Alternative Investments 1 easy

• Alternative investments are investments that do not fall under traditional investments.

Traditional investments

• Long-only investments in cash.
• Publicly traded stocks and bonds.

Alternative investments

• Actively managed
• Hedge funds
• Private equity funds
• Real estate investments
• Investments in commodities, infrastructure, and illiquid securities

Benefits of Alternative Investments

• Risk reduction through diversification
• Potential for higher returns from holding illiquid securities
• Less efficient markets which may create opportunities for higher returns

Key Characteristics

• More specialized knowledge required for investment managers.
• Relatively low correlation with returns of traditional investments.
• Lower liquidity of assets held.
• Longer time horizons for investors.
• Larger size of investment commitments

Unique Features

• Investment structures that facilitate direct investment by managers.
• Information asymmetry between fund managers and investors, often addressed through incentive-based fee structures.
• Difficulty in appraising performance, due to problematic and less available historical returns and volatility data.
• Low correlation with traditional investments, but correlations may increase significantly during economic stress periods.

Categories

• Private Capital (Private Equity and Private Debt)
• Real Assets
• Hedge Funds

Private Capital

• Includes private equity and private debt

Private Equity

• Involves investing in the equity of non-publicly traded companies or taking public companies private.
• Target companies are often in the mature or declining phases of their life cycles.

Types of private equity investments

• Leveraged Buyout funds(LBO): Uses borrowed money to buy established companies( the most part of PE funds)
• Venture Capital funds: Invests in young ,unproven companies at the start-up or early stages in their life cycle

Private Debt

• Private debt funds lend directly to companies.

Types of private debt investments

• Venture debt: Loans provided to early-stage firms.
• Distressed debt: Investments in the debt of struggling firms that may be facing bankruptcy.

Real assets

• Includes real estate, infrastructure, natural resources, and other assets such as digital assets:

Real estate investments

• Includes residential or commercial properties, as well as real estate-backed debt.

Natural resources

• Includes commodities, farmland, and timberland.

Infrastructure

• Refers to long-lived assets that provide public services like roads, airports, schools and hospitals.

Other Types

• Includes collectibles such as art, intangible assets such as patents, and digital assets such as cryptocurrencies.”

Hedge Funds

• Investment companies typically open only to qualified investors.
• May use leverage, hold long and short positions, use derivatives, and invest in illiquid assets.
• Managers of hedge funds use many different strategies in attempting to generate investment gains.
• They do not necessarily hedge risk, as the name might imply.

Fund investment

• Refers to investing in a pool of assets alongside other investors, using a fund manager who selects and manages a pool of investments using an agreed-upon strategy.
• The individual investors do not control the selection of assets for investment or their subsequent management and sale.
• The manager typically receives a percentage of the investable funds (management fee) as well as a percentage of the investment gains (incentive fee).
• Compared to funds that invest in traditional asset classes, alternative investment funds typically require investors to commit larger amounts of capital for longer periods, provide less information on positions held and returns earned, and charge higher management fees.
• A fund's term sheet describes its investment policy, fee structure, and requirements for investors to participate.

Co-investing

• An investor contributes to a pool of investment funds (as with fund investing)
• Has the right to invest, directly alongside the fund manager, in some of the assets in which the manager invests
• Can reduce overall fees while benefiting from the manager's expertise
• Can provide an investor with an opportunity to gain the skills and experience to pursue direct investing.
• Permitting co-investment may increase the availability of investment funds and expand the scope and diversification of the fund's investments

Direct investing

• An investor purchases assets itself, rather than pooling its funds with others or using a specialized outside manager.
• No fees to outside managers
• The investor has more control over investment choices.

Disadvantages

• Less diversification across investments
• Higher minimum investment amounts
• Greater investor expertise required to evaluate deals and perform their own due diligence.

Investments ownership

Limited Partnerships

• Alternative investments are often structured as limited partnerships.
• The general partner (GP) is the fund manager and makes all the investment decisions.
• The limited partners (LPs) are the investors, who own a partnership share proportional to their investment amounts.
• LPs typically have no say in how the fund is managed and no liability beyond their investment in the partnership.
• The GP takes on the liabilities of the partnership, including the repayment of any partnership debt.
• Partnerships typically set a maximum number of LPs that may participate.
• LPs commit to an investment amount, and in some cases, they only contribute a portion of that initially, providing the remaining funds over time as required by the GP (as fund investments are made).
• General partnerships are less regulated than publicly traded companies, and limited partnership shares are typically only available to accredited investors-those with sufficient wealth to bear significant risk and enough investment sophistication to understand the risks.

Limited Partnership Agreement

• The rules and operational details that govern a partnership are contained in the limited partnership agreement.
• Special terms that apply to one limited partner but not to others can be stated in side letters.
• For example, an LP might negotiate an excusal right to withhold a capital contribution that the GP would otherwise require.
• Some limited partners may require that special terms offered to other LPs also be offered to them, this is known as a most-favored-nation clause in a side letter.
• While most alternative investment limited partnership holdings are illiquid, a fund may be structured as a master limited partnership (MLP) that can be publicly traded.
• Master limited partnerships are most common in funds that specialize in natural resources or real estate.

Fee structures

• Total fees paid by investors in alternative investment funds often consist of a management fee, typically between 1% and 2% of the fund's assets, and a performance fee or incentive fee (sometimes referred to as carried interest).
• The fund manager earns the management fee, regardless of investment performance.
• For hedge funds, the management fees are calculated as a percentage of assets under management (AUM), typically the net asset value of the fund's investments.
• For private equity funds, the management fee is calculated as a percentage of committed capital, not invested capital.
• Committed capital is typically not all invested immediately; rather, it is "drawn down" (invested) as securities are identified and added to the portfolio.
• Committed capital is usually drawn down over three to five years, but the drawdown period is at the discretion of the fund manager.
• Committed capital that has not yet been drawn down is referred to as dry powder.
• The reason for basing management fees on committed capital is that otherwise, the fund manager would have an incentive to invest capital quickly instead of selectively.
• Performance fees (also referred to as incentive fees) are a portion of profits on fund investments.
• Most often, the partnership agreement will specify a hurdle rate (or preferred return) that must be met or exceeded before any performance fees are paid.
• Hurdle rates can be defined in two ways: either "hard" or "soft."
• If a soft hurdle rate is met, performance fees are a percentage of the total increase in the value of each partner's investment.
• With a hard hurdle rate, performance fees are based only on gains above the hurdle rate.

Fee structures 2

• Typically, performance fees are paid at the end of each year based on the increase in the value of fund investments, after management fees and other charges, which may include consulting and monitoring fees that are charged to individual portfolio companies.
• A catch-up clause in a partnership agreement is based on a hurdle rate and is similar in its effect to a soft hurdle rate.
• Another feature that is often included is a high-water mark, which means no performance fee is paid on gains that only offset prior losses.
• A partnership's waterfall refers to the way in which payments are allocated to the GP and the LPs as profits and losses are realized on deals.

Deal-by-deal waterfall

• Profits are distributed as each fund investment is sold and shared according to the partnership agreement.
• Favors the GP because performance fees are paid before 100% of the LPs' original investment plus the hurdle rate is returned to them.

Whole-of-fund waterfall

• The LPs receive all distributions until they have received 100% of their initial investment plus the hurdle rate (typically after all fund investments have been sold).

Clawback provision

• Stipulates that if the GP accrues or receives incentive payments on gains that are subsequently reversed as the partnership exits deals, the LPs can recover previous (excess) incentive payments.
• A clawback provision would allow the LPs to recover these performance fees to the extent that the subsequent losses negate prior gains on which performance fees had been paid.