Alternative Investment Features, Methods, and Structures (2024 CFA® Level I Exam – AI – LM 1)

Summary

The 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

00:00

😀 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.

05:00

💡 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.

10:02

📚 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.

15:03

💼 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.

20:05

🤝 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.

25:05

📊 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.

Keywords

💡Alternative Investments

Alternative investments refer to financial assets that do not fall into the traditional categories of equity, fixed income, and cash equivalents. They are often considered for their potential to diversify a portfolio and provide returns that are not correlated with the broader market. In the video, Jim discusses how alternative investments like private capital, real assets, and hedge funds can offer unique opportunities for portfolio diversification and potentially higher returns.

💡Direct and Co-investment

Direct investment involves buying a non-publicly traded asset outright, while co-investment allows multiple parties to pool their resources to invest in the same asset. In the context of the video, Jim explains that co-investment can provide investors with more control and flexibility, albeit with higher management fees and the need for specialized knowledge to evaluate the investment.

💡Hedge Funds

Hedge funds are a type of alternative investment vehicle that pools capital from accredited investors and uses a variety of strategies to earn active returns. They are known for their flexibility and the ability to employ leverage, short selling, and derivatives. In the script, Jim mentions the origin of hedge funds with A.W. Jones and how they differ from traditional mutual funds in terms of investment freedom.

💡Liquidity

Liquidity refers to the ease with which an asset can be converted into ready cash without affecting its market price. The video script emphasizes that alternative investments typically have lower liquidity compared to traditional securities, which can impact an investor's ability to buy or sell the investment quickly.

💡Investment Horizon

The investment horizon is the length of time an investor expects to hold an investment before selling it. The script mentions that alternative investments often have a longer investment horizon compared to traditional investments, which can require a longer-term commitment from investors.

💡Specialized Knowledge

Specialized knowledge is the expertise required to understand, evaluate, and manage investments in a particular field or asset class. In the context of alternative investments, as highlighted in the video, investors or managers need specialized knowledge to assess the value and risks associated with these non-traditional assets.

💡Correlation Coefficient

The correlation coefficient is a statistical measure that expresses the extent to which two variables are linearly related. It is mentioned in the script to illustrate the low correlation between alternative investments and traditional securities, which is a key reason for including alternatives in a portfolio to achieve diversification.

💡Risk-Return Profile

The risk-return profile of an investment describes the potential risks versus the potential returns of that investment. Jim discusses in the video how alternative investments aim to improve the risk-return profile of a portfolio by potentially offering higher returns for a given level of risk.

💡Efficient Frontier

The efficient frontier is a concept from modern portfolio theory that represents the set of optimal portfolios that offer the highest expected return for a defined level of risk. In the video, Jim refers to the efficient frontier to explain how alternative investments can help investors achieve better portfolios by shifting towards the top left corner of the efficient frontier, indicating higher returns for lower risk.

💡Portfolio Diversification

Portfolio diversification is a risk management strategy that involves spreading investments across various financial instruments, industries, and other categories to reduce exposure to any one risk. The video emphasizes diversification as a key benefit of alternative investments, as they can provide returns that are not closely tied to the performance of traditional asset classes.

💡Management Fees and Performance Fees

Management fees are regular fees charged by investment managers, typically based on assets under management. Performance fees, on the other hand, are fees that are contingent on the investment's performance. The video script discusses how these fees can be structured in alternative investments, especially in hedge funds, where managers may receive a percentage of profits above a certain threshold (hurdle rate).

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