Intro to Alternative Investments
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TL;DR: Alternative investments (“alts”) refer to any assets that are not stocks, bonds, or cash. Common types of alts include private equity, private debt, hedge funds, real estate, and crypto, but the world of alts is vast and can include collectibles like art and NFTs. Alts tend to be less liquid than public equities (stocks and bonds) and are usually made accessible to investors through funds. Historically, alts like VC funds and private equity have only been available to institutional investors. But these investment vehicles have recently become more common with individual investors despite regulatory requirements for investing in certain funds. Investors often turn to alts for their high return potential and ability to diversify an existing portfolio.
What are alts?
Alternative investments, also known as “alts”, are defined by what they are not: “traditional” assets, such as stocks, bonds, or cash. As a broad category, alternative investments can include everything from private equity, real estate, commodities, crypto, and hedge funds to art and other collectibles.
Alts tend to be less liquid
One of the most important attributes about alts is their lower liquidity. They tend to be harder to value, sell, and buy compared to stocks and bonds. This illiquidity comes from the absence of centralized marketplaces to connect buyers and sellers. Time frames and restrictions in exiting investments (such as a “lock-up period” for private equity) also make it harder to buy and sell these assets on the spot.
How can you invest in alts?
Notably, investors usually invest in alts through funds, a structure most commonly used in private equity, but also used in private debt and real estate. Generally, a firm will raise capital by setting up individual legal entities (funds) in which they act as General Partners (GPs), managing the capital raised from different investors, referred to as Limited Partners (LPs).
A fund usually has an average life of 7-11 years and three stages in its life cycle. First the GPs will raise the fund (“raising”), then source investment opportunities and deploy the raised capital over an investment period that typically lasts 3-5 years (“deployment”), and finally harvest the returns (“harvesting”).
The “perpetual fund” model is also a major category in alternative funds, providing the fund manager with a “permanent” source of capital to manage (as opposed to exiting all investments at the end of a set period).
The right manager can make a significant difference when it comes to performance. As shown in the chart below, there is a strong correlation between skilled fund managers and performance, meaning that good managers can achieve consistently good returns. This is in contrast with actively managed mutual funds, where 90% consistently underperform the market at large. The information and access asymmetries that exist in alts markets mean that the right information and network can provide an edge.
Why would you invest in alts?
- High return potential - Alts can provide some of the highest rates of absolute returns across all asset classes. Successful VC investments are numerous: Uber, Airbnb, Facebook, Google. The best performing asset class of the decade was an alt (crypto): Bitcoin hit $60,000 in 2021 and returned an annualized 230% (and cumulatively over 20,000,000%), ten times higher than the Nasdaq 100. Alts can also provide a reliable income stream. For example, real estate assets can provide a constant yield in the form of rent, and then can deliver capital appreciation when assets are sold at a higher price after a given period.
- Risk reduction - Alts can also exhibit less volatility than traditional assets due to their long-term nature (e.g. day trading is very volatile compared to having your capital locked up in a fund over various years). Some alts can also hedge against inflation (e.g. real estate, commodities and crypto).
- Diversification - Since alts tend to have a low correlation to traditional assets, they are highly appealing to investors looking to diversify their portfolio.
Who can invest in alts?
Historically, investors in alts have overwhelmingly consisted of “institutional investors”, such as pension funds, university endowments, sovereign wealth funds, and foundations. In contrast, individuals invest much less frequently in alts due to lack of access and regulatory considerations, as well as their smaller appetite for risk and less average liquidity.
In the US, only SEC-determined “accredited investors” can invest in alts. An individual can become an accredited investor by satisfying any one of three factors:
- Consistent income of over $200,000 annually (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expects the same for the current year, OR
- Net worth exceeding $1 million either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence), OR
- Holds in good standing a Series 7, 65 or 82 license
Some alts require investors to hold a greater designation, that of a “qualified purchaser,” meaning they own $5 million or more in investments (as opposed to net worth).
Even assuming they are legally eligible to invest, many individuals are excluded from certain opportunities in alts due to investment minimums (e.g. some firms require a minimum investment size of $1 million). Broadly speaking, investing in alts is a “people” business, where access to deals relies on reputation, network, and information. Particularly because there is a notable correlation between a manager’s skill and performance, some VCs are so highly regarded and in-demand that they only take money from name brand institutions or LPs through warm intros. This structure can mean that some individuals, lacking the capital and network, end up placing their capital with lower quality or unproven managers.
What are the main types of alts?
Several different asset classes count as alts, including:
Private equity (“PE”) refers to several strategies that invest in equity (an ownership position). PE financing is characterized by the fund structure, and exits are its primary source of liquidity. Investors can access this category of investments through managed investment funds or via direct investments (e.g. angel investments into individual companies).
There are three categories in PE. Following the life cycle of a company, they are:
- Venture Capital - VC funds invest in companies at inception or the idea stage. At the earliest stage, there are no financials and maybe no employees. The fund manager helps support the company in its growth. Generally, high risk is accompanied by high returns.
- Growth Equity - At this stage, the company is still growing rapidly. By now, it probably has a few years of financials and might be generating positive cash flows. There is more certainty about product-market fit and business viability. A growth equity firm provides capital for further growth or could be used to provide liquidity to early investors or management, and helps prepare the stage for an exit event.
- Buyout - This is the largest segment of private equity in terms of money raised. Buyout firms invest in mature companies. They are the least volatile and least risky of the three, yet provide consistent and generous returns compared to public equities, even compared to riskier and more volatile small value stocks.
Private equity fund managers typically work closely with management to improve the company. It is also common for private equity managers in the buyout category to finance a significant portion of their purchase prices through leverage or debt financing, hence these deals are commonly referred to as leveraged buyouts (LBOs).
Private Debt (Direct Lending)
Private debt refers to any debt not financed by banks or traded publicly. Companies that would struggle to secure credit from a bank turn to private debt firms. These firms then evaluate the company through deep due diligence to ensure it has a sound business before making a customized debt offer. Private debt has been the fastest growing sector of alts since the 2008 financial crisis. Generally, the appeal of private debt lies in providing consistent and contractual returns with higher returns than public fixed income investments. At the same time, it holds a lower risk profile than private equity while providing portfolio diversification and opening up otherwise inaccessible market sectors and opportunities.
Categories of private debt are less distinct than in PE, but generally include:
- Direct Lending - This debt is senior in the capital structure of a company, meaning lenders have a priority claim on the cash flows generated by the business and on the assets of the company in the event of default or bankruptcy. The debt is typically “originated” or “syndicated” (i.e. negotiated directly with the borrower).
- Mezzanine - This debt is junior in the capital structure, and consequently higher risk (since you’re behind the senior lenders in line to get repaid) but carries a higher return.
- Distressed - This debt may be senior or junior; the distinction is that the borrower is usually in trouble, and in many cases the debt is acquired rather than originated. This category blurs the line between private equity and private credit, since buying a distressed company’s securities will often result in ownership of equity in the surviving business.
Hedge funds seek to make a positive return by pooling investors’ money and investing it. They typically have more flexible investment strategies than other pooling methods like mutual funds. Many hedge funds look to make returns across a range of markets through the use of leverage—borrowing capital in order to increase the size of the investment (and consequently, risk)—as well as short-selling (selling securities which one does not own at the time, in the hope of buying at a lower price before the security must be delivered) and other speculative investing practices that mutual funds generally don’t use.
A major difference between hedge funds and private equity or private credit funds is that hedge funds take investors’ money and invest it all at once (as opposed to calling capital over time, as is common with PE funds). By the same token, hedge funds often do not automatically return investors’ money as their investments are realized. Instead, hedge funds retain that capital and can reinvest it into new opportunities as the manager sees fit (sometimes they are called “permanent capital” or “evergreen vehicles” for this reason).
Hedge funds may pursue a wide range of different strategies (e.g. merger arbitrage, long/short equity, global macro) because the common features relate more to their structure than their investment strategy. Hedge funds have the ability to charge performance fees and management fees, and typically have a “lock up” provision limiting how quickly investors can redeem their money from the fund.
Real estate is the largest asset class in the world, and the main source of people’s wealth. In 2020, global real estate assets were valued at $326.5 trillion compared to global equity markets at $93 trillion. Historically, it has proven to be a smart investment choice with a record of high returns. It is considered attractive for its tendency at reducing portfolio risk, hedging against inflation and deflation, and delivering strong income and cash flows.
Real estate investment vehicles can vary in their levels of risk and return profiles, time horizons, and property types. Real estate can be categorized along different dimensions, for instance by usage—residential vs. commercial (including multifamily, retail, industrial, hospitality)—or by risk/return profile. To accommodate these differences, the commercial real estate industry has developed a categorization system to describe the various aspects of an investment opportunity. Those categories are:
- Core - Lowest risk; income producing
- Core-plus - Somewhat higher risk; light renovation and repositioning
- Value-add - Heavier renovating, repositioning; often not generating positive cash flow initially
- Opportunistic - Very heavy renovation and repositioning; longer time to generate cash flow
The cryptocurrency market has become a popular alt investment in recent years. Many recent factors make this asset class more attractive including regulation changes, mainstream appeals, and high liquidity/potential for returns. You can read more about crypto investing in our guide here.
The world of alts is vast, ranging from the common categories mentioned above to more tangible assets, including commodities, forestry, infrastructure, and collectibles (such as wine, art, stamps, vintage cars and more recently—NFTs). Alternative investments play an important role in most investors’ portfolios. They give investors a way to achieve certain income, diversification, downside protection, and returns that would be harder to achieve using only traditional investments. Along these benefits, however, they also tend to be more illiquid due to their private and unique traits. If you’re considering investing in alts, contact your Financial Advisor.