This reading will cover the basic categories and characteristics of alternative investments and how to value them. We will also briefly look at the role alternative investments play in diversifying a portfolio.
Traditional investments refer to long-only positions in stocks, bonds, and cash.
All other investments are classified as alternative investments.
Alternative investments can be divided into five main categories:
The general characteristics of alternative investments are listed below:
Since the mid-1990s assets under management in alternative investments have grown significantly. Institutional investors such as endowments and pension funds, and family offices have primarily contributed to this growth.
These investors consider alternative investments due to:
The main categories of alternative investments are:
Agricultural land (or farmland):
The three methods of investing in alternative investments are:
Exhibit 2 from the curriculum summarizes the advantages and disadvantages of the different methods of investing.
|Fund investing||● Fund managers offer investment services and expertise
● Lower level of investor involvement compared with the direct and co-investing methods
● Access to alternative investments without possessing a high degree of investment expertise
● Potentially valuable diversification benefits
● Lower minimum capital requirements
|● Costly management and performance fees
● Investor must conduct thorough due diligence when selecting the right fund because of the wide dispersion of fund manager returns
|Co-investing||● Investors can learn from the fund’s process to become better at direct investing
● Reduced management fees
● Allows more active management of the portfolio compared with fund investing and allows for a deeper relationship with the manager
|● Reduced control over the investment selection process compared with direct investing
● May be subject to adverse selection bias
● Requires more active involvement compared with fund investing, which can be challenging if resources and due diligence experience are limited
|Direct investing||● Avoids paying ongoing management fees to an external manager
● Greatest amount of flexibility for the investor
● Highest level of control over how the asset is managed
|● Requires more investment expertise and a higher level of financial sophistication compared with fund investing and co-investing, resulting in higher internal investment costs
● Less access to a fund’s ready diversification benefits or the fund manager’s sourcing network
● Requires greater levels of due diligence because of the absence of a fund manager
● Higher minimum capital requirements
Investors have to conduct a proper due diligence before investing in alternative investments. The due diligence approach depends on the method of investing: fund, co-investing, or direct.
Due diligence for fund investing
Hedge fund and private equity returns depend heavily on the fund manager. Due diligence of the manager is important to ascertain he has the right skill and expertise. When evaluating past results, investors should be wary of consistent, good performance as there is a possibility of fraud.
Due diligence for fund investing should assess whether:
Due diligence for direct investing
Due diligence for direct investing requires the investor to conduct a thorough investigation into the important aspects of the target asset or business such as:
Direct investors often supplement their due diligence with analysis prepared by external consultants.
Due diligence for co-investing
Since direct investing is an element of co-investing, the due diligence process is similar to direct investing.
The key difference between the two is that: In co-investing, investors often depend heavily on the due diligence conducted by the fund manager. Whereas, direct investing due diligence may be more independent because the direct investing team is typically introduced to opportunities by third parties and they have more control over the due diligence process.
The most common structure for many alternative investments is a partnership. It consists of two entities:
The partnership between the GP and LPs is governed by a limited partnership agreement (LPA). It is a legal document that outlines the rules of the partnership and establishes the framework for the fund’s operations.
The general partner typically receives a management fee based on assets under management (commonly used for hedge funds)or committed capital (commonly used for private equity). Management fee typically ranges from 1% to 2%.
Apart from the management fee, the GP also receives a performance fee (also called incentive fee or carried interest) based on realized profits. Performance fees are designed to reward GPs for good performance. A common fee structure is 2 and 20 which means 2% management fee and 20% performance fee.
Generally, the performance fee is paid only if the returns exceed a hurdle rate (also called a preferred rate). A hurdle rate of 8% is typically used.
Common investment clauses, provisions and contingencies specified in the LPA include:
Catch-up clause: A catch-up clause allows the GP to receive 100% of the distributions above the hurdle rate until he receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP. This clause is meant to make the manager whole so that their incentive fee is a function of the total return and not solely on the return in excess of the hurdle rate.
Assume that the GP has earned an 18% IRR on an investment, the hurdle rate is 8%, and the partnership agreement includes a catch-up clause.
In this case the distribution would be as follows:
Thus, the GP effectively earns: 18% x 20% = 3.6% and the LP effectively earns 18% x 80% = 14.4%.
In the absence of a catch-up clause the distributions would have been:
Thus, in this case the GP effectively earns a lower return of (18% – 8%) x 20% = 2.0%
High water mark: In some cases, the incentive fee is paid only if the fund has crossed the high-water mark. A high-water mark is the highest value net of fees (or the highest cumulative return) reported by the fund so far for each of its investors. This is to ensure investors do not pay twice for the same performance.
Waterfall: The waterfall defines the way in which cash distributions will be allocated between the GP and the LPs. In most waterfalls, a GP receives a disproportionately larger share of the total profits relative to their initial investment. This is typically done to incentivize GPs to maximize profitability.
There are two types of waterfalls:
Clawback: A clawback provision allows LPs to reclaim a part of the GP’s performance fee. For example, if a fund makes profitable exits in early years, but the subsequent exits are less profitable, then the GP has to pay back profits to ensure that the profit split is in line with the fund prospectus.