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Alternative Investment

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EduPristine CFA L I\ Alternative Investment

Alternative Investment

Characteristics

Fund of Funds

Private Equity

EduPristine CFA L I\ Alternative Investment

Valuation of Real
Estate Investments

Hedge Funds

Commodities

Alternative Investment

Characteristics

Fund of Funds

Lower liquidity than


traditional investments.
Difficult to determine fair
market values.
Limited historical
performance data available

Private Equity

Valuation of Real
Estate Investments

Hedge Funds

Commodities

Advantages:
Allows to invest in hedge fund with limited capital.
HNI can diversify their investments by taking small exposure to
large number of hedge funds through fund of funds.
Manager will have expertise in selection of large number of good
hedge funds and expertise to do the necessary due diligence.

Drawbacks:
Fund of funds charge mgmt fee in addition to mgmt fees charged
by hedge fund.
Diversification will reduce the investors' risk but at the cost of
returns.
Fund manager may or may not outperform the single hedge fund.

EduPristine CFA L I\ Alternative Investment

Alternative Investment

Characteristics

Fund of Funds

Leveraged Buyouts (LBOs)

Referred to as a going private


transaction. i.e. a public
company, goes private after an
LBO
MBO Management Buyout
Management Acquires
MBI Management Buy-In
Current Management is being
replaced
Debt (leveraged) is used in an
LBO high yield bonds
Mezzanine Financing preferred
shares with warrant or
conversion option can also be
used

Private Equity

Venture Capital

Target company is known as


Portfolio Company
Stage Anytime from inception
to IPO
Investors demand a very high
rate of return
Venture Capitalists generally
actively manage the Portfolio
Company
VCs usually get equity of the
Portfolio Company, although
sometimes they may provide
debt financing as well
Stages of VC
Formative Stage
Later Stage:
Mezzanine

EduPristine CFA L I\ Alternative Investment

Valuation of Real
Estate Investments

Hedge Funds

Development Capital

Usually done by private


companies who want to sell a
portion of shares before an IPO
For public companies Private
Investment in Public Equities
(PIPE)

Commodities

Distressed Investing

They are the securities of


companies that have filed or are
close to filing for bankruptcy or
are seeking out of court debt
restructuring to avoid
bankruptcy
Known as Vulture Investing

Alternative Investment

Characteristics

Fund of Funds

Private Equity

Valuation of Real
Estate Investments

Hedge Funds

Commodities

Valuation Methods

Market or Comparable
Approach
The Valuation of a company
can be a multiple of EBITDA

Discounted Cash Flow (DCF)


The present value of all
Free Cash Flows to Firm,
discounted at the
companys WACC.
An estimate can be a cash
flow divided by the
capitalization rate

EduPristine CFA L I\ Alternative Investment

Asset Based
Most appropriate approach
if company is going to
liquidate
Measured as a companys
assets its liabilities (equal
to shareholders equity)
Asset values can be taken as
market/fair values or
liquidation values

Alternative Investment

Characteristics

Fund of Funds

Private Equity

Valuation of Real
Estate Investments

Hedge Funds

Commodities

Valuation methods: Cost method, sales comparison method &


income method
Income method uses a discounted cash flow model similar to
that for a perpetuity: Value = NOI / Market cap rate
Net Operating Income (NOI):
Equals gross operating income less estimated vacancy.
Collections & other operating expenses, (including property
taxes, but excluding income taxes). NOI does not include
depreciation or financing costs.

EduPristine CFA L I\ Alternative Investment

Alternative Investment

Characteristics

Fund of Funds

Types of Hedge Funds

Event-driven strategies are


typically based on a corporate
restructuring or acquisition that
creates profit opportunities for
long or short positions in
common equity, preferred
equity, or debt of a specific
corporation.

Valuation of Real
Estate Investments

Private Equity

Hedge Funds

Hedge Fund Biases

Risk

Relative value strategies involve


buying a security and selling
short a related security with the
goal of profiting when a
perceived pricing discrepancy
between the two is resolved.

EduPristine CFA L I\ Alternative Investment

Commodities

Macro: Use Top-Down Approach


to take positions in fixed
income, equity, currency and
commodities

Equity hedge: Use bottom-up


approach to profit from both
long and short positions in
publicly traded equities and
equity derivatives.

Alternative Investment

Characteristics

Fund of Funds

Types of Hedge Funds

Liquidity

Hedge Funds

Settlement
Errors

Risk of Counterparty: Failure to


deliver security on settlement day
as agreed upon.

EduPristine CFA L I\ Alternative Investment

Commodities

Hedge Fund Biases

Risk

Potential for
Mispricing

Investments in esoteric,
infrequently traded securities may
lead to difficulty in determining
the true value.

Valuation of Real
Estate Investments

Private Equity

Counterparty
Credit Risk

Risk that managers have to cover


their shorts & repurchase
securities at price higher than
where they originally sold.

Short
Covering

Margin
Calls

Can result in forced selling of


assets, possibly at a loss, on an
already highly leveraged position.

Alternative Investment

Characteristics

Fund of Funds

Valuation of Real
Estate Investments

Private Equity

Types of Hedge Funds

Investment Style
Investment Process
Competitive Advantage
Track Record
Fund Size
Longevity
Management Style
Key-Person Risk
Reputation
Investor Relations
Plans for Growth
Systems Risk Management

EduPristine CFA L I\ Alternative Investment

Risk

Survivorship Bias: Only best


performing hedge funds survive
in this industry and thus only
funds with successful track
records are likely to be included
in calculating index.

Hedge Funds

Commodities

Hedge Fund Due Diligence, Bias and Fee

Fee Structure & Gaming: Fee


structure is designed in a such a
way that manager is paid small
fixed amount & large variable
component based on the
performance of fund. It may
compel managers to take a big
bets in order to get higher
remuneration.

Alternative Investment

Characteristics

Fund of Funds

Private Equity

Valuation of Real
Estate Investments

Hedge Funds

Commodities

Contango: Future Price > Spot Price


Backwardation: Future Price < Spot Price

Roll Yield:
Contango Negative Yield Roll
Backwardation Positive Yield Roll

When treasuries are pledged as collateral


for a commodities futures trade, the yield
on the treasuries is called collateral yield.

Unlike equity index funds, the commodity


index strategies are ACTIVE since future
contracts need to be rolled.

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Question 1
1. Which of the following is least likely a feature of hedge funds?
a) It is usually open to a limited number of investors who are able to make a large initial
payment
b) It has investments in almost all domains with very few restrictions
c) Investors can withdraw their investment anytime without paying any fee

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Solution 1
Solution: (c) In a hedge fund, the investors are usually asked to keep their money for a
minimum period, known as the lockup period. Also, they may be charged a fee to
redeem shares or make withdrawals before maturity.

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Question 2
2. An activist shareholder strategy is most likely expected to perform which of the following
functions?
a) Buy shares of a firm at high prices to increase the market value of the stock
b) Buy a large number of the stock to influence companys policies and increase companys
value
c) Buy securities of a distressed firm and sell them later when the situation improves

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Solution 2
Solution: (b) In an activist shareholder strategy, a large number of shares are bought to
influence the companys policies. The main aim of this is to increase company value.

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Question 3
3. The treatment of real estate property purchased with a mortgage is the closest to which
of the following?
a) Owners equity is the book value of the property minus the outstanding loan amount
b) Owners equity is the market value of the property minus the outstanding loan amount
c) Owners equity is the market value of the property, and loan is accounted for in liabilities

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Solution 3
Solution: (b) Property purchased with a mortgage is referred to as leveraged investment.
Owners equity is the property value minus the outstanding loan amount. Thus, changes
in property value over time affect the owners equity.

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Question 4
4. Which of the following is least likely correct?
a) A hard hurdle rate means that incentive fees are only earned on returns in excess of the
benchmark
b) A 2 and 20 is a hedge fund structure which charges 2% of the value of the assets as
management fee and 20% of the total profits as incentive fee
c) Incentive fee is paid on all gains, irrespective of whether it offset prior losses

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Solution 4
Solution: (c) In hedge fund, a very common feature is the high water mark. This means that
the incentive fees are only paid to the extent that the current value of an investors
account is above the highest value previously recorded. This ensures that the investors
are not charged twice for the same gain in their portfolio values.

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Question 5
5. Which of the following statements is most accurate?
a) Index strategy employed by portfolio managers in equities is considered an active
strategy
b) The weightings of various commodities in indexes change with the value of the
derivative positions in the portfolio
c) Index strategy employed by portfolio managers in commodities is considered an active
strategy

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Solution 5
Solution: (c) Index strategy employed by portfolio managers in commodities is considered an
active strategy. Index strategy employed by portfolio managers in equities is considered
a passive strategy. The weightings of various commodities in indexes do not necessarily
change with the value of the derivative positions in the portfolio.

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Question 6
6. Which of the following is least accurate for Hard Hurdle rate:
a) It ensures that profits are earned only when the returns from the Hedge Fund exceeds
the benchmark rate.
b) It ensures that investors do not pay multiple incentive fees for the same performance.
c) It can be set as a percentage or a rate plus a premium.

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Solution 6
Answer B
Explanation Hard hurdle rate ensures that the Investors pay the incentive fees to Hedge
Fund managers only when they have profits in excess of the benchmark and can be decided
as a percentage or as rate plus premium. High Water Mark is used to ensure an investor
does not pay incentive fees multiple times on the same gains in their investor portfolios.

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Question 7
7. Which of the following is most likely the measure to downside the risk from Hedge funds
with asymmetric returns:
A) Sortino ratio
B) Sharpe ratio
C) Standard deviation

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Solution 7
Ans: A) Sortino ratio is based on the downside deviations from the mean and downside the
risk for asset class with asymmetric returns.

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Question 8
8. Which of the following implications is least correct in the context of Fund of Funds (FOF):
a) It enables investors with limited capital to take advantage of hedge funds.
b) It is not very costly for the Investors.
c) It helps investors in diversifying their investments among different Hedge Fund
strategies.

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Solution 8
Answer B
Explanation Fund of Funds refers to a company that invests in Hedge Funds thus giving
small investors a chance to invest in Hedge funds while also helping them in diversification of
their Portfolio. It is very costly for an investor as these fund managers charge additional fees
to the one that Hedge funds will charge.

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Question 9
9. What is the term for financing where debt or preferred shares issued are subordinate to
high yield bonds and carry warrants or conversion features?
a) mezzanine financing
b) venture capital financing
c) vulture capital financing

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Solution 9
Answer: a)
Mezzanine financing refers to the financing where debt or preferred shares issued are
subordinate to high yield bonds and carry warrants or conversion features.

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Contact:
E: help@edupristine.com
Ph: +1 347 647 9001

EduPristine www.edupristine.com
EduPristine CFA L I\ Alternative Investment