Reading 47 - Introduction To Alternative Investments

Alternative Investment
Introduction to Alternative
Investments
Study Session 16
Reading No – 47
Version 2022
Approach for Exam
• This is very different kind of reading and subject itself. To safely conclude this is
more of a : Qualitative/ Subjective Reading
• You might find very little calculation based questions from this reading in the
exam, with may be a change of fees calculation
• After going through this notes, its highly recommended to build a perspective on
alternative investment rather than memorizing
• A Detailed reading once on different cases presented by CFA curriculum is
recommended to knock this topic off from your worrying list
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Learning Outcome Statements
The candidate Should be able to:
a. describe types and categories of alternative investments;
b. describe characteristics of direct investment, co-investment, and fund investment methods for alternative
investments;
c. describe investment and compensation structures commonly used in alternative investments;
d. explain investment characteristics of hedge funds;
e. explain investment characteristics of private capital;
f. explain investment characteristics of natural resources;
g. explain investment characteristics of real estate;
h. explain investment characteristics of infrastructure;
i. describe issues in performance appraisal of alternative investments;
j. calculate and interpret returns of alternative investments on both before-fee and after-fee bases
Los a: Types of Alternative Investment
Private Equity
Hedge Funds Private Debt
Private Capital Real Estate

Non Traditional
Alternative Land, Timberland
Natural Resources
Investment Commodities
PPP( Public Private

Infrastructure
Partnership)
Others Art, Stamps, Wine
You must understand that alternative investment doesn’t mean new fancy way of investment. These types
have been a part of the AI investment universe since ages, however its just non traditional
Los a: AIF ( Alternative Investment in India)
In India the first category of alternative investment is also called as AIF Category 3, and Private capital
alternative investment in the form of a fund falls under category 2 and 1. Compared to U.S, India’s formal
alternative investment journey has just begun. The question to ask ourselves is how is a formal structure
of AIF different from a mutual fund?.
• Consider that mutual fund is a traditional route,
which is open to any one to invest
• Traditional investment are heavily regulated and
leverage is almost 0.
• However what if we want to design a new strategy,
which uses complex algorithms and uses 20 times
leverage ?
• You can’t launch that for the larger public, because
they won’t be able to understand the risk and any
ways won’t have any good use of such exposure
• Hence although the regulations for AIF are less
stringent than MF’s but the entry requirement to
investment is a minimum of INR 1 Cr.
• Now consider who would invest that amount in AIF,
considering alternatives are diversifying tools? A
person with at least wealth above INR 50 Cr.
Source: SEBI
Los b: Methods of Investing
AIF & Investor Co
Investment 1 Investing Example:
I. AIF: 2 point
Limited Partner capital in
India
II. Co Investing:
Investing in
particular
Investment 2 AIF- Pooled
Investors company
Capital along side the
AIF
III. Direct
Investing:
Fund Manager Directly
investing in a
private
Investment 3 company
Los b: Comment on Methods of Investing
You might actually be inclined to think about Scale & Skills is the answer:
the methods of investing, just because we are 1. Investing in a stock directly: Do you have the
covering this in this reading and study session. resources( analysts, data, knowledge), to pick
However just pause and think, isn't the stocks, manage risks, beat benchmarks, create
methods true even if its not alternative an investment philosophy and stick to it? Also
investment? after considering for that costs, will your
1. You could directly buy a stock, then why performance still be better than a mutual fund.
mutual fund? A Bloomberg terminal costs $2000 per month
or INR 15 lacs a year.
2. You could also invest in a start up, then 2. Do you have enough capital to invest in a start
why find a partner to invest? up or your investment is too small ?
3. You could invest in mutual fund, then why 3. You understand a certain sector too well,
buy stocks directly? compared to even analysts, and would like to
take higher exposure directly, that won’t be
possible using a fund structure
Los b: Investing via Fund
Advantages Disadvantages
• Fund managers offer investment services and • Costly management and performance fees
expertise
• Investor must conduct thorough due diligence
• Lower level of investor involvement compared when selecting the right fund because of the wide
with the direct and co-investing Methods dispersion of fund manager returns
• Access to alternative investments without
possessing a high degree of investment expertise
• Potentially valuable diversification benefits
• Lower minimum capital requirements
Los b: Co Investing
• Investors can learn from the fund’s process to • Reduced control over the investment selection
become better at direct investing process compared with direct investing
• Reduced management fees • May be subject to adverse selection bias
• Allows more active management of the portfolio • Requires more active involvement compared with
compared with fund investing and allows for a fund investing, which can be challenging if
deeper relationship with the manager resources and due diligence experience are limited
Los b: Direct Investing
• Avoids paying ongoing management fees to an • Requires more investment expertise and a higher
external manager level of financial sophistication compared with
fund investing and co-investing, resulting in higher
• Greatest amount of flexibility for the investor
internal investment costs
• Highest level of control over how the asset is
• Less access to a fund’s ready diversification
• managed 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
Los b: Perspective of Fund Management costs
• A typical mutual fund charges :1%- 2% management fee annually
• A typical hedge fund or AIF may charge 2%(MF)+ 20% (Performance fee) based on a higher water
mark principle and with a hurdle rate of 8%.
I. Which means if on 2020 the fund generated 20% return and in 2021 a return of -20%. The fund cant
charge performance fee until we make up for the loss.
II. Hurdle rate means that there is no fee if returns are equal to or less than 8%, because there was no
performance
• In both the cases you could assess that for the amount of value addition given by a fund
structure, the costs are reasonable.
• Also the truth is that even large investors, and analysts use the fund structure itself.
• Also you will learn in CFA level III, that almost 90% of your wealth creation happens due to
strategic asset allocation( 70% equity, 30% Bonds), rather than selecting a particular stock.
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Los b: Due diligence in selecting a fund
Selecting an alternative investment fund is more complex and difficult compared to a mutual fund because the
regulations on strategy and risk is not as regulated as a mutual fund industry. This chart is still an over simplified
version of due diligence
Due Diligence
Organisation or Portfolio
Operations Risk Management Legal Review Fund Terms
Team Management
Investment process, Reporting, Leverage limits,

Experience, track Fees, Contractual
asset types, sourcing Statements, policy, key risk Registrations
record terms, Exit method
of capital Insurance factors
Conflicts,
Structure, Litigation
Distribution
Los c: Investment Structure
• Alternative investment funds are
usually done in LLP, structure with
the GP being the fund manager and
LP’s being investors.
• LP’s don’t involve in the active
management activities but they can
depending upon
• The GP assumes unlimited liability in
case anything goes wrong, and can
run multiple such funds at time
• The relationship between LP’s and GP
is governed by the LP Agreement,
which includes all the terms,
framework, rules and roles
• Also there could be different rules for
different LP’s based on their level or
Source: CFA Curriculum stage investment, basically covered in
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Los c: Compensations structure
Although the CFA text doesn’t get too detailed in this calculation
but we have gone one step ahead in showing how the calculation
M. Fee 2% actually works
1. In year 2018 the LP invests $20 mn, and between 2018 and
P.Fee 20%
2019 the total gross gain is $8 mn.
Hurdle 8%
2. Hence the performance fee is 20% of $8mn and
Investment( in Perf
management fee is 2% of the beg capital which is $20 mn.
Year $Mn) Returns Gain/Loss Capital Mgt Fee Perf Fee Fee% Also notice that the performance is >8%
3. But in 2020 there is a loss of -30%, hence no performance
2018 -20 20 fee but management fee exists
4. In 2021 is where the principle of higher water mark kicks in.
2019 40% 8.00 28 0.4 1.6 20%
You will not again pay performance fee for entire $11.76 mn
2020 -30% -8.40 19.6 0.56 0% gain because there was loss of $-8.40 mn in 2020
5. Hence the performance fee gets calculated on (11.76-8.40) x
2021 60% 11.76 31.36 0.392 0.672 6% 20% which is 0.672
6. A Note here that in some funds the performance fee is not
Source: calculation spreadsheet even calculated upto 8% hurdle rate, because you are
already compensation 2% manage fee on that 8%, hence
calculating performance fee even up to 8% would be double
compensation- that’s called as higher water mark
Los c: Catch Up Clause
Catch Up
Clause A B C1 D E2 F G H I K
GP- GP
Year Return Hurdle- LP-1 Remaining GP- 20% Remaining LP-80% 20% Total LP Total GP Performance
With Catchup 18.0% 8.0% 10.0% 2.0% 8.0% 6.4% 1.6% 14.4% 3.6% 20.0%
Without
Catch Up 18.0% 8.0% 10.0% 2.00% 8.00% 16.0% 2.0% 11.1%
1. The CFA curriculum has puzzled this in many ways, the simple calculation is a step by step distribution
based on 80/20 rule after the initial hurdle rate 8% to the investor
2. Look at Col d, before D everything is same, after the hurdle rate given to investor, then the calculation
changes.
3. So essentially what we are saying is that without catch up we share only once after giving the hurdle
rate to investor but in case of catch up, we share once at the start and again above hurdle rate whats
remaining, we share again in the 80/20 split.
You can check this spreadsheet for illustration using our previous example: calculation spreadsheet
Los c: Distribution Structure
Majorly useful distinction when we are dealing with private equity investments
1. Deal by Deal distribution: Which basically means that GP earns as we keep exiting one deal at
time in a series of investments we do. Which means the GP has regular income
2. Water Fall: In this case the GP earns only after the entire investments are exited and LP’s have
earned their hurdle rate and initial investments
3. Clawback: Provision reflects the right of LP’s to reclaim pat of the GP’s performance fee, if the
investment experiences losses later
investments;
Los d: Characteristics Of Hedge Funds
• Involves a complex mix of asset classes, leverage and
takes positions on both long and short
• Its goal is to generate absolute returns, as opposite to
traditional investments which are benchmarked
• Set up as a private fund structured as either as off shore
or domestic with limitations on the no of investors
• It may include lock in periods and have notice period of
30-90 days for redemption
• Fund of funds are basically portfolio of hedge funds, this
might be useful for people who have less capital and
need diversification across strategies
• On the right you can see the hedge fund performance in
the best years where assets under management went
from $39 Bn in 1990 to $3.32 trillion in 2000. With
volatility closer to bonds and returns better than stocks.
• However post 2015 hedge funds haven’t performed well
and allocations have gone down and correlation with
equity markets increased which made them less useful.
Los d: Opinion
• Its difficult to conclude basis a short period of 2015- 2019 that
hedge funds are over. If we do that then we make the same
mistake, CFA curriculum taught or will teach in quant about curve
fitting or data mining or data snooping.
• However we can reflect on the possible reasons:
• Pre 2015 the commodities market have swung both ways, generating high
volatility usually good for hedge funds
• Post 2015 the volatility has gone down and equity markets have
performed extremely well, in such situations hedge funds, which have
may be less allocation to equity and more allocation other assets
• Or may be where hedge funds are trying to be net neutral to the market,
but being long generated more returns, toppled with high fees.
• However hedge funds or any alternative investment is for those days
which no one can predict but its certain the volatility can return and will
return
• At the same time a different breed of hedge funds known as managed
futures have performed better than even S&P 500.
• So are we looking at a time period bias?
Los d: Hedge Fund Strategies
1. Equity Hedge:
i. Market Neutral: Short over valued stocks and long under valued
maintaining a net neutral position, added with leverage to magnify returns.
ii. L/S Growth( Long short)” Long positions on companies expected to grow
and short on companies under downward pressure. Make a note that the
managers do end up being net long most of the time
iii. Fundamental value: Find companies overlooked by most but the manager
identifies a path for turnaround
iv. Short Biased: They use quantitative models to short overvalued securities
v. Sector specific: For eg: Bio tech which might be a complex area to study and
research but with the managers expertise in this sector, they seek to gain
more
2. Event Driven Strategies
I. Merger arbitrage: Going long the stock to be acquired and short the acquiring company. A simple logic or
perspective could be, that the acquirer generally pais more than the fair value.
II. Distressed restructure: Investing in fixed income securities of companies which are nearing bankruptcy but
the bonds which might be trading at a discount but still good enough for getting paid due its seniority or
collateral backing
III. Special situation: These strategies focus on opportunities to get involved in the equity of companies that
are engaged in restructuring activities other than mergers, acquisitions, or bankruptcy
IV. Activist: Manager secures sufficient equity holding to influence a companies policy and then directing the
company to generate a certain outcome
3. Relative Valuation Strategies
I. Convertible bond Arbitrage: Buying convertible debt securities and selling common stock. This is done if
there is any mis pricing between the bond and its component parts
II. Fixed Income: This is a straight forward fixed income asset class but the manager tries to find value,
mispricing
III. Fixed Income( ABS, Mortgage backed, high yield): Finding value in investment grade securities and find
mispricing
IV. Volatility: These strategies involve go long or short volatility. For eg if volatility in the markets are low, then
its better selling options and earning the premiums and long volatility exactly opposite
3. Macro & CTA Strategies
I. Macro:These funds try to identify economics trends which might be in
equity, currency, commodity or fixed income. The greats like George Soros
would fall under this category
II. Managed Futures: These are usually commodity biased and hence called as
CTA’s and can be useful for portfolio diversification. They use momentum
and trend following techniques to take positions
investments;
Los e: Private Capital Types
Leverage Buy Out
Venture Capital Trade Sales

Equity
Others IPO
Private Capital
Exit Strategies Recapitalisation
Direct Lending Secondary Sale
Mezzanine Debt Write off
Debt Venture Debt
Distressed Debt
Others
Los e: Strategies
Underlying Type Strategy Gain
Acquire companies equity financed with debt. If management Improve the companies cash flow and use it
Equity LBO acquires the equity then MBO. pay debt.
Investing in private companies with high growth potential.

1: Pre seed: Idea stage funding 2:Seed stage: supporting
product development 3:Early stage:moving towards
operations 4: Later stage:Post commercial prodution but
Equity VC before IPO High Returns if IPO occours
Direct
Debt Lending Private debt firms giving debt at high interest High Yields
Private debt senior than equity but subordinate to secured
Debt Mezzanine debt High returns and equity participation
Venture Basically private debt but at early stages usually given along
with venture capital and hence more control over the
Debt Debt company High returens but high default risk
Distressed Identifying companies with distressed financial situation but Generate high returns when cash flow
Debt Debt good business at a discount stabalises
Los e: Exit Strategies
Exit Strategy Description

Trade Sale Sell to a strategic buyer / Competitor
IPO Selling the stock to public
Increase leverage and pay out using

Recapitalisation dividend
Secondary Sales Sell to another private equity
Write off Liquidating the portfolio company
Los e: Risk in Private Equity
Although returns out here might seem high but we need to understand the
disclosure of data in private equity is low and there is no set benchmark and
even if there is then it suffers from survivorship bias.
Source: CFA Curriculum
Los e: Risk in Private Debt
Private debt has gained popularity after the 2008 crisis, earning high returns in return
for the liquidity risk.
Los e: Diversification Benefits of Private
Capital

investments;
Los f: Natural Resources Characteristics
Energy
Natural Resources
Base Metals
Commodities Precious Metals
Farmland or Timberland Agricultural This table actually is interesting to note

that commodities overall have
generated negative return -1.7%.
Others- Carbon credits, However we need to understand that
Freight, Forest products commodities is pretty large universe and
taking an average would give us the
wrong signal. Check the next slide.
Periodic Table of Commodity Returns
How often would you
consider buying all the
commodities? Probably not.
For eg:
1. Gold, Silver- safe assets
2. Copper, zinc and nickel-
as the manufacturing
metal
3. Natural gas, crude- in
energy
All of them seem to have to

have had their fair share of
high returns. Also point to
be noted that commodities
need to be used as a
diversification tool
Supply and Demand
Commodity prices are a function of supply

and demand. In 2011 the supply was low
post the crisis and as recovery started the
demand for copper outstripped the supply
leading to a 30% surge in on year
Los f: Natural Resources Characteristics
Commodity Pricing can be approximated using the following equation
Futures price ≈ Spot price(1 + r) + Storage costs − Convenience yield, where r is the short-term
risk-free rate
Cost of carry
• A futures buyer doesn’t not get the product or resource immediately and hence doesn’t benefit from any
convenience hence reduced
• Similarly the convenience may differ from location and its benefits.
• The future price gets affected due to the changes in the convenience yield
• When future price > spot price, its called as contango and the commodity curve is upward sloping
• When future price < spot price, its called backwardation, this occurs when the convenience yield is higher
Los f: Risk and Return of Timberland and
farmland
Both these assets have similar risk profile of
real estate investments, however Farmland
with its high return also has
1. High illiquidity
2. High operating costs
3. High effect of weather
4. Indirect risk with global commodities
risk which the farmland produces
Los f: Diversification Benefits of Natural
Resources
1. Low correlation with traditional assets
Source:https://goldenopportunitiesforinvestors.
Los f: Diversification Benefits of Natural
Resources
2. Hedge Against
Inflation: in a
positive inflation
commodities
always outrank the
other asset classes
but do the exact
opposite during
negative inflation

Los f: Instruments for Exposure
ETP( Exchange
Traded Products)
Commodities Futures and CTA’s
Instruments Funds
Timberland & REITS( Real estate

Farm investment trusts)
investments;
Los g: Real Estate
Key Reasons for Real estate investment Some facts about real estate market
1. Competitive long term total returns- 1. Residential real estate is the largest sector
income and appreciation globally
2. Stable income for fixed leases 2. The size of global real estate market is
3. Low correlation with other assets approximately $9.6 Trillion as on 2019
from $6.8 Trillion in 2013.
4. Inflation hedge
3. Illiquidity is common, with price discovery
5. Leverage- only place where a retail being difficult since no two properties are
investor can use leverage to fund an asset identical
4. They are also affected by government
rules and regulations
Los g: Forms of real estate ownership
MBBS
CMO
Public
REITS Mortgage
ETFs debt
Debt
Mortgages
Construction
Private
Lending
Real Estate
Mezzanine Debt
Shares in Real
estate companies
Listed REITS
Public
Mutual Funds
ETF’s
Equity
Direct ownership
Private Real estate funds
Private ETDS
Los g: Characteristics of Real Estate
Investment options
Direct Indirect Mortgages Private Fund REITS
Overview Purchase the property Taking Exposure through Taking exposure on Similar to private equity A trust for pooling funds and
using debt or cash and pooled investments lending products of real investment structure then managed by a manager
additional costs funds estate
Investment • Personal • REITS • Fixed rate • Core real estate • Large infra projects
• Joint Ventures • Mutual funds • Floating rate • Non core • Residential projects
Options
• MBS • Core plus • Business parks
Pros • Taxation benefits • Liquidity • Exposure in fixed • Exposure to • No operational hassle

• Control • Lesser additional income with real commercial real • Lower capital required
costs estate estate • Taxation benefits- ( No
• High variety • Large double taxation)
diversification
Cons • Time consuming • Complexity of • Default Risk • Similar to the real • Project delays
• Concentration of products • Pre Payment Risk estate risk itself • Manager research and skill
geography • No control • Illiquidity
• Maintenance
Los g: Characteristics of Real Estate
Categories
Residential Commercial REITS MBS
Overview Taking exposure by 10-20% Considered appropriate for Similar to mutual fund, they create A liquid security created after pooling of mortgages and
equity and financing the rest institutional investors trusts with different real estate transferring risk from issuer to investor
categories
Structure The owner pays the Buy the property and maintain They can either be debt based The MBS Manager creates an SPV to buy mortgages from
mortgage payment and the and generate income or equity based REITS lenders and create various income distribution pools or
property acts as a collateral MBS Securities
for the mortgage
Market REITS are often listed on stock MBS can either be public or private
exchanges but can also be
private
Risk Magnified loss in Business sentiment and general Risk relate to underlying investments, Borrowers pre paying their loan and the general interest
case of property market conditions, location risk as well as the management rate risk applies to MBS
depreciation,
illiquidity
Los g: Risk and Return- Real Estate
• Real Estate Indexes:
Some of the popular real
estate indexes but the return
data on these can have
disparity because of multiple
factors. Hence regional indexes
are needed in the future
1. National association of Real
estate Investment Trusts- U.S
2. European Public Real estate
association
3. Asia Public Real estate
Association Source: CFA Curriculum
investments;
Los h: Infrastructure
These are slightly different from real estate because more Strategic&
than just the real estate in it, it has larger functions like a Long Lives
port, airport, highway projects ,power plants. So the
factor that makes it more complicated is the final
business that it does it. Monopolistic
High Capex
& Regulated
Infrastructure investing has grown over the years
significantly majorly because of privatisation.
Infrastructure
High Defined
Leverage Risks
Stable Long
term
cashflow
Los g: Categories of Infrastructure
Investments and Forms
Basis the Purpose: Forms of Investment
1. Transportation 1. Direct investment would mean running
the entire project and having full control
2. ICT- Telecommunications, data centres but requires significant capital
3. Utility- Power plants, Gas, Water etc investment. This usually happens hence in
consortia with partners strategic and
4. Social- Health care, social housing, financial
correctional facilities, schools
Basis the Stage 2. Indirect Investment includes investment
in infrastructure funds either public or
1. To be constructed: Green Field private
1. Intent to hold and operate the 1. Private Equity
asset after construction and sell to 2. Mutual Funds
new investors 3. ETFS
2. Existing Infra: Brown Field 4. Company Shares
1. Example could an infra which the
government wants to privatise
3. Location
Los g: Risk and Return-Infra Investments
Los g: Diversification Benefits
investments;
Los h: Performance Appraisal
Before you understand the appraisal, the fundamental root cause are the
following :
1. Limited Transparency
2. Low Liquidity
3. High Leverage
4. Complexity of strategy
5. Marked to marked values with niche assets
6. Limited Redemption
7. Fee Drag
8. Manager selection and differentiation
Los h: Common Performance Metrics
1. Sharpe: Usually loosely used while marketing for alternative
Sharpe investment strategies but sharpe is based on st dev which
assumes normal distribution. Since most AI strategies use
Performance
leverage the returns to st dev might appear too high but does
Sortino not capture the leverage risk

2. Sortino: Instead of using total SD, this uses the downside
deviation
3. Treynor: can be useful if we are looking at risk relative to a
Treynor benchmark in the denominator over the excess return it
generates. However the challenge is that beta is historical and
for some investments, this might not be available itself
Calmar 4. Calmar: Compares the CAGR to the maximum draw down
5. MAR : is a variation to CALMAR, which uses average drown
instead
MAR
Los h: PE & Real Estate Performance Appraisal
Private Equity Investments tend to
experience what we call as the J curve
Eventual effect. This is to say that the return line is
Positive downward sloping for many years and then
High Fee sudden positive returns when things to our
Return
Drag way.
Substantial
Investment
Similar to private equity but the rental
Property Sale income tends to make the investment
Rental returns more smoother than private equity
Income
Additional
Improvement In both the cases as a general rule we use the IRR method for return
Substantial –ve cashflows
Investment calculation. Also a short cut method generally used is the Multiple of
Invested capital method or simply total value over initial investment( 2x,
3x)
Los h: PE & Real Estate Performance Appraisal
Other Appraisal Metrics
• Cap Rate: Annual Rent/ Value of property at purchase
• Capital Loss ratio: Capital deals sold below cost/ total invested capital
investments;
Los j: Calculation of Fees
Variations of Fee structure apart from 1/10 or 2/20 :
1. Fees based on liquidity terms and asset size
2. Founders shares- lower fee structure for early investors
3. Either/or fees: An option to pay management fee or only performance fee
Its best to understand fee calculation using an example, covered in the next slide
and most of the calculation we already covered initially at the start of this reading
Fee Calculation Case: CFA Curriculum
• AWJ Capital is a hedge fund with $100 million of initial investment capital. It charges a 2% management fee based
on year-end AUM and a 20% incentive fee. In its first year, AWJ Capital has a 30% return. Assume management fees
are calculated using end-of- period valuation.
• 1 What are the fees earned by AWJ if the incentive and management fees are calculated independently? What is an
investor’s effective return given this fee structure?
• 2 What are the fees earned by AWJ assuming that the incentive fee is calculated from the return net of the
management fee? What is an investor’s net return given this fee structure?
• 3 If the fee structure specifies a hurdle rate of 5% and the incentive fee is based on returns in excess of the hurdle
rate, what are the fees earned by AWJ assuming the performance fee is calculated net of the management fee?
What is an investor’s net return given this fee structure?
• 4 In the second year, the fund value declines to $110 million. The fee structure is as specified for Question 1 but
also includes the use of a high-water mark (computed net of fees). What are the fees earned by AWJ in the second
year? What is an investor’s net return for the second year given this fee structure?
• 5 In the third year, the fund value increases to $128 million. The fee structure is as specified in Questions 1 and 4.
What are the fees earned by AWJ in the third year? What is an investor’s net return for the third year given this fee
structure?
Solution
1. AWJ fees $130 million × 2% = $2.6 million management fee. ($130 − $100) million × 20% = $6 million incentive
fee. Total fees to AWJ Capital = $8.6 million. Investor return: ($130 − $100 − $8.6) million/$100 million = 21.40%.
2. $130 million × 2% = $2.6 million management fee. ($130 − $100 − $2.6) million × 20% = $5.48 million incentive
fee. Total fees to AWJ Capital = $8.08 million. Investor return: ($130 − $100 − $8.08) million/$100 million =
21.92%.
3. $130 million × 2% = $2.6 million management fee. ($130 − $100 − $5 − $2.6) million × 20% = $4.48 million
incentive fee. Total fees to AWJ Capital = $7.08 million. Investor return: ($130 − $100 − $7.08) million/$100 million
= 22.92%.
4. $110 million × 2% = $2.2 million management fee. No incentive fee because the fund has declined in value.Total
fees to AWJ Capital = $2.2 million. Investor return: ($110 − $2.2 − $121.4) million/$121.4 million = –11.20%. The
beginning capital position in the second year for the investors is ($130 − $8.6)million = $121.4 million. The ending
capital position at the end of the second year is ($110 − $2.2) million = $107.8 million.
5. $128 million × 2% = $2.56 million management fee. ($128 − $121.4) million × 20% = $1.32 million incentive fee.
The $121.4 million represents the high-water mark established at the end of Year 1. Total fees to AWJ Capital =
$3.88 million. Investor return: ($128 − $3.88 − $107.8) million/$107.8 million = 15.14%. The ending capital
position at the end of Year 3 is $124.12 million. This amount is the new high-water mark.
Summary
• Alternative investments are supplemental strategies to traditional long-onlypositions in stocks, bonds, and cash. Alternative investments include investments in five main categories: hedge funds, private capital,
natural resources real estate, and infrastructure.
• Alternative investment strategies are typically active, return-seeking strategies that also often have risk characteristics different from those of traditional long-only investments. Characteristics common to many
alternative investments, when compared with traditional investments, include the following: lower liquidity, less regulation, lower transparency, higher fees, and limited and potentially problematic historical risk and
return data.
• Alternative investments often have complex legal and tax considerations and may be highly leveraged.
• Alternative investments are attractive to investors because of the potential for portfolio diversification resulting in a higher risk-adjusted return for the portfolio.
• Investors can access alternative invests in three ways: ●● Fund investment (such as a in a PE fund) ●● Direct investment into a company or project (such as infrastructure or real estate) ●● Co-investment into a
portfolio company of a fund
• Investors conduct due diligence prior to investing in alternative investments. The due diligence approach depends on the investment method (direct, co-investing, or fund investing).
• Operational, financial, counterparty, and liquidity risks may be key considerations for those investing in alternative investments. These risks can beanalyzed during the due diligence process. It is critical to perform fund
due,diligence to assess whether (a) the manager can effectively pursue the proposed, investment strategy; (b) the appropriate organizational structure and policies for managing investments, operations, risk, and
compliance are in place; and (c) the fund terms appear reasonable.
• Many alternative investments, such as hedge and private equity funds, use a partnership structure with a general partner that manages the business and limited partners (investors) who own fractional interests in the
partnership.
• The general partner typically receives a management fee based on assets under management or committed capital (the former is common to hedge funds, and the latter is common to private equity funds) and an
incentive fee based on realized profits.
• Hurdle rates, high-water marks, lockup and notice periods, and clawback provisions are often specified in the LPA.
• The fee structure affects the returns to investors (limited partners), with a waterfall representing the distribution method under which allocations are made to LPs and GPs. Waterfalls can be on a whole-of- fund basis
(European) or deal-by- deal basis (American). ‘
• Hedge funds are typically classified by strategy. One such classification includes four broad categories of strategies: equity hedge (e.g., market neutral), event driven (e.g., merger arbitrage), relative value (e.g.,
convertible bond arbitrage), macro and CTA strategies (e.g., commodity trading advisers).
• Funds-of- hedge- funds are funds that create a diversified portfolio of hedge funds. These vehicles are attractive to smaller investors that don’t have the resources to select individual hedge funds and build a portfolio
of them.
• Private Capital is a broad term for funding provided to companies that is sourced from neither the public equity nor 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.
Summary
• Returns to commodity investing are based on changes in price and do not include an income stream, such as dividends, interest, or rent
(apart from income earned on the collateral). However, timberland offers an income stream based on the sale of trees, wood, and other
products. Timberland can be thought of as both a factory and a warehouse. Plus, timberland is a sustainable
• investment that mitigates climate-related risks.
• Farmland, like timberland, has an income component related to harvest quantities and agricultural commodity prices. However, farmland
doesn’t have the production flexibility of timberland, because farm products must be harvested when ripe.
• Real estate includes two major sectors: residential and commercial. Residential real estate is the largest sector, making up some 75% of the
market globally. Commercial real estate primarily includes office buildings, shopping centers, and warehouses. Real estate property has
some unique features compared with other asset classes, including heterogeneity (no two properties are identical) and fixed location.
• Real estate investments can be direct or indirect, in the public market (e.g., REITs) or private transactions, and in equity or debt.
• The assets underlying infrastructure investments are real, capital intensive, and long lived. These assets are intended for public use, and
they provide essential services. Examples include airports, health care facilities, and power plants.Funding is often done on a public–private
partnership basis.
• Social infrastructure assets are 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.
• Infrastructure investments may also be categorized by the underlying asset’s stage of development. Investing in infrastructure assets that
are to be constructed is generally referred to as greenfield investment. Investing in existing infrastructure assets may be referred to as
brownfield investment.
• Conducting performance appraisal on alternative investments can be challenging because these investments are often characterized by
asymmetric risk– return profiles, limited portfolio transparency, illiquidity, product complexity, and complex fee structures.
Summary
• Traditional risk and return measures (such as mean return, standard deviation of returns, and beta) may
provide an inadequate picture of alternative investments’ risk and return characteristics. Moreover, these
measures may be unreliable or not representative of specific investments.
• A variety of ratios can be calculated in order to review the performance of alternative investments, including
the Sharpe ratio, Sortino ratio, Treynor ratio, Calmar ratio, and MAR ratio. In addition, batting average and
slugging percentage can also be used. The IRR calculation is often used to evaluate private equity
investments, and the cap rate is often used to evaluate real estate investments.
• Redemption rules and lockup periods can bring special challenges to performance appraisal of alternative
investments.
• When comparing the performance of alternative investments versus an index, the analyst must be aware
that indexes for alternative investments may be subject to a variety of biases, including survivorship and
backfill biases.
• Analysts need to be aware of any custom fee arrangements in place that will affect the calculation of fees
and performance. These can include such arrangements as fee discounts based on custom liquidity terms or
significant assetsize; special share classes, such as “founders’ shares”; and a departure from thetypical
management fee + performance fee structure in favor of “either/or” fees

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Alternative Investment

Hedge Funds Private Debt

Private Capital Real Estate

PPP( Public Private

Others Art, Stamps, Wine

All Rights Reserved -Mentor Me Careers www.mentormecareers.com

Investment process, Reporting, Leverage limits,

Venture Capital Trade Sales

Direct Lending Secondary Sale

Mezzanine Debt Write off

Debt Venture Debt

Investing in private companies with high growth potential.

Exit Strategy Description

Increase leverage and pay out using

Source: CFA Curriculum

Source: CFA Curriculum

Source: CFA Curriculum

Commodities Precious Metals

Farmland or Timberland Agricultural This table actually is interesting to note

All of them seem to have to

Commodity prices are a function of supply

Source: CFA Curriculum

Source: CFA Curriculum

Commodities Futures and CTA’s

Timberland & REITS( Real estate

Private Real estate funds

Pros • Taxation benefits • Liquidity • Exposure in fixed • Exposure to • No operational hassle

Source: CFA Curriculum

Source: CFA Curriculum

Sortino not capture the leverage risk

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