Alternative Investment - Exam Ready Notes

CFA Level 1 Alternative Investments – Summary Notes

1. What Are Alternative Investments?

Definition:

Assets outside traditional stocks, bonds, and cash.

Categories:

• Private Capital: Private equity, private debt
• Real Assets: Real estate, infrastructure, natural resources
• Hedge Funds
• Digital Assets: Cryptocurrencies, tokens, NFTs, etc.

Key Features Table

2. Why Invest in Alternatives?

• Diversification: Low correlation with traditional assets (see correlation matrix below)
• Potential for Higher Returns: Often compensate for illiquidity and complexity
• Inflation Protection: Especially real assets and commodities

3. Investment Methods

Investment Methods

4. Structures & Compensation

Limited Partnerships (LP/GP): 

• • GP (General Partner): Manages, unlimited liability, earns management + performance fees
  • LP (Limited Partner): Passive investor, limited liability

Fee Structure: 

• • Management Fee: % of committed capital or AUM (1–2%)
  • Performance Fee (Carry): % of profits above hurdle (often 20%)
  • Hurdle Rate: Minimum return before carry applies
  • High-Water Mark: No performance fee unless NAV exceeds prior peak
  • Clawback: LPs can reclaim excess performance fees if later losses occur

5. Private Capital

Private Equity

• Venture Capital: Early-stage, high-growth firms
• Buyouts: Mature firms, often with leverage
• Distressed/Turnaround: Struggling firms, restructuring

Key Concepts:

• Exit Strategies: IPO, trade sale, secondary sale, recapitalization, write-off
• Valuation: Comparable companies, precedent transactions, DCF

Private Debt

• Direct Lending: Loans to mid-market companies
• Mezzanine Debt: Subordinated, often with equity kicker
• Distressed Debt: Buying at discount, aiming for restructuring gains

6. Real Assets

Real Estate

• Types: Residential, commercial, industrial, REITs
• Returns: Rental income, capital appreciation
• Valuation: Sales comparison, income approach, cost approach

Infrastructure

• Types: Economic (roads, airports), Social (schools, hospitals)
• Features: Long life, inflation-linked cash flows, public-private partnerships

Natural Resources

• Types: Commodities, farmland, timberland
• Returns: Price appreciation, yield (e.g., crops, timber harvest)

7. Hedge Funds

·       Fee Structure: “2 and 20” (2% management, 20% performance)

·       Liquidity: Lock-ups, gates, notice periods

8. Digital Assets

• Types: Cryptocurrencies (Bitcoin, Ethereum), tokens, NFTs, stablecoins
• DLT/Blockchain: Distributed ledger, consensus mechanisms (Proof of Work, Proof of Stake)
• Risks: High volatility, regulatory uncertainty, custody/security

9. Performance & Returns

• Return Calculation: Often IRR (Internal Rate of Return) due to irregular cash flows
• MOIC (Multiple on Invested Capital): (Total value returned + remaining value) / total invested
• J-Curve Effect: Initial negative returns (fees, investments), positive returns later

J-Curve Graph (for Word):

• X-axis: Time, Y-axis: Cumulative Return
• Curve dips below zero, then rises above

10. Risks in Alternatives

11. Due Diligence

• Assess manager skill, experience, and track record
• Review fund terms, lockups, redemption policies
• Analyze underlying asset risks, valuation methods

12. Key Formulas