Alternative Investments in CFA Level 2 focus on valuation techniques, performance analysis, and risk return characteristics of non traditional asset classes.
Unlike Level 1, which introduces basic concepts, Level 2 requires candidates to:
- evaluate alternative investment performance
- apply valuation models
- understand investment strategies
- analyze risk and return tradeoffs
Alternative investments are widely used by institutional investors to enhance diversification and improve portfolio performance.
10.1 Private Equity Valuation
Private equity involves investing in companies that are not publicly traded. Valuation of private companies is more complex due to lack of market prices.
Private equity investments typically follow a life cycle from initial investment to exit.
Investment Stages
Private equity investments occur at different stages of a company’s development.
Venture Capital
Investment in early stage companies with high growth potential.
Characteristics include:
- high risk
- high return potential
- focus on innovation driven businesses
Growth Stage
Investment in companies that are already established and generating revenue.
Capital is used for:
- expansion
- entering new markets
- scaling operations
Buyout Stage
Private equity firms acquire controlling stakes in companies.
This often involves restructuring operations to improve efficiency and profitability.
Exit Strategies
Private equity firms generate returns by exiting investments.
Common exit strategies include:
Initial Public Offering
Selling shares to the public.
Trade Sale
Selling the company to another business.
Secondary Sale
Selling the stake to another private equity firm.
The timing and method of exit significantly impact investment returns.
Valuation Methods
Private equity valuation often uses:
- comparable company analysis
- discounted cash flow analysis
- precedent transactions
Valuation requires careful estimation of future cash flows and appropriate discount rates.
10.2 Hedge Fund Strategies
Hedge funds use advanced strategies to generate returns, often independent of overall market performance.
Risk and Return Characteristics
Hedge funds aim to deliver:
- absolute returns rather than benchmark returns
- lower correlation with traditional assets
- risk adjusted performance
However, hedge funds may involve:
- higher fees
- complex strategies
- limited liquidity
Common Hedge Fund Strategies
Long Short Equity
Managers take long positions in undervalued stocks and short positions in overvalued stocks.
Goal is to profit from relative price differences.
Global Macro
Investment decisions are based on macroeconomic trends such as:
- interest rates
- currency movements
- economic growth
Event Driven
Focuses on corporate events such as:
- mergers and acquisitions
- restructurings
- bankruptcies
Performance Evaluation
Hedge fund performance is evaluated using:
- risk adjusted returns
- consistency of performance
- drawdowns
Investors must consider both returns and associated risks.
10.3 Real Estate Valuation
Real estate is an important alternative asset class that provides both income and capital appreciation.
Valuation of real estate focuses on estimating the value of income generating properties.
Income Approach
The income approach values real estate based on the income it generates.
Basic idea
Property Value = Net Operating Income / Capitalization Rate
Where:
Net Operating Income represents income after operating expenses.
Capitalization rate reflects required return based on risk.
Discounted Cash Flow Approach
The discounted cash flow approach estimates property value based on future cash flows.
DCF Formula
Property Value = Present value of future cash flows + Present value of sale price
This approach considers:
- rental income
- operating expenses
- expected growth in income
- terminal value at sale
Key Factors Affecting Real Estate Value
- location
- demand and supply
- interest rates
- economic conditions
Importance of Alternative Investments in Level 2
This module is important because it helps candidates:
- evaluate non traditional asset classes
- apply valuation techniques to illiquid investments
- understand hedge fund strategies
- analyze risk return characteristics
In CFA Level 2, questions often require candidates to compare different alternative investments and evaluate their performance and risks.