1. Introduction 
This learning module covers: 
•    Features and categories of alternative investments 
•    Methods of investing in alternative investments; the advantages and disadvantages of 
each method 
•    Investment and compensation structures commonly used in alternative investments 
Traditional investments refer to long-only positions in stocks, bonds, and cash. All other 
investments are classified as alternative investments.  
Alternative investments can be divided into three main categories: 
•    Private capital 
•    Real assets 
•    Hedge funds 
2. Alternative Investment Features 
Why Investors Consider Alternative Investments 
Since the mid-1990s assets under management in alternative investments have grown 
significantly. Investors consider alternative investments due to: 
•    The potential for portfolio diversification. Alternative investments have low 
correlation with traditional asset classes. 
•    The opportunities for enhanced returns. Adding alternative investments can increase 
the portfolio’s risk-return profile. 
•    The potentially increased income through higher yields. During low-interest rate 
periods, alternative investments can provide significantly higher yields as compared 
to traditional investments. 
Alternative Investments: Features and Categories 
Some features of alternative investments are same as traditional investments, while some 
features are significantly different. Features that distinguish alternative investments are: 
•    Need for specialized knowledge: For example, within private equity, you have 
leveraged buyout and venture capital. There are managers who focus only on 
leveraged buyouts within private equity. 
•    Relatively low correlation with traditional investments. But correlation may increase 
during times of financial crisis. 
•    Illiquidity, long investment time horizons, and large capital outlays 
Due to these features, alternative investments have the following characteristics: 
•    Different investment structures to solve the challenges of direct investment 
•    Incentive-based fee structure to address information asymmetry between managers 
and investors. 
•    Performance appraisal challenges 
Categories of Alternative Investments 
The main categories of alternative investments are: 
Private capital 
Private equity:  
•    Private equity funds invest in the equity of private companies or public companies 
that want to become private. 
•    They are further divided into 
o   Leveraged buyout funds: Invest in established companies. 
o   Venture capital funds: Invest in startups or early-stage companies. 
Private debt: 
•    Includes debt provided to private entities. 
•    Forms of private debt include: 
o   Direct lending: private loans with no intermediary. 
o   Mezzanine loans: private subordinated debt. 
o   Venture debt: private loans to startups or early-stage companies. 
o   Distressed debt: private loans to distressed companies, e.g., companies facing 
bankruptcy. 
Real Assets 
Real estate: 
•    Investments in buildings or land either directly or indirectly. 
•    Securitization has broadened the definition of real estate investing and it now 
includes: 
o   Private commercial real estate equity: e.g., ownership of an office building 
o   Private commercial real estate debt: e.g., directly issued mortgages on commercial 
property 
o   Public real estate equity: e.g., real estate investment trusts (REITS) 
o   Public real estate debt: e.g., mortgage-backed securities (MBS). 
Infrastructure: 
•    Investments in capital intensive, long-lived, real assets such as roads, dams, and 
schools, which are intended for public use and provide essential service. 
•    A common approach to infrastructure investing is a public–private partnership (PPP) 
in which both the government and investors have a stake. 
Natural Resources: 
Commodities: 
•    Investment in physical assets such as grains, metals, crude oil, etc. 
•    Commodity investments can be done by either owning physical assets, using 
derivative products, or investing in business engaged in the exploration and 
production of physical commodities. 
Agricultural land (or farmland): 
•    Investments in land used for the cultivation of crops or livestock. 
•    Income can be generated from the growth, harvest and sale of crops or livestock; or by 
leasing the land back to farmers. 
Timberland: 
•    Investments in natural forests or managed tree plantations. 
•    The return comes from the sale of trees, wood, and other timber products. 
Digital Assets: 
•    An umbrella term that covers assets that can be created, stored, and transmitted 
electronically an have associated ownership or use rights. 
•    E.g., cryptocurrencies and tokens. 
Hedge funds 
•    They are private investment vehicles that manage portfolios of securities and 
derivative positions using a variety of strategies. 
•    Some hedge funds aim for absolute returns independent of market performance. 
3. Alternative Investment Methods 
Alternative Investment Methods 
The three methods of investing in alternative investments are: 
•    Fund investing: The investor contributes capital to a fund, and the fund makes 
investments on the investors’ behalf, e.g., investments in a PE fund.  
•    Co-investing: The investor can make investments alongside a fund, e.g., investments 
in a portfolio company of a fund. In co-investing, the investor is able to invest both 
directly and indirectly in the same assets. 
•    Direct investing: The investor makes a direct investment in a company or project 
without the use of an intermediary, e.g., direct investments in infrastructure or real 
estate assets. 
Exhibit 1 from the curriculum illustrates the three methods of investing in alternative 
investments: 
 
Advantages and Disadvantages of Direct Investing, Co-Investing, and Fund Investing 
The following table summaries the advantages and disadvantages of the different methods of 
investing. 
                                         Advantages                                                Disadvantages 
Fund 
investing 
•    Lower level of investor 
involvement as the fund manager 
provides investment services and 
expertise 
•    Access to alternative investments 
without possessing a high degree 
of investment expertise 
•    Lower minimum capital 
requirements 
•    Costly management and 
performance fees 
•    Investor must conduct thorough 
due diligence when selecting the 
right fund because of the wide 
dispersion of fund manager 
returns 
•    Investors less able to exit the 
investment as funds typically 
have lock-ups and other 
restrictions  
Co-
investing 
•    Investors can learn from the 
fund’s process to become better 
at direct investing 
•    Reduced management fees 
•    Allows more active management 
of the portfolio compared with 
fund investing and allows for a 
deeper relationship with the 
manager 
•    Reduced control over the 
investment selection process 
compared with direct investing 
•    May be subject to adverse 
selection bias 
•    Requires more active 
involvement compared with 
fund investing, which can be 
challenging  
Direct 
investing 
•    Avoids paying ongoing 
management fees to an external 
manager 
•    Greatest amount of flexibility for 
the investor 
•    Highest level of control over how 
the asset is managed 
•    Requires more investment 
expertise and a higher level of 
financial sophistication resulting 
in higher internal investment 
costs 
•    Less access to a fund’s ready 
diversification benefits or the 
fund manager’s sourcing 
network 
•    Requires more complex due 
diligence because of the absence 
of a fund manager 
•    Higher minimum capital 
requirements 
4. Alternative Investment Structures 
Partnership Structures 
The most common structure for many alternative investments is a partnership. It consists of 
two entities: 
•    General partner (GP): The fund manager is the general partner (GP). The GP is 
responsible for managing the fund and making investment decisions. The GP 
theoretically bears unlimited liability for anything that goes wrong. 
•    Limited partners (LP): LPs are outside investors who provide capital to the fund in 
return for a fractional partnership in the fund. They bear the risk associated with 
investments. LPs usually play a passive role and are not involved with the 
management of the fund. 
The partnership between the GP and LPs is governed by a limited partnership agreement 
(LPA). It is a legal document that outlines the rules of the partnership and establishes the 
framework for the fund’s operations. 
In addition to LPAs, side letters may also be negotiated, which are additional terms between 
the GP and certain LPs that exist outside the LPA (which is a common document for all LPs).  
Other structures may be adopted for specific alternative investments. For example: 
•    Infrastructure investors often enter into public-private partnerships, which are 
agreements between the public sector and private sector. 
•    Real estate direct investing often involves a joint venture structure. 
•    Real estate fund investing often involves a unitholder structure. 
Compensation Structures 
The general partner typically receives a management fee based on assets under 
management (commonly used for hedge funds) or committed capital (commonly used for 
private equity). Management fee typically ranges from 1% to 2%. 
Apart from the management fee, the GP also receives a performance fee (also called 
incentive fee or carried interest) based on realized profits. Performance fees are designed to 
reward GPs for good performance. A common fee structure is 2 and 20 which means 2% 
management fee and 20% performance fee. 
Generally, the performance fee is paid only if the returns exceed a hurdle rate (also called a 
preferred rate). A hurdle rate of 8% is typically used. 
•    Hard hurdle rate: The GP earns fees on annual returns in excess of the hurdle rate. 
•    Soft hurdle rate: The GP earns fees on the entire annual gross return as long as the set 
hurdle is exceeded. 
Common Investment Clauses, Provisions, and Contingencies 
Common investment clauses, provisions and contingencies specified in the LPA include: 
Catch-up clause: A catch-up clause allows the GP to receive 100% of the distributions above 
the hurdle rate until he receives 20% of the profits generated, and then every excess dollar is 
split 80/20 between the LPs and GP. This clause is meant to make the manager whole so that 
their incentive fee is a function of the total return and not solely on the return in excess of 
the hurdle rate. 
Example: 
Assume that the GP has earned an 18% IRR on an investment, the hurdle rate is 8%, and the 
partnership agreement includes a catch-up clause. 
In this case the distribution would be as follows: 
•    The LPs would receive the entirety of the first 8% profit. 
•    The GP would receive the entirety of the next 2% profit—because 2% out of 10% 
amounts to 20% of the profits accounted for so far. 
•    The remaining 8% would be split 80/20 between the LPs and the GP 
Thus, the GP effectively earns: 18% x 20% = 3.6% and the LP effectively earns 18% x 80% = 
14.4%. 
In the absence of a catch-up clause the distributions would have been: 
•    The LPs would still receive the entirety of the first 8% profit. 
•    The remaining 10% would be split 80/20 between the LPs and GP. 
Thus, in this case the GP effectively earns a lower return of (18% - 8%) x 20% = 2.0%  
High water mark: In some cases, the incentive fee is paid only if the fund has crossed the 
high-water mark. A high-water mark is the highest value net of fees (or the highest 
cumulative return) reported by the fund so far for each of its investors. This is to ensure 
investors do not pay twice for the same performance. 
Waterfall: The waterfall defines the way in which cash distributions will be allocated 
between the GP and the LPs. In most waterfalls, a GP receives a disproportionately larger 
share of the total profits relative to their initial investment. This is typically done to 
incentivize GPs to maximize profitability. 
There are two types of waterfalls: 
•    Whole-of-fund (or European) waterfalls: As deals are exited, all distributions go to the 
LPs first. The GP does not participate in any profits until the LPs receive their initial 
investment and the hurdle rate has been met. 
•    Deal-by-deal (or American) waterfalls: Performance fees are collected on a per-deal 
basis. This is more advantageous for a GP as he can get paid before LPs receive both 
their initial investment and their preferred rate of return on the entire fund. 
Clawback: A clawback provision allows LPs to reclaim a part of the GP’s performance fee. 
For example, if a fund makes profitable exits in early years, but the subsequent exits are less 
profitable, then the GP has to pay back profits to ensure that the profit split is in line with the 
fund prospectus. 
 
 
 
 
                                                        
Summary 
LO: Describe features and categories of alternative investments. 
Traditional investments refer to long-only positions in stocks, bonds, and cash. All other 
investments are classified as alternative investments.  
Alternative investments can be divided into three main categories: 
•    Private capital – Includes private equity and private debt 
•    Real assets – Includes real estate, infrastructure, natural resources and others 
•    Hedge funds 
Features that distinguish alternative investments from traditional investments are: 
•    Need for specialized knowledge: For example, within private equity, you have 
leveraged buyout and venture capital. There are managers who focus only on 
leveraged buyouts within private equity. 
•    Relatively low correlation with traditional investments. But correlation may increase 
during times of financial crisis. 
•    Illiquidity, long investment time horizons, and large capital outlays 
LO: Compare direct investment, co-investment, and fund investment methods for 
alternative investments. 
The three methods of investing in alternative investments are: 
•    Fund investing: The investor contributes capital to a fund, and the fund makes 
investments on the investors’ behalf, e.g., investments in a PE fund.  
•    Co-investing: The investor can make investments alongside a fund, e.g., investments in 
a portfolio company of a fund. 
•    Direct investing: The investor makes a direct investment in a company or project 
without the use of an intermediary, e.g., direct investments in infrastructure or real 
estate assets. 
LO: Describe investment ownership and compensation structures commonly used in 
alternative investments. 
The most common structure for many alternative investments is a partnership. It consists of 
two entities: General partner (GP) who is responsible for managing the fund and making 
investment decisions, and limited partners (LPs) who provide capital to the fund in return 
for a fractional partnership in the fund. 
The general partner typically receives a management fee based on assets under management 
(commonly used for hedge funds) or committed capital (commonly used for private equity). 
Apart from the management fee, the GP also receives a performance fee (also called 
incentive fee or carried interest) based on realized profits. Generally, the performance fee is 
paid only if the returns exceed a hurdle rate. 
 Please create 10 MCQs for CFA exam preparation from the provided content.
Use this exact structure for each question:
	
{
    question: "The full question text goes here",
    options: [
        { label: "A", text: "First option text" },
        { label: "B", text: "Second option text" },
        { label: "C", text: "Third option text" },
        { label: "D", text: "Fourth option text" }
    ],
    answer: "The correct letter (A, B, C, or D)",
    explanation: Structure every explanation as follows:
1.	Definition: What the correct answer is, in precise terms.
2.	Reasoning: How the question's clues point to it.
3.	Example: A  practical illustration.
4.	Incorrect Option Nuances: Why each distractor fails (and when it might apply). Integrate the richer “nuance + counter-example” so each wrong option becomes a mini-lesson, not just a dismissal.
}