CFA Level 1 Revision Series Alternative Investment

Summary

This script offers a comprehensive review of alternative investments, contrasting them with traditional investments and highlighting their unique characteristics such as higher risk, performance fees, and lower liquidity. It delves into various asset classes like private equity, venture capital, and hedge funds, and discusses investment structures, fees, and strategies. The importance of understanding key investment terms, ratios for evaluating fund managers, and the impact of time value of money on metrics like MOIC is emphasized. The script also covers exit strategies, biases in investment analysis, and specific strategies within private equity and hedge funds, providing a solid foundation for those interested in the alternative investment space.

Takeaways

• 🏦 Alternative Investments are typically accessible to high-net-worth individuals (HNIs) and institutional investors due to their unique characteristics and higher risk profiles.
• 📚 The regulatory environment for Alternative Investments differs from traditional investments, often with higher performance and incentive fees associated with them.
• 🔒 These investments are highly illiquid, which means investors expect higher returns to compensate for the liquidity risk they undertake.
• 💼 The types of alternative asset classes include private equity, venture capital, hedge funds, infrastructure, real estate, commodities, farmland, timberland, and private debt.
• 🤝 In alternative investments, the manager is known as the General Partner (GP), and the investors are Limited Partners (LPs), with their relationship governed by a Limited Partnership Agreement.
• 📑 Special terms given to certain investors are documented in side letters, while preferential terms for early investors are known as founder shares.
• 💰 LPs provide GPs with two types of fees: management fees, which are paid regardless of profit or loss, and incentive fees, which are performance-based and only paid upon profits.
• 📉 The concept of 'dry powder' refers to uninvested capital, which is significant in the context of alternative investments.
• 🌐 Incentive fees can be structured in three styles: soft hurdle rate, hard hurdle rate, and high-water mark, with the latter being specific to hedge funds.
• 🔄 Clawback provisions can benefit limited partners by allowing them to penalize the general partner for losses, effectively recouping some incentive fees paid out.
• 📊 Various ratios such as Sharpe, Sortino, and Calmar are used to evaluate the performance of fund managers, taking into account risk-adjusted returns and maximum drawdowns.

Q & A

What is the primary difference between alternative investments and traditional investments?

Alternative investments are typically available only to high-net-worth individuals (HNIs) and institutional investors, have different laws and regulations, higher performance and incentive fees, and higher risk compared to traditional investments.

Why are alternative investments considered to have a lower correlation with traditional assets?

Alternative investments, such as private equity, venture capital, and hedge funds, often have different risk and return profiles and are less influenced by market fluctuations, leading to a lower correlation with traditional assets.

What is the main reason for the higher return expectations from alternative investments?

Alternative investments are highly illiquid, and investors expect higher returns to compensate for the liquidity risk they take on.

What are some examples of alternative asset classes mentioned in the script?

Examples of alternative asset classes include private equity, venture capital, hedge funds, infrastructure, real estate, commodities, farmland, timberland, and private debt.

What is the role of a fund manager in alternative asset classes?

A fund manager in alternative asset classes manages pooled investment vehicles, where they pool money from several investors and invest on their behalf.

What are the two types of fees that limited partners (LPs) give to general partners (GPs) in alternative investments?

The two types of fees are incentive fees, also known as performance fees, and management fees. Management fees are given irrespective of profit or loss, while incentive fees are given only in case of profits.

What is the term used for uninvested capital in alternative investments?

Uninvested capital in alternative investments is referred to as 'dry powder.'

What is a 'clawback provision' and why is it beneficial for limited partners?

A clawback provision allows limited partners to penalize the general partner by not giving them incentive fees to the extent of the losses, which is beneficial as it aligns the interests of the GP with the LPs.

What is the difference between a European waterfall and an American waterfall in profit distribution?

A European waterfall is based on a total basis, covering losses as well, while an American waterfall is on a deal-by-deal basis, compensating the general partner for profitable deals but not penalizing for loss-making deals.

What are some common exit strategies for venture capital funds?

Common exit strategies for venture capital funds include IPOs, trade sales, secondary sales, write-offs or liquidation, and leveraged recapitalization.

Why are standard deviation measurements for illiquid investments often biased downwards?

Standard deviation measurements for illiquid investments are biased downwards because the prices of these investments are not known on a daily basis, leading to an overstatement of returns and an understatement of volatility.