02 - Alternative Investments

• Not a traditional investment like stocks or bonds

• Often involves non-public or illiquid assets

• Includes things like real estate, hedge funds, private equity

1. Real assets (e.g., real estate, timber, commodities)

2. Hedge funds

3. Private equity

4. Private debt

5. Structured products

• Real assets are physical things (like land or commodities)

• Financial assets are paper claims (like stocks and bonds)

• Real assets can protect against inflation

1. Publicly traded real estate (REITs)

2. Liquid alternatives (mutual funds with hedge fund strategies)

3. Business development companies (BDCs)

1. Used to mean low-risk, income-focused assets

2. Now includes private equity, hedge funds, and real assets

3. Shift driven by regulation and market evolution

1. Return computation (IRR, time-weighted, etc.)

2. Statistical analysis (e.g., skewness, kurtosis)

3. Valuation methods (DCF, comparables)

4. Portfolio methods (e.g., optimization with illiquidity)

1. They are often illiquid

2. Market prices may be inefficient

3. Returns may not be normally distributed

4. Information can be limited or private

1. Achieve higher returns (alpha)

2. Manage risk better

3. Exploit inefficiencies (e.g., arbitrage)

4. Diversify the portfolio

5. Avoid outdated strategies

1. Absolute return: Compared to the risk-free rate

2. Relative return: Compared to a benchmark index

3. Alternative investments often aim for absolute return

1. Takes advantage of price differences

2. Involves buying and selling similar assets

3. Pure arbitrage is risk-free

4. Most arbitrage includes some risk

1. Enhanced return + public = Hedge Funds

2. Enhanced return + private = Private Equity

3. Risk control + public = Real Assets

4. Risk control + private = Private Credit or Real Assets

1. Pension plans

2. Endowments and foundations

3. Family offices

4. Sovereign wealth funds

1. Private limited partnerships

2. Hedge fund platforms

3. Master limited partnerships (MLPs)

4. Separately Managed Accounts (SMAs)

5. Mutual funds (’40 Act) and UCITS funds

1. Large investment banks

2. Brokers and dealers

3. Front office: investment and client work

4. Middle office: risk and compliance

5. Back office: operations and systems

1. Prime brokers

2. Accountants and auditors

3. Legal counsel

4. Fund administrators (NAV, P&L, investor statements)

1. Maintain general ledger account

2. Mark a fund’s books

3. Maintain fund records

4. Perform monthly accounting

5. Provide P&L statements and calculate returns

6. Verify asset existence

7. Independently calculate fees

8. Provide unbiased 3rd-party price confirmation

9. Produce capital account statements

10. Apportion fund income/loss among investors

1. Financial platforms

2. Financial software

3. Financial data providers

They safeguard and hold assets (e.g., Depository Trust Company – DTC).

They are fee-based advisors; many serve as Fund-of-Funds (FoF) managers for clients.

1. Germany allows universal banking (both commercial & investment services).

2. Prohibited in the U.S.

3. Japan allows cross-ownership; large banks monitor borrower management.

1. Buy-and-hold strategies matching index risk-return

2. Limited liability with minimal investor control

They provide limited liability and distribute profits; LLCs protect investors from losses beyond investment.

A bankruptcy-remote entity used to separate legal and financial risks from the parent firm.

GPs create a parent LLC and form two LLCs:

• One as GP

• One as investment adviser LPs contribute most capital.

1. Bottom – Portfolio companies

2. Middle – PE funds holding portfolios

3. Top – PE firms acting as GPs

Tax-efficient structure where:

• Master fund holds investments

• Feeder funds (onshore/offshore) provide investor access

1. Private-placement memorandum (PPM)

2. Partnership agreement (LPA)

3. Subscription agreement

4. Management company operating agreement

1. Investor protection clauses (strategy, key-person)

2. Economic terms (management fees, etc.)

1. Adverse selection (misleading entry)

2. Moral hazard (post-contract misconduct)

3. Hold-up problem (opportunistic behavior after investment)

1. Corporate governance (LPAC, voting rights)

2. Investment objectives, fund size & term

3. Management fees & expenses

1. MiFID: EU directive on financial instruments

2. AIFMD: Regulates managers of alternative investment funds in the EU

• FIFs (Australia)

• SICAVs/SICAFs/SIFs (Europe)

• ICAVs (Ireland)

1. Master-feeder based structure

2. Exempted vehicles

3. $100k min. investment (CIMA)

4. No investment risk restrictions

• Management fees: based on committed or invested capital, lower for large funds

• Incentive fees / carried interest: profit-sharing, key GP incentive

• Other fees: should ideally offset management fees

1. LPs claw back incentive fees from GP if returns < preferred return

2. Applies when unrealized gains > actual gains

3. Clawback escrow: part of incentive fee held until liquidation or > preferred return

1. Hurdle zone: 100% of profit to LPs until capital + preferred return

2. Catch-up zone: 100% to GP until carried interest % is met

3. Full carried-interest zone: shared (e.g., 80% LP / 20% GP)

1. Excessive risk-taking (high hurdles)

2. Gaming of realization timing

• ~1% of fund capital

• Tied to GP's personal wealth

• Discourages excessive risk-taking

If key person leaves/stops contributing, LPs may suspend or terminate the fund

• Master-feeder based structure

• Exempted vehicles

• $100k min. investment (CIMA)

• No investment risk restrictions

1. Bad leaver: for-cause GP removal

2. Good leaver: LPs stop funding with majority vote if fund is failing

Fund management covenants:

• Size, use of debt, co-investing restrictions, profit distribution GP activity covenants:

• Investment limits, share sale limits, fundraising restrictions, expertise requirements

Primary: IPOs, secondary issues, securitization Secondary: Trading existing securities via

• Limit order, Market order, Bid-ask spread, Market making

• Third: Exchange-listed trades OTC

• Fourth: Trades via ECNs Pros: lower costs, fast/easy trading Cons: less transparency, more info asymmetry

• Systemic risk: loss due to major participant failure Regulation includes:

1. Establishment (e.g. registration)

2. Distribution/marketing limits

3. Operational limits (e.g. leverage)

4. Reporting rules

1. Borrow → sell → post margin with broker

2. Rebate/substitute dividend to lender

3. Stock rise = borrower may post cash

4. Stock fall = buy low, return stock, pocket spread

5. Calculation : Capital gain/loss

   • Rebate – Dividend – Commission

1. Special stock – Hard to borrow, high fees; may include negative rebate

   • General collateral stock: Not in high demand

2. Crowded shorts – Many traders hold similar short positions

3. Lack of stock supply – Borrowing revoked, forcing buy-in

4. Short squeeze – Forced exit at high prices

5. Forced liquidation – Buy shares in market to close position if no lender available

• Public securities; used by most HFs

• Indefinite lifespan

• Fees: % AUM + incentive (high-water mark)

• May close to new subscriptions

• Lock-ups:

  
  

  • Hard: no redemption

  • Soft: redemption with fee

  
  

• Gates: limit redemptions

• Semi-liquid closed-end funds

• Repurchase some shares periodically

• No secondary trading

• Focus on private securities

• Unregistered; managed by GPs

• Fixed life: raise capital, invest, return capital

• May request all capital upfront

• Capital called as needed

• Managers state target size

• Investors commit capital

• GPs issue capital calls

• GPs choose exit and distribute proceeds

• Market risk

• Liquidity risk

• Funding risk

• Realization risk (depends on GP value creation, equity market conditions, company-specific issues)

• Diversified portfolio

• Exposure to liquid assets

• Cap total capital call

• Diversify across companies and exits

• HFs: regular incentive fees (quarterly), PE: at exit

• HFs: fees before capital return, PE: after

• HFs: no clawbacks, PE: often clawbacks

• HFs: rarely use hurdle rates

• Alt strategies in liquid, transparent ETFs

• Growth: diversification, shift to DC plans

• Unconstrained clones

• Constrained clones

• Liquidity-based replication

• Skill-based replication

• Hedge fund replication

• Closed-end mutual funds

• Leverage

• Concentration

• Illiquidity

• Leverage

• Liquidity

• Lower total fees (liquid alts)

• Managerial skill and expertise

• FoF Investing: AO invests in a FoF, which invests in funds run by GPs.

• PE Fund Investing: AO invests directly in a fund managed by a GP.

• Co-investing: AO also takes direct stake in the asset.

• Partnership: AO forms partnership with GP or other AOs.

• Solo: AO acquires asset stake alone (most active).

1. Solo investing – Requires most management from AOs.

1. Partnership investing – Enables larger deals, risk-sharing.

2. Co-investment – GP invites AO to invest outside the fund.

   
   

   • Lower fees, access to GP skills.

   
   

• Main fund’s portfolio companies

• Top-up fund (future investments)

  
  

  • Annex fund = for existing investments

  
  

• Deal-by-deal programs

➡️ No universal model; LPs must indicate interest early on.

• Lock-step provision: Same terms as GP/LP.

• Bridge financing (bridging): GP invests temporarily, sells to co-investors later.

• Fee structures:

  
  

  1. No fees

  2. 0% management fee, 20% carry

  3. 1% annual fee, 10% carry

  
  

• LPs can enhance returns with lower/no fees

• Some LPs pay promote = profit-based incentive fee

• Passive / lower resource needs:

  
  

  • Co-investment within FoF

  • Multi-manager co-investment fund

  
  

• Active / higher resource needs:

  
  

  • Deal-by-deal program

  • Direct investment in company

  • LPs investing in GP-managed fund

  
  

🖼️ Includes 2D matrix showing passive-to-active vs. single-to-portfolio deal positions.

• Traditional PE fund: GP leads all stages

• Co-investment: Shared responsibilities

• Partnership: AO takes increasing responsibility

• Solo investment: AO handles full process

🖼️ Includes table showing stages from research to asset sale by investment type.

Advantages:

• No double management fees

• Better returns, targeted allocations

• Improved diversification, dilution control

• Enhanced monitoring and fund access

• Reduced J-curve

Disadvantages:

• Unbalanced portfolios

• Higher fiduciary risk

• Conflicts and disagreements among LPs

• Fee allocation challenges

Challenges for LPs:

• In-house resources and expertise

• Access to co-investments

• Reduced diversification

• Organizational constraints

Challenges for GPs:

• Few LPs execute co-investments

• Deal process delays

• Additional costs/resources

• Strained LP relationships

• Fang et al: Co-investments underperform (higher risk/principal-agent issue)

• Braun et al: Co-investments outperform (larger data set)

• Costs lower than fund investments

• No evidence of GPs offering lower-quality deals to LPs

Top 3 GP motives for offering co-investments:

1. Stronger LP relationships

2. Access to additional capital

3. Improved fundraising success

• Build internal expertise and staff

• Source own co-investments

• Efficient approval process

• Manage co-investment program risks

• Can reduce J-curve: Capital deployed immediately; no fees for years

• Can magnify J-curve: Broader outcome exposure