Alternative Investment Features, Methods, and Structures

This reading defines alternative investments, the reasons investors hold them and how they differ from traditional investments. It compares fund investing, co-investing and direct investing, and explains limited partnership structures, management and performance fees, hurdle rates, catch-up clauses, high-water marks, waterfalls and clawbacks, including how to calculate the fee under each hurdle.

LOS 80.a — What counts as an alternative investment

Traditional investments are long-only holdings of cash and publicly traded stocks and bonds. Anything outside that box is an alternative investment. Most alternatives are actively managed. They fall into three broad categories: private capital, real assets and hedge funds.

Why investors add them (perceived benefits)

• Diversification: returns have relatively low correlations with those of stocks and bonds, so adding them can reduce portfolio risk.
• Higher potential returns: investors may earn an illiquidity premium, and markets for some alternatives may be less efficient than public markets.

Typical features compared with traditional investments

Resulting characteristics

• Investment structures designed to let the manager invest directly in the underlying assets.
• Information asymmetry between managers and investors, which funds try to offset with incentive-based fees.
• Difficulty appraising performance: historical return and volatility data are scarce and less reliable.
• Correlations that are low on average can rise sharply during periods of economic stress.

Three broad categories

1. Private capital: private equity and private debt. Private equity funds hold shares of unlisted firms, or buy listed firms with the aim of delisting them; many targets sit in the mature or declining phase of their industry. Most private equity funds are leveraged buyout (LBO) funds, which finance the purchase of established firms largely with debt. Venture capital funds finance new firms with no track record, in their start-up and early phases. Private debt funds make direct loans, provide venture debt to young firms, or buy distressed debt of borrowers that are struggling with payments or are in bankruptcy.
2. Real assets: real estate, natural resources, infrastructure and other real assets.
   • Real estate covers residential and commercial property and real estate-backed debt. It can be held through outright or leveraged ownership of a building, a single property loan, private or listed securities whose collateral is a pool of properties or mortgages, or a limited partnership.
   • Natural resources are commodities, farmland and timberland. Commodity exposure can come from physical holdings, commodity derivatives (some funds track a commodity index with futures) or shares of commodity producers. Farmland earns lease income or income from crops and livestock; timberland earns cash flows from harvesting trees.
   • Infrastructure means long-lived assets that provide public services: economic infrastructure (roads, airports, utility grids) and social infrastructure (schools, hospitals). Governments often finance and build infrastructure, but more recently public-private partnerships have also taken large stakes in such projects, and an asset may later return to public ownership.
   • Other real assets include collectibles (art), intangibles (patents) and digital assets (cryptocurrencies).
3. Hedge funds: pooled vehicles open to qualified investors that may use leverage, short positions and derivatives. Despite the name, they do not necessarily hedge.

LOS 80.b — Fund investing, co-investing and direct investing

A fund's term sheet sets out its investment policy, fee structure and the requirements investors must meet to participate.

The fee saving in co-investing comes from the part of the money that goes into a deal directly rather than through the fund, while the investor still relies on the manager to find and evaluate the deal. For the manager, allowing co-investment can bring in more capital and widen the scope and diversification of the fund.

LOS 80.c — Ownership and compensation structures

Limited partnerships. The general partner (GP) is the fund manager: it makes all investment decisions and bears the partnership's liabilities, including its debt. The limited partners (LPs) are the investors: they own shares in proportion to their contributions, have no say in management and no liability beyond their investment. LP interests are usually limited to accredited investors, who have the wealth to bear significant risk and the sophistication to understand it, and a partnership typically caps the number of LPs it admits. LPs often commit an amount up front and contribute it over time as the GP calls capital.

• The limited partnership agreement holds the rules of the partnership.
• A side letter gives terms to one LP that others do not get (e.g., an excusal right to skip a capital call). A most-favored-nation clause requires that special terms granted to other LPs also be offered to this LP.
• A master limited partnership (MLP) is publicly traded; MLPs are common in natural resources and real estate.

Management fee. Typically 1%–2% a year, earned regardless of performance.

• Hedge funds: a percentage of assets under management (AUM), usually the fund's NAV.
• Private equity funds: a percentage of committed capital rather than invested capital. Committed capital is drawn down over roughly three to five years, at the manager's discretion; undrawn commitments are dry powder. Charging on committed capital removes the incentive to invest quickly rather than selectively.

A fee quoted as "$m$ and $p$" means an $m\%$ management fee and a $p\%$ performance fee, so "2 and 20" is a 2% management fee and a 20% incentive fee.

Calculating the performance fee

Performance fee. The performance fee (also incentive fee or carried interest) is a share of profits. It is usually paid only after a hurdle rate (preferred return) is reached: the minimum return the fund must earn before the GP receives any performance fee. Below the hurdle, the GP earns no performance fee at all.

• Soft hurdle rate: once the hurdle is met, the fee applies to the whole gain.
• Hard hurdle rate: the fee applies only to the gain above the hurdle.
• Catch-up clause: after LPs receive the hurdle return, the GP receives 100% of the next slice of gains until it has received its full share of all gains so far; after that, gains are split normally. The clause favors the GP.
• Performance fees are usually settled once a year. The base is typically the year's gain in the fund's investments net of the management fee and other charges, such as consulting and monitoring fees billed to portfolio companies. A fund's terms may instead compute the performance fee independently of the management fee, on the full gain.
• High-water mark: no performance fee on gains that only recover earlier losses. The fee is paid only on value above the highest previous net-of-fees value, so investors are never charged twice for the same gain. Each investor can have a different high-water mark.

With a performance fee rate $p$, a hurdle $h$ and a fund return $R$ at or above the hurdle (no fee if $R<h$):

With a full catch-up, the GP receives $R-h$ while $R$ is between $h$ and $h/(1-p)$, and $p\times R$ once $R$ is above that point.

With a catch-up instead, LPs get the first 4%, the GP gets 100% of the next slice until it holds 20% of the total. That total is $4\%/0.80=5\%$, so the GP's catch-up is 1%. The remaining $11\%-5\%=6\%$ is split 80/20, which gives the GP another 1.2%. The GP's total is $1\%+1.2\%=2.2\%$, exactly 20% of 11%.

The catch-up gives the same result as a soft hurdle once the gain is large enough to complete the catch-up, here 5%. Between the 4% hurdle and 5%, the GP receives less than a soft hurdle would pay. Had the fund earned 4.6%, the GP would receive the whole 0.6% above the hurdle, less than its full 20% share of 0.92%.

Waterfalls and clawbacks

Waterfalls. A waterfall sets how realized profits are split between the GP and the LPs:

The deal-by-deal waterfall favors the GP because carried interest is paid on each profitable exit before the LPs have received all of their contributed capital plus the hurdle return.

A clawback provision lets LPs recover incentive fees paid on earlier gains that are later reversed by losses on other deals. For example, if the GP took fees on early winners, the clawback makes sure the LPs still receive their agreed share (e.g., 80%) of the fund's total profit. A clawback is most valuable with a deal-by-deal waterfall.