Alternative Investments Questions

A private equity firm that provides equity capital to a publicly traded company to finance the company's restructuring, but does not take the company private, is best described as engaging in: A)private investment in public equity. B)mezzanine financing. C)angel investing.

A

When valuing real estate investment trusts (REITs), funds from operations is calculated by: A)adding depreciation to net income. B)subtracting depreciation from operating income. C)subtracting recurring capital expenditure from net income.

A

Which of the following risk measures is based on downside deviation rather than standard deviation? A)Sortino ratio. B)Roy's safety-first criterion. C)Value at risk.

A

Adjusted funds from operations (AFFO) is best described as an estimate of a real estate investment trust's: A)free cash flow. B)operating cash flow. C)net operating income

A AFFO equals funds from operations minus recurring capital expenditures and is analogous to free cash flow.

The value of an existing single-family home used for residential purposes will most likely be calculated using the: A)sales comparison approach. B)cost approach. C)income approach.

A An existing single-family home for residential purposes will most likely be valued using the sales comparison method.

Return and risk data on alternative investments may be affected by backfill bias if: A)a firm's historical returns are included when it is added to an index. B)data only include currently existing firms. C)the incorrect distribution is used to model volatility.

A Backfill bias refers to bias introduced by including the previous performance data for firms added to a benchmark index.

A hedge fund has a 2-and-20 fee structure with a soft hurdle rate of 5% and a high water mark. Incentive fees are calculated net of management fees. The fund's gross return is 15% in Year 1, −10% in Year 2, and 30% in Year 3. Incentive fees for Year 3 will be: A) less than 20% of the increase in value in Year 3 after management fees. B) equal to 20% of the increase in value in Year 3 after management fees. C) greater than 20% of the increase in value in Year 3 after management fees.

A Because the fund lost value in Year 2 and has a high water mark, incentive fees for Year 3 will be 20% of only the portion of the Year 3 gain that exceeds the previous highest value.

A hedge fund that employs a fundamental growth strategy using equity securities is most likely to seek out shares of companies that are: A)growing revenues and earnings rapidly. B)either undervalued or overvalued. C)undervalued only.

A Fundamental growth refers to investing in companies that are experiencing high growth and for which the fund managers anticipate significant capital appreciation.

Kettering Incorporated is a successful manufacturer of technology hardware. Kettering is seeking capital to finance additional growth that will position the company for an initial public offering. This stage of financing is most accurately described as: A)mezzanine-stage financing. B)angel investing. C)early-stage financing.

A Mezzanine stage capital prepares a company for and IPO. Angel investing and early-stage financing describe venture capital in a company's formative stages.

For which of the following investments is an investor most likely to require the greatest liquidity premium? A)Private equity funds. B)Real estate investment trusts. C)Commodity futures.

A Private equity funds tend to have lockup periods; investors will require liquidity premiums as compensation. REITs and commodity futures are exchange-traded instruments and much more liquid than private equity funds.

The stage at which venture capital financing is used to fund market research and product development is best characterized as the: A)seed stage. B)early stage. C)angel investing stage.

A Seed stage financing is used for market research and to fund product development and/or marketing and is typically the first stage at which a venture capital fund will invest in a start-up company.

To exit an investment in a portfolio company through a trade sale, a private equity firm sells: A)the portfolio company to another private equity firm. B)the portfolio company to one of the portfolio company's competitors. C)shares of a portfolio company to the public.

B A trade sale involves selling a portfolio company to a competitor or another strategic buyer. An IPO involves selling all or some shares of a portfolio company to the public. A secondary sale involves selling a portfolio company to another private equity firm or a group of investors.

Compared to traditional investments, alternative investments are most likely to be more: A)liquid. B)leveraged. C)transparent.

B Alternative investments tend to use more leverage and are typically less liquid and less transparent than traditional investments.

For a given set of underlying real estate properties, the type of real estate index that is most likely to have the lowest standard deviation is a(n): A)repeat sales index. B)appraisal index. C)REIT trading price index.

B Appraisal index returns are based on estimates of property values. Because estimating values tends to introduce smoothing into returns data, appraisal index returns are likely to have lower standard deviations than index returns based on repeat sales or trading prices of REIT shares.

An investment in commodities will most likely provide returns from: A)cash flows from the assets. B)changes in commodity spot prices. C)the yield on collateral deposits.

B Returns from holding commodities depend on changes in spot prices. Investing directly in commodities requires no collateral deposit; this is required for investing in commodity derivatives. Commodities typically do not generate cash flows.

Under which approach to valuing real estate properties is an analyst most likely to estimate a capitalization rate? A)Comparable sales approach. B)Income approach. C)Cost approach.

B The income approach estimates values by calculating the present value of expected future cash flows from property ownership or by dividing the net operating income (NOI) for a property by a capitalization rate. The comparable sales approach estimates a property value based on recent sales of similar properties. The cost approach is based on the estimated cost to replace an existing property.

Which of the following is least likely an important element of risk management for alternative investment funds? A)Obtaining independent valuations of fund positions. B)Designating a risk management officer who also works as part of the investment team. C)Setting leverage limits.

B The risk officer should be separate from those who manage the investment process. Setting leverage limits and getting third party (not in-house) valuations of fund investments are both important elements of risk management for alternative investment funds.

A portfolio manager who adds commodities to a portfolio of traditional investments is most likely seeking to: A)increase expected returns only. B)decrease portfolio variance only. C)both increase expected returns and decrease portfolio variance.

B Unlike most alternative investments, expected returns on commodities are typically less than expected returns on traditional investments. However, because their returns typically have a low correlation with returns on traditional investments, adding commodities to a portfolio of traditional investments can decrease portfolio variance.

Compared to a traditional mutual fund, a hedge fund is more likely to feature: A)lower leverage. B)higher liquidity. C)higher fees.

C A hedge fund typically is more likely to use leverage, is less liquid, and charges higher fees than a traditional mutual fund.

A due diligence factor that is common to analyzing real estate investment trusts, hedge funds, and private equity is (are): A)dividend distribution requirement. B)drawdown procedures. C)variability of manager performance.

C All of these classifications of alternative investments share variability of manager performance as a due diligence factor. Drawdown procedures are primarily a due diligence factor for analyzing private equity. Dividend distribution requirement is specific to REITs.

deposited to establish the position is called the: A)current yield. B)roll yield. C)collateral yield.

C Collateral yield is the return earned on the collateral posted to satisfy margin requirements. In most cases, the collateral posted will be U.S. Treasury Bills, in which case the collateral yield is the T-bill yield.

A portfolio manager who adds hedge funds to a portfolio of traditional securities is most likely seeking to: A)increase expected returns only. B)decrease portfolio variance only. C)both increase expected returns and decrease portfolio variance.

C For a portfolio of traditional securities, adding alternative investments such as hedge funds can potentially increase the portfolio's expected returns, because these investments often have higher expected returns than traditional investments, and decrease portfolio variance, because returns on these investments are less than perfectly correlated with returns on traditional investments.

Social infrastructure assets most likely include: A)broadcasting towers. B)waste treatment plants. C)health care facilities.

C Health care facilities are categorized as social infrastructure. Waste treatment plants are utility infrastructure. Broadcasting towers are communications infrastructure.

An example of a relative value hedge fund strategy is: A)merger arbitrage. B)market neutral. C)convertible arbitrage.

C Relative value strategies include convertible arbitrage fixed income, asset-backed fixed income, general fixed income, volatility, and multi-strategy. Market neutral is an equity hedge strategy. Merger arbitrage is an event driven strategy.

Supplying capital to companies that are just moving into operation, but do not as yet have a product or service available to sell, is a description that best relates to which of the following stages of venture capital investing? A)Angel investing stage. B)Mezzanine stage. C)Early stage.

C The description relates best to the early stage wherein the capital that is supplied helps speed up product development and also helps pay for the beginning of a marketing campaign.

The notice period for a hedge fund is best described as the period following: A)an investment in the fund, during which the investor is not permitted to redeem shares. B)the opening of the fund to investors, before the fund is closed to new investors. C)a request for redemption of shares, within which the fund must fulfill the request.

C The notice period is the time within which a hedge fund must fulfill a request for redemption of shares. The period during which investors may not redeem shares is called a lockup period.

Bulldog Fund is a hedge fund with a value of £100 million at the beginning of the year. Bulldog Fund charges 1.5% management fee based on assets under management at the end of the year and a 25% incentive fee with no hurdle rate. Incentive fees are calculated independent of management fees. The fund's value at the end of year before fees is £120 million. Compared to a 2 and 20 fee structure, Bulldog Fund's total fees for the year are: A)higher. B)lower. C)the same.

A

The yield from an investment in commodities that results from a difference between the spot price and a futures price is the: A)roll yield. B)collateral yield. C)convenience yield.

A

Historical data on returns of real estate are most likely to exhibit: A)smoothing. B)downward-biased Sharpe measures. C)overstated correlations with other asset classes.

A Appraisal methods used to value real estate tend to produce smoothed return patterns that understate standard deviations of returns. This causes Sharpe ratios to be biased upward. Methods used to construct real estate indexes tend to understate the correlation of real estate returns with other asset classes (and thus overstate its diversification benefits).

If a commodity futures market is in backwardation: A)the commodity has a high convenience yield. B)a long futures position will have a negative roll yield. C) the futures price is of the commodity is higher than the spot price.

A Backwardation refers to a situation where the futures price is less than the spot price for a commodity. Because commodities have no monetary yield, only a convenience yield greater than the opportunity (interest) cost and storage costs of holding the commodity can lead to backwardation. When a futures market is in backwardation, the roll yield is positive because the futures price moves towards the spot price over the life of the contract.

An additional risk of direct investment in real estate, which is not typically a significant risk in a portfolio of traditional investments, is: A)liquidity risk. B)market risk. C)counterparty risk.

A Direct investment in real estate involves liquidity risk because large sums may be invested for long periods before a sale of the property can take place. Market risk exists for both traditional portfolio and real estate investments. Counterparty risk applies mainly to derivative contracts that require a payment from a counterparty, such as swaps and forwards.

A Hong Kong hedge fund was valued at HK$400 million at the end of last year. At year's end the value before fees was HK$480 million. The fund charges 2 and 20. Management fees are calculated on end-of-year values. Incentive fees are independent of management fees and calculated using no hurdle rate. The previous year the fund's net return was 2.5%. The annualized return for the last two years is closest to: A)7.9%. B)13.6%. C)8.1%.

A Management fee is HK$480 million × 0.02 = HK$9.6 million. Incentive fee is (HK$480 million - HK$400 million) × 0.20 = HK$16.0 million. Total fee is HK$9.6 million + HK$16.0 million = HK$25.6 million. Net of fee: HK$480.0 - HK$25.6 = HK$454.4 million Net return: (HK$454.4 / HK$400.00) - 1 = 13.6% Two year annualized return is (1.136 × 1.025)1/2 - 1 = 7.9%

The typical trade used by a merger arbitrage fund is: A)short position in acquirer, long position in firm being acquired. B)long position in acquirer, short position in firm being acquired. C)short positions in both the acquirer and the firm being acquired.

A Merger arbitrage funds typically short the stock of the acquirer and buy the stock of the firm being acquired

For the valuation of real estate investment trusts (REITs), the asset-based approach estimates value by: A)subtracting total liabilities from the total value of the real estate assets and dividing by the number of shares outstanding. B)subtracting recurring capital expenditures from funds from operations. C)adding depreciation, subtracting gains from property sales, and adding losses on property sales.

A The asset-based approach provides an estimate of the net asset value of REITs by subtracting total liabilities from the total value of the real estate assets and dividing by the number of shares outstanding. The income-based approach uses either funds from operations (FFO) or adjusted funds from operations (AFFO) to compute cash flows. FFO is calculated from net income with depreciation added back and with gains from property sales subtracted and losses on property sales added. AFFO is FFO with recurring capital expenditures subtracted.

The difference between a hedge fund's trading net asset value and its accounting net asset value is that: A)trading NAV tends to be lower because of illiquid assets. B)accounting NAV tends to be higher because of estimated liabilities. C)accounting NAV tends to be lower because of model prices

A Trading NAV adjusts accounting NAV downward to account for illiquidity of a hedge fund's investments, such as positions that are large relative to trading volume.

Which of the following will result from futures prices for a particular commodity being in contango? A)Negative collateral yield. B)Negative roll yield. C)Positive current yield.

B A positive roll yield results from a backwardated market, whereas a negative yield is produced in a contango market. In backwardated (contango) markets, futures prices are lower (higher) than spot prices.

Which of the following is least likely a type of hedge fund strategy? A)Event-driven. B)Exchange-traded. C)Market-neutral.

B Hedge funds do not typically trade on exchanges.

The formative stage of venture capital investing when capital is furnished for market research and product development is best characterized as the: A)angel investing stage. B)seed stage. C)early stage.

B In the seed stage of venture capital investing, capital is furnished for product development, marketing, and market research. The angel investing stage is when investment funds are used for business plans and assessing market potential. The early stage refers to investments made to fund initial commercial production and sales.

Indices for alternative investments are least likely to exhibit: A)backfill bias. B)time-period bias. C)survivorship bias.

B Index returns for alternative investments are often subject to both backfill and survivorship bias. Time-period bias is a concern in hypothesis testing.

Springfield Fund of Funds invests in two hedge funds, DXS and REF funds. Springfield initially invested $50.0 million in DXS and $100.0 million in REF. After one year, DXS and REF were valued at $55.5 million and $104.5 million, respectively, net of both hedge fund management fees and incentive fees. Springfield Fund of Funds charges 1.0% management fee based on assets under management at the beginning of the year and a 10.0% incentive fee independent of management fees. The annual net return for Springfield Fund of Funds is closest to: A)5.5%. B)5.0%. C)6.0%.

B Management fee = $150.0 × 1.0% = $1.5 million Net value at end of year after hedge fund fees = $55.5 + $104.5 = $160.0 million Incentive fee = ($160.0 - $150.0) × 10% = $1.0 million Total fees = $1.5 + $1.0 = $2.5 million Net of fees: $160.0 - $2.5 = $157.5 million Net return = ($157.5 / $150.0) - 1 = 5.0%

When conducting due diligence on a vehicle for alternative investments, which of the following observations would most likely be positive for a potential investor? A)A well-known and highly regarded investor holds shares that represent 20% of the vehicle's assets under management. B)Auditing and reporting to investors are performed by reliable third parties. C)The general partner is prohibited from commingling his own funds with the limited partners' funds.

B Use of quality third-party service providers by an investment vehicle is a positive sign for potential investors. Manager and investor interests are more likely to be aligned if the general partner invests alongside the limited partners. If a single investor represents a large portion of assets under management, and that investor chooses to withdraw, the manager may be forced to liquidate assets at unfavorable prices.

A hedge fund that charges an incentive fee on all profits, but only if the fund's rate of return exceeds a stated benchmark, is said to have a: A)high water mark. B)soft hurdle rate. C)hard hurdle rate.

B With a soft hurdle rate, a hedge fund charges an incentive fee on all profits, but only if the fund's rate of return exceeds a stated benchmark. With a hard hurdle rate, a hedge fund charges an incentive fee only on the portion of returns that exceed a stated benchmark. With a high water mark, a fund's value must exceed its highest previous value before the fund may charge an incentive fee.`

A hedge fund has a 2-and-20 fee structure, based on beginning-of-period assets, with a soft hurdle rate of 5%. Incentive fees are calculated before management fees. An endowment invests $60.0 million in the hedge fund. The value of the endowment's investment, before fees, decreases to $56.2 million after one year and increases to $58.0 million the next year. In the second year the endowment will be charged management and incentive fees closest to: A)$1.10 million. B)$1.70 million. C)$1.15 million.

B Year 1: Management fee = $60.0 million × 2% = $1.2 million. No incentive fee is charged because the fund decreased in value. Value after fees = $56.2 million - $1.2 million = $55.0 million. Year 2: Management fee = $55.0 million × 2% = $1.1 million. Year 2 return = $58.0 million / $55.0 million - 1 = 5.45% which is greater than the hurdle rate. With a soft hurdle rate and no high water mark provision, the entire gain is eligible for incentive fees: ($58.0 million - $55.0 million) × 20% = $0.6 million. Total fees in Year 2 = $1.1 million + $0.6 million = $1.7 million.

With respect to risk management for alternative investments, counterparty and liquidity risk are introduced as additional considerations by the use of: A)lock-up periods. B)foreign currencies. C)derivatives.

C

An equity hedge fund strategy that focuses primarily on exploiting overvalued securities is best described as a(n): A)fundamental value strategy. B)event driven strategy. C)short bias strategy.

C Equity hedge funds with a short bias attempt to profit from short positions in equities they believe to be overvalued. These funds may hold long equity positions but typically have net short exposure to the market. An event driven strategy focuses on companies involved in mergers, in financial distress, or in other special situations. A fundamental value strategy attempts to identify undervalued equities.

A hedge fund strategy that takes positions in shares of firms undergoing restructuring or acquisition is an: A)macro strategy. B)equity hedge strategy. C)event driven strategy.

C Event-driven strategies include merger arbitrage, distressed/restructuring, and special situations strategies that involve long or short positions in common equity, preferred equity, or debt of a specific corporation. Macro strategies are based on global economic trends and events, and may involve long or short positions in equities, fixed income, currencies, or commodities. Equity hedge strategies seek to profit from long and short positions in publicly traded equities and derivatives with equities as their underlying assets, but are not based on events such as restructuring or acquisition.

Relatively infrequent valuations of private equity portfolio companies most likely cause: A)average fund returns to be biased upward. B)standard deviations of fund returns to be biased upward. C)correlations of fund returns with equity returns to be biased downward.

C Infrequent valuation results in downward bias in both standard deviations and correlations.

A Canadian hedge fund has a value of C$100 million at the beginning of the year. The fund charges a 2% management fee based on assets under management at the beginning of the year and a 20% incentive fee with a 10% hard hurdle rate. Incentive fees are calculated net of management fees. The value at the end of the year before fees is C$112 million. The net return to investors is closest to: A)8%. B)9%. C)10%.

C Management Fee: C$100.0 × 2.0% = C$2.0 million Gross value at end of year (given) = C$112.0 million Incentive fee = [(C$112.0 - C$100.0 - C$2.0 - (C$100.0 × 10.0%)] × 20% = C$0 Total fee = C$2.0 million Net of fee: C$112.0 - C$2.0 = C$110.0 million Net return = (C$110.0 / C$100.0) - 1 =10.0%

A British hedge fund has a value of £100 million at the beginning of the year. The fund charges a 2% management fee based on assets under management at the end of the year and a 20% incentive fee with a soft hurdle rate of LIBOR + 2.5%. Incentive fees are calculated net of management fees. If the relevant LIBOR rate is 2.5% and the fund's value at the end of the year before fees is £120 million, the net return to investors is closest to: A)16.5%. B)17.6%. C)14.1%.

C Management fee = £120.0 × 2.0% = £2.4 million. Gross value at end of year (given) = £120.0 million. Gross return = (£120.0 / £100.0) - 1 = 20.0%. The soft hurdle rate of 2.5% + 2.5% = 5.0% was exceeded. Incentive fee = (£120.0 - £100.0 - £2.4) × 20% = £3.52 million. Total fee = £2.40 + £3.52 = £5.92 million. Net of fee: £120.00 - £5.92 = £114.08 million. Net return = (£114.08 / £100.00) - 1 = 14.1%

An investor made an investment in a hedge fund at the beginning of the year, when the NAV after fees was €80 million. The NAV after fees for Year 1 was €75 million. For Year 2, the end-of-year value before fees is €90 million. The fund has a 2 and 20 fee structure. Management fees are paid independently of incentive fees and are calculated on end-of-year values. Incentive fees are calculated using a high water mark and a soft hurdle rate of 2%. Total fees paid for Year 2 are: A)€5.8 million. B)€4.4 million. C)€3.8 million.

C Management fee = €90 million × 0.02 = €1.8 million. Gross return above high water mark = (€90 / €80) - 1 = 12.5%. The soft hurdle rate was exceeded. Because of the high water mark, incentive fees are paid only on the increase in NAV above the previous year-end NAV after fees of €80 million. Incentive fee = (€90 million - €80 million) × 0.20 = €2.0 million. Total fee: €1.8 million + €2.0 million = €3.8 million.

The risk measure for alternative investments that is least likely to be affected by tendency of returns to be leptokurtic is: A)coefficient of variation. B)standard deviation. C)the Sortino ratio.

C Standard deviation and coefficient of variation, which is based on standard deviation of returns, both may be misleading for alternative investments because their returns distributions tend to be leptokurtic (i.e., they have "fat tails"). The Sortino ratio, in contrast, measures risk as downside deviation from the mean.

Josh Lacy, CFA, is analyzing a portfolio company held by his private equity firm to estimate its value in liquidation. Lacy should most appropriately use: A)a discounted cash flow-based approach. B)a comparables-based approach. C)an asset-based approach.

C The asset-based approach uses either the liquidation values or fair market values of assets. The discounted cash flow approach involves calculating the present value of expected future cash flows. The comparables-based approach uses market or private transaction values of similar companies to estimate multiples of EBITDA, net income, or revenue.

Which of the following statements is least likely a risk management consideration for alternative investments? A)Alternative investment returns should reflect a premium to compensate investors for a lack of liquidity. B)Historical returns and standard deviations may not reflect future returns and volatility for alternative investments. C)The standard deviation of alternative investment returns may be misleading because returns distributions tend to be positively skewed.

C The standard deviation of returns may be a misleading measure of risk because returns distributions are not approximately normal; they tend to be leptokurtic (i.e., fat tails) and negatively skewed (i.e., possibility of extreme negative outcomes).