Alternative Investments

Study Guide

Alternative Investment Features, Methods, and Structures

Alternative Investments (AIs) are a class of assets outside of traditional investments like stocks, bonds, and cash.

Common Characteristics:

• Low Liquidity: Assets are not easily converted to cash.
• Diversification: Low correlation with traditional asset classes.
• High Fees: Typically include both management and performance fees.
• Limited Information: Less transparency and public data compared to traditional assets.
• Specialist Management: Requires managers with specific expertise.
• Less Regulation: Often structured as private partnerships, avoiding some public market regulations.

Investment Structures and Compensation:

• Limited Partnership (LP): The most common structure.
  • General Partner (GP): The fund manager who makes investment decisions. Has unlimited liability.
  • Limited Partners (LPs): The investors who provide capital. Have limited liability.
• Compensation Structure:
  • Management Fee: A percentage of Assets Under Management (AUM) or committed capital (e.g., 1-2%).
  • Performance (Incentive) Fee: A share of the profits, typically after a hurdle rate is met (e.g., 20%).
  • Hurdle Rate: The minimum rate of return the fund must earn before the GP can receive performance fees.
    • Soft Hurdle: GP receives performance fees on all profits if the hurdle is cleared.
    • Hard Hurdle: GP receives performance fees only on profits in excess of the hurdle rate.
  • High-Water Mark: The highest peak in asset value a fund has reached. The GP only earns performance fees on new profits above this mark, preventing them from being paid twice for the same performance.

Alternative Investment Performance and Returns

Performance measurement for AIs is challenging due to their unique characteristics.

Measurement Issues:

• Appraisal-Based Valuations: Illiquid assets are often valued by appraisal, which can lead to stale pricing and artificially smooth returns.
• Survivorship Bias: Failed funds are excluded from performance databases, inflating reported returns.
• Backfill Bias: Successful funds are added to a database, and their past performance is included, also inflating returns.

Key Performance and Risk Metrics:

• Internal Rate of Return (IRR): The most common metric for private capital, which has irregular cash flows.
• Sharpe Ratio: $\frac{R_p - R_f}{\sigma_p}$. Less effective for AIs due to non-normal return distributions (skewness and kurtosis).
• Sortino Ratio: Similar to the Sharpe ratio but uses downside deviation instead of standard deviation, focusing only on negative volatility.
• Drawdown: The maximum percentage loss from a peak to a trough. A measure of downside risk.

Investments in Private Capital: Equity and Debt

Private capital refers to investments in non-publicly traded companies.

Private Equity (PE): Equity investments in private companies.

• Exit Strategies: The primary ways PE firms realize returns are through an Initial Public Offering (IPO), a sale to another company (M&A), or a secondary sale to another PE firm.

Private Debt (PD): Debt financing provided to private companies.

• Direct Lending: Senior, secured loans made directly to companies.
• Mezzanine Debt: A hybrid of debt and equity. It is subordinated to senior debt but has equity features like warrants, offering higher returns.
• Distressed Debt: Buying the debt of companies that are in or near bankruptcy, often with the goal of taking control of the company during restructuring.

Real Estate and Infrastructure

Real Estate: Investment in physical property or securities tied to property.

• Investment Forms:
  • Direct Ownership: Owning physical properties (commercial, residential). Illiquid.
  • Indirect Ownership: Investing in Real Estate Investment Trusts (REITs) or private real estate funds. More liquid.
• Valuation Approaches:
  • Income Approach: Value is based on the property's ability to generate income. Value = $\frac{\text{Net Operating Income (NOI)}}{\text{Capitalization Rate}}$.
  • Cost Approach: Value is based on the cost to replace the property.
  • Sales Comparison Approach: Value is based on recent sale prices of similar properties.

Infrastructure: Assets that provide essential services to the public.

• Characteristics: Long-lived assets, stable and predictable cash flows, high barriers to entry, often regulated.
• Investment Types:
  • Brownfield: Investing in existing, operational assets (lower risk).
  • Greenfield: Funding and developing new projects (higher risk).

Natural Resources

Investments in assets derived from the earth.

• Commodities: Raw materials like oil, gas, and metals.
  • Sources of Return (Futures):
    1. Spot Price Return: Change in the underlying commodity's price.
    2. Roll Yield: The return generated from rolling a maturing futures contract into a new, longer-dated one.
       • Backwardation: Futures Price < Spot Price. Roll yield is positive.
       • Contango: Futures Price > Spot Price. Roll yield is negative.
    3. Collateral Yield: The interest earned on the margin required to hold the futures contract.
• Timberland and Farmland:
  • Returns are generated from biological growth, commodity price changes (e.g., timber, crops), and land price appreciation.
  • Low correlation with other asset classes.

Hedge Funds

Private investment funds that use complex strategies and leverage to generate returns.

• Key Features: Target absolute returns, lightly regulated, use of short selling and derivatives, "2 and 20" fee structure is common.
• Major Strategies: | Strategy | Description | | :--- | :--- | | Equity Hedge | Takes long and short positions in equity securities. Aims to profit from both rising and falling markets. | | Event-Driven | Seeks to profit from specific corporate events, such as mergers, acquisitions, or bankruptcies. Merger arbitrage is a common sub-strategy. | | Relative Value | Exploits small price discrepancies between related securities (e.g., convertible arbitrage). | | Macro | Makes bets on broad macroeconomic trends using currencies, commodities, and sovereign bonds. | | Managed Futures (CTA) | Trades in futures and options markets based on systematic, trend-following models. |

Introduction to Digital Assets

Assets that exist in a digital form on a cryptographically secured distributed ledger (blockchain).

• Distributed Ledger Technology (DLT) / Blockchain: A decentralized and immutable database that records transactions. Key features are transparency, security, and lack of a central authority.
• Cryptocurrencies: Digital or virtual tokens that use cryptography for security.
  • Bitcoin (BTC): The first decentralized cryptocurrency, operating on a Proof-of-Work (PoW) consensus mechanism.
  • Ethereum (ETH): A decentralized platform that runs smart contracts and supports decentralized applications (dApps). It uses a Proof-of-Stake (PoS) mechanism.
• Other Digital Assets:
  • Non-Fungible Tokens (NFTs): Unique digital assets representing ownership of items like art, music, or collectibles.
  • Security Tokens: Digital representations of traditional financial assets (e.g., stocks, bonds) on a blockchain.
• Key Risks: Extreme price volatility, regulatory uncertainty, custody and security risks (hacking), and operational risks of the underlying technology.