CHAPTER 2
INTRODUCTION TO ALTERNATIVE INVESTMENTS

LEARNING OUTCOMES

The candidate should be able to:

• describe types and categories of alternative investments;
• describe characteristics of direct investment, co-­investment, and fund investment methods for alternative investments;
• describe investment and compensation structures commonly used in alternative investments;
• explain investment characteristics of hedge funds;
• explain investment characteristics of private capital;
• explain investment characteristics of natural resources;
• explain investment characteristics of real estate;
• explain investment characteristics of infrastructure;
• describe issues in performance appraisal of alternative investments;
• calculate and interpret returns of alternative investments on both before-­fee and after-­fee bases.

Summary Overview

This chapter provides a comprehensive introduction to alternative investments. Some key points of the chapter are as follows:

• Alternative investments are supplemental strategies to traditional long-­only positions in stocks, bonds, and cash. Alternative investments include investments in five main categories: hedge funds, private capital, natural resources, real estate, and infrastructure.
• Alternative investment strategies are typically active, return-­seeking strategies that also often have risk characteristics different from those of traditional long-­only investments.
• Characteristics common to many alternative investments, when compared with traditional investments, include the following: lower liquidity, less regulation, lower transparency, higher fees, and limited and potentially problematic historical risk and return data.
• Alternative investments often have complex legal and tax considerations and may be highly leveraged.
• Alternative investments are attractive to investors because of the potential for portfolio diversification resulting in a higher risk-­adjusted return for the portfolio.
• Investors can access alternative invests in three ways:
• Fund investment (such as a in a PE fund)
• Direct investment into a company or project (such as infrastructure or real estate)
• Co-­investment into a portfolio company of a fund
• Investors conduct due diligence prior to investing in alternative investments. The due diligence approach depends on the investment method (direct, co-­investing, or fund investing).
• Operational, financial, counterparty, and liquidity risks may be key considerations for those investing in alternative investments. These risks can be analyzed during the due diligence process. It is critical to perform fund due diligence to assess whether (a) the manager can effectively pursue the proposed investment strategy; (b) the appropriate organizational structure and policies for managing investments, operations, risk, and compliance are in place; and (c) the fund terms appear reasonable.
• Many alternative investments, such as hedge and private equity funds, use a partnership structure with a general partner that manages the business and limited partners (investors) who own fractional interests in the partnership.
• The general partner typically receives a management fee based on assets under management or committed capital (the former is common to hedge funds, and the latter is common to private equity funds) and an incentive fee based on realized profits.
• Hurdle rates, high-­water marks, lockup and notice periods, and clawback provisions are often specified in the LPA.
• The fee structure affects the returns to investors (limited partners), with a waterfall representing the distribution method under which allocations are made to LPs and GPs. Waterfalls can be on a whole-­of-­fund basis (European) or deal-­by-­deal basis (American).
• Hedge funds are typically classified by strategy. One such classification includes four broad categories of strategies: equity hedge (e.g., market neutral), event driven (e.g., merger arbitrage), relative value (e.g., convertible bond arbitrage), macro and CTA strategies (e.g., commodity trading advisers).
• Funds-­of-­hedge-­funds are funds that create a diversified portfolio of hedge funds. These vehicles are attractive to smaller investors that don't have the resources to select individual hedge funds and build a portfolio of them.
• Private capital is a broad term for funding provided to companies that is sourced from neither the public equity nor debt markets. Capital that is provided in the form of equity investments is called private equity, whereas capital that is provided as a loan or other form of debt is called private debt.
• Private equity refers to investment in privately owned companies or in public companies with the intent to take them private. Key private equity investment strategies include leveraged buyouts (e.g., MBOs and MBIs) and venture capital. Primary exit strategies include trade sale, IPO, and recapitalization.
• Private debt refers to various forms of debt provided by investors to private entities. Key private debt strategies include direct lending, mezzanine debt, and venture debt. Private debt also includes specialized strategies, such as CLOs, unitranche debt, real estate debt, and infrastructure debt.
• Natural resources include commodities (hard and soft), agricultural land (farmland), and timberland.
• Commodity investments may involve investing in actual physical commodities or in producers of commodities, but more typically, these investments are made using commodity derivatives (futures or swaps). One can also invest in commodities via a CTA (see hedge funds)
• Returns to commodity investing are based on changes in price and do not include an income stream, such as dividends, interest, or rent (apart from income earned on the collateral). However, timberland offers an income stream based on the sale of trees, wood, and other products. Timberland can be thought of as both a factory and a warehouse. Plus, timberland is a sustainable investment that mitigates climate-­related risks.
• Farmland, like timberland, has an income component related to harvest quantities and agricultural commodity prices. However, farmland doesn't have the production flexibility of timberland, because farm products must be harvested when ripe.
• Real estate includes two major sectors: residential and commercial. Residential real estate is the largest sector, making up some 75% of the market globally. Commercial real estate primarily includes office buildings, shopping centers, and warehouses. Real estate property has some unique features compared with other asset classes, including heterogeneity (no two properties are identical) and fixed location.
• Real estate investments can be direct or indirect, in the public market (e.g., REITs) or private transactions, and in equity or debt.
• The assets underlying infrastructure investments are real, capital intensive, and long lived. These assets are intended for public use, and they provide essential services. Examples include airports, health care facilities, and power plants. Funding is often done on a public-­private partnership basis.
• Social infrastructure assets are directed toward human activities and include such assets as educational, health care, social housing, and correctional facilities, with the focus on ­providing, operating, and maintaining the asset infrastructure.
• Infrastructure investments may also be categorized by the underlying asset's stage of development. Investing in infrastructure assets that are to be constructed is generally referred to as greenfield investment. Investing in existing infrastructure assets may be referred to as brownfield investment.
• Conducting performance appraisal on alternative investments can be challenging because these investments are often characterized by asymmetric risk-­return profiles, limited portfolio transparency, illiquidity, product complexity, and complex fee structures.
• Traditional risk and return measures (such as mean return, standard deviation of returns, and beta) may provide an inadequate picture of alternative investments' risk and return characteristics. Moreover, these measures may be unreliable or not representative of specific investments.
• A variety of ratios can be calculated in order to review the performance of alternative investments, including the Sharpe ratio, Sortino ratio, Treynor ratio, Calmar ratio, and MAR ratio. In addition, batting average and slugging percentage can also be used. The IRR calculation is often used to evaluate private equity investments, and the cap rate is often used to evaluate real estate investments.
• Redemption rules and lockup periods can bring special challenges to performance appraisal of alternative investments.
• When comparing the performance of alternative investments versus an index, the analyst must be aware that indexes for alternative investments may be subject to a variety of biases, including survivorship and backfill biases.
• Analysts need to be aware of any custom fee arrangements in place that will affect the calculation of fees and performance. These can include such arrangements as fee discounts based on custom liquidity terms or significant asset size; special share classes, such as "founders' shares"; and a departure from the typical management fee + performance fee structure in favor of "either/or" fees.

PROBLEMS

1. Which of the following is...