Mar 7, 20224 min read

Categories of Alternative Investments Can be pivotable for interview.

Considering the variety of characteristics common to many alternative investments, it is not surprising that no consensus exists on a definitive list of these investments. There is even considerable debate as to what represents a category versus a sub-category of alternative investments. For instance, some listings define distressed securities as a separate category, whereas others consider distressed securities a sub-category of the hedge funds and/or private equity categories, or even a subset of high-yield bond investing. Similarly, managed futures are sometimes defined as a separate category and sometimes as a sub-category of hedge funds. The following list offers one approach to defining broad categories of alternative investments. Each category is described in detail later in this reading.

■ Hedge funds.

Hedge funds are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. They may use long and short positions and may be highly leveraged, and some aim to deliver investment performance that is independent of broad market performance.

■ Private equity.

Investors can invest in private equity either via direct investment (including co-investment) or indirectly via private equity funds. Private equity funds generally invest in companies (either startup or established) that are not listed on a public exchange, or they invest in public companies with the intent to take them private. The majority of private equity activity involves leveraged buyouts of established profitable and cash-generative companies with solid customer bases, proven products, and high-quality management. Venture capital, a specialized form of private equity, typically involves investing in or providing financing to startup or early-stage companies with high growth potential and represents a small portion of the private equity market.

■ Real estate.

Real estate investments may be in buildings and/or land, including timberland and farmland, either directly or indirectly. The growing popularity of securitizations broadened the definition of real estate investing. It now includes private commercial real estate equity (e.g., ownership of an office building), private commercial real estate debt (e.g., directly issued loans or mortgages on commercial property), public real estate equity (e.g., REITs), and public real estate debt investments (e.g., mortgage-backed securities).

■ Commodities.

Commodity investments may be in physical commodity products, such as grains, metals, and crude oil, either through owning cash instruments, using derivative products, or investing in businesses engaged in the production of physical commodities. The main vehicles investors use to gain exposure to commodities are commodity futures contracts and funds benchmarked to commodity indexes. Commodity indexes are typically based on various underlying commodity futures.

■ Infrastructure.

Infrastructure assets are capital-intensive, long-lived, real assets, such as roads, dams, and schools, that are intended for public use and provide essential services. Infrastructure assets may be financed, owned, and operated by governments, but increasingly the private sector is investing in infrastructure assets. An increasingly common approach to infrastructure investing is a public–private partnership (PPP) approach in which governments and investors each have a stake. Investors may gain exposure to these assets directly or indirectly. Indirect investment vehicles include shares of companies, ETFs, private equity funds, listed funds, and unlisted funds that invest in infrastructure.

■ Other.

Other alternative investments include tangible assets (such as fine wine, art, antique furniture and automobiles, stamps, coins, and other collectibles) and intangible assets (such as patents and litigation actions).

Investment Structures

A partnership structure is a common structure for many alternative investments, such as hedge funds, infrastructure funds, and private equity funds. In this approach, the fund manager is the general partner (GP) and investors are limited partners (LPs). Limited partnerships are restricted to investors who are expected to understand and to be able to assume the risks associated with the investments. These types of fund investments, because they are not offered to the general public, are less regulated than offerings to the general public.11 The GP runs the business and theoretically bears unlimited liability for anything that might go wrong. Limited partners own a fractional interest in the partnership based on their investment amount and according to the terms in the partnership documentation. These partnerships are frequently located in tax-efficient locations, which benefit both the GP and the LPs. Funds set up as private investment partnerships typically have a limit on the number of LPs.12 Funds are generally structured with a management fee based on assets under management (sometimes called the “base fee”) plus an incentive fee (or performance fee) based on realized profits. Sometimes, the fee structure specifies that the incentive fee is earned only after the fund achieves a specified return known as a hurdle rate. Fee calculations also take into account a high-water mark, which reflects the highest cumulative return used to calculate an incentive fee. In other words, it is the highest value, net of fees, of the fund investment by the individual LP. Note that not all LPs will have the same high-water mark, because it depends on the timing of their individual investment. The use of high-water marks protects clients from paying twice for the same performance.