Reading 59: performance calculation and appraisal of alternative investments

Question 1

Standard deviation is least likely an appropriate measure of risk for:
hedge funds.
publicly traded REITs.
exchange-traded funds.

Answer 1

Hedge funds may hold illiquid assets that may use estimated values to calculate returns. Risk as measured by standard deviation could be understated. For publicly traded securities, such as REITs and ETFs, standard definitions of risk are more applicable. (LOS 59.a)

Question 2

A hedge fund has a return of 30% before fees in its first year. The fund has a management fee of 1.5% on end-of-year fund value and a 15% incentive fee, with an 8% hard hurdle rate on gains net of the management fee. The return after fees for an investor in this fund is closest to:
20.5%.
21.5%.
25.0%.

Answer 2

This is easiest to see with an assumed initial value. Assume 100 was invested.
Year-end gross value = 130

Management fee = 1.5% × 130 = 1.95

Gains net of management fee = 30 – 1.95 = 28.05

Hurdle gains = 8% × 100 = 8

Incentive fee = 15% × (30 – 1.95 – 8) = 3.0075

Total fees = 1.95 + 3.0075 = 4.9575

Ending value after fees = 130 – 4.9575 = 125.0425

Return after fees = 125.0425/100 – 1 = 25.0425%

(LOS 59.b)

Question 3

A private equity fund has a “2 and 20” fee structure with the incentive fee independent of management fees. The fund will sell a holding for a profit of 9%. The hurdle rate is specified as 8%. The provision that would result in an incentive fee of 1% is:
a hard hurdle rate.
a soft hurdle rate.
a catch-up provision.

Answer 3

With a catch-up provision, the limited partners get the first 8% of gross return and the general partner gets all returns above that to a maximum of 2%, and gains above that are shared 80% to the limited partners and 20% to the general partner.
With a soft hurdle rate of 8%, the incentive fee would be 20% of 9%, or 1.8%.

With a hard hurdle rate of 8%, the incentive fee would be 20% of (9% – 8%), or 0.2%.

(LOS 59.b)