Alternative Investments 2023 Level I High Yield Notes
LM01 Categories, Characteristics, and Compensation Structures of
Alternative Investments
Introduction
Traditional investments refer to long-only positions in stocks, bonds, and cash. All other
investments are classified as alternative investments.
Alternative investments can be divided into three main categories:
Private capital – Includes private equity and private debt
Real assets – Includes real estate, infrastructure, natural resources and others
Hedge funds
The general characteristics of alternative investments are:
Narrow manager specialization
Relatively low correlation with traditional investments
Low level of regulation and less transparency
Limited and potentially problematic risk and return data
High fees because of active management and expertise required in managing
portfolios
Concentrated positions
Restrictions on redemptions
Investment methods
The three methods of investing in alternative investments are:
Fund investing: The investor contributes capital to a fund, and the fund makes
investments on the investors’ behalf, e.g., investments in a PE fund.
Co-investing: The investor can make investments alongside a fund, e.g.,
investments in a portfolio company of a fund.
Direct investing: The investor makes a direct investment in a company or project
without the use of an intermediary, e.g., direct investments in infrastructure or real
estate assets.
Exhibit 2 from the curriculum summaries the advantages and disadvantages of the
different methods of investing.
Advantages Disadvantages
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Alternative Investments 2023 Level I High Yield Notes
Fund Lower level of investor Costly management and
investing involvement as the fund performance fees
managers provide investment Investor must conduct thorough
services and expertise due diligence when selecting the
Access to alternative investments right fund because of the wide
without possessing a high degree dispersion of fund manager
of investment expertise returns
Lower minimum capital Investors less able to exit the
requirements investment as funds typically
have lock-ups and other
restrictions
Co- Investors can learn from the Reduced control over the
investing fund’s process to become better investment selection process
at direct investing compared with direct investing
Reduced management fees May be subject to adverse
Allows more active management selection bias
of the portfolio compared with Requires more active
fund investing and allows for a involvement compared with
deeper relationship with the fund investing, which can be
manager challenging
Direct Avoids paying ongoing Requires more investment
investing management fees to an external expertise and a higher level of
manager financial sophistication resulting
Greatest amount of flexibility for in higher internal investment
the investor costs
Highest level of control over how Less access to a fund’s ready
the asset is managed diversification benefits or the
fund manager’s sourcing
network
Requires more complex due
diligence because of the absence
of a fund manager
Higher minimum capital
requirements
Investment and compensation structures
The most common structure for many alternative investments is a partnership. It consists
of two entities: General partner (GP) who is responsible for managing the fund and making
investment decisions, and limited partners (LPs) who provide capital to the fund in return
for a fractional partnership in the fund.
The general partner typically receives a management fee based on assets under
management (commonly used for hedge funds)or committed capital (commonly used for
private equity). Apart from the management fee, the GP also receives a performance fee
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Alternative Investments 2023 Level I High Yield Notes
(also called incentive fee or carried interest) based on realized profits. A common fee
structure is 2 and 20 which means 2% management fee and 20% performance fee.
Generally, the performance fee is paid only if the returns exceed a hurdle rate. A hurdle rate
of 8% is typically used.
Hard hurdle rate: The GP earns fees on annual returns in excess of the hurdle rate.
Soft hurdle rate: The GP earns fees on the entire annual gross return as long as the
set hurdle is exceeded.
Common investment clauses
Catch-up clause: A catch-up clause allows the GP to receive 100% of the
distributions above the hurdle rate until he receives 20% of the profits generated,
and then every excess dollar is split 80/20 between the LPs and GP
High water mark: In some cases, the incentive fee is paid only if the fund has crossed
the high-water mark. A high-water mark is the highest value net of fees (or the
highest cumulative return) reported by the fund so far for each of its investors.
Waterfall: The waterfall defines the way in which cash distributions will be allocated
between the GP and the LPs. There are two types of waterfalls:
Whole-of-fund (or European) waterfalls: As deals are exited, all distributions go
to the LPs first. The GP does not participate in any profits until the LPs receive
their initial investment and the hurdle rate has been met.
Deal-by-deal (or American) waterfalls: Performance fees are collected on a per-
deal basis. This is more advantageous for a GP as he can get paid before LPs
receive both their initial investment and their preferred rate of return on the
entire fund.
Clawback: A clawback provision allows LPs to reclaim a part of the GP’s
performance fee if the fund makes profitable exits in early years but losses in later
years.
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