Accessing Alternative Investments
Structure determines economics and economics determine alignment. This is the topic where the exam most reliably asks you to compute something.
Access routes compared
The trade-off to articulate: as you move down that list, cost falls and control rises, but the required internal capability rises faster. The right answer for any institution is set by its governance budget, not by the theoretical fee saving.
Fee mechanics
Management fee. Typically 1.5–2% during the investment period, charged on committed capital — which is why the fee drag is heaviest before any capital is deployed and contributes directly to the J-curve. After the investment period it usually steps down and switches to a base of invested capital, cost of unrealised investments, or NAV. Offsets to check in the LPA: transaction, monitoring and director fees charged to portfolio companies should be credited back to LPs (typically 80–100%).
Carried interest. The GP's share of profits, conventionally 20%, paid above a preferred return (hurdle) of roughly 8%. Three variants you must be able to compute:
with catch-up
Hedge fund fee features: the high-water mark prevents charging performance fees on the same gains twice after a loss (note the perverse incentive it creates for a deeply underwater manager to take risk or close and relaunch); a hurdle may be absolute or tied to a cash rate; crystallisation frequency matters, since more frequent crystallisation raises the effective fee on a volatile return path.
Fee drag arithmetic. Always compute net, not gross. A 2-and-20 structure on a 12% gross return with an 8% soft hurdle and full catch-up leaves the LP close to 8% net — and a fund-of-funds layer on top can take another 1-and-10. When an exam gives you gross returns and a fee schedule, it wants the net number.
European vs American waterfalls
Distributions follow a strict order for the fund as a whole: (1) return of all contributed capital including fees and expenses, (2) preferred return, (3) GP catch-up, (4) 80/20 split of the remainder. The GP receives no carry until every LP dollar plus the preferred return is back. LP-friendly; clawback rarely needed; GP compensation is heavily back-loaded.
The same order applied to each realised investment individually, so carry is paid on early winners before later losers are known. GP-friendly and cash-flow-attractive for retaining talent. Requires protective mechanics: clawback (GP repays excess carry at the end), escrow of a share of carry, interim true-ups, and a GP guarantee — because a clawback is only as good as the GP's ability to pay it, often after taxes have been paid on the carry.
Worked pattern to rehearse. Fund draws $100m, returns $180m, 8% preferred (say $30m cumulative), 100% catch-up, 20% carry. European: LPs get $100m capital, then $30m preferred; the remaining $50m goes first to the GP catch-up until the GP has 20% of the $80m profit ($16m), then 80/20 on the rest. Work these slowly on paper until the order is automatic — the exam's marks are in the sequencing, not the arithmetic.
Other LPA terms that carry marks: key-person clauses (suspension of the investment period if named principals depart), no-fault divorce and for-cause removal provisions, LP advisory committee rights over conflicts and valuation, most-favoured-nation clauses on side letters, recycling provisions (allowing distributions to be reinvested, which raises the multiple but extends the fund life), and GP commitment — the amount of the GP's own money in the fund, the single cleanest alignment signal.
Subscription lines & IRR distortion
A subscription (capital call) credit facility is borrowing secured against LPs' uncalled commitments. The GP funds an investment with the facility and calls LP capital later, sometimes months later. Legitimate uses: operational smoothing, fewer and larger capital calls, speed to close a deal.
The distortion. IRR is a money-weighted return computed from the timing of the LP's own cash flows. Delaying the outflow shortens the period over which the return compounds, which raises the reported IRR without changing the amount of money made. The multiple (TVPI/MOIC) is unaffected, except by the facility's interest cost, which slightly reduces it. Hence the rule: a subscription line raises IRR and lowers the multiple. Any comparison of IRRs across funds with different facility usage is meaningless without adjustment.
Other risks of the facility: it is a genuine leverage layer, so a broad market shock plus a lender pulling the line forces simultaneous large capital calls across many LPs; and the LP's uncalled commitment is a contingent liability that must be included in its own liquidity planning. Look for a stated maximum outstanding amount and maximum days outstanding — 90 to 180 days is a common LP-protective limit.
Liquid alts & semi-liquid wrappers
The spectrum. Regulated mutual funds and UCITS offering hedge-fund-like strategies; interval and tender-offer funds with periodic repurchases; non-traded REITs and non-traded BDCs; evergreen private-market funds. Each trades some of the strategy for liquidity, and the exam wants the specific mechanism of that trade.
What the wrapper costs the strategy. Regulatory constraints on leverage, illiquid holdings and concentration force a manager to run a diluted version of the offshore original — documented as a persistent performance gap between liquid-alt versions and their private counterparts. A cash and liquid-securities buffer is required to meet redemptions, producing permanent cash drag. Daily or quarterly valuation forces mark-to-model on assets that have no market price, so NAV accuracy becomes the central diligence question.
What the wrapper gives. Lower minimums, no capital calls, simplified tax reporting, regulated disclosure and an independent board, daily or periodic liquidity, and — for smaller investors — access to a return stream otherwise unavailable. For an institution the calculus is different: it usually has the ability to hold the illiquid version, so paying for liquidity it does not need is value destruction.
The structural warning repeated throughout the curriculum: a vehicle offering more liquidity than its assets possess is stable only while flows are calm. Gates, queues, prorated repurchases and NAV-strike lags are the designed response, and they concentrate the cost on whoever is slowest to the exit.
Co-investment & secondaries
Co-investment economics. Typically no management fee and no carry, so a programme that puts, say, 30% of private-market capital into co-investments can reduce the blended fee load by roughly a third. It also accelerates deployment and improves vintage pacing. The analytical questions: is there adverse selection (the GP keeps the best and syndicates the rest — check whether allocation is contractual and pro-rata, or discretionary); can the LP underwrite independently rather than relying on the GP's memo; and does the concentration created fit the risk budget, since co-investments are single assets, not portfolios.
Secondaries — LP-led. An existing LP sells a fund interest, usually for liquidity, portfolio pruning, or denominator-effect relief. The buyer receives a seasoned portfolio of known assets, mitigating blind-pool risk, shortening the J-curve, and typically buying at a discount to a reference NAV. Pricing mechanics to know: the reference date, whether interim cash flows accrue to buyer or seller, the remaining unfunded commitment assumed, and the staleness of the reference NAV relative to current markets.
Secondaries — GP-led / continuation vehicles. The GP transfers one or more assets from an existing fund into a new vehicle, offering existing LPs the choice to cash out at the transaction price or roll into the new fund. It solves a real problem — a good asset outliving its fund — but the GP prices a trade with itself. Diligence and governance points: an independent valuation and fairness opinion, LPAC approval, a genuinely equivalent roll option (no penalty for status quo), disclosure of how existing carry is crystallised and how new carry is set, and whether the GP is rolling its own carry into the new vehicle as an alignment signal.
LPA terms & side letters
Fees are the terms candidates study; the alignment terms are the ones that decide outcomes. Know what each protects and who it protects.
Excuse and default provisions round out the set: an LP may need to be excused from an investment on legal or policy grounds, and the penalty for failing to fund a capital call (interest, forfeiture of a portion of the interest, forced sale) can be severe — relevant to any question about an over-committed investor in a drawdown.
Confusion pairs
Practice
Six multiple-choice questions in exam style, with the reasoning — not just the letter.
1. A GP draws heavily on a subscription line for the first nine months of each investment. Compared with calling capital immediately, this will:
2. Which waterfall structure most requires a clawback provision, and why?
3. A fund with an 8% soft hurdle, 100% catch-up and 20% carry returns a 20% gross annual profit. Relative to a hard hurdle, the GP's carry will be:
4. The primary analytical concern with a co-investment programme is:
5. A UCITS version of an offshore hedge fund persistently underperforms it by 150–250bp annually. The most likely explanation is:
6. An LP is offered the choice to roll into a continuation vehicle or cash out at the transaction price. The strongest evidence of alignment would be:
Constructed-response practice
Write these under time. Each outline is the shape the rubric rewards, not a model answer to memorise.
Prompt A (15 minutes). Two buyout funds report identical 22% net IRRs. Fund A uses a subscription line for up to 180 days and a deal-by-deal waterfall; Fund B calls capital immediately and uses a whole-fund waterfall. Explain which you would prefer and what additional information you would require.
- State the headline problem: identical IRRs do not mean identical performance, because IRR is sensitive to cash-flow timing and to the fee-payment schedule.
- Fund A's IRR is flattered by the facility; ask for IRR gross of the line and for TVPI/DPI, which are timing-immune.
- Fund A's deal-by-deal carry accelerates GP payment and shifts risk to the LP; ask about escrow levels, interim true-ups and the GP guarantee behind the clawback.
- Add the like-for-like comparison: a public market equivalent for each, using identical cash flows against the same index.
- Conclude with a preference conditional on the data — B on structure, but note that structure is not performance and manager quality dominates both.
Prompt B (12 minutes). A $3bn pension plan currently accesses private equity only through commingled funds. Recommend a structure to reduce the blended fee load, and identify the organisational requirements and risks your recommendation creates.
- Quantify the starting point: 2-and-20 on the whole programme, and where the fee actually falls (committed capital during the investment period).
- Recommend a co-investment sleeve at a stated share of the programme, with a fallback of separately managed accounts for fee negotiation and customisation.
- Organisational requirements: dedicated underwriting staff, delegated authority for fast decisions, legal capacity, and a monitoring framework — the governance budget question.
- Risks: adverse selection, single-asset concentration, correlated timing (co-investments cluster in hot markets), and reduced diversification per dollar.
- Controls: contractual pro-rata rights, an independent underwriting standard, per-deal and per-GP limits, and pacing rules integrated with the main commitment plan.