Alternative Investments

• Topic 01

  Private Equity Valuation

  61 questions
• Topic 02

  Venture Capital Valuation Methods

  56 questions
• Topic 03

  Real Estate Valuation: Advanced

  54 questions
• Topic 04

  Real Estate Investment Analysis

  54 questions
• Topic 05

  Commodity Futures Strategies

  39 questions
• Topic 06

  Infrastructure and Private Debt

  54 questions
• Topic 07

  Hedge Fund Strategy Analysis

  40 questions
• Topic 08

  Alternatives in Portfolio Construction

  42 questions

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

1. An LBO model assumes \$200m of senior debt at SOFR + 400 bps and \$50m of mezzanine at 14% PIK. SOFR is currently 5%. Calculate annual cash interest, the PIK accrual in Year 1, and explain the impact on the equity sponsor's cash returns.

   • A
     DPI = 1.75×; RVPI = 0×; TVPI = 1.75×; IRR ≈ 17.0%
   • B
     DPI = 1.50×; RVPI = 0×; TVPI = 1.50×; IRR ≈ 11.5%
   • C
     DPI = 2.00×; RVPI = 0×; TVPI = 2.00×; IRR ≈ 14.5%
   • D
     DPI = 1.75×; RVPI = 0×; TVPI = 1.75×; IRR ≈ 14.9%
     Correct answer
   Explanation

   Cash interest on senior debt = \$200m × (5% + 4%) = \$200m × 9% = \$18m per year. PIK accrual on mezzanine = \$50m × 14% = \$7m added to principal (no cash). In Year 1: total cash interest = \$18m; mezzanine balance grows to \$57m. The PIK structure preserves cash for the operating company — the \$7m that would otherwise be a cash interest payment instead accrues as debt. For the equity sponsor, this means: (a) Higher cash flow available for operations/reinvestment; (b) But the mezzanine debt compounds, increasing exit leverage. By Year 5 (at 14% compounding): mezzanine balance = \$50m × (1.14)^5 ≈ \$96.5m. This compounding effect reduces equity value at exit if the exit EV doesn't grow proportionally.

2. A pension fund's investment policy requires monthly rebalancing to a 15% alternatives target. During a severe equity market decline of 35%, the alternatives (PE + real estate) NAV falls only 5% due to appraisal lags. The fund manager calculates that the alternatives allocation has risen to 21%. Which of the following governance responses is most consistent with ERISA's prudent expert standard?

   • A
     Immediately sell alternatives at whatever price is available in the secondary market to restore the 15% policy target within one month
   • B
     Suspend rebalancing activity permanently and reclassify alternatives as a separate sleeve exempt from policy constraints
   • C
     Transfer the excess alternatives allocation to a side pocket to isolate it from the rebalancing mechanism until liquidity improves
   • D
     Document the over-allocation as a deliberate breach triggered by the denominator effect, reduce new PE capital calls where possible, and establish a 6-to-12-month rebalancing plan that avoids distressed secondary sales at large discounts to NAV
     Correct answer
   Explanation

   ERISA's prudent expert standard requires a pension fund to act as a prudent, experienced investor would. Distressed secondary sales at large discounts (often 20–30%+ in a crisis) destroy value for beneficiaries. The prudent response is to document the denominator effect breach as involuntary, reduce new commitments to slow future capital calls, and create a realistic rebalancing timeline. Forced sales at distressed prices are inconsistent with prudence. Changing the policy target to justify the over-allocation would violate the fund's governance standards. Side pockets are a hedge fund mechanism, not applicable to a PE allocation in a pension fund.

3. A prime logistics warehouse property generates NOI of \$1,200,000 per year. Comparable properties in the market are transacting at cap rates of 4.5%. What is the estimated market value of this property, and what does the low cap rate indicate?

   • A
     \$5,400,000; the low cap rate is applied as a multiplier rather than a divisor
   • B
     \$26,666,667; the low cap rate reflects high vacancy risk and lower expected NOI growth
   • C
     \$26,666,667; the low cap rate reflects strong demand, low risk, and/or high growth expectations for the logistics sector
     Correct answer
   • D
     \$26,666,667; the low cap rate indicates the property is overvalued relative to its income
   Explanation

   Property Value = NOI / Cap Rate = \$1,200,000 / 0.045 = \$26,666,667. A cap rate of 4.5% is at the low end of the range for commercial real estate, which means investors are paying a high price relative to current income. This reflects: strong structural demand (e-commerce driving logistics), limited supply in prime locations, low perceived risk, and expectations of NOI growth over time. Cap rates in industrial/logistics have compressed substantially in recent years due to secular demand growth from online retail.