Alternative Investments

• Alternative investments encompass assets beyond the traditional scope of long-only, publicly traded stocks, bonds, and cash.
• A key benefit of alternative investments is diversification, stemming from their low correlation with traditional assets, which can reduce overall portfolio risk.
• Alternative investments offer the potential for higher returns due to market inefficiencies and the illiquidity premium.

Key Differences from Traditional Investments:

• AI necessitates specialized knowledge due to its unique characteristics.
• AIs tend to be less liquid than traditional investments.
• AIs typically involve longer time horizons for realizing returns.
• AIs often have redemption restrictions that limit when investors can withdraw their funds.
• AIs generally require larger capital commitments compared to traditional investments.
• AI involves direct investment by managers.
• AI has limited historical data on returns and volatility.
• AIs are subject to fewer regulations than traditional investments.
• AIs are typically available only to accredited investors due to their complexity and risk.

Alternative Investment Classifications:

• Private capital includes private equity and private debt.
• Private equity consists of leveraged buyout (LBO) funds and venture capital.
• Private debt includes venture debt and distressed debt.
• Real assets encompasses real estate, natural resources, commodities, farmland and timberland, and infrastructure.
• Other AI categories covers collectibles and intangible assets.
• Hedge funds employ diverse strategies to invest in stocks and bonds.

Alternative Investment Methods:

• Fund investing pools capital from multiple investors, managed by professionals.
• Fund investing offers the advantage of professional management and diversification, but investors lack control over asset selection.
• A disadvantage of fund investing is higher fees, including management and incentive fees.
• Co-investing combines fund investing with direct investment options alongside the fund manager.
• Co-investing can reduce overall fees and provide hands-on experience.
• Direct investing involves investors buying assets themselves, cutting out external management fees.
• Direct investing requires higher minimum investments and more expertise from the investor.
• Direct investing may lead to less diversification.

Due Diligence in AIs:

• Skill in manager selection is crucial for fund investing.
• With co-investing, investors can partially rely on the due diligence performed by the fund.
• Direct investing requires considerable expertise in due diligence.

Investment Ownership Structure

• Most AI funds are structured as limited partnerships (LPs).
• The structure includes a GP (General Partner) who acts as the fund manager with unlimited liability.
• LPs are the investors, often accredited, with limited liability.
• LP investments are proportional to their capital commitment.
• A limited partnership agreement (LPA) governs the partnership, outlining investment policies, and special terms like most-favored-nation clauses.
• Side letters are agreements between the GP and specific LPs outside the LPA.
• Side letters might include extra reporting, excusal rights to withhold capital contributions, or fee matching.
• A fund can be structured as a Master Limited Partnership (MLP) for publicly traded natural resources and real estate funds.

Fee Structures in AI Funds:

• Management fees typically range from 1% to 2% of AUM for hedge funds or committed capital for private equity.
• Performance fees are usually around 20% of investment gains.
• A soft hurdle charges the performance fee on the entire return if a minimum threshold (hurdle rate) is met.
• A hard hurdle charges the performance fee only on returns exceeding the hurdle rate.
• GPs generally do not earn performance fees until LPs are fully compensated and the hurdle rate is exceeded.
• The catch-up clause enables the GP to recover fees after LPs achieve an 8% return.
• With a catch-up clause, for example, LPs receive the first 8% of gains, the subsequent 2% goes entirely to the GP, and gains beyond 10% are split 80% to LPs and 20% to the GP.
• The high water mark ensures performance fees are paid only on new gains above the highest previously recorded portfolio value.
• The clawback provision allows LPs to recover excess incentive payments if gains are later reversed.

Waterfall Structures

• The waterfall describes how profits are allocated between the GP and the LPs
• In an American waterfall (deal by deal), profits are distributed as each fund investment is sold.
• The GP receives its carried interest (profit share) on a deal-by-deal basis in an American waterfall.
• The American waterfall structure benefits the GP because it provides carried interest sooner.
• In a European waterfall (whole of fund), LPs must recover 100% of their initial investment + hurdle rate before the GP receives carried interest.
• The European waterfall structure benefits the LP because it means they are fully compensated before GPs get performance fees.

AI Risk Factors:

• AIs have a higher risk due to the timing of cash flows, use of leverage, opaque asset valuation, and complex fee structures.
• In the capital commitment phase, fund managers identify investments and make capital calls, resulting in negative returns.
• During the capital deployment phase, fund managers fund and directly involve themselves in firms and projects; returns remain negative.
• In the capital distribution phase, successful investments generate income and cash flows, leading to accelerating positive returns.

J-Curve Effect:

• The J-curve effect graphically illustrates the initial dip in returns (negative early phases) followed by recovery and growth in later stages.

Measures of Investment Performance:

• IRR (Internal Rate of Return) is the most suitable measure of after-tax investment performance.
• The IRR relies on assumptions about the cost of capital and reinvestment rate.
• Multiple of Invested Capital (MOIC) is calculated as (Total Capital Return + Residual Value of Assets) / Total Capital Invested.
• MOIC does not consider the timing of cash flows.

Leverage

• The purpose of using leverage is to magnify returns from small pricing anomalies
• Funds might borrow funds to invest additional capital with leverage.
• Without leverage, Return = r × V₀
• With leverage: Leveraged Return = (r(V₀+Vb)-r_B×V_B)/V₀

Risks Associated with Leverage

• Margin calls can force liquidations at unfavorable prices.
• Lenders may restrict further borrowing if positions decline.

Valuation of Investments:

• Level 1 assets trade in active markets with readily available prices.
• Level 2 assets lack readily available prices but can be valued based on direct or indirect inputs (e.g., derivatives).
• Level 3 assets require unobservable inputs to establish a fair value.
• Fair values tend to remain near their initial cost for long periods.
• Fair values makes reported returns appear higher, less risky, and less correlated.

Key Risks in Alternative Investment:

• Negative returns increase the likelihood of investor redemptions.
• Early-year negative returns (J-curve effect) make alternative investment funds restrict early redemptions.

Redemption Restrictions:

• A lockup period is the time during which LPs (limited partners) cannot redeem their investment.
• The notice period is the time (30–90 days) given to managers to fulfill redemption requests.
• Gate provisions are temporary restrictions on redemptions to manage liquidity risks.
• Redemption fees offset transaction costs incurred during redemptions.

Fee Structures

• Standard fees are often expressed as "2 and 20" (2% management fee, 20% incentive fee) or "1 and 10".
• Customized terms include side letters that provide tailor-made fees or terms for individual investors.
• Founder class shares mean early investors may receive lower fees or better liquidity as incentives to invest during a fund's inception.
• "Either-Or Fees" means annual fees are the higher of the management or incentive fee (e.g., 1% management fee and 30% incentive fee; only the larger fee applies each year).

Biases in AI Returns

• Survivorship bias overstates returns as hedge fund databases often exclude failed funds.
• A significant percentage of hedge funds fail within the first three years (e.g., 25%).
• Backfill bias occurs when managers only include successful funds in indexes.
• Vintage year comparisons address biases by comparing funds that originated in the same year.

Return Calculations in AIs

• Before-fee returns are calculated using standard methods (e.g., holding period returns, periodic rates of return).
• After-fee returns adjust cash flows or values to account for management and performance fees.
• Complex fee provisions include hurdle rates, high-water marks, and fee interdependencies.