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CAIA Level II study materials
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CAIA Level II practice questions

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Question 1Asset Allocation and Institutional Investors

A university endowment sets its annual distribution as a percentage of a moving average of the portfolio's market value. Which spending rate range is most consistent with common practice?

  1. 4% to 5% Correct answer.
  2. 15% to 20%
  3. 0.5% to 1.5%
  4. 9% to 11%

Explanation

Endowment spending policies are typically calibrated to the long-run expected real return plus inflation, which places common practice near 4% to 5% of a moving average of market value. Rates sustained above that level tend to erode real purchasing power.

Question 2Asset Allocation and Institutional Investors

A defined benefit plan has plan assets of $800 million and a present value of projected benefit obligations of $950 million. The plan's funded status is:

  1. a surplus of $150 million
  2. a deficit of $800 million
  3. a deficit of $150 million Correct answer.
  4. a surplus of $950 million

Explanation

Funded status equals the market value of plan assets minus the present value of benefit obligations. Here $800 million less $950 million leaves a shortfall of $150 million.

Question 3Asset Allocation and Institutional Investors

In a defined contribution retirement plan, which party bears the investment risk of the account?

  1. the asset manager
  2. the plan trustee
  3. the plan participant Correct answer.
  4. the plan sponsor

Explanation

In a defined contribution plan the sponsor's obligation is limited to making contributions, so the participant bears the investment risk and the resulting retirement outcome. In a defined benefit plan the sponsor bears that risk instead.

Question 4Asset Allocation and Institutional Investors

The Santiago Principles are voluntary governance, transparency, and investment-practice standards designed primarily for which type of institution?

  1. sovereign wealth funds Correct answer.
  2. life insurance companies
  3. hedge fund managers
  4. large public defined benefit pension plans

Explanation

The Santiago Principles were developed by the International Working Group of Sovereign Wealth Funds to guide governance, transparency, and investment behavior at state-owned investment funds. They were not written for hedge funds, public pensions, or insurers.

Question 5Asset Allocation and Institutional Investors

Which type of institutional investor is generally best positioned to accept illiquidity and to hold very long-duration assets?

  1. a defined contribution plan offering daily liquidity
  2. a bank's trading book
  3. a stable value fund
  4. a perpetual endowment with no fixed liability schedule Correct answer.

Explanation

A perpetual endowment has no contractual payout schedule and can tolerate extended lockups, making it a natural holder of illiquid, long-duration assets. Vehicles that must redeem daily or hold assets for resale cannot take that risk.

Question 6Asset Allocation and Institutional Investors

Calendar rebalancing of a strategic asset allocation involves:

  1. restoring weights only when they drift outside a preset tolerance band
  2. restoring policy weights at predetermined time intervals Correct answer.
  3. trading only when a tax loss can be harvested
  4. trading continuously to hold weights exactly constant

Explanation

Calendar rebalancing restores the policy weights on a fixed schedule, such as quarterly or annually, regardless of how far the weights have drifted. Threshold or band rebalancing trades only when a deviation exceeds a preset limit.

Question 7Asset Allocation and Institutional Investors

Tactical asset allocation is best described as:

  1. deviating from policy weights in the short term on market views Correct answer.
  2. setting long-run policy weights from the plan's liability profile
  3. hedging the portfolio's foreign currency exposure back to the base currency
  4. choosing weights to replicate a broad market benchmark index

Explanation

Tactical asset allocation deliberately departs from long-run policy weights to exploit short- to medium-term market views. Strategic asset allocation, by contrast, establishes the long-run policy mix.

Question 8Asset Allocation and Institutional Investors

In asset allocation, Monte Carlo simulation is most commonly used to:

  1. determine the single optimal portfolio with certainty
  2. simulate a range of outcomes for a given allocation Correct answer.
  3. guarantee a target funding ratio at the horizon
  4. eliminate estimation error in expected returns

Explanation

Monte Carlo methods draw many random return paths from assumed distributions and report the resulting distribution of terminal wealth or funding ratios. This informs the probability of meeting a goal; it does not produce a certain optimum.

Question 9Asset Allocation and Institutional Investors

The Black-Litterman model begins with market capitalization weights and reverse-optimizes to derive:

  1. the covariance matrix implied by option prices
  2. an efficient frontier constructed without reference to any investor views
  3. implied equilibrium returns blended with investor views Correct answer.
  4. factor loadings estimated from fundamental data

Explanation

Black-Litterman reverse-optimizes market capitalization weights to obtain a set of implied equilibrium expected returns, then blends those priors with the investor's views using Bayesian weighting. The result is typically more stable than expected returns estimated directly from history.

Question 10Asset Allocation and Institutional Investors

A well-known criticism of unconstrained mean-variance optimization is that it tends to:

  1. ignore the risk-free asset entirely
  2. underweight assets with high estimated returns
  3. produce weights that are insensitive to input changes
  4. overweight assets whose returns were overestimated Correct answer.

Explanation

Mean-variance optimizers treat inputs as known with certainty, so assets with overstated expected returns and understated variances receive extreme weights. This error-maximization behavior is why raw optimized portfolios are often unstable.

Question 11Asset Allocation and Institutional Investors

In a risk parity portfolio, capital is allocated so that:

  1. each asset has the same expected return
  2. each asset has the same volatility
  3. each asset contributes equally to portfolio risk Correct answer.
  4. each asset has the same market capitalization weight

Explanation

Risk parity equalizes each asset's marginal contribution to total portfolio risk rather than equalizing capital, volatility, or expected return. Because equities are far more volatile than bonds, this usually requires leveraging the bond allocation.

Question 12Asset Allocation and Institutional Investors

A classic immunization strategy applied to a fixed income portfolio requires that:

  1. the portfolio is rebalanced monthly regardless of rate moves
  2. the portfolio holds only zero-coupon Treasury securities of any maturity
  3. the portfolio's convexity is set to zero
  4. portfolio duration equals liability duration and present values match Correct answer.

Explanation

Classic immunization matches both the present value and the duration of the assets to the liability. That combination makes the portfolio's value largely insensitive to small parallel shifts in interest rates.

Question 13Asset Allocation and Institutional Investors

Surplus optimization differs from standard mean-variance optimization because it:

  1. maximizes expected return without regard to risk
  2. treats the liability as a risk-free asset with zero duration
  3. ignores the correlation between asset returns and liability returns
  4. maximizes expected surplus return per unit of surplus risk Correct answer.

Explanation

Surplus optimization rewrites the objective in terms of surplus returns, defined as asset returns minus liability returns, and maximizes expected surplus return per unit of surplus volatility. Because the liability enters the risk calculation, both its duration and its correlation with asset classes matter.

Question 14Asset Allocation and Institutional Investors

Michaud's resampled efficiency approach to portfolio optimization is designed primarily to:

  1. reduce how much optimized weights respond to input errors Correct answer.
  2. replace the covariance matrix with raw historical returns
  3. increase the number of assets eligible for inclusion in the portfolio
  4. eliminate the need for a risk aversion parameter

Explanation

Resampled efficiency repeatedly resamples the inputs, re-optimizes each draw, and averages the resulting weights, which shrinks the influence of estimation error. The output is typically a more diversified and more stable portfolio than a single optimization.

Question 15Asset Allocation and Institutional Investors

A U.S. investor who holds a global equity allocation but places 70% of the equity sleeve in U.S. stocks is exhibiting:

  1. home bias Correct answer.
  2. currency hedging
  3. factor neutrality
  4. tracking error minimization

Explanation

Home bias is the tendency to overweight domestic assets relative to their share of global market capitalization. A 70% domestic weight in a global equity sleeve is a classic illustration.

Question 16Asset Allocation and Institutional Investors

In a goals-based investing framework, the overall portfolio is typically:

  1. optimized as a single mean-variance efficient portfolio for the whole entity
  2. split into sub-portfolios each managed against a specific goal Correct answer.
  3. restricted to cash and short-duration government bonds
  4. managed relative to a single broad market benchmark

Explanation

Goals-based investing decomposes wealth into mental accounts, each funded to meet a specific goal with its own horizon and risk budget. Each sub-portfolio is then managed against its stated goal rather than the total being optimized against one benchmark.

Question 17Asset Allocation and Institutional Investors

Compared with a life insurer, the investment portfolio of a property and casualty insurer generally has:

  1. no meaningful need to align assets with liabilities
  2. a heavier allocation to venture capital and buyouts
  3. a shorter duration and greater emphasis on liquidity Correct answer.
  4. a longer duration, driven by long-dated nominal liabilities

Explanation

Property and casualty claims are typically settled over shorter and less predictable periods than life insurance or annuity obligations, so P&C portfolios emphasize liquidity and shorter duration. Life insurers, facing long-dated nominal liabilities, hold longer duration assets.

Question 18Asset Allocation and Institutional Investors

A bank classifies a bond position as held-to-maturity. Under U.S. GAAP, that position is measured at:

  1. fair value through other comprehensive income
  2. fair value through net income
  3. the lower of amortized cost or fair value
  4. amortized cost Correct answer.

Explanation

Held-to-maturity classification requires both the positive intent and the ability to hold the security to maturity, and the position is then carried at amortized cost. Available-for-sale securities are carried at fair value through other comprehensive income, while trading securities are carried at fair value through income.

Question 19Asset Allocation and Institutional Investors

A U.S. investor holds a portfolio of German government bonds denominated in euros. Hedging the euro exposure back into dollars will most likely:

  1. increase expected return by the interest rate differential
  2. eliminate the credit risk of the German bonds
  3. reduce the dollar volatility of the portfolio Correct answer.
  4. raise the correlation with U.S. equities to one

Explanation

Hedging a foreign bond position into the base currency removes currency volatility, which is often a large fraction of the total risk of high-quality foreign government bonds. Under covered interest parity the forward hedge shifts expected return roughly by the interest rate differential rather than adding a gain to it.

Question 20Asset Allocation and Institutional Investors

Under U.S. tax rules, a private foundation must generally distribute each year at least what percentage of the average fair market value of its investment assets?

  1. 10%
  2. 1%
  3. 5% Correct answer.
  4. 15%

Explanation

U.S. private foundations must distribute at least 5% of the average fair market value of their non-charitable-use assets annually. This minimum distribution requirement, together with the excise tax on net investment income, shapes foundation spending and growth policy.

Question 21Asset Allocation and Institutional Investors

An endowment with targets of 60% public equity and 20% private equity experiences a sharp fall in public equity values while private marks lag. The most likely consequence is:

  1. total assets increase
  2. private equity's weight falls below its target
  3. private equity's weight rises via the denominator effect Correct answer.
  4. the endowment must sell private assets immediately

Explanation

When public equity values fall faster than stale private marks, total assets shrink more than the private equity valuation, so private equity's percentage weight rises above target. The institution then chooses among selling illiquid assets, slowing new commitments, or accepting the drift.

Question 22Asset Allocation and Institutional Investors

An endowment compares three spending rules: (i) a fixed dollar amount, (ii) a constant percentage of current market value, (iii) a percentage of a three-year moving average of market value. Ranked from most to least volatile annual spending, the order is:

  1. (iii), (ii), (i)
  2. (ii), (iii), (i) Correct answer.
  3. (ii), (i), (iii)
  4. (i), (ii), (iii)

Explanation

Spending a constant percentage of current market value transmits every market swing directly into the budget, making it the most volatile rule. A moving-average rule dampens those swings, while a fixed dollar amount produces no spending volatility at all, although its real purchasing power varies.

Question 23Asset Allocation and Institutional Investors

A leveraged risk parity portfolio is most likely to underperform a 60/40 stock-bond portfolio during:

  1. a steady decline in bond yields alongside rising equity prices
  2. stable inflation with slowly rising equity markets
  3. a parallel downward shift in the yield curve
  4. a sharp rise in bond yields while equity prices fall Correct answer.

Explanation

Leveraged risk parity portfolios hold a large bond allocation, so a sharp rise in yields inflicts heavy losses while falling equities remove the diversification benefit the strategy relies on. The structure assumes a reliably negative stock-bond correlation.

Question 24Asset Allocation and Institutional Investors

A pension plan wants to hedge its liability interest rate risk without liquidating its equity portfolio. It would most likely use:

  1. a tail-risk hedge using out-of-the-money equity put options
  2. a currency overlay hedging non-dollar bond exposure
  3. an interest rate swap overlay that extends asset duration Correct answer.
  4. a total return swap on a broad bond index funded with cash

Explanation

A completion overlay uses derivatives, typically interest rate swaps or long bond futures, to lengthen asset duration so it matches the liability while the growth portfolio is left intact. This separates the growth-seeking decision from the liability-hedging decision.

Question 25Asset Allocation and Institutional Investors

For a portfolio of volatile assets that is rebalanced regularly, the portfolio's geometric return tends to exceed the weighted average of the constituents' geometric returns because:

  1. rebalancing drives transaction costs to zero
  2. rebalancing removes the possibility of a loss
  3. rebalancing earns a diversification return from asset variance Correct answer.
  4. rebalancing raises the expected arithmetic return of each asset

Explanation

A rebalanced portfolio has lower variance than the weighted average variance of its components whenever correlations are below one, and lower variance raises the geometric return relative to the arithmetic mean. The resulting gap is known as the diversification or rebalancing return.

Question 26Asset Allocation and Institutional Investors

An investor's psychological willingness to accept investment risk, as distinct from the financial ability to bear losses, is best described as the investor's:

  1. Risk capacity
  2. Risk budgeting
  3. Risk tolerance Correct answer.
  4. Risk parity

Explanation

Risk tolerance measures the investor's attitude toward risk, while risk capacity measures the financial wherewithal to absorb losses without jeopardizing goals. Both matter in setting an allocation, and the more binding of the two generally constrains the policy portfolio.

Question 27Asset Allocation and Institutional Investors

An individual has a taxable brokerage account and a tax-deferred retirement account, each funded with the same total portfolio allocation of taxable bonds and a low-turnover equity index fund. Which placement is most consistent with tax-efficient asset location?

  1. Hold the equity index fund in both accounts and meet the bond allocation entirely with municipal bonds inside the taxable account.
  2. Place the taxable bond portfolio in the taxable account and the equity index fund in the tax-deferred account, because interest income is taxed at lower rates than equity returns.
  3. Split every asset class proportionally across both accounts so that each account mirrors the total portfolio allocation.
  4. Hold the taxable bonds in the tax-deferred account and the low-turnover equity index fund in the taxable account. Correct answer.

Explanation

Assets generating ordinary income and high turnover belong in the tax-deferred account, where taxes are deferred or never applied to the same degree, while tax-efficient assets such as low-turnover index funds belong in the taxable account. This placement preserves more after-tax value without changing the overall target allocation.

Question 28Asset Allocation and Institutional Investors

A portfolio insurance program applies the constant proportion portfolio insurance (CPPI) rule with a multiplier greater than one and a specified floor value. Which statement best describes how the program behaves?

  1. Risky-asset exposure is held at a fixed fraction of total assets and rebalanced back to that fraction at each review date, which is the essence of constant-mix and yields a concave payoff profile in trending markets.
  2. Exposure to the risky asset is reduced to zero as soon as the portfolio value first reaches the floor, and no further adjustments are made until the floor is reset by the sponsor.
  3. Exposure to the risky asset is increased as the cushion between portfolio value and floor shrinks, which locks in gains during falling markets and produces the strategy's convex payoff.
  4. Risky exposure equals the multiplier times the cushion, so exposure shrinks as portfolio value approaches the floor, giving a payoff that is convex relative to the risky asset. Correct answer.

Explanation

In CPPI the dollar allocation to the risky asset is the multiplier times the cushion, defined as portfolio value minus the floor, with the remainder held in cash or bonds. Because the cushion shrinks as losses accumulate, exposure is cut mechanically, which limits downside while preserving upside participation and gives a convex payoff relative to the risky asset.

Question 29Private Equity

In a typical private equity fund, the term "J-curve" describes which pattern?

  1. Net fund returns are negative in the early years and turn positive later Correct answer.
  2. Committed capital is drawn down in a straight line across the investment period
  3. Fund distributions peak in the first years and decline steadily thereafter
  4. Gross fund returns decline steadily as management fees and organizational expenses accumulate over the fund's life

Explanation

The J-curve reflects early negative net returns caused by management fees, organizational costs and losses on immature portfolio companies, followed by gains as companies grow and are realized. It is normally plotted on a cumulative net return basis.

Question 30Private Equity

During the investment period, most buyout fund limited partnership agreements calculate the annual management fee as a percentage of:

  1. Total committed capital Correct answer.
  2. Capital actually invested, plus a fixed retainer
  3. Realized gains on exited portfolio companies
  4. The fund's net asset value at each year end

Explanation

The standard convention charges the management fee on total commitments during the investment period, then steps down to invested cost or net asset value once the fund enters its harvest phase. Charging on commitments ensures the GP is paid for managing the whole vehicle, not just deployed capital.

Question 31Private Equity

A 20% carried interest in a private equity fund entitles the general partner to:

  1. 20% of gross portfolio company proceeds before fees and expenses
  2. 20% of the fund's committed capital at inception
  3. 20% of fund profits after limited partners recover capital and the preferred return Correct answer.
  4. 20% of each portfolio company's enterprise value at the time of exit

Explanation

Carried interest is a share of profits, not of capital or revenue, and it is paid only after LPs have received back their contributed capital and any preferred return. The ordering of these payments is set out in the fund's distribution waterfall.

Question 32Private Equity

A private equity fund's DPI (distributions to paid-in capital) ratio is calculated as:

  1. Cumulative distributions divided by cumulative paid-in capital Correct answer.
  2. Unrealized portfolio value divided by paid-in capital
  3. Cumulative distributions plus residual value, divided by paid-in capital
  4. Total fund value divided by total committed capital

Explanation

DPI captures only cash actually returned to LPs relative to cash actually contributed. It excludes unrealized value, which is why it is sometimes called the realized or cash-on-cash multiple.

Question 33Private Equity

When a private equity fund draws down a portion of committed capital from its limited partners to fund an acquisition, the event is known as:

  1. A clawback
  2. A capital call Correct answer.
  3. A distribution in kind
  4. A recycling provision

Explanation

A capital call, also called a drawdown, is the mechanism by which LPs fund their commitments when the GP identifies an investment or needs cash for fees and expenses. LPs are typically given a short notice period, often ten business days.

Question 34Private Equity

Which exit route involves selling a portfolio company to another private equity sponsor?

  1. An earn-out arrangement
  2. A dividend recapitalization
  3. A secondary buyout Correct answer.
  4. An initial public offering

Explanation

A secondary buyout, or sponsor-to-sponsor sale, transfers the company from one private equity owner to another. It has become one of the most common exit routes in mature buyout markets.

Question 35Private Equity

In private equity, "dry powder" refers to:

  1. Unused borrowing capacity available to a portfolio company under its LBO credit agreement
  2. Realized proceeds set aside by a fund for follow-on investments
  3. Capital committed to funds but not yet called or invested Correct answer.
  4. Cash held inside portfolio companies for general working capital purposes

Explanation

Dry powder is committed but undeployed capital, either at the fund level or across the industry. It matters because large volumes of dry powder can pressure purchase prices and lengthen the time needed to deploy capital.

Question 36Private Equity

A private equity fund's vintage year is best described as:

  1. The year of the fund's first capital call or first investment Correct answer.
  2. The year in which the first portfolio company is sold and proceeds are distributed
  3. The year in which the fund makes its final investment before the investment period expires
  4. The year in which the fund is fully liquidated and dissolved

Explanation

Vintage year is the year a fund begins investing, conventionally the year of its first capital call or first investment. It is the standard basis for grouping funds into peer groups for benchmarking, because market conditions at deployment strongly affect returns.

Question 37Private Equity

In a European (whole-of-fund) distribution waterfall, carried interest is:

  1. Paid to the GP as soon as the hurdle rate is met, before any LP capital is repaid
  2. Calculated deal by deal as each portfolio company is sold, with carry paid on each realized gain
  3. Deferred until every asset has been liquidated and all escrows, earn-outs and contingent liabilities have been fully resolved
  4. Calculated on aggregate fund profits after all LP capital and the preferred return have been returned Correct answer.

Explanation

A whole-of-fund waterfall aggregates all profits and losses across the portfolio before allocating carry, so the GP is paid only once LPs have received capital plus the preferred return on the fund overall. This contrasts with the deal-by-deal approach common in US fund agreements.

Question 38Private Equity

A clawback provision in a private equity fund agreement protects limited partners by:

  1. Requiring the GP to return carried interest if later losses show total carry exceeded the agreed share of fund profits Correct answer.
  2. Allowing LPs to remove the general partner for poor performance without cause, penalty or notice period
  3. Giving LPs the right to purchase the GP's management company stake at book value
  4. Capping aggregate management fees at a fixed percentage of total commitments over the fund's life

Explanation

A clawback ensures that, once the fund is wound up, the GP's total carry equals the agreed percentage of total profits. It is most needed when carry has been paid on early winners before later losers are realized.

Question 39Private Equity

A fund uses a subscription line of credit to delay capital calls from its limited partners. The primary effect of this practice is that it:

  1. Transfers management fee obligations from the fund to the portfolio companies drawing the facility
  2. Shortens the time LP capital is at work, raising the reported IRR Correct answer.
  3. Reduces the fund's gross IRR while raising the TVPI reported to LPs at year end
  4. Eliminates the need for a preferred return to be paid to limited partners

Explanation

Because LPs are called later, their capital is outstanding for a shorter period while the same cash flows are eventually received, which mechanically lifts IRR. The multiple of capital (TVPI) is essentially unaffected because no new profit is created.

Question 40Private Equity

The Kaplan-Schoar public market equivalent (PME) compares a private fund's cash flows with:

  1. A public market index, with fund cash flows discounted and compounded at the index's return Correct answer.
  2. A peer group median fund of the same vintage, using reported net returns from a commercial database
  3. The fund's own stated preferred return
  4. A public market index, comparing only terminal values without regard to the timing of contributions and distributions

Explanation

The Kaplan-Schoar PME discounts contributions at the index return to present value and compounds distributions forward at the same rate, then divides the two. A value above 1.0 indicates the fund beat the public market benchmark on a timing-matched basis.

Question 41Private Equity

In a down round, broad-based weighted-average anti-dilution protection benefits the investor by:

  1. Restoring the investor's original price per share regardless of the size of the new round
  2. Raising the number of common shares the preferred converts into, at a rate that scales with the size of the down round Correct answer.
  3. Converting the preferred stock into subordinated debt with a senior claim on the recapitalized company's assets
  4. Guaranteeing the investor a board seat in the recapitalized company

Explanation

Weighted-average anti-dilution adjusts the conversion price using a formula that weighs new shares issued against shares outstanding, so the benefit grows with the size of the dilutive round. It is gentler on founders than a full ratchet.

Question 42Private Equity

A non-participating preferred stock with a 1x liquidation preference entitles the investor to:

  1. The preference amount plus a pro rata share of all remaining proceeds after every preferred holder is paid
  2. Either the preference amount or the as-converted common value, whichever is greater Correct answer.
  3. The preference amount settled in additional preferred shares rather than cash
  4. Only the as-converted common value, with no claim on the preference amount

Explanation

Non-participating preferred gives the investor a choice: take the liquidation preference and walk away, or convert to common and share in the upside. Rational investors elect whichever produces the larger payoff.

Question 43Private Equity

In a leveraged buyout, the largest driver of equity returns in a typical deal is usually:

  1. Tax shield benefits from interest deductibility and accelerated depreciation on acquired assets
  2. Deleveraging as free cash flow repays the acquisition debt Correct answer.
  3. Dividend recapitalizations completed partway through the holding period
  4. Multiple expansion from rising sector valuations and improved trading comparables at exit

Explanation

Most LBO value creation comes from paying down debt with the company's free cash flow, which transfers value from lenders to equity holders. Multiple expansion and tax shields contribute but are less reliably under the sponsor's control.

Question 44Private Equity

In an LBO sources-and-uses table, increasing the sponsor's equity contribution while holding debt constant will:

  1. Increase the interest coverage burden borne by the portfolio company
  2. Reduce the sponsor's ownership percentage of the company at exit
  3. Raise the purchase price multiple paid to the seller because more equity is available at closing
  4. Lower leverage and debt service, typically reducing the equity IRR while increasing the margin of safety Correct answer.

Explanation

More equity means less debt, so interest costs and covenant risk fall but the return is spread over a larger equity base. This trade-off lowers expected IRR in most deals while making the outcome less sensitive to operating shortfalls.

Question 45Private Equity

Limited partners that co-invest alongside a sponsor's main fund in a single transaction most commonly:

  1. Pay no management fee or carried interest on the co-investment, as a common but discretionary concession Correct answer.
  2. Pay the same management fee and carried interest as investors in the main fund
  3. Must commit capital to every transaction the sponsor pursues for a fixed multi-year period
  4. Receive preferential governance rights over the sponsor's main fund investors, including LPAC seats

Explanation

Fee-free and carry-free co-investment is the standard incentive sponsors offer to large or strategic LPs, though allocation remains at the GP's discretion and is not a contractual right. Co-investors typically have limited governance and no say in deal selection.

Question 46Private Equity

In an LP-led secondary transaction, the selling limited partner typically:

  1. Sells its fund interest to a buyer at a negotiated discount or premium to net asset value Correct answer.
  2. Sells individual portfolio companies directly to strategic buyers in a series of negotiated trade sales
  3. Redeems its interest from the fund at net asset value on demand
  4. Exchanges its fund interest for shares in the general partner's management company at an agreed valuation

Explanation

An LP-led secondary transfers an existing fund commitment to a secondary buyer at a price struck relative to reported net asset value, which may be at a discount or a premium. The underlying assets stay in the fund; only the identity of the limited partner changes.

Question 47Private Equity

A primary drawback of investing in private equity through a fund of funds is:

  1. An inability to access top-quartile managers because those firms refuse to accept fund-of-funds capital
  2. Loss of diversification across managers, strategies and vintage years relative to direct investing
  3. Layered fees and carried interest that reduce net returns relative to direct fund investing Correct answer.
  4. Forced liquidation of the underlying funds after five years of operation

Explanation

A fund of funds typically charges its own management fee and carry on top of those charged by the underlying funds, creating a fee drag. It also often holds back a portion of commitments as a cash buffer, causing some return dilution.

Question 48Private Equity

A key person clause in a private equity fund typically provides that:

  1. The investment period is suspended and new investments halted if named individuals cease to devote substantial time to the fund Correct answer.
  2. LPs may require the fund to liquidate all portfolio companies immediately following a departure
  3. The GP must replace any departing investment professional within thirty days or forfeit a portion of its management fee
  4. The GP's carried interest is forfeited if the fund underperforms the preferred return

Explanation

A key person clause is a governance backstop: if specified individuals leave, die or reduce their involvement, the fund's ability to make new investments is suspended. LPs then vote on whether to resume the investment period or wind down.

Question 49Private Equity

Why do venture capital funds typically hold many more portfolio companies than buyout funds?

  1. VC funds cannot take board seats, so they need more positions to monitor their investments effectively
  2. VC returns are highly skewed, so many positions are needed for a few winners to drive the fund, while buyouts rely on control and leverage Correct answer.
  3. VC funds are required by regulation to hold at least twenty portfolio companies before they may charge carried interest
  4. Buyout funds are contractually prohibited from holding more than five portfolio companies in a single fund

Explanation

Venture outcomes follow a power-law distribution in which a small number of companies produce most of the fund's return, so investors diversify widely to ensure exposure to those outliers. Buyouts generate more predictable returns per deal through control, leverage and operational improvements, so concentration is economical.

Question 50Private Equity

A fund whose large distributions arrive early and whose large capital calls arrive late may report an attractive IRR that overstates the investor experience. The main reason is that:

  1. IRR ignores the time value of money entirely throughout the calculation
  2. IRR assumes interim cash flows are reinvested at the IRR itself and is highly sensitive to the timing of early cash flows Correct answer.
  3. IRR cannot be computed whenever a fund's cash flow stream changes sign more than once during its life
  4. IRR is calculated on committed capital rather than on invested capital

Explanation

The IRR solves for a single discount rate and implicitly assumes every interim cash flow is reinvested at that same rate, which flatters funds with early inflows. It is also mathematically sensitive to timing, so manipulating call dates or using subscription lines can lift the reported figure without improving economics.