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Table of Contents

Introduction to Alternative Investments ................................................................................................ 4

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Foreword
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make the difference and turn your journey with us into a memorable one.

Authored by: Jay Gandani, Mohit Madhiwalla and Shaili Shah

Illustrated by: Aayush Shah
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Introduction to Alternative Investments

Exam Focus and Learning Outcomes

"Alternative Investments" collectively refers to the various asset classes that fall outside the traditional
definitions of stocks and bonds. At the end of the reading, one must be familiar with multiple
categories of alternative investments like infrastructure, real estate, private equity, hedge funds,
natural resources, and other investments such as collectables and the unique types of every
investment. One should also be familiar with the various strategies, due diligence, and other issues
arising with the different investments valuation and calculating returns.

Ensure that you have understood the various risks and diversification benefits of each asset class and
that you are thorough with the calculation of returns net of fees.

Describe types and categories of alternative investments.

Alternative investments collectively refer to the various asset classes that fall outside the traditional
definitions of stocks and bonds. These assets provide diversification benefits over traditional
investments such as publicly-traded stocks, bonds, and cash.

Examples of traditional investments include:

➢ Shares of Reliance Industries Limited.

➢ Aditya Birla Sun Life Corporate Bond Fund.
➢ Cash saving.

Consider the portfolio of Mr. Ratan Tata, the chairman of the Tata group. Let's assume that the total
value of this said portfolio is ₹100 crores. Let's also assume the portfolio comprises of the following:

Particulars Amount (Rs. crore)

Stocks listed on the National Stock Exchange such as 80.00
ITC, Infosys
Government Bonds 4.00
Cash 1.00
Total 85.00

Private Equity Investments 7.00

Real Estate 5.00
Natural resources 1.00
Collectibles 2.00
Total 15.00
Grand Total 100.00

As you can see, ₹15 crores or 15% of the portfolio is invested in alternative investments comprising
private equity investments, real estate properties, various natural resources, and various
collectables. Notice the difference between traditional and alternative investments in the portfolio
above.
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We will explore the following types of alternative investments in this reading:

Hedge Funds

➢ These are private investment vehicles that invest in stocks, bonds, and derivatives.
➢ They are typically less regulated than other asset managers, so they have some room to
deploy complex investment strategies.
➢ These funds typically have a high lock-in period.
➢ They usually provide higher risk-adjusted returns than traditional asset managers but are
riskier, too, due to leveraged positions (long and short).
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Private Capital

Point of Distinction Private Equity Private Debt

Participation Investors may participate directly in Investors participate by providing
private equity (by holding shares of debt to privately held companies.
privately held companies) or by
investing in private equity funds
that hold a private ownership in
several companies.

Types Private equity transactions usually These include:

involved leveraged buyouts of
profitable companies with stable
cash flows.
Venture capital funds are a type of
private equity fund that invests in
start-ups or early-stage companies.
a. Private loans with no financial
intermediary.
b. Mezzanine loans.
c. Venture debt.
d. Distressed debt (debt lent to
companies under bankruptcy
proceedings or cannot meet
their existing debt obligations)

Example Examples of a few famous private

equity funds:
The Blackstone Group Inc.
The Carlyle Group Inc.
KKR & Co. Inc.

Indian start-ups raised about Rs 4,500 crore ($600 million) of venture debt in 2021, more than double
the previous high for an asset class which is seen as the new kid on the block, as companies went on a
shopping spree and investors raised larger funds.

Real Estate

➢ Investors may own real estate directly, such as a home or rental property.
➢ Indirect ownership involves owning a security through an investment vehicle. This includes:
o Mortgage-backed securities.
o REITs (real estate investment trusts): Shares of a REIT may trade publicly. For instance,
Mindspace is a REIT that trades on Indian stock markets.

These vehicles give investors indirect exposure to the real estate markets, and these securities
perform well when the real estate asset class performs well.
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Natural Resources

Commodities

➢ Include products like

grains, metals, and crude Agricultural Land
oil.
➢ Cultivation of livestock
➢ These are all physical (like cattle or chicken)
assets. and crops (like wheat or Timberland
rice).
➢ Investors typically gain ➢ Includes investing in
exposure via commodity natural forests or tree
➢ Investors can buy
futures contracts. plantations.
farmland and lease it to a
farmer, and this acts as
➢ Commodity indexes are ➢ The sale of wood is an
an income source.
also constructed by using income source for the
commodity futures prices. owner of timberland.

Recently the NYSE added 'Water Futures' to its commodity market. It's funny how a necessity like
water has become a commodity to be traded and gives us the implication of a water scarcity crisis that
could be a significant issue in the future.

Infrastructure

➢ Long-term assets that offer public services.

➢ Includes investment in economic infrastructure like:

o Roads.
o Airports.
o Power grids.

➢ Includes investment in social infrastructure like:

o Schools.
o Hospitals.

➢ These are usually government-funded projects, but they can include some private investment
too. A public-private partnership is a case where a private sector entity invests with the local
governmental authorities.
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Other Alternative Investment Assets

➢ Antiques

➢ Fine wine

➢ Art

➢ Vintage automobiles

➢ Stamps

➢ Coins

➢ Collectables items

➢ Patents and litigation actions are intangible investments

Coca-Cola has not patented its recipe! To patent, they would have to reveal the recipe that they follow
for its drinks publicly. Coca-Cola claims its recipe is the world's most guarded secret.

The alternative investments fee structure is a bit different from the one followed in traditional
investments. The fee for alternative investments is commonly referred to as management fees and is
higher than traditional investments. A performance-based incentive fee is also included in alternative
investment management. Alternative investments have had low return correlations with traditional
investments overall.

1. Which of the following is least likely to be viewed as an alternative investment?

A. Real estate
B. Natural resources
C. Long-only mutual funds

2. Which of the following is the most liquid investment?

A. Private equity investment in Byju's

B. Mindspace REIT
C. A 50-year-old wine bottle
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3. Alternative investment funds are most likely managed

A. Actively
B. To generate positive beta return
C. Assuming markets are efficient

4. Compared to traditional investments, alternative investments are most likely to have

A. Greater leverage use

B. Long-only positions in equity
C. Transparent data

5. The following are the most common strategies used by private equity funds?

A. Market neutral strategies

B. Merger arbitrage
C. Leverage buyout strategies

Answers

1. C is correct. Long-only mutual funds are classified as traditional investments. These types of
funds deploy only one type of long strategy in traditional asset classes like equity or debt. A
and B are both alternative investments.

2. B is correct. Although a REIT invests in real estate, the shares of a REIT are traded on
exchanges. These are significantly more liquid than the underlying real estate assets. A is
incorrect because private equity investments require long periods (usually 5 years) to
materialise. C is incorrect because there may not be many market participants for such items,
even if there is an exchange for collectables, antiques, and other such alternative investments.

3. A is correct. Private equity funds and hedge funds require active management of investments
to generate positive excess risk-adjusted returns (i.e., alpha). C is incorrect because this
assumption would not allow such funds to generate consistent positive returns.

4. A is correct. Hedge funds deploy leverage to gain additional returns from potential mispricing.
B is incorrect because this is most likely a feature of traditional investment funds. C is incorrect
because private equity funds and hedge funds are not as regulated as other traditional funds.
They are required to disclose less information.

5. C is correct. Private equity funds borrow debt to buy a stake in profitable companies with
stable cash flows. This debt is then paid off by generating more cash from restructuring the
company’s operations.
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Describe characteristics of direct investment, co-investment and fund investment

methods for alternative investments.
Fund Investing
The investor provides capital to a fund and allows the fund to invest on its behalf. The fund charges a
fee to the investor. This is usually a management fee based on the assets under management (AUM)
provided by the investor and a performance fee based on certain return-based benchmarks.

The investor must carry out appropriate due diligence about the fund because they do not control
how the fund is managed. The investor must understand the fund’s strategy and decide whether its
mandate matches its risk profile.

This method is usually available for private equity funds, hedge funds, real estate funds, infrastructure,
and natural resources.

Advantages

➢ The investor can participate in alternative investments without expertise in this asset class
because professional, experienced fund managers make all the investment decisions.

➢ The fund itself invests in diverse asset classes, thereby providing diversification benefits via
one single investment vehicle.

Disadvantages

● Management fees for such funds are typically higher than fees for traditional vehicles like
mutual funds. Performance fees also add to the cost of investing in such funds. These fees
stem from:
o The fund using more complex strategies to manage investments.
o Costs for investment due diligence by fund managers.
o Information costs to obtain data that is not publicly available to seek alpha.

● Such funds do not provide detailed information regarding their strategy (otherwise, they will
lose their competitive edge). So, the investor must conduct thorough due diligence to know if
the fund matches their risk profile.

Co-Investing
The investor indirectly invests in the assets through the fund, but they also hold co-investment rights
so that they have the right to directly invest in the assets.

This way, the investor is not limited to their investment in the fund. Suppose there is a private equity
fund that has identified a new buyout opportunity. The investor specifically wants exposure to this
deal, so they invest an additional amount only for this deal.
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Advantages

➢ Investors can learn the processes and strategies to directly invest in alternative assets from
the fund they are investing in.

➢ Investors benefit from diversification by investing in the entire fund, and they can also benefit
from specific deals or investments based on their risk profile.

➢ Investors can have a more active role in managing their investments instead of simply
providing capital to a fund and letting the fund manager invest the entire amount on their
behalf.

Disadvantages

➢ Co-investors may not have a lot of control over which investment the manager chooses. They
may be subject to adverse selection where they do not get the best investment because other
fund managers are higher in the pecking order.

➢ While co-investors have more control over their investments, they must also dedicate more
time to carry out research. This requires more due diligence and expertise, which can be
costly.

➢ This method may be challenging for smaller firms with fewer resources and due diligence
expertise.

Direct Investing
The investor makes a direct investment in an asset without the need for a third-party fund. This is like
purchasing a direct stake in a privately held company without carrying out the transaction through a
private equity fund.

This gives investors the most control over all the routes discussed above.

Large institutions with the resources prefer carrying out such transactions – it is typically most
common in real estate and private equity. Pension funds and sovereign wealth funds, for example,
may invest directly in infrastructure and real estate projects.

Advantages

➢ The investor does not need to pay management fees or performance fees to another manager
to manage their investments. Note that these costs may seem small, but they compound over
time.

➢ The investor has total control and flexibility in their investment decisions.

➢ The investor has a direct influence when they purchase a stake in a privately held company.
For instance, they can steer the operations of a company or vote for certain management
changes.
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Disadvantages

➢ This method requires the most expertise, financial knowledge, and due diligence.

➢ The investor may put all eggs in one basket, so they lose out on the diversification benefits
provided by fund investing or co-investing.

Due Diligence
It is important to evaluate whether the expertise of the fund manager exceeds the investor’s own
expertise. Suppose the investor thinks that they can do a better job managing their own investments
and have the financial and non-financial resources to do so. Then they may not require fund investing
and may prefer direct investing.

The investor should also be able to assess the fund's risk-return profile with the limited information
that fund managers provide. For instance, fund managers may not provide complete information
regarding the fund’s performance to show an upside bias. The investor must be aware of such
practices.
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Following is a typical due diligence process:

Organization ➢ Experience and quality of management team, compensation,

and staffing

➢ Analysis of prior and current funds

➢ Track record/ alignment of interests

➢ Reputation and quality of third-party service providers (e.g.,

lawyers, auditors, prime brokers)

Portfolio management ➢ Investment process

➢ Target markets/ assets types/strategies

➢ Sourcing of investments

➢ Role of operating partners

➢ Underwriting

➢ Environmental and engineering review process

➢ Integration of asset management/ acquisitions/ dispositions

➢ Disposition process, including its initiation and execution

Operations and controls ➢ Reporting and accounting methodology

➢ Audited financial statement and other internal controls

➢ Valuations – frequency and approach(es)

➢ Insurance and contingency plans

Risk management ➢ Fund policies and limits

➢ Risk management policy

➢ Portfolio risk and key risk factors

➢ Leverage and currency – risks/ constraints/ hedging

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Legal review ➢ Fund structure

➢ Registrations

➢ Existing/ prior litigation

Fund terms ➢ Fees (management and performance) and expenses

➢ Contractual terms

➢ Investment period and fund term and extensions

➢ Carried interest

➢ Distributions

➢ Conflicts

➢ Limited partners’ rights

Direct Investing
The investor must conduct an in-depth analysis of the asset or the business. For instance, it is
extremely important for private equity investors to carry out technological and legal due diligence to
understand if a company is infringing on patents. This will not be seen simply by the financial or
strategic performance of the company.

The investor must also look at the company's entire operational and strategic plan, including its supply
chain, internal controls, audit, etc. In the case of real estate investment, the investor must look at the
things like the quality of tenants, management team, and potential for growth in that neighbourhood.

There are several qualitative factors that an investor must consider when investing directly in an
alternative asset.

Co-Investing

Investors can count on the fund manager’s expertise and conduct their due diligence when making
independent co-investments. The due diligence here is a combination of the fund investing and direct
investing methods.
Investing in private or public enterprises to take them private is known as private equity. The sponsors
(or investment managers) raise money over time to invest in many enterprises in a particular industry
or location.
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Describe investment and compensation structures commonly used in alternative

investments.
Hedge funds and private equity funds are typically formed as limited liability partnerships (LLPs). This
follows a limited partner (LP) and general partner (GP) structure. The limited partnership agreement
(LPA) sets the strategic framework of the fund, and it outlines the terms of the partnership.

The limited partners provide committed capital while the general partners actively manage the
investments. General partners have theoretically unlimited liability because they bear all the
downside risk of mismanaging the investments. But the personal property of owners is safeguarded
since it is an LLP.

Limited partners do not have to provide the entire amount of the committed capital. Depending on
the milestones and mandates, the general partners may draw down a certain amount quarterly or
annually.

Side letters may be negotiated over and above the LPA. These include details and clauses like:

➢ The limited partners’ additional reporting requirements due to unique circumstances.

➢ First right of refusal, co-investment rights, secondary sales, and other matters regarding the
relationships between the different LPs.

➢ Notice requirements in case of insolvency or other legal matters.

➢ Most favoured clauses where LPs that pay lower fees are given preference.

Compensation Structure
Remember that the GPs actively manage the investments of the fund. First, there is a management
fee that is based either on:

➢ Assets under management or AUM (typically for hedge funds).

➢ Total committed capital (typically for private equity funds).

Additionally, GPs receive a performance fee which is also called carried interest. This is given in case
the GPs deliver excess profits above a certain benchmark rate.

The most typical hedge fund fee structure is "2 and 20" or "2 plus". This means that the management
fee is 2% of the value of the assets under management plus a 20% incentive fee on profits (typically
above a benchmark rate called the hurdle rate).

Suppose the limited partners have committed $10 million of total capital, and the current AUM is $1
million. This means that the GPs have not used the entire committed capital yet and have used only
$1 million out of the $10 million provided. Suppose the fee structure is 2 and 20. Assume for now that
there is no hurdle rate and that all the profits are used to calculate the performance fee.

The management fee is simply 2.00% of the AUM = 2.00% × $1 million = $2,000

Suppose the profits from using these funds is $50,000. The performance fee is 20% of the profits =
20% × $50,000 = $10,000. This is given to the general partners, and the remaining $40,000 is given to
the limited partners.
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The profits can be calculated in three different ways:

➢ Gain in value.
➢ A gain above management fee.
➢ A gain above a hurdle rate.

Now let us assume that there is a hurdle rate for the profits. The hurdle rate is either a set percentage
like 5.00% or LIBOR+ (where the underlying rate is the LIBOR plus a certain percentage).

Let us assume that the hurdle rate is 5.00%. We can see that the profit (as a percentage of AUM) is
$50,000 ÷ $1,000,000 = 5.00%. Now there are two ways to look at this:

➢ Hard hurdle rate: Performance fees are earned only on profits above the hurdle rate.

➢ Soft hurdle rate: Performance fees are earned on all profits if the hurdle rate is met.

We can see from our simple example that no performance fee is paid if there is a hard hurdle rate
applied to these investments, but the $10,000 performance fee is valid if there is a soft hurdle rate
applied to these investments.

The managers of the funds of funds charge additional fees to investors in a funds of funds. The "1 and
10" charge structure is a typical fee structure used by funds of funds. In addition to any fees imposed
by the individual hedge funds inside the fund-of-funds structure, a 1% management fee and a 10%
incentive fee are charged.

Clauses and Contingencies

High-Water Mark

Some hedge funds also use a high-water mark. This is like a high score that GPs must reach before
they are paid an incentive fee. This allows the LPs to track the level of investment performance and
the fluctuation of performance over time. So, if a GP provides excellent returns in one year but the
performance drops in the next year (although profitable), then the LP must not pay twice for
inadequate performance.

Suppose a hedge fund has a value of $150 million at the initiation. They charge a 2% management fee
based on assets under management at the beginning of the year and a 20% incentive fee with a 5%
soft hurdle rate. There is also a high-water mark clause. Incentive fees are calculated on gains net of
management fees.

The values before fees are given as follows:

Year 1: $142.20 million

Year 2: $158.00 million

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Year 1

Management fee: $150.00 million × 2.00% = $3.00 million

The value of the fund at the end of the year is given as $142.20 million

Return net of management fee = [($142.20 million - $3.00 million) ÷ 150.00 million] - 1= -7.20%

There is no incentive fee because the return is less than the hurdle rate.

Total fees = $3 million

Ending value net of fees = $142.20 million – $3.00 million = $139.20 million

Year 2

Management fee: $139.20 million × 2.00% = $2.80 million

Gross value end of year (given): $158.00 million

Return net of management fee = [($158.00 million - $2.80 million) ÷ $139.20 million] - 1= 11.94%

This is higher than the soft hurdle, so an incentive fee is applicable.

Incentive fee = ($158.0 million - $2.80 million - $150.0 million) × 20.00% = $1.04 million

Note that the incentive fee is calculated based on gains in value above $150 million because that is
the high-water mark.

Total fees = $2.80 million + $1.04 million = $3.84 million

Net return = [($158.00 million - $3.84 million) ÷ $139.20 million] - 1 = 10.74%

As a result, incentive fees are not paid on gains that compensate for the previously negative returns.
Recall that the high-water mark is like a high score and that incentive fees are paid only when the
high score is exceeded.

Catch-up Clause

Suppose there is a 2 and 20 fee structure, and the hurdle rate is 4%. The IRR of an investment is 9%.

The LPs immediately get the first 4% of the 9%. Now, the GPs are entitled to 20% of the remainder,
that is 20% of the 5% without a catch-up clause. Note that the GP return here is directly 20.00% ×
5.00% = 1.00%.

With a catch-up clause, the GPs can receive 20% of all the 9%. The flow is as follows:

➢ LPs earn the initial 4.00%.

➢ The excess 5.00% profit above the hurdle rate is split 80-20 between LPs and GPs in
increments.
o GPs receive 20% of the initial 5.00% = 1.00%

● Now there is 4% that is yet to be distributed among the GPs and LPs
o GPs receive 20% of this 4.00% = 0.80%
o LPs receive 80% of this 4.00% = 3.20%
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Note that the GP has now received a total of 1.00% + 0.80% = 1.80%, while the LP has received 3.20%
of the profit above the hurdle rate. Compare this result to the profit-sharing without a catch-up clause
where the LPs receive 4.00% of the profit above the hurdle rate, and the GPs receive 1.00% of the
profit above the hurdle rate.

Waterfall Structure

This structure draws out how payments are allocated to LPs and GPs. There are two types of waterfall
structures:

➢ Deal-by-deal (or American): GPs get paid per deal, and this is beneficial to them because they
earn their return before the LPs receive the initial investment plus the expected return (hurdle
rate).
➢ Whole-of-fund (or European): The LPs receive their share of the return when all investments
in the fund are exited and before any GPs are paid.

Clawback

This provision allows the LPs to reclaim a proportion of the GPs’ performance fee. It is usually activated
when the GPs exit investments early but incur losses later.

Explain investment characteristics of hedge funds.

Hedge funds have been increasingly popular recently, particularly among wealthy individuals and
institutions (the minimum ticket size for a hedge fund is usually $1 million). Unlike traditional long-
only funds, hedge funds can take advantage of:

➢ Leverage.

➢ Short positions in equities.

➢ Long or short derivatives positions.

For instance, a hedge fund might want to transact on Reliance, ITC, and Bajaj Finance shares. However,
it may be unsure about the market movements due to the high volatility expected in the coming week.
A hedge fund might take a short position on the NIFTY 50 index to hedge its bets as all the companies
mentioned above are a part of the index, and hence it will offset the losses if the market goes bearish.

Hedge funds also provide custodial services, administrative services, money lending, securities lending
for short sells, and trading; the managers trade through prime brokers. Hedge fund managers typically
maintain good relationships with prime brokers and negotiate service standards such as margin
requirements. Prime brokers provide services to large institutions across securities lending, execution
of leveraged trades, etc.

To further learn about hedge funds, here are the few characteristics that can give a better
understanding of the working of a hedge fund:

➢ Return objectives can be stated on an absolute or relative basis. For instance, a 15% return
can be understood on an absolute basis; however, a 6% above a benchmark index can be
understood on a relative basis.

➢ Less regulation.
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➢ Forms a limited liability partnership with the investors.

➢ A hedge fund limited partnership can only have a certain number of investors, all of whom
must have sufficient wealth, liquidity, and financial sophistication.

➢ The general partner is the management firm, which is paid a management fee based on the
value of assets managed and an incentive fee depending on fund returns.

➢ Less liquid investments.

➢ Restrictions on redemptions. There may be a lock-in period or notice period during which
withdrawals on investment can't be made. A notice period is when a fund has a withdrawal
request, which is usually 30-90 days. This discourages withdrawals.

➢ There is an additional fee charged for redemption. The cost incurred by managers to redeem
the investments is offset by the redemption fees charged.

➢ The notice period is in place so that the hedge fund can liquidate the investments orderly.

➢ Redemptions increase during a poor performance, and this poses a risk to the fund itself.

➢ A fund of funds is a type of fund that invests in various hedge funds and offers its investors
various investing options. They typically charge a 1 and 10 fee structure.

Since hedge funds are not extremely regulated, some hedge funds do not even disclose their
performance to the public. If a hedge fund has a bad fiscal year, then the data for that year need not
be presented. This leads to survivorship bias when hedge fund returns are analysed – you will see
only the best of the best performers and will not see the hedge funds that did not do so well.

Hedge Fund Strategies

Equity Hedge Strategies

➢ Market Neutral:

Identifies undervalued/overvalued assets using technical/fundamental research. Long and

short positions are taken in proportion to generate a profit from their respective price
fluctuations while avoiding market risk.

➢ Fundamental L/S Growth:

Identifies companies with excellent growth potential and capital appreciation through
fundamental analysis. For instance, artificial intelligence and electric vehicle sectors are
considered the future, and stocks like Tesla are considered high growth stocks.

➢ Fundamental Value:

Uses fundamental analysis to identify undervalued companies. Long positions in such stocks
can be profitable in the long as well as the short run. Positions are taken purely based on
fundamental analysis alone.
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➢ Short Bias:

Overvalued securities are identified, and short positions are taken. Long positions are taken
as well in small quantities, but the overall market exposure is negative.

➢ Sector Specific:

Takes advantage of manager expertise in a specific sector. For instance, a veteran analyst in
the healthcare industry can advise the hedge fund manager to tilt their portfolio towards
certain stocks that can benefit from trends in that sector.

Event-Driven Strategy

These strategies are typically based on restructuring or acquiring a company that can create long or
short opportunities either in equity or debt securities. A short-term investment strategy aims to profit
from pricing inefficiencies before or after a big corporate event, such as a bankruptcy, spin-off,
merger, or acquisition.

There are several event-driven strategies that a hedge fund can execute. Some of them are listed
below.

➢ Merger Arbitrage:

Buy the stock of the acquiring company and short sell the stock of the acquired company. For
instance, one could buy the shares of Idea and short the Vodafone shares during the
Vodafone-Idea merger. Note that sometimes the company that is being acquired might
benefit from the merger if they are still their own entity.

➢ Distressed/Restructuring:

Purchase debt or equity securities of companies either in bankruptcy or nearing bankruptcy,

and the analysis indicates a bright future by restructuring – additionally, short the securities
considered overvalued. For example, General Motors, a well-known company, announced
bankruptcy, and after successful restructuring, it bounced back to be the General Motors we
know today.

➢ Activist Purchase:

Buying an equity stake in a company that is believed to be mismanaged and then influences
its policies. The goal is to increase the company's value. For instance, Bill Ackman – CEO of
Pershing Capital – is one of the most famous activist shareholders, and he has a reported
investment of about $900 million in Starbucks. This investment gives him or his representative
a seat on the board and allows him to influence the decisions at Starbucks.

➢ Special Situations:

Purchase equity of companies engaged in restructuring activities other than

merger/bankruptcy, spinning off divisions, or distributing capital.
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Relative Value Strategy

Relative value is a strategy that estimates an asset's worth that considers the value of similar
securities. It involves buying a security and selling a related security to profit when a mispricing is
perceived. For instance, Bajaj Finance and Bajaj Finserv stocks follow a similar pattern and can be
considered related financial instruments. If one of them has shown a significant change than the other
one, then the other entity might follow suit, and a fund can benefit from this event.

Some relative value strategies are discussed below.

● Convertible Bond Arbitrage:

A market-neutral strategy to exploit mispricing in convertible bonds and issuer's stock. The
convertible bond is analysed as two different parts – the bond and the value of the underlying
shares. The hedge fund can buy the convertible bonds and sell the underlying shares at a
certain price to benefit from the mispricing.

● Fixed-Income Arbitrage (General):

Exploit mispricing between various types of fixed income securities. For example, one may
look at two similar securities in coupon and maturity but are trading at different prices. Then
if mispricing is perceived, the hedge fund can long one and short the other. Similarly, a fixed-
income manager can take advantage of the same issuer’s capital structure and holding
structure.

● Fixed-Income Arbitrage (Asset-Backed):

These securities are traded over the counter, and their prices are not very transparent. The
manager of an ABS portfolio can exploit mispricing from opaque mark-to-market information
provided by dealers if they have an informational edge. The manager may also be able to take
advantage of mispricing from credit spreads.

● Volatility:

A long volatility strategy benefits when there is a lot of anticipation and uncertainty over a
market-wide event like a U.S. Federal Reserve meeting. A short volatility strategy benefits
when the risk premium cools off after such events.

➢ Multi-Strategy:

To exploit the price discrepancies, present in the asset classes and markets that were
previously not mentioned.

Macro and CTA Strategy

This uses a top-down approach to identify significant trends affecting the markets, and it may involve
positions in equity, debt, currencies, or natural resources. For instance, it may involve taking
long/short positions around the day that the budget is announced in India, where markets have
proven to be highly responsive to the budget.

A CTA strategy involves commodity trading advisors, and they essentially provide information
regarding commodity futures and pricing discrepancies in the commodity markets.
22

Potential Risks and Diversification Benefits

● They have performed better than global equities when the markets have given negative
returns but given a lag in returns when the market has shown growth.

● Not perfectly correlated with global equity markets and hence gives diversification benefits.

● Partially illiquid.

● Many items required for due diligence are challenging to quantify, and a fund with positive
historical returns can tend to give lesser than average returns in the future.

● Percentage of assets under management held by a single investor to be considered. Suppose

a single person holds many assets. In that case, it should be of concern to other investors
because if any significant investor pulls the plug, then it may significantly affect the entire
hedge fund.

Explain investment characteristics of private capital.

The private capital category consists of:

➢ Private investment funds.

➢ Entities that invest directly in the equity or debt securities of companies, real estate, or other
privately held assets.

Private Equity

In comparison to traditional investments, private equity may offer more significant returns. PE funds
may own a significant or majority stake in several companies, and these are called portfolio
companies. Following are some of the advantages of private equity:

➢ Access to private companies.

➢ Ability to actively manage and enhance portfolio firms.

➢ Portfolio diversification due to lesser correlation with equities and bonds.

➢ Easy-to-use leverage.

Some of the risks include the following:

➢ The standard deviation of private equity returns has been higher than that of equity index
returns, implying a higher risk.

➢ Risk of not having a skilled fund manager to manage investments.

There are various PE funds available to investors. An FMCG PE Fund or a Healthcare PE fund may invest
in private companies in the respective sectors as and when the opportunity arises.

For instance, Swiggy, which is a privately held company, requires funding or requires raising capital.
An FMCG PE fund may seize the opportunity and invest the funds raised by them via investors. It is
comparatively difficult for individuals to invest directly in a private company as it has enormous
financial requirements and various compliances.
23

Various strategies are used by private equity funds to invest the capital and earn the high returns
promised to the investors.

Strategies Used by PE Funds

Leveraged buyouts (LBOs)

This strategy involves borrowing money (hence it is a “leveraged” buyout) to purchase an existing
business. The business will be restructured to improve operations and, as a result, increase cash flow
and profit. If the target company were formerly public, it would become private after the investment.

The private equity fund can either invest its own funds or raise funds from a variety of sources. Bank
debt (leveraged debt), high-yield bonds, or mezzanine finance are all options. Mezzanine financing
refers to debt or preferred shares that are subordinate to high-yield bonds and include warrants or
conversion features that allow investors to participate in rises in equity value.

There are two sorts of LBOs:

➢ Management buyouts (MBOs): The firm is purchased and controlled by the current
management team.

➢ Management buy-ins (MBIs): The incumbent management team is replaced by the acquirer
who runs the company.

LBOs enhance the portfolio company's operations, add value, and ultimately raise cash flow and
profitability. Once the restructuring/growth strategy is complete and the company becomes
profitable, leverage will increase prospective returns. An LBO's debt structure is crucial. Equity is rarely
used entirely in buyouts.

The provision of funds for business expansion or restructuring is called development capital or
minority equity investing. Private investments in public equities are the term for such investments in
public corporations (PIPEs).

Venture Capital (VC)

These investments include investments in young enterprises with a lot of growth potential. The
difference between venture funds and LBOs is that venture funds invest in firms with significant future
growth potential. These investments represent a high level of risk, but the return on such investments
is exponential, particularly in a firm filing for an IPO.

Ratan Tata has his start-up fund called Tata Capital Innovations Fund and in the recent past has
invested in start-ups like Ola, Cure.fit, and Urban company which might have earned him an
exponential return. Tata invested ₹10 Lakhs in LensKart at the formative stage, and this investment.
has earned him close to 28 times his original investment.
24

VC financing can happen at several stages:

➢ Pre-seed or angel investment: This is the “ideation” stage of the company. Business strategies
and market potential are assessed using investment dollars. Individuals ("angels"), rather than
venture capital funds, are the most common source of investment.

➢ Seed stage funding: Investors provide capital for product development and market research.
This is usually when venture capital funds make their first investments in ordinary or
convertible preferred stock.

➢ Early-stage funding: Financing to start commercial production and sales at an early stage.

➢ Later stage financing: After commercial productions and sales, but before the IPO, for
expansion. They are typically used for a large-scale marketing campaign.

➢ Mezzanine financing: Financing provided to a firm to prepare for its public issue.

Exit Strategies

1. Trade sale: Selling a stake in a portfolio firm to a competitor or another strategic buyer. For
instance, an FMCG PE fund may invest in a departmental store and sell it to DMart for a
handsome sum after a couple of successful years.

2. IPO: Sell all or a portion of a company's stock. An IPO stands for Initial Public Offering. A
complete or partial stake can be sold at an attractive price to the public. For instance, investors
of Burger King may have earned a considerable amount by selling their shares after acquiring
them in the IPO in 2020.

3. Recapitalization: A new debt issue will be issued to pay a dividend to equity holders, including
the PE fund. This is not an exit because the fund still owns the company, although it is
frequently a precursor to one.

4. Secondary sale: Selling a company's stake to a different private equity firm or a group of
investors.

5. Write-off/liquidation: Book a loss on an unprofitable investment by writing it off or

liquidating it.

Private Debt

This includes all debt that is extended to private limited companies.

Direct Lending

Fund managers will deploy the funds raised by providing loans to mid-market companies or by lending
to other private equity funds seeking high-yield debt.

➢ Mezzanine Debt:

This has a residual claim that is senior to equity but is subordinated to senior debt. It is likely
to be used to finance LBOs, recapitalizations, or acquisitions. It yields a high interest rate
because of its low seniority.
25

● Venture Debt:

This is provided to early-stage or start-up companies. Venture debt can act as an addition to
already existing equity financing. Even this type of debt yields a high-interest rate due to the
uncertainty of the company’s operations at this stage.

● Other Private Debt Strategies:

Unitranche debt can also be extended to companies. This is a hybrid structure that combines
secured and unsecured debt. It yields an interest rate that is in between the rate on secured
debt and unsecured debt.

Real estate is debt extended specifically to finance real estate investments, while
infrastructure debt funds projects related to infrastructure (construction, operation, and
maintenance).

Potential Risks and Diversification Benefits

➢ These types of investments deliver higher yields by exploiting opportunistic positions.

➢ However, the potential for higher returns comes with a higher risk profile of these
investments.

➢ PE funds also typically have high lock-in periods. It is costly to redeem funds prematurely.

Explain investment characteristics of natural resources.

Investment in oil, gold, silver, grains, etc., is considered an investment in natural resources. It is
possible to invest in and take delivery of such natural resources. However, the commonly used practice
is to gain exposure to this asset class via derivatives. This is due to the storage, transportation, and
opportunity costs of holding the physical asset.

Investors can also purchase ETFs that are geared towards commodities or invest in shares of
companies that are directly related to natural resources (like ONGC).

Commodities
These can be standardised across quality, location, and delivery. Returns are largely gained from price
movements rather than interest income from investing in this asset class.

Derivatives give exposure to price movements. Commodity derivatives largely include futures and
forwards. Such contracts can also be used to hedge commodity positions. For instance, an oil
extracting company can sell an oil futures contract to lock in a specific price later.

Soft commodities include livestock, grain, cash crop, coffee, etc. These are grown or cultivated over
time. Hard commodities include metals and crude oil. These are mined or extracted.
26

The following table shows a classification of commodity sectors:

Sector Sample Commodities

Energy Oil, natural gas, electricity coal
Base metals Copper, aluminium, zinc, lead, tin, nickel
Precious metals Gold, silver, platinum
Agriculture Grains, Livestock, coffee
Other Carbon credits, freight, forest products

Valuing Natural resources is a complicated task as the value of a commodity keeps changing. For
example, the price of crude oil today and in 6 months is not the same. Ordering oil today for 6 months
later saves us storage costs but results in cash being blocked.

Futures Price ≈ Spot Price (1 + Risk-free rate) + Storage costs − Convenience Yield

What is convenience yield?

The value of holding the commodity for use throughout the futures contract.

Futures prices will be higher than spot prices if there is little or no convenience yield, a phenomenon
known as contango. Futures prices will be lower than spot prices when the convenience yield is high,
a circumstance known as backwardation.

Three ways to measure commodity returns are:

● Collateral Yield: Interest is paid on money invested in entering into a futures transaction on
margin.

● Roll Yield: Difference between a commodity's spot price and the price stipulated by its futures
contract, or between two futures prices with different expiration dates. As contracts approach
expiration, futures prices converge toward spot pricing. A market in backwardation has a
positive roll yield, while a market in contango has a negative roll yield.

● Spot Prices: The present supply and demand relationship determines the price. Throughout

the futures contract, the total price return combines the change in spot prices and the
convergence of futures prices to spot prices.

During 2020, when the pandemic was at its peak, oil prices for the first time in history became negative
and caused havoc in the commodity markets. That means oil producers were paying buyers to take
the commodity off their hands over fears that storage capacity could run out.
27

Timberland and Farmland

We will refer to the crop that these sources yield rather than the land and rights of the land itself for
the purpose of commodities.

Timberland generates income from the sale of trees, wood, and other timber products. The primary
sources of growth are:

➢ Biological growth.

➢ Increases in spot price of the sold goods.

➢ Increases in value of the underlying land.

Farmland is perceived as a hedge against inflation. For instance, if crop prices increase, there is likely
to be an increase in the general basket of goods comprising inflation statistics. The owners of farmland
benefits from such increases in price; therefore, they are protected against food price inflation (if the
crop is included in the basket of goods). Farmland can also be used as pasture for livestock.

The primary sources of growth are:

➢ Harvest quantities.

➢ Increases in commodity prices.

➢ Increases in value of the underlying land.

Potential Risks and Diversification Benefits

● Lower Sharpe ratios due to comparatively lower returns than equity and high volatility.

● Can earn a high return over short periods by speculators.

● Dependent on weather.

● Extremely volatile for elastic demand natural resources as long lead times can alter production
values.

● Depend on economic events and future supply estimate.

● Low correlation with global equities and provide diversification benefits.

● Hedge against inflation risk.

Instruments for Exposure to Natural Resources

Commodities

➢ Exchange-Traded Products: An investor can purchase either ETFs or ETNs. Examples include
the SPDR Gold Shares ETF, which tracks the price of physical gold. Note that one must look at
the expense ratios that such products charge to the investors.

➢ Managed Futures: CTAs or managed futures accounts are other avenues to obtain exposure
to commodity markets. These avenues are subject largely to demand and supply factors. A
sudden supply shock can increase commodity prices, and long positions will benefit from this,
whereas a sudden drop in consumption can lead to a fall in prices.
28

➢ Specialised Commodity Funds: These funds invest in specific commodity sectors. Private
energy partnerships are an example of such funds. Management fees can range from 1.00%
to 3.00%, and there is usually a lock-in period of 10 years. Publicly available mutual funds also
exist. Such funds may focus their investments on upstream (like drilling), midstream (like
refineries), or downstream (like chemicals) companies. These have lower management fees
from 0.4% to 1.00%.

Timberland and Farmland

REITs are the most popular avenue for such natural resources. They may be good for providing a
diverse portfolio of timberland or farmland. However, direct ownership of farmland gives the owner
the option to invest heavily in very specific produce like vegetables, nuts, fruits, etc.

In 2021, Lumber prices reached their all-time high after soaring more than 250%, beating expectations.

Explain investment characteristics of real estate.

Investments in real estate can provide returns in various manners. It can be in the form of rent
provided by the tenants. It can be in the form of capital gains if the property is sold. Real estate
investments also act as a hedge towards inflation as the prices tend to be directly proportional to
inflation.

The following table displays the different avenues to gain exposure to real estate markets:

Debts Equity

Private ➢ Mortgage ➢ Direct ownership of real estate:

ownership through sole ownership,
➢ Construction lending joint ventures, separate accounts, or
real estate limited partnerships
➢ Mezzanine debt
➢ Indirect ownership via real estate
funds

➢ Private REITs
29

Public ➢ MBS (residential and commercial) ➢ Shares in real estate operating and
development corporations
➢ Collateralized mortgage
obligations ➢ Listed REIT shares

➢ Mortgage REITs ➢ Mutual funds

➢ ETFs that own securitized ➢ Index funds

mortgage debt
➢ ETFs

Various types of investments under real estate include:

Direct Real Estate Investing

Purchased to occupy such as homes, apartment buildings, and vacation properties. Most homebuyers
are unable to finance their purchase totally with cash – mortgages help to facilitate such purchases.

There is a lot of due diligence and time that must be invested before making such purchases. An
investor may also hire an account manager to manage the investor’s real estate investments in a
separate account. An investor may also engage in a joint venture to pool together the finances and
interests of other real estate investors.

Indirect Real Estate Investment

Real Estate Investment Trusts (REITs) are companies that own several properties and then issue
publicly traded shares so that the public can get exposure to all the underlying assets. The majority of
the profit they make throughout the year is distributed in the form of dividends. They trade like any
other stock on the stock exchange. Embassy Office Parks is India's first publicly listed Real Estate
Investment Trust trading on the stock exchanges in India.

Mortgage-backed securities also provide exposure to investors.

Mortgages

A lender provides a loan to another entity to purchase a house, and the return is the passive stream
of interest income. The mortgage may be backed by the house itself. The interest rate may be fixed,
variable, or a combination of the two.

Private Fund Investing Style

Real estate private equity funds are structured as open-ended mutual funds with an infinite life. This
allows investors to invest and redeem funds throughout the fund's life (usually quarterly) directly with
the PE fund. The GPs may invest in core real estate assets plus real estate assets with more leasing risk
to increase the fund's returns. Secondary and tertiary investments include housing, self-storage
spaces, and data centres.

REITs

REITs appeal to the issuer because they can avoid income taxes if they distribute 90-100% of the rental
income as dividends. Listed REITs allow the public to invest in a diversified portfolio of real estate
30

ownership. The REIT does not need to sell the underlying portfolio when investors redeem their funds
simultaneously.

Real Estate Investment Categories

Residential Property

This is direct ownership of a home that is usually the preferred route for families. A mortgage is usually
taken to fund such a purchase. The owner’s equity in the home increases as the property value
increases. The lender may sell the mortgage to an SPE as an RMBS.

Commercial Real Estate

This is a direct route for clients seeking long-term investments across commercial properties like high-
rise apartments, multifamily properties, offices, retail, industrial, etc. These have long investment
horizons, and returns are earned from rental income.

REIT Investing

Mortgage REITs that invest primarily in mortgages are like fixed-income securities, while equity REITs
that invest in properties are like stocks. The issuers of REIT securities aim to maximise rental occupancy
and rent rates from the underlying properties.

Mortgage-Backed Securities

Depending on the risk appetite, an entity may invest in different tranches of commercial mortgage-
backed securities or residential mortgage-backed securities. Investors with a low-risk appetite would
choose the more senior tranches. The details are covered in the Fixed Income readings.

Potential Risks and Diversification Benefits

➢ Real estate indexes may be used to assess the performance of real estate investments. Listed
REIT indexes are easy to calculate based on the price of the underlying REITs in the index and
dividends. A repeat sales index is based on fluctuations in the price of properties that have
been sold several times. It doesn't have a wide range because attributes aren't chosen at
random.

➢ Real estate returns are usually uncorrelated with traditional investments, providing good
diversification benefits. However, it is important to note that returns on real estate indices
may be unreliable due to infrequent data.

➢ Direct investment in real estate is illiquid and requires large sums of money.

India has approximately 650 million sq. Ft. of Grade A office space, of which 310-320 million sq. Ft. is
REIT-able stock. The current 3 REITs cover 87 million sq. Ft. – Mindspace 31 million sq. Ft, Embassy
42million sq. Ft. and Brookfield 14 million sq. Ft.
31

Explain investment characteristics of infrastructure.

Infrastructure investments are capital-intensive, long-lived assets. Infrastructure assets were earlier
handled wholly by the government. Lately, they are financed privately with the intent of selling the
newly built assets to the government. Infrastructure investments can be in the form of airports,
railways, or utility facilities as well.

For instance, the Adani Group in 2019 won a bid to run and operate over five airports in India. This
can be considered a private infrastructure investment.

Categories of Infrastructure Investments

Transportation Assets

These include roads, bridges, tunnels, airports, etc., that facilitate the transport of goods.

ICT Assets

These include telecom towers, data centres, broadcasts, etc., that facilitate the distribution of
information.

Utility and Energy Assets

These generate power, portable water, and transmit gas, water, electricity, etc.

Social Infrastructure Assets

These include the building and maintenance of goods that serve the public. For instance, infrastructure
that supports public hospitals and public education.

Infrastructure investments can be mainly classified into two types:

➢ Brownfield Investments: Investments in infrastructure that are already constructed. High

cash flows and high yield can be received immediately, but no growth is expected. As
mentioned earlier, Adani Group investing in 5 airports is a Brownfield investment.

➢ Greenfield Investments: Investments in infrastructure assets are yet to be constructed. These

are risky investments and generate no immediate cash flows, but a high level of growth is
expected. For instance, investment in the latest Mumbai Metro project is a greenfield
investment.

Some forms of infrastructure investment include:

● Indirect investment: This includes infrastructure funds (like private equity funds that can be
open-ended or close-ended), infrastructure ETFs, and company shares.

● REITs and MLPs: This is the preferred route for investors seeking more liquidity. Master
limited partnerships, or MLPs, are pass-through securities just like REITs.
32

Potential Risks and Diversification Benefits

➢ Low-risk infrastructure investments are those that are already established and have stable
cash flows. Higher risk investments include funds that are invested at the seed stage or early
stage of a project. Additionally, greenfield investments could have a higher turnaround time
and risk because the project must be started from the ground up.

➢ Investors should also look out for the use of leverage in such investments. High leverage
reduces the after-tax cash flow, so the revenues and operating income from the project must
be sufficient.

➢ These types of investments may be suited to match a long-term liability structure like that of
a pension fund or a life insurance company.

Describe issues in performance appraisal of alternative investments.

It is difficult to assess the risk and return of alternative investments due to reasons like:

➢ Lack of transparency.

➢ Illiquidity.

➢ Leverage.

➢ Complexity of strategies.

➢ Limited redemptions.

➢ Lack of mark-to-market data for specialised transactions.

➢ Compounded fee drag related to such funds.

The following tools may be used to assess performance:

Sharpe Ratio

This measures the excess return over a benchmark for each unit of risk (measured as standard
deviation). However, note that the assumption of a normal distribution may not hold in reality due to
the nature of the return characteristics of such investments.

Sortino Ratio

This is similar to the Sharpe ratio, but it accounts only for downside risk, i.e., downside volatility. If an
investment increases the return of a portfolio while also making sure that the downside risk is not
increased, then it may be preferred by the fund manager.

Treynor Ratio and Correlation

The Treynor ratio measures the portfolio return over the risk-free rate, adjusted for beta (systematic
risk). It is more useful for portfolios that can be compared to a benchmark so that the beta has
informational value.

Correlations of risk are important to note because an alternative investment only provides
diversification benefits when it is uncorrelated (or slightly negatively correlated) to the other assets in
an investor’s portfolio. Correlations also may be inaccurate due to illiquidity and lack of data.
33

The Calmar ratio is the ratio of the average annual rate of return to the maximum drawdown in a year
– the higher, the better. The MAR ratio takes the entire investment history and compares it to the
average drawdown. Both ratios help to assess the downside risk (left-tail risk) of an alternative
investment.

Private Equity and Real Estate

Private equity investors must commit a certain amount of capital, but the fund managers do not
immediately take this. Rather, the capital is called as and when the PE fund finds investment
opportunities. PE returns usually follow a J-curve: the initial investment suffers losses for the first few
years, but once the portfolio company has been restructured, the investment reaps exponential gains
later.

Direct investments in real estate also require a big capital outlay, and the returns are earned over a
long period. The investor may get tax benefits if the capital gains are indexed based on the investment
horizon.

Both methods may use the IRR approach due to the nature of cash flows. However, this requires an
appropriate method to forecast the timing and amount of cash flows. Additionally, the IRR must be
compared to the cost of capital for these projects, which is also simply an estimate.

The multiple of invested capital (MOIC) circumvents issues related to IRR. This is taken on the total
paid-in capital and is calculated as an exit multiple. So, if the total paid-in capital is $100 million and
the expected exit is worth $500 million in 10 years, then there is a 5× return on the investment in 10
years. However, remember that PE investments can suffer deep losses in the middle of their life. So,
it is important to see the fluctuation and life of the cash flows rather than just the entry and exit.

It is also possible that the valuation of such investments gets impacted due to short-term economic
downturns. The end value of a project may be revised downwards due to significant drawdowns in
the middle of the project. But it is important to assess how long-lived these impacts will be and if the
project's long-term value is still intact.

The cap rate measures the annual rent earned divided by the value of the underlying real estate assets.
The higher, the better. The capital loss ratio measures a percentage of capital in deals that have
resulted in losses relative to the total invested capital.

Hedge Funds

Leverage

Hedge funds may borrow securities or use leverage by engaging in derivative contracts by using prime
brokers. The hedge fund may negotiate the terms of interest and repayment with these brokers. The
hedge fund may have to meet margin calls when the investment position falls below a certain point.
These can be significant if the markets are facing high periods of stress.

Hedge funds can suffer deep losses if many market participants hold very similar positions and they
all liquidate these positions during periods of significant drawdowns. Therefore, measures like the
Sharpe ratio or the Sortino ratio do not uncover the tail risk of hedge funds during financial stress.
Instead, the analyst must try to uncover how the leverage strategy has been made and the risk
management methods used to mitigate significant losses.
34

Tail events are those that are perceived with a low probability of occurrence but have a high impact
when they do occur. For instance, a build-up of geopolitical tensions can create a sudden and
significant war that might wipe out economic growth. One may not see a war coming, but it will
destroy economies and financial valuations.

Illiquidity and Redemption Pressures

Portfolios may not be marked to market, or the way they are marked to market do not provide
accurate returns data. This is true even for long-short equity managers who trade in illiquid securities.
For illiquid investments, one can look at the bid price for long positions and ask for a price for short
positions. This gives a more realistic view of the market perception of the investment’s value.

Valuations are threatened by a lack of data transparency and the implications of redemption penalties
and fees. Valuations may be done quarterly or monthly, leading to infrequent information of an
investor’s current position.

Mass redemptions may force a hedge fund manager to sell (or purchase in case of short positions) the
underlying asset to facilitate the proceeds from redemption requests. This may happen in times of
financial stress and when investors, in general, are looking for the exit during a fire.

Calculate and interpret returns of alternative investments on both before-fee and

after-fee bases.
Fees and Structure of Private Equity

➢ The funds are typically set up as limited partnerships with the investors, meaning the risk is
restricted to the amount invested.

➢ The amount of capital invested in the fund is referred to as committed capital. The entire
capital is not used at the same time. As opportunities are identified and added to the portfolio,
the capital is 'drawn down' (invested).

➢ The committed money is typically pulled down over 4-5 years, only at the fund manager's
discretion.

➢ The management fees are charged at 1-3% on the committed capital and not on the invested
capital

➢ Private equity funds typically charge 20% incentive fees on earnings, but these costs are not
paid until the fund has recovered investors' initial cash. When all portfolio companies have
been liquidated, the incentive fees paid over time may approach 20% of the profits obtained.
This occurs when portfolio company returns are high at first and then drop.

➢ For the reasons stated above, a clawback clause in place mandates the fund to repay any
incentive charge to investors if it results in their receiving less than 80% of the profit
generated.

We have already seen the implications of high-water marks, hurdles and catch-up clauses. The whole-
of-fund structure implies that the aggregate of portfolio companies must be in a net profit for the GPs
to receive a performance fee. However, the deal-by-del structure implies that the GPs can earn an
incentive fee on individually profitable exits.
35

For instance, if the total fund’s loss is $15 million (even if there are some profitable ventures in this
portfolio), then the GP will not receive any incentive fee in the whole-of-fund structure. However, the
GPs will receive an incentive fee on all profitable exits within the portfolio in a deal-by-deal structure.

Additionally, certain fees can be customised and negotiated with the fund managers:

Liquidity Terms and Asset Size

An investor may be charged lower management fees based on the liquidity and lock-in terms
negotiated with the PE or hedge fund.

Founder’s Shares

Fund managers have offered incentives to investors to encourage them to invest in early-stage funds.
This also leads to lower fees.

“Either/Or” Fees

For example, managers may ask for a 1% management fee or a 30% incentive fee above a hurdle rate.
This will encourage investors to take either option depending on their perception of the fund
manager’s competence.

But there may be certain adjustments that may be negotiated with the PE fund’s or hedge fund’s
manager.

Example:
Mr. Maguire invested $10 million in a private equity fund. The amount invested over 2 years is $7
million. The management fee is 2%, and the incentive fee is 1%. There is a profit of $1 million earned
at the end of the year
Conclusions from the above statement

Committed capital = $10 million

The management fee is charged on the entire committed capital and not on the amount which is
invested.

Hence 2% of 10 million (0.02 × 10,000,000) is $200,000

Now, we come to the incentive fee.

The incentive is earned on the profit made on the money invested.

Please note that not all the money is invested at once. It is only charged on the profit earned, i.e., $
1 million

As concluded, the incentive fee is 1.00% i.e., 1.00% of $1million: (1.00% × 10,00,000) = $10,000

Alignment of Interest and Survivorship Bias

The fund manager is encouraged to run an alternative investment fund due to the relatively higher
fees and AUM. However, high fees charged to clients consistently can significantly deter their net
returns. So, the managers must find a balance between high fees and performance.
36

There is also a lock-in by which the investor must abide, or they will face redemption penalties. The
fund manager draws down the committed capital over the fund's life, and fund managers must
ensure that the timing of investment and returns on investment are adequate to keep the investors
invested over the long term.

The funds must also survive periods of significant drawdowns. There is, therefore, a survivorship
bias in the hedge fund indices – only those funds that have survived will report high returns while
the ones that have “dropped out” of the game will not disclose any returns at all. There is also a
backfill bias which means that only the funds that have survived an initial period of success will be
added to indices. These biases result in potentially inflated hedge fund returns simply because those
who did not survive could not tell their story of losses. The “losers” are not included in the index, so
if an index is full of winners, then there is bound to be an upside bias.

Sancho Ltd intends to expand its energy storage device business. While designing the most efficient
energy storage device, Sancho Ltd has already created the product and filed over ten patents. The
company has also finished the pilot production and engaged a firm production staff. The pilot
production was a big success. Sancho Ltd now plans to build a whole plant to manufacture efficient
energy storage devices. They approached a fund about investing in the business.

1. Which form of a fund should the business approach?

A. Seed stage
B. Mezzanine fund
C. Growth capital fund

2. What is the most significant drawback of the repeat sales index?

A. Selection bias
B. Volatility understatement
C. Relying on subjective appraisal

3. An investor opts for a Brownfield infrastructure project over a Greenfield infrastructure

project. Which of the following is most likely driving the investor?
A. Growth opportunities
B. Predictable cash flow
C. Economic infrastructure investing

4. If the natural resources forward curve is contango, the components of a commodity future
return are most likely to reflect?
A. Roll yield
B. Collateral yield
C. Spot prices

5. Hedge fund strategies that are event-driven and macro hedge fund strategies are used.
A. Long-short positions
B. A top-down approach
C. Long term market cycles
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6. An analyst wanting to assess the downside risk of an alternative investment is least likely to
use the investments
A. Sortino ratio
B. Value at Risk (VaR)
C. Standard Deviation of Returns

7. The following applies to Zell Advisors, which is a hedge fund:

$288 million assets under management at the year-end.

2% management fee
20% incentive fee calculated
5% soft hurdle
High water mark at $357 million
Current year return 25%

The incentive fees are calculated before/after management fees is taking into consideration.
Also management fees is calculated on end of year values or beginning of year values.
What is the total fee earned?
A. $6.36 million
B. $20.16 million
C. $21.60 million

8. A Hedge fund has the following structure:

Management fee 2%
Incentive fee 20%
Hurdle rate before incentive fee collection is 4%
High water mark at $610 million
Fund value at the beginning of the year is $583.1 million
End of year value is $642 million

What is the net return of an investor for the year closest to?
A. 6.72%
B. 6.8 %
C. 7.64%

9. Alternative investment funds' risk management processes are likely to contain the following:
A. In house valuations
B. Internal custody of assets
C. Segregation of risk and investment process duties
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Answers :

1.B is correct

2.A is correct

3.B is correct

4.A is correct

5.A is correct

6.C is correct

7.A is correct

If we take end of year value, management fees will be 288 +25% = 360
High water mark = 357. Therefore incentive fee will be only on 360-357 = 3 million
Incentive fee = 3*20% = 0.6
Management fees = 360 * 2% = 7.2
Total fees = 7.8
If we take beginning of year value, management fees will be 288*2% = 5.76
Incentive fees = 0.6
Total will be 6.36

8.B is correct

Highwater mark is 610

End of year value = 642
There return will be calculated above 610
Incentive fees will be (642-610)*20% = 6.4
Soft hurdle rate = 4%
However high water mark is much higher at 610.
Management fees = 2%*642 = 12.84
Total cost = 19.24
Return = (642-583.1-19.24)/583.1 = 6.8%

9.C is correct
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