Alternative Investment Features, Methods, and Structures (2024 CFA® Level I Exam – AI – LM 1)
Summary
TLDRThe video script is an introductory module on alternative investments for the CFA program. It defines alternative investments as any investment vehicle that doesn't fit into fixed income or equity securities. The speaker, Jim, explains that these investments are appealing due to their potential to increase expected returns and improve portfolio risk-return profiles, especially in low-interest-rate environments. The script delves into the characteristics of alternative investments, including specialized knowledge requirements, low liquidity, and longer investment horizons. It also discusses various types of alternative investments, such as private capital, real assets, and hedge funds, and touches on the complexities of valuing and managing these assets. The module outlines the structure of investment funds, including management fees, performance fees, and the concept of co-investment. It concludes with a brief overview of the limited partnership agreement and the role of accredited investors, emphasizing the importance of diversification and the modern portfolio theory in alternative investments.
Takeaways
- 📚 **Alternative Investments Overview**: The script introduces alternative investments as a category of investment vehicles that do not fit into traditional fixed income or equity securities.
- 🤔 **Diversification and Risk Reduction**: Alternative investments are used to diversify portfolios and potentially lower the standard deviation of a portfolio, aiming to improve the risk-return profile.
- 💡 **Direct and Co-investment**: The concept of direct investment in alternative assets versus investing in a fund that pools capital for such investments is discussed, highlighting the focus areas for further learning.
- 🏦 **Private Capital and Real Assets**: Examples of alternative investments include private capital, real assets like commercial real estate, and hedge funds, with further details provided in subsequent modules.
- 📈 **Potential for Higher Returns**: The script touches on the potential for alternative investments to offer higher returns, especially in a low-interest-rate environment.
- 💰 **Specialized Knowledge and Valuation**: Investing in alternative assets requires specialized knowledge due to the unique nature of these investments and the complexities associated with valuing them.
- 🔗 **Correlation with Traditional Assets**: The low correlation between alternative investments and traditional equity or fixed income securities is a key reason for their inclusion in a diversified portfolio.
- 🚨 **Liquidity and Investment Horizons**: Alternative investments typically have less liquidity and longer investment horizons compared to traditional investments.
- 💼 **Management and Performance Fees**: The script explains the complex fee structures associated with alternative investments, including management fees and performance or carried interest fees.
- 📜 **Legal Agreements and Structures**: The importance of legal agreements like limited partnership agreements and the role of side letters in defining the relationship and terms between investors and fund managers are discussed.
- 🔍 **Due Diligence and Trust**: Emphasizes the need for investors to conduct thorough research and place trust in the expertise and integrity of the fund manager when investing in alternative investments.
Q & A
What is the definition of alternative investments in the context of the CFA program?
-Alternative investments are any kind of investment vehicle that doesn't fit into fixed income and equity securities. They are considered for their potential to diversify a portfolio and potentially improve its risk-return profile.
Why are alternative investments considered for inclusion in a portfolio?
-Alternative investments are considered to add securities to the portfolio that can lower the standard deviation of the portfolio, thereby reducing risk, and at the same time, increase expected return, thus potentially improving the portfolio's risk-return profile.
What are the three main categories of alternative investments mentioned in the script?
-The three main categories of alternative investments mentioned are private capital, real assets, and hedge funds.
What is the concept of direct and co-investment in alternative investments?
-Direct and co-investment refers to the opportunity for investors to invest not only in a fund that holds a diversified portfolio of alternative assets but also to invest directly into specific alternative assets alongside the fund, offering a chance for more active involvement and potentially reduced management fees.
What are some of the challenges associated with alternative investments?
-Challenges include the need for specialized knowledge to value cash flows and risks, lower liquidity, longer investment horizons, large capital outlay, complex compensation structures, and the difficulty in evaluating the performance of the investments.
How does the compensation structure for a hedge fund manager typically work?
-The compensation structure often involves a management fee based on assets under management or committed capital, a performance fee based on returns above a certain hurdle rate, and a carried interest, which is a share of the profits above the hurdle rate, often split between the fund manager and the investors.
What is a hurdle rate in the context of alternative investments?
-A hurdle rate is a minimum return threshold that must be met before the fund manager can receive a performance fee. It's used to ensure that the investors receive an adequate return before the manager is compensated for outperformance.
What is a high-water mark in the context of performance fees for alternative investments?
-A high-water mark is a reference point that indicates the highest value that a fund has reached historically. Performance fees are typically only paid if the fund's value exceeds this high-water mark, ensuring that managers do not receive fees following a period of decline.
What is a limited partnership agreement and how does it relate to alternative investments?
-A limited partnership agreement is a legal contract that outlines the terms of the relationship between a general partner, who runs the business, and the limited partners, who are passive investors. It is a common structure in alternative investments, particularly in private equity and real estate.
What are side letters in the context of limited partnerships?
-Side letters are private agreements between a limited partner or a group of limited partners and the general partner. They may stipulate special terms or conditions that are not included in the main limited partnership agreement, such as different compensation arrangements or distribution timings.
What are the advantages and disadvantages of investing in a fund versus direct investment in alternative assets?
-Advantages of fund investment include access to the manager's expertise, lower minimum capital requirements, and reduced responsibility for the investor. Disadvantages include higher management fees, the need to research and trust the fund manager, and potentially less control over individual investments.
Outlines
😀 Introduction to Alternative Investments
Jim introduces the topic of alternative investments, defining them as any investment vehicle that doesn't fit into fixed income or equity securities. He emphasizes the lack of similar features among alternative investments and the need to understand their unique characteristics. The concept of direct and co-investment is introduced, along with the potential benefits of alternative investments in terms of diversification and improved portfolio risk-return profiles.
💡 Features and Challenges of Alternative Investments
The paragraph delves into the features of alternative investments, such as specialized knowledge requirements, unique risks, and the absence of cash flows, making valuation complex. Jim uses the example of a James Bond swimsuit to illustrate the challenges in valuing alternative investments. He also discusses the low liquidity, longer investment horizons, and large capital outlay associated with these investments.
📚 Diverse Categories of Alternative Investments
Jim outlines various categories of alternative investments, including private capital, real assets, and infrastructure. He provides examples such as investing in privately held companies, commercial real estate, and natural resources. The paragraph also touches on the importance of understanding the different types of assets and the potential for diversification across these categories.
💼 Hedge Funds and Their Compensation Structures
The paragraph discusses the history and structure of hedge funds, starting with A.W. Jones in 1949. Jim explains that hedge funds have more flexibility than mutual funds, allowing managers to invest in a wide range of assets. He also covers the compensation structure of hedge funds, including management fees, performance fees, and carried interests, highlighting the complexity and the need for investors to trust the fund manager.
🤝 Co-Investment Opportunities and Structures
Jim introduces the concept of co-investment, where investors can invest directly in the same alternative assets that a fund manager is investing in. He discusses the advantages of co-investment, such as reduced management fees and more active involvement, as well as the disadvantages like higher oversight costs and the need for specialized knowledge. The paragraph also covers different investment structures like limited partnerships and master limited partnerships.
📊 Understanding Performance Fees and Hurdle Rates
The final paragraph focuses on the financial aspects of hedge fund investments, particularly performance fees and hurdle rates. Jim explains the difference between assets under management and committed capital, and how performance fees are calculated based on excess returns. He also discusses the concept of a high-water mark and clawback clauses, which protect investors by allowing them to reclaim some of the performance fees paid out in the event of subsequent poor performance.
Mindmap
Keywords
💡Alternative Investments
💡Direct and Co-investment
💡Hedge Funds
💡Liquidity
💡Investment Horizon
💡Specialized Knowledge
💡Correlation Coefficient
💡Risk-Return Profile
💡Efficient Frontier
💡Portfolio Diversification
💡Management Fees and Performance Fees
Highlights
Alternative Investments are defined as any investment vehicle that doesn't fit into fixed income and equity securities.
Alternative investments can provide diversification and potentially improve the risk-return profile of a portfolio.
Direct and co-investments are a key focus, where investors can directly invest in assets alongside a fund.
Private capital, real assets, and hedge funds are examples of alternative investments.
Investing in alternative investments often requires specialized knowledge due to their unique features and structures.
Alternative investments typically have lower liquidity, longer investment horizons, and larger capital outlays compared to traditional investments.
The concept of the efficient frontier is applied to alternative investments to balance risk and return.
Investors are interested in alternative investments to pursue higher returns, especially in low interest rate environments.
Hedge funds have the flexibility to invest in a wide range of assets and strategies, unlike traditional mutual funds.
Management fees and performance fees are common in alternative investments, with structures like carried interest adding complexity.
Co-investment allows investors to participate directly in specific alternative investments, offering potential advantages like reduced fees.
Investing in alternative investments can involve complex performance evaluation and compensation structures, such as hurdle rates and catch-up clauses.
The limited partnership structure is a common way to organize investments in alternative assets, with defined roles and agreements between general and limited partners.
Side letters can be used to create additional agreements between a limited partner and the fund manager, potentially affecting compensation and distribution.
Public-private partnerships are another structure used in alternative investments, particularly for large infrastructure projects.
Understanding the definitions of management fees, performance fees, hurdle rates, and high-water marks is crucial for evaluating alternative investment performance.
The concept of a waterfall in alternative investments refers to the distribution of profits after certain thresholds are met.
Clawback clauses allow limited partners to reclaim some compensation from the fund manager under certain conditions, such as a significant drop in fund value.
Transcripts
hey it's Jim and this is level one of
the CFA program the topic on alternative
Investments and the learning module on
alternative investment features methods
and
structures this is truly an introductory
learning module and we're going to treat
it as such as you'll see in this
relatively short slide deck over the
next six or seven learning modules
however we'll get into great details but
in the Simplicity of this first learning
module let me go ahead and give you kind
of my
definition of alternative Investments
and what it means for the level one of
the CFA
program if I asked you to close your
eyes and envision an equity security
you'll probably think of things
like dividends You'll Think of executive
leadership team you'll think of things
like positive Net Present Value traded
on an organized exchange or or uh an
over-the-counter Market in other words
Equity Securities have similar features
right if I asked you to close your eyes
and think about fixed income securities
you think about coupon payments and you
think about uh a principal payment you
might think about uh interest rate risk
and default risk but fixed income
securities they all have their own kind
of similar features there's a great
Melissa E song called uh similar
features that you guys ought to listen
to from back in the old days
but alternative Investments uh there are
no similar features in fact I want you
just to think of alternative Investments
are any kind of an investment vehicle
that doesn't fit into fixed income and
uh Equity Securities so there we go
features and categories investment
ownership and compensation structure and
then probably the most interesting part
of this first learning module is this
concept of direct and co-investment and
fund invest in fact I think that's
probably where the focus ought to be in
this introductory learning module
because when we get to those six or
seven subsequent learning modules we're
really going to dive into not just the
mathematics of you know compensation and
returns but we're going to get into way
more way more breadth and way more depth
depth so here we go typical introductory
slide that we have what are alternative
Investments what well there we go what
did I just say this means that they fall
outside the traditional Equity
Securities fixed income securities and
then whatever money market Securities
you can throw
in so here's just three quick examples
private Capital real assets and hedge
funds but what you'll see over the next
six or seven learning modules is that
we'll have uh different discussions on
these three but then some others as well
so here's a good question for the exam
you know why why are we interested in
doing this well if you go back and think
about what you can earn by investing in
fixed income securities right you get
the income you get the coupon payments
and you have a yield to maturity but
remember there's all different sorts of
ways to measure that kind of return but
you're kind of limited with fixed income
securities because of the maturity value
uh that's locked into that $1,000 right
when you think of equity Securities you
know you think of dividends and you
think of capital appreciation I mean you
could clearly buy a share stock at 10
and sell it for you know $10,000 or
$220,000 so there's unlimited upside
potential you can only lose whatever you
invest and recall our really really good
conversations on correlation coefficient
standard deviation and variance well
what are we trying to do here what we're
simply trying to do is add Securities to
the portfolio in this case alternative
Securities that will continue
to lower the standard deviation of the
portfolio however however the idea here
is that not only are we going to reduce
risk we're going to increase our
expected
return so think about that Harry marwitz
efficient Frontier right that little
curve and what we're trying to do is
we're trying to take our hands and we're
trying to push up towards that left top
Corner we want to get less return right
diversification we want to get more
expected return
and so that's that second um Box Point
there improve portfolio risk return
profile I think if you if you um just
think of Harry marowitz and trying to
add Alternatives into his Equity
universe and then the fixed income
Universe on the vertical axis I think
you'll be able to get the sense of where
this fits into you know modern portfolio
Theory going all the way back to the
1950s with Harry
marowitz now that final box point I
think is a really good potential exam
questions so what do we know we know
that in the last you know 20 or 30 years
or so and of course just forget about
the you know the early 2020s you know we
had a super low interest rate
environment so the idea here is that
even when interest rates are low that we
can pursue alternative Investments and
then increase our increase our return
that third box point is coupled it's
coupled with the second box point
however notice that the important part
of that sentence is the low interest
rate period so look for that in the
question stem it'll give you the idea of
looking at just you know moving up on
the vertical axis in the Harry marcoz
World rather than worrying so much about
the horizontal
axis all right how about some features
of these alternative Investments what do
we know we know if we invest in a bond
or going to get interest if we invest in
a share stock or might get get a
dividend but sooner or later that
company is probably going to pay us a
dividend well what do we and what do we
get if we invest in uh some type of an
alternative investment so these are
specialized uh these are this requires
specialized knowledge to be able to
Value the cash flows and the risks I
mean think about investing in some kind
of an alternative investment and I'll
give you the example may maybe you've
heard me say this before years and years
ago after that great James Bond movie
came out Casino Royale which by the way
my wife and I just watched on TV last
night um there's a scene where James
Bond comes out of the uh comes out of
the ocean or wherever he is and he's got
this you know kind of a skimpy bathing
suit and for kicks and Giggles I typed
in James Bond bathing suit on eBay now
this is 2007 or 2008 and there it was
the James Bond swimming suit $188,000
and I thought man that's a great
alternative investment so I point this
out to my students and you know we talk
about uh Hollywood movie memorabilia but
how do you value I I have no idea what
that thing is worth today you know how
many years ago was that uh you know it's
nearly 20 years ago and so what are what
are we saying if I paid 18,000 for that
two decades ago what would it be worth
today would it be worth 9,000 or would
it be worth a million dollars I mean
whatever it is how do you value there
are no cash flows how do you value that
how do you value the risks oh excuse
me so there's uh there's that need for
specialized knowledge and then of course
that specialized knowledge it directly
relates to the need to be able to
compute and understand what that
correlation coefficient is between let's
say the James Bond swimming suit and a
share of Johnson and Johnson stock so
let me just go back here real quick what
did we say why alternative Investments
diversification let me just remind you
that the reason we get that extra
diversification is because there's low
correlation between all of these
investment alternative Investments and
fixed income securities and uh and
Equity Securities I would have no idea
what the correlation coefficient between
uh movie memorabilia and a share of
Proctor and Gamble or Johnson and
Johnson I mean I could guess it's
probably close to zero but who knows it
might be a minus uh
point4 now what I was just describing
there leads into that third Diamond
point of course if I buy James Bond
swimming suit can I sell it tomorrow I
mean I might I'd have to list it
somewhere and nobody might be interested
in it
so absolute less liquidity in the
alternative investment Universe way
longer investment Horizons and then a
large capital outlay of course 18,000 is
not too much for a large capital outlay
I wouldn't want you to think about that
but if we want to get into a hedge fund
we we might need $5
million so those different uh features
up top they lead to Super extra
challenges right if we want to know
about Microsoft or AT&T or Proctor and
Gamble I mean all we really need to do
is go to Yahoo finance or any other
search and just figure it out and
somebody will have done all this extra
work for us and we can at least get our
get our feet wet in trying to figure out
how to value that particular security
but how do you value Hollywood movie
movie memorabilia how do you value an
apartment building how do you value a
hedge fund you know so this is really
really complex and then what you have to
figure out is how do you pay some kind
of a fund manager for doing all of this
stuff and then how do you uh how do you
appraise not only the asset itself if
it's if it's like the James Bond
swimsuit or uh how do you evaluate the
performance right suppose I'm a hedge
fund manager and you send me $100 and I
turn it into $200 uh in a week well I'm
going to come back and say I'm a genius
right and you're going to say hey you
know what Jim if you could repeat that
every week I won't need you for much
longer but then suppose after the next
week I turn it back down to $100 well
then what so what did you pay me that
first week and then do I have to pay you
back during that second week because
right at the beginning of the first week
it was 100 and at the end of the second
week it's it's still 100 and you're out
all that compensation that you paid me
after that first week so there are super
challenges now here's a preview of these
future learning modules we'll talk about
uh this whole private Universe we'll
talk about real assets there's an entire
learning module on natural resources uh
there's one on infrastructure there's
one on real estate notice down at the
bottom there are others uh Fine Art
patents digital assets there's one at
the very end on digital assets and then
and then of course hedge funds
so let's just quickly go through some of
these definitions I'm guessing that you
probably know some of this stuff um this
will be re-emphasized when we get to
that learning module on private uh
capital in the future but for now you
know just think about these as uh as you
know some kind of a fund manager let's
just suppose I'm Jim and I say you know
what you guys send me all your money you
send me but don't send me $10 or don't
even send me $18,000 send me $10 million
so I'll raise all this money you know
suppose I have a billion dollars and
what I'll do is I'll go out and I'll try
to find privately held companies and
I'll go and I'll buy these privately
held companies either their debt or
their Equity I'll make them Al loone
right or I'll go buy the a portion of
their company um and then the other part
and this might be a good exam question
is that I can do some research on a
publicly held company that has interest
in uh in becoming private you know back
in the old days um you know these were
called management buyouts and leverage
buyouts even though those terms Still
Still um are appropriate it's usually
under the uh the terminology of of
private
Equity Real assets um we can do this
either directly or indirectly commercial
real estate debt commercial real estate
Equity any kind of things that you think
about you might remember that in a
previous learning module uh for some
reason and this goes back to my
childhood
uh when my family would go to the beach
and my favorite thing was swimming in
the ocean but my nearly favorite thing
was playing miniature golf so when I
think of investing in real assets for
some reason I just think of uh investing
in all of the miniature golf courses at
the beach because they're always always
super
crowded now it could be almost anything
I have an acquaintance who uh who has
purchased over the years apartment
buildings commercial buildings but he
has also purchas buildings that are uh
that he leases to the federal government
like post
offices uh so there's all different
sorts of things in in that real the real
asset real estate category uh
infrastructure you know so roads and
schools and airports remember our
conversation back in fixed income
securities where we had a conversation
on uh municipal bonds and so lots of
times you'll have a municipality issue a
bond and that Bond will say something
like a you know what we're going to go
ahead and build this bridge and what
we're going to do is we're going to
charge a toll for people to go over the
bridge so there's a natural
repayment of the bond issue and what
happens then is there can be this Union
between the local municipality and some
kind of uh public
entity which then would be coupled with
some kind of a private like a like a
construction company who was going to go
ahead and uh and build that uh build
that bridge or an airport or a mall or
whatever it
is natural resources The Institute is
very big on dividing these into three
categories we'll have a future learning
module on this commodi uh land for both
farming and for
forestry and then down at the bottom
other assets so art collectible items
there's my James Bond example isn't the
James Bond example much more exciting
than than than stamps at least it is to
me although coins you guys ever watch
that great movie The Deep uh this was a
long long time ago where they uh they
found some coins in a in a ship that was
uh crashed at sea oh man super tense
really great acting in that movie
intangible assets patents and litigation
let me just remind you we had great
conversations in our financial statement
analys analysis conversations about uh
those intangible assets so they're app I
think take all that knowledge that we
had from that previous learning module
and throw it into this one as well and
then there'll be an entire learning
module on digital
assets the hedge fund Universe goes back
to
1949 with a dude named uh aw Jones and
he was just like me he said hey send me
your money but but send me $5
million and you know I'm not going to
invest in fixed income securities I'm
not going to invest in equity Securities
I'm going to invest in whatever I want
to invest in and so the hedge fund
universe is really identical to the
mutual fund Universe with the with the
distinguishing uh difference is that the
manager can do pretty much whatever he
or she wants now of course that has to
it has to be in the perspectiv it has to
say something like look look at some of
those bullet points I'm going to invest
in derivatives I'm going to do short
selling I'm going to use leverage I'm
going to do anything that I want to do
as long as it's inside of uh of the
perspectus and by the way um this dude
aw Jones what he did in 1949 sounds
pretty silly today but back then this
was revolutionary what he did is said
you know what I'm going to start
borrowing money and I'm going to use
that to buy shares of stock and I'm
going to short sell so that was pretty
much the first hedge
fund and it has evolved of course
expanded to include anything out there
look publicly traded fixed income assets
private Capital real estate including
miniature golf courses hedge
funds all right so what happens here an
investor contributes Capital to a fund
right so you guys would send me each
five million or $10 million and what I'm
going to do is I'm going to identify let
me go back here quickly I'm going to
identify these publicly or privately or
real estate I'm going to or the James
Bond swimsuit I'm going to invest in all
these kinds of things and I'm not going
to do it for free I'm going to do it uh
for a fee and that fee is probably not
going to be embedded like it is in the
mutual fund Universe where the the
manager of the fund you know might get a
1% fee or a half percent fee or
something like that what I'm going to do
is I'm going to say something like look
if I turn my your $100 into $200 I want
a fee sure you can pay me one or two%
but I want to be compensated for that
extra 98 or 99% that I provided with you
now what did I say a while ago of course
this makes this compensation structure
way more way more
complex all right so what are the
advantages these are good questions here
you get my investment service and my
expertise you don't have to worry about
anything you just send me your money and
I'll do all the
stuff um lower minimum capital
requirements um for fund investment
lower than in direct investment you know
like if you're going to go out and buy a
whole bunch of miniature golf courses
you might need a couple uh 10 or 20 or
$30 million whatever it is uh
disadvantages of course you're going to
have to pay me and then uh you're going
to have to do a lot of research on who I
am and what my record is and can you
really trust me I mean that's pretty
much what it comes down to when uh when
evaluating a hedge fund manager I say
this to my students all the time even
when I'm when I have conversations about
companies like Proctor and Gamble or
Johnson and Johnson you know when you
buy a bond or you buy a share of stock
you're essentially just trusting the
executive leadership team and the board
of directors but in the investing in
debt or Equity Securities you know you
have a whole bunch of people on your
side a whole bunch of people on your
team like the board of directors like
the SEC like the entire uh financial
institution industry sometimes it works
in most of the time it works in your
favor some sometimes it doesn't but here
when you're involved when you're
investing in um a hedge fund you you
don't have all those people on your side
I mean you do to some extent but not
nearly the
amount right how about this concept of
co-investment so this is what's
happening here I'll say something like
here send me your money send me $5
million and I'll go invest in a
diversified portfolio of these
Alternatives and then oh by the way over
over here I'm going to invest in this uh
a bunch of miniature golf courses at the
beach and I'm going to give you a chance
to go ahead and make another investment
that would go directly into miniature
golf courses so your original investment
right the the original investment would
be you're just going to invest in me I
got all these assets here but then you
can do this extra it's almost like an
option you can co-invest by directly in
some of those same uh Advantage some of
those same alternative advantages and
what that I'm sorry alternative
Investments so what that does then is
that gives you um the idea of you know
what if you know something about
miniature golf courses or you want to
know something about miniature golf
courses well then that's is your chance
to do it
right now with co-investment you have
reduced management fees and allows for
more active and uh active ad management
as I just mentioned reduce control
higher over sight costs and more active
involvement those things make sense here
so what why why do we do this why do we
want to choose one or more co-investor
so it allows for expansion of investment
opportunities I say this to you kind of
regularly in the academic world we call
that spanning right so spanning
necessarily gives the investor more
choices and it probably increases
diversification and then what it does to
it speeds up that uh that investment
cycle now like my acquaintance you could
just directly invest in a post office
without an intermediate you could do
this uh as much as you want of course
you have a lot of money I mean you could
go to your local municipality and say
you know what I think there should be a
bridge from here over to there and you
could go ahead and build it yourself I
mean you probably have to get you know
some zoning approvals and all sorts of
other kind of crazy things and you're
probably not likely to do that unless
you're a construction company but of
course you know you can do you can make
all these kinds of Investments on your
own what this means is you have don't
have to worry about all those management
fees you have lots and lots of
flexibility and more control but then uh
it's probably going to cost you more and
you probably need to know something
about uh about Building
Bridges all right so back in my uh back
to my example I'm going to go ahead and
be the general partner so you guys send
me all your money right I use some of my
money right I run the business I have
unlimited liability you're the limited
partner
you guys play a passive role you're
known as the accredited investors
accredited investors which means that
you went ahead and read the perspectives
you know I'm not just investing in
proactor and Gamble and a treasury bond
I'm investing in all sorts of things out
there and I'm doing it for your benefit
right the benefit is what greater uh
risk return profile and low correlation
coefficients now here are some good uh
some good definitions that show up at
the questions at the end of this
learning module the limited partnership
agreement you can imagine what that
looks like right so the relationship
between me and you depends on this
agreement which will have things in
there that sounds something like okay
I'm going to go ahead and do this and if
it pays off then I'm going to distribute
this uh this extra capital or this earn
Capital to you
guys now I know that each one of you out
there is going to have your own kind of
bias your own kind of Interest your own
kind of agenda so you're going to call
me privately and you're going to say hey
you know what Jim How about if this
happens so these are side letters side
agreements
between um a limited partner or or a
group of limited partners and so one of
the skills that I have to have is to try
to figure out how to go ahead and uh
craft these side agreements so that it
benefits you it benefits me and it
doesn't hurt all those other limited
partners that are not part of that side
letter and it might be something as
simple as the let's go back to my
example right I turn $100 into $200 so
everyone's happy but yeah some of you
have a side letter that says hey you
know what if Jim ever doubles our money
I get another 2% or something like that
I sure hope I wouldn't sign that S
letter but you know you get this
different kinds of compensation
agreements uh or different timing of
those distributions and there's a master
limited
partnership uh other common adopted
structures here this public private
partnership this is a uh this could be
just a regular old partnership it could
be a joint
venture uh common between construction
companies and municipalities who are
building things like Bridges and tunnels
but we'll have an entire learning module
on that one all right let's go ahead and
finish up this with a little bit of math
let's start with a couple of definitions
here we have this management fee a lot
of times it's called a base fee we need
to worry about the difference between uh
this fee which is based on assets under
management or committed Capital so this
is super important it's a great exam
question that the assets under
management would be you know some big
number like a billion dollars where I'm
actually managing $1 billion worth of
assets but committed capital and this is
typically with private Equity you guys
might say to me all right Jim here's $5
million so I'm I'm managing let's say
hundred
million but over the next three or five
or maybe seven years I don't know that
it would go out to 10 years you guys
have committed to another 80 million or
200 million you've committed that
capital in the future and so uh we're
going to base my performance on your
committed Capital right 1 to 2% is
pretty common
so we can have performance fees we can
have carried interests which has
tremendous political kinds of uh
conversations we'll talk about that
length at some other date The Institute
doesn't emphasize that in this learning
module as
well so these things are based on excess
returns so what was that 100 100 what
did I turn 100 into 200 so that's 100%
well that sounds like an excess return
no matter what but we need to figure out
what is it exceeding I mean you could
come to me and say Hey you know Jim I
expect you to earn
98% and so I'm like oh boy okay I'll
earn so if I double your money that's
100% so your excess compensation your
excess return will only be 2% in that uh
in that silly example so we need to
worry about hurdle rates right that
hurdle rate maybe it's 8% maybe it's 10
maybe it's 12% so there's a hard hurdle
rate which is the the the the GP earns
those returns above that hurdle rate but
then there's a a soft hurdle rate which
is a little bit more complex and I'll
show you that here in just a
second couple of extra definitions this
uh this catch-up Clause uh 100% of
performance fees based on returns above
that hurdle rate and then whatever is
over top of that that
split you know so if I go from $100 to
$200 and the uh hurdle rate is
10% well I'll get all that uh I'll get
all that and then what will happen
happen is that the other 90% will be
distributed maybe it's 9010 maybe it's
8020 maybe it's 75 25 whatever it
is high water mark suppose that I go
from 100 to 200 right and then the next
year I go down to 50 well you paid me
from the 100 to the 200 right now it's
all the way down to 50 so that high
water mark is set now at 200 so there's
not going to be this uh performance fee
until until I get that fund back up over
over the two
200 waterfall this goes back to what I
was saying earlier about that side
letter so without side letters the
waterfall what happens you know you go
like this and then it spills over and it
spills over so this determines what what
does that allocation look like and then
there's that clawback Clause that gives
the uh the limited partners the right to
reclaim you know so if I go from 100 to
200 and you guys pay me a whole bunch
and then I go down to 50 where you can
say you know what Jim you kind of stink
so we need some of that money
back let's do a let's just do a quick
example
here here are some good
equations um there's the return for uh
the GP it's the max of zero right zero
meaning that I don't get anything and
then uh R minus RH R is that funds uh
rate of return for that period and then
the H stands for the hurdle rate and
then if we have that catchup provision
we'll go ahead and subtract backed out a
couple of other things in the
denominator uh let's just do just a
quick example here 20% performance fee
8% hurdle rate
um suppose the fund receives a 12%
period for the return let's do this
return with and without and so there's a
uh what do we get we earned 12 there's
the hurdle rate of eight so 12 minus 8
that's four So 20% of four gives me
uh8 there's my uh
fees suppose then there's this catch-up
Clause uh suppose it's 8% so let's go
ahead and just do the math down at the
bottom and uh there you get
1.44% and that takes us through our
learning outcomes there are eight good
questions uh covered most of those
inside of this learning module recording
so you ought to be able to get through
those in in less than 10 minutes or so
just focus on the focus on all the
definitions so hey thanks for watching
and have a great day and good luck
studying
5.0 / 5 (0 votes)