Institute Q's Alternative Investments

Capricorn Fund of Funds invests GBP 100 million in each of Alpha Hedge Fund and ABC Hedge Fund. Capricorn FOF has a "1 and 10" fee structure. Management fees and incentive fees are calculated independently at the end of each year. After one year, net of their respective management and incentive fees, the investment in Alpha is valued at GBP80 million and the investment in ABC is valued at GBP140 million. The annual return to an investor in Capricorn, net of fees assessed at the fund of funds level, is closest to:

7.9% First, note that "1 and 10" refers to a 1% management fee, and a 10% incentive fee. End of year capital = GBP140 million + GBP80 million = GBP220 million Management fee = GBP220 million × 1% = GBP2.2 million Incentive fee = (GBP220 − GBP200) million × 10% = GBP2 million Total fees to Capricorn = (GBP2.2 + GBP2) million = GBP4.2 million Investor net return: (GBP220 − GBP200 − GBP4.2) / GBP200 = 7.9%

An investor in a private equity fund is concerned that the general partner can receive incentive fees in excess of the agreed-on incentive fees by making distributions over time based on profits earned rather than making distributions only at exit from investments of the fund. Which of the following is most likey to protect the investor from the general partner receiving excess fees?

A clawback provision A clawback provision requires the general partner in a private equity fund to return any funds distributed (to the general partner) as incentive fees until the limited partners have received back their initial investments and the contracted portion of the total profits. A high hurdle rate will result in distributions occurring only after the fund achieves a specified return. A high hurdle rate decreases the likelihood of, but does not prevent, excess distributions. Management fees, not incentive fees, are based on committed capital.

Which of the following forms of infrastructure investments is the most liquid?

A publicly traded infrastructure security, such as an exchange-traded MLP, provides the benefit of liquidity.

A hedge fund invests primarily in distressed debt. Quoted market prices are available for the underlying holdings but they trade infrequently. Which of the following will the hedge fund most likely use in calculating net asset value for trading purposes?

Avg quotes adjusted for liquidity Many practitioners believe that liquidity discounts are necessary to reflect fair value. This has resulted in some funds having two NAVs - for trading and reporting. The fund may use average quotes for reporting purposes but apply liquidity discounts for trading purposes.

High-water marks are typically used when calculating the incentive fee on hedge funds. They are most likely used by clients to:

Avoid paying 2x for the same performance

Downside risk

Both the Sortino ratio and the value-at-risk measure are both measures of downside risk.

The privatization of an existing hospital is best described as:

Brownfield investment Investing in an existing infrastructure asset with the intent to privatize, lease, or sell and lease back the asset is referred to as a brownfield investment. An economic infrastructure asset supports economic activity and includes such assets as transportation and utility assets. Hospitals are social infrastructure assets, which are focused on human activities.

Capital provided for companies moving toward operation but before commercial manufacturing and sales have occurred best describes which stage in venture capital investing?

Early Stage

Angel investing capital is typically provided in which stage of financing?

Formative stage Formative-stage financing occurs when the company is still in the process of being formed and encompasses several financing steps. Angel investing capital is typically raised in this early stage of financing.

Hedge fund losses are most likely to be magnified by a:

Margin calls can magnify losses. To meet the margin call, the hedge fund manager may be forced to liquidate a losing position in a security, which, depending on the position size, could exert further price pressure on the security, resulting in further losses. Restrictions on redemptions, such as lockup and notice periods, may allow the manager to close positions in a more orderly manner and minimize forced-sale liquidations of losing positions.

An argument for investing in commodities is that they:

May provide a hedge against inflation

An investor chooses to invest in a brownfield rather than a greenfield infrastructure project. The investor is most likely motivated by:

Predictable cash flows A brownfield investment is an investment in an existing infrastructure asset, which is more likely to have a history of steady cash flows compared with that of a greenfield investment. Growth opportunities and returns are expected to be lower for brownfield investments, which are less risky than greenfield investments.

What is the most significant drawback of a repeat sales index to measure returns to real estate?

Sample selection bias A repeat sales index uses the changes in price of repeat-sale properties to construct the index. Sample selection bias is a significant drawback because the properties that sell in each period vary and may not be representative of the overall market the index is meant to cover. The properties that transact are not a random sample and may be biased toward properties that changed in value. Understated volatility and reliance on subjective appraisals by experts are drawbacks of an appraisal index.

A measure that is most likely well suited to analyzing the performance of alternative investments that may exhibit negative skewness in returns is the:

Sortino ratio The Sharpe ratio and the safety-first measure use standard deviation as the measure of risk, which ignores the negative skewness in returns. The Sortino ratio uses the downside deviation as the measure of risk, which will reflect negative skewness if present.

Which attribute would a private equity firm most likely desire when deciding if a company is particularly attractive as a leveraged buyout target?

Sustainable cash flow

Which of the following is most likely to be available when conducting hedge fund due diligence?

The benchmark used by the fund It should be possible to identify the benchmark against which the fund gauges its performance in the hedge fund due diligence process. It should also be possible to establish the range of markets in which the fund invests as well as the fund's general strategy. Hedge funds consider their strategies, systems, and processes to be proprietary and are unwilling to provide much information to potential investors.

Commodity futures prices are most likely in backwardation when:

The convenience yield is high

United Capital is a hedge fund with $250 million of initial capital. United charges a 2% management fee based on assets under management at year end, and a 20% incentive fee based on returns in excess of an 8% hurdle rate. In its first year, United appreciates 16%. Assume management fees are calculated using end-of-period valuation. The investor's net return assuming the performance fee is calculated net of the management fee is closest to:

The net investor return is 12.54%, calculated as: End of year capital = $250 million × 1.16 = $290 million Management fee = $290 million × 2% = $5.8 million Hurdle amount = 8% of $250 million = $20 million; Incentive fee = ($290 − $250 − $20 − $5.8) million × 20% = $2.84 million Total fees to United Capital = ($5.8 + $2.84) million = $8.64 million Investor net return: ($290 − $250 − $8.64) / $250 = 12.54%

If a commodity's forward curve is in contango, the component of a commodities futures return most likely to reflect this is:

The roll yield Roll yield refers to the difference between the spot price of a commodity and the price specified by its futures contract (or the difference between two futures contracts with different expiration dates). When futures prices are higher than the spot price, the commodity forward curve is upward sloping, and the prices are referred to as being in contango. Contango occurs when there is little or no convenience yield.

An investor seeks a current income stream as a component of total return, and desires an investment that historically has low correlation with other asset classes. The investment most likely to achieve the investor's goals is:

Timberland Timberland offers an income stream based on the sale of timber products as a component of total return and has historically generated returns not highly correlated with other asset classes.

A private equity fund desiring to realize an immediate and complete cash exit from a portfolio company is most likely to pursue a(n):

Trade Sale Private equity funds can realize an immediate cash exit in a trade sale. Using this strategy, the portfolio company is typically sold to a strategic buyer.

An investor may prefer a single hedge fund to a fund of funds if he seeks:

a less complex fee structure. Hedge funds of funds have multi-layered fee structures, while the fee structure for a single hedge fund is less complex. Funds of funds presumably have some expertise in conducting due diligence on hedge funds and may be able to negotiate more favorable redemption terms than could an individual investor in a single hedge fund

Hedge funds are similar to private equity funds in that both

are typically structured as partnerships. Private equity funds and hedge funds are typically structured as partnerships where investors are limited partners (LP) and the fund is the general partner (GP). The management fee for private equity funds is based on committed capital whereas for hedge funds the management fees are based on assets under management. For most private equity funds, the general partner does not earn an incentive fee until the limited partners have received their initial investment back.

As the loan-to-value ratio increases for a real estate investment, risk most likely increases for:

both debt/equity holders The higher the loan-to-value ratio, the higher leverage is for a real estate investment, which increases the risk to both debt and equity investors.

The three main sources of return for commodities futures contracts most likely are:

collateral yield, roll yield, and spot price return.

Until the committed capital is fully drawn down and invested, the management fee for a private equity fund is based on:

committed capital

An equity hedge fund following a fundamental growth strategy uses fundamental analysis to identify companies that are most likely to:

experience high growth and capital appreciation. Fundamental growth strategies take long positions in companies identified, using fundamental analysis, to have high growth and capital appreciation. Fundamental value strategies use fundamental analysis to identify undervalued companies. Market-neutral strategies use quantitative and/or fundamental analysis to identify under- and overvalued companies.

Both event-driven and macro hedge fund strategies use:

long-short positions. Long-short positions are used by both types of hedge funds to potentially profit from anticipated market or security moves. Event-driven strategies use a bottom-up approach and seek to profit from short-term events typically involving a corporate action, such as an acquisition or a restructuring. Macro strategies seek to profit from expected movements in evolving economic variables.

Which of the following least likely describes an advantage of investing in hedge funds through a fund of funds? A fund of funds may provide investors with:

lower fees because of economies of scale. The fees on funds of funds are usually higher. The fund of funds manager charges a fee, and there is a fee charged by each hedge fund.