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CFA Level II Chartered Financial Analyst Questions 5–9 (page: 78)

The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:

1. Sverig, a rapidly expanding Swedish start-up construction company.
2. L'Offre, a struggling French department store in existence since the late 19th Century.
Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.

IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.

Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.

Sverig's post-money valuation at the first round of financing, using the NPV venture capital method, is closest to:

The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:

1. Sverig, a rapidly expanding Swedish start-up construction company.
2. L'Offre, a struggling French department store in existence since the late 19th Century.

Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.

IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.
Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.

The appropriate stock price after the first-round of financing for Sverig's first-round investors is closest to:

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:

Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).

Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. One of the advantages is comparability between the two methods since both calculate return relative to systematic risk.

Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:

1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.

Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.

How many of Darin's first two statements to Nielsen regarding Jensen's alpha and the Sharpe ratio are correct?

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:

Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).

Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. One of the advantages is comparability between the two methods since both calculate return relative to systematic risk.

Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:

1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.

Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.

Nielsen's comment on the advantage of put options over short selling is:

Chris Darin, CFA, works as a sell-side senior analyst and vice president for a large Toronto brokerage firm researching mainly hedge funds and alternative investments. Darin recently hired Simon Nielsen for the position of junior analyst at the firm. Although Nielsen does not have experience evaluating hedge funds, Darin hired him mainly for his previous experience at a discount brokerage firm and for his passion for the industry. Darin frequently mentors Nielsen on market trends, investment styles, and on risks inherent in alternative investment vehicles. In a recent conversation, Darin makes the following statements:

Statement 1: One way to measure hedge fund investment performance is through Jensen's alpha. A portfolio with negative Jensen's alpha would plot above the Security Market Line (SML).

Statement 2: Both the Sharpe ratio and Jensen's alpha can be used to measure risk-adjusted hedge fund returns. One of the advantages is comparability between the two methods since both calculate return relative to systematic risk.

Their conversation later shifts to discussing hedge fund classifications and how derivatives affect hedge fund performance measurement. Nielsen mentions that put options are often more advantageous than short selling in a market neutral strategy because of their asymmetric returns.
The following week Darin asks Nielsen to research potential problems and biases in hedge fund indexes and general risks inherent in investing in hedge funds. Nielsen compiles the information and presents the following findings:

1. One of the data problems in hedge fund indexes is that managers often do not disclose negative fund performance.
2. The historical performance of hedge funds that are recently added to an index is often added to the past performance of the index.
3. Long/short equity hedge funds are subject to equity market risk. This risk is typically greater than with equity market neutral or risk arbitrage funds due to the higher standard deviations and market correlations inherent in long/short funds.
4. Fixed income arbitrage funds are also subject to equity market risk. These funds are short Treasuries and long high-credit-risk bonds. In an economic downturn the short position in Treasuries provides a buffer against the long position and provides a net gain.
Finally, the two discuss the risk-free rate and various risk measures in hedge fund performance evaluation. Darin explains that even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Nielsen does not understand and asks him to clarify. Darin further states that risk measures such as Value at Risk have several limitations as a risk measurement tool.

The biases Nielsen refers to in his first two findings, respectively, are:

Managers' discretion in disclosing returns Adding historical performance