Alternative investment

Question 1

“Alternative investments

Answer 1

The terms “traditional” and “alternative” should not imply that alternatives are necessarily uncommon or that they are relatively recent additions to the investment universe. Alternative investments include such assets as real estate and commodities, which are arguably two of the oldest types of investments

Alternative investments offer broader diversification (because of their lower correlation with traditional asset classes), opportunities for enhanced returns (by increasing the portfolio’s risk–return profile), and potentially increased income through higher yields (particularly compared with traditional investments in low–interest rate periods).

Alternative investments are not free of risk, of course, and their returns may be correlated with those of other investments, especially in periods of financial crisis. Over a long historical period, the average correlation of returns from alternative investments with those of traditional investments may be low, but in any particular period, the correlation can differ from the average. During periods of economic crisis, correlations among many assets (both alternative and traditional) can increase dramatically

Question 2

characteristics of alternative investment

Answer 2

Narrow specialization of the investment managers

Relatively low correlation of returns with those of traditional investments

Less regulation and less transparency than traditional investments

Limited historical risk and return data

Unique legal and tax considerations

Higher fees, often including performance or incentive fees

Concentrated portfolios

Restrictions on redemptions (i.e., “lockups” and “gates”)

Question 3

Categories of Alternative Investments

Answer 3

1. hedge funds
   2.private capital : private equity
   private debt
   real estate
   3.natural resources : commodities
   agricultural land
   timberland
2. infrastructure
3. other

Question 4

hedge funds

Answer 4

Hedge funds are private investment vehicles that manage portfolios of securities and/or derivative positions using a variety of strategies. Although hedge funds may be invested entirely in traditional assets, these vehicles are considered alternative because of their private nature. Hedge funds typically have more leeway to pursue investments and strategies offering the potential for higher returns, whether absolute or compared with a specific market benchmark, but these strategies may increase the risk of investment loss. They may involve long and short positions and may be highly leveraged. Some aim to deliver investment performance that is independent of broader market performance.

Question 5

private equity

Answer 5

Investors participate in private equity through direct investments or indirectly through private equity funds. Private equity funds generally invest in companies, whether startups or established firms, that are not listed on a public exchange, or they invest in public companies with the intent to take them private. The majority of private equity activity involves leveraged buyouts of established profitable and cash-generating companies with solid customer bases, proven products, and high-quality management. Venture capital funds, a specialized form of private equity that typically involves investing in or providing financing to startup or early-stage companies with high growth potential, represent a small portion of the private equity market.

Question 6

private debt

Answer 6

Private debt largely encompasses debt provided to private entities. Forms of private debt include direct lending (private loans with no intermediary), mezzanine loans (private subordinated debt), venture debt (private loans to startup or early-stage companies that may have little or negative cash flow), and distressed debt (debt extended to companies that are “distressed” because of such issues as bankruptcy or other complications with meeting debt obligations).

Question 7

real estate

Answer 7

Real estate investments are made in buildings or land, either directly or indirectly. The growing popularity of securitizations broadened the definition of real estate investing. It now includes private commercial real estate equity (e.g., ownership of an office building), private commercial real estate debt (e.g., directly issued loans or mortgages on commercial property), public real estate equity (e.g., real estate investment trusts, or REITs), and public real estate debt (e.g., mortgage-backed securities).

Question 8

commodities

Answer 8

Commodity investments may take place in physical commodity products, such as grains, metals, and crude oil, either through owning cash instruments, using derivative products, or investing in businesses engaged in the production of physical commodities. The main vehicles investors use to gain exposure to commodities are commodity futures contracts and funds benchmarked to commodity indexes. Commodity indexes are typically based on various underlying commodity futures.

Question 9

agricultural land or farmland

Answer 9

Agricultural land is for the cultivation of livestock or plants, and agricultural land investing covers various strategies, including the purchase of farmland in order to lease it back to farmers or receive a stream of income from the growth, harvest, and sale of crops (e.g., corn, cotton, wheat) or livestock (e.g., cattle).

Question 10

timberland

Answer 10

Investing in timberland generally involves investing capital in natural forests or managed tree plantations in order to earn a return when the trees are harvested. Timberland investors often rely on various drivers, such as biological growth, to increase the value of the trees so the wood can be sold at favorable prices in the future.

Question 11

infrastructure

Answer 11

Infrastructure assets are capital-intensive, long-lived real assets, such as roads, dams, and schools, that are intended for public use and provide essential services. Infrastructure assets may be financed, owned, and operated by governments, but private sector investment is on the rise. An increasingly common approach to infrastructure investing is a public–private partnership (PPP) approach, in which governments and investors each have a stake. Infrastructure investments provide exposure to asset cash flows, but the asset itself is generally part of a long-term concession agreement, ultimately going back to the public authority. Investors may gain exposure to these assets directly or indirectly. Indirect investment vehicles include shares of companies, exchange-traded funds (ETFs), private equity funds, listed funds, and unlisted funds that invest in infrastructure.

Question 12

others

Answer 12

Other alternative investments may include tangible assets, such as fine wine, art, antique furniture and automobiles, stamps, coins, and other collectibles, and intangible assets, such as patents and litigation actions.

Question 13

methods of investing in alternative investments

Answer 13

direct investing,
co-investing, and
fund investing

Question 14

direct investing

Answer 14

Direct investing occurs when an investor makes a direct investment in an asset (labeled “Investment A”) without the use of an intermediary. In private equity, this may mean the investor purchases a direct stake in a private company without the use of a special vehicle, such as a fund. Direct investors have great flexibility and control when it comes to choosing their investments, selecting their preferred methods of financing, and planning their approach. The direct method of investing in alternative assets is typically reserved for larger and more sophisticated investors and usually applies to private equity and real estate. Sizable investors, such as major pensions and sovereign wealth funds, however, may also invest directly in infrastructure and natural resources.

Institutional investors typically begin investing in alternative investments via funds. Then, as they gain experience, they can begin to invest via co-investing and direct investing. The largest and most sophisticated direct investors (such as some sovereign wealth funds) compete with fund managers for access to the best investment opportunities.

Question 15

co-investing

Answer 15

In co-investing, the investor invests in assets indirectly through the fund but also possesses rights (known as co-investment rights) to invest directly in the same assets. Through co-investing, an investor is able to make an investment alongside a fund when the fund identifies deals; the investor is not limited to participating in the deal solely by investing in the fund. Exhibit 1 illustrates the co-investing method: The investor invests in one deal (labeled “Investment #3”) indirectly via fund investing while investing an additional amount directly via a co-investment.

Question 16

fund investing

Answer 16

In fund investing, the investor contributes capital to a fund, and the fund identifies, selects, and makes investments on the investor’s behalf. For the fund’s services, the investor is charged a fee based on the amount of the assets being managed, and a performance fee is applied if the fund manager delivers superior results. Fund investing can be viewed as an indirect method of investing in alternative assets. Fund investors have little or no leeway in the sense that their investment decisions are limited to either investing in the fund or not. Furthermore, fund investors are typically unable to affect the fund’s underlying investments. Note that fund investing is available for all major alternative investment types, including hedge funds, private capital, real estate, infrastructure, and natural resources

Question 17

Advantages of Fund Investing

Answer 17

The primary advantages of fund investing include the professional services offered by fund managers, a lower level of investor involvement (compared with the direct and co-investing methods), and access to alternative investments without the prerequisite of advanced expertise. Additionally, diversification benefits stem from the multiple investments found in a single investment vehicle overseen by a fund manager. (Consider instead the time and attention that would be required of a single investor to achieve similar diversification levels by directly investing in and managing multiple alternative assets.) Fund investing in alternative assets demands less participation from the investor than the direct and co-investing approaches, because it is up to the fund manager to identify, select, and manage the fund’s investments. The investor may also heavily rely on the fund manager to carry out the due diligence that accompanies the investment process. Finally, specialist fund managers may expand the investment universe for an investor who lacks expertise for the sector in question.

Question 18

Disadvantages of Fund Investing

Answer 18

Fund investing in alternative investments is costly because the investor is required to pay management fees and performance fees that are typically higher than fees for traditional asset classes. The higher fees can be attributed to the increased costs of (1) running an alternative fund that may have a more complex strategy or require more skills and resources to source, (2) conducting due diligence, and (3) managing opportunities that have limited publicly available information. Alternative managers may also command higher fees if they face little competition. Despite the fact that a fund may provide due diligence expertise when it comes to choosing investments, an investor is still required to conduct thorough due diligence when selecting the right fund in the first place. Selecting the right fund itself is not an easy task because of asymmetry of information

Question 19

Advantages of Co-Investing

Answer 19

Co-investors, who are essentially engaging in a hybrid of direct investing and fund investing, can learn from the fund’s process and leverage the experience they gain to become better at direct investing. Many institutional investors begin with fund investing, because it provides instant diversification while requiring less costly minimum participation levels (lower minimums) and less due diligence. As investors’ investment experience and investable assets grow, they may be granted “co-investment rights” with an investment in a fund, giving them a taste of direct investing. It works as follows: Alongside the fund’s direct investment, investors co-invest an additional amount into that same investment often without paying management fees on the capital they used for the direct investment (a co-investment, in this case). Compared with fund investing, co-investing allows investors to be more actively involved with the management of their portfolio. Later, as their experience and capital increase, investors may prefer direct investing, bringing the expertise in-house and avoiding fund management fees.

Question 20

Disadvantages of Co-Investing

Answer 20

Co-investors have reduced control over the investment selection process (compared with direct investing) and may be subject to adverse selection bias, where the fund manager makes less attractive investment opportunities available to the co-investor while allocating its own capital to more appealing deals. Co-investing, furthermore, requires more active involvement from the investor, who must evaluate both investment opportunities and the fund manager, which demands more resources, concentration, and expertise. Moreover, co-investors usually have a limited amount of time to make the decision to invest or not. The co-investing approach can prove to be challenging for smaller firms with limited resources and due diligence experience.

Question 21

Advantages of Direct Investing

Answer 21

When an investor chooses direct investing, she avoids paying ongoing management fees to an external manager because the investor conducts the investment process on her own, bypassing the use of a special vehicle, such as the fund. Direct investing allows the investor to build a portfolio of investments to her exact requirements. Direct investing provides the greatest amount of flexibility for the investor and grants the highest level of control over how the asset is managed. For example, an investor who directly purchases an ownership stake in a business typically has the ability to influence important matters, such as selecting the management team and controlling the strategic direction and investment decisions of the company.

Question 22

Disadvantages of Direct Investing

Answer 22

Compared with fund investing and co-investing, direct investing demands more investment expertise and a higher level of financial sophistication. Such experience would otherwise be provided by a fund manager or investment firm during the complex investment and management process. Furthermore, concentration increases risk: The direct investor won’t enjoy the ready diversification benefits of fund investing; it would require time and resources for an investor to mirror this advantage through direct investing. Plus, fund managers may enjoy reputational benefits that see them secure participation in attractive investments unavailable to certain direct investors operating on their own behalf.

Question 23

Due Diligence for Fund Investing

Answer 23

Manager selection is a critical factor in portfolio performance. A manager should have a verifiable track record and display a high level of expertise and experience with the asset type. The asset management team should be assigned an appropriate workload and provided sufficient resources. Moreover, it should be rewarded with an effective compensation package to ensure alignment of interest, continuity, motivation, and thoughtful oversight of assets.

Fraud, although infrequent, is always a possibility. The investor should be skeptical of unusually good and overly consistent reported performance. Third-party custody of assets and independent verification of results can help reduce the chance of an investor being defrauded. Diversification across managers is also wise. Finally, separate accounts make theft more difficult because the investor retains custody of the assets and sometimes can select the prime broker or other service providers, binding them to the client’s interest.

For an investor considering a new investment, a proper due diligence process should be carried out to ensure that the targeted investment is in compliance with its prospectus and that it will meet her investment strategy, risk and return objectives, and restrictions. Existing investors should monitor results and fund holdings to determine whether a fund has performed in line with expectations and continues to comply with its prospectus.

Question 24

Due Diligence for Direct Investing

Answer 24

Due diligence for direct investing requires the investor to conduct a thorough investigation into the target asset or business, including but not limited to the quality of its management team, the quality of its customers, the competitive landscape, revenue generation, risks, and so on. When considering direct investments in private equity, the investor conducts reference checks and interviews to evaluate the quality of interactions between the business and each of its stakeholders (e.g., customers and suppliers). Due diligence for private debt investing could entail credit analysis of borrowers to assess their ability to service the regular interest and principal payments of debt, and background checks on the owners and management team would round out the effort. In direct real estate, the building’s occupancy rate and the quality of its structure and tenants should be analyzed prior to investing. In infrastructure, an investor would perform an assessment of the quality of the assets held and operated (e.g., an airport) and their ability to generate future cash flows. In conducting due diligence, direct investors often supplement their due diligence with analysis prepared by external consultants.

Question 25

Due Diligence for Co- Investing

Answer 25

Given that direct investing is an element of co-investing, aspects of the due diligence process apply to both. In co-investing, investors often rely heavily on the due diligence conducted by the fund manager. Direct investing opportunities, however, are often sourced differently from co-investing opportunities, and so the level of independence sitting behind the due diligence can differ. Consider that direct investing opportunities are usually sourced by the direct investment team at a large pension or sovereign wealth fund, whereas co-investing opportunities are usually provided by the private equity, real estate, or infrastructure fund manager for the investor’s consideration. Direct investing due diligence may be more independent than co-investing due diligence because the direct investing team is typically introduced to opportunities by third parties and they have more control over the due diligence process.

Question 26

Partnership Structures

Answer 26

In the world of alternative investments, partnership structures are common. In limited partnerships, the fund manager is the general partner (GP) and investors are the limited partners (LPs). LPs, who are generally accredited investors (owing to legal restrictions on the fund), are expected to understand and be able to assume the risks associated with the investments, which are less regulated than offerings to the general public. The GP runs the business and theoretically bears unlimited liability for anything that goes wrong. The GP may also run multiple funds at a time.

Limited partners are outside investors who own a fractional interest in the partnership based on the amount of their initial investment and the terms set out in the partnership documentation. LPs commit to future investments, and the upfront cash outflow can be a small portion of their total commitment to the fund. Funds set up as limited partnerships typically have a limit on the number of LPs allowed to invest in the fund. LPs play passive roles and are not involved with the management of the fund (although co-investment rights allow for the LPs to make additional direct investments in the portfolio companies); the operations and decisions of the fund are controlled solely by the GP. Exhibit 4 illustrates the limited partnership structure for a hypothetical $500 million investment fund

Question 27

limited partnership agreement (LPA)

Answer 27

The partnership between the GP and LPs is governed by a limited partnership agreement (LPA), a legal document that outlines the rules of the partnership and establishes the framework that ultimately guides the fund’s operations throughout its life. LPAs vary in length and complexity and may be dense with provisions and clauses, some of which are discussed later in this section. In addition to LPAs, side letters may also be negotiated. Side letters are side agreements created between the GP and a certain number of LPs that exist outside the LPA. Some examples of clauses or details that may be included in a side letter include the following:

Potential additional reporting due to an LP’s unique circumstances, such as regulatory or tax requirements

First right of refusal and other similar clauses to outline potential treatment (regarding fees, co-investment rights, secondary sales, and, potentially, other matters) in comparison to other LPs

Notice requirements in the event of litigation, insolvency, and related matters

Most favored nation clauses, such as agreeing that if similar LPs pay lower fees, they will be offered to the LP

Certain structures are commonly adopted for specific alternative investments. For example, infrastructure investors frequently enter into public–private partnerships, which are agreements between the public sector and the private sector to finance, build, and operate public infrastructure, such as hospitals and toll roads. In real estate fund investing, investors may be classified as unitholders, and joint ventures are a partnership structure common in real estate direct investing.

Question 28

Compensation Structure

Answer 28

Funds are generally structured with a management fee typically ranging from 1% to 2% of assets under management (e.g., for hedge funds) or committed capital (e.g., for private equity funds), which is how much money in total that LPs have committed to the fund’s future investments. On top of the management fee, a performance fee (also referred to as an incentive fee or carried interest) is applied based on excess returns.

Private equity funds raise committed capital and draw down on those commitments, generally over three to five years, when they have a specific investment to make. Note that the management fee is typically based on committed capital, not invested capital; the committed-capital basis for management fees is an important distinction from hedge funds, whose management fees are based on assets under management (AUM). Having committed capital as the basis for management fee calculations reduces the incentive for GPs to deploy the committed capital as quickly as possible to grow their fee base. This allows the GPs to be selective about deploying capital into investment opportunities.

The partnership agreement usually specifies that the performance fee is earned only after the fund achieves a return known as a hurdle rate. The hurdle rate is a minimum rate of return, typically 8%, that the GP must exceed in order to earn the performance fee. GPs typically receive 20% of the total profit of the private equity fund net of any hard hurdle rate, in which case the GP earns fees on annual returns in excess of the hurdle rate, or net of the soft hurdle rate, in which case the fee is calculated on the entire annual gross return as long as the set hurdle is exceeded. Hurdle rates are less common for hedge funds but do appear from time to time.

Performance fees are designed to reward GPs for enhanced performance and to motivate investment professionals to work hard and stay involved for years to come

Question 29

Common Investment Clauses, Provisions, and Contingencies

Answer 29

refer curriculum