Last Updated on Oct 19, 2023 by Anjali Chourasiya
Alternate Investments are non-traditional Investments that investors use for hedging, speculation or investment. They are the asset classes that fall outside the traditional investment of stocks and bonds. These investments can provide diversification and potential for higher returns but often come with increased risk and complexity.
These investments are less regulated as compared to the traditional investments of stocks and bonds and may often require higher investment with a longer investment horizon. Alternate investments can be classified into Alternate assets (such as Real Estate, Commodities, and Infrastructure) and Alternate Investment Strategies (Hedge funds, Private Equity).
Table of Contents
Features of Alternate investments
Alternate Investments have the following common features:
- Lower liquidity and longer investment Horizons (as in the case of hedge funds and Real Estate)
- There is less regulation and transparency as compared to the traditional investments of stocks and bonds.
- Unique legal and Tax considerations
- They usually have limited historical risk and return data.
- Alternate Investments are managed actively, which means the aim is not to replicate the benchmark but rather to outperform it.
- They usually charge higher fees, use high leverage (like in Hedge funds and Real Estate) and have a restriction on redemptions.
- It has a low correlation with traditional investments, which makes it attractive to Investors mainly for hedging.
The low correlation between Alternate Investments and Traditional Investments is a major reason why Investors invest in Alternate Investments. This gives investors a chance to compensate for the losses they incurred in traditional Investments and even make huge gains from it.
Different Methods of Investing in Alternate Investments
There are primarily 3 methods which investors use to invest in alternate investments, namely:
- Fund Investing
- Co-Investing
- Direct Investing
Let’s look at each of them in brief:
Fund Investing
In this type of investing, the Investor appoints a Fund Manager who invests the investor’s money on his behalf. The Investor contributes capital to the fund which is identified and invested. The Fund Manager charges a fee based on the AUM (Asset Under Management) and the performance of the fund.
The Investor has no say or influence on the Investment decisions. This is available for all major AI’s such as Hedge Funds, Private Equity, Infra and Natural Resources.
Co-Investing
This type of Investing helps the Investors to invest in the fund directly and indirectly. In this type of Investment, the Investor Invests indirectly through the fund but also possesses the right to invest directly in the same assets when the fund identifies deals.
Some investors prefer Co-investing over fund Investing as they can invest an additional amount directly via Co-investment.
Direct Investing
This type of Investing is the simplest but the most risky type of investing as it involves no intermediary. The Investor invests directly, having flexibility and control to choose investments, financing and approach. This type of investing is typically reserved for larger and more sophisticated investors like pension funds and SWF (Sovereign Wealth Funds).
Investment and Compensation structures
Fund Structure
Investment funds are structured as Limited Liability Agreements. It also includes Side Letters and negotiated agreements with Limited partners outside the LPA. The Fund manager is the General Partner, and Investors are the Limited partners. The General partners play an active role in the management of the fund, whereas the Limited Partners play a passive role. The General Partner (i.e. the fund Manager) also bears unlimited Liability if something goes wrong.
Compensation Structure
The Fund manager or the Fund charges 1-2% of the Assets under management (Hedge Funds) or committed Capital under Private Equity. They also earn an Incentive fee only if the Hurdle rate is met.
Hurdle rate can be of two types: soft hurdle rate or hard hurdle rate. In a soft Hurdle rate, incentive fees are earned on all profits only if the hurdle rate is met. Whereas in the hard hurdle rate, incentive fees are earned more than the benchmark in the provided proportion.
Other compensation structures include a Catch-up clause, High watermark provision and Distribution waterfall.
Types of Alternate Investments
Alternate Investments are non-Traditional Investments which usually have limited Liquidity. Some of the important Alternate Investments are as follows:
- Hedge Funds
- Private Capital
- Real Estate
- Commodities
- Farmland and Timberland
- Infrastructure.
About Different Alternate Investments
Hedge Funds
If simply stated, Hedge funds are Pooled Investments used by Fund managers to make profits by taking long and short positions and/or using derivatives to achieve high absolute Returns. Hedge funds are usually open to sound investors who are willing to invest large amounts of money. They often impose restrictions on redemption and sometimes even include a lock-up period.
They are actively managed funds, which means the Fund manager puts efforts to outperform the benchmark. They also have lighter compliance as compared to Mutual funds, which allows them to be more flexible.
Private Capital
They are actively managed funds, which means the Fund manager puts efforts to outperform the benchmark. They also have lighter compliance as compared to Mutual funds, which allows them to be more flexible.
Private capital refers to entities that provide financing to companies without issuing securities in the public markets. Private capital comprises –
Private Equity
Private equity refers to equity Investment in private companies or public companies with the intent to make them private.
Major Categories of Private Equity are:
- Venture Capitalists
- Growth Equity
- Leverage Buy-Outs (LBO)
- Venture Capitalist
Venture capitalists are funds which invest in companies with high growth potential. Typically, these are start-ups or early-stage companies but can extend to the IPO stage.
Funding by Venture capitalists is mainly provided through equity, convertible preference shares and debt.
There are three stages of VC investing:
- Formative stage: It is the pre-seed investing. It is also known as angel investing since it is only done by the three main F’s (Friends, Family or Fools).
- Later Stage: This investing takes place when the company is already running its business and can be seen as a commercial identity.
- Mezzanine Stage: This investment bridges the game between and after the company goes public.
- Growth Equity
It refers to the provision of investment for business growth or restructuring. The firms financed may be public or private. If the investment is made by private companies in public, it is known as Private Investment in Public Equities (PIPEs).
- Leverage Buy-Outs
These are highly leveraged transactions that acquire public companies or establish private companies with a significant percentage of the purchase price financed through debt. Target Company’s assets serve as collateral. There are two types of LBOs:
- Management Buy-out (MBO): When the existing management buys the company and takes it private.
- Management Buy-in (MBI): When existing management is involved in the purchase.
Private Debt
This involves investing in loans to individuals, companies, or projects. Private debt can offer fixed income-like returns and may include peer-to-peer lending, direct lending, or mezzanine financing.
Real Estate
Real Estate is a tangible, immobile, indivisible investment. Investors are driven by its long-term return and capital appreciation. Also, Real Estate has a low correlation with any other asset class.
Illiquidity and large capital requirements result in high transaction costs. There is a lack of diversification for small Investors.
There are different categories for Investment in Real Estate:
- Residential Property: The intent is for self-occupation and is considered a direct investment in Real Estate. Some buyers make a down payment, while most borrow.
- Commercial Property: This generates income from rents. Typical investors are wealthy individuals who are willing to put in high capital with low liquidity needs.
- REITs (Real Estate Investment Trusts): REITs issue shares that trade publically like shares of stock. They provide diversification to small investors, giving them ownership of a property and making gains by its capital appreciation and rents.
- Mortgage-Backed Securities (MBS): MBS involves securitising a pool of assets and assigning the income and principal returns into individual security tranches.
Commodities
Commodities are physical products which incur costs for storage and transportation. They are either ‘hard’- mined or extracted or ‘soft’- grown, such as livestock, grains, and cash crops.
Commodity investors are driven by returns, inflation protection and portfolio diversification due to low correlation with other asset classes.
Hedgers (producers and consumers) and speculators (retail, institutional investors, and hedge funds) participate in the commodity market.
Farmland and Timberland
Timberland involves ownership of raw land and harvesting of trees for lumber, thus generating an income stream and potential capital gain. Timberland offers income from the sale of trees, wood, and other timber products and is not highly correlated with other asset classes. Farmland income is earned via the harvesting of agricultural commodities, including raw crops planted and harvested multiple times a year and permanent crops grown on trees (nuts) or vines (grapes).
These asset classes have low liquidity, risk of negative cash flows and variable revenue depending on the weather.
Infrastructure
Infrastructure investments are real, capital-intensive and long-lived. These are intended for public use and provide essential services, e.g. Airports, power plants.
These assets generate long-term cash flows with high use of leverage. Social Infrastructure assets are directed towards human activities, including education, healthcare, and social housing.
It includes Greenfield projects and Brownfield projects. Greenfield projects are assets to be constructed, whereas Brownfield Investments are investments in existing assets with lower levels of risk, hence lower returns than Greenfield projects.
