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Study guide · Session 2

Alternative Investments

6-9% of the exam · session 2 · 7 learning modules

Alternative Investments covers private equity and debt, real estate, infrastructure, natural resources and hedge funds: how they are structured and accessed, how managers are paid, and how their returns and risks are measured. The topic also opens with the one-period binomial model for valuing an option. Level I questions test features and structures, with short calculations on fees, waterfalls, cap rates, commodity returns and binomial values.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of this topic's 7 learning modules in the 2027 curriculum, named in our own words.

At a glance

Session 2
6-9%

of the exam, as CFA Institute weights it for 2027

Weight
6-9%
Modules
7
Key terms
10

What this guide covers, module by module

  1. ALT.1Alternative assets: types, access and fees
  2. ALT.2Measuring alternative returns after fees
  3. ALT.3Private equity and private credit funds
  4. ALT.4Property and infrastructure investing
  5. ALT.5Land, timber, farmland and commodities
  6. ALT.6Hedge fund strategies and vehicles
  7. ALT.7Ledger technology and crypto assets

ALT.1Alternative assets: types, access and fees

  • Alternatives include private capital, real estate, infrastructure, natural resources and hedge funds; they tend to be illiquid, less regulated and transparent, harder to value and more expensive than traditional assets.
  • Fund investment pools capital with a manager (lowest effort, highest fees); co-investment adds direct stakes alongside the fund at lower fees; direct investment buys assets without a fund (most control, needs the most skill).
  • Limited partnership: limited partners supply most of the capital with limited liability; the general partner manages the fund, has unlimited liability and usually commits some capital.
  • Compensation: a management fee on committed or invested capital or on assets, plus an incentive fee or carried interest on profits, often above a hurdle rate.
  • A whole-of-fund (European) waterfall pays carry only after limited partners recover capital and the preferred return across the fund; a deal-by-deal (American) waterfall pays carry deal by deal.
  • Clawbacks make the general partner repay carry later found excessive; high-water marks stop incentive fees on gains that only recover past losses.
  1. The situationA private equity fund has USD 500 million of committed capital, a 2% management fee on commitments and 20% carried interest.
  2. Step 1Annual management fee = 2% x 500 = USD 10 million, paid whether or not the fund profits.
  3. Step 2Carried interest is paid only on profits, after the waterfall's conditions are met.
  4. Where questions turnDeal-by-deal waterfalls pay the general partner earlier; whole-of-fund waterfalls favour limited partners.
  5. The takeawayManagement fees are steady income for the manager; carry ties its pay to results.
Practise ALT.1

ALT.2Measuring alternative returns after fees

  • Appraisal-based and infrequently priced returns are smoothed, understating volatility and correlation with listed markets and flattering Sharpe ratios.
  • Database returns suffer survivorship bias (failed funds drop out) and backfill bias (funds add good histories when they join), both overstating average returns.
  • Private funds are judged with money-weighted measures (IRR) and multiples: DPI = distributions / paid-in, RVPI = remaining value / paid-in, TVPI = DPI + RVPI.
  • Net return = (gross gain - management fee - incentive fee) / beginning capital; read each fund's terms on what the fees are charged on.
  • Hard hurdle: incentive only on returns above the hurdle. Soft hurdle: once the hurdle is cleared, incentive on the whole return.
  • Fee terms such as high-water marks, hurdles, and whether incentive is computed net of the management fee change the investor's net return.
  1. The situationA fund starts at 100 and ends at 112 before fees; 2% management fee on beginning capital; 20% incentive above a 6% hard hurdle, computed net of the management fee.
  2. Step 1Management fee = 2; gain net of it = 12 - 2 = 10.
  3. Step 2Excess over the hurdle = 10 - 6 = 4; incentive = 20% x 4 = 0.8.
  4. Step 3Net return = (12 - 2 - 0.8) / 100 = 9.2%.
  5. Where questions turnCharging the incentive on the gross gain instead of the gain net of the management fee (or ignoring the hurdle) overstates fees.
  6. The takeawayA gross return of 12% becomes 9.2% net; the fee terms decide the gap.
Practise ALT.2

ALT.3Private equity and private credit funds

  • Private equity stages: venture capital (early-stage, high risk), growth equity (minority stakes in expanding firms) and buyouts (control, often leveraged).
  • Leveraged buyouts finance most of the price with debt secured on the target, so equity returns depend on leverage, operating improvements and the exit multiple.
  • Exits: trade sale, IPO, sale to another fund (secondary buyout), recapitalization or write-off.
  • Private debt includes direct lending, mezzanine debt (subordinated, often with warrants), venture debt and distressed debt; it offers income and seniority with limited upside.
  • Reported private capital correlations with listed markets are understated by smoothing, so diversification benefits are smaller than they look; private debt diversifies an equity portfolio more than private equity does.
  • Capital is committed, then drawn down over years and returned at exits, which creates the J-curve of early negative returns.
  1. The situationA buyout fund buys a company for EUR 500 million with 60% debt, repays EUR 100 million of debt and exits five years later at EUR 600 million.
  2. Step 1Equity invested = 40% x 500 = 200; debt = 300.
  3. Step 2Debt at exit = 300 - 100 = 200; equity at exit = 600 - 200 = 400.
  4. Step 3Equity multiple = 400 / 200 = 2.0x, while the company's value rose only 20%.
  5. Where questions turnSmoothed private equity returns look less correlated with listed equity than they really are.
  6. The takeawayLeverage and debt repayment turn a modest rise in company value into a large equity gain.
Practise ALT.3

ALT.4Property and infrastructure investing

  • Real estate can be held as debt or equity, privately or publicly: direct property, mortgages, private funds, REITs and mortgage-backed securities.
  • Property types include residential, office, industrial and logistics, and retail; each responds differently to the economy and lease terms.
  • Income approach: value = net operating income / cap rate, where NOI = rental income - operating expenses (before financing and depreciation).
  • Real estate offers income, some inflation protection and diversification, but is illiquid, lumpy, costly to trade and valued by appraisal.
  • Infrastructure assets (transport, utilities, communications, social) are long-lived, often regulated or contracted, with steady cash flows.
  • Greenfield infrastructure is still to be built and carries construction risk; brownfield is already operating with a track record.
  1. The situationAn office building earns NOI of USD 2.4 million a year, and similar buildings trade at a 5% cap rate.
  2. Step 1Value = 2.4 / 0.05 = USD 48 million.
  3. Step 2If the cap rate rose to 6%, value would fall to 2.4 / 0.06 = USD 40 million.
  4. Where questions turnCapitalize net operating income, not gross rent.
  5. The takeawayValue moves inversely with the cap rate, much as a bond's price moves inversely with its yield.
Practise ALT.4

ALT.5Land, timber, farmland and commodities

  • Raw land earns little or no income; its return comes from appreciation and the option to develop it.
  • Timberland returns come from biological growth, timber prices and land value; owners can delay harvest when prices are low.
  • Farmland produces seasonal crops that must be harvested; returns come from crop income and land value, with weather and price risk.
  • Commodities are mostly accessed through futures: total return = spot price return + roll yield + collateral return.
  • Contango (futures above spot) gives long investors a negative roll yield; backwardation gives a positive one.
  • Natural resources can hedge inflation and diversify financial assets, but commodity prices are volatile and driven by supply shocks.
  1. The situationOver a year a collateralized long commodity futures position earns a spot return of 4%, a roll yield of 1% in backwardation and a collateral return of 3%.
  2. Step 1Total return = 4% + 1% + 3% = 8%.
  3. Step 2In contango with a -1% roll yield instead, the total would be 6%.
  4. Where questions turnContango hurts a long futures investor; backwardation helps.
  5. The takeawayInvestors in commodity futures earn more than the spot price change, or less, depending on the curve's shape.
Practise ALT.5

ALT.6Hedge fund strategies and vehicles

  • Hedge funds are lightly regulated private funds that use leverage, short selling and derivatives, with high fees and restricted liquidity (lock-ups, notice periods, gates).
  • Strategy groups: equity hedge (long/short, market neutral), event driven (merger arbitrage, distressed), relative value (arbitrage on pricing gaps) and global macro (top-down views on rates, currencies and markets).
  • Equity market-neutral funds hedge out market beta, so returns come from stock selection and correlate little with equity markets.
  • Vehicles: master-feeder structures for investors in different tax regimes, funds of funds (diversification and selection at an extra layer of fees) and separately managed accounts (transparency and control).
  • Risks include leverage, liquidity mismatch, operational and model risk; reported returns carry survivorship and backfill biases.
  • High-water marks mean incentive fees are earned only on value above the previous peak.
  1. The situationA fund's NAV per share falls from a peak of 100 to 90, then rises to 105 before incentive fees; the incentive fee is 20%.
  2. Step 1High-water mark = 100, so only 105 - 100 = 5 is chargeable.
  3. Step 2Incentive fee = 20% x 5 = 1.0 per share, not 20% x 15 = 3.0.
  4. Where questions turnMarket neutral means low correlation with the market, not low risk.
  5. The takeawayThe high-water mark stops investors paying twice for the same gains.
Practise ALT.6

ALT.7Ledger technology and crypto assets

  • A distributed ledger is a shared database kept in sync across many participants; a blockchain stores transactions in linked blocks secured by cryptography, and a consensus mechanism (such as proof of work or proof of stake) decides which records are valid.
  • Permissionless networks let anyone take part and validate; permissioned networks restrict who can read, write or validate, which suits regulated financial uses such as settlement and tokenised securities.
  • Digital assets include cryptocurrencies, stablecoins (designed to hold a stable value, often against a fiat currency), tokenised real or financial assets and non-fungible tokens; most cryptocurrencies have no cash flows, so their value rests on adoption and supply and demand.
  • Investors gain exposure directly (holding coins in a wallet or on an exchange) or indirectly through funds, exchange-traded products, futures and shares of companies in the industry.
  • Returns have been very volatile with deep drawdowns; risks include custody and hacking, fraud, regulatory change, liquidity and the lack of a fundamental valuation anchor.
  • Historical correlation with traditional assets has been low on average but unstable, often rising in market stress, so the diversification benefit is less reliable than long-run averages suggest.
  1. The situationAn investor compares holding a cryptocurrency directly with buying a regulated exchange-traded product that holds the same coin.
  2. Step 1Direct holding requires managing private keys and carries custody and exchange failure risk.
  3. Step 2The exchange-traded product uses a professional custodian and trades in a brokerage account, but charges fees and may trade away from the coin's value.
  4. Step 3Both carry the same exposure to the coin's price volatility.
  5. Where questions turnAssuming that a low long-run average correlation guarantees diversification when correlations with equities have tended to rise in sell-offs.
  6. The takeawayThe vehicle changes custody, cost and access, not the underlying price risk.
Practise ALT.7

Key terms

Risk-neutral probability
The probability that makes the underlying earn the risk-free rate in expectation; used to price options.
Limited partner
An investor in a fund whose liability is limited to its commitment and who takes no part in management.
Carried interest
The general partner's share of fund profits, usually after a preferred return.
Hurdle rate
The return a fund must exceed before an incentive fee is paid.
High-water mark
The previous peak value above which incentive fees are earned.
Clawback
A term requiring the general partner to repay carried interest later found excessive.
TVPI
Total value to paid-in capital: distributions plus remaining value, divided by paid-in capital.
Cap rate
Net operating income divided by property value.
Roll yield
The gain or loss from replacing an expiring futures contract with a longer one.
Brownfield
An existing infrastructure asset with an operating history.

After this guide: You should be able to value an option with a one-period binomial model, describe the structures and risks of each alternative asset class, and calculate net returns after fees, cap rates and commodity futures returns.

Practise Alternative Investments

Built to the topics and weights CFA Institute publishes for the 2027 Level I curriculum. The module names, explanations, worked examples and traps are ExamDragon's own. Every source this path is built on.