Features and Categories of Alternative Investments

Alternative investments represent a category of investments that do not fit into the traditional asset classes of public equity securities, fixed-income instruments, or cash. The term ‘alternative’ is used to describe these investments due to their unique characteristics and structure.

Alternative Investment Features

Unlike traditional public debt and equity securities, alternative investments possess unique features that set them apart. These features include:

• The requirement for specialized knowledge to value cash flows and risks: For instance, investing in a private equity fund requires an understanding of the specific industry, the company’s financials, strategies such as short selling and leverage, and the overall market conditions.
• Typically low correlation of returns with more traditional asset classes: For example, real estate investments may not follow the same market trends as stocks and bonds, providing a diversification benefit.
• Illiquidity, long investment time horizons, and large capital outlay: For instance, investing in a start-up company may require a significant initial investment and a long-term commitment, as the company may not go public or be sold for several years.

Alternative Investment Characteristics

The unique features of alternative investments lead to certain characteristics:

• Different investment structures due to direct investment challenges: For example, a hedge fund might use a limited partnership structure, where the fund manager is the general partner and the investors are the limited partners.
• Incentive-based fees to address or minimize information asymmetry between managers and investors: For instance, a private equity fund manager might receive a performance fee based on the fund’s profits, aligning the manager’s interests with those of the investors.
• Performance appraisal challenges: Due to the unique nature and complexity of alternative investments, evaluating their performance can be challenging. For example, how do you accurately measure the performance of a private equity investment in a company that is not publicly traded?

Alternative investments often exhibit characteristics of both equity and debt. However, they typically demand a larger or longer financial commitment due to the extended life cycle of the underlying investments or the use of different methods and vehicles to align the interests of managers and investors over time.

Contrary to individual securities, the scale and type of some alternative investments may be unattainable to some investors. Large pension funds, sovereign wealth funds, and not-for-profit endowments, which have the longest investment time horizons, have a tendency to devote a higher portion of their portfolio to these assets.

Alternative Investment Categories

Alternative investment categories include:

• Private capital: This includes investments in private equity and venture capital funds, which invest in private companies or conduct buyouts of public companies.
• Real assets: This includes investments in physical assets like real estate, commodities, and natural resources.
• Hedge funds: These are pooled investment funds that use various strategies to earn active return, or alpha, for their investors.

Private Capital

Private Capital is a broad term that refers to the funding provided to companies from sources other than public equity or public debt markets. It is categorized into two main types: private equity and private debt. For instance, a tech startup might raise private capital from venture capitalists or angel investors rather than going public or taking on traditional debt.

Private Equity

Private Equity is the capital provided in the form of equity investments. It is used for investment in privately owned companies or in public companies with the intent to make them private. Private equity is typically used in the mature life cycle stage or for firms in decline. The key approach used in private equity is leveraged buyouts.

Consider a scenario where a private equity firm acquires a struggling retail chain with the aim of enhancing its operations and profitability before divesting it. Private equity managers often enact changes in management and strategy, which may involve shutting down, selling, or restructuring business lines. This strategic approach aims to enhance profitability over several years, leveraging the increased control and flexibility afforded by private ownership compared to public ownership.

Venture Capital is a specialized form of private equity where ownership capital is used for non-public companies in the early life cycle or startup phase. Often, an idea or business plan exists with a limited operation or customer base in this phase. For example, a biotech company with a promising new drug might receive venture capital to fund its clinical trials and other development efforts.

Private Debt

Private Debt is the capital provided as a loan or other form of debt. It includes private loans or bonds, venture debt, and distressed debt. Venture debt is extended to early-stage firms with little or no cash flow. Distressed debt involves public or private debt of corporate issuers believed to be close to or in bankruptcy that could benefit from investors with capital restructuring skills. For instance, a hedge fund might buy the distressed debt of a bankrupt airline, hoping to profit from its restructuring or liquidation.

Comparing Private Equity and Debt with Public Equity and Debt

Private equity and private debt are alternative investments with features similar to public equity and public debt. For example, both private and public equity investors are company owners with residual claims to future cash flows and dividends.

Investors in private equity have full access to company information and the ability to influence day-to-day management and strategy decisions. On the other hand, investors in publicly traded equity receive only publicly available information, such as annual reports and periodic financial statements, with voting rights limited to decisions requiring shareholder approval.

Real Assets

Real assets encompass a broad range of assets, which can include tangible items like real estate and natural resources, as well as intangible holdings like patents, intellectual property, and goodwill. These assets have the potential to either generate immediate or anticipated future cash flows, or they may serve as a reservoir of value. For instance, a piece of land (real estate) can generate cash flow through rent, or its value can appreciate over time, providing a return on investment.

Real Estate

Real estate encompasses both borrowed and owned capital invested in structures or land, and it can be categorized into developed and undeveloped land.

Commercial real estate comprises properties where the primary source of revenue is derived from private business activities, like a shopping mall where rental income from stores constitutes the primary cash flow.

On the other hand, the cash flows in residential real estate are generated through rents or mortgage payments made by households. For example, in the case of an apartment building, the primary cash flow source is the rent collected from tenants.

Publicly traded forms of real estate investments encompass entities like real estate investment trusts (REITs), which issue equity securities and mortgage-backed debt securities.

Infrastructure

Infrastructure represents a unique category of real assets, often comprising land, buildings, and other durable fixed assets designed for public benefit, offering crucial services. Infrastructure projects may be initiated either solely by governmental entities or through a public-private partnership (PPP) involving private investors.

Infrastructure assets produce revenue either directly through fees, leases, or compensation for access rights or indirectly by stimulating economic growth and boosting a government’s ability to generate higher tax revenue from future economic activities. Take, for instance, a toll road developed through a Public-Private Partnership (PPP), which can generate direct cash flows through the collection of toll fees.

Natural Resources

Natural resources encompass underdeveloped land, which inherently holds economic value, or naturally occurring goods that can be extracted. Underdeveloped land categories consist of farmland, timberland, or land designated for the exploration of natural resource deposits like minerals or energy sources.

Farmland can yield revenue through the sale of crops, while land containing a gold mine can generate income by extracting and selling gold. The potential returns from such underdeveloped land types include anticipated price appreciation over time and generated cash flows.

Commodities are standardized, traded goods, including plant, animal, energy, and mineral products used in goods and services production. Commodities do not themselves generate cash flows but, rather, are ultimately sold by commodity producers to commodity consumers for economic use.

For example, a farmer who grows wheat (a commodity) does not generate cash flow from the wheat itself but from selling the wheat to a bread manufacturer. Investors seek to benefit from commodity price changes based on their future economic use as well as a lower correlation of returns versus other asset classes over the economic cycle.

Other Real Alternative Assets

Among the various alternative assets, there are other tangible collectible items like fine art, wine, rare coins, watches, and similar unique holdings. Additionally, there are intangible assets like patents, litigation claims, and what is commonly referred to as ‘digital assets.’ This term, ‘digital assets,’ encompasses a wide range of assets that can be electronically created, stored, and transmitted and possess associated ownership or usage rights.

For example, a patent for a new technology is an intangible asset that can generate cash flows through licensing fees, while a rare coin can appreciate in value over time, providing a return on investment.

Hedge Funds

Hedge funds are a unique type of private investment vehicle. They have the flexibility to invest in a wide array of assets, including but not limited to public equities, publicly traded fixed-income assets, private capital, and real assets. For instance, a hedge fund might invest in shares of a publicly traded company like Apple Inc. or in private equity of a startup company. However, the distinguishing factor of hedge funds is not merely the investments they make but the unique approach they adopt towards investing.

Hedge funds often employ a diverse range of investment strategies, including:

• Use of Leverage: Involves using borrowed money to increase potential returns. For example, a hedge fund might borrow money to invest in a risky venture, with the hope that the returns from the venture will exceed the cost of borrowing.
• Derivatives: Financial contracts whose value is derived from an underlying asset. For instance, a futures contract on gold is a derivative, as its value is derived from the price of gold.
• Short selling: This involves selling assets that are not currently owned with the intention of buying them back at a lower price. For example, a hedge fund might short-sell shares of a company if it believes that the company’s share price is overpriced and is going to fall.

These strategies often result in a risk and return profile that is substantially different from that of simply buying and holding the underlying assets in an investment portfolio.

Investors also have the option to invest in a portfolio of hedge funds. This is often referred to as a fund of funds. For instance, an investor might choose to invest in a fund of funds that includes hedge funds focusing on technology companies, emerging markets, and real estate, thereby diversifying their investment.

Question #1

Which of the following factors is least likely a consideration when incorporating alternative investments into a portfolio?

1. The liquidity and market efficiency of the investments.
2. The current market trends and popular investment choices.
3. The potential for greater diversification and higher expected returns.

The correct answer is B.

When adding alternative investments to a portfolio, it’s crucial not to rely solely on current market trends and popular choices. While these trends offer insights, decisions should be based on a profound understanding of specific asset classes like private equity, hedge funds, real estate, and commodities. Consideration should extend to their risk and return profiles and how they integrate into the broader portfolio, rather than being driven solely by the prevailing market trends or popular choices.

The decision to incorporate alternative investments into a portfolio should be based on a thorough analysis of the investor’s risk tolerance, investment objectives, time horizon, and other personal circumstances. Following market trends or popular investment choices without a proper understanding of the underlying asset class can lead to poor investment decisions and potential losses.

C is incorrect. The potential for greater diversification and higher expected returns is indeed a consideration when incorporating alternative investments into a portfolio. Alternative investments can provide diversification benefits due to their low correlation with traditional asset classes, and they can potentially offer higher returns, albeit at a higher level of risk.

A is incorrect. The liquidity and market efficiency of the investments are also important considerations when incorporating alternative investments into a portfolio. Many alternative investments are illiquid and inefficiently priced, which can create opportunities for skilled investors but also pose significant risks.

Question #2

In the context of hedge funds, how would you most likely define the concept of leverage, and how does it impact the potential returns of the fund?

1. Leverage is the process of investing only in high-risk assets to maximize potential returns.
2. Leverage is the process of investing in a diversified portfolio to spread the risk and potentially increase returns.
3. Leverage is the process of buying more assets than the fund’s capital would allow, thus increasing the potential returns but also the risk of loss.

The correct answer is C.

Leverage, in the context of hedge funds, is indeed the process of buying more assets than the fund’s capital would allow, thus increasing the potential returns but also the risk of loss. Hedge funds use leverage to amplify their potential returns by borrowing money to invest in more assets. This strategy can significantly increase the potential returns of the fund if the investments perform well. However, it also increases the risk of loss if the investments perform poorly.

The use of leverage can magnify both gains and losses, making it a double-edged sword. It is a key characteristic of hedge funds and a major reason why they can deliver high returns. However, it also makes them riskier than traditional investment vehicles. Therefore, investors in hedge funds need to be aware of the risks associated with leverage and be prepared for the possibility of significant losses.

A is incorrect. Investing only in high-risk assets to maximize potential returns is not the definition of leverage. While it is true that leverage can increase the potential returns of a fund, it does not involve investing only in high-risk assets. Leverage involves borrowing money to invest in more assets, regardless of their risk level. It is a strategy that can be used in conjunction with a variety of investment strategies, including investing in both high-risk and low-risk assets.

B is incorrect. While investing in a diversified portfolio is a common strategy used by many investment vehicles, including hedge funds, to spread the risk and potentially increase returns, it is not what is meant by leverage. Diversification and leverage are two different investment strategies. Diversification involves spreading investments across a variety of assets to reduce risk, while leverage involves borrowing money to invest in more assets to increase potential returns.