Reading 58: categories, characteristics and compensation structures of alternative investments

Question 1

Compared with managers of traditional investments, managers of alternative investments are likely to have fewer restrictions on:
holding cash.
buying stocks.
using derivatives.

Answer 1

Traditional managers can hold cash and buy stocks but may be restricted from using derivatives. (LOS 58.a)

Question 2

Compared with alternative investments, traditional investments tend to:
be less liquid.
be less regulated.
require lower fees.

Answer 2

Traditional investments typically require lower fees, are more regulated, and are more liquid than alternative investments. (LOS 58.a)

Question 3

An investor that wants to gain exposure to alternative investments but does not have the in-house expertise to perform due diligence on individual deals is most likely to engage in:
co-investing.
fund investing.
direct investing.

Answer 3

With fund investing, due diligence on the fund’s portfolio investments is a responsibility of the fund manager rather than the fund investors. Direct investing and co-investing require greater due diligence of individual deals on the part of the investor. (LOS 58.b)

Question 4

Management fees for a private capital fund are determined as a percentage of:
invested capital.
committed capital.
assets under management.

Answer 4

For a private capital fund, management fees are a percentage of committed capital rather than invested capital. For a hedge fund, management fees are a percentage of assets under management. (LOS 58.c)

Question 5

For an investor in a private equity fund, the least advantageous of the following limited partnership terms is:
a clawback provision.
a European-style waterfall provision.
an American-style waterfall provision.

Answer 5

An American-style waterfall structure has a deal-by-deal calculation of incentive fees to the general partner. In this case, a successful deal where incentive fees are paid, followed by the sale of a holding that has losses in the same year, can result in incentive fees greater than those calculated with a European-style (whole-of-fund) waterfall. A clawback provision benefits the limited partner investors by allowing them to recover incentive fees paid earlier if the fund realizes losses later. A clawback provision coupled with an American-style waterfall will result in the same overall incentive fees as a European-style waterfall if the transactions occur in subsequent years. (LOS 58.c)