ALT 1 Alternative Investment Features, Methods, and Structures
Alternative investments are holdings that sit outside the three traditional asset classes: public equity, public fixed-income instruments, and cash. What binds them together is not a shared set of features but the fact that each one behaves differently from those traditional assets. In broad terms, the group covers private capital, real assets, and hedge funds.
Investors usually turn to alternatives for two reasons: broader portfolio diversification and higher expected returns. The price of chasing those benefits is a longer holding period, reduced liquidity, and markets that price assets less efficiently than public exchanges do. Evaluating and monitoring such positions also demands specialized knowledge that many investors simply do not have.
Features that set alternatives apart
Some traits of alternatives overlap with public debt and equity, while others differ sharply. The features that most clearly distinguish them are:
- A need for specialized expertise to value the cash flows and gauge the risks.
- Returns that typically show low correlation with traditional asset classes.
- Illiquidity, long time horizons, and large capital commitments.
Those features, in turn, drive three practical characteristics of alternative investing:
- Distinct investment structures, because investing directly is difficult and capital intensive.
- Incentive-based fees, designed to reduce the information gap between managers and investors.
- Genuine challenges in appraising performance.
Because many alternatives require a larger or longer financial commitment, and because the size of some deals is simply too large for smaller investors, most investors restrict alternatives to the slice of a portfolio earmarked for obligations several years away. The investors who commit the biggest share are those with the longest horizons, namely big pension funds, endowments run for non-profit purposes, and sovereign wealth funds.
Sorting holdings into traditional versus alternative depends on how an asset is structured and traded, not only on what it ultimately owns.
Alternatives fall into three broad categories. Private capital is money supplied to companies from outside the public markets. Real assets are tangible holdings such as property and natural resources. Hedge funds are private vehicles set apart by how they invest rather than by what they hold.
Private capital
Private capital is funding supplied to companies from outside both the public equity market and the public debt market. When it is supplied as an ownership stake it is private equity; when it is supplied as a loan or other borrowing it is private debt.
Private equity resembles public equity in that owners hold a residual claim on future cash flows, but the access differs greatly. A private equity owner can usually see full company information and shape day-to-day management and strategy, whereas a public shareholder receives only published disclosures and votes only on matters needing shareholder approval. Private equity typically targets mature companies or firms in decline, often through leveraged buyouts, and managers use their control to restructure operations, sell or close weak business lines, and lift profitability over several years. Venture capital is a specialized branch of private equity, backing non-public companies in their early or startup phase, where often only an idea or business plan and a small customer base exist.
Heartfield Digital, a digital media venture in its early stage, was founded 18 months ago to turn conventional music and art collections into digital form for sale. Its founders are seeking early-stage investors to fund market research, partnerships, and initial operations. Arguston Inc. is a mid-sized manufacturer in a mature industry, with a stagnant share price, a high cost base, and dwindling operating cash flow that leaves it unable to fund needed technology upgrades.
Private debt covers private loans and bonds, and it also includes two more specialized forms. Venture debt is lent to early-stage firms that have little or no cash flow. Distressed debt is the public or private debt of issuers thought to be near or in bankruptcy, which can reward investors who bring capital-restructuring skills.
Real assets
Real assets differ from financial ones by being, for the most part, tangible physical holdings, for example real estate and natural resources, though the label also reaches certain intangibles like patents, intellectual property, and goodwill. Such holdings either produce current or expected future cash flows or act as a store of value.
Real estate covers borrowed or ownership capital in land and buildings. Commercial real estate earns its cash flow from private business activity on the property, while residential real estate earns rents or mortgage payments from households. Publicly traded forms include real estate investment trusts (REITs), which issue equity securities, and mortgage-backed debt securities.
Infrastructure is a special real asset built from long-lived fixed assets, buildings, and land intended for public use and essential services, for example bridges and toll roads. A government may build it alone, or it may arise from a public-private partnership (PPP) that gives private investors a stake. Infrastructure produces cash flows directly through fees, leases, or access charges, or indirectly by supporting economic growth and a government’s future tax base. When private investors participate, a concession agreement usually sets out the obligation to build and maintain the asset together with the exclusive right to operate it and collect fees for a set period.
PT Indonesia Infrastructure Finance (IIF), a private national company, was created in 2010 by Indonesia’s government. Working alongside institutions that include the World Bank and the Asian Development Bank, IIF aims to widen private participation in the country’s infrastructure. Looking ahead, IIF expects that USD150 billion will be needed over a five-year period to build power plants and toll roads.
Natural resources take one of two forms: less developed land that is itself the source of value, or standardized goods that get harvested, extracted, or refined. The land category spans farmland, timberland, and acreage held to explore for minerals or energy; returns arrive through expected price appreciation and through cash flows such as crop yields, agricultural leases, timber harvests, or mineral and drilling rights. Some of these holdings also serve environmental, social, and governance (ESG) aims, for example promoting sustainable farming or generating carbon offsets. In a timberland carbon-offset arrangement, companies pay timber owners not to cut trees: the growing trees absorb carbon, the company earns offsets to show it is reducing pollution, and the owner earns non-timber income while the trees keep growing toward larger future harvests.
Commodities are standardized, traded goods, spanning products from plants, animals, energy, and minerals that feed into production. They do not themselves generate cash flows; producers ultimately sell them to consumers for economic use. Investors seek to profit from price movements and from a return pattern that tends to have low correlation with other asset classes over the economic cycle, which lets commodities act as a countercyclical holding and an inflation hedge. Demand for lithium illustrates the point: as electric vehicle sales climb, from 2.5 million in 2020 toward roughly 11 million in 2025 and more than 30 million by 2030 (about 32 percent of new car sales), demand for the metal in batteries is expected to rise in step.
Other real alternatives include tangible collectibles such as fine art, wine, rare coins, and watches, along with intangibles such as patents and litigation, and digital assets. The label digital assets covers anything created, stored, and moved electronically that carries linked ownership or use rights, including cryptocurrencies, security and utility tokens, and digital collectibles. The key technical distinction is that a cryptocurrency has its own blockchain (Bitcoin and Ethereum are examples), whereas a token sits on a blockchain that already exists, for example the many tokens within the Ethereum ecosystem.
Both use cryptography to assure authenticity. A cryptocurrency is the native asset of its own blockchain, while a token lives on a blockchain that already exists and is issued as part of a platform built on top of it. That is why a coin like Bitcoin is a cryptocurrency, while an asset created within the Ethereum network for a marketplace or decentralized finance project is a token.
Hedge funds
Hedge funds are private vehicles that can hold public equities, publicly traded fixed income, private capital, or real assets. Their defining trait is approach rather than holdings: they lean heavily on leverage, derivatives, short selling, and similar strategies, which often produces a risk and return profile far removed from simply buying and holding the underlying assets. Investors can also hold a portfolio of hedge funds, known as a fund of funds.
Once an investor decides to hold alternatives, the next question is how to enter. Because these positions are long-term and illiquid and require specialized judgment, they leave investors dependent on manager decisions for long stretches. There are three access routes, and they trade off control and effort against fees:
- Fund investment, for example investing in a private equity fund.
- Co-investment, investing alongside a fund into one of its portfolio companies.
- Direct investment placed straight into a company or project, for instance a piece of infrastructure or real estate.
Institutions usually begin with funds and, as they build experience, move toward co-investing and then direct investing. The biggest and most sophisticated direct investors, for example certain sovereign wealth funds, end up competing against fund managers for the best deals.
Fund investment
Investors with limited resources or experience typically enter through fund investing: they contribute capital to a fund, which then identifies, selects, and carries out the investments for them. In return the investor pays a management fee, plus a performance fee when the manager beats a hurdle rate or benchmark. This is an indirect route. Fund investors have almost no discretion, since their only decision is whether to invest in the fund at all, and they cannot influence the underlying holdings. Fund investing is on offer across every major alternative type, covering private capital, hedge funds, real estate, infrastructure, and natural resources.
Fund structures for alternatives differ sharply from public equity or fixed-income funds and ETFs. They usually involve pre-committing capital before any investment is selected, followed by a long period during which the position cannot be sold; higher management fees with more complex fee arrangements; and less frequent disclosure of returns and positions. To align incentives over these long horizons, investors compensate managers through a performance-based rather than a flat fee. The important terms sit in a term sheet, such as the one below.
| Term | Detail |
|---|---|
| Fund | Tenderledge Investment Fund VIII, L.P. |
| General Partner | Tenderledge Investment LLC |
| Fund Manager | Tenderledge Investments |
| Maximum Size | Not to exceed USD750 million |
| General Partner’s Commitment | At least 2% of aggregate limited partner commitments |
| Initial Closing Date | When aggregate commitments reach or exceed USD500 million |
| Final Closing Date | Twelve months from the initial closing date |
| Term of the Fund | Ten years from the initial closing date |
| Investment Policy | Attractive long-term return from a diversified alternative portfolio |
| ESG | In line with the General Partner’s ESG policy |
| Management Fee | 1.5% per annum of each limited partner’s commitment |
| Hurdle Rate | A hard hurdle rate of 10% |
| Performance Fee | 20% of fund returns above the hard hurdle rate |
| Side Letters | Any more favorable rights granted to one partner extend to all partners |
Co-investment
After gaining some fund experience, and before investing fully on their own, many investors take an intermediate step through co-investing. Here the investor holds a deal indirectly through the fund and also holds co-investment rights to invest directly in that same deal. This lets the investor put money alongside the fund when the fund sources an opportunity, rather than being limited to the fund alone. Co-investing expands the investor’s knowledge and experience, gives access to a deal at a lower fee than a fund-only investor would pay, and builds a path toward eventual direct investing. The trade-off is that the investor accepts higher oversight costs in exchange for greater control and lower fees.
Managers, for their part, bring in co-investors to:
- accelerate timing when available capital and expected inflows fall short for a specific deal,
- widen the range of new investments they can pursue, and
- increase the diversification of the existing pool of fund investments.
Moreton Bay Pension Plan invests in the Tenderledge LLC Alternatives Fund. Tenderledge has found a take-private deal in Fancy Roofing Co. that needs USD1.5 billion, but its fund concentration limit caps any single investment at USD1 billion.
Direct investment
The largest and most sophisticated investors, those with the skills and resources to manage individual holdings themselves, often invest directly, without any intermediary. Direct investors keep maximum flexibility and control over which assets to buy, how to finance them, and when to act. For private equity this means buying a stake in a private company without a fund or external general partner, so the investor must supply all the specialized knowledge and oversight itself. Direct investing generally covers private capital and real estate, though certain very large investors, such as pension and sovereign wealth funds, also take direct stakes in infrastructure and natural resources. As an illustration, in 2021 the Singapore sovereign wealth fund GIC committed a direct USD240 million to Arctic Green Energy, becoming an equity partner to help the firm expand its geothermal operations.
Because alternatives are illiquid, complex, and long-lived, they need structures that bridge the gaps between manager and investor interests. Those structures do two things: they spell out the roles and responsibilities of each side, and they shape how returns are shared so incentives line up. A manager might require investors to fund future capital contributions, while investors might restrict what the manager can select in order to avoid conflicts. Performance-based compensation, which can include minimum returns for investors, delayed payouts, and the right to reclaim incentive pay after poor results, pushes managers to maximize returns for investors.
Ownership structures
Alternative vehicles often take the form of partnerships, which give the flexibility to allocate risk, return, and special responsibilities between the two sides. A limited partnership has at least one general partner (GP), who runs the fund and in theory bears unlimited liability, and limited partners (LPs), the outside investors who own a fractional interest based on how much they invested and the terms of the partnership documents. LPs pledge to fund future investments, so the cash they pay in at the outset can be only a small slice of what they have committed overall. They play a passive role and leave operations and decisions to the GP, although co-investment rights let them place extra direct stakes into the portfolio companies. Crucially, an LP’s liability is capped at the amount it invests. LP investors must usually meet minimum net worth, institutional, or other requirements as accredited investors, since these funds are less regulated than public offerings.
A limited partnership agreement (LPA) sets the terms of the partnership: how profits and losses are distributed, the manager’s roles and responsibilities including investment criteria and restrictions, and rules for transfers, withdrawals, and dissolution. When a specific investor has unique legal, regulatory, or reporting needs, a side letter is issued between the GP and one or more LPs to override or modify the LPA. Side letter terms can include broader rights to transfer investments to a successor fund, first right of refusal, the ability to skip a required capital contribution (an excusal right), or extra reporting. A most favored nation clause is one common feature, ensuring that any better terms negotiated with other investors also apply to the covered LP. These customized terms contrast with the single standardized indenture that governs all bondholders in a public fixed-income issue.
Other alternatives adopt their own specialized structures. Infrastructure investors often use public-private partnerships, in which the public and private sectors jointly finance, build, and operate public assets, frequently through a special purpose entity that raises debt and equity to construct and run a specific asset governed by a concession agreement, and once that ends the asset is sold or handed back to the public sector. Real estate and natural resource fund investors are often unitholders in a master limited partnership (MLP), which resembles a limited partnership but is usually more liquid and often publicly traded. Other relatively liquid alternatives include REITs, commodity funds, and exchange-traded funds, while joint ventures are common in direct real estate.
Compensation structures
The information asymmetry between a GP, who has specialized knowledge and control, and the LPs pushes alternatives toward more complex compensation than traditional funds use. Traditional funds that own public securities typically charge a flat management fee as a percentage of assets. Alternative funds usually pair a higher management fee (often 1% to 2%) with a performance fee, also known as an incentive fee or carried interest, tied to a slice of fund returns.
The base for the management fee differs by type. Hedge funds and REITs charge on assets under management (AUM). Private equity funds instead charge on committed capital, the total amount LPs have promised to fund future investments. A private equity fund draws down these commitments, usually across a three to five year span, as specific deals appear, and a typical fund runs for ten years. Charging on committed capital rather than on invested capital or asset value matters: it removes the incentive for the GP to deploy capital as fast as possible just to grow near-term fees, and it avoids paying the GP on asset values that the GP itself heavily influences.
Performance fees are usually subject to a hurdle rate, sometimes called a preferred return, together with other adjustments. A hurdle rate can be hard, where the manager earns fees only on returns above the hurdle, or soft, where the fee applies to the whole return once the hurdle is cleared. If we ignore management fees and let the single-period fund return be r, the hard hurdle rate be r sub h, and the GP performance fee be p as a percentage of the excess return, the GP return is:
| Symbol | Meaning |
|---|---|
| r sub GP | General partner’s rate of return |
| p | General partner’s performance fee |
| r | Single-period fund rate of return |
| r sub h | Hard hurdle rate |
A fund earns a single-period return of 18 percent. The manager receives a performance fee of 20 percent on returns above a hard hurdle rate of 8 percent, with no catch-up clause.
Modifications can reward managers for clearing the hurdle or penalize them for weak results. A catch-up clause accelerates the performance fee once a soft hurdle is exceeded. Under a catch-up, the LP first receives 100 percent of distributions until it earns the hurdle rate, then the GP receives 100 percent of distributions until the overall profit split reaches the agreed ratio (here 80 percent to the LP and 20 percent to the GP), after which remaining distributions follow that same 80/20 split. With the catch-up, the GP return becomes:
Take the same fund return of 18 percent, a hard hurdle of 8 percent, and a 20 percent performance fee, but now add a catch-up return, r sub cu, of 2 percent.
| GP share | LP share | |
|---|---|---|
| With catch-up clause | 3.6% | 14.4% |
| Without catch-up clause | 2.0% | 16.0% |
Two further modifications protect LPs. A high-water mark, common with hedge funds, records the fund’s peak value net of fees; if the value later drops below that mark, the manager cannot charge performance fees until the value climbs back above it, so LPs do not pay twice for the same gains. A clawback provision goes further and lets LPs reclaim part of a GP’s performance fee, usually when the GP was paid on early winning deals but later deals produce losses. High-water marks generally carry across calendar years, but for hedge funds an investor can no longer claw back incentive fees from a prior calendar year once later losses occur; private equity and real estate, being more illiquid and longer-term, are more likely to carry clawback clauses across the entire life of the portfolio.
Distribution waterfalls
Alternatives often use a waterfall to set the order in which cash flows reach GPs and LPs, and GPs typically take a share of profits larger than their initial stake, which sharpens their incentive to maximize gains. There are two types. A deal-by-deal (or American) waterfall favors the GP, because performance fees are collected deal by deal, so the GP can be paid before the LPs have recovered their whole-fund initial investment and hurdle return. A whole-of-fund (or European) waterfall favors the LP: each distribution flows to the LPs as deals are realized, and the GP collects nothing until the LPs recover their initial capital plus the hurdle at the level of the whole fund.
The table below runs the same eight investments through both waterfalls. Under the deal-by-deal method the GP is paid on each profitable exit (Investments 1, 2, and 3), but because the fund only breaks even overall, a clawback forces the GP to return those early payouts. Under the whole-of-fund method the GP receives nothing, since the fund never clears its initial investment and hurdle at the aggregate level.
| Investment | Year invested | Year sold | Invested | Sold | Profit | Profit % | GP deal-by-deal | GP whole-of-fund |
|---|---|---|---|---|---|---|---|---|
| 1 | 1 | 4 | $10 | $20 | $10 | 26.0% | $2 | 0 |
| 2 | 2 | 5 | $20 | $35 | $15 | 20.5% | $3 | 0 |
| 3 | 2 | 7 | $40 | $80 | $40 | 14.9% | $8 | 0 |
| 4 | 3 | 7 | $20 | $20 | 0 | 0 | 0 | 0 |
| 5 | 3 | 8 | $35 | $25 | ($10) | neg | ($2) | 0 |
| 6 | 4 | 9 | $25 | $20 | ($5) | neg | ($1) | 0 |
| 7 | 5 | 9 | $30 | $0 | ($30) | neg | ($6) | 0 |
| 8 | 5 | 10 | $20 | $0 | ($20) | neg | ($4) | 0 |
| Total | 1 | 10 | $200 | $200 | 0 | 0 | 0 | 0 |
A general partner is paid on the following terms: single-period fund return of 20 percent, hard hurdle rate of 10 percent, performance fee of 18 percent, and no catch-up clause.
The single most important reason investors in alternative funds pay a performance-based rather than a flat fee is to line up manager and investor interests across long horizons. Penalizing weak performance and avoiding paying twice for the same returns matter too, but they are secondary to the core goal of alignment.