markets or lending institutions. Venture capitalists fund these high-risk, illiquid, and unproven ideas by purchasing senior equity stakes while the start-up companies are still privately held. The ultimate goal is to generate large profits primarily through the business success of the companies and their development into enterprises capable of attracting public investment capital (typically through an initial public offering, or IPO) or via their sale to other companies. In the context of investment management, venture capital is sometimes treated as a separate asset class from other types of private equity.
Leveraged buyouts (LBOs) refer to those transactions in which the equity of a publicly traded company is purchased using a small amount of investor capital and a large amount of borrowed funds in order to take the firm private. The borrowed funds are secured by the assets or cash flows of the target company. The goals can include exploiting tax advantages of debt financing, improving the operating efficiency and the profitability of the company, and ultimately taking the company public again (i.e., making an IPO of its new equity). Management buyouts and management buy-ins are types of LBOs with specific managerial changes.
Mezzanine debt derives its name from its position in the capital structure of a firm: between the ceiling of senior secured debt and the floor of equity. Mezzanine debt refers to a spectrum of risky claims, including preferred stock, convertible debt, and debt that includes equity kickers (i.e., options that allow investors to benefit from any upside success in the underlying business, also called hybrid securities).
Distressed debt refers to the debt of companies that have filed or are likely to file in the near future for bankruptcy protection. Even though these securities are fixed-income securities, distressed debt is included in our discussion of private equity because the future cash flows of the securities are highly risky and highly dependent on the financial success of the distressed companies, and thus share many similarities with common stock. Private equity firms investing in distressed debt tend to take longer-term ownership positions in the companies after converting all or some portion of their debt position to equity. Some hedge funds also invest in distressed debt, but they tend to do so with a shorter-term trading orientation.
1.2.4 Structured Products
Structured products are instruments created to exhibit particular return, risk, taxation, or other attributes. These instruments generate unique cash flows as a result of partitioning the cash flows from a traditional investment or linking the returns of the structured product to one or more market values. The simplest and most common example of a structured product is the creation of debt securities and equity securities in a traditional corporation. The cash flows and risks of the corporation's assets are structured into a lower-risk fixed cash flow stream (bonds) and a higher-risk residual cash flow stream (stock). The structuring of the financing sources of a corporation creates option-like characteristics for the resulting securities.
Collateralized debt obligations (CDOs) and similar instruments are among the best-known types of structured products. CDOs partition the actual or synthetic returns from a portfolio of assets (the collateral) into securities with varied levels of seniority (the tranches).
Credit derivatives, another popular type of structured product, facilitate the transfer of credit risk. Most commonly, credit derivatives allow an entity (the credit protection buyer) to transfer some or all of a credit risk associated with a specific exposure to the party on the other side of the derivative (the credit protection seller). The credit protection seller might be diversifying into the given credit risk, speculating on the given credit risk, or hedging a preexisting credit exposure.
Historically, the term structured products has referred to a very broad spectrum of products, including CDOs and credit derivatives. In recent decades, however, the term is being used to describe a narrower set of financially engineered products. These products are issued largely with the intention of meeting the preferences of investors, such as providing precisely crafted exposures to the returns of an index or a security. For example, a major bank may issue a product designed to offer downside risk protection to investors while also offering the potential for the investor to receive a portion of the upside performance in an index. Part 5 discusses these specially designed structured products along with more generic structured products, including credit derivatives and CDOs.
When the structuring process creates instruments that do not behave like traditional investments, those instruments are considered alternative investments.
1.2.5 Limits on the Categorizations
These four categories of alternative investments are the focus of the CAIA curriculum. While the categorization helps us understand the spectrum of alternative investments, the various alternative investment categories may overlap. For example, some hedge fund portfolios may contain substantial private equity or structured product exposures and may even substantially alternate the focus of their holdings through time. This being said, the four categories discussed in the previous sections represent the investment types central to the Level I curriculum of the CAIA program.
1.3 Structures among Alternative Investments
The previous sections defined the category of alternative investments by describing the investments that are or are not commonly thought of as alternative. But the question remains as to what the defining characteristics of investments are that cause them to be classified as alternative. For example, why is private equity considered an alternative investment but other equities are considered traditional investments? What is the key characteristic or attribute that differentiates these equities? The answer is that traditional equities are listed on major stock exchanges whereas private equity is not. We use the term structure to denote this attribute and others that differentiate traditional and alternative investments. In this case, traditional equities possess the characteristic of public ownership, which can be viewed as a type of institutional structure.
Because structures are a descriptive and definitional component of alternative investments, they are a crucial theme to our analysis of asset classes. Structures denote a related set of important aspects that identify investments and distinguish them from other investments. There are five primary types of structures:
1. Regulatory structures
2. Securities structures
3. Trading structures
4. Compensation structures
5. Institutional structures
For example, mutual funds are usually considered to be traditional investments, and hedge funds are usually considered to be alternative investments. But many hedge funds invest in the same underlying securities as many mutual funds (e.g., publicly traded equities). So if they have the same underlying investments, what distinguishes them? If we look at the funds in the context of the five structures, we can develop insight as to the underlying or fundamental differences. For example, hedge funds are less regulated, often have different compensation structures, and often have highly active and esoteric trading strategies or structures. Each of these attributes is viewed as a structure in this book.
When we analyze a particular type of investment, such as managed futures, we should think about the investment in the context of these various structures: Which structural aspects are unique to managed futures, how do particular structural aspects affect managed futures returns, and how do particular structural aspects cause us to need new or modified methods for our analysis?
1.3.1 Structures as Distinguishing Aspects of Investments
Exhibit 1.2 illustrates the concept of structures. On the left-hand side is the ultimate source of all investment returns: real assets and the related economic activity that generates and underlies all economic compensation
