Alternative Investments

    Exam weight 7–10%
    105 questions in the bank
    5 subtopics

    Alternatives is descriptive with a hard computational core: fees. Management and incentive fee arithmetic, hurdle rates, and high-water marks account for a large share of the questions, and they are entirely learnable.

    What you need to be able to do

    • Compute net returns through a two-part fee structure
    • Apply a hurdle rate and a high-water mark in the right order
    • Explain why reported alternative returns understate volatility and correlation
    • Match a structure (fund, direct, co-investment) to its liquidity and control profile

    Where candidates lose marks

    Charging the incentive fee on the gross return when the structure charges it on the return after the management fee. Read the order the fees are applied.

    10 free Alternatives practice questions

    Real questions from the CFAQuiz bank, one or two per subtopic, with the full explanation. No account needed.

    1
    Alternative Investment Features
    medium
    ALT-FEAT-6

    Which statement best characterizes the distribution of returns commonly observed in many alternative investment strategies?

    1. A.Returns are typically normally distributed due to daily mark-to-market pricing.
    2. B.Return distributions often exhibit negative skew and excess kurtosis (fat tails).
    3. C.Betas are stable and close to 1.00 across strategies, easing factor modeling.
    Show answer and explanation

    Correct answer: B

    Many alternatives exhibit non-normal returns, including negative skewness and excess kurtosis, reflecting tail risks, leverage, and nonlinear payoffs.

    • Option A is wrong because many alternatives are illiquid, appraisal-based, and/or employ nonlinear strategies, undermining normality and daily marking.
    • Option C is wrong because exposures vary by strategy and over time; stable betas near 1.00 are not a general feature of alternatives.
    2
    Hedge Funds
    medium
    ALT.HF.Fees

    A hedge fund has beginning-of-year NAV of $110 million and a prior high-water mark (HWM) of $120 million. The fund earns a gross return of 20% over the year before fees. The management fee is 2% of beginning-of-year NAV, and the incentive fee is 20% of new profits above the HWM, calculated after deducting the management fee. What is the investor’s net return for the year?

    All amounts in millions.

    1. A.16.22%
    2. B.14.40%
    3. C.15.82%
    Show answer and explanation

    Correct answer: A

    Compute end NAV before any fees:

    110×1.20=132110 \times 1.20 = 132

    Management fee (2% of beginning NAV):

    0.02×110=2.20.02 \times 110 = 2.2

    NAV after management fee:

    132−2.2=129.8132 - 2.2 = 129.8

    New profits above HWM (after management fee):

    129.8−120=9.8129.8 - 120 = 9.8

    Incentive fee (20% of new profits above HWM):

    0.20×9.8=1.960.20 \times 9.8 = 1.96

    Ending investor NAV after all fees:

    129.8−1.96=127.84129.8 - 1.96 = 127.84

    Investor net return:

    127.84−110110=0.1621818=16.22%\frac{127.84 - 110}{110} = 0.1621818 = 16.22\%
    • Option B uses profits over beginning NAV instead of over the HWM. After the management fee, profit over beginning NAV is 129.8−110=19.8129.8 - 110 = 19.8; incentive =0.20×19.8=3.96= 0.20 \times 19.8 = 3.96; ending NAV =129.8−3.96=125.84= 129.8 - 3.96 = 125.84; return =125.84−110110×100=14.40%= \frac{125.84 - 110}{110} \times 100 = 14.40\%.
    • Option C calculates the incentive before the management fee. Profit above HWM before the management fee is 132−120=12132 - 120 = 12; incentive =0.20×12=2.4= 0.20 \times 12 = 2.4; then deduct management fee 2.2; ending NAV =132−2.4−2.2=127.4= 132 - 2.4 - 2.2 = 127.4; return =127.4−110110×100=15.82%= \frac{127.4 - 110}{110} \times 100 = 15.82\%.
    3
    Infrastructure and Natural Resources
    easy
    ALT-INFR-1

    An infrastructure investor is evaluating two public–private partnership (PPP) opportunities: (1) a demand-based toll road concession where revenues depend on traffic volumes and (2) an availability-based social infrastructure PPP where the government pays a fixed availability fee subject to performance deductions. Which statement is most accurate?

    1. A.Demand-based toll road concessions typically have lower demand risk than availability-based PPPs because volume guarantees are common.
    2. B.Availability-based PPPs generally face high commodity price exposure and are unsuitable for long-term fixed-rate debt.
    3. C.Availability-based PPPs shift demand risk to the public sector, resulting in more stable cash flows and lower required returns than demand-based concessions.
    Show answer and explanation

    Correct answer: C

    Availability-based PPPs pay project companies for making the asset available, transferring demand risk (e.g., traffic volumes) to the public sector. This generally produces more stable cash flows and supports lower required returns than demand-based concessions.

    • Option A is wrong because demand-based assets bear volume/demand risk; volume guarantees are uncommon and typically partial if present.
    • Option B is wrong because availability-based PPP cash flows are typically well-suited to long-term fixed-rate debt; commodity price exposure is not a defining feature.
    4
    Private Equity and Debt
    easy
    ALT-PE-04

    A venture investor pays $7.5 million for a 25% post-money ownership stake in a startup. What is the company’s pre-money valuation?

    1. A.$22.5 million
    2. B.$30.0 million
    3. C.$10.0 million
    Show answer and explanation

    Correct answer: A

    Compute post-money valuation from the ownership percentage, then back out the investment to get pre-money.

    Post-money=7.50.25=30.0 million\text{Post-money} = \frac{7.5}{0.25} = 30.0 \text{ million} Pre-money=30.0−7.5=22.5 million\text{Pre-money} = 30.0 - 7.5 = 22.5 \text{ million}
    • Option B reports the post-money valuation instead of pre-money.
    Post-money=30.0 million (not pre-money)\text{Post-money} = 30.0 \text{ million (not pre-money)}
    • Option C divides by the complement ownership, which is incorrect for pre-money.
    7.50.75=10.0 million (mis-applies the formula)\frac{7.5}{0.75} = 10.0 \text{ million (mis-applies the formula)}
    5
    Real Estate
    easy
    ALT.RE.03

    A lender evaluates a loan on a property with net operating income (NOI) of $240,000 and annual debt service of $190,000. What is the debt service coverage ratio (DSCR)?

    1. A.0.79
    2. B.1.26
    3. C.0.26
    Show answer and explanation

    Correct answer: B

    DSCR = NOIDebt Service\frac{\text{NOI}}{\text{Debt Service}}.

    DSCR=240,000190,000=1.2632≈1.26\text{DSCR} = \frac{240{,}000}{190{,}000} = 1.2632 \approx 1.26
    • Option A inverts the ratio: 190,000240,000=0.7917≈0.79\frac{190{,}000}{240{,}000} = 0.7917 \approx 0.79.
    • Option C subtracts first, then divides by debt service: 240,000−190,000190,000=50,000190,000=0.2632≈0.26\frac{240{,}000 - 190{,}000}{190{,}000} = \frac{50{,}000}{190{,}000} = 0.2632 \approx 0.26.
    6
    Alternative Investment Features
    medium
    ALT-FEAT-6

    An investor is evaluating an alternative strategy with negatively skewed, fat-tailed (leptokurtic) returns. Which statement is most accurate regarding the use of standard deviation and the Sharpe ratio to assess risk and return?

    1. A.Standard deviation fully captures the tail risk, so the Sharpe ratio remains a reliable risk-adjusted metric.
    2. B.Standard deviation may understate downside risk, making the Sharpe ratio potentially misleading for non-normal returns.
    3. C.Because returns are non-normal, correlations with equities cannot be estimated and diversification benefits cannot be assessed.
    Show answer and explanation

    Correct answer: B

    With negative skew and excess kurtosis, downside tail risk is not fully captured by standard deviation, so the Sharpe ratio can be misleading.

    • Option A is wrong because standard deviation assumes symmetric dispersion and misses tail shape and skewness.
    • Option C is wrong because correlation can still be estimated; non-normality does not preclude assessing diversification, though smoothing and tails warrant caution.
    7
    Hedge Funds
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    ALT-HF-Fees-3

    A hedge fund charges a 1.5% management fee (on beginning-of-year NAV) and a 20% incentive fee calculated on profits after the management fee. The incentive uses a hard 6% hurdle with no catch-up and there is no high-water mark. Beginning NAV is $10,000,000 and the gross return for the year is 10%.

    What is the investor’s net return for the year?

    1. A.6.8%
    2. B.8.0%
    3. C.7.7%
    Show answer and explanation

    Correct answer: B

    Compute end-of-year values with a hard hurdle (no catch-up), applying the incentive only to profits above the hurdle and after the management fee.

    Gross end-of-year pre-fee NAV:

    10,000,000×(1+10%)=11,000,00010{,}000{,}000 \times (1 + 10\%) = 11{,}000{,}000

    Management fee (1.5% of beginning NAV):

    0.015×10,000,000=150,0000.015 \times 10{,}000{,}000 = 150{,}000

    NAV after management fee:

    11,000,000−150,000=10,850,00011{,}000{,}000 - 150{,}000 = 10{,}850{,}000

    Profit after management fee relative to beginning NAV:

    10,850,000−10,000,000=850,00010{,}850{,}000 - 10{,}000{,}000 = 850{,}000

    Hurdle amount (6% of beginning NAV):

    0.06×10,000,000=600,0000.06 \times 10{,}000{,}000 = 600{,}000

    Excess over hurdle (after mgmt fee):

    850,000−600,000=250,000850{,}000 - 600{,}000 = 250{,}000

    Incentive fee (20% of excess over hurdle):

    0.20×250,000=50,0000.20 \times 250{,}000 = 50{,}000

    Ending NAV after incentive fee:

    10,850,000−50,000=10,800,00010{,}850{,}000 - 50{,}000 = 10{,}800{,}000

    Net return:

    10,800,000−10,000,00010,000,000=8.0%\frac{10{,}800{,}000 - 10{,}000{,}000}{10{,}000{,}000} = 8.0\%
    • Option A: Treats the hurdle as soft (applies 20% to all profits after mgmt fee): incentive 0.20×850,000=170,0000.20 \times 850{,}000 = 170{,}000; ending 10,850,000−170,000=10,680,00010{,}850{,}000 - 170{,}000 = 10{,}680{,}000 ⇒ 6.8%.
    • Option C: Applies the excess-over-hurdle test before the management fee (uses gross profit): excess =1,000,000−600,000=400,000= 1{,}000{,}000 - 600{,}000 = 400{,}000; incentive 0.20×400,000=80,0000.20 \times 400{,}000 = 80{,}000; ending 11,000,000−150,000−80,000=10,770,00011{,}000{,}000 - 150{,}000 - 80{,}000 = 10{,}770{,}000 ⇒ 7.7%.
    8
    Infrastructure and Natural Resources
    medium
    ALT-INFNR-NR-01

    An E&P company owns a 60% working interest in an oil property subject to a 20% royalty burden (on gross). Daily gross production is 5,000 barrels. The oil price is $70/bbl, lifting cost is $25/bbl, and transportation cost is $5/bbl. Assuming 365 days in a year, what is the company’s annual netback cash flow from this asset?

    1. A.$43,800,000
    2. B.$29,200,000
    3. C.$35,040,000
    Show answer and explanation

    Correct answer: C

    Compute netback per barrel:

    70−25−5=4070 - 25 - 5 = 40

    Compute net revenue interest (NRI):

    0.60×(1−0.20)=0.480.60 \times (1 - 0.20) = 0.48

    Annual gross barrels:

    5,000×365=1,825,0005{,}000 \times 365 = 1{,}825{,}000

    Annual net barrels at NRI:

    1,825,000×0.48=876,0001{,}825{,}000 \times 0.48 = 876{,}000

    Annual netback cash flow:

    876,000×40=35,040,000876{,}000 \times 40 = 35{,}040{,}000
    • Option A ($43,800,000) ignores the royalty (uses WI only): 1,825,000×0.60×40=43,800,0001{,}825{,}000 \times 0.60 \times 40 = 43{,}800{,}000
    • Option B ($29,200,000) miscomputes NRI as WI minus royalty: (0.60−0.20)=0.40; 1,825,000×0.40×40=29,200,000(0.60 - 0.20) = 0.40;\ 1{,}825{,}000 \times 0.40 \times 40 = 29{,}200{,}000
    9
    Private Equity and Debt
    medium
    ALT-PE-02

    An LBO acquires a company for an enterprise value of $300 million, financed with 60% debt and 40% equity. Over the holding period, net debt is reduced to $90 million. At exit, EBITDA is $50 million and the exit multiple is 8.0x. What is the equity investor’s multiple on invested capital (MOIC)?

    1. A.2.58x
    2. B.3.33x
    3. C.1.83x
    Show answer and explanation

    Correct answer: A

    Compute initial equity, exit enterprise value, exit equity value, and MOIC.

    Initial Equity=0.40×300=120\text{Initial Equity} = 0.40 \times 300 = 120 Exit EV=8.0×50=400\text{Exit EV} = 8.0 \times 50 = 400 Exit Equity Value=Exit EV−Exit Net Debt=400−90=310\text{Exit Equity Value} = \text{Exit EV} - \text{Exit Net Debt} = 400 - 90 = 310 MOIC=310120=2.58\text{MOIC} = \frac{310}{120} = 2.58
    • Option B ignores debt at exit and treats enterprise value as equity: 400120=3.33\frac{400}{120} = 3.33.
    • Option C subtracts the initial debt instead of the exit debt: 400−180=220; 220120=1.83400 - 180 = 220; \ \frac{220}{120} = 1.83.
    10
    Real Estate
    medium
    ALTS.RE.02

    An investor purchases an apartment property for $5,000,000 using a 70% loan-to-value, interest-only mortgage at 5%. First-year NOI is projected at $400,000. What is the equity dividend rate (cash-on-cash return) for year 1?

    1. A.26.7%
    2. B.4.5%
    3. C.15.0%
    Show answer and explanation

    Correct answer: C

    Compute loan amount, annual debt service (interest-only), equity invested, BTCF, then equity dividend rate.

    Loan amount=5,000,000×0.70=3,500,000\text{Loan amount} = 5{,}000{,}000 \times 0.70 = 3{,}500{,}000 Annual debt service=3,500,000×0.05=175,000\text{Annual debt service} = 3{,}500{,}000 \times 0.05 = 175{,}000 Equity invested=5,000,000−3,500,000=1,500,000\text{Equity invested} = 5{,}000{,}000 - 3{,}500{,}000 = 1{,}500{,}000 BTCF=400,000−175,000=225,000\text{BTCF} = 400{,}000 - 175{,}000 = 225{,}000 Equity dividend rate=225,0001,500,000=0.150=15.0%\text{Equity dividend rate} = \frac{225{,}000}{1{,}500{,}000} = 0.150 = 15.0\%

    Correct answer: 15.0%.

    • Option A uses NOI instead of BTCF in the numerator: 400,0001,500,000=0.2667=26.7%\frac{400{,}000}{1{,}500{,}000} = 0.2667 = 26.7\%
    • Option B uses total purchase price instead of equity in the denominator: 225,0005,000,000=0.045=4.5%\frac{225{,}000}{5{,}000{,}000} = 0.045 = 4.5\%

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