Lesson 3.3: Private Funds Flashcards
A pooled investment fund buys all the shares of a publicly-traded company. The fund takes the company private, reorganizes the company, and replaces its management team. Three years later, the fund exits the investment through an initial public offering of the company’s shares. This pooled investment fund is best described as:
A private equity fund or buyout fund is one that acquires entire public companies, takes them private, and reorganizes the companies to increase their value. A hedge fund will rarely get involved with reorganizing an existing company. Venture capital funds invest in start-up companies. Leveraged ETFs do not take part in the management of their investments.
A college endowment fund might consider investing a portion of its portfolio into hedge funds to obtain the benefit of:
increased diversification.
As a different subclass of equity investment that is not generally correlated with traditional investments, institutional investors adding hedge funds to their portfolio increase the overall diversification. Hedge funds have higher—not lower—expenses, and ERISA compliance is only relevant to qualified retirement plans, not college endowment funds.
When discussing the differences between purchasing a mutual fund and a hedge fund, the investor should be aware that:
hedge funds do not offer the transparency of mutual funds.
Because hedge funds are not registered with the SEC (or the states), there are limited disclosures—the transparency is not nearly what investors have with mutual funds. Mutual fund investment managers always register with the SEC, and the same is true of must hedge fund managers, typically those with AUM of at least $150 million. Neither hedge funds nor mutual funds trade on listed exchanges, and hedge funds do not have traditional share classes; they may offer a choice of different currencies, but that is totally different from the share classes of mutual funds.
All of the following statements are features of hedge funds except
A) they are generally organized as private investment partnerships or offshore investment corporations.
B) they are usually composed of a wide array of global investments.
C) they generally have relatively low minimum initial investments.
D) they frequently employ speculative strategies to maximize returns.
C) they generally have relatively low minimum initial investments.
Hedge funds generally require high minimum investments, ranging from $250,000 to $1 million. They are organized as either domestic partnerships or offshore investment corporations and employ highly speculative investment strategies to maximize returns. Hedge funds have become very global and typically feature diverse international investments such as swaps, currencies, commodities, warrants, and other derivatives.
An individual seeking capital and possible guidance with a start-up would most likely seek funding from:
A venture capital fund, typically organized as a limited partnership, seeks out opportunities to get in on the ground floor. In additional to an ownership position, usually at least 10%, the venture capitalists provide managerial input. Because these start-ups are rarely publicly traded, they are of little interest to the other investment company choices.
One of your clients wishes to invest in a fund of hedge funds. You could tell him what?
Expenses for these funds tend to be higher than those for other funds.
Funds of hedge funds purchase interests in a variety of hedge funds, which typically use risky strategies to generate profit regardless of market direction. Redemption may be difficult with these funds, and the steps management must take to try to generate profits incur higher expenses than traditional mutual funds.
What would be a common feature of mutual funds and hedge funds?
Investors have pooled their money together
Both of these are in the category of pooled investment vehicles. Only the mutual fund is registered with the SEC, and that means full disclosure, including portfolio holdings. No such disclosure is required of hedge funds. The mutual fund offers the seven-day redemption—no such policy exists with hedge funds. In fact, most have a lock-up period where redemption cannot take place.
What would be least likely to be organized as a limited partnership?
ETFs are rarely organized as a limited partnership
Compared to traditional investments, hedge funds and private equity are most likely to be more
leveraged
Alternative investments tend to use more leverage and are typically less liquid and less transparent than traditional investments.
A hedge fund manager is compensated using the 2 & 20 rate. If the management contract calls for a hurdle rate of 5%, it means that if the fund’s return is 20%,:
the manager’s incentive fee applies to the excess return of 15%.
The hurdle rate in a hedge fund is the minimum performance required before the incentive rate (the 20%) kicks in. That incentive rate applies only to the performance in excess of the hurdle; in this case, 20% exceeds 5% by 15%.
A hedge fund and a traditional mutual fund are similar in that:
their portfolio managers are required to adhere to the fund’s stated objective.
Both hedge funds and mutual funds have stated objectives. It is expected by owners that the management will follow those objectives. Only the hedge fund always has performance incentives, and only the mutual fund has a low initial investment requirement. Mutual funds are prohibited from selling short.
The offering document for a fund states that the minimum initial investment is $500,000. This is most likely what type of fund?
Hedge funds, due to their much higher risk, usually limit their investors to those who can afford to take that higher risk by having very high minimums. Do not be surprised if you see a test question referring to the hedge fund offering document as a prospectus. That is an acceptable term even though we tend to think of a prospectus as referring to a registered issue (and hedge funds do not register with the SEC or the state).
The most common form of investment vehicle for venture capital is:
The limited partnership structure is by far the most common for venture capital.
A private equity fund would most likely be structured as:
Private equity investments, including hedge funds, are typically structured as limited partnerships.
Hedge Fund characteristics:
A) Most can borrow funds and use derivatives.
B) They require large entry-level investment amounts.
C) Their investment style is generally aimed at producing “absolute” returns.
Hedge funds are unregulated collective investment vehicles. This means they cannot be generally marketed to private individuals because they are considered too risky for investors who are less financially sophisticated. The initial outlay is usually quite high. Financial leverage and derivatives are a common practice with hedge funds. By hedging, the portfolio manager attempts to produce returns in both up and down markets.
Hedge fund portfolios are more concentrated (i.e., less diversified), so individual positions provide a significant contribution to the portfolio’s return
Hedge funds attempt to attract the top managers because they offer performance-based fees, which vary based on fund performance. The typical fee structure is 2% + 20% where 2% is the fixed fee and 20% of the profits is the performance portion. The other choices are true. You can assume that any hedge fund on the exam is organized as a private limited partnership and is not registered on the federal or state level. One of the reasons hedge funds are considered alternative investments is that a portion of their portfolio generally consists of alts, such as private equity and structured products. Unlike mutual funds, hedge funds can use leverage and sell short. In addition, it is not unusual to find as much as 25 to 30% of the hedge fund’s portfolio concentrated in the securities of a single issuer.
