ALTERNATIVE INVESTMENTFEATURES, METHODS, ANDSTRUCTURES
Describe features and categories of alternative
investments.
Alternative investments comprise various types of investments that do not fall under the heading of traditional investments, which refers to long-only investments in cash or publicly traded stocks and bonds.
Types of alternative investment structures include hedge funds, private equity funds, and various types of real estate investments. Alternative investments typically are actively managed and may include investments in commodities, infrastructure, and illiquid securities.
The perceived benefits of including alternative investments in portfolios are risk reduction from diversification (due to low correlations of alternative investments with traditional investments) and possible higher returns from holding illiquid securities, and from markets for some alternative investments possibly being less efficient than those for traditional investments.
Compared with traditional investments, alternative investments typically exhibit the following features:
More specialized knowledge required of investment managers
Relatively low correlations with returns of traditional investments Less liquidity of assets held
Longer time horizons for investors
Larger size of investment commitments
As a result of these unique features, alternative investments exhibit the following characteristics:
Investment structures that facilitate direct investment by managers
Information asymmetry between fund managers and investors, which funds typically address by means of incentive-based fee structures
Difficulty in appraising performance, such as more problematic and less available historical returns and volatility data
Although correlations of returns on alternative investments with returns on traditional investments may be low on average, these correlations may increase significantly during periods of economic stress.
We will examine several types of alternative investments in detail in separate readings in this topic area. We may classify alternative investments into three broad categories of private capital, real assets, and hedge funds.
1. Private capital includes private equity and private debt:
– As the name suggests, private equity funds invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the funds intend to take private. These firms are often in the mature or decline stages of their industry life cycle. Leveraged buyout (LBO) funds use borrowed money to purchase equity in established companies and comprise most private equity investment funds. Venture capital funds invest in young, unproven companies at the start-up or early stages in their life cycles.
– Private debt funds may make loans directly to companies, lend to early-stage firms (venture debt), or invest in the debt of firms that are struggling to make their debt payments or have entered bankruptcy (distressed debt).
2. Real assets include real estate, infrastructure, natural resources, and other assets such as digital assets:
– Real estate investments include residential or commercial properties, as well as real estate– backed debt. These investments are held in various structures, including full or leveraged ownership of individual properties, individual real estate–backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.
– Natural resources include commodities, farmland, and timberland. To gain exposure to commodities, investors can own physical commodities, commodity derivatives, or the equity of commodity-producing firms. Some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts (futures) that are expected to track a specific commodity index. Farmland can produce income from leasing the land out for farming or from raising crops or livestock for harvest and sale. Timberland investment involves purchasing forested land and harvesting trees to generate cash flows.
– Infrastructure refers to long-lived assets that provide public services. These include economic infrastructure assets (e.g., roads, airports, and utility grids) and social infrastructure assets (e.g., schools and hospitals). While often financed and constructed by government entities, infrastructure investments have more recently been undertaken by public-private partnerships, with each holding a significant stake in the infrastructure assets. Various deal structures are employed, and the asset may revert to public ownership at some future date.
– Other types of real assets include collectibles such as art, intangible assets such as patents, and digital assets such as cryptocurrencies.
3. Hedge funds are investment companies typically open only to qualified investors. These funds 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 investing 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. In this case, 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.
With co-investing, an investor contributes to a pool of investment funds (as with fund investing) but also has the right to invest, directly alongside the fund manager, in some of the assets in which the manager invests. Compared to fund investing, co-investing can reduce overall fees while benefiting from the manager’s expertise. Co-investing also can provide an investor with an opportunity to gain the skills and experience to pursue direct investing. For a fund manager, permitting co-investment may increase the availability of investment funds and expand the scope and diversification of the fund’s investments.
Direct investing refers to an investor that purchases assets itself, rather than pooling its funds with others or using a specialized outside manager. Larger, more knowledgeable investors may purchase private companies or real estate directly. For example, a sovereign wealth fund may have its own specialized managers to invest in real estate, agricultural land, or companies in the venture stage.
Direct investing has advantages in that there are no fees to outside managers, and the investor has more control over investment choices. Disadvantages include the possibility of less diversification across investments, higher minimum investment amounts, and greater investor expertise required to evaluate deals and perform their own due diligence.
Alternative investments are often structured as limited partnerships. In a limited partnership, 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. The 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.
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
The 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.
For example, consider a fund with a hurdle rate of 8% that has produced a return of 10% for the year. We will use a performance fee structure of 20% of gains. If the 10% is a soft hurdle rate, the performance fee will be 20% of the entire 12%, or 2.4%. If the 8% is a hard hurdle rate, the performance fee will be 20% of the gains above the hurdle rate (12% – 8% = 4%), which would be 0.8%.
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. Consider a fund with returns of 18%, a hurdle rate of 8%, and a 20% performance fee. A catch-up clause would result in the first 10% of gains going to the LPs and the next 2% going to the GP, allowing the GP to “catch up” to receiving 20% of the first 10% of gains. After the catchup, further gains are split 80/20 between the LPs and the GP.
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. Thus, performance fees are only paid to the extent that the current value of an investor’s account is above the highest net-of-fees value previously recorded (at the end of a payment period). This feature ensures that investors will not be charged performance fees twice on the same gains in their portfolio values. Because investors invest in a fund at different times, they each may have a different high-water mark value.
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. With a deal-by-deal waterfall (or American waterfall), profits are distributed as each fund investment is sold and shared according to the partnership agreement. This favors the GP because performance fees are paid before 100% of the LPs’ original investment plus the hurdle rate is returned to them. With a whole-of-fund waterfall (or European 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).
A 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. With a deal-by-deal waterfall, successful deals might be exited initially, while losses are realized later. 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.