A pension fund allocates 10% of its $500M portfolio to a private equity fund in 2025. By 2028 a liquidity crisis hits and the fund needs $50M to meet retiree payments. The PE stake cannot be sold on an exchange; the secondary market quotes a 25% haircut. The pension chooses between selling at $37.5M (losing $12.5M) or holding and missing rebalancing. This is the illiquidity tax on alternatives, quantifiable and not theoretical.
Secondary buyers discount PE stakes to compensate for due diligence burden, unfunded commitment risk, and vintage uncertainty. A 25% haircut on a $50M stake is $12.5M of realized loss, a cost the pension would not face with public equities. Illiquidity is not "takes longer to sell," it is a quantifiable price concession. Each characteristic below resolves to a number in a crisis.
Illiquidity. Lock-ups, capital calls, and thin secondary markets mean you cannot exit without a meaningful discount. Capital calls go the other direction. The GP demands cash within 10 business days and a default forfeits your stake at a penalty price.
Common mistakes
- Calling structured products a fifth category. CAIA classifies four categories: Real Assets, Hedge Funds, Private Equity, Private Credit. Structured products (CDOs, credit derivatives) live inside private credit as a special-situations strategy. The exam will offer "five categories including structured products" as a distractor.
- Treating illiquidity as theoretical. The denominator effect is a real historical phenomenon. In 2008-2009, LPs literally could not meet capital calls because their public-market allocation had halved, and secondary markets quoted 40%+ discounts on PE stakes.
- Using NAV for valuation in a secondary sale. Secondary buyers discount 15-40% to NAV depending on vintage, fund quality, and unfunded commitments. An LP modeling an exit at NAV is modeling a transaction that does not exist. The exam trap is to give you a NAV-based exit value as a distractor.
Bottom line
- CAIA classifies four alternative categories (Real Assets, Hedge Funds, Private Equity, Private Credit). Structured products and CDOs live inside private credit, not as a fifth category.
- Alternatives share four frictions (illiquidity, opacity, weak regulation, complex structures) and three return characteristics (illiquidity, inefficiency, non-normality), the last sourced from securities and trading structuring.
- Private equity spans VC (start-ups), growth equity (expansion), and LBOs (mature take-privates); private credit spans direct lending, mezzanine, distressed, and tranched CDOs.
- Real assets cover natural resources, commodities, real estate, infrastructure, and intellectual property, split into operational and non-operational types.
Exam shortcut
Five pattern reads win most fee and structure questions. "Four categories" means Real Assets, Hedge Funds, Private Equity, Private Credit; if you see structured products listed separately, it is wrong. "Denominator effect" means public markets fell, so the alternative allocation looks over-weighted, and the LP may be forced to sell in a discounted secondary.
The full lesson (about 6,499 words, 43 min read) adds 2 worked examples, all 9 common mistakes, a self-check, free in the app.
Learning objectives
- defining alts
- blurred lines
- history us
- history asia
- risk return characteristics
- goals
- buy sell side
- service providers
- legal structures
- fund types
- fund features
- fund terms
- drawdown fees
- waterfall calcs
- hedge fund fees
- fees and behavior
- return math
- irr
- irr problems
- modified irr
- other measures
- j curve
- notional principal
- return distributions
- moments
- covariance correlation
- beta autocorrelation
- std dev variance
- normality testing
- market efficiency
- time value
- forward rates
- arbitrage
- binomial trees
- single factor models
- hypothesis testing
- sampling problems
- forwards vs futures
- forward foundations
- forwards on rates
- carry forwards
- managing long short
- option exposures
- rate options
- rate swaps
- option pricing
- risk measures
- var
- benchmarking
- ratio measures
- risk adjusted
- pricing data
- appraisals smoothing
- alpha beta overview
- estimating alpha
- return attribution
- statistical issues
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