Alternate Investment Markets

Module 1
Introduction to alternate investment markets

The slides provide summary points . Students are expected to read the reference material and class notes for detailed understanding
Source:Open source materials/ CFA modules / Taxmann Alternate markets
Meaning

Alternate investment refers to investments other than traditional asset classes ( stocks, bonds, deposits, cash). It
is a different investment class which includes tangible as well as financial assets.

Tangible
Precious Metal
Artwork
Antiques
Coins
Winery
Stamps

Financial Assets
Real Estate
Private Equity
Commodities
Hedge Funds
Digital Currency
Features
• one of the critical features of alternative investments is that investing in them requires special skills and
information
• relatively low correlation with returns of traditional investments or risk-return profiles very different from
traditional long-only investments
• lower liquidity of assets held
• longer time horizons for investors
• larger size of investment commitments
Reasons For investment in alternate investment markets
• Diversification
• Enhanced return through portfolio risk-return profile
• Increased return through higher yield in a low-interest period

General Characteristics
• Limited reliable historical risk and return data
• Less regulated and less transparent
• Unique legal and tax considerations
• Higher fees, often including performance or incentive fees
• Concentrated portfolios
• Restrictions on redemptions (i.e., “lockups” and “gates”)
Categories of alternative investments
• Private Capital:
• Private Equity (PE)
• Venture Capital
• Private Debt
• Leveraged Buy out (LBO)
• Real Assets:
• Real Estate
• Infrastructure
• Natural Resources
• Commodities
• Others ( eg Wine funds, Art)
• Hedge Funds
• Structured products
• Digital Currency

(Relevant for the term)

 Investment methods

• Investors can access alternative investments in three ways:

• Fund investment (such as 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

• Different approaches to due diligence are necessary for alternative investments depending on the investment method (direct,
co-investing, or fund investing).
• Operational, financial, counterparty and liquidity risks may be critical considerations for those investing in alternative
investments. These risks can be analyzed during the due diligence process.
 Advantages and Disadvantages of Fund Investing, Co-Investing, and Direct Investing

Advantages Disadvantages
Fund Investing Low involvement Costly management and performance fees
Higher degree of expertise not required Thorough due diligence required while selecting funds
Lower minimum capital required Typically have lock-ups and other restrictions

Co-Investing Investors can learn from the fund’s process to Reduced control over the investment selection process
become better at direct Investing compared with direct investing
Reduced management fees May be subject to adverse selection bias
Active portfolio management as compared to Require active involvement
fund investing

Direct Investing No fees to external manager Requires higher internal investment Costs
Greater amount of flexibility Less access to a fund’s ready diversification benefits or the
fund manager’s sourcing network
Higher level of control over the assets Requires more complex due diligence because of the absence
of a fund manager
Higher minimum capital requirements
Investment and Fees/ Compensation structures

• 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.
• General partners
• Management fees (Based on AUM or committed capital ) + Incentives
• The fee structure affects the returns to investors (limited partners).
Important Terms/ Structure/ Fees/ methods
• Principle agent problem exists between GP and LP
• Limited partnership agreements (lpaS)
• Legal Document
• Rules of partnership
• Framework for fund’s operations
• Side letters
• agreements created between the GP and a certain number of LPs that exist outside the LPA

• Examples of clauses (side letters)

• Potential additional reporting due to an LP’s unique circumstances, such as regulatory or tax requirements
• First right of refusal and other similar clauses to outline potential treatment (regarding fees, co-investment rights,
secondary sales, and, potentially, other matters) in comparison to other LPs
• Notice requirements in the event of litigation, insolvency, and related matters
• Most favored nation clauses, such as agreeing that if similar LPs pay lower fees, they will be offered to the LP
Contd..
Contd..
Catch-up clause-
Catch-up takes effect when an investor's returns reach the defined hurdle rate, giving them an agreed level of preferred
return. The manager then enters a catch-up period, in which it may receive an agreed percentage of the profits until the profit
split determined by the carried interest agreement is reached.
Without a catch-up clause, the LPs receive the hurdle rate and then all the profit above the hurdle rate is split according to
the proportion specified in the LPA. So, a catch-up clause is advantageous to the GP and no catch-up clause is advantageous
to the LPs.

High water mark

high-water mark which is a parameter specifying that the incentive fee is not calculated for profits covering losses from
previous periods. Performance fees are only paid to the extent that the current value of an investor’s account is above the
highest net- of-fees value previously recorded.

Distribution Waterfall
It is a mechanism that defines the rules under which the investment profit is paid to the GP and LPs. There are two methods
used:
1) deal-by-deal method (American waterfall) according to which the performance fee is collected for each deal separately
and may be unfavorable for the LPs
2) whole-of-fund method (European waterfall) where performance fee is paid to the GP after the LPs receive their total
initial investment plus hurdle rate.
Clawback
Clawback refers to the provision limiting the remuneration of a GP. The GP has to return the performance fee if in
subsequent periods the fund's net asset value decreases.
Life Cycle of Alternate investments

 Capital Commitment phase- Identifying invest

 Capital Deployment phase
 Capital distribution phase
Return Leveraged return

Leveraged return

Some alternative investment funds borrow to magnify their gains,

After fees return
• Before fees return on alternate investments are calculated the same way as returns on any investment.
• Calculating after fee returns simply requires adjustment of the cashflows or values for the various fees
involved, typically management and performance fees.
 Common Approaches to Performance Appraisal and
Application Challenges

CALMAR
Calmar Ratio
• The Calmar ratio compares the average annual compounded return to this maximum drawdown
risk. The higher (lower) the Calmar ratio, the better (worse) an alternative asset performed on a
risk-adjusted basis over a specified period. The Calmar ratio is typically calculated using the
prior three years of performance, and it thus adjusts over time. Variations of the ratio exist:

• The MAR ratio uses an entire investment history and the maximum drawdown.
Risk of Alternate Investment Markets

• Limited transparency
• Low portfolio liquidity
• High leverage and use of derivatives
• High product complexity
• Mark-to-market issues, especially for specialized products/Valuation of investments without observable
markets
• Limited redemption availability
• Difficulty in manager selection and diversification
• High fees, which can have a non-trivial impact on performance
The End