2023 L1 3 Alternative

Last Revised: 06/22/2022
2023 Level 1 - Alternative Investments

Readings Page
Categories, Characteristics, and Compensation Structures of

2
Alternative Investments
Performance Calculation and Appraisal of Alternative Investments 7
Private Capital, Real Estate, Infrastructure, Natural Resources, and

14
Hedge Funds
Review 25
M.M120501571.
This document should be used in conjunction with the corresponding readings in the 2023 Level 1 CFA® Program curriculum.
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1
Categories, Characteristics, and Compensation Structures of

Alternative Investments
a. describe types and categories of alternative investments
b. describe characteristics of direct investment, co-investment, and fund investment

methods for alternative investments
c. describe investment and compensation structures commonly used in alternative

investments
Performance Calculation and Appraisal of Alternative Investments
a. describe issues in performance appraisal of alternative investments
b. calculate and interpret returns of alternative investments both before and after fees
Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge

Funds
a. explain investment characteristics of private equity
b. explain investment characteristics of private debt
c. explain investment characteristics of real estate
d. explain investment characteristics of infrastructure
e. explain investment characteristics of natural resources
f. explain investment characteristics of hedge funds
Dr. Mark put all three modules in one video (as it appeared in previous years).
M.M120501571.
The LOS lettering may not match up, but the LOS learning objectives do.
2
Introduction to Alternative Investments
LOS a (5p) Types of Alternative Investments - describe
LOS b (8.5p) Investment Methods - describe
LOS c (7.5p) Investment and Compensation Structures - describe
LOS d (10.5p) Hedge Funds - explain
LOS e (13p) Private Capital (Equity and Debt) - explain
LOS f (16p) Natural Resources - explain
LOS g (16p) Real Estate - explain
LOS h (9.5p) Infrastructure - explain
LOS i (11.5p) Issues in Performance Appraisal - describe
LOS j (9p) Calculating Fees and Returns - calculate/interpret
Page 1
AI - anything other than long-only publicly-traded investments LOS a
in stocks, bonds, and cash - describe
not just assets but strategies/approaches (i.e. HF/PE)

typically involve active management (more inefficient pricing)
Characteristics/ narrow specialization of mgrs.

low correlations of returns with traditional investments
limited historical risk and return data
unique legal and tax considerations
higher fees ➞M.M120501571.
mgmt. + performance fees
concentrated portfolios
restrictions on redemptions
Offer (potentially) broader diversification

enhanced returns (risk-adjusted)
increased income through higher yields (pub. vs. pr., illiquid)
3
Page 2
Categories/ LOS a
Hedge Funds - private investment vehicles - describe
- can use traditional investments
- absolute return investments (most commonly)
(Private Capital)
Private Equity - direct investments or through PE funds
- PE funds ➞ private or public-to-private
➞ majority typically involve LBOs
- VCs ➞ invest in start-ups (small portion of PE mkt.)
Private Debt ➞ debt provided to private entities
Real Estate - directly or indirectly

private CRE equity/debt
public RE equity/debt
Page 3
Categories/ LOS a
Natural Resources Commodities - futures, ETFs - describe
Agricultural Land - farmland (lease or cropshare)
Timberland - natural forests or managed tree plantations
Infrastructure - capital intensive, long-lived assets

- intended for public use and provide essential services
Others - Tangibles (art, wine, collectibles)

- Intangibles (patents, litigation actions)
LOS b
Fund Investing ➞ investor contributes capital to a fund
- describe
➞ fund makes investments
M.M120501571.
➞ involves mgmt. + performance fees
Co-Investing ➞ investor in a fund has the right to invest directly in the

same assets
Direct Investing ➞ no intermediary, typically large and more sophisticated
investors
4
Page 4
LOS b
- describe
Page 5
Due Diligence: Direct Inv. - requires considerable expertise LOS b
Fund Investing - skill in manager selection - describe
Ex h. #3 Co-Investing - can rely on DD performed by the fund
LOS c
most funds are structured as limited partnerships
- describe
GP - general partner ➞ fund manager - unlimited liability
LP - limited partner ➞ investor - limited liability as long as they

do not get involved in day-to-day operations)
- governed by a Limited Partnership Agreement (LPA)

may also be side letters: agreements between the GP and
M.M120501571.
certain LPs that exist outside the LPA
e.g./ extra reporting

first right-of-refusal (for co-investments)
fee matching
5
Page 6
Infrastructure - public-private partnerships LOS c
Real Estate funds - unitholders (trusts) - describe
JVs - direct real estate
Compensation/
management fee ➞ 1% to 2% of AUM (HF) or committed
capital (PE)
performance fee (incentive fee, carried interest)
- based on excess return above a hurdle rate
e.g./ 20% of return above a hard hurdle rate

or 20% of total return if soft hurdle is met
may also be consulting and monitoring fees for certain types

of PE (i.e. LBO)
- typically, GPs do not earn performance fees until LPs are made
whole and hurdle rate exceeded
Page 7
Catch-up clause (PE) : e.g. 18% IRR, 8% HR LOS c
- describe
GP
with: GP = 2% + 1.6%
8% 10% 18%
LPs = 3.6%
GP = 20%
LPs = 80%
without: GP = 2%
8% 18%
LPs
GP = 20%
LP = 80%
High-Water Mark (HF): highest value used to calculate an incentive fee
- incentive fees are only available above this level
M.M120501571.
- possible that LPs have different HWMs depending on

when they invested
Distribution Method (PE) ➞ waterfall

1/ Deal-by-deal (or American)
2/ Whole-of-fund (or European)
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Page 8
Distribution Method (PE) ➞ waterfall LOS c
- describe
Deal-by-Deal
called a clawback
(LPs made whole on
inv. #8)
Whole-of-Fund
both end with

the same outcome
(LPs made whole on
inv. #6)
Page 9
Hedge Funds/ LOS d
Characteristics - explain
- creatively (actively) managed, involved in one or more
asset classes and geographic regions, use of leverage,
short positions, and derivatives
- goal is to generate high returns on an absolute or
risk-adjusted basis
- very few investment restrictions
- private investment partnership open to a limited number
of accredited investors
- lightly regulated
- minimum investments M.M120501571.
- restrictions on redemptions
- hard lockup - no redemptions
- soft lockup - redemption for a fee (penalty)
- notice periods - 30 to 90 days notice of a
redemption
7
Page 10
Hedge Funds/ LOS d
Fund-of-Funds: - explain
- invest in HFs
- DD expertise + manager diversification
- better able to negotiate redemption or fee terms
- 1% mgmt. fee, 10% incentive fee on top of underlying HF fees
- all HF fees have moderated over time

HF : 1.3% mgmt. fee + 15.5% incentive (avg.)
FoF: 1% flat or 50 bps mgmt. + 5% incentive (avg.)
HF Strategies/
Equity Hedge: public equities, long and short positions, derivatives
bottom-up or top-down approach
quantitative or fundamental
Page 11
HF Strategies/ Equity Hedge LOS d
- explain
a) Market Neutral: identify over and under-valued securities
- take long and short positions, target 𝜷 = 𝟎
- typically use significant leverage
b) Fundamental Long/Short growth:
- identify companies expected to exhibit high growth
and capital appreciation for long positions
- short companies under downward pressure
- typically net long
c) Fundamental Value - identify undervalued companies (unloved)
for long positions
- possibly short overvalued growth
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- typically long-biased (𝛃 > 𝟎), value + small-cap factor

exposure
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Page 12
HF Strategies/ Equity Hedge LOS d
d) Short-biased: short overvalued equity with no or - explain
some long exposure (index ETFs)
e) Sector-Specific: manager expertise in a particular sector
Event-Driven - seek to profit from defined events, typically changes

in corporate structures
- bottom-up, security specific analysis
a) Merger Arbitrage: long the target, short the acquirer

- deal spread narrows as closing date approaches
- typically use leverage
- risk ➞ deal may fall through
b) Distressed/Restructuring: securities of companies in or near

bankruptcy
Page 13
HF Strategies/ Event-Driven LOS d
b) Distressed/Restructuring: - explain
- buy debt at discount that is expected to have a
higher recovery rate (money good)
- buy debt that is expected to become the new equity of
the restructured company (fulcrum securities)
c) Special Situations: - equity of companies restructuring other than
M&A or bankruptcy
d) Activist: take large enough positions to affect change
(divestitures, capital distributions, mgmt. change)
Relative Value - seek to profit from pricing discrepancies between

M.M120501571.
related securities
a) Convertible Bond Arbitrage - buy the bond, sell the stock
9
Page 14
HF Strategies/ Relative Value LOS d
- explain
b) Fixed-Income (general) long/short trades between
2 issuers, between 2 issues at different parts of
the capital structure, or between different parts of
an issuers YC
c) Fixed-Income (ABS, MBS, HY) - higher coupon + relative mispricing

between securities and assets backing them
d) Volatility - long/short market volatility

e) Multi-Strategy - combinations of strategies above
Macro and CTA Strategy/ macro: top-down approach to identify

economic trends
- use all asset classes, long and short
- managed futures (a.k.a. commodity trading advisers) - primarily trade
futures contracts on commodities and beyond (eq./fix.-inc./forex)
Page 15
Private Capital - funding provided to companies not LOS e
sourced from public markets - explain
Private Equity/ - investments in private companies or public companies

with the intent to take them private
a) LBOs (Leveraged Buyouts)

- acquire public companies or established private companies with a
significant %’age of the purchase price financed through debt
- target’s assets serve as collateral
- target’s cash flows expected to service the debt
- MBO - current mgmt. involved in the buyout
- MBI - management buy-in : new mgmt. involved in the buyout
M.M120501571.
b) Venture Capital - investments in private companies with high growth

potential
- typically start-ups or young companies
- active involvement in portfolio companies
10
Page 16
b) Venture Capital
LOS e
i) formative stage - explain
- pre-seed capital/angel investing idea stage
typically F/F and not VC
- seed stage - support product development and marketing
earliest VC stage efforts
- early stage - moving towards operations but pre-revenue
ii) later-stage financing - post-revenue, pre-IPO

- support growth
iii) mezzanine financing - prepares a company to go public

- bridge financing
- equity investments typically made through convertible preferred shares

- later stage may involve convertible debt
Page 17
c) Other PE strategies/ LOS e
growth capital - minority stakes in more mature - explain
companies to expand or restructure operations,
enter new markets, or finance major acquisitions
Exit Strategies/
a) Trade Sale: sale to a strategic buyer
- auction or private negotiation
- immediate cash exit for the PE fund
- higher valuation from a strategic buyer (vs. financial buyer)
- lower costs thatM.M120501571.
IPO
- lower levels of disclosure
-/ possible opposition by mgmt.

less attractive to employees
limited # of strategic buyers
lower valuation than IPO
11
Page 18
Exit Strategies/ LOS e
b) IPO highest valuation - explain
mgmt./staff buy-in
publicity for the PE firm
future upside if PE firm retains shares
-/ high costs
long lead times
high disclosure requirements
lockup periods that require PE firm to hold shares for a period of
potential weak market on IPO time
c) Recapitalization - lever up the portfolio company, pay a

dividend to the PE firm
- not a true exit but still a liquidity event
d) Secondary Sale - sale to another PE firm
e) Write-off/Liquidation
Page 19
Private Debt: debt provided by investors to private entities LOS e
a) Direct Lending: typically senior secured - explain
- carry higher rates than public debt
- many loans will be leveraged loans
(e.g. Lend $20M at 6%, borrow $10M at 4%, $10M equity)
b) Mezzanine Loan: subordinate to senior secured but senior to equity

- often used for LBOs, recapitalizations and acquisitions
- higher rate than sen. sec. and may also have equity kickers
(warrants, options, conversion rights)
c) Venture Debt: provided to start-up or early stage companies

- typically convertible
M.M120501571. or has warrants
d) Distressed Debt: buying the debt of mature companies with financial

difficulty that have prospects for turnaround
12
Page 20
e) Other: CLOs - private debt that becomes securitized LOS e
into various tranches of credit quality and - explain
equity
unitranche debt - partially secured debt - lower than

senior secured but above senior unsecured
real-estate debt - mortgage

infrastructure debt
specialty loans, e.g. litigation loans
Risk/Return ➞ PE/
PE riskier than public equity plus illiquid, should offer higher
- but is it higher risk-adjusted return? return
- historical data problematic
self report, ∴ subject to survivorship bias which
overstates returns
lack of market prices leads to understatement of
volatility
Page 21
Risk/Return - PD/ illiquidity, higher POD, private market LOS e
inefficiencies lead to potential higher return - explain
but with higher risk
moderate
diversification benefits
M.M120501571. for stocks/bonds
P ➞ .47 to .75
13
Page 21a
Growth LOS e
GDP (30.4%, 1.7x)
Oriented - explain
VC
Growth Equity
(13.3%, 1.6x)
Growth Buyouts
Buy-and-Build
Low to no
Leverage
LBO
Leverage increase
Value
Oriented Mezzanine (9.1%, 1.3x)
Infrastructure
Recapitalizations
Distressed
(11.5%, 1.5x) may
include
leverage
Page 22
Natural Resources/ LOS f
commodities and raw land used for farming and timber - explain
hard ➞ those that are mined/extracted
soft ➞ those that are grown/cultivated
timberland ➞ ownership of land and harvesting of trees for
lumber (income + cap. gain)
farmland ➞ leased or crop shared
Characteristics/
i) commodities - physical standardized products
- cap. gains (price) returns
M.M120501571.
e.g. precious/base metals, energy, agriculture, cash crops

- each may be divided further by physical location and
grade or quality
- commodity indexes typically use futures prices rather than spot prices
- different indexes have different constituents with different weights
14
Page 23
i) commodities LOS f
- traded either physically (rare) or through ETFs/futures - explain
𝐅𝟎 > 𝐒𝟎 , futures curve is upward sloping - contango
𝐅𝟎 < 𝐒𝟎 , futures curve is downward sloping - backwardation
- some ETFs try to avoid contango markets
ii) Timberland/Farmland:
Timberland - income stream based on sale of trees/wood
- factory and warehouse (growth ~ 5%/yr.)
- return from growth, commodity price, cap. gains
Farmland - row crops and permanent crops (nuts, fruits)

- must be harvested regardless of price
- return from quantities, price, land
Page 24
Risk/Return/ LOS f
Commodities - price return, diversification, inflation - explain
protection but with high volatility

- price affected by supply and demand - each commodity
has its own drivers of supply and demand
- supply moves in long cycles (30 year supercycles)

- demand changes much faster than supply
Timber/Farmland - price appreciation + yield
risk = weather, climate, global supply
Diversification benefits:
Commodities - hedge against inflation
- low correlation with other asset classes
M.M120501571.
Timberland/Farmland - low/no correlation with stocks/bonds

- does add ESG considerations to a portfolio
15
Page 25
Instruments/ Commodities LOS f
derivatives - forwards, futures, options, swaps - explain
Exchange-traded products (funds or notes) - futures or physical
- may use leverage, be long or short
Managed futures (CTA)
Specialized funds - private energy partnerships, energy MFs,
- Timberland/Farmland
Investment funds (REITs) or private funds
LOS g
Real Estate/
- explain
owner-occupied ➞ residential housing
commercial ➞ rental properties leased to tenants (including residential)
➞ income producing
Investments can be direct or indirect, equity or debt
Page 26
Real Estate/ LOS g
bond-like long-term income + equity-like capital gains - explain
low correlation with other asset classes
inflation hedge (income and property value)
- direct investing requires large capital investments, illiquid markets,

location sensitive, high transaction costs, low diversification,
professional property management, specialized expertise by area
- basic forms of
real estate
M.M120501571.
investments
16
Page 27
Direct Real Estate Investing/ LOS g
- explain
- purchasing a property or making a loan
- each can be levered
+/ control (tenants, lease, when to sell, what to buy, CAPEX)
taxes ➞ depreciation and interest tax shield
- may be possible to be CF positive but taxable inc. neg.
-/ property management, large capital investments, expertise required
Indirect Real Estate Investing ➞ pooled investment vehicles, public or

private
LLPs, MFs, REITs, ETFs
equity mortgage (mREITS)
Mortgages - loans against property

- fixed or floating, fully/partially amortizing, residential or
- private or public (MBS) commercial
Page 28
Private Fund Investing Styles LOS g
infinite-life open-ended funds - explain
- investors can enter and exit at any time
- offer exposure to core real estate (well-leased, high quality)
- stable returns, primarily from income
core-plus strategies
- non-core markets (secondary or tertiary cities) or properties
with slightly higher leasing risk (hotels, nursing homes)
finite-life closed-end funds

value-added ➞ require modest redevelopment, upgrades or
M.M120501571.
repositioning
opportunistic ➞ development or major redevelopment
- involves the selling of the real-estate asset
17
Page 29
REITs/ - eliminates double corporate taxation as long as LOS g
REIT distributes 90%-100% of taxable rental income - explain
- may also require 75% or more of income produced by
real estate assets (property, debt) or 75% or more of net income
- investors gain liquidity, lower trading costs, and better transparency
Characteristics/
1/ Residential Property - owner-occupied, typically leveraged equity position
2/ Commercial Real Estate - suitable for investors with long investment

horizons and low liquidity needs
- requires day-to-day active mgmt.
- debt typically limited to a max. loan-to-value (LTV)
- property cash flows critical to service debt ratio ~ 75%
3/ REITs - mREITs - invest in mortgage securities

- equity REITs - invest in properties
Page 30
Characteristics/ 4/ MBS - covered in fixed income LOS g
- explain
Risk/Return Characteristics/
Real Estate Indexes

listed REIT indexes - basically like any other
equity index, also investable
Private investment performance

- based on either funds or underlying property performance
- indexes are not investable
- most property-based indexes are appraisal-based which
smooths out volatility
- fund indexes rely on self-report (sample selection bias)
M.M120501571.
Repeat-sales indexes - transaction-based

- more reliable the greater the number of sales per period
- sold properties may not be representative of the
entire market (a form of sample selection bias)
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Risk/Return Characteristics/ LOS g
Risks ➞ interest rate risk - explain
economic conditions (leasing, rates)
operating risk (costs)
financial risk (leverage, securing debt)
Diversification/ ~ 50% of returns (private core, listed real estate)

derived from income
~ moderate correlations with equities and bonds
question remains ➞ does public RE overstate volatility
or does private RE understate volatility
LOS h
Infrastructure/ assets intended for public use, mostly financed, - explain
owned and operated by governments
- growing share being financed privately through
public-private partnerships (PPPs)
Page 32
Infrastructure/ LOS h
- lease assets back to the gov’t., sell assets to the - explain
gov’t., or hold and operate the assets
Investment characteristics/
stable long-term cash flows, inelastic demand, adjusts for inflation
significant capital investment
high barriers to entry
monopolistic and regulated
long operational lives
strategically important allows for
highly leveraged financial structure
defined risks M.M120501571.
Categories/
Social - directed towards human activity (education, health care,
social housing, correctional facilities)
- income derived from lease payments called availability pmts.
- based on the ability of the asset to provide the service
19
Page 33
Categories/ LOS h
Economic - explain
1/ transportation assets - roads, bridges, tunnels, airports,
seaports, rail
- income based on usage - tolls, fees, charges
(thus has market risk)
2/ ICT assets - stores, broadcasts, transmits information or data

(telecom towers, data centers)
3/ Utility and energy assets - generate and transmit power and

produce potable water
(solar, wind, waste-to-energy)
- may also be classified by stage of development
greenfield investments - need to be developed
- build to sell, build to lease, build to operate
- financial investors + strategic investors
Page 34
Categories/ LOS h
brownfield investments - existing assets - explain
- privatized, sale and leaseback, sale from
greenfield project
- financial or strategic investors
Forms of Investment/
direct investment - provides control, large capital investments,
concentration risk, liquidity risk
indirect investment - infrastructure funds, ETFs, company shares
- through equity (77%) or debt
publicly-traded M.M120501571.
infrastructure securities
master limited partnerships (MLPs)
Diversification/ income + some growth

some inflation protection, low exposure to GDP growth
issues
20
Page 35
Risk/Return Characteristics LOS h
- explain
LOS i
- describe
Issues in Performance Appraisal/ AI are generally actively managed
(although there are passive choices)
Sharpe ratio - requires normally distributed returns

- return profiles tend to be asymmetric and skewed
- standard deviation is not a good measure of dispersion
∴ SR is not a good measure of risk-adjusted return
Page 36
Issues in Performance Appraisal/ LOS i
Sharpe Ratio - regardless of shortcomings, ratios of 1-2 - describe
are targeted
- higher is a signal of significant volatility smoothing
(model-based pricing, short-option strategies)
Sortino Ratio - return relative to only downside volatility
- both do not consider the correlation of the AI program with the

rest of the portfolio
- may improve risk/return relationship in a portfolio context
(or not)
Treynor Ratio - measure of excess average return relative to its
M.M120501571.
beta to a relevant benchmark

- the lower the 𝜷, the higher the TR
(note: 𝜷 is historical and may be different in the future)
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Page 37
Issues in Performance Appraisal/ LOS i
Calmar Ratio − 𝐚𝐯𝐠. 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐞𝐝 𝐫𝐞𝐭𝐮𝐫𝐧 (𝐨𝐯𝐞𝐫 𝟑 𝐲𝐫𝐬. ) - describe
𝐦𝐚𝐱𝐢𝐦𝐮𝐦 𝐝𝐫𝐚𝐰𝐝𝐨𝐰𝐧
MAR = 𝐚𝐯𝐠. 𝐜𝐨𝐦𝐩. 𝐫𝐞𝐭. (𝐟𝐮𝐥𝐥 𝐡𝐢𝐬𝐭𝐨𝐫𝐲) max. loss peak to
𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐫𝐚𝐰𝐝𝐨𝐰𝐧 trough
PE/RE Performance Evaluation
Return J-curve - measurement of success

depends far more on the
liquidity events
timing and magnitude of
time
cash flows in and out of
- capital calls investments
- fee drag - use of IRR as a key metric
(since timing of CFs are a key
part of the investment decision)
cash cash inflows
outflows
Page 38
PE/RE Performance Evaluation LOS i
MOIC - multiple of invested capital (money multiple) - describe
𝐃𝐢𝐬𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧𝐬 + 𝐍𝐀𝐕
ignores timing of CFs
𝐏𝐚𝐢𝐝 − 𝐢𝐧 − 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
- less emphasis placed on correlation benefits over shorter periods
NAV may not reflect short-term changes in value
thus understating volatility
- appear to deliver smooth returns over time thus making
PE/RE appear less correlated than they actually are
Quartile Ranking - performanceM.M120501571.

against cohort of peer investments
with same vintage year (year funded)
RE managers also evaluated by the cap. rate being earned on properties

𝐍𝐎𝐈G
𝐏𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐕𝐚𝐥𝐮𝐞
Capital loss ratio = 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐥𝐨𝐬𝐬
- probability of permanent
𝐭𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
impairment of an investment
22
Page 39
Hedge Funds/ LOS i
Leverage - performance measures won’t capture use of - describe
leverage but it may be critical to the strategy
Illiquidity and Potential Redemptions - valuations are important for

calculating performance and NAV
- redemptions have to be met at NAV, so NAV
should reflect liquidation effects
Level 1 asset pricing - exchange-traded, publicly available pricing

Level 2 - broker quotes - use of bid for long positions,
Level 3 - mark-to-model ask for short positions
(L1/L2)
- funds typically have 2 NAVs performance
redemption
Tail-events - low probability, high severity events

- stress testing, scenario analysis used
Page 40
Hedge Funds/ LOS i
- redemptions increase during times of poor performance - describe
- funds charge redemption fees or suspend redemptions
during stress times
- notice periods allow orderly liquidations
- lock-up periods allow time for a strategy to work
LOS j
Custom Fee Arrangements
- calculate
1/ Fees based on liquidity terms and asset size - interpret
- longer lockups = lower fees
- larger investment = lower fees
2/ Founder’s shares - entitle early investors to a lower fee structure

M.M120501571.
(e.g. first $100M)

or/ - early investors get a lower fee once a
certain level of AUM is reached
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Page 41
Custom Fee Arrangements LOS j
3/ Either/or fees - 1% mgmt. fee or 30% incentive above - calculate
- interpret
the hurdle, whichever is greater
- if the 1% mgmt. fee is paid, it reduces the 30% incentive
fee for next year
HF databases and indexes report performance net of fees

(fees can differ by investor, so each investor may
realize a different return)
Example 4, 5, 6
M.M120501571.
24
REVIEW
M.M120501571.
25
Introduction to Alternative Investments

Review - 1
LOS a - describe/ AI - anything other than long-only investments
in stocks, bonds, cash (assets or strategies)
Characteristics/
narrow specialization of mgrs., low correlation w/ traditional assets,
higher fees (mgmt. + incentive), concentrated portfolios,
restrictions on redemptions, limited historical data
Offer: diversification, enhanced risk-adjusted returns, higher yields
Categories: Hedge funds - att. or traditional assets
Private Equity
Private Capital
Private Debt
Real Estate - Private funds or direct investment
Natural Resources - commodities, timberland, farmland
Infrastructure
Others - art, wine, patents, litigation actions
Review - 2
LOS b - describe/ +/ fund mgmt., lower level of investor involvement,
1/ Fund Investing diversification, no expertise required, lower cap. inv.
-/ mgmt. + incentive fees, mgmt. due diligence
+/ follow fund’s lead, lower mgmt. fees, more active investor

2/ Co-Investing
mgmt.
-/ lack of control over investment selection, adverse
selection bias, more active investor mgmt.
3/ Direct Investing +/ no mgmt. fees, flexibility, control

-/ expertise required, low diversification, higher DD, higher
cap. inv.
LOS c - describe/ most funds structured as partnerships
GP - general partner
M.M120501571. LP - limited partner (limited liability)
- governed by LPA - may also be side letters (agreements outside the LPA)
- Real estate funds - trusts/corporations/funds/JVs
- Infrastructure - public/private partnerships
26
Review - 3
LOS c - describe/ Compensation:
- mgmt. fee ➞ 1% - 2% AUM or committed capital
- performance fee (carried interest) - based on excess return above
a hurdle rate
hard hurdle - 20% above that
soft hurdle - 20% of total return if met
- catch-up clause - with without

8% 10% 18% 8% 18%
LP LP
GP 20% GP GP = 20%
80% LP LP = 80%
high-water mark ➞ highest value used to calculate an incentive fee
➞ incentive fees only available above this
Distribution method ➞ waterfall

1/ Deal-by-deal (American) 2/ Whole of funds (European)
- may be subject to a - LPs made 100% whole first
clawback
Review - 4
LOS d - explain/ Hedge funds:
Characteristics - active mgmt., one or more asset classes, use of leverage,
short positions, derivatives, absolute return mandate,
private investment structure, accredited investors, lightly
regulated, restrictions on redemptions (hard lockup - none,
soft lockup - exit for a fee, notice periods of 30-90 days)
Fund-of-funds - invest in HFs: DD expertise, mgr. diversification, 1/10
Strategies: Equity hedge - public equities, long and short

Market neutral (𝜷 = 𝟎)
fundamental long/short - typically net long
M.M120501571.
fundamental value - typically long biased

short-biased - net short
sector-specific - mgr. expertise
Event-Driven - corporate structure events typically
merger arbitrage distressed/restructuring
27
Review - 5
LOS d - explain/ Hedge funds:
Strategies: Event-Driven
Special situations Activist
Relative Value - profit from price discrepancies between
related securities
Convertible bond arbitrage (buy bond, sell stock)
Fixed Income (general) - between 2 issuers, between 2
issues, between 2 parts of the YC
Fixed Income - ABS/MBS
Volatility
Multi-Strategy
Macro and CTA Strategy - economic trends, all asset classes,
long and short
- managed futures - primarily trade futures
Review - 6
LOS e - explain/ Private Capital
Private equity - investments in private companies or public companies

with the intent to take them private
a) LBO (Leveraged Buyout) - buy a company with a significant

amount of debt
MBO - mgmt. buyout
MBI - mgmt. buy-in
b) Venture Capital - investments in private companies with high
growth potential
- typically start-ups/young companies
formative stage later-stage mezzanine financing

post-rev. pre-IPO
pre-seed seed later stage M.M120501571.
idea stage development pre-rev.
c) Others - growth capital - expansion, new markets, restructuring

Exit Strategies/ Trade Sale - strategic buyer
+/ cash exit lower costs than IPO -/ limited # of buyers
higher valuation vs. financial buyer lower valuation than IPO
28
Review - 7
Exit Strategies/ IPO +/ highest valuation, mgmt. buy-in
-/ high costs, long lead times, disclosures
Recapitalization - use debt to issue a dividend to the PE firm
Secondary Sale - sale to a financial buyer
Write-off/Liquidation
Private Debt:
Direct Lending - typically senior secured
Mezzanine Loans - subordinate to senior (LBOs, recaps)
Venture Debt - typically convertible or warrants included
Distressed Debt
Other CLOs unitranche debt (partially secured debt)
mortgages infrastructure debt specialty loans
Risk/Return - PE: riskier than public, illiquid

- indexes are self-report - survivorship bias problem
Review - 8
Risk/Return ➞ PD: illiquid, higher POD, higher yield
Private Equity/Co investments

increasing risk
Mezzanine Debt
and return
Unitranche Debt
Senior Direct Lending
Senior Mortgage
Infrastructure Debt
LOS f - explain/ Natural Resources - commodities, farmland, timberland

Commodities - physical standardized products (price returns)
- indexes typically use futures prices, different constituents
- exposure gained through futures of ETFs
M.M120501571. and weights
Timberland - income + cap. appreciation - both a factory and a warehouse

price land
Farmland - income + cap. app.
crop yield price land
29
Review - 9
LOS f - explain/ Natural Resources low corr. w/other asset classes
Risk/Return - commodities - price return, diversification, inflation protection,
high volatility (supply/demand determined pricing)
- timberland/farmland - price appreciation + yield

risks - weather, climate, global supply
- low corr. with stocks/bonds, adds ESG component
Instruments - commodities - derivatives, ETFs, managed futures, specialized
funds
- timberland/farmland - REITs, private funds, direct investment
LOS g - explain/ Real Estate

owner occupied - residential
income
commercial - any income producing property
capital gains
- Public or private, debt or equity
- low corr. with other asset classes, inflation hedge
Review - 10
Direct Investing - large capital outflows, illiquid, location sensitive, high
transactions costs, low diversification, mgmt. required
Indirect Investing - pooled investment vehicles - public or private

LLPs, MFs, REITs, ETFs
Mortgages - public or private (LLPs, MBS)

LLPs-funds - infinite-life open-ended - core real estate, stable returns
core-plus strategies - non-core markets or properties
finite-life closed-end - value-added or opportunistic
(upgrades) (development)
REITs/ - no corporate tax if > M.M120501571.

90% of taxable income paid as dividends
> 75% of assets in real estate
> 75% of income from rental or interest income
+ liquidity, lower trading costs, exp. mgmt., diversification, transparency
30
Review - 11
1/ Residential Property - owner occupied, leveraged
2/ Commercial Real Estate - long IH, low liquidity needs
- requires active mgmt. + leverage
3/ REITs - equity REIT - own properties
- mREITs - lend money against properties
Real Estate Indexes/

REIT indexes - like any other equity index
Private Investments - based on funds or underlying properties
- most appraisal-based
self-report
- smooths volatility
Repeat Sales Index - transaction-based
- relies on regression with time as the IV (time series)
- more reliable as # of transactions increase
Risks - interest rates, economic conditions, operations, financial
costs leverage, securing debt
Diversification - moderate corr. with equities/bonds
Review - 12
LOS h - explain/ Infrastructure - assets intended for public use
- growing share being financed through public/private partnerships
Investment - lease assets back to gov’t., sell to gov’t., or operate

- stable, long-term CFs, adjusts for inflation, long lived assets,
highly leveraged financial structure
Categories: Social (education, health care, social housing, correctional facilities)

- lease payments called availability payments
Economic (transportation, ICT assets, utility/energy assets)

- may also be classified by stage of development
greenfield - new development (highest risk)
M.M120501571.
brownfield - existing assets (low - medium risk)
Forms of Investment: Direct investment - large capital investments

Indirect investment - infrastructure funds, ETFs, company
shares
31
Review - 13
LOS h - explain/ Infrastructure - income, some growth, inflation
protection, low exposure to GDP growth issues
LOS i - describe/ Issues in performance appraisal

Sharpe ratio ➞ AI return profiles generally not normally distributed
(1-2 targeted) ∴ sd is not a good measure of risk
Sortino ratio ➞ return relative to downside volatility
- both do not consider correlation of AI with rest of portfolio
Treynor ratio ➞ excess avg. return relative to its 𝛃, lower 𝛃, higher TR
(3 yrs.)
Calmer ratio ➞ (avg. annual comp. ret.)/max. drawdown
MAR = (avg. comp. ret.)/avg. drawdown

(full history)
- Performance - J-curve effect

- depends on timing of cash flows
∴ use of IRR liquidity events
- capital calls
- fee drag
Review - 14
LOS i - describe/ Issues in performance appraisal
Hedge funds: perf. measures don’t capture use of leverage
Illiquidity & Redemptions - NAV should reflect liquidation effects

- funds typically have 2 NAVS performance
redemption
Tail events - captured by VaR, stress testing, scenario analysis.
Redemptions - increase during times of poor performance (funds may
even suspend redemptions)
- notice periods, lock-up periods
LOS j - calculate/interpret/ Custom Fee Arrangements
M.M120501571.
longer lockups lower

1/ Fees based on liquidity terms and asset size
larger inv. fees
2/ Founders shares - entitle early investors to a lower fee structure
3/ Either/or fees - 1% mgmt. or 30% incentive, whichever is greater
- if the 1% is paid, reduces 30% incentive fee for
next period
32

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2023 Level 1 - Alternative Investments

Categories, Characteristics, and Compensation Structures of

Performance Calculation and Appraisal of Alternative Investments 7

Private Capital, Real Estate, Infrastructure, Natural Resources, and

© markmeldrum.com. All rights reserved.

Categories, Characteristics, and Compensation Structures of

a. describe types and categories of alternative investments

b. describe characteristics of direct investment, co-investment, and fund investment

c. describe investment and compensation structures commonly used in alternative

Performance Calculation and Appraisal of Alternative Investments

a. describe issues in performance appraisal of alternative investments

Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge

a. explain investment characteristics of private equity

b. explain investment characteristics of private debt

c. explain investment characteristics of real estate

d. explain investment characteristics of infrastructure

e. explain investment characteristics of natural resources

f. explain investment characteristics of hedge funds

Introduction to Alternative Investments

LOS a (5p) Types of Alternative Investments - describe

LOS b (8.5p) Investment Methods - describe

LOS c (7.5p) Investment and Compensation Structures - describe

LOS d (10.5p) Hedge Funds - explain

LOS e (13p) Private Capital (Equity and Debt) - explain

LOS f (16p) Natural Resources - explain

LOS g (16p) Real Estate - explain

LOS h (9.5p) Infrastructure - explain

LOS i (11.5p) Issues in Performance Appraisal - describe

LOS j (9p) Calculating Fees and Returns - calculate/interpret

not just assets but strategies/approaches (i.e. HF/PE)

Characteristics/ narrow specialization of mgrs.

Offer (potentially) broader diversification

Real Estate - directly or indirectly

Infrastructure - capital intensive, long-lived assets

Others - Tangibles (art, wine, collectibles)

➞ involves mgmt. + performance fees

Co-Investing ➞ investor in a fund has the right to invest directly in the

LP - limited partner ➞ investor - limited liability as long as they

- governed by a Limited Partnership Agreement (LPA)

e.g./ extra reporting

e.g./ 20% of return above a hard hurdle rate

may also be consulting and monitoring fees for certain types

- possible that LPs have different HWMs depending on

Distribution Method (PE) ➞ waterfall

both end with

- all HF fees have moderated over time

- typically long-biased (𝛃 > 𝟎), value + small-cap factor

Event-Driven - seek to profit from defined events, typically changes

a) Merger Arbitrage: long the target, short the acquirer

b) Distressed/Restructuring: securities of companies in or near

Relative Value - seek to profit from pricing discrepancies between

a) Convertible Bond Arbitrage - buy the bond, sell the stock

c) Fixed-Income (ABS, MBS, HY) - higher coupon + relative mispricing

d) Volatility - long/short market volatility

Macro and CTA Strategy/ macro: top-down approach to identify

Private Equity/ - investments in private companies or public companies

a) LBOs (Leveraged Buyouts)

b) Venture Capital - investments in private companies with high growth

- early stage - moving towards operations but pre-revenue

ii) later-stage financing - post-revenue, pre-IPO

iii) mezzanine financing - prepares a company to go public

- equity investments typically made through convertible preferred shares