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Alternative Investment

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© EduPristine CFA L – I\ Alternative Investment

Alternative Investment

Characteristics

Fund of Funds

Private Equity

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Valuation of Real
Estate Investments

Hedge Funds

Commodities

2

• Fund manager may or may not outperform the single hedge fund. • 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.Alternative Investment Characteristics Fund of Funds • Lower liquidity than traditional investments. • Diversification will reduce the investors' risk but at the cost of returns. • 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. • Difficult to determine fair market values. Drawbacks: • Fund of funds charge mgmt fee in addition to mgmt fees charged by hedge fund. © EduPristine CFA L – I\ Alternative Investment 3 .

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 • VC’s 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 4 . a public company. i.Alternative Investment Characteristics Fund of Funds Leveraged Buyouts (LBOs) • Referred to as a “going private” transaction.e.

• 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 company’s assets – its liabilities (equal to shareholder’s equity) • Asset values can be taken as market/fair values or liquidation values 5 . discounted at the company’s WACC.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.

NOI does not include depreciation or financing costs. but excluding income taxes). © EduPristine CFA L – I\ Alternative Investment 6 . • Collections & other operating expenses. (including property taxes. 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.Alternative Investment Characteristics Fund of Funds Private Equity Valuation of Real Estate Investments Hedge Funds Commodities • Valuation methods: Cost method.

or debt of a specific corporation. preferred equity.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. 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. 7 . 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. © EduPristine CFA L – I\ Alternative Investment Commodities • Macro: Use Top-Down Approach to take positions in fixed income.

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. possibly at a loss. © EduPristine CFA L – I\ Alternative Investment Commodities Hedge Fund Biases Risk Potential for Mispricing Investments in esoteric. Short Covering Margin Calls Can result in forced selling of assets. 8 . on an already highly leveraged position. 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.

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. Hedge Funds Commodities Hedge Fund Due Diligence.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. 9 . 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. © EduPristine CFA L – I\ Alternative Investment 10 . the commodity index strategies are ACTIVE since future contracts need to be rolled.

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 © EduPristine CFA L – I\ Alternative Investment 11 .

Also. they may be charged a fee to redeem shares or make withdrawals before maturity. known as the lockup period.Solution 1 Solution: (c) In a hedge fund. © EduPristine CFA L – I\ Alternative Investment 12 . the investors are usually asked to keep their money for a minimum period.

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 company’s policies and increase company’s value c) Buy securities of a distressed firm and sell them later when the situation improves © EduPristine CFA L – I\ Alternative Investment 13 .

The main aim of this is to increase company value. © EduPristine CFA L – I\ Alternative Investment 14 .Solution 2 Solution: (b) In an activist shareholder strategy. a large number of shares are bought to influence the company’s policies.

Question 3 3. The treatment of real estate property purchased with a mortgage is the closest to which of the following? a) Owner’s equity is the book value of the property minus the outstanding loan amount b) Owner’s equity is the market value of the property minus the outstanding loan amount c) Owner’s equity is the market value of the property. and loan is accounted for in liabilities © EduPristine CFA L – I\ Alternative Investment 15 .

Owner’s equity is the property value minus the outstanding loan amount. Thus.Solution 3 Solution: (b) Property purchased with a mortgage is referred to as leveraged investment. changes in property value over time affect the owner’s equity. © EduPristine CFA L – I\ Alternative Investment 16 .

irrespective of whether it offset prior losses © EduPristine CFA L – I\ Alternative Investment 17 .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.

This means that the incentive fees are only paid to the extent that the current value of an investor’s 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. © EduPristine CFA L – I\ Alternative Investment 18 . a very common feature is the high water mark.Solution 4 Solution: (c) In hedge fund.

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 © EduPristine CFA L – I\ Alternative Investment 19 .

© EduPristine CFA L – I\ Alternative Investment 20 .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.

b) It ensures that investors do not pay multiple incentive fees for the same performance.Question 6 6. c) It can be set as a percentage or a rate plus a premium. 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. © EduPristine CFA L – I\ Alternative Investment 21 .

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. © EduPristine CFA L – I\ Alternative Investment 22 .

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 © EduPristine CFA L – I\ Alternative Investment 23 .Question 7 7.

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. © EduPristine CFA L – I\ Alternative Investment 24 .

Question 8 8. © EduPristine CFA L – I\ Alternative Investment 25 . 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.

It is very costly for an investor as these fund managers charge additional fees to the one that Hedge funds will charge. © EduPristine CFA L – I\ Alternative Investment 26 .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.

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 © EduPristine CFA L – I\ Alternative Investment 27 .Question 9 9.

© EduPristine CFA L – I\ Alternative Investment 28 .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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