MODULE #1: Alternative Investment Features, Methods, and Structures

Key Notes:

●​ What are Alternative Investments?

○​ They're not traditional assets like public equity, fixed-income, or cash. Simple as that.
○​ Grouped because they have distinct characteristics, not similar ones.
○​ Often offer greater diversification and higher expected returns than traditional
investments.
○​ Typically involve longer-term, illiquid investments in less efficient markets.
○​ Require specialized knowledge to evaluate and manage.
○​ Rely on complex and richer compensation structures to align manager and investor
incentives over longer periods.
●​ Distinguishing Features
○​ Need for specialized knowledge to value cash flows and risks.
○​ Typically low correlation of returns with traditional assets.
○​ Illiquidity, long investment time horizons, and large capital outlays.
○​ Incentive-based fees to address/minimize information asymmetry.
○​ Performance appraisal challenges.
○​ Size and type may be prohibitively large for certain investors, usually suited for
sophisticated investors with long horizons (e.g., pension funds, sovereign wealth
funds, endowments).
●​ Categories of Alternative Investments
○​ Private Capital: Broad term for funding to companies not from public equity or debt
markets. Includes private equity and private debt.
■​ Private Equity: Investment in privately owned companies or public companies
with intent to take them private. Used in mature life cycle or for firms in decline
(e.g., Leveraged Buyouts).
■​ Venture Capital (VC): Specialized form of private equity for non-public
companies in early life cycle or startup phase, often with high growth potential.
■​ Private Debt: Capital provided as a loan or other form of debt to private entities
(e.g., venture debt, distressed debt).
○​ Real Assets: Tangible physical assets like real estate (land, buildings) and natural
resources, also intangibles like patents. Generate current/expected future cash flows
or are a store of value.
■​ Real Estate: Borrowed or ownership capital in buildings or land (commercial,
industrial, residential). Public forms include REITs and MBS.
■​ Infrastructure: Special type of real asset, typically land, buildings, and long-lived
fixed assets for public use, providing essential services (e.g., bridges, toll
roads). Often developed via Public-Private Partnerships (PPPs). Creates cash
flows from fees or promotes economic growth.
 ■​ Natural Resources: Less developed land (farmland, timberland, mineral
exploration) or naturally occurring standardized products (commodities).
■​ Land-based (Farmland, Timberland): Returns from price appreciation
and cash flows (crop yields, lease payments, timber harvests, drilling
rights). Can have ESG purposes (e.g., carbon offsets).
■​ Commodities: Standardized, traded goods (plant, animal, energy,
mineral products). Do not generate cash flows directly, but benefit from
price changes. Can be countercyclical and inflation hedges.
○​ Hedge Funds: Private investment vehicles distinguished by investment approach
(leverage, derivatives, short selling) rather than underlying investments (which can be
traditional or alternative).
○​ Digital Assets: Umbrella term for assets created, stored, transmitted electronically
with ownership/use rights (e.g., cryptocurrencies, tokens, digital collectibles).
■​ Cryptocurrencies: Native asset of a blockchain (e.g., Bitcoin, Ethereum).
■​ Tokens: Built on an existing blockchain (e.g., ERC-20 tokens on Ethereum).
●​ Alternative Investment Methods
○​ Fund Investment: Investor contributes capital to a fund, and the fund identifies,
selects, and makes investments on the investor's behalf. Full outsourcing of control.
■​ Pros: Suitable for investors with limited resources/experience.
■​ Cons: High fees (management + performance), little investor leeway, less
frequent transparency, pre-commitment of funds, extended non-sale period.
○​ Co-Investment: Investor invests indirectly through a fund but also has rights to invest
directly in the same assets alongside the fund.
■​ Pros: Greater investor effort/control, lower fees than fund-only (e.g., reduced or
zero performance fees), expands knowledge/experience.
■​ Benefits for Manager: Accelerates investment timing when funds are
insufficient, expands scope of new investments, increases diversification of
existing fund.
○​ Direct Investment: Investor makes a direct investment in an asset without an
intermediary.
■​ Pros: Maximum flexibility and control over investment choice, financing, and
timing.
■​ Cons: Typically reserved for larger, most sophisticated investors with sufficient
skills, knowledge, and resources for specialized oversight.
●​ Alternative Investment Structures
○​ Ownership Structures: Often use partnerships (e.g., limited partnerships) for flexibility
in risk/return allocation and responsibilities.
■​ Limited Partnership (LP):
■​ General Partner (GP): Manages the fund, theoretically bears unlimited
liability. Agrees to manage fund operations under a standard of care.
■​ Limited Partners (LPs): Outside investors with fractional interest,
liability capped at their investment. Play passive roles, not involved in
management (though co-investment rights allow direct investment).
Commit to future investments, upfront cash outflow can be small.
 ■​ Limited Partnership Agreement (LPA): Establishes terms (profit/loss
distribution, manager roles, investment criteria, transfers, withdrawals,
dissolution).
■​ Side Letter: Supplemental document between GP and one or more
LPs, overriding or modifying original LPA terms for unique investor
requirements (e.g., transfer rights, fee treatment, co-investment rights,
reporting). Can include "most favored nation" clauses.
■​ Other Structures: Trusts, Limited Liability Companies (LLC).
■​ Publicly Traded Structures: Master Limited Partnerships (MLPs) for real
estate/natural resources (more liquid, publicly traded). REITs, commodity funds,
ETFs for liquid alternative assets.
●​ Compensation Structures
○​ More complex than traditional investments due to illiquidity, complexity, and long-term
nature; aims to align GP/LP incentives.
○​ Management Fee: Fixed percentage (e.g., 1%–2%).
■​ Hedge funds: % of Assets Under Management (AUM).
■​ Private equity: % of Committed Capital (total committed by LPs for future
investments). This reduces GP incentive to deploy capital quickly, encouraging
selectivity.
○​ Performance Fee (Incentive Fee / Carried Interest / Carry): Percentage of periodic
fund returns.
■​ Earned only after a Hurdle Rate (minimum return) is achieved.
■​ Hard Hurdle Rate: GP earns fees only on returns in excess of the
hurdle.
■​ Formula: rGP = max[0, p(r – rh)]
■​ Soft Hurdle Rate: GP earns fees on the entire return once the hurdle is
exceeded (catch-up clause).
■​ Formula (with catch-up): rGP = max[0, rcu + p(r – rh –
rcu)]
■​ High-Water Mark: Fund's peak value (net of fees). Manager cannot charge
performance fees until fund value exceeds previous high-water mark. Protects
LPs from paying twice for same returns.
■​ Clawback Provision: Grants LPs the right to reclaim a portion of GP's
performance fee, typically activated if GP earns early profits but incurs later
losses, leading to aggregate fund underperformance. More common in illiquid,
long-term PE/real estate.
○​ Waterfall Structure: Determines cash flow distribution between GPs and LPs. GPs
usually get disproportionately larger share of total profits to incentivize maximization.
■​ Deal-by-deal (American) Waterfall: More advantageous to GP. Performance
fees collected per deal before LPs receive initial investment and preferred
return on entire fund.
■​ Whole-of-fund (European) Waterfall: More advantageous to LPs. All
distributions go to LPs as deals exit; GP participates only after LPs receive
initial investment and hurdle rate on aggregate fund.
Mind-Map Outline:

●​ Main Node: Alternative Investment Features, Methods, and Structures

○​ Introduction
■​ Distinct from traditional investments
■​ Offer diversification, higher returns
■​ Longer-term, illiquid, less efficient markets
■​ Require specialized knowledge
■​ Complex compensation structures
○​ Alternative Investment Features
■​ Specialized knowledge for valuation
■​ Low correlation with traditional assets
■​ Illiquidity, long horizons, large capital
■​ Incentive-based fees
■​ Performance appraisal challenges
■​ Suited for sophisticated investors
○​ Alternative Investment Categories
■​ Private Capital
■​ Private Equity (LBO, Venture Capital)
■​ Private Debt (Venture Debt, Distressed Debt)
■​ Real Assets
■​ Real Estate (Commercial, Residential, REITs)
■​ Infrastructure (PPPs, essential services)
■​ Natural Resources (Farmland, Timberland, Commodities)
■​ Hedge Funds (distinguished by investment approach)
■​ Digital Assets (Cryptocurrencies, Tokens)
○​ Alternative Investment Methods
■​ Fund Investment
■​ Outsourced control
■​ Higher fees
■​ Limited investor leeway
■​ Co-Investment
■​ Alongside fund
■​ Lower fees, more control than fund investing
■​ Direct Investment
■​ Maximum flexibility & control
■​ For sophisticated investors
○​ Alternative Investment Structures
■​ Ownership Structures
■​ Limited Partnership (LP)
■​ General Partner (GP): Unlimited liability, manages fund
■​ Limited Partner (LP): Limited liability, passive role
■​ Limited Partnership Agreement (LPA): Governs terms
■​ Side Letter: Tailored terms for specific LPs
■​ Other: Trusts, LLCs, MLPs, REITs
■​ Compensation Structures
 ■​ Management Fee (AUM for HFs, Committed Capital for PE)
■​ Performance Fee (Carried Interest)
■​ Hurdle Rate (Hard vs. Soft)
■​ rGP = max[0, p(r – rh)] (Hard Hurdle)
■​ rGP = max[0, rcu + p(r – rh – rcu)] (Soft
Hurdle with Catch-up)
■​ High-Water Mark: No fees until previous peak exceeded
■​ Clawback Provision: LPs reclaim fees for later losses
■​ Waterfall Structures
■​ Deal-by-deal (American): GP paid per deal
■​ Whole-of-fund (European): LP paid first on aggregate

Module Summary:

Alternative investments are distinct from traditional assets, often offering diversification and higher
expected returns for a trade-off of illiquidity, longer horizons, and less efficient markets. They
necessitate specialized knowledge and use complex fee structures like management and
performance fees, often with hurdle rates, high-water marks, and clawback provisions to align
incentives. Investors can access alternatives through fund investing (for limited
resources/experience), co-investing (some control, lower fees), or direct investing (maximum control,
for sophisticated investors). Limited partnerships are common ownership structures, differentiating
general partners (unlimited liability, active management) from limited partners (limited liability,
passive). Understanding these features, methods, and structures is fundamental for CFA candidates
to grasp how these unique investments operate and are compensated.

Exam Tips:

●​ Always understand why alternative investments exist (diversification, returns) and their
inherent trade-offs (illiquidity, complexity).
●​ Distinguish clearly between the three investment methods (fund, co-investment, direct) and
who they are suitable for. Think about the level of control and fees.
●​ Master the compensation structures: management fees (committed vs. AUM), performance
fees, hurdle rates (hard vs. soft), high-water marks, and clawback provisions. You'll likely need
to calculate these.
●​ Know the GP/LP relationship in limited partnerships.
MODULE #2: Alternative Investment Performance and Returns

Key Notes:

●​ Performance Appraisal of Alternative Investments

○​ More challenging than traditional assets due to unique features.
○​ Distinct Features Impacting Appraisal:
■​ Staggered capital commitments and longer required investment horizons.
■​ Unique patterns of cash flows (IRR is key).
■​ Use of borrowed funds (leverage magnifies gains/losses).
■​ Illiquid positions and valuation challenges (fair value hierarchy).
■​ More complex fee structures and tax/accounting treatment.
■​ Returns are usually less normally distributed.
●​ Investment Life Cycle
○​ Typically longer than traditional assets, with distinct phases:
■​ Capital Commitment: Initial fees/expenses, little to no income. Negative
returns.
■​ Capital Deployment: Cash outflows exceed inflows (e.g., construction,
turnaround expenses). Management fees further reduce returns.
■​ Capital Distribution: Assets appreciate, generate excess income, fund
realizes capital gains from liquidation/exit (e.g., IPOs). Positive returns.
○​ J-curve Effect: Represents the initial negative return in the commitment phase,
followed by acceleration through deployment, and leveling off as capital is distributed.
●​ Return Measures
○​ Internal Rate of Return (IRR): Often the preferred measure for long-lived alternative
investments (e.g., private equity, real estate). It accounts for the timing and magnitude
of cash flows.
■​ Calculation: Sum of (CFt / (1+r)^t) = 0. Requires assumptions on financing and
reinvestment rates.
○​ Multiple of Invested Capital (MOIC) / Money Multiple: Shortcut measure.
■​ Formula: MOIC = (Realized value of investment + Unrealized
value of investment) / Total amount of invested capital
■​ Key limitation: Ignores the timing of cash flows. Easier to understand.
●​ Use of Borrowed Funds (Leverage)
○​ Increases investment returns by allowing larger market positions. Magnifies both gains
and losses.
○​ Formula for Leveraged Rate of Return: rL = r + Vb/Vc(r – rb)
■​ rL: Leveraged portfolio return
■​ r: Cash portfolio return
■​ Vc: Cash investment
■​ Vb: Borrowed funds
■​ rb: Borrowing rate
 ○​ Hedge funds use derivatives or prime broker borrowing (margin). Margin calls magnify
losses if not met.
○​ Leveraged return > cash return if r > rb.
●​ Valuation Challenges (Fair Value)
○​ Illiquidity makes performance appraisal and comparison difficult.
○​ Investments recorded at Fair Value (market-based, exit price).
○​ Fair Value Hierarchy (ASC 820 / IFRS 13):
■​ Level 1: Quoted prices in active markets for identical assets (e.g., public
equity). Most reliable.
■​ Level 2: Inputs other than Level 1 quoted prices, directly or indirectly
observable (e.g., OTC derivatives pricing models using market data).
■​ Level 3: Unobservable inputs used when there's little market activity (e.g.,
private equity, real estate using cash flow projection models). Most challenging.
○​ Level 3 assets can lead to smoothed or overstated returns and understated volatility if
values are anchored to cost or not regularly marked to market. Requires independent
testing, benchmarking, and consistent application of valuation models.
●​ Alternative Investment Returns (Impact of Fees)
○​ Complex, customized fee arrangements (management + performance fees) vary
based on size, timing, and terms of investor participation.
■​ Fees based on liquidity terms and asset size: Longer lockups or larger
investments can mean lower fees.
■​ Founders Shares: Lower fee structure for early participants in startup funds.
■​ "Either/Or" Fees: Manager chooses between low management fee or high
incentive fee, whichever is greater.
○​ Fee Calculation Formulas:
■​ GP Return (currency terms, independent fees): RGP = (P1 × rm) +
max[0, (P1 – P0) × p]
■​ GP Return (net of management fee): RGP(Net) = (P1 × rm) + max{0,
[P1(1 – rm) – P0] × p}
■​ GP Return (net of management fee + hard hurdle): RGP(Net with Hurdle)
= (P1 × rm) + max{0, [P1(1 – rm) – P0×(1.06)] × p}
■​ GP Return (High-Water Mark): RGP(High-Water Mark) = (P2 × rm) +
max[0, (P2 – PHWM) × p]
■​ Investor Periodic Rate of Return: ri = (P1 – P0 – RGP)/P0
○​ Investor Redemptions: Can force liquidation at disadvantageous prices.
■​ Redemption Fees: Discourage early redemption, offset transaction costs for
remaining investors.
■​ Notice Period: Required time to notify fund of redemption intent (e.g., 30-90
days), allows orderly liquidation.
■​ Lockup Period: Minimum holding period before withdrawals, allows manager
time to implement strategy. Soft lockup allows early redemption with a fee.
■​ Gate: Limits or restricts redemptions for a period, usually at manager
discretion.
○​ Relative Alternative Investment Returns and Survivorship Bias
 ■​ Selection Bias: Inconsistent fund allocation to peer groups, voluntary reporting
leads to overestimation.
■​ Survivorship Bias: Exclusion of failed funds from indexes leads to overly
optimistic return expectations. Mitigation: include returns of funds of funds.
■​ Backfill Bias: Inclusion of past performance data for newly reported successful
funds, increasing average reported returns. Larger indexes have less.
■​ Time Lag: Performance data often published with a delay (e.g., 4 weeks/1
month).
■​ Non-Investable Indexes: Difficult to replicate performance.
■​ Equal vs. AUM-Weighted: Many indexes are equal-weighted, skewing
comparisons.

Mind-Map Outline:

●​ Main Node: Alternative Investment Performance and Returns

○​ Introduction
■​ Unique features complicate performance measurement
○​ Performance Appraisal
■​ Comparability Challenges with Traditional Assets
■​ Timing of cash flows
■​ Use of borrowed funds (leverage)
■​ Valuation of portfolio positions
■​ Complex fee structures & tax treatment
■​ Investment Life Cycle
■​ Capital Commitment (negative returns)
■​ Capital Deployment (outflows > inflows)
■​ Capital Distribution (gains realized)
■​ J-curve effect (initial negative, then acceleration)
■​ Return Measures
■​ Internal Rate of Return (IRR)
■​ Preferred for long-lived investments
■​ Accounts for timing of cash flows
■​ Multiple of Invested Capital (MOIC)
■​ MOIC = (Realized value + Unrealized value) /
Invested capital
■​ Ignores timing
■​ Leverage
■​ Magnifies gains/losses
■​ rL = r + Vb/Vc(r – rb)
■​ Margin calls
■​ Valuation Challenges
■​ Fair Value Hierarchy
■​ Level 1: Observable prices (public equity)
■​ Level 2: Observable inputs (OTC derivatives)
■​ Level 3: Unobservable inputs (PE, RE)
 ■​ Level 3: Smoothed/overstated returns, understated volatility
■​ Fees & Investor Returns
■​ Complex fee arrangements
■​ Fees based on liquidity/size
■​ Founders Shares
■​ "Either/Or" Fees
■​ Fee Calculations
■​ Formulas for RGP (independent, net, hurdle, HWM)
■​ Formula for ri (investor return)
■​ Redemption Terms
■​ Redemption Fees, Notice Periods, Lockup Periods, Gates
■​ Relative Returns & Biases
■​ Selection Bias
■​ Survivorship Bias (exclusion of failed funds)
■​ Backfill Bias (inclusion of past data for new funds)
■​ Time Lag, Non-Investable Indexes, Weighting Issues

Module Summary:

Appraising alternative investments is inherently more complex than traditional assets due to their long
investment life cycles (J-curve), unique cash flow patterns, use of leverage, and illiquidity, which
complicates valuation (especially Level 3 assets). Key performance measures are IRR (preferred,
accounts for timing) and MOIC (simpler, ignores timing). Fee structures are intricate, involving
management fees (often on committed capital for private equity), performance fees, hurdle rates,
high-water marks, and clawback provisions, all impacting net investor returns. Beware of biases in
hedge fund indexes like survivorship and backfill bias, which can overstate reported performance.
Understanding these nuances is critical for accurately evaluating and comparing alternative
investment performance.

Exam Tips:

●​ Know the J-curve phases and how cash flows look.

●​ Understand when to use IRR (timing matters) versus MOIC (simple multiple). Be ready to
calculate MOIC.
●​ The Fair Value Hierarchy (Level 1, 2, 3) is a big deal for illiquid assets. Know why Level 3 is
problematic.
●​ Review the fee modification calculations (hurdle rates, high-water marks) and how they impact
GP and LP returns.
●​ Be able to explain survivorship bias and backfill bias. These are common traps in hedge fund
performance data.
MODULE #3: Investments in Private Capital: Equity and Debt

Key Notes:

●​ Private Capital Overview

○​ Broad term for funding to companies not sourced from public markets or traditional
institutions.
○​ Primary sub-categories: private equity and private debt.
●​ Private Equity Investment Characteristics
○​ Similarities with Public Equity: Direct ownership, voting rights, claim to residual cash
flows/dividends, capital gains as primary driver of returns.
○​ Differences from Public Equity: Private equity allows more direct control due to
significant shareholdings. Requires specialized industry knowledge.
○​ Strategies:
■​ Leveraged Buyout (LBO): Acquire public or private companies with significant
debt financing (target's assets as collateral, cash flows service debt). Often
called "going private" transactions. Managers add value by improving
operations, cutting costs, making acquisitions. Returns highly depend on
leverage.
■​ Management Buyout (MBO): Current management participates.
■​ Management Buy-in (MBI): Current management replaced.
■​ Venture Capital (VC): Investment in private companies with high growth
potential (start-ups, young companies).
■​ Injected at various stages (concept to near-IPO).
■​ VCs are active investors.
■​ May provide financing as equity or convertible debt (for protection).
■​ Stages of Venture Capital (Exhibit 2 is key here):
■​ Pre-seed Capital (Angel Investing): Idea stage, small financing
from individuals.
■​ Seed-stage Financing: Product development, marketing. First
stage VC funds typically invest.
■​ Early-stage Financing (Start-up VC): Moving towards operation,
prior to commercial production.
■​ Later-stage Financing (Expansion VC): After commercial
production, before IPO. Supports
growth/expansion/improvements. Management may sell control.
■​ Mezzanine-stage Financing (Mezzanine VC): Bridge financing to
fund a private firm until IPO/sale. Distinction is timing, not
method (can use equity-debt hybrids).
■​ Convertible preferred shares common in startups for investor
protection/seniority over common shareholders.
■​ Growth Capital (Minority Equity Investing): Less-than-controlling interest in
more mature companies seeking capital for expansion, restructuring, market
entry, acquisitions. Management often retains control.
 ■​ PIPE (Private Investment in Public Equity): Private offering to select
investors in already-publicly traded companies. Faster, cheaper capital
raising than public offerings, common in "work-out" or "rescue"
situations. Dilutive to existing shareholders, new investors demand
discount.
●​ Private Equity Exit Strategies
○​ Firms seek to improve and then exit at higher valuations (average 5-year holding).
○​ Maximize return by selling/auctioning to highest bidder.
○​ Investment period (first 5 years) and harvesting period (exit).
○​ Main Strategies: (Exhibit 3 provides Pros/Cons)
■​ Trade Sale: Sell portion/division to a strategic buyer (direct sale or auction).
■​ Advantages: Premium from synergies, fast/simple execution, lower
transaction costs, confidentiality.
■​ Disadvantages: Potential management/employee resistance (job
security, higher public monetization), limited universe of buyers,
regulatory scrutiny.
■​ Public Listing:
■​ Initial Public Offering (IPO): Most common, company sells shares to
public investors via underwriters.
■​ Advantages: Highest potential price, increased visibility, retained
upside for PE firm, management support.
■​ Disadvantages: High transaction fees, long lead time, onerous
disclosure, stock market volatility, lockup period. Not suitable for
all companies.
■​ Direct Listing: Equity floated on public markets without underwriters,
reducing complexity/cost.
■​ Special Purpose Acquisition Company (SPAC): "Blank check"
company acquires unspecified private company.
■​ Advantages: Extended disclosure time, fixed valuation (lower
volatility/uncertainty), flexible structure, association with
high-profile sponsors.
■​ Disadvantages: Higher capital costs (dilution, warrants),
valuation spread, deal risk, regulatory scrutiny (SEC
reconsidering), post-merger stockholder overhang.
○​ Other Exit Strategies:
■​ Recapitalization: Firm increases/introduces leverage to portfolio company to
pay itself a dividend. Not a true exit, but extracts money, improves IRR.
■​ Secondary Sale: Sale of company to another private equity firm or financial
buyers. Growing trend.
■​ Write-off/Liquidation: Investment loses value, firm revises value downward or
liquidates.
●​ Risk–Return from Private Equity Investments
○​ Higher-return opportunities due to investing in private companies, management
influence, and use of leverage.
○​ Riskier than common stocks; requires higher return for illiquidity and leverage risks.
 ○​ Challenges in Measuring Performance:
■​ Unreliable published indexes (self-reporting, survivorship bias, backfill bias).
Overstates returns.
■​ Lack of mark-to-market (prior to 2008 crisis), illiquidity leads to understated
volatility and correlations.
■​ Need for data adjustments and independent valuations (quarterly/annually).
●​ Private Debt Investment Characteristics
○​ Directly provided by investors to private entities. Expanded post-2008 due to reduced
traditional lending.
○​ Investors receive interest and principal return; debt is typically secured with covenants.
○​ Categories: (Exhibit 4 links to corporate life cycle)
■​ Venture Debt: Funding for start-up/early-stage companies (little/negative cash
flow). Often line of credit/term loan. Complements equity, avoids dilution. May
have equity participation features for increased risk.
■​ Direct Lending: Capital provided directly to borrowers (mid-market firms, other
PE funds). Typically senior, secured, with fixed payments and covenants.
Higher interest rates than bank loans, for entities lacking traditional financing.
■​ May involve Leveraged Loans: Private debt firms borrow money to
finance the debt, then extend it to another borrower, enhancing return.
■​ Mezzanine Debt: Subordinated to senior secured debt but senior to equity.
Used for LBOs, recapitalizations. Riskier due to junior ranking/unsecured
status; demands higher interest rates and often equity participation (warrants,
conversion rights).
■​ Distressed Debt: Buying debt of mature companies in financial difficulty
(bankruptcy, default). Investors expect debt to increase in value.
■​ Turnaround investors: More active in management/direction to
restructure/revive.
■​ Debtor-in-Possession (DIP) Financing: Provides operating funds for
firms already in bankruptcy.
■​ Unitranche Debt: Hybrid/blended loan combining secured/unsecured debt
tranches into single loan with single blended interest rate. Usually structured
between senior/subordinated in priority.
■​ Specialty Loans: Extended to niche borrowers (e.g., litigation finance).
●​ Risk–Return of Private Debt
○​ Higher-yielding opportunities than traditional bonds due to market inefficiencies,
illiquidity premium.
○​ Offers increased portfolio diversification.
○​ Interest rate often floating (e.g., SOFR + bps).
○​ Requires specialized knowledge (company life cycle, debt structure, underlying
assets).
○​ Riskier than traditional bonds: Senior private debt (moderate risk/yield), mezzanine
(higher growth/risk, equity upside).
○​ Challenges: Lack of good-quality data, artificially smooth returns.
●​ Diversification Benefits of Private Capital
○​ Performance depends on specific life cycle phase, company performance, and risk.
 ○​ Vintage Year: Year a fund makes its first investment. Critical for comparative
purposes.
■​ Vintage Diversification: Investing across multiple vintage years to offset
adverse performance effects of ill-timed fund launches (e.g., investing in a
high-valuation environment before a crash).
■​ Funds seeded in expanding cycles do well with early-stage companies; those in
contracting cycles do well with distressed companies.
○​ Risk/Return Across Capital Structure: Private equity (riskiest, highest return) down
to infrastructure debt (safest). (Exhibit 6)
○​ Low Correlation with Public Assets: Private capital funds can add moderate
diversification to public stocks/bonds. Correlations vary (0.63 to 0.86), but generally
lower than traditional assets.
○​ Excess Returns: Possible from skillful managers due to additional leverage, market,
and liquidity risks.

Mind-Map Outline:

●​ Main Node: Investments in Private Capital: Equity and Debt

○​ Private Capital Definition
■​ Not public market sourced
■​ Sub-categories: Private Equity, Private Debt
○​ Private Equity Investment Characteristics
■​ Similarities to Public Equity (ownership, cash flow)
■​ Differences (direct control, specialized knowledge)
■​ Strategies
■​ Leveraged Buyout (LBO)
■​ Management Buyout (MBO)
■​ Management Buy-in (MBI)
■​ Venture Capital (VC)
■​ Stages: Pre-seed, Seed, Early-stage, Later-stage,
Mezzanine-stage
■​ Convertible preferred shares
■​ Growth Capital (Minority Equity)
■​ PIPE (Private Investment in Public Equity)
■​ Exit Strategies
■​ Trade Sale
■​ Public Listing
■​ IPO
■​ Direct Listing
■​ SPAC
■​ Other: Recapitalization, Secondary Sale, Write-off/Liquidation
■​ Risk-Return
■​ Higher Returns, Higher Risks (illiquidity, leverage)
■​ Measurement Challenges (biases, lack of mark-to-market)
○​ Private Debt Investment Characteristics
■​ Definition: Debt directly to private entities
 ■​ Categories
■​ Venture Debt (early-stage, avoids dilution)
■​ Direct Lending (senior, secured, for underserved borrowers)
■​ Leveraged Loans
■​ Mezzanine Debt (subordinated, equity participation)
■​ Distressed Debt (companies in financial difficulty)
■​ Debtor-in-Possession (DIP) Financing
■​ Unitranche Debt (blended loan)
■​ Specialty Loans
■​ Risk-Return
■​ Higher yields than traditional bonds
■​ Illiquidity premium, diversification benefits
■​ Requires specialized knowledge
○​ Diversification Benefits of Private Capital
■​ Vintage Year & Diversification (invest across multiple years)
■​ Risk-Return Levels by Category (equity > debt)
■​ Moderate Diversification with Public Assets (low correlation)

Module Summary:

Private capital, encompassing both private equity and private debt, provides funding outside public
markets. Private equity aims for high returns through strategies like LBOs and venture capital, actively
managing companies and leveraging debt. Exit strategies include trade sales and public listings (IPO,
SPACs), alongside recapitalizations and secondary sales. Private debt fills lending gaps, offering
higher yields through direct lending, venture debt, mezzanine, and distressed debt. Both face
measurement challenges and illiquidity risk. A key concept for private capital is the "vintage year," and
investors diversify across these years to mitigate business cycle timing risk. Overall, private capital
offers moderate diversification benefits to traditional portfolios due to its lower correlation with public
assets.

Exam Tips:

●​ Know the corporate life cycle stages and which private equity/debt fits where.
●​ Understand the purpose and mechanics of LBOs and PIPEs.
●​ Be able to list and distinguish the various private equity exit strategies. Pros and cons are
important.
●​ Familiarize yourself with the different types of private debt and their risk profiles.
●​ Vintage Year and Vintage Diversification are key concepts for managing timing risk in
private capital. Don't forget why they matter!
●​ Understand the general diversification benefit (low correlation) of private capital with traditional
assets.
MODULE #4: Real Estate and Infrastructure

Key Notes:

●​ Real Estate Features and Characteristics

○​ Definition: Land and buildings (developed land).
○​ Categories: Residential (single/multi-family, largest sector by value, >75% global
value) and Commercial (office, retail, industrial, warehouse, hospitality).
○​ Unique Features:
■​ Heterogeneity: No two properties are identical (location, age, tenant mix, lease
terms).
■​ Large Initial Investment: Typically significant capital outlays.
■​ Fragmentation: Local demand/supply conditions determine value, not a single
market.
■​ Price Discovery Challenges: Opaque private markets, historical prices may
not reflect current, high transaction costs, limited activity.
■​ Costly & Time-Consuming Transactions: Involves many professionals.
■​ Requires specialized knowledge for selection, valuation, management,
divestment.
●​ Real Estate Investment Structures
○​ Direct Real Estate Investment: Purchasing a property, originating debt for own
account.
■​ Advantages: Control (buy/sell timing, capital projects, tenants, lease terms),
Tax Benefits (depreciation, interest deduction), Diversification (historically low
correlation with other asset classes).
■​ Disadvantages: Complexity, need for specialized/local knowledge, significant
capital needs, concentration risk (hard to diversify for smaller investors), lack of
liquidity, high transaction costs.
■​ Owners may hire advisors or use separate accounts.
○​ Indirect Real Estate Investment: Pools assets from different investors.
■​ Forms: Limited partnerships, mutual funds, equities, REITs, ETFs, joint
ventures.
■​ Real Estate Investment Trusts (REITs): Tax-advantaged trusts that own,
operate, develop income-producing real estate.
■​ Types: Equity REITs (invest in properties), Mortgage REITs (loans to
RE/MBS), Hybrid REITs.
■​ Main Appeal: Elimination of double corporate taxation (distribute
90-100% of taxable net rental income as dividends).
■​ Business Strategy (Equity REITs): Maximize occupancy/rents,
minimize expenses to maximize cash income/dividends.
■​ Advantages (Publicly Traded REITs): Greater transparency, easier
trading (shares vs. direct property), not forced to sell underlying real
estate during redemptions, professional management.
 ■​ Disadvantage (Publicly Traded REITs): Higher correlation with public
equity markets than private real estate.
■​ Open-End Funds: Infinite-life, allow contribution/redemption like mutual
funds. Focus on Core real estate strategies (well-leased, high-quality,
stable income).
■​ Closed-End Funds: Finite-life, used for opportunistic investments
(development, redevelopment).
●​ Real Estate Investment Characteristics
○​ Sources of Returns: Income generation (rental/lease payments) + potential price
appreciation.
■​ Over half of commercial RE returns from income (stable, predictable).
○​ Risk and Return Spectrum (Exhibit 4 is key):
■​ Low Risk/Low Return: Senior Debt (first mortgages, investment-grade
CMBS). Bond-like.
■​ Core: Stable income-producing, long-term leases, low default risk (e.g.,
residential, sale-leaseback). Bond-like returns from lease payments.
■​ Core-Plus: Modest refurbishment/upgrades, tenant repositioning. Higher
risk/return, main source still leases but acquisition/maintenance costs higher.
■​ Value-Add: Larger-scale redevelopment, repositioning. Returns increasingly
equity-like, price appreciation meaningful.
■​ Opportunistic: Distressed properties, property development. Highest
risk/return. Equity-like. Subject to regulatory issues, construction delays, cost
overruns, economic changes.
○​ Inflation Protection: If leases adjust regularly. Varies by location, segment, time.
○​ Leverage: Magnifies gains/losses, increases default risk.
●​ Real Estate Diversification Benefits
○​ Historically low correlations with other asset classes (stocks, bonds).
○​ Can increase portfolio diversification and reduce risk.
○​ Public REITs have higher correlation with public equity than private real estate.
●​ Infrastructure Investment Features and Characteristics
○​ Definition: Real, capital-intensive, long-lived assets for public use, providing essential
services.
○​ Purpose: Societal, economic, technological, social development.
○​ Cash Flow Sources: Contractual payments (availability, usage-based fees/tolls),
"take-or-pay" arrangements. Not commercial tenants.
○​ Financing: Historically by governments. Increasingly via Public-Private Partnerships
(PPPs) (long-term contractual relationship between public/private sectors). Also
development finance institutions.
○​ Categories (by Underlying Assets):
■​ Economic Infrastructure: Transportation (roads, bridges, airports), ICT
(towers, data centers), Utility/Energy (power, water, gas). Can carry
market/demand risk.
■​ Social Infrastructure: Educational, health care, social housing, correctional
facilities. Income from availability payments/maintenance.
○​ Stages of Development:
 ■​ Greenfield Investments: Developing new assets/infrastructure. Opportunistic,
highest expected return, highest risk.
■​ Build-Operate-Transfer (BOT) Life Cycle: Build (negative cash flow),
Operate (income via concession), Transfer (to government/third party).
■​ Brownfield Investments: Expanding existing facilities, privatization of public
assets, sale-leaseback of completed greenfield. Shorter investment, immediate
cash flows, operating history. Incrementally riskier than secondary-stage.
■​ Secondary-Stage Investments: Existing, fully operational assets, no further
investment/development needed. Lowest expected return, lowest risk.
○​ Forms of Investment:
■​ Direct Investment: Provides control, full value capture. Requires large
investment, concentration/liquidity risks. Often involves consortiums (e.g., large
pension funds, sovereign wealth funds - prioritize domestic needs).
■​ Indirect Investment: Infrastructure funds (closed/open-end), ETFs, publicly
traded infrastructure providers, Master Limited Partnerships (MLPs - trade on
exchanges, pass-through entities, common in energy).
■​ Publicly traded securities offer liquidity, reasonable fees, transparency,
but are small segment of market.
●​ Infrastructure Investment Characteristics (Risk/Return)
○​ Expected return/risk defined by type, stage, location, structure. (Exhibit 8)
○​ Operational secondary-stage assets: lowest risk/return.
○​ Greenfield in developing countries: exceptional return opportunities, but considerable
risks.
○​ Most funds gravitate to medium/low risk (avg. ~10% annual return).
○​ Less liquid direct equity: highest return/risk. Publicly traded debt: lowest potential
returns.
●​ Infrastructure Diversification Benefits
○​ Stable long-term cash flows (inelastic demand, high barriers to entry).
○​ Equity investments: Lower correlation with public market equities/economy.
○​ Provides income stream, increases portfolio diversification (low correlation with other
public investments).
○​ GDP growth protection, inflation protection (rates rise with inflation).
○​ Infrastructure debt: Lower default rates, higher recovery, less fluctuation than similar
fixed-income.
○​ Matches long-term liabilities of pension funds, sovereign wealth funds (largest
allocators).

Mind-Map Outline:

●​ Main Node: Real Estate and Infrastructure

○​ Real Estate
■​ Features
■​ Categories: Residential, Commercial
■​ Unique: Heterogeneity, Large Investment, Fragmentation, Price
Discovery Challenges, High Transaction Costs, Specialized Knowledge
■​ Investment Structures
 ■​ Direct Ownership (Control, Tax Benefits, Diversification; but Complex,
Capital Needs, Concentration Risk, Illiquidity)
■​ Indirect Ownership
■​ REITs (Equity, Mortgage, Hybrid)
■​ Benefits: No Double Taxation, Transparency, Liquidity
(for public REITs), Professional Mgmt
■​ Drawbacks: Higher correlation with public equity
■​ Fund types: Open-end (Core), Closed-end (Opportunistic)
■​ Investment Characteristics (Risk & Return)
■​ Sources of Returns: Income + Appreciation
■​ Risk-Return Spectrum (Senior Debt -> Core -> Core-Plus -> Value-Add
-> Opportunistic)
■​ Inflation Protection
■​ Leverage Impact
■​ Diversification Benefits
■​ Low correlation with traditional assets
○​ Infrastructure
■​ Features
■​ Definition: Capital-intensive, long-lived assets for public use
■​ Cash Flow Sources: Contractual payments (availability, usage,
take-or-pay)
■​ Financing: Governments, Public-Private Partnerships (PPPs)
■​ Categories (by underlying asset): Economic (Transportation, ICT,
Utility/Energy), Social (Healthcare, Education)
■​ Investment Characteristics (Risk & Return)
■​ Stages of Development
■​ Greenfield (New, Highest Risk/Return, BOT cycle)
■​ Brownfield (Existing/Expanding, Incrementally Riskier)
■​ Secondary-Stage (Fully Operational, Lowest Risk/Return)
■​ Forms of Investment
■​ Direct (Control, Concentration Risk, Consortia)
■​ Indirect (Funds, ETFs, Publicly traded, MLPs)
■​ Diversification Benefits
■​ Stable Cash Flows (inelastic demand, barriers to entry)
■​ Low Correlation with Public Markets
■​ Inflation Protection
■​ Matches Long-Term Liabilities

Module Summary:

Real estate and infrastructure are crucial alternative asset classes, offering diversification and stable
income or appreciation. Real estate is characterized by heterogeneity, high transaction costs, and
valuation challenges (often using appraisals). Investors can choose direct ownership (control, tax
benefits but illiquidity, concentration) or indirect via REITs (tax-advantaged, liquid, but higher public
market correlation). Real estate strategies range from low-risk senior debt to high-risk opportunistic
development. Infrastructure assets, typically for public use, generate cash flows from contractual
payments. They're categorized by economic/social function and development stage (greenfield,
brownfield, secondary-stage), with greenfield being riskiest. Both offer inflation protection and
valuable portfolio diversification due to generally low correlations with traditional assets and steady
cash flow characteristics.

Exam Tips:

●​ Know the key differentiating features of real estate (heterogeneity, illiquidity) and why
valuation is tricky.
●​ Understand the appeal of REITs (tax-advantaged, liquidity) and their main drawback (higher
correlation with public equity).
●​ Be able to map real estate investment strategies to their risk/return profiles (Core, Core-Plus,
Value-Add, Opportunistic).
●​ For infrastructure, grasp the concept of PPPs and the distinct development stages (Greenfield,
Brownfield, Secondary-Stage) and their associated risk/return.
●​ The general point about low correlation with traditional assets for both real estate and
infrastructure is a constant theme for diversification.
MODULE #5: Natural Resources

Key Notes:

●​ Natural Resources Definition

○​ Comprise commodities and raw land for agriculture (farmland, timberland).
○​ Basic production inputs to the economy (plants, animals, energy, minerals, metals).
○​ Increasingly used by institutional investors to fulfill ESG objectives (sustainability, water
conservation, carbon offsets).
●​ Land Investments (Farmland, Timberland, Raw Land) vs. Real Estate
○​ Similarities: Unique, illiquid assets, distinct geographic location affecting value, forms
of ownership capital, can have steady cash flow (farmland, developed RE).
○​ Key Differences:
■​ Focus: Land investments have limited or no focus on physical improvements
(value from soil quality, climate, geology). Real estate values primarily from
actual/planned improvements.
■​ Financing: Fewer alternatives for land (bank loans, private debt). More for real
estate.
■​ Liquidity: Highly illiquid with limited buyers/sellers due to specialized
knowledge/capital needed.
■​ Specialized Knowledge: Investors need specific understanding (e.g., TIMOs
for timberland).
●​ Features and Forms of Farmland and Timberland Investment
○​ Drivers: Common nature (food, shelter), recurring income, inflation protection,
insulation from financial volatility.
○​ Timberland:
■​ Long market cycle (new-growth forest).
■​ Acts as both a "factory" (grows trees) and a "warehouse" (can delay harvest to
optimize prices). Offers harvest flexibility.
■​ Return drivers: biological growth, lumber prices, land price changes.
■​ Ownership: Large institutional holdings (often thousands of acres).
■​ TIMOs (Timberland Investment Management Organizations): Support
institutional investors by managing timberland investments.
○​ Farmland:
■​ Can be found in smaller sizes (tens/hundreds of acres).
■​ Row crops (planted/harvested multiple times/year) and permanent crops
(trees/vines).
■​ Farm products must be harvested when ripe – little flexibility.
■​ Return drivers: harvest quantities, commodity prices (crops), land price
changes.
■​ Ownership: Mostly family-owned (e.g., 98% US farmland).
 ○​ Forms of Ownership (both): Direct ownership, partnerships, REITs
(farmland/timberland), separately managed accounts (owner vs. owner-operator
models).
○​ Risks: Highly sensitive to unexpected weather/climate (drought, flooding can destroy
crops), global risks (trade interruptions, competition). Raw land has even greater risk
than farmland/timberland.
○​ Indirect Benefits: Carbon offsets (trees absorb CO2), water rights, ESG
considerations.
●​ Commodity Investment Forms and Features
○​ Definition: Standardized, raw products.
○​ Features:
■​ Do not generate cash flows directly; usually incur costs of carry (transportation,
storage, insurance).
■​ Investors benefit from price appreciation (in excess of carry cost) based on
future economic value.
■​ Governments play increasing role (subsidies, price support, control over
extractable rights).
■​ Environmental factors play a direct role (climate policies shifting demand for
certain minerals).
○​ Distinguishing Characteristics:
■​ Sectors: Energy, base metals, precious metals, agriculture, other (carbon
credits, freight).
■​ Investing Methods: Majority via derivatives (futures, forwards, options on
futures) due to tax obligations, physical costs (storage, insurance, brokerage,
transportation), and lack of price transparency in physical markets.
■​ Derivatives offer liquidity and price discovery.
■​ Physical settlement risk (e.g., oil in 2020).
■​ Indirect Exposure through:
■​ Exchange-Traded Products (ETPs): ETFs, ETNs. Simplified trading
via brokerage, can hold physical or futures, may use leverage. Charge
fees.
■​ Commodity Trading Advisers (CTAs): Managed futures funds, make
directional investments in futures markets (technical/fundamental
strategies). Originally commodity-focused, now often diversified across
futures (commodities, equities, fixed income, FX). Useful for portfolio
diversification, profit from short positions in falling markets.
■​ Specialized Funds: Private energy partnerships, publicly available
energy mutual funds (upstream, midstream, downstream).
●​ Basics of Commodity Pricing
○​ Direct relationship between cash (spot) and derivative (forward) prices due to
no-arbitrage conditions.
○​ Cost of Carry (c): Opportunity cost of holding, storage, transport, insurance. Increases
forward price.
○​ Convenience Yield (i): Non-cash benefit of holding physical commodity (e.g., ensuring
continuous access, when inventories are low). Reduces forward price.
 ○​ Forward Price Formula (continuous compounding): F0(T) = S0e^(r+c–i)T
○​ Backwardation: Spot price > Forward price (downward-sloping curve). Occurs when
convenience yield > cost of carry (e.g., low inventories). Enhances long-only investor
returns.
○​ Contango: Spot price < Forward price (upward-sloping curve). Occurs when cost of
carry > convenience yield. Lowers long-only investor returns.
●​ Natural Resource Investment Risk, Return, and Diversification
○​ Commodities:
■​ Supply Dynamics: Determined by production, seasonal yields, inventory (short
term). Slow to adjust due to long lead times (growing cycles, infrastructure
build-out). Weather is a key exogenous risk.
■​ Demand Dynamics: Driven by end-user needs, global manufacturing,
economic growth.
■​ Returns: High potential return, but also highest volatility among traditional
assets/farmland/timberland. Worst performance often during financial crises.
○​ Farmland and Timberland:
■​ Less frequently traded than commodities.
■​ Value from growing seasons (farmland) or long growth cycle/lumber demand
(timberland).
■​ Appear less volatile than commodities/stocks (appraisal-based, infrequent
pricing). But face significant risks (weather).
●​ Inflation Hedging and Diversification Benefits
○​ Inflation Hedge:
■​ Commodities: Strong inflation hedge. Prices are components of CPI, react
quickly to inflation. Perform well when inflation is higher, poorly when lower.
Volatility higher than CPI.
■​ Farmland/Timberland: Less evidence of significant difference in performance
during differing inflation environments. Low correlation with inflation (0.02 to
-0.17), implying less effective as direct inflation hedge, but don't suffer negative
returns in low inflation like commodities.
○​ Portfolio Diversification:
■​ Overall Natural Resources: Exhibit significant diversification potential due to
low correlations with traditional assets (stocks, bonds) during business cycle.
■​ Farmland/Timberland: Low/near-zero correlation with global bonds, low with
global stocks (e.g., Timberland ~0.02 with stocks, Farmland ~0.12). *
Introduction
■​ Commodities, Raw Land, Timberland, Farmland
○​ Land Investments (Farmland, Timberland, Raw Land)
■​ Vs. Real Estate
■​ Similarities: Unique, Illiquid, Geographic influence, Ownership
■​ Differences: Focus (improvements vs. soil/climate/geology), Financing,
Liquidity, Specialized Knowledge
■​ Farmland/Timberland Features
■​ Income Stream & Price Changes
■​ Harvest Flexibility (Timberland: Yes; Farmland: No)
 ■​ Ownership Forms: Direct, Partnership, REITs, TIMOs
■​ Risks: Weather, Global trade
■​ ESG: Carbon offsets, Water rights
○​ Commodity Investments
■​ Features
■​ No direct cash flows, incur 'cost of carry'
■​ Price appreciation focus
■​ Government role
■​ Environmental factors (ESG)
■​ Distinguishing Characteristics
■​ Sectors (Energy, Metals, Agriculture)
■​ Investment Forms: Mostly Derivatives (Futures, Forwards, Options)
■​ Indirect Exposure: ETPs, CTAs, Specialized Funds
■​ Pricing Basics
■​ Cost of Carry (c)
■​ Convenience Yield (i)
■​ Forward Price: F0(T) = S0e^(r+c–i)T
■​ Backwardation (Spot > Forward, i > c)
■​ Contango (Spot < Forward, c > i) [4 Farmland/Timberland: Less Direct
Hedge, but stable in low inflation
■​ Portfolio Diversification
■​ Overall: Low correlation with traditional assets
■​ Farmland/Timberland: Low/near zero correlation with stocks/bonds
■​ Commodities: Positive, but lower, correlation with stocks; near zero with
bonds

Module Summary:

Natural resources, including farmland, timberland, and commodities, offer unique investment
characteristics. Unlike real estate, land investments value the inherent quality and natural growth
rather than physical improvements. Timberland offers unique harvest flexibility, while farmland does
not. Commodities, accessed mainly through derivatives, do not generate cash flows but offer
appreciation potential influenced by the "cost of carry" and "convenience yield," leading to
backwardation or contango. All natural resources, especially commodities, serve as an inflation hedge
and provide significant portfolio diversification due to their low historical correlations with traditional
stocks and bonds, although they often exhibit higher volatility. Understanding these distinct drivers
and risks is essential.

Exam Tips:

●​ Crucial Distinction: Farmland vs. Timberland (harvest flexibility). This is a common test point.
●​ Commodity Pricing: Know the F0(T) = S0e^(r+c–i)T formula conceptually. Understand
backwardation and contango based on c and i.
●​ Biases: Remember that appraisal-based valuations for farmland/timberland can understate
volatility.
 ●​ The Inflation Hedge and Diversification Benefit for commodities (strong hedge, decent
correlation) versus farmland/timberland (less direct hedge, lower correlation) is a key
takeaway.

MODULE #6: Hedge Funds

Key Notes:

●​ Hedge Fund Investment Features

○​ Definition: Private pooled investment vehicles, distinguished by their investment
approach/strategies rather than the underlying assets (can invest across traditional
and alternative).
○​ Name Misnomer: Originally for offsetting long/short positions, but now often amplify
risks using leverage. Internally neutralizing market risk is key. [4-worth (HNW)
investors (accredited investors).
○​ Time Horizon: Typically shorter than private equity.
○​ Benchmarking: Difficult due to complex strategies; often use absolute return
standards or hedge fund-specific indexes.
●​ Hedge Fund vs. Other Fund Types
○​ Vs. Mutual Funds:
■​ HF: Performance-based fees (managers invest in fund), great trading freedom,
lightly regulated, private, shorter time horizon, more liquid assets.
■​ MF: Fixed compensation (managers may not invest), highly regulated, public,
daily liquidity.
○​ Vs. Private Equity:
■​ HF: Shorter time horizon, more liquid assets, use leverage on marketable
securities.
■​ PE: Longer time horizon, illiquid assets (direct investment in private operating
companies), managers do not apply leverage to their fund directly.
●​ Hedge Fund Categories (by Strategy)
○​ Equity Hedge Funds: Focus on public equity.
■​ Long/Short Equity: Balanced long/short exposure, bottom-up. Manager typically
net long bias.
■​ Fundamental Growth/Value: Long positions in high-growth/undervalued
companies.
■​ Short Biased: Primarily short overvalued equities, limited long exposure.
Contrarian. Useful in market stress.
■​ Market Neutral: Long undervalued, short overvalued, aiming for zero overall
beta. Profits from individual security movements, requires leverage for
meaningful returns.
○​ Event-Driven Strategies: Profit from defined corporate events (acquisitions,
restructuring).
■​ Merger Arbitrage: Long target, short acquirer (if cash deal or overvalued
acquirer). Profit from deal spread. Risk: deal failure.
 ■​ Distressed/Restructuring: Purchase debt of companies near bankruptcy (at
discount, or "fulcrum security" for equity conversion).
■​ Special Situations: Opportunities from security issuance/repurchase, capital
distributions, asset sales.
■​ Activist: Acquire sufficient equity to influence corporate policy/direction (board
seats, divestitures, management changes). Operate primarily in public equity.
○​ Relative Value Strategies: Profit from short-term pricing discrepancies between
related securities.
■​ capital efficiently across various strategies.
○​ Opportunistic Strategies: Focus on macro events, commodity trading.
■​ Macro Strategies: Top-down, trade based on expected movements in economic
variables (FX, fixed-income, equity, commodities). Benefit from high volatility.
■​ Managed Futures Funds (CTAs): Actively managed funds making diversified
directional investments primarily in futures markets (technical/fundamental
strategies). Originally commodity futures, now broad (equities, fixed income,
FX). Useful for diversification, especially in trending markets.
○​ Multi-Manager Hedge Funds (Fund of Funds): Diversified portfolio of hedge funds.
●​ Distinguishing Characteristics of Hedge Fund Investments
○​ Less legal/regulatory constraints, flexible mandates (shorting, derivatives).
○​ Larger investment universe, aggressive styles (concentrated positions, credit, volatility,
liquidity risk premiums).
○​ Liberal use of leverage.
○​ Liquidity constraints: ** investments.
●​ Hedge Fund Investment Forms
○​ Typically set up as private limited partnerships or LLCs, GP is manager.
○​ Direct Forms:
■​ Master-Feeder Structure: Offshore and onshore feeder funds feed into a
master fund for tax efficiency and global investor access.
■​ Fee Structure: "Two and twenty" (2% management, 20% performance fee)
common, but evolving (e.g., "1 or 30").
■​ Side Letters: Address specific investor requirements (legal, regulatory, tax,
operational, reporting). Can supersede fund docs.
■​ Fund of One / Separately Managed Account (SMA): Separate investment
accounts for larger investors (institutional). Investor retains more influence,
customizable portfolio, better transparency, efficient capital, higher liquidity,
enhanced control, potentially lower fees. Operationally complex, demands
greater governance. Potential for manager to reduce motivation if fees too low,
or* Managers provide due diligence, monitoring, better negotiation.
■​ Hedge Fund Replication ETFs: Seek to replicate hedge fund investment
styles without directly investing in hedge funds. Use liquid assets, quantitative
tools. Benefit from liquidity, lower fees, transparency. Often fall short of pure HF
returns due to regulatory burden, redemption restrictions, leverage limits.
●​ Hedge Fund Investment Risk, Return, and Diversification
○​ Sources of Return:
 ■​ Hedge funds emphasize idiosyncratic risk and alpha (manager-specific returns
from mispriced securities, market timing, operational control, leverage) rather
than market beta.
■​ Market Beta: Broad market exposure (traditional funds).
■​ Strategy Beta: Beta attributed to HF investment strategy across broad market.
○​ Performance Appraisal Challenges (Biases)
■​ Based on voluntary self-reported data. Likely overestimates performance.
○​ Risk and Returns (Historical):
■​ Historically (e.g., 1990-2014), higher returns than stocks/bonds with volatility
similar to bonds.
■​ Later period (2015-2019), absolute returns declined, correlation with equities
increased, making them arguably less useful for some allocators.
■​ Some strategies (e.g., Short Bias) have generated negative average returns. ]
■​ Historical low correlation with traditional asset classes (investment bonds,
currencies).

Mind-Map Outline:

●​ Main Node: Hedge Funds

○​ Investment Features
■​ Private pooled vehicle
■​ Distinguished by approach, not assets
■​ Flexible strategies (leverage, shorting, derivatives)
■​ Lightly regulated, for accredited investors
■​ Shorter horizon than PE
■​ Objective: Absolute/risk-adjusted returns, low correlation
○​ Vs. Other Funds
■​ Mutual Funds (regulated, fixed fees)
■​ Private Equity (long-term, illiquid, direct company stakes)
○​ Strategies (Categorization)
■​ Equity Hedge (Long/Short, Market Neutral, Short Biased)
■​ Event-Driven (Mer8]
■​ Reduced transparency, fraud risk
○​ Investment Forms & Vehicles
■​ Direct: Master-Feeder, Fund of One/SMA (customizable, transparency, control
for large investors)
■​ Indirect: Fund of Funds (diversification, lower minimums, but "double fee"
layering), Replication ETFs (liquid, lower fees, but less pure HF return)
○​ Risk, Return, & Diversification
■​ Sources of Return: Alpha (manager skill, inefficiencies), Strategy Beta, Market
Beta
■​ Performance Appraisal Challenges (Biases): Selection, Survivorship, Backfill,
Time Lag, Weighting
■​ Historical Performance: High returns, volatility similar to bonds (historically)
■​ Diversification Benefits: Lower correlation with traditional assets, can decrease
portfolio standard deviation, increase Sharpe ratio
**Module Summary (survivorship, backfill). Historically, hedge funds have offered strong
diversification benefits by adding alpha and lowering portfolio risk, despite evolving correlations.

Exam Tips:

●​ Know the core differences between hedge funds and mutual funds/private equity. This is a
common comparative question.
●​ Be able to identify and briefly describe the main hedge fund strategies. Don't get lost in the
weeds, but know what each aims to do.
●​ Understand the liquidity constraints (lockups, gates, notice periods, redemption fees).
These protect the fund from massive outflows.
●​ 0, 583]
○​ Based on Distributed Ledger Technology (DLT), especially blockchain.
○​ Utilize advanced encryption (cryptography) for authenticity.
○​ Can offer diversification and higher expected returns than traditional investments, but
with higher risks.
●​ Distributed Ledger Technology (DLT)
○​ A type of database shared among many entities in a network. 85, 599, 600, 621]
○​ Cryptography: Algorithmic process to encrypt data, verify identity, ensure integrity.
○​ Smart Contracts: Computer programs that self-execute based on pre-specified terms
(e.g., automatic execution of derivatives, collateral transfer on default).
○​ Blockchain: A type of DLT where information is recorded sequentially in "blocks" that
are cryptographically "chained" together. [603 Ethereum).
■​ Proof of Stake (PoS): Selected participants (validators) pledge capital
("stake") to vouch for block validity. Majority of other stakers attest. Validators
earn rewards. Security relies on stake controlling network.
○​ Permissioned vs. Permissionless Networks:
■​ Permissionless (Open): Open to any user, all users see all transactions, no
central authority for validation. Highly decentralized, no single point of failure.
Bitcoin is an example. Requires more processing power, less cost-effective.
■​ Permissioned: Network members restricted from certain activities; varying
levels of access/viewing. Partially decentralized, faster, more cost-effective.
●​ Types of Digital Assets [586, 614.g., 21 million Bitcoins), viewed as "digital gold." * Altcoins:
Thousands of other cryptos. * Ether (ETH): Prominent altcoin, programmable blockchain for
applications (smart contracts). * Stablecoins: Designed to maintain stable value by pegging to
another asset (fiat currency, precious metals, other cryptos), collateralized by a reserve
basket. Protects from volatility. [586, 594, 636, Bank Digital Currencies (CBDCs)*: Tokenized
versions of fiat currency, explored by central banks.
○​ Tokens: Built on existing blockchains.
■​ Tokenization: Representing ownership rights to physical assets on a
blockchain (streamlines verification, creates single digital record).
■​ Non-Fungible Tokens (NFTs): Unique, link digital assets to certificates of
authenticity via blockchain. For digital art, virtual19, 620, 673]
■​ Utility Tokens: Provide services within a network (pay for services, network
fees).
 ■​ Governance Tokens: Provide votes to determine how permissionless
networks are run (e.g., technical problem solutions, major changes).
●​ Digital Asset Investment Features (Contrast with Traditional Financial Assets)
○​ Inherent Value: *Most digital assets have currencies are foundation.
○​ Legal/Regulatory Protection: Evolving, unclear, ambiguous framework for digital
assets; generally unregulated, minimal protection. Traditional assets have well-defined,
predictable frameworks.
■​ Digital exchanges often unregulated, leading to fraud/manipulation
(pump-and-dump schemes).
●​ Digital Asset Investment Forms
○​ Direct Digital Asset Investment: Buying on exchanges using cryptocurrency wallets
(stores public/private digital codes).
■​ Centralized Exchanges: Most popular, privately held. Volume, liquidity, price
transparency. Susceptible to security vulnerabilities/hacks. Some regulation,
but less than traditional.
■​ Decentralized Exchanges (DEX): Emulate blockchain's decentralized
protocol. No central control. More resilient to attacks but difficult to regulate
(allows potentially illegal activity). [ fees, can trade at premium/discount.
■​ Cryptocurrency Futures Contracts: Agreements to buy/sell crypto at future
date/price (e.g., Bitcoin futures on CME). Typically cash settled. Inherently
leveraged. Market can be less developed/liquid.
■​ Cryptocurrency Exchange-Traded Funds (ETFs): Replicate crypto returns
using cash and crypto derivatives (don't directly hold crypto). collateralized by
underlying asset. Increase liquidity (fractional ownership), immutable record,
reduces costs. Often classified as securities by regulators.
■​ Decentralized Finance (DeFi): Movement for decentralized financial
applications (dApps) based on open-source code and smart contracts. A
marketplace of dApps for lending, trading, settlement, etc. Advocates claim
time saving, risk reduction. Still nascent, often extends leverage for speculation
in digital assets. *, 685]
■​ Brief Track Record: High uncertainty.
○​ Diversification Benefits:
■​ Historically low correlations with traditional asset classes.
■​ Price drivers are distinct (market adoption, network effects, tech advancement,
regulation, speculation, risk appetite).
■​ Can be potential portfolio diversifiers.

* Blockchain: Blocks chained cryptographically

■​
■​ Consensus Protocols
■​ Proof of Work (PoW): Miners solve puzzles, energy intensive, 51%
attack
■​ Proof of Stake (PoS): Validators pledge capital, less energy
■​ Network Types
■​ Permissionless (Open, Decentralized, Bitcoin)
 ■​ Permissioned (Restricted access, fastervolving, ambiguous, less
protection)
■​ Investible Digital Assets
■​ Cryptocurrencies
■​ Bitcoin, Altcoins (Ether, Stablecoins, Meme Coins, CBDCs)
■​ Tokens
■​ NFTs, Security Tokens, Utility Tokens, Governance Tokens
■​ ICO (Initial Coin Offering)
○​ 1] * Crypto Coin Trusts * Crypto Futures Contracts * Crypto ETFs (Derivatives-based) *
Crypto Stocks * Hedge Funds
■​ Digital Forms for Non-Digital Assets
■​ Asset-Backed Tokens (Fractional ownership, increase liquidity)
■​ Decentralized Finance (DeFi) (dApps, smart contracts for finance)
[6peer transactions. Key concepts include consensus protocols (Proof
of Work vs. Proof of Stake) and network types (permissioned vs.
permissionless). Digital assets span cryptocurrencies (Bitcoin, altcoins,
stablecoins, meme coins, CBDCs) and tokens (NFTs, security, utility,
governance). They differ from traditional assets by lacking inherent
fundamental value (driven by speculation/scarcity), using decentralized
validation, having limited legal tender status, and facing an evolving,
ambiguous regulatory environment. Investments can be direct (via
exchanges) or indirect (trusts, futures, ETFs, funds). While offering high
returns and historical low correlation for), regulation, and transaction
validation. This is a common comparative question.
●​ Investment Forms: Understand the pros and cons of direct vs. indirect exposure (e.g.,
centralized vs. decentralized exchanges, trusts, ETFs).
●​ Risk & Return: Remember the high return, high volatility, and historically low (but rising)
correlation points. The diversification benefit is key, but so are the risks.