Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Alternative Investments - CFA Level I/Alternative Investment Features, Methods, and Structures

Alternative Investment Features, Methods, and Structures

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Categories of Alternative Investments5 min

Alternative investments are diverse asset classes that fall outside traditional stocks and bonds. This section details six main categories. Hedge funds are characterized by their structure resembling mutual funds but for high-net-worth individuals, using leverage and derivatives to manage illiquid assets. Private Equity includes Venture Capital for early-stage firms and Leveraged Buyouts for established companies using debt. Real Estate covers residential and commercial properties and debt securities like MBS. Commodities offer exposure through physical ownership, derivatives, or equity, though equity exposure can be dampened by company hedging. Infrastructure assets are split into Economic types like airports and utility grids, and Social types like hospitals. The 'Other' category captures collectibles and intangibles.

Key Points

Hedge funds use leverage and long/short strategies.
Venture Capital targets early-stage; LBOs target established firms using debt.
Infrastructure is categorized as Economic or Social.
Commodity equity returns may not perfectly track commodity prices due to hedging.

Investment Methods4 min

Investors can access alternative assets through three main channels. Fund Investment is the most common for those with limited expertise or capital, involving a contribution to a pool managed by a GP. Co-Investment sits between indirect and direct investing; investors participate in specific deals alongside the fund, which helps lower overall fee burdens and build internal expertise. Direct Investment requires the highest level of sophistication and resources, as the investor purchases and manages the asset (e.g., a building or infrastructure project) entirely on their own, bypassing fund structures.

Key Points

Fund Investment: Best for limited resources/experience.
Co-Investment: Reduced fees and direct experience.
Direct Investment: Requires specialized skills and high resource availability.

Structures and Compensation6 min

Alternative funds are generally structured as limited partnerships to define risk and return allocations. The GP runs the business with unlimited liability, while LPs are passive investors. Compensation includes management fees (often based on committed capital in PE) and performance fees. To align interests, funds use hurdle rates (minimum return thresholds), high-water marks (prevents double-charging on recovered losses), and clawbacks (returns performance fees to LPs if overall fund performance drops). Distribution waterfalls determine the order of payouts: Deal-by-deal (American) allows GPs to get paid on individual successes, while Whole-of-fund (European) requires investors to be fully repaid their capital before GPs receive profits.

Key Points

LPs have limited liability; GPs have unlimited liability.
Management fees in PE are often charged on committed capital, not just invested capital.
Deal-by-deal waterfalls favor GPs; Whole-of-fund waterfalls favor LPs.
Clawback provisions protect LPs from overpaying incentive fees.

Questions

Question 1

Which of the following best describes the typical target investor and strategy for hedge funds?

Alternative Investment Features, Methods, and Structures

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