Alternative investment Flashcards
“Alternative investments
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
characteristics of alternative investment
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”)
Categories of Alternative Investments
- hedge funds
2.private capital : private equity
private debt
real estate
3.natural resources : commodities
agricultural land
timberland - infrastructure
- other
hedge funds
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.
private equity
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.
private debt
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).
real estate
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).
commodities
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.
agricultural land or farmland
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).
timberland
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.
infrastructure
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.
others
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.
methods of investing in alternative investments
direct investing,
co-investing, and
fund investing
direct investing
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.
co-investing
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.
fund investing
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
Advantages of Fund Investing
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.
Disadvantages of Fund Investing
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
Advantages of Co-Investing
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.
Disadvantages of Co-Investing
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.
Advantages of Direct Investing
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.
Disadvantages of Direct Investing
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.
Due Diligence for Fund Investing
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.
Due Diligence for Direct Investing
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.
