Concept 96: Types of Alternative Investments

Hedge funds

• Uses a partnership structure with a general partner who manages the fund and accepts unlimited liability and limited partners (investors) who own fractional interests in the partnership and have limited liability.
• The general partner typically receives a management fee based on assets under management and an incentive fee based on the performance of the fund.
• Hedge funds are typically classified by strategy into four broad categories:
  • Event-driven: Includes merger arbitrage, distressed/restructuring, activist shareholder and special situation.
  • Relative value: Strategies that seek to profit from pricing discrepancies.
  • Macro: Strategies based on top-down analysis of global economic trends.
  • Equity hedge: Strategies based on bottom-up analysis. Includes market neutral, fundamental growth, fundamental value, quantitative directional, and short bias.
• During financial crisis the correlation of returns between global equities and hedge funds tends to increase, which reduces the hedge funds’ usefulness as a diversifying asset class.

Private equity

• Uses a partnership structure with a general partner who manages the fund and accepts unlimited liability and limited partners (investors) who own fractional interests in the partnership and have limited liability
• The general partner typically receives a management fee based on committed capital and an incentive fee based on the performance of the fund.
• Dominant strategies in private equity funds are leveraged buyouts and venture capital. Other strategies include development capital and distressed investing.
• Types of LBOs include
  • Management buyouts: The existing management team is involved in the purchase.
  • Management buy-ins: External management team replaces the current management.
• Stages in venture capital include
  • Formative stage: Consists of angel investing, seed and early stages.
  • Later stage: Company is in expansion phase.
  • Mezzanine stage: Company is preparing for an IPO.
• Exit strategies for investments in portfolio companies include
  • Trade sale: Company is sold to a competitor or another strategic buyer.
  • IPO: Company is sold to the public.
  • Recapitalization: Company is re-leveraged when interest rates are low.
  • Secondary sale: Company is sold to another private equity firm or another investor.
  • Write off/ liquidation: Assets are sold and liabilities are settled.
• Historically, private equity has provided potential diversification benefits. However, an investor must identify top performing private equity managers to benefit from private equity.

Real estate

• Primary reasons to invest in real estate include:
  • Potential for competitive long term returns
  • Rental income
  • Diversification benefits
  • Inflation hedge
• Investment characteristics of real estate include:
  • Indivisibility
  • Unique characteristics(no two properties are identical)
  • Fixed location
  • Operational management
  • Local markets can be very different from national or global markets
• Basic forms of real estate investments are shown in the following table:

• Historically, real estate returns are highly correlated with global equity returns but less correlated with global bond returns.

Commodities

• Commodity investments can be achieved by investing in actual physical commodities or in companies that produce commodities. However, usually commodity investing is achieved using commodity derivatives.
• The return on a commodity investment includes:
  • Collateral yield: Return on collateral posted to satisfy margin requirements.
  • Price return: The gain or loss due to changes in the spot price.
  • Roll yield: Gain or loss resulting from re-establishing future positions. Roll yield is positive if futures market is in backwardation and negative if the market is in contango.
• Commodities are viewed as a good inflation hedge. They also have a low correlation with traditional investments and can provide diversification benefits.

Infrastructure

• Infrastructure assets are real assets that are planned for public use and to provide essential services. They are typically capital intensive and long-lived.
• These assets are expected to generate stable cash flows that should adjust for economic growth and inflation. They may also provide capital appreciation.

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