CFA Level 1 – Alternative Investments

Traditional Investments

• Long-only positions in:
  • Stocks
  • Bonds
  • Cash

These dominate most retail portfolios and are highly regulated and liquid.

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Alternative Investments

A broader set of assets and strategies that fall outside traditional long-only securities.

Grouped into:

• Private Capital
• Real Assets
• Hedge Funds

Analogy:
Traditional investments are like public highways — regulated, visible, and accessible.
Alternatives are private roads — harder to access, less regulated, but sometimes faster or more profitable.

Alternative investments share several defining features:

• Narrow management specialization
• Low correlation with traditional assets
• Less regulation and transparency
• Limited historical data
• Unique legal and tax considerations
• Higher fees
• Concentrated portfolios
• Restrictions on redemptions

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Why Institutions Like Alternatives

• Portfolio diversification
• Potential for higher risk-adjusted returns
• Inflation protection (real assets)
• Access to illiquidity premiums

A. Fund Investing

Definition:
Investor contributes capital to a fund, and the fund manager invests on the investor’s behalf.

Pros

• Access to manager expertise
• Low investor involvement
• Built-in diversification
• Lower minimum capital requirements

Cons

• Highest cost (management + incentive fees)
• Requires fund-level due diligence
• Lock-ups restrict liquidity

Analogy:
Like hiring a professional chef — you get expertise, but you pay for it and don’t control the menu.

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B. Co-Investing

Definition:
Investor:

• Invests in the fund and
• Invests directly in assets identified by the fund

Pros

• Lower management fees
• Learn from fund’s investment process
• More active involvement
• Stronger relationship with fund managers

Cons

• Less control over asset selection
• Adverse selection risk
• Requires more time and expertise

Analogy:
You’re allowed into the kitchen — but the chef still decides what’s cooked.

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C. Direct Investing

Definition:
Investor makes a direct investment in the asset without an intermediary.

Pros

• No management fees
• Maximum flexibility
• Full control over decisions

Cons

• Requires deep expertise
• High minimum capital
• Less diversification
• No access to fund networks

Analogy:
You build the house yourself — no contractor fees, but full responsibility.

Most alternative funds are structured as limited partnerships.

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Limited Partners (LPs)

• Provide committed capital
• Liability limited to capital invested
• Passive investors

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General Partners (GPs)

• Manage the fund
• Make investment decisions
• Unlimited liability
• Earn:
  • Management fees
  • Performance (incentive) fees

Management Fee

• Based on committed capital
• Paid regardless of performance
• Covers operating costs

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Performance (Incentive) Fee

• Paid only if returns exceed a threshold
• Aligns GP and LP interests

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Hurdle Rates

Hard Hurdle Rate (HHR)

• Performance fee applies only to returns above the hurdle
• Example:
  • 8% hurdle → fees charged only on returns above 8%

Analogy:
GP only gets a bonus if they exceed the sales target — and only on the excess.

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Soft Hurdle Rate (SHR)

• If return exceeds hurdle → incentive fee applies to all profits

Analogy:
Once the target is hit, the bonus applies retroactively to the entire year.

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High Water Mark (HWM)

• The highest fund value previously achieved
• Incentive fees only charged on new profits

Purpose:
Prevents GPs from earning fees twice on the same performance.

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Waterfall Structures

Whole-of-Fund (European) Waterfall

• Performance fees paid only after LPs recover:
  • Initial investment
  • Required return

LP-friendly structure

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Deal-by-Deal (American) Waterfall

• Performance fees collected per deal
• GPs earn fees earlier

GP-friendly but riskier for LPs

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Clawback Provision

• Allows LPs to reclaim excess incentive fees
• Used when later losses reveal overpayment to GPs

Analogy:
A year-end bonus adjustment if earlier bonuses were too generous.

Alternative vs Traditional Investments

Feature	Traditional	Alternative
Liquidity	High	Low
Regulation	High	Low
Fees	Low	High
Transparency	High	Limited
Correlation	High	Low

Investment Methods Comparison

Method	Fees	Control	Expertise Required
Fund Investing	High	Low	Low
Co-Investing	Medium	Medium	Medium
Direct Investing	Low	High	High

Hurdle & Waterfall Compensations

Feature	Hard Hurdle	Soft Hurdle
Fee Applies To	Excess returns only	All returns
LP Friendly	More	Less

• Alternative investments differ mainly in liquidity, fees, and transparency
• They provide diversification due to low correlation
• Fund investing is easiest but most expensive
• Direct investing offers control but requires expertise
• LPs provide capital; GPs manage and earn fees
• Hard hurdles protect LPs more than soft hurdles
• High water marks prevent double-charging
• European waterfalls favor LPs; American favor GPs
• Clawbacks protect LPs from premature GP payouts

Alternative investments differ from traditional assets, making standard performance metrics less reliable.

Key Performance Evaluation Issues

• Limited transparency
• Illiquidity
• Complex structures and fees
• Asymmetric return profiles
• Redemption restrictions
• Valuation uncertainty

Analogy:
Evaluating alternatives is like judging a movie before the ending — incomplete information distorts conclusions.

Traditional performance measures assume:

• Frequent pricing
• Liquid markets
• Symmetric returns

These assumptions do not hold for many alternative investments.

Sharpe Ratio

Measures:
Return per unit of total risk$$\text{Sharpe Ratio}=\frac{R_p-R_f}{{\sigma }_p}$$Sharpe Ratio=σp​Rp​−Rf​​

• Penalizes upside and downside volatility equally
• Less useful for skewed return distributions

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Sortino Ratio

Measures:
Return per unit of downside risk$$\text{Sortino Ratio}=\frac{R_p-R_{MAR}}{{\sigma }_d}$$Sortino Ratio=σd​Rp​−RMAR​​

• Focuses only on harmful volatility
• Better suited for asymmetric returns

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MAR Ratio

Measures:
Annualized return relative to maximum drawdown$$\text{MAR Ratio}=\frac{\text{Annual Return}}{\text{Maximum Drawdown}}$$MAR Ratio=Maximum DrawdownAnnual Return​

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Calmar Ratio

Measures:
Annual return relative to max drawdown over past 3 years$$\text{Calmar Ratio}=\frac{\text{Annual Return}}{\text{Max Drawdown (3 yrs)}}$$Calmar Ratio=Max Drawdown (3 yrs)Annual Return​

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⚠️ CFA Rule:
For all ratios above → Higher is better

J-Curve Effect

• Early years:
  • Capital outflows
  • Fees
  • Limited exits
• Later years:
  • Positive cash inflows as investments exit

Analogy:
Like planting an orchard — early costs with no fruit, then harvest years later.

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Why Short-Term Metrics Fail

• Negative early returns distort ratios
• Illiquidity masks true performance
• NAV estimates dominate early valuations

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Internal Rate of Return (IRR)

Most common PE performance metric

• Incorporates timing of cash flows
• Highly sensitive to:
  • Financing rate assumptions for capital calls
  • Reinvestment rate assumptions for distributions

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Multiple of Invested Capital (MOIC)

$$\text{MOIC}=\frac{\text{Realized Value}+\text{Unrealized Value}}{\text{Initial Investment}}$$

• Measures total value created
• Ignores timing of cash flows

CFA Insight:
IRR measures speed of returns, MOIC measures magnitude.

Capitalization Rate (Cap Rate)

$$\text{Cap Rate}=\frac{\text{Net Operating Income (NOI)}}{\text{Market Value}}$$

Where:

• NOI = Rental income − operating expenses

Interpretation:

• Higher cap rate → higher income yield (and often higher risk)

Analogy:
Cap rate is like a rental property’s “earnings yield.”

Leverage Effects

• Leverage magnifies:
  • Gains
  • Losses
• Makes volatility and tail risk more severe

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Redemption Constraints

• Lock-up periods
• Notice periods
• Gates

These restrict investor liquidity and complicate evaluation.

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Valuation Challenges

• Liquid securities: use market prices
• Illiquid securities: use quoted prices or valuation models

Model Risk

• Smoothing returns
• Overstating performance
• Understating volatility

Analogy:
Using models can make returns look “too smooth” — like editing out the bumps in a roller coaster.

Management Fees

• Applied to all assets under management (AUM)
• Charged regardless of performance

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Performance (Incentive) Fees

Designed to align GP/manager incentives with investors

Applied only to profits

Performance Metrics by Asset Class

Asset Class	Common Metric
Private Equity	IRR, MOIC
Real Estate	Cap Rate
Hedge Funds	Sharpe, Sortino, Drawdown Ratios

Risk-Adjusted Ratios

Ratio	Focus
Sharpe	Total volatility
Sortino	Downside risk
MAR	Max drawdown
Calmar	Recent drawdown

• Alternative investments are harder to evaluate due to illiquidity and opacity
• Traditional metrics can mislead due to asymmetric returns
• Sharpe ratio penalizes upside volatility
• Sortino ratio is better for downside risk
• Private equity returns follow a J-curve
• IRR depends heavily on reinvestment assumptions
• MOIC ignores timing but shows total value
• Cap rate measures real estate income yield
• Hedge fund valuation models may smooth returns
• Management fees apply to all AUM; incentive fees apply only to profits

Definition

Capital raised outside public markets, typically through private funds.

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A. Private Equity (PE)

• Equity ownership in private firms or public firms taken private
• Typical holding period: ~5 years
• Goal: operational improvement + exit at higher valuation

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1. Leveraged Buyouts (LBOs)

• Acquisition funded largely with borrowed money
• Debt becomes part of firm’s capital structure
• Leverage magnifies returns and risk

Types

• Management Buyout (MBO): Existing management acquires firm
• Management Buy-In (MBI): External management replaces current team

Analogy:
Buying a house mostly with a mortgage — leverage boosts gains if prices rise.

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2. Venture Capital (VC)

Investments in high-growth, high-risk companies

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Formative (Early) Stage

1. Angel Investing
   • Idea stage
   • Business plan & market analysis
2. Seed Stage
   • Product development
   • Early marketing
3. Early-Stage Financing
   • Before full production/sales

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Later Stage

• After production and sales
• Prior to IPO
• Capital used for expansion

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Mezzanine Stage

• Pre-IPO financing
• Prepares firm for public markets

Analogy:
VC is like nurturing a startup from idea → prototype → scaling → IPO.

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3. Growth Capital

• Minority equity stake
• Invests in established but growing firms
• Funds used for:
  • Expansion
  • Restructuring
  • New markets
  • Acquisitions

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Exit Strategies (Highly Testable)

Trade Sale

• Sell to another company
• Pros: fast, immediate cash, synergies
• Cons: limited buyers, management resistance

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IPO

• Go public
• Pros: highest potential price, publicity
• Cons: high costs, long timeline, disclosure, lockups

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SPAC

• Merge with publicly traded shell company
• Pros: fixed valuation, flexible structure
• Cons: dilution, redemptions, sponsor fees

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Other Exits

• Recapitalization (dividends via leverage)
• Secondary sale (to another PE firm)
• Write-off / liquidation

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B. Private Debt

Debt financing provided to non-public firms

Types

Type	Description
Direct Lending	Loans to firms unable to borrow from banks
Mezzanine Debt	Subordinate, often unsecured
Venture Debt	Debt for early-stage firms
Distressed Debt	Buy debt of troubled firms
Unitranche	Blended senior & subordinated debt

Core Features

• Rental income + capital appreciation
• Inflation hedge
• Low correlation with traditional assets

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Unique Characteristics

• Large capital requirements
• Illiquidity
• Property uniqueness
• Fixed location
• Requires professional management

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Categories

Residential

• Single-family, multi-family
• Typically leveraged

Commercial

• Offices, retail, warehouses
• Rental income focus

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REITs (Very Testable)

• Pool investor capital
• Invest in real estate
• Avoid double taxation
• Types:
  • Equity REITs
  • Mortgage REITs

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Real Estate Indexes

• Appraisal indexes
• Repeat sales indexes
• REIT indexes

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Forms of Real Estate Investing

Method	Features
Direct	Control + tax benefits, high expertise
Indirect	Funds, REITs, mortgages
Mortgages	Fixed cash flows, prepayment risk
Private Funds	Open-end, infinite life
REITs	Liquid, diversified income

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Real Estate Risks

• Economic cycles
• Interest rates
• Regulation
• Unexpected costs
• Leverage risk

Definition

Long-lived, capital-intensive assets providing essential public services

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Categories

Economic Infrastructure

• Transportation (roads, airports)
• Utilities & energy
• Telecom & data centers

Social Infrastructure

• Schools
• Hospitals

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Stage of Development

Stage	Risk
Brownfield	Lower, stable cash flows
Greenfield	Higher risk, higher return

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Infrastructure Risks

• Demand risk
• Operational risk
• Construction risk
• Financing risk
• Regulatory & political risk
• Currency & tax risk

Commodities

Standardized physical products

Types

• Hard: oil, metals
• Soft: agricultural products

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Pricing Relationship

$$F_0=S_0(1+r)+\text{Storage Costs}-\text{Convenience Yield}$$

• Contango: $F_0>S_0$
• Backwardation: $F_0<S_0$F0​

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Investment Methods

• Direct ownership
• Derivatives (futures, options)
• Indexes
• ETPs
• Managed futures
• Commodity funds

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Benefits

• Diversification
• Inflation protection
• Return potential

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Digital Commodities

• Blockchain-based assets
• Include tokens and virtual currencies

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Timberland

• Income from timber sales
• Acts as:
  • Factory (tree growth)
  • Warehouse (storage)

Returns

• Biological growth
• Commodity prices
• Land appreciation

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Farmland

• Crop/livestock production
• Returns from:
  • Harvest sales
  • Commodity prices
  • Land appreciation

Event-Driven

• Merger arbitrage
• Distressed
• Activism
• Special situations

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Relative Value

• Convertible bond arbitrage
• Fixed income arbitrage
• ABS
• Volatility strategies

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Macro

• Top-down economic bets
• Interest rates, FX, inflation

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Equity Hedge

• Long/short equity
• Market neutral
• Growth
• Value
• Short-biased
• Sector-specific

Alternative Asset Classes

Asset	Key Return Driver
Private Equity	Operational improvement
Real Estate	Income + appreciation
Infrastructure	Stable cash flows
Commodities	Price changes
Hedge Funds	Strategy execution

• Private capital operates outside public markets
• PE returns enhanced via leverage and active management
• VC investments follow firm life-cycle stages
• Exit strategy choice critically affects returns
• Real estate offers income, diversification, inflation hedge
• Infrastructure provides stable, long-term cash flows
• Commodity prices driven by storage, convenience yield
• Contango vs backwardation affects futures returns
• Hedge funds use leverage, short selling and complex strategies
• Fund-of-funds improve access but add fees