LM04 Hedge Fund Strategies 2024 Level II Notes

LM04 Hedge Fund Strategies

1. Introduction and Classification of Hedge Fund Strategies ............................................................... 3

1.1 Classification of Hedge Funds and Strategies ............................................................................... 3
2. Equity Strategies: Long/Short Equity ...................................................................................................... 5
2.1 Long/Short Equity ................................................................................................................................... 5
3. Equity Strategies: Dedicated Short Selling and Short-Biased ......................................................... 7
4. Equity Strategies: Equity Market Neutral ............................................................................................... 9
5. Event-Driven Strategies: Merger Arbirage .......................................................................................... 11
5.1 Merger Arbitrage ................................................................................................................................... 11
6. Event-Driven Strategies: Distressed Securities ................................................................................. 13
7. Relative Value Strategies: Fixed Income Arbitrage .......................................................................... 16
7.1 Fixed-Income Arbitrage ...................................................................................................................... 16
8. Relative Value Strategies: Convertible Bond Arbitrage .................................................................. 18
9. Opportunistic Strategies: Global Macro Strategies .......................................................................... 20
9.1 Global Macro Strategies ...................................................................................................................... 21
10. Opportunistic Strategies: Managed Futures..................................................................................... 22
11. Specialist Strategies ................................................................................................................................... 24
11.1 Volatility Trading ................................................................................................................................ 25
11.2 Reinsurance/Life Settlements ....................................................................................................... 27
12. Multi-Manager Strategies ........................................................................................................................ 28
12.1 Fund-of-Funds ..................................................................................................................................... 28
12.2 Multi-Strategy Hedge Funds........................................................................................................... 31
13. Analysis of Hedge Fund Strategies using a Conditional Factor Risk Model ......................... 32
13.1 Conditional Factor Risk Model ...................................................................................................... 33
14. Evaluating Equity Hedge Fund Strategies: Application ............................................................... 35
15. Evaluating Multi-Manager Hedge Fund Strategies: Application .............................................. 39
16. Portfolio Contribution of Hedge Fund Strategies ........................................................................... 42
16.1 Performance Contribution to a 60/40 Portfolio .................................................................... 42
16.2 Risk Metrics .......................................................................................................................................... 44
Summary ............................................................................................................................................................... 47

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LM04 Hedge Fund Strategies 2024 Level II Notes

This document should be read in conjunction with the corresponding learning module in the 2024
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.

Version 1.0

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LM04 Hedge Fund Strategies 2024 Level II Notes

1. Introduction and Classification of Hedge Fund Strategies

Hedge funds are an important sub-set of alternative investments. They tend to attract the
best investment talent; investors can access this talent by investing in hedge funds.
Many hedge funds claim to offer superior returns, especially when the rest of the market is
underperforming. Hedge funds have low correlation with traditional asset classes such as
stocks and bonds. Therefore, they can provide diversification benefit when added to a
portfolio comprising of traditional asset classes.
However, the superior returns and diversification benefit of hedge funds come at a high
cost. Hedge funds have high fees, complex offering documentation, and often lack full
underlying investment transparency/attribution.
Different hedge fund managers use different strategies which have different risk profiles.
Typically, hedge fund investing requires a long commitment, and there are limited
redemption options available.
Over the last decade, liquid alternatives (liquid alts) have been introduced – which are
based on an ETF structure and invest in various hedge fund-like strategies. They are meant
to provide liquidity and access to hedge funds for average investors. However, liquid alts
have underperformed similar strategy hedge funds; which suggests that perhaps the high
performance of traditional hedge funds is due to their illiquidity.
This reading covers the investment characteristics of the major categories of hedge fund
strategies. Section 1 discusses ways to classify hedge fund strategies. Sections 2 to 12 cover
the following six hedge fund strategies:
• equity-related
• event-driven
• relative value
• opportunistic
• specialist
• multi-manager strategies
Sections 13 to 15 cover the analysis of hedge fund strategies. Finally, section 16 evaluates
the contributions of each hedge fund strategy to the return and risk profile of a traditional
portfolio of stocks and bonds.
1.1 Classification of Hedge Funds and Strategies
Important characteristics of hedge funds include:
• Legal/regulatory requirements: The legal/regulatory requirements for hedge funds
vary across countries. From an investor’s perspective, regulations in most countries
limit access to hedge funds to sophisticated investors with a minimum income or
net-worth requirement. Small investors are generally discouraged from investing in
hedge funds.

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LM04 Hedge Fund Strategies 2024 Level II Notes

From the fund manager’s perspective, hedge funds are far less regulated as
compared to other investment vehicles such as mutual funds.
• Flexible mandates: Due to low legal and regulatory constraints, hedge funds have
very flexible mandates. They can invest in a broad universe of asset classes and
securities. They can use leverage, short positions, and derivatives.
• Large investment universe: As discussed above, due to low regulatory constraints
and flexible mandates, hedge funds have a large investment universe.
• Aggressive investment styles: As compared to traditional investment funds, hedge
funds can pursue aggressive strategies that are relatively riskier, such as significant
shorting, concentrated positions in foreign and domestic securities, etc.
• Relatively liberal use of leverage: To generate significant returns, hedge funds use
significant leverage.
• Hedge fund liquidity constraints: Most hedge funds have lock-up periods. This
allows hedge-funds to pursue relatively illiquid strategies.
• Relatively high fee structures: Hedge funds have relatively high fee structures.
Typically, the fee structure includes a management fee of 1% or more of AUM and an
incentive fee of 10% - 20% of annual returns.
Hedge fund strategies are generally classified based on a combination of:
1. Instrument in which the manager invests
2. Trading philosophy
3. Types of risks the manager assumes
Some of the leading hedge fund index providers are Hedge Fund Research, Inc.; Lipper
TASS; Morningstar Hedge/CISDM; Eurekahedge; and Credit Suisse. Each provider classifies
hedge fund strategies differently.
The curriculum classifies hedge fund strategies into the following six categories and sub-
categories. Each strategy is covered in detail in the subsequent sections.
1. Equity strategies: focus on the equity markets.
• Long/short equity
• Dedicated short bias
• Equity market neutral
2. Event-driven strategies: focus on corporate events, such as mergers and acquisitions,
bankruptcy, etc.
• Merger arbitrage
• Distressed securities
3. Relative value strategies: focus on the relative valuation between two or more
securities.
• Fixed-income arbitrage
• Convertible bond arbitrage

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LM04 Hedge Fund Strategies 2024 Level II Notes

4. Opportunistic strategies: focus on a multi-asset opportunity set using a top-down

approach.
• Global macro
• Managed futures
5. Specialist strategies: focus on niche opportunities that require specialized skill or
knowledge of specific markets.
• Volatility strategies
• Reinsurance strategies
6. Multi-manager strategies: focus on creating a portfolio by combining two or more
strategies.
• Multi-strategy
• Fund-of-funds
2. Equity Strategies: Long/Short Equity
This category of hedge funds primarily invests in equity and equity-related instruments.
They generate alpha by investing in a wide variety of instruments and by using long and
short positions. The classification of equity hedge fund strategies is based on the size and
sign of market exposure. For example, long/short equity hedge fund strategy uses both
long and short positions in equities, but long positions dominate, and the fund is net long
equity.
2.1 Long/Short Equity
• In this strategy, the fund manager buys equities which are expected to rise and sells
equities which are expected to fall.
• This is the most popular hedge fund strategy and represents approximately 30% of all
hedge funds.
• In L/S equity, the fund has a net long position, i.e., long exposure is more than the short
exposure.
• Stock selection is a primary skill set, and market timing ability is a secondary
consideration.
Investment Characteristics
• This strategy has a global opportunity set and diverse investment styles such as
value/growth, large cap/small cap, discretionary/quantitative, and industry
specialization.
• Since stock selection is a primary skill set, many L/S equity managers specialize in
either a specific geographic region, sector, or investment style.
• The approach towards short positions can vary
o Some managers use index-based short hedges to reduce market risk.
o However, most managers use single-name shorts to generate an additional
absolute return and improve portfolio alpha.

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LM06 Private Company Valuation 2024 Level II Notes

LM06 Private Company Valuation

1. Introduction ....................................................................................................................................................... 2
2. Public Vs. Private Company Valuation ..................................................................................................... 2
3. Private Company Valuation Uses and Areas of Focus ........................................................................ 3
4. Earnings Normalization and Cash Flow Estimation ........................................................................... 6
5. Private Company Discount Rates and Required Rates of Return ............................................... 11
6. Valuation Discounts and Premiums ....................................................................................................... 14
7. Private Company Valuation Approaches.............................................................................................. 16
8. Private Company Valuation: Income-Based Approach ................................................................... 27
9. Private Company Valuation: Market-Based Approach ................................................................... 28
Summary ............................................................................................................................................................... 29

This document should be read in conjunction with the corresponding learning module in the 2024
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.

Version 1.0

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 R27 Private Company Valuation 2022 Level II Notes

1. Introduction
Private companies are those whose shares are not listed on public markets. Private
companies range from sole proprietorships to multigenerational family businesses to
publicly traded companies that have been privatized.
This learning module covers:
• Comparison of public and private companies
• Major purposes for which private valuations are performed
• Earnings normalization
• Private company discount rates and required rates of return
• Valuation discounts and premiums
• Private company valuation approaches
2. Public Vs. Private Company Valuation
Exhibit 1 from the curriculum presents features that distinguish private companies from
public companies.

Public companies tend to be relatively mature. Their shares are liquid, i.e. they can be
easily traded. They have greater transparency and standardized disclosures because public
companies are obligated to make timely and high-quality disclosures of financial and other
information. Public companies usually have owner-manager separation; public
shareholders own the company and the management runs the company.
The differences between private and public companies can be categorized into company-
specific and stock-specific factors:
Company specific factors:
Company specific factors include:
• Stage in lifecycle: Typically, private companies tend to be in early lifecycle stages,

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 R27 Private Company Valuation 2022 Level II Notes

whereas public companies tend to be in advanced lifecycle stages. However, some

private companies may also include large, stable, going concerns. The stage of the
lifecycle will influence the valuation process for a company.
• Size: Private companies tend to be smaller in size than public companies and
therefore more risky. Analysts often apply a higher risk premium when valuing
private companies to account for the higher risk.
• Concentrated ownership: Private companies are often characterized by family
ownership or other forms of concentrated control.
• Limited disclosures: There is limited availability of financial information which leads
to greater uncertainty, higher risk, and a lower valuation.
• Overlap of shareholders and management: In most private companies, top
management has a controlling ownership interest. Therefore, they face less pressure
from external investors as compared to public companies and are able to make
decisions based a long-term perspective.
Stock-specific factors:
The stock-specific differences between private and public companies are:
• Liquidity: The stock in private companies is generally much less liquid as compared
to the stock in similar public companies. The limited number of existing and
potential buyers reduces the value of the shares in private companies.
• Concentration of control: Control of private companies may be limited to one or two
investors. This can lead to transactions that benefit controlling shareholders at the
expense of minority shareholders.
• Sale restrictions: Private companies may have agreements in place that limit the
ability to sell shares. These agreements reduce the marketability of the shares.
3. Private Company Valuation Uses and Areas of Focus
Uses of Private Company Valuation
The uses of private company valuation fall into three groups:
• Transaction-related
• Compliance-related
• Litigation-related
This is illustrated in Exhibit 2 of the curriculum.

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 R27 Private Company Valuation 2022 Level II Notes

Transaction-related: Transactions include events that affect the ownership or financing of a

company. The types of transactions include:
• Venture capital financing (early stage): Companies in the development stage often
need external capital. To reduce risk, venture capital investors typically invest
through multiple rounds of financing tied to the achievement of specific objectives
known as ‘milestones.’ Due to the uncertainty of future cash flows, valuations are
usually informal and are based on negotiations between the company and investors.
• Private equity financing (growth or buyout stage): Growth equity funds target
companies with the potential for scalable growth. They usually take a minority
position with the intention of rapidly growing the business.
Unlike VC and growth equity funds which involve minority stake investments,
leveraged buyout funds acquire majority control. They seek to add value by
improving business practices and optimizing the balance sheet.
• Debt financing: Private companies may approach a lender for debt financing. The
lender may perform a valuation to determine the company’s ability to repay debt
from current operating cash flows.
• Initial public offering: An IPO is one liquidity option available to private companies.
Investment banking firms value the company as part of the IPO process by
comparing the private firm with a similar public firm.

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