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Alternative Investments

April 2022

1. Which of the following dominates the global value of private equity investments?

A. Investments in venture capital deals

B. Investments in buyout deals

C. Investments in Asia/Pacific deals

D. Investments in distressed company deals?

2. Which of the following most accurately describes the economic role of venture capital?

A. Increase cash flow in order to service debt

B. Unlock value in companies that are not fulfilling their potential

C. Support development of businesses that cannot access traditional forms of capital

D. None of the above

3. What is the typical length of the Venture Capital investment life cycle?

I. 5 –10+ years

J. 2 –5 years

K. 2 –10+ years

L. 1 –3 years

4. Which of the following concerning sourcing and evaluation of private equity investments is NOT a true statement?

M. Due diligence of buyouts is similar to venture capital due diligence

N. People are a key focus of venture capital due diligence

O. More effort is required to identify and screen potential venture capital investments than with buyouts

P. All of the above

5. What type of exit is the most common in private equity deals?

Q. IPO

R. Sale of company to a third-party

S. Write off

T. Management buy-back

6. Which of the following is NOT a reason why VCs tend to fund portfolio companies with a series of cash injections over time based on achieving agreed milestones instead of injecting all of the cash at the beginning?

U. The profitability and growth of the company may not support achieving the desired IRR on a large up-front investment

V. VCs usually do not have very much cash available to invest

W. The funds may not be used wisely

X. The company managers’ ownership is likely to be greatly diluted

7. Which of the following documents provides the primary basis for entrepreneurs negotiating their deal with venture capitalists?

A. Shareholders’ Agreement

B. Side-Pocket Letter

C. Reps and Warranties Agreement

D. Term Sheet

8. Which one of the following was not a “Take-Away” from the Centex Telemanagement case?

A. Emotions are as important as the hard economic issues of a deal

B. Valuation is an art

C. It is important to eliminate all the problems of a deal before investing

D. VC deals are like getting married

9. Which of the following is a true statement about the valuation of companies?

Y. Multiple valuation approaches should always be used to assess a company’s value

Z. Use of comparable company ratios usually yields the most accurate result

AA. Discounted cash flow techniques usually yields the most accurate result

AB. Target return analysis should only be used for venture capital not buyouts

10. When are valuations of private equity investments known most accurately?

A. At quarter end when investments are marked-to-market

B. When investment bankers value the company for an IPO

C. When investments are exited

D. When new investment rounds happen

11. What key skill will buyout funds increasingly require in order to achieve superior investment returns?

AC. Superior financial engineering

AD. Raising larger funds

AE. Adding value to portfolio companies

AF. Close relationships with investment banks

12. Which of the following techniques is most often used to make consistent comparisons amongst the returns of private equity funds?

E. Comparing returns over a given time-horizon – eg, five years

F. Comparing vintage year returns

G. Comparing annual returns in a given year

H. Comparing gross returns

13. What is the “J-Curve”?

A. A period of losses in the early period of a private equity company deal

B. A period of negative returns in the early stages of a private equity fund’s life

C. The characteristic shape of the graph of 1st through 4th quartile fund returns

D. The typical shape of private equity fund returns over time in emerging markets

14. What historically has been a reliable criterion to use in identifying private equity funds that are likely to be top performers?

A. Selecting funds with low fees

B. Selecting funds with a top quartile management team

C. Selecting funds with historically top-quartile investment returns

D. Selecting funds with high risk adjusted returns

15. What is the primary factor that historically has explained the superior investment returns of top-quartile venture capital funds, compared to funds with only average performance?

A. Outstanding due diligence

B. Fewer deals that lose money

C. High proportion of home-run deals

D. Avoidance of dilution

16. How does the median and standard deviation of private equity fund returns compare relative to those of quoted equities?

A. Private equity median return is lower and standard deviation lower

B. Private equity median return is higher and standard deviation higher

C. Private equity median return is similar and standard deviation higher

D. Private equity median return similar and standard deviation is lower

17. Between 1997 & 2000 the total assets under management by Hedge Funds grew by 34% but between 2000 & 2003 they grew by 67%. What is the most likely explanation for this sudden increase in growth?

A. Hedge Fund returns were much higher in the second period.

B. Poor equity market returns drove investors to look for alternative investments.

C. Changes in regulation.

D. The collapse of LTCM

18. Which of the following is a role of a Prime Broker?

A. Calculation of Net Asset Values & Fees

B. Maintenance of Partnership's books and records

C. Processing subscription applications

D. Clearing Trades

19. Why do investors expect a hedge fund manager to invest a substantial portion of their own net worth in the fund?

A. To ensure they receive pass-through tax treatment

B. To avoid registration under the Investment Company Act 1940

C. To align the incentives of the manager & investors

D. To reduce management fees

20. Hedge fund performance fees are similar to a:

A. free call option granted to managers on an annual basis.

B. call option sold to managers on an annual basis, where the option premium is equal to the expected return on the fund.

C. free put option granted to managers on an annual basis.

D. put option sold to managers on an annual basis, where the option premium is equal to the expected return on the fund.

21. Alpha Capital Partners was established in January 2020, it does not charge a management fee but does charge a 25% incentive fee which is collected annually & has a high-water mark provision.

The fund generated (net of fees) returns of -60% in 2020 & -50% in 2021.

Assuming there have been no redemptions or subscriptions, what rate of return does Alpha Capital Partners need to produce in 2022 before it starts charging incentive fees?

A. 50%

B. 110%

C. 400%

D. 500%

22. Suppose a hedge fund has a 2 and 20 fee arrangement and a net asset value (NAV) of $150 million at the beginning of the year. The high-water mark was $160 million at the beginning of the year. The NAV increased to $190 million at the end of the year, before fees. If management fees are distributed annually based on the NAV at the beginning of the year, what are the total annual fees including both management and incentive fees for this year?

A. $3.2 million

B. $5.4 million

C. $8.4 million

D. $11.2 million

23. A long/short equity fund has a gross exposure of 160% and a net exposure of 100%. The relative long and short positions are:

A. 100% and 60%.

B. 130% and 30%.

C. 160% and 60%.

D. 160% and 100%.

24. A fund with capital of $100m buys $60m of a stock with a beta of 1.5 and partially hedges this position by selling $30m notional value of index futures (which have a beta of 1.0).

What is the beta adjusted net exposure of the fund?

A. 0.30

B. 0.60

C. 0.90

D. 1.20

25. Based on historical data from Credit Suisse, which of the following hedge fund strategies did not have positive, moderate correlation with the MSCI World Equity index?

A. Dedicated Short Bias

B. Global Macro

C. Merger/Risk Arbitrage

D. Convertible Arbitrage

26. Which of the following statements about the global macro strategy is NOT true?

A. Global macro strategies may invest in commodities.

B. Global macro managers have a broad investment universe.

C. Global macro strategies tend to be unable to apply leverage.

D. Global macro funds tend to have large amounts of investor capital.

27. Why do CTA/Managed Futures funds tend to diversify across many different markets?

A. Diversification reduces volatility and makes the options cheaper.

B. It helps to avoid short squeezes.

C. Trading many markets reduces margin requirements.

D. At least one market should be trending even if others are not.

28. Which of the following statements does NOT accurately describe a risk of convertible bond arbitrage?

A. Credit risk refers to the risk that bond prices will fall when credit spreads widen.

B. Regulatory rulings may limit the use of leverage or short selling.

C. Convertible bonds are exposed to changes in the risk-free interest rate, causing bond prices to fall when rates rise.

D. The strategy uses short correlation between the underlying stock and bond.

29. In a recent press release, Biomed Devices announced their intention to take over Pharmacore Industries in a 1 for 1 stock swap. A merger arbitrage hedge fund manager noticed that prior to the announcement, Biomed’s stock was trading at $121 per share, while Pharmacore’s stock was trading at $98 per share. After the merger announcement, Biomed’s stock dropped to $112 per share, while Pharmacore’s stock climbed to $107 per share.

Which of the following best identifies the appropriate merger arbitrage strategy and potential profit once the deal is complete?

A. Buy Pharmacore Industries, short sell Biomed Devices; Profit = $5.00.

B. Buy Pharmacore Industries, short sell Biomed Devices; Profit = $9.00.

C. Buy Biomed Devices, short sell Pharmacore Industries; Profit = $9.00.

D. Buy Biomed Devices, short sell Pharmacore Industries; Profit = $5.00.

30. Which of the following hedge fund strategies has the least amount of market risk?

A. Dedicated Short Bias

B. Equity Market Neutral

C. Long/Short Equity

D. Convertible Arbitrage

31. Which of the following best describes the main source of risk in a merger arbitrage hedge fund strategy?

A. Liquidity risk.

B. Credit risk.

C. Systematic risk.

D. Event risk.

32. Which of the following strategies has the most extensive investment universe?

A. Fixed Income Arbitrage

B. Merger Arbitrage

C. Global Macro

D. Long/Short Equity

33. Distressed debt hedge funds performed very badly in both 1998 and 2008, why was that?

A. Their returns are negatively skewed.

B. Their returns are sensitive to widening credit spreads.

C. Their returns reached their capacity constraint.

D. Their returns rely on short selling equities.

34. A Hedge Fund following which of the following strategies would theoretically require the longest lock-up & least frequent redemption frequency?

A. Distressed Securities

B. Long Short Equity

C. Global Macro

D. Managed Futures

35. Which of the following strategies has historically performed best in periods of widening credit spreads?

A. Distressed Securities

B. Fixed Income Arbitrage

C. Managed Futures

D. Emerging Markets

36. Which of the following strategies returns would you expect to show the highest level of serial correlation?

A. Long Short Equity

B. Distressed Securities

C. Managed Futures

D. Global Macro

37. In Fung & Hsieh (2004) the authors found that on average Long/Short Equity Hedge Funds have which of the following exposures?

A. Net Long the Market and Short the Small versus Large cap spread

B. Net Long the Market and Long the Small versus Large cap spread

C. Net Short the Market and Long the Small versus Large cap spread

D. Net Short the Market and Short the Small versus Large cap spread

38. Which of the following statements best describes the underlying assumption for the factor-based approach to hedge fund replication?

A. The returns are normally distributed.

B. The factors explain a significant amount of hedge fund returns.

C. The returns have autocorrelation through time.

D. The Fama-French four-factor model explains hedge fund returns.

39. Which of the following factors has been shown to have the LEAST influence on hedge fund returns?

A. S&P 500 returns

B. Small Cap minus Large Cap returns

C. Value minus Growth returns

D. Changes in Credit Spreads

40. Various academic studies have suggested that the bulk of the diversification benefit can be achieved with a portfolio of 10-15 hedge funds, however in practice most Funds of Hedge Funds invest in a much larger number.

What could explain the disparity between academic research & practitioner behaviour?

A. Holding more funds reduces the risk of a single catastrophic loss

B. Holding more funds increases the correlation with equity markets.

C. Holding more funds is costless

D. Holding more funds will lead to higher fees.

41. In “10 Things Investors Should Know about Hedge Funds” Harry Kat says that hedge funds “do not combine very well with equity”, how does he explain this?

A. Introducing hedge funds to a traditional stock and bond portfolio will reduce the standard deviation.

B. Hedge funds generally have a high correlation with stocks and bonds

C. Hedge funds returns generally exhibit positive serial correlation.

D. Introducing hedge funds to a traditional stock and bond portfolio leads to a significant drop in skewness.

42. FUND ECONOMICS (18 marks total)

$150 million was invested at the beginning of a private equity fund’s 10-year life.

The fund’s fees are a 2% annual management fee and 20% carried interest.

There is a 5% soft hurdle rate, calculated on a simple annual interest basis (ie, not compounded interest).

Proceeds are distributed to LPs and carried interest paid out to the GPs as soon as each deal has been exited.

The first exit occurs at the end of Year 6 with gross proceeds of $90 million, the total investment in this deal was $35 million.

The second exit million occurs at the end of Year 7. The Gross Capital Gain is $80 million, and the GP receives carried interest of $16 million from the second exit.

What carried interest will the GP of the fund receive from the first exit? (8 marks)

What proceeds will be received by LPs after the second exit? (10 marks)

52. VENTURE CAPITAL VALUATION AND DEAL STRUCTURING (19 marks total)

Grossflix Ltd, an early-stage venture capital-backed company, received an initial first round investment of £5 million from Friendly Ventures. Grossflix wants to raise a second round of financing of £2 million at the beginning of its fourth year of operations. Friendly Ventures has asked your own venture capital firm to invest in this second-round financing.

Grossfix Ltd has three shareholders:

· Friendly Ventures owning 2,000 shares

· The founder and CEO, who owns 5,000 shares

· The CTO, who owns 3,000 shares

Key members of the management team have been given options that can be exercised at the end of Year 4 entitling them to 20% of the company’s shares.

Your firm aims to achieve an IRR that is equivalent to achieving a multiple of 10.5X over a 10-year period.

Friendly wants to maintain their existing percentage ownership of Grossflix

Grossflix believes they will be able to sell the company at the end of five years for a PE multiple of 20X when the company will achieve £4 million of net profit in Year 5.

What percentage ownership of Grossflix would your fund need to own at the conclusion of the second round of financing? (10 marks)

If Grossflix is sold at the end of Year 5, what investment multiple would Friendly Ventures achieve? (9 marks)

53. BUYOUT VALUATION (18 marks total)

Using information about Anacott Steel from Exhibit B, calculate the cash flows required for determining the company’s valuation using the Adjusted Present Value (APV) Method (Use the three boxes provided for Question 53a in the Answer Sheet for your answers for Years 1,2,3) (12 marks)

Using information about Anacott Steel from Exhibit B calculate the interest tax shields required for determining the company’s valuation using the Adjusted Present Value (APV) Method (Use the three boxes provided for Question 53b in the Answer Sheet for your answers for Years 1,2,3) (6 marks)

54. BUYOUT DEAL STRUCTURING (20 marks total)

Projections for Anacott Steel which currently has $60 million of senior debt, are shown in Exhibit B. You are a General Partner in a buyout fund contemplating a buyout of Anacott Steel, which you believe can be acquired for 5X historical EBITDA which was $27m last year.

The most you can borrow for the deal is 70% of the amount to be financed, at an interest rate of 4% and you know that transactions fees will be 1%.

The most the management team can contribute to the deal is $1m for which you are prepared to award them 10% of the equity.

a. What capital gain will the management team achieve if Anacott is sold at the beginning of Year 3 at the same multiple it was purchase at? (15 marks)

b. Can you successfully meet a required Covenant Ratio (EBITDA/Debt Interest) of 7.5X? (5 marks)

Question 55

Fung & Hsieh (1999) found that linear regression models were less successful at explaining the returns of hedge funds when compared to mutual funds. In order to overcome this, some subsequent research has focussed on using option strategies as explanatory variables with more success.

Using your knowledge of the Trend Following and Risk Arbitrage strategies as well as the academic literature, discuss which option strategies best explain the returns of these two strategies and why this might be the case. (25 marks)

Question 56

The way in which hedge fund indices are constructed mean that they are potentially subject to several biases and these biases can lead to a distorted view of hedge fund performance.

A colleague suggests that to overcome these issues investable hedge fund indices should be used as a benchmark as they are most definitely bias free.

Briefly discuss the three key biases, including causes and magnitude. Do you agree with your colleague or is there a better solution? (25 marks)