CFA - Alternative Investments

venture capital

Private equity investment in a startup or early-stage company involving high risk and a high rate of failure.

real assets

Generally, these are tangible physical assets, such as real estate, infrastructure, and natural resources, but they also include such intangibles as patents, intellectual property, and goodwill. These generate current or expected future cash flows and/or are considered a store of value.

infrastructure

A type of real asset that is intended for public use and provides essential services. These assets are typically long-lived fixed assets, such as bridges and toll roads.

concession agreement

A contractual arrangement under which an entity (also known as a grantor) establishes terms and conditions with a developer or operator (referred to as a concessionaire) to plan, build, operate, finance, and maintain an infrastructure asset for a specific period.

natural resources

These include commodities (hard and soft), agricultural land (farmland), and timberland.

commodities

A product or service from a firm that is indistinguishable from products or services of competing firms, usually conforming to a common standard or grade imposed by convention or regulation.

digital assets

The umbrella term covering assets that can be created, stored, and transmitted electronically and have associated ownership or use rights. These include a variety of assets, such as cryptocurrencies, tokens (security and utility), and digital collectables.

hedge funds

Private investment vehicles that may invest in public equities or publicly traded fixed-income assets, private capital, and/or real assets, but they are distinguished by their investment approach rather than by the investments themselves.

fund of funds

Funds that hold a portfolio of hedge funds

private capital; real assets; hedge funds

What are the three alternative investment categories?

fund investing

The investor invests in assets indirectly by contributing capital to a fund as part of a group of investors. This is available for all major alternative investment types.

co-investing

The investor invests in assets indirectly through the fund but also possesses rights (known as co-investment rights) to invest directly in the same assets. Through this, an investor is able to make an investment alongside a fund when the fund identifies deals.

limited partnership agreement

A legal document that outlines the rules of the partnership and establishes the framework that ultimately guides the fund’s operations throughout its life.

side letter

A side agreement created between the GP and specific LPs. These agreements exist outside the LPA. These agreements provide additional terms and conditions related to the investment agreement.

master limited partnership

Has similar features to limited partnerships but is usually a more liquid investment that is often publicly traded.

carried interest

A performance fee (also referred to as an incentive fee, or carry) that is applied based on excess returns above a hurdle rate.

committed capital

The amount that the limited partners have agreed to provide to the private equity fund.

hurdle rate

Also called “preferred return.” The minimum rate of return on investment that a fund must reach before a GP receives carried interest.

hard hurdle rate

Hurdle rate where the manager earns fees on annual returns in excess of the hurdle rate

soft hurdle rate

Hurdle rate where the fee is calculated on the entire return when the hurdle is exceeded. With this, GPs are able to catch up performance fees once the hurdle threshold is exceeded.

catch-up clause

A clause in an agreement that favors the GP. For a GP who earns a 20% performance fee, a this clause allows the GP to receive 100% of the distributions above the hurdle rate until she receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP.

high-water mark

The highest value, net of fees, that a fund has reached in history. It reflects the highest cumulative return used to calculate an incentive fee.

clawback provision

A requirement that the general partner return any funds distributed as incentive fees until the limited partners have received their initial investment and a percentage of the total profit.

deal-by-deal or American waterfall

Type of waterfall that is more advantageous to the GP because performance fees are collected on a per-deal basis, allowing the GP to get paid before LPs receive both their initial investment and their preferred rate of return (i.e., the hurdle rate) on the entire fund.

whole-of-fund or European waterfall

Type of waterfall where all distributions go to the LPs as deals are exited and the GP does not participate in any profits until the LPs receive their initial investment and the hurdle rate has been met. In contrast to deal-by-deal waterfalls, these waterfalls occur at the aggregate fund level and are more advantageous to the LPs.

public-private partnership

An agreement between the public sector and the private sector to finance, build, and operate public infrastructure, such as hospitals and toll roads.

real estate direct investment

A joint venture is an alternative investment structure that is most likely used for:

net investment value / total invested capital

Multiple of Invested Capital Formula

prime broker

A broker that provides services that commonly include custody, administration, lending, short borrowing, and trading. Hedge funds typically borrow capital from this entity.

margin financing

A financing arrangement whereby the prime broker lends shares, bonds, or derivatives and the hedge fund (or investment manager) deposits cash or other collateral into a margin account at the prime broker based on certain fractions of the investment positions.

return + (borrowed funds / original capital)(return - funding cost)

Leveraged Portfolio Return Formula

redemption fee

A fee charged to discourage redemptions and to offset the transaction costs for remaining investors in the fund.

notice period

The length of time (typically 30–90 days) in advance that investors may be required to notify a fund of their intent to redeem some or all of their investment. This allows a fund manager to liquidate a position in an orderly fashion without magnifying losses.

lockup period

The minimum holding period before investors are allowed to make withdrawals or redeem shares from a fund. Its purpose is to allow the hedge fund manager the required time to implement and potentially realize a strategy’s expected results.

gate

A provision that when implemented limits or restricts redemptions for a period of time.

founders class shares

A way to entice early participation in startup funds whereby managers offer incentives that entitle investors to a lower fee structure and/or other favorable terms.

either/or fees

A custom fee arrangement whereby major investors are offered a structure where managers agree to charge either a lower management fee or a higher incentive fee, whichever is greater.

(end of period assets * fixed AUM fee) + ( (end of period assets - beg. of period assets) * performance fee)

GP Return Formula

survivorship bias

Relates to the inclusion of only current investment funds in a database. As such, the returns of funds that are no longer available in the marketplace (have been liquidated) are excluded from the database.

backfill bias

A problem whereby certain surviving hedge funds may be added to databases and various hedge fund indexes only after they are initially successful and start to report their returns.

leveraged buyout

A transaction in which a private acquiror uses equity and a high proportion of debt to acquire a public or private company in order to make changes to increase value over an investment period.

management buyout

A private sale to a strategic buyer that includes a company’s existing management. The management team commits their own equity capital along with other investors as an incentive to grow the firm’s cash flows and value. This is a type of LBO.

management buy-in

A type of leveraged buyout where the current management team is replaced with the acquiring team involved in managing the company. This is a type of LBO.

portfolio companies

The individual companies owned by a private equity firm.

mezzanine-stage financing

Venture capital that prepares a company to go public as it continues to expand capacity and enhance its growth trajectory. It represents the bridge financing needed to fund a private firm until it can execute an IPO or be sold. Main financing is either equity-like (to capture potential gains from the planned IPO) or short-term debt.

private investment in public equity

A private offering to select investors with fewer disclosures and lower transaction costs that allows the issuer to raise capital more quickly and cost effectively. Common in work-out or distressed situations.

trade sale

A portion or division of a private company sold via either direct sale or auction to a strategic buyer interested in increasing the scale and scope of an existing business. This is one of the two main ways a PE firm exits an investment.

stockholder overhang

The downward pressure on the share price of stock as large blocks of shares are being sold on the open market.

recapitalization

This via private equity describes the steps a firm takes to increase or introduce leverage to its portfolio company and pay itself a dividend out of the new capital structure.

secondary sale

Sale of a private company stake to another private equity firm or group of financial buyers.

write-off/liquidation

Refers to a transaction that has not gone well, and the investment is likely to lose value. The private equity firm revises the value of its investment downward or liquidates the portfolio company.

direct lending; mezzanine; venture; distressed

What are the four categories of private debt investing?

venture debt

Private debt funding that provides venture capital backing to start-up or early-stage companies that may be generating little or negative cash flow.

direct lending

Providing capital directly from private debt investors. The debt itself typically is senior and secured and has covenants in place to protect the lender/investor.

leveraged loan

Where private debt investor firms borrow money to make a direct loan to a borrower.

mezzanine debt

Refers to private credit subordinated to senior secured debt but senior to equity in the borrower’s capital structure. Often comes with additional features, such as warrants or conversion rights.

distressed debt

Debt of mature companies in financial difficulty, in bankruptcy, or likely to default on debt.

debtor-in-possession financing

Provides operating funds for firms already in bankruptcy.

unitranche debt

A hybrid or blended loan structure combining different tranches of secured and unsecured debt into a single loan with a single, blended interest rate.

direct lending; mezzanine financing; leveraged lending

What are the three private debt categories that are featured in the later stages of the corporate life cycle?

vintage year

The year in which a private capital fund makes its first investment.

infrastructure debt

What is the most secured form of debt?

initial investment period; harvesting period

What are the two stages in the life cycle of a PE fund?

Level 1

___________ assets have an exchange-traded, publicly traded price available that is mandated to be used for valuation purposes.

Level 2

____________ asset values use outside quotes from brokers when publicly traded prices are not available.

Level 3

____________ asset values are computed using only internal models when outsider broker quotes are not available or not reliable.

core real estate strategies

Strategies with exposure to well-leased, high-quality commercial and residential real estate in the best markets, generally offered by open-end funds. Investors expect this to deliver stable returns, primarily from income from the property.

core-plus real estate strategies

Value-add investments that require modest redevelopment or upgrades to lease any vacant space together with possible alternative use of the underlying properties. Compared to core real estate strategies, these may be appealing for investors seeking higher returns and willing to accept additional risks from development, redevelopment, repositioning, and leasing.

value-add real estate strategies

Strategies that involve larger-scale redevelopment and repositioning of existing assets and that may allow the investor to earn a higher return compared with core-plus real estate strategies.

opportunistic real estate strategies

Include major redevelopment, repurposing of assets, taking on large vacancies, or speculating on significant improvement in market conditions. These may be appealing for investors seeking higher returns and willing to accept additional risks from development, redevelopment, repositioning, and leasing.

free and clear

When a property title that is transferred to a new owner is unencumbered by any financing liens, such as from outstanding mortgages, the new ownership is considered:

development finance institutions

specialized financial intermediaries that provide risk capital for economic development projects on a non-commercial basis

economic; social

What are the two categories of infrastructure investments?

economic infrastructure investments

A category of infrastructure investments that support economic activity through transportation assets, information and communication technology assets, and utility and energy assets.

greenfield investments

New, “to-be-built” infrastructure projects and assets created to provide a specific essential service or to supply a public good.

build-operate-transfer

The greenfield investment life cycle common among public–private partnerships is called the ______________________ life cycle.

brownfield investments

The third stage of development of an infrastructure asset. These involve expanding existing facilities and may involve privatization of public assets or a sale leaseback of completed greenfield projects. They are characterized by a shorter investment period with immediate cash flows and an operating history.

secondary-stage investments

The second stage of development of an infrastructure asset. These involve existing infrastructure facilities or fully operational assets that do not require further investment or development over the investment horizon. These assets generate immediate cash flow and returns expected over the investment period.

contractual payments

Infrastructure cash flows primarily arise from:

governments

Most infrastructure assets are financed, owned, and operated by:

double corporate taxation

The main appeal of the REIT structure is the elimination of:

brownfield investments

Which of the three infrastructure types would most likely appeal to an investor who wants long-term, stable returns?

timber;and investment management organizations

Entities that support institutional investors by managing their investments in timberland by analyzing and acquiring suitable timberland holdings.

backwardation

A downward-sloping, or inverted, forward curve in a futures market.

contango

Refers to spot price below forward price in a futures market.

equity; event-driven; relative value; opportunistic; multi-manager

What are the 5 categories of hedge fund strategies?

fundamental long/short

In this strategy, the hedge fund takes a long position in companies that are trading at inexpensive levels compared to their potential intrinsic value and shorts those that trade in the other direction, with the intention of reversing this trade to obtain alpha.

fundamental growth

These strategies use fundamental analysis to identify companies expected to exhibit high growth and capital appreciation.

fundamental value

These strategies use fundamental analysis to identify undervalued and unloved companies for which there is a possibility that a corporate turnaround, with future revenue and cash flow growth, will result in higher valuations.

short biased

These strategies use quantitative, technical, and fundamental analysis to short overvalued equity securities with limited or no long-side exposures.

market neutral

These strategies use quantitative, fundamental, and technical analysis to identify under- and overvalued equity securities. The hedge fund takes long positions in undervalued securities and short positions in overvalued securities, while seeking to maintain a market-neutral net position.

distressed/restructuring

These strategies focus on securities of companies either in or perceived to be near bankruptcy. In one approach, hedge funds simply purchase fixed-income securities trading at a significant discount to par but that are still senior enough to be backed by sufficient corporate assets.

special situation

An area of private capital investment which targets return by investing in stressed, distressed, or event-driven opportunities.

activist

Managers secure sufficient equity holdings to allow them to seek a position in a company’s board and influence corporate policies or direction.

convertible bond arbitrage

This conceptually market-neutral investment strategy seeks to exploit a perceived mispricing between a convertible bond and its component parts: the underlying bond and the embedded call option. There may be relative mispricing between equity and the convertible bond. The strategy typically involves buying convertible debt securities and simultaneously selling a certain amount of the same issuer’s common stock based on the delta of the embedded call option. This strategy can be sensitive to bankruptcy risks; however, they may be hedged away using either equity put options or credit default swap derivatives on the issuer.

market beta; strategy beta; alpha

The performance of hedge funds can be attributed to three distinct sources:

market beta

the broad market beta that can be realized using market index–based funds/ETFs

strategy beta

the beta attributed to the investment strategy of the hedge fund applied across the broad market

alpha

the manager-specific returns, due to the selection of specific positions

selection bias

when the benchmark inclusion criteria cover only those funds that have good performance and hence report their performance to attract new investors