Alternative Investments

• Topic 01

  Alternative Investments Overview

  40 questions
• Topic 02

  Private Equity and Venture Capital

  32 questions
• Topic 03

  Real Estate Investments

  79 questions
• Topic 04

  Commodities Markets

  25 questions
• Topic 05

  Infrastructure Investments

  26 questions
• Topic 06

  Hedge Fund Strategies

  46 questions
• Topic 07

  Alternative Investment Performance Measurement

  45 questions
• Topic 08

  Due Diligence in Alternative Investments

  27 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A VC fund has invested \$3m (seed) and \$12m (Series A) in a biotech company developing a new cancer therapy. The Phase II clinical trial has failed. The VC has \$8m reserved for a Series B. Management requests the \$8m to fund an alternative therapy. A junior associate argues the VC should invest the \$8m because the company has spent \$15m and abandoning it wastes the prior investment. What is the correct analytical framework for this decision?

   • A
     The prior \$15m investment is a sunk cost and irrelevant to the forward-looking decision; the VC should invest the additional \$8m only if the expected value of the alternative therapy justifies the \$8m outlay on a standalone basis
     Correct answer
   • B
     The associate is correct; the VC should invest \$8m because the total investment of \$23m has synergy value that exceeds the standalone value of the \$8m
   • C
     The decision should be made based on whether the alternative therapy generates a 10x return, consistent with typical VC return targets
   • D
     The VC must invest the $8m because declining to do so triggers the clawback provision in the fund's LP agreement
   Explanation

   This is a classic sunk cost fallacy situation. The \$15m already invested in the failed Phase II trial cannot be recovered and is irrelevant to the decision about whether to invest an additional \$8m. The correct analytical framework is to evaluate the \$8m investment as a new standalone decision: what is the expected value of the alternative therapy, what probability does it have of reaching commercialisation, and does investing \$8m in this opportunity create more expected value than investing the same \$8m elsewhere? If the alternative therapy's expected value justifies the \$8m, invest; if not, do not. Investing simply to avoid 'wasting' the prior \$15m is irrational and will systematically reduce fund returns. Staged financing is designed precisely to create these hard decision points.

2. An investor holds shares in a major oil exploration company as a substitute for direct commodity exposure. During a period of sharply rising oil prices, the company's share price increases by only 12% while crude oil spot prices rise 35%. Which factors best explain why the equity position underperformed direct commodity exposure?

   • A
     Oil company equities underperform during commodity price spikes because rising energy costs increase the company's operating expenses, reducing margins.
   • B
     The oil company's shares carry additional equity market beta, operational risk (cost overruns, production issues), currency exposure, management quality, and corporate leverage that dilute the pure commodity price signal; equity market sentiment and sector rotation also affect share prices independently of commodity prices.
     Correct answer
   • C
     The company's equity underperformed because short sellers were targeting energy equities during the same period, suppressing the share price.
   • D
     The underperformance is fully explained by currency effects; if measured in the oil company's reporting currency, the return would equal the 35% spot increase.
   Explanation

   Commodity-linked equities provide indirect commodity exposure but add multiple sources of non-commodity risk: equity market beta (the share moves with broad equity sentiment), operational risk (production volumes, cost structures, exploration success), corporate leverage, management execution, and ESG or regulatory risks specific to the company. These factors often cause commodity equity returns to significantly deviate from underlying commodity price changes — sometimes outperforming in a leveraged way, sometimes underperforming when company-specific or market factors dominate. This is why commodity-linked equities are an imperfect substitute for direct commodity exposure.

3. How do collectibles (art, wine, classic cars) and natural resources (timber, farmland) differ from mainstream alternative investment categories such as private equity or hedge funds in terms of investment structure and return characteristics?

   • A
     Collectibles offer higher risk-adjusted returns than private equity because their values are independent of financial market conditions.
   • B
     Natural resources differ from hedge funds primarily because they use more leverage to amplify commodity price exposure.
   • C
     Collectibles and natural resources are predominantly held as physical assets with no standardised fund structures, limited price transparency, and returns driven by supply constraints and taste or biological factors rather than financial leverage or manager skill.
     Correct answer
   • D
     Collectibles and natural resources are more liquid than private equity because they can be sold at auction at any time.
   Explanation

   Collectibles (art, wine) and natural resources (timber, farmland) are niche alternative asset classes that are typically owned as physical assets without standardised fund structures. Returns from collectibles depend on taste, provenance, and supply scarcity; returns from natural resources depend on biological cycles (timber growth rates, crop yields) and commodity prices. Neither category resembles the LP/GP structure, carried interest mechanics, or mark-to-model valuation that characterises mainstream alternatives like PE or hedge funds. Their lack of price transparency and non-standardised markets make due diligence and valuation particularly challenging.