Features, Methods and Structures

Question 1

What are alternative investments?

Answer 1

Investments other than ownership of public equity securities, fixed-income instruments, or cash that represent the more traditional asset classes. These investments are referred to as alternatives to traditional asset classes because of their characteristics and the way they are structured.

Question 2

What are distinct features of alternative investments?

Answer 2

The need for specialized knowledge to value cash flows and risks.
Typically low correlation of returns with more traditional asset classes.
Illiquidity, long investment time horizons, and large capital outlays.

Question 3

Who are the typical large investors in alternative investments?

Answer 3

Long investment horizon investors like pension funds, wealth funds etc.

Question 4

What are the three broad categories of alternative investments?

Answer 4

Private capital, real assets, and hedge funds

Question 5

What is private capital?

Answer 5

Funding provided to companies that is sourced from neither the public equity nor the public debt markets. Capital provided in the form of equity is called private equity, whereas capital that is provided as a loan or other debt is called private debt.

Question 6

What is the difference between private equity and public equity investments?

Answer 6

Private equity investors have full access to company information and latitude to influence day-to-day management and strategic decisions. Public equity investors only receive publicly available information with limited control through voting rights.

Question 7

What is the difference between private equity and venture capital?

Answer 7

Private equity refers to investment in privately owned companies or in public companies with the intent to take them private. In general, private equity is used in the mature life cycle stage or for firms in decline. Venture capital is a specialized form of private equity whereby ownership capital is used for non-public companies in the early life cycle.

Question 8

What are private debt, venture debt and distressed debt?

Answer 8

Debt extended to early-stage firms with little or no cash flow, while 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.

Question 9

What are real assets?

Answer 9

Broad category that includes tangible physical assets, natural resources but also intangible assets. Real assets generate current or expected future cash flows and are considered a store of value.

Question 10

What is real estate and what are four forms of real estate?

Answer 10

Borrowed or ownership capital in buildings or land. Developed land includes commercial, industrial and residential real estate and infrastructure.

Question 11

What is infrastructure in investment context?

Answer 11

Special type of real asset that typically involves land, buildings and other long-lived fixed assets that are intended for public use and provide essential services such as bridges or toll roads.

Question 12

How are infrastructure investments organized?

Answer 12

Infrastructure may be developed either solely by governments or through a public-private partnership (PPP) in which private investors also have a stake. Infrastructure assets create cash flows either directly in the form of fees, leases or other compensation for access rights or indirectly by promoting economic growth and supporting higher future tax earnings.

Question 13

What is a concession agreement in a PPP?

Answer 13

It usually governs the investor’s obligations to construct and maintain infrastructure as well as the exclusive right to operate and earn fees for a pre-determined period.

Question 14

What are natural resources in investment context?

Answer 14

Less developed land or naturally occurring standardized products that are harvested, extracted, and/or refined. Less developed land includes farmland/timberland or land for exploration for natural resource deposits, such as minerals or energy. Sources of return for these types of less developed land include expected price appreciation over time and cash flows. Standardized, traded goods are known as commodities including plant, animal, energy and mineral products used in goods and services production. Commodities don’t generate cash flows themselves but are sold by commodity producers to commodity consumers for economic use. Investors seek to benefit of their price changes based on future economic use as well as lower correlation of returns.

Question 15

Name an extensive list of types of real assets.

Answer 15

Real estate, infrastructure, natural resources, collectible assets (art, wine, watches), intangible assets (patents, litigation, digital assets).

Question 16

What are digital assets?

Answer 16

Assets that can be created, stored and transmitted electronically and have associated ownership or use rights such as cryptocurrencies (bitcoin, altcoins, CBDCs) or tokens (NFTs, security token, utility token)

Question 17

What are hedge funds?

Answer 17

Private investment vehicles that may invest in public equities or fixed-income assets, private capital, or in real assets. However, they are distinguished by their investment approach, which includes the use of leverage, derivatives, short selling and other strategies which result in a very different risk and return profile. A portfolio of hedge funds is called a fund-of-funds.

Question 18

Why would an investor invest in alternative investments?

Answer 18

It can give higher diversification and higher expected returns.

Question 19

What are three ways to access alternative investments?

Answer 19

Fund investment (invest in a fund that invests in alternative investments)
Co-investment (invest into a portfolio company of a fund)
Direct investment (invest without intermediary)

Question 20

Institutional investors typically begin investing in alternative investments via funds. Then, as they gain experience, they may begin to invest via co-investing and direct investing. The largest and most sophisticated direct investors compete with fund managers for access to the best investment opportunities.

Question 21

What is fund investment?

Answer 21

Investors with limited resources and/or experience generally enter into alternative investments through fund investing, where the investor contributes capital to a fund and the fund identifies, selects, and makes investments on the investor’s behalf. For the fund’s services, the investor is charged a management fee, plus a performance fee if the fund manager delivers superior results versus a hurdle rate or benchmark. Fund investing is available for all major alternative investment types.

Question 22

What is the difference between an alternative investment fund and a traditional investment fund?

Answer 22

Alternative investment funds usually involve the pre-commitment of funds prior to investment selection and an extended period during which the fund may not be sold, higher management fees with more complex fee structures, and less frequent transparency on periodic returns and fund positions versus equity/fi funds. Investors in alternative funds usually compensate managers using a performance-based fee structure to better align manager and investor incentives over longer periods.

Question 23

What is co-investment?

Answer 23

Once investors have some experience investing in funds, prior to investing directly themselves, many investors gain direct investing experience via co-investing, where the investors invest in assets indirectly through the fund but also possess the right to invest directly in the same assets. Hence, through co-investing, an investor is able to make an investment alongside a fund when the fund identifies deals; the investor is not limited to participating in the deal solely by investing in the fund.

Question 24

Co-investors can learn from the fund’s process to eventually pursue direct investments themselves. Co-investors weigh the benefits of greater control and lower fees versus higher oversight costs.

Question 25

How can fund managers benefit from choosing one or more co-investors?

Answer 25

It can accelerate investment timing when available funds and expected inflows are insufficient for a specific deal. It can expand the scope of available new investments. It can increase diversification of an existing pool of fund investments.

Question 26

What is direct investment?

Answer 26

The largest, most sophisticated investors with sufficient skills and knowledge to manage individual alternative investments often do so via direct investing without the use of an intermediary. Direct investors retain maximum flexibility and control when it comes to investment choice, methods of financing, and timing. It also requires the direct investor to have the resources to provide the specialized knowledge, skills, and oversight capabilities that direct investment requires. Although the direct investment approach usually applies to private capital and real estate, some very large investors, such as pensions and sovereign wealth funds, also invest directly in infrastructure and natural resources.

Question 27

Beyond the direct or indirect method of investing in alternatives, the illiquidity, complexity, and long-term nature of alternative investments require more complex structures to bridge potential gaps between manager and investor interests.

Question 28

Describe the most common ownership structure of alternative investment vehicles.

Answer 28

Limited partnership. This is done to maximize flexibility in the investment structure to allocate business risk and return and to distribute special responsibilities between investors and managers as required. Limited partnerships involve at least one General Partner with unlimited liability who is responsible for managing the fund. Limited partners are outside investors who own a fractional interest in the partnership based on the amount of their initial investment and the terms set out in the partnership documentation.

Question 29

What are Limited Partners in an alternative investment vehicle?

Answer 29

LPs commit to future investments, and the upfront cash outflow can be a small portion of their total commitment to the fund. Funds set up as limited partnerships typically have a limit on the number of LPs allowed to invest in the fund. LPs play passive roles and are not involved with the management of the fund; the operations and decisions of the fund are controlled solely by the GP. LPs have their liability capped at the amount of their investment in the partnership.

Question 30

Who can invest in alternative investment funds?

Answer 30

LP investors must generally meet certain minimum regulatory net worth, institutional, or other requirements, which makes them accredited investors.

Question 31

What is a Limited Partnership Agreement (LPA)?

Answer 31

It establishes the terms of an LP as governed by a limited partnership agreement. Key features of an LPA include the distribution of profits and losses; manager roles and responsibilities, such as investment criteria and restrictions; and terms governing transfers, withdrawals, and dissolution of the agreement.

Question 32

Adjustments to LP terms can be made to address the unique legal, regulatory, or reporting requirements of a specific investor. This document is known as a side letter.

Question 33

Infrastructure projects often involve a special purpose entity that raises borrowed and ownership capital for the construction and operation of a specific road, bridge, or other long-lived asset under the terms of a concession agreement, after which the asset is sold or returned to a public sector entity.

Question 34

Describe the ownership structure of real estate or natural resource funds.

Answer 34

Fund investors are defined as unitholders in what is referred to as a Master Limited Partnership (MLP), which has similar features to the limited partnership described earlier but is usually a more liquid investment that is often publicly traded. Other forms of more liquid investments are REITs, commodity funds, and various ETFs.

Question 35

In the case of direct real estate investments, joint ventures are also a common partnership structure.

Question 36

The asymmetry in information between the GP, with specialized knowledge and control, and the LPs means that more complex compensation structures are used to better align general and limited partner incentives.

Question 37

Alternative investment funds usually combine a higher management fee with a performance fee (incentive fee/carried interest) based on a percentage of periodic fund returns.

Question 38

While hedge funds and REITs typically charge a management fee on AUM, private equity funds often levy this fee on committed capital, which consists of the total amount that LPs have promised to fund future investments.

Question 39

Describe the compensation structure of a private equity fund and how it differs from hedge funds.

Answer 39

They charge a management fee on committed capital, which consists of the total amount that LPs have promised to fund future investments. This makes them different from hedge funds who want a management fee over AUM. Using committed capital reduces the incentive to quickly invest all available money and increases the incentive to wait for the right opportunity. Private equity funds raise committed capital and draw down on those commitments, generally over three to five years when they have a specific investment to make. The life of a private equity fund is 10 years.

Question 40

Describe a performance fee under a hard and soft hurdle rate.

Answer 40

Performance fees are often subject to a minimum fund return or hurdle rate to align manager incentives as closely as possible with those of investors over long investment periods. Under a hard hurdle rate, the manager earns fees on annual returns in excess of the hurdle rate. Under a soft hurdle rate, the fee is calculated on the entire return if the hurdle rate is exceeded.

Question 41

What is a catch-up clause?

Answer 41

An acceleration of performance fees once a fund exceeds the soft hurdle rate. Once the return exceeds the hurdle rate, the manager receives the catch-up rate, and beyond that rate, the remaining percentages are split 80/20.

Question 42

What is a high-water mark?

Answer 42

It reflects the fund's peak value as of a performance calculation date net of fees. If the fund's value subsequently declines below the high-water mark, the hedge fund manager may not charge performance fees until the fund value exceeds the previous high-water mark.

Question 43

What is a clawback provision?

Answer 43

It actually grants the LPs the right to reclaim a portion of the GP's performance fee. Clawback provisions are usually activated when a GP exits successful deals early on but incurs losses on deals later in the fund's life.

Question 44

Describe the difference between deal0by-deal (American) and whole-of-fund waterfall structures.

Answer 44

Deal-by-deal waterfalls are more advantageous to the GP because performance fees are collected on a per-deal basis, allowing the GP to get paid before LPs receive both their initial investment and their preferred rate of return on the entire fund. In whole-of-fund waterfalls, all distributions go to the LPs as the deals are exited and the GP does not participate in any profits until the LPs receive their initial investment and the hurdle rate has been met.