases during financial crises
3. LOW REGULATION & LESS TRANSPARENCY
4. LIMITED & POTENTIALLY PROBLEMATIC RISK-RETURN DATA: risk & return of HF & PE indices are biased
5. High Fees because ACTIVE MANAGEMENT & EXPERTISE required. Includes performance incentives.
6. CONCENTRATED portfolios; sometimes illiquid
7. Restrictions on redemptions (lockups & gates): how & when investors can withdraw money

Lockups in HFs: limits on TENURE over which money can be withdrawn
Gates: limits on AMOUNT that can be withdrawn at a given time

LOCKUPS: TIME LIMITS
GATES: MONEY LIMITS

Question 4

HILTON’S LBO

Answer 4

• In 2007, Blackstone Group executed a $26 billion LBO to take Hilton Hotels private.
• Financed with $20.5 billion in debt (78.4%) and $5.6 billion in equity.
• Saw opportunity in Hilton’s strong brand, global presence, and growth potential.
• LBO occurred just before the 2008 financial crisis; Hilton’s revenue and EBITDA initially declined by 20% and 40%.
• Blackstone turned Hilton around by improving operations, expanding globally, and enhancing the brand.
• In 2018, Blackstone sold its remaining stake, realizing nearly $14 billion in profits - almost 3x its investment.
• Considered one of the most successful private equity deals, showcasing LBO potential.

Question 5

CATEGORIES OF AIs

Answer 5

1. PRIVATE CAPITAL: Debt & Equity
2. REAL ASSETS: Real Estate, Commodities, Agricultural Land, Infra etc.
3. HEDGE FUNDS: long, short, macro, algo, blackbox (ALGOS)

Question 6

PRIVATE CAPITAL

Answer 6

2 Types:
1. Private Equity
2. Private Debt

Question 7

PRIVATE DEBT

Answer 7

Includes debt provided to pvt entities

TYPES:

1. Direct Lending: pvt loans w no intermediaries
2. Mezzanine Loans: Private subordinated debt (mixed D+E): bank giving loan gets paid first & then you get paid second upon bankruptcy
3. Venture Debt: pvt loans to startups & early-stage companies
4. Distressed Debt: pvt loans to distressed companies eg: companies facing bankruptcy

RISK INCREASES AS WE GO DOWN from 1-4

Question 8

PRIVATE EQUITY

Answer 8

PE funds invest in the equity of PVT companies or PUBLIC companies that wanna go PVT

2 types:
1. LBO funds: invest in established companies
2. VC funds: invest in startups & early-stage companies

Question 9

REAL ASSETS

Answer 9

Real Estate, INFRA, Natural Resources & Others

REAL ESTATE:

• Investments in buildings or land either DIRECTLY or INDIRECTLY

PVT VS PUBLIC
DEBT VS EQUITY

• Securitization has broadened the definition of real estate investing & it now includes:

1. Pvt Commercial RE Equity: ownership of an office building
2. Pvt Commercial RE Debt: directly issued mortgages on commercial property
3. Public RE Equity: REITs
4. Public RE Debt: MBS

Question 10

NATURAL RESOURCES

Answer 10

Commodities: Investment in physical assets viz. grains, metals, crude oil etc.

Commodity Investments can be done by either owning physical assets using derivative products, or investing in business engaged in the exploration & production of physical commodities: GOOD HEDGE AGAINST INFLATION

Agricultural Land or Farmland: Investments in land used for the cultivation of crops or livestock, or by leasing the land back to farmers: FARMING or LEASING

Timberland: investments in natural forests or managed tree plantations

The return comes from sale of trees, wood & other timber products

Question 11

INFRASTRUCTURE

Answer 11

Investments in capital-intensive, long-lived, real assets viz. Roads, Dams & Schools, which are intended for public use & provide essential service

A common approach to infrastructure investing is a Public-Private Partnership (PPP) in which both the govt & investors have a stake: TOLL ON HIGHWAYS to get returns back

Others:
Investments in any other tangible asset viz art, fine wine, stamps, coins etc. or intangible assets viz. patents & litigation actions

Question 12

HEDGE FUNDS

Answer 12

Pvt. Investment Vehicles that manage portfolios of securities & derivative positions using a variety of strategies

Some HFs aim for absolute returns independent of market performance

AIFs:
Cat 1: VCs, PE, Startups & MSMEs: Infra fund, Angel Fund, Social Venture fund
Cat 2: Debt & Equity: PE funds
Cat 3: Options: HF or PIPEs

Question 13

INVESTMENT METHODS

3 METHODS:

1. FUND INVESTING
2. CO-INVESTING
3. DIRECT INVESTING

Answer 13

1. FUND INVESTING: Investor contributes capital to a fund & fund makes investments on investor’s behalf; Limited Partners or LPs (give funds) & General Partners or GPs (manage funds)
2. CO-INVESTING: Investor can make investments alongside a fund eg: investments in a portfolio company of a fund. Investor is able to invest both directly & indirectly in same assets
3. DIRECT INVESTING: Investor makes direct investment in company or project without an intermediary; eg: direct investments in infra or RE

Direct: w/o intermediary
Fund: w intermediary
Co-Investing: you copy fund’s calls

Fund: Simplest + Most Costly
Co-Investing: Little Harder + Less Costly
Direct: Hardest

Question 14

Advantages & Disadvantages: FUND INVESTING

Answer 14

Advantages:

• Low investor involvement; fund managers handle investments.
• Access to alternative investments without needing expertise.
• Lower minimum capital requirements.

Disadvantages:

• High management and performance fees.
• Requires thorough due diligence to select the right fund.
• Difficult to exit due to lock-ups and restrictions.

Question 15

Advantages & Disadvantages: CO-INVESTING

Answer 15

Advantages:

• Learn from the fund’s process to improve direct investing skills.
• Reduced management fees.
• More active portfolio management and deeper relationship with the manager.

Disadvantages:

• Less control over investment selection compared to direct investing.
• Potential for adverse selection bias.
• Requires more active involvement than fund investing.

Question 16

Advantages & Disadvantages: DIRECT INVESTING

Answer 16

Advantages:

• No ongoing management fees.
• Greatest flexibility for the investor.
• Highest control over asset management.

Disadvantages:

• Requires more expertise and financial sophistication, increasing internal costs.
• Less access to fund diversification and sourcing networks.
• More complex due diligence needed.
• Higher minimum capital requirements.

Question 17

DUE-DILIGENCE FOR DIRECT INVESTING

Answer 17

Investor has control over which portfolio company to invest in; the focus of due diligence is the company itself

As compared to other methods, this requires CONSIDERABLE EXPERTISE

Question 18

DUE-DILIGENCE FOR CO-INVESTING

Answer 18

Similar to direct investing

Difference between the two: In co-investing, investors often depend heavily on due diligence conducted by the fund manager. Whereas, direct investing due diligence is more independent

Question 19

INVESTMENT & COMPENSATION STRUCTURES

Answer 19

General Partners (GPs): Fund Managers: bears UNLIMITED liability if anything goes wrong. ACTIVE ROLE.

Limited Partners (LPs): Fund Providers: bear LIMITED liabilities associated with investments. provide capital in return for fractional partnership in the fund. PASSIVE ROLE.

Rules outlined in LIMITED PARTNERSHIP AGREEMENT (LPA): outlines rules of partnership & establish framework for fund’s operations

SIDE LETTERS: may be negotiated: additional terms between GP & certain LPs that exist outside the LPA (common doc for all LPs)

Question 20

Other structures maybe adopted for specific Alternative Investments eg:

Answer 20

Infra investors often enter into PPP which are agreements between public & pvt sector

RE direct investing involves Joint Venture structure

RE fund investing involves a unit-holder structure

Question 21

GP FEES

Answer 21

2 Categories:

1. MANAGEMENT fees: fixed based on AUM or COMMITTED CAPITAL: 1-2%
2. PERFORMANCE fees: variable: incentive fee or carried interest based on realized profits

2:20 STRUCTURE: 2% Management fee & 20% performance fee (only paid on realized profits)

Question 21

COMPENSATION STRUCTURES

Generally, performance fee is paid only if the returns exceed a HURDLE RATE or PREFERRED RATE

usually 8%

Answer 21

HARD HURDLE RATE: GP earns fees on ANNUAL RETURNS in EXCESS of hurdle rate: EXTRA WINNINGS: only earned on amount above a certain level

SOFT HURDLE: GP earns fees on entire ANNUAL GROSS RETURN as long as set hurdle is exceeded: ALL WINNINGS: bonus on entire amount

eg: 100M fund grows to 120M

SOFT HURDLE: As long as you make more than the minimum requirement, you will get 20% performance fee on the WHOLE PROFIT i.e. 20% of 20M= 4M

HARD HURDLE: @110: you get to 120. then you only get 20% on the 10M from 110 to 120

Question 22

COMMON INVESTMENT CLAUSES, PROVISIONS & CONTINGENCIES IN THE LPA

Answer 22

1. Catch-up Clause: Managers get a chance to earn more after returning initial investment to investors; they get to catch-up on opportunities they missed when focusing on returning original investment. GPs get paid after LP has made money above hurdle rate.
2. High-water Mark: Fees are only charged on profits that exceed the fund’s previous highest value or high-water mark.
3. Waterfall: How profits are split & how they flow amongst managers & investors in stages like steps in a waterfall
4. Clawback: Managers have to return excessive fees if their later performance doesn’t justify them: it’s like clawing back money previously paid out, ensuring fairness by returning unjustified earnings

Question 23

CATCHUP CLAUSE

Answer 23

Allows GP to receive 100% of the distributions above the hurdle rate until he receives 20% of profits generated & then every excess dollar is split 80/20 between the LPs & GP.

Allows GP to catchup

This clause is meant to make the manager whole so that their incentive fee is a function of total return & not solely on the return in excess of the hurdle rate.

eg: fund goes from 100 to 110 M
10% hurdle rate
so, upto 110= all money goes to LP
after 110, everything goes to GP till he catches up & the proportion is 80:20
110-112: additional 2M goes to LP till 80:20 requirement is met

Question 23

CATCHUP CLAUSE
HIGHWATER MARK
WATERFALL
CLAWBACK

Answer 23

CATCHUP CLAUSE: managers earn more after returning initial investments

HIGHWATER MARK: fees charged on profits above previous peak

WATERFALL: profits distributed in stages

CLAWBACK: managers return excessive fees if needed

Question 24

Assume that a GP has earned an 18% IRR on an investment, the hurdle rate is 8% & the partnership agreement includes a catchup clause

80:20 of IRR

WITHOUT CATCHUP:
made 18
min 8
made 10 extra
20% of 10 goes to GP

WITH CATCHUP:
80% of IRR= goes to LP
20% of IRR= goes to GP

Answer 24

In the absence of a catchup clause, the distributions would’ve been:

You made 18
Minimum was 8
So, you made 10 extra
20% of this 10 extra= 2% goes to GP

IN CASE OF CATCHUP CLAUSE:

After first 8% profit
100% of profit goes to GP
So, LPs receive full 8% profits

GP receives entirety of next 2% profit because 2% out of 10% amounts to 20% of profits accounted for so far

Remaining 8% would be split 80:20 between LPs & GP
Thus, GP effectively earns: 18%20%= 3.6%
and LP earns= 18%80%= 14.4%

Question 25

HIGH WATER MARK

Answer 25

In some cases, the incentive fee is paid only if the fund has crossed the high-water mark.

A high-water mark is the highest value net of fees (or highest cumulative return) reported by the fund so far for each of its investors

This is to ensure investors don’t pay twice for same performance

eg:
100M to 120M to then 105M to 109M
Should the LP get paid a performance fee for going from 105M to 109M? The 4M increase?

NO! Because they must go beyond 120M (previous high-water mark) to get paid the performance fees

Question 26

WATERFALL

Whole-of-Fund (European) waterfalls
OR
Deal-by-Deal (American) waterfalls

Answer 26

The waterfall defines the way in which cash distributions will be allocated between GP & LPs.

In most waterfalls, a GP receives a disproportionately larger share of total profits relative to their initial investment.

This is typically done to incentivize GPs to maximize profitability

2 TYPES:

Whole-of-Fund (European) waterfalls: As deals are exited, all distributions go to the LPs first. The GP doesn’t participate in any profits until the LPs receive their initial investment & the hurdle rate has been met

eg: 100M to 80M
fund has 2 projects:
investment 1= goes from 50M to 60M
investment 2= goes from 50M to 20M
americans: can give performance fees on a per-deal basis, so LP can get a performance fee on inv1
european: don’t; only give performance when GPs have received all investments back & the hurdle rate has been met

Deal-by-Deal (American) waterfalls: Performance fees are collected on a per-deal basis. This is more advantageous for a GP as he can get paid before LPs receive both their initial investment & their preferred rate of return on the entire fund.

Question 27

European or Whole-of-Fund Waterfalls
American or Deal-by-Deal Waterfalls

Answer 27

2 TYPES:

Whole-of-Fund (European) waterfalls: As deals are exited, all distributions go to the LPs first. The GP doesn’t participate in any profits until the LPs receive their initial investment & the hurdle rate has been met

eg: 100M to 80M
fund has 2 projects:
investment 1= goes from 50M to 60M
investment 2= goes from 50M to 20M
americans: can give performance fees on a per-deal basis, so LP can get a performance fee on inv1
european: don’t; only give performance when GPs have received all investments back & the hurdle rate has been met

Deal-by-Deal (American) waterfalls: Performance fees are collected on a per-deal basis. This is more advantageous for a GP as he can get paid before LPs receive both their initial investment & their preferred rate of return on the entire fund.

Question 28

CLAWBACK

Answer 28

A clawback provision allows LPs to reclaim a part of the GPs performance fees

eg: if a fund makes profitable exits in early hyears, but the subsequent exists are less profitable, then the GP has to pay back profits to ensure that the profit split is in line with the fund prospectus

100M to 120M (took performance fee of 20M)
then made loss from 120 to 105
GPs say you made a loss, we deserve some profits from 100 to 105.
Since you lost all the money you made for us from 120 to 105M, you PAYBACK performance fees for the loss

i.e.
120-105= 15*20%