Investment Methods in Alternative Investments

Methods of investing in alternative investments include:

• Fund investing.
• Co-investing.
• Direct investing.

Fund Investing

In fund investing, investors contribute capital to a fund, and then the fund identifies, chooses, and makes investments on behalf of the investors. Investors pay a fee based on the value of the fund managers’ assets. In addition, they pay a performance fee if the fund manager delivers a return above the benchmark.

Fund investing can be termed as indirect investing in alternative assets. This is because fund investors’ investment decisions are based on whether to invest in a fund or not. Furthermore, investors do not influence a fund’s investments.

Fund investing applies to all types of alternative investments.

Advantages of Fund Investing

• Fund investing requires less investor involvement compared to direct and co-investing.
• The alternative investment option is accessible to anyone, regardless of their expertise.
• Diversification benefits come from the multiple investments found in a single fund.
• It requires a low minimum capital compared to the other investments.

Disadvantages of Fund Investing

• It is costly since an investor must pay management and performance fees.
• An investor is expected to conduct due diligence when selecting the appropriate fund.
• There are exit restrictions due to lockups and similar limitations.

Co-investing

In co-investing, an investor indirectly invests in assets through a fund. Nevertheless, the investor owns the rights (co-investment rights) to invest in the same assets directly. Intuitively, co-investing allows the investor to make parallel investments when the fund identifies a lucrative deal.

Advantages of Co-investing 

• An investor can learn from the fund’s expertise and improve at direct investing.
• Investors co-invest an additional amount into an investment, often without paying management fees on the capital they used for direct investments.
• Co-investing allows investors to be more actively involved in managing their portfolios than fund investing.

Disadvantages of Co-investing 

• Co-investors have limited control over the investment selection process compared to direct investing.
• It may be subject to adverse selection.  A fund may offer less attractive investment opportunities to the co-investor while allocating capital to more appealing deals.

• Co-investing requires an investor to be more actively involved since they must evaluate both investment opportunities and the fund manager.

Direct Investing

In direct investment, an investor directly invests in an asset without using any intermediary. Direct investing, therefore, gives investors higher control and flexibility when selecting investments, financing methods, and approaches. However, investing directly in alternative investments is most popular among established private equity and real estate investors. Pension funds and sovereign wealth funds may also invest in infrastructure and natural resources.

Advantages of Direct Investing 

• An investor avoids paying ongoing management fees to an external manager.
• Direct investing allows an investor to create a portfolio of investments that suits their needs.
• Direct investing provides an investor with the utmost flexibility and control over their investment.

Disadvantages of Direct Investing 

• Direct investing requires a greater level of investment expertise.
• A direct investor won’t enjoy the diversification benefits of fund investing.
• Direct investing requires more significant levels of due diligence because of the absence of a fund manager.
• Compared to fund investing, it requires a higher minimum capital.

Due Diligence for Fund Investing, Direct Investing, and Co-investing

In direct investment, an investor chooses the company to invest in. However, there is a need for high and competence-based due diligence before they invest in a private company.

Fund investing provides the benefits of a diversified portfolio, but this advantage comes at an additional cost. Even though the fund performs due diligence on the ventures to invest in, the investor, too, must perform due diligence on the fund manager, before investing in a fund.

In co-investing, the general partner assists the investor in performing direct due diligence on a portfolio company.

Question

 Which of the following is most likely a disadvantage of co-investing?

A. It may be subject to adverse selection bias.

B. The investor won’t enjoy fund diversification benefits.

C. Selecting the right fund is not easy because of the information asymmetry.

Solution

The correct answer is A.

Co-investing may be subject to adverse selection bias. This is because the fund avails less attractive investment opportunities to the co-investor while allocating its own capital to more appealing deals.

B is incorrect. Being unable to enjoy the diversification benefits is a disadvantage of direct investing, not co-investing.

C is incorrect. Selecting the right fund is difficult because information asymmetry is a disadvantage of fund investing.