Alternative investment 2 hard

• Calculating after-fee returns requires adjusting cash flows or values for management and performance fees.

Total Fees

• General partner's total fees in money terms: total fees = mV₁ + max[0,p(V₁ - V₀)], where m = management fee, p = performance fee, V₀= beginning-of-period assets and V₁ = end-of-period assets.
• Rate of return for an investor after fees: r = (V₁ - V₀ - total fees) / V₀.
• Fee structure provisions such as hurdle rates and high-water marks, increase the complexity of calculating total fees.
• Exam questions will specify all applicable provisions as these aspects are not standardised across alternative investment funds.

Returns

• Alternative investment indexes may not provide meaningful information due to the unique structure of each fund and varying life cycle phases.
• Comparing funds from the same vintage year helps mitigate issues arising from different life cycle phases.
• Survivorship bias is more pronounced in hedge fund databases, with over 25% of hedge funds failing in their first three years.
• Indexes excluding failed funds can overstate returns and understate risks.
• Backfill bias, which occurs when managers selectively include successful funds in indexes and can magnify these effects.

Lockup Period

• Margin calls can force leveraged funds to exit investments at unfavorable times and prices.
• Investor redemptions can pose a similar risk, with increased likelihood as returns decrease.
• Alternative investment funds often restrict early redemptions to mitigate these risks and the I-curve effect.
• Lockup period: time after initial investment during which limited partners cannot request redemptions or incur significant fees.
• Notice period: amount of time (typically 30-90 days) a fund has to fulfill a redemption request giving managers time to reduce positions in an orderly manner.
• Redemption fees can offset significant transactions costs when shares are redeemed.
• Gates restrict redemptions for a temporary period, at the discretion of fund managers.
• Customized fee structures in side letters may offer different terms to certain investors.
• Investors with larger commitments can negotiate lower fees.
• Tradeoffs exist between liquidity provisions and fees, with investors potentially negotiating for lower fees or better liquidity via shorter lockups and notice periods.

Founders Class Shares

• Early investors in a fund may receive lower fees or better liquidity terms as an incentive to invest at the fund's inception.
• Investment interests of early investors who receive relatively better terms are called founders class shares.
• Annual investor fees can also be either-or fees, the maximum of the management fee or the incentive fee, where under such a structure there will be a management fee unless the calculated incentive fee is higher.

Fair Value Hierarchy

• Fee structures are subject to negotiation and may vary depending on when an investor commits capital during a fund's life cycle.
• Different investors in the same fund may realize significantly different returns.
• Fair value hierarchy groups assumptions into three levels based on asset tradability and observability.
• Level 1: Assets trade in active markets with readily available quoted prices (e.g., exchange-traded securities).
• Level 2: Assets lack readily available quoted prices but can be valued using observable inputs (e.g., derivatives priced using models).
• Level 3: Assets require unobservable inputs to establish fair value (e.g., real estate or private equity investments without market transactions), and the absence of market activity can result in valuations that remain near their initial cost for long periods.
• Relative lack of change in fair values can make reported returns for alternative investments appear higher, less risky, and less correlated with traditional investments than they really are.

Use of Leverage

• Some alternative investments, especially hedge funds, use borrowing or derivatives to magnify gains and losses.
• Unleveraged portfolio return (in money amount): r × V₀.
• Leveraged portfolio return (in money amount) after subtracting the interest cost: r (V₀+Vb) - (rbVb), where V₀ is the amount the fund can invest without leverage and Vb is the amount the fund can borrow.
• Leveraged rate of return: (r (V₀ + Vb) - rbVb) / V₀.
• Funds use leverage to exploit small pricing anomalies.
• Margin calls can force funds to liquidate investments at unfavorable prices, and if the fund sells a large position in a security, it may depress its price further.
• Lenders may limit access to additional borrowing.

Timing of Cash Flows

• Alternative investments have a life cycle that exhibits three phases: capital commitment, capital deployment, and capital distribution.
• Capital commitment phase: managers identify investments and make capital calls and returns tend to be negative.
• Capital deployment phase: managers fund firms or projects and returns typically remain negative.
• Capital distribution phase: fund's investments succeed and generate income and cash flows and returns turn positive and accelerate.
• J-curve effect: reflects negative returns in the capital commitment phase, followed by increasing returns in the capital deployment phase and maximum returns in the capital distribution phase.
• Internal rate of return (IRR) over the life of a fund is the most appropriate measure of after-tax investment performance.
• Multiple of invested capital (or money multiple): ratio of total capital returned plus the value of any remaining assets, to the total capital paid in over the life of the investment.

Additional Risks

• Alternative investments are typically exposed to greater risks than unleveraged long-only traditional investments.
• Risks arise from the timing of cash flows over an investment's life cycle, use of leverage by fund managers, valuation of investments that may or may not have observable market prices and complexity of fees, taxes, and accounting.
• Returns on alternative investments should ideally be adjusted for these risks.
• Evaluating returns without considering these additional risks would be naïve and possibly misleading.