Definition : Performance fees distributed to executives are reimbursed when a company incurs losses after profits. To ensure that the clause is respected, a percentage of the performance fee can be deposited in an Escrow account.

Chap 3 - Quantitative Foundations Flashcards by Jorge V.C Enrique

What is the classic yield and it’s formula ?

Definition : Rate of return at which an asset changes value

Return = ( Final value - Initial value ) / Initial value

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What is the notional yield and it’s formula ?

Definition : Yield calculation based on contract notional amount

Notional Yield = Change in value of contract / Notional Value

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What is the return based on fully collateralized position and it’s formula ?

Definition : Calculating the return on the combination of a contract and a hypothetical investment equivalent to the notional amount

Rfcoll = ln(1+R) + Rf

R = Change in value of contract, divided by preceding price or notional value

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What is the return based on partially collateralized position and it’s formula ?

Definition : Calculation of the return on the combination of a contract and a notional
percentage.

Rpcoll = [l * ln (1+R)] + Rf

1/l = Required ammount of collateral

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What is a Internal Rate of Return (IRR) and it’s types ?

Definition : Discount rate equivalent to the present value of cash inflows and outflows

Types of IRR:
* Lifetime
* Interim
* Since-inception

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What is a IRR - Lifetime ?

Definition : Contains all cash flows realized or anticipated over the life of the investment

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What is a IRR - Interim / Since-inception ?

Definition : Calculation of the internal rate of return before all cash flows are returned to the LP.

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What are the problems with IRR ?

Problems with the IRR :
* Potential multiple values fir the IRR
* Does not take investment size into
account
* Reinvestment assumption

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What is a IRR modified and it’s formula ?

IRR Modified :
* Solves the problem with multiple IRRs
* Rule for the reinvestment hypothesis
problem

MIRRt = (FV of positive cash flows at the reinvestment rate / -PV of negative cash flows at capital cost) ^ 1/t -1

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What is a Cascading cash distribution (Cash Waterfall) ?

Cascading cash distribution (Cash Waterfall)
* Limited Partnerships have provisions for the distribution of income between
General Partners (GP) and Limited Partners (LP).

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What are the Cascading cash distribution (Cash Waterfall) characteristics ?

Performance fees
Hurdle Rate
Catch-up provision
Clawback
Vesting

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What are the performance fees in the cash waterfall distribution ?

Performance fees :

Carried Interest: Private Equity I Real Estate
Incentive Fee: Hedge Funds

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What are the distribution performance fees in the cash waterfall distribution ?

Distribution of performance fees :

Fund-as-a-whole Carried Interest
Deal-by-deal Carried Interest

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What is Clawback ?

Definition :

Performance fees distributed to executives are reimbursed when a company
incurs losses after profits.
To ensure that the clause is respected, a percentage of the performance
fee can be deposited in an Escrow account.

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What is a hard hurdle rate ?

Definition :
* Limits performance fees on profits in excess of hurdle rate

Example :
Let’s consider a 10M fund with a 20% performance fee that has generated 2M in profits. The
fund is subject to a 10% hard hurdle rate.

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What is a soft hurdle rate ?

Definition :
* Enables performance fees to be charged when the hurdle rate has been
exceeded on all profits.

Example:
Let’s consider a 10M fund with a 20% performance fee that has generated 2M in profits.
The fund is subject to a 10% soft hurdle rate.

What simple interest and how does it work ?

Simple interest is an interest rate computation approach that does not
incorporate compounding. But returns are often compounded. For example, earning
10% over one year is equivalent to earning 9.64% per year compounded quarterly:
[1 + (.0964∕4)]^4 = 1.10.

What is continuous compounding and Discrete compounding ?

Continuous compounding assumes that earnings can be instantaneously reinvested to generate additional earnings. Discrete compounding includes any compounding interval other than continuous compounding such as daily, monthly, or annual.

Define the internal rate of return (IRR) ?

The internal rate of return (IRR) can be defined as the discount rate that equates the present value of the costs (cash outflows) of an investment with the present value of
the benefits (cash inflows) from the investment. Using the terminology and methods
of finance, the IRR is the discount rate that makes the net present value (NPV) of an
investment equal to zero.

What is a borrowing type cash
flow pattern ?

A borrowing type cash
flow pattern begins with one or more cash inflows and is followed only by cash outflows. An example of the borrowing pattern is when an investment such as a real
estate project is sold and leased back. The divestment generates current cash at the
cost of future cash outflows and may be viewed as a form of borrowing.

What is a multiple
sign change cash flow pattern ?

A multiple
sign change cash flow pattern is an investment where the cash flows switch over time
from inflows to outflows, or from outflows to inflows, more than once. An example of a multiple sign change investment would be a natural resource investment
involving (1) negative initial cash flows from purchasing equipment and land to set
up an operation such as mining, (2) positive interim cash flows from operations, and
(3) negative terminal cash flows from ceasing operation and restoration expenses.

In fact, the maximum number of possible IRRs is
equal to the number of sign changes. When more than one IRR is calculated, none of
the IRRs should be used. There is no easy way for the IRR model to overcome this
particular shortcoming.

True

What is a Scale difference ?

Scale differences are when investments have
unequal sizes and/or timing of their cash flows. When comparing investments with
different scales, an investment with a higher IRR may be inferior to an investment
with a lower IRR.

Why is modified IRR (MIRR) usefull ?

The modified IRR approach addresses the
challenges of multiple IRRs and the restrictiveness of the reinvestment assumption in the IRR approach by discounting all project cash outflows into a present value using
a financing rate, compounding all cash inflows into a future value using an assumed
reinvestment rate, and calculating the modified IRR as the discount rate that sets
the absolute values of that future value and that present value equal to each other.

To address this problem, the modified IRR (MIRR) imposes userspecified rates to compound all cash inflows forward to the project’s termination date
and discount all cash outflows back to the project’s inception date.

However, the MIRR approach is viewed as having substantial disadvantages that make it a rarely used approach relative to the IRR. Note that the values of CC and RR chosen by the user drive the value of the resulting MIRR. For example, a high RR combined with a low CC will cause the MIRR to be high by increasing the future value of the distributions and lowering the present value of the contributions. So unlike IRR, MIRR is driven by user-selected rates (RR and CC) that conceptually are unrelated to the project.

True

What are time-weighted returns and Dollar-weighted returns ?

1- Time-weighted returns are averaged returns that assume that no cash was contributed or withdrawn during the averaging period, meaning after the initial investment. 2- Dollar-weighted returns are averaged returns that are adjusted for and therefore reflect when cash has been contributed or withdrawn during the averaging period. The IRR is the primary method of computing a dollar-weighted return.

What is a hurdle rate ?

A hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees. When a fund has a hurdle rate, the first priority of cash profits is to distribute profits to the LPs until they have received a rate of return equal to the hurdle rate. Thus, the hurdle rate is the return threshold that a fund must return to the fund’s investors, in addition to the repayment of their initial commitment, before the fund manager becomes entitled to incentive fees.

What is a catch-up provision ?

A catch-up provision permits the fund manager to receive a large share of profits once the hurdle rate of return has been achieved and passed. A catch-up provision gives the fund manager a chance to earn incentive fees on all profits, not just the profits in excess of the hurdle rate. A catch-up provision contains a catch-up rate, which is the percentage of the profits used to catch up the incentive fee once the hurdle is met. A full catch-up rate is 100%. To be effective, the catch-up rate must exceed the rate of carried interest.

What is Vesting ?

Vesting is the process of granting full ownership of conferred rights, such as incentive fees. Rights that have not yet been vested may not be sold or traded by the recipient and may be subject to forfeiture.

What is a clawback clause ?

A clawback clause, clawback provision, or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses. A clawback provision requires the GP to return cash to the LPs to the extent that the GP has received more than the agreed profit split. A GP clawback option ensures that if a fund experiences strong performance early in its life and weaker performance at the end, the LPs get back any incentive fees until their capital contributions, expenses, and any preferred return promised in the partnership agreement have been paid.

What is a compensation scheme ?

The compensation scheme is the set of provisions and procedures governing management fees, general partner investment in the fund, carried-interest allocations, vesting, and distribution.

The term carried interest tends to be used in private equity and real estate; the term incentive fee is more often used in hedge funds.

True

Carried interest can be fund-as-a-whole carried interest, which is carried interest based on aggregated profits and losses across all the investments, or can be structured as deal-by-deal carried interest. Deal-by-deal carried interest is when incentive fees are awarded separately based on the performance of each individual investment.

True

Explain the sequence of cash distributions of a hard hurdle rate:

The sequence of cash distributions with a hard hurdle rate is as follows: 1. Capital is returned to the limited partners until their investment has been repaid. 2. Profits are distributed only to the limited partners until the hurdle rate is reached. 3. Additional profits are split such that the fund manager receives an incentive fee only on the profits in excess of the hurdle rate.

What is a soft hurdle rate ?

A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved.

Explain the sequence of cash distributions of a soft hurdle rate:

The sequence of cash distributions with a soft hurdle rate is as follows: 1. Capital is returned to the limited partners until their investment has been repaid. 2. Profits are distributed only to the limited partners until the hurdle rate is reached. 3. Additional profits are split, with a high proportion going to the fund manager until the fund manager receives an incentive fee on all of the profits.