It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.
—George Soros, hedge fund manager1
Life insurance companies like MetLife, Prudential, and State Farm have traditionally invested heavily in bonds. These investments have usually provided safety along with competitive yields. They also are more predictable compared to stocks.
But with interest rates at low levels, life insurance companies have been challenged in meeting their long-term obligations. Because of this, they have been investing more in alternative investments. These are assets that go beyond the typical stocks and bonds.
Life insurance companies have certainly not been the only ones that have been making this transition. Pension funds and university endowments have as well.
While alternative investments have been mostly for institutions and wealthy investors, this trend is starting to change. The fact is that it is much easier for anyone to get exposure to this type of investment. This has been especially because of changes in regulations and the emergence of online platforms.
In the next five chapters, we’ll take a look at the main categories of alternative investments: private equity, hedge funds, commodities/real estate/collectibles, angel investing, and crypto. As for this chapter, we’ll cover the basics of alternative investments.
The Partnership Structure
Many alternative investments are part of a fund, and the structure is typically in the form of a partnership. This allows for more flexibility as well as tax advantages.
Keep in mind that a partnership is a pass-through structure. This means that profits and losses flow through it tax-free. Instead, the partnership will report any distributions to the IRS and other tax authorities by filing partnership returns. For those who invest in these funds, you will get a K-1 statement each year. This will report your gains and losses. You need to keep this in order to prepare your own tax return.
There are two types of partners. First, the general partner runs the partnership, and this is usually an investment firm. An example is Sequoia Capital, which Don Valentine founded in 1972. The firm currently has nearly 1,000 employees.
Raise Capital: For a top firm like Sequoia, this is not particularly difficult. Because of its impressive long-term track record, there are many investors that want to invest. However, for a typical venture investment firm, the process is usually challenging and time-consuming. It could easily take a couple years. The fundraising will have a minimum threshold amount. Once this is met, the general managers can begin their investment activities. They can also continue to raise money for the fund.
Investing: The partners will find deals and vet them. Usually, they will select a small number of them and negotiate the financings.
Manage the Portfolio: The partners will track the performance of their investments. They will often help the companies, such as with recruiting employees, finding partners and referring potential customers. It’s common for the partners to take some board seats for their investments.
Follow-On Investments: The initial investment is usually not the last, at least when it comes to venture capital funds. The general partners will often participate on the next rounds of financing. This can help reduce the dilution of their stakes.
Disclosures: Partners will provide periodic updates on the fund’s progress, such as with quarterly letters and annual reports.
Recruiting: Partners will spend considerable time building the team for their investment firm. Interestingly enough, founders and executives of portfolio companies may ultimately become partners.
Skin-in-the-Game: Partners will usually be investors in the fund. This may account from 1% to 5% of the overall assets. This is to allow better alignment of interests between the partners and limited partners.
The general partner may have different vintages of funds. This means there are more than one version. These may be created every five to ten years. A general partner may also set up funds for different objectives. In the case of Sequoia, there is one for the United States, China, India, and Israel.
Next, an investment partnership will have limited partners, which commit money to the fund. They do not participate in the selection or management of the investments. This is why they are called “passive investors” and their investments are referred to as “blind pools.”
Corporate and Government Pensions: These organizations manage the money to finance the retirement of their workforces.
Insurance companies: They generate substantial amounts of money from premiums from clients. This is known as the float. With it, insurance companies will allocate the money to long-term investments so as to pay off the long-term claims.
Wealthy individuals: These are people who are classified as accredited investors (defined later in the chapter).
Family Offices and Funds of Funds: These are money managers who invest the money of wealthy individuals or institutions.
Sovereign Wealth Funds: These are state organizations that manage a government’s excess reserves. Some of the largest funds include the Norway Government Pension Fund Global, China Investment Corporation, and the Kuwait Investment Authority.
Private Foundations: These are organizations that are focused on charitable purposes. Some of the largest ones are the Melinda Gates Foundation, the Ford Foundation, and the Lilly Foundation.
Limited partners usually do not put up all the money upfront. Instead, they will allocate it based on the “cash calls” from the fund.
Management Fees: This is an annual fee that is based on the amount of assets in the fund. It often ranges from 1% to 3% and usually depends on the size of the fund. Basically, it is often higher for smaller funds. The fee is paid regardless of the performance. It is used to pay for the everyday costs, such as office rent, salaries, bonuses, software, subscriptions, and so on. Moreover, a fund contract may specify that the fee will be reduced over time as the investments are realized and distributions are made to the limited partners.
Carried Interest: This is the incentive for the portfolio managers. The carried interest is a percentage of the profits of the fund. A common one is 20%.
Other Fees: This includes income from consulting with portfolio companies, serving on the board of directors, or providing monitoring services. These fees may also involve equity compensation like stock options or restricted stock.
Let’s take an example. Suppose you want to set up a venture capital firm. You have three other partners who will join the team. You will create a company called ABC Venture Partners and this will create a partnership for the first fund to invest in startups. The fund will be called ABC Venture Partners Fund I. For the next year, you raise $100 million from various endowments and insurance companies. These investors are the limited partners of the ABC Venture Partners Fund I.
There is a 2% management fee, which means you generate $2 million a year for the ABC Venture Partners. After this, you and your partners invest in eight startups. And this goes on for the next five years. In all, the ABC Venture Partners Fund I generated profits of $250 million and the carried interest is 20%. This means that 80% of the gains or $200 million go to the limited partners. As for the remaining profits, these go to the ABC Venture Capital Partners. The amount is $50 million. As you can see, it should be no surprise how venture capitalists can get rich! The carried interest on the gains on a large fund can definitely add up.
Recycling: If there is a quick exit of a portfolio company – say within a couple years of the investment – then a portion of these proceeds may be put back into the fund. This can help increase the overall return.
Claw back: When the fund closes and all the distributions are made to the limited partners, the general partners may have received excess amounts from the carried interest. A common reason for this is if there were losses generated in later years. When this happens, the general partners will need to return the excess amounts to the limited partners.
Hurdle Rate: This is a minimum return that the limited partners will receive before the general partners get any carried interest. This is often set at 8%.
Extensions: While the typical term of a fund is ten years, there may be a provision to extend this. A rule-of-thumb is to allow another two years or 10+2.
Cash Calls: A general partner usually has contractual rights if a limited partner does not meet a cash call. Some of the actions include imposing higher interest or penalties, as well as forcing the sale of the interest.
Limited partners are usually structured as tax-free organizations. This is why funds are often in the form of partnerships because they can distribute gains to the investors without triggering tax consequences.
The Pros and Cons of Alternative Investments
Lower Volatility: For the most part, the swings in asset values for alternative investments are generally muted. For example, based on the Goldman Sachs Alternative Investment Allocation Tool, putting 20% of a portfolio’s assets into alternative assets means that there is lower volatility 100% of the time (this is based on returns from 1990 to 2018).2 This assumes that the portfolio has 50% in stocks and 30% in bonds.
Correlation: There is often low correlation between alternative investments and stocks and bonds. This can provide additional diversification for your portfolio. That is, if stocks and bonds fall, then alternative investments may see gains and vice versa. According to an iCapital Network survey of investment advisors, they consider diversification as one of the top reasons to invest in alternatives.3
Talent: As noted, alternative investments can generate substantial compensation for portfolio managers. As a result, the industry attracts some of the world’s best investors.
Protections: Alternative investments often have more security for investors. The portfolio managers can negotiate directly to get better terms, such as with preferred stock. There may also be the grant of board seats. This type of control is more than about protections though. The investment firm will be in a position to guide the strategic position of the company. This may ultimately mean opting for certain long-term strategies.
Taxes: You are usually a part-owner of the assets with alternative investments. And this can allow for attractive tax benefits. For example, it may mean getting to use depreciation or depletion deductions for real estate or oil/gas holdings. It is also possible to make investments in alternatives through retirement accounts like 401(k)s and IRAs. This can provide an additional layer of tax advantages.
Income: Alternative investments can be structured to generate strong annual cash payments to investors, and they may be over 10%. This is especially the case with assets like real estate and pipelines.
Flexibility: Traditional investments are focused mostly on making money when assets increase in value. But with alternatives, you can have portfolio managers use short selling or hedging. This can help soften the impact of bear markets. Note that there are some funds that are short only.
Absolute Returns: Traditional investments are measured on relative returns. This means that the fund will compare itself to an index like the S&P 500. If the index falls 10% but the fund is off by 8%, then this means that the relative performance was good. But of course, the portfolio would still be down. But with alternatives, the mandate is for absolute returns. This means that the portfolio managers will try to make positive returns regardless of the overall market moves.
Alternative investments definitely have their downsides too. The reality is that there are many that underperform traditional investments.
Fees: As seen earlier in this chapter, the fees can be substantial. This can make it tough for the limited partners to get strong returns.
Access: You may be prohibited from investing in some types of funds that focus on alternatives. This could be that the fund is no longer available to outside investors, or they are very selective in who they allow to join. Some funds will simply want to only have institutional investors.
Minimum investment: They can be high. Some may be $1 million or more.
Transparency: The regulations for alternatives are not as stringent compared to publicly traded stocks and bonds. The reason is that the investors are considered to be “sophisticated” and are capable of doing their own due diligence. As a result, an alternative investment may not have extensive disclosures. In fact, another reason for this is that the fund wants to keep its investment strategies secret. In a way, an alternative investment can be like a “black box.” Essentially, you are betting on the expertise and track record of the portfolio managers.
Lockups or Gates: A fund may restrict you from selling any of your interest for a long period of time, say over a year. This is to allow the portfolio manager to invest for the long-term or have enough time to effectively sell illiquid assets.
High Risk: The investments of a fund may be complex or illiquid. The portfolio manager may also take concentrated positions that can be risky.
Drift: This is where the portfolio manager diverges from the investment focus. This may not necessarily be bad. But then again, it could mean that there are challenges with generating competitive returns.
With less transparency, there is the potential for more fraud. The biggest example of this was with Bernie Madoff. For decades, he masterminded a Ponzi scheme that amounted to nearly $65 billion. In 2009, he pleaded guilty to 11 felonies, such as for wire fraud, mail fraud, money laundering, and so on. The judge in the case sentenced Madoff to 150 years in prison. He would die in April 2021.
The overall business
Fees
Assets under management
Clients
Conflicts of interest
Disciplinary actions
You can look up a Form ADV at the Investment Adviser Public Disclosure (IAPD) website (https://adviserinfo.sec.gov/). Another useful resource is FINRA’s BrokerCheck database, which provides background information on brokers and financial advisors (https://brokercheck.finra.org/).
J Curve
The J Curve is graph that shows the returns of a fund over time. As seen in Figure 3-1, it has a distinct J shape. The reason is based on the cash outflows and inflows over the life of a fund.
In the early years, there are mostly cash contributions from the limited partners. This means that the returns will increasingly go negative. True, there may be some early exits, but these will likely not have a big impact on the fund. If anything, bad investments tend to reveal themselves early in the investment period – which further depresses the returns.
But by year three to five, the returns should improve and when they hit the x axis, this will represent break-even for the fund. The top investments will start to show momentum. There will also be fewer outflows because much of the fund capital will have been invested.
A J Curve. It illustrates the returns of funds over time, from year 1 to 10. The curve begins from 0, drops to almost negative 30 at year 2, and then rises to almost 50 percent by year 10.
This is the J Curve, which shows the returns of a fund over time
Accredited Investors
For certain types of alternative investments, you will need to qualify as an accredited investor. Some of the common types include private securities – which have not been registered, say through an IPO – such as the sale of shares in startups (called a private placement) or interests in private equity funds or hedge funds.
Annual income over $200,000 (if single) or $300,000 (if married and filing a joint return) for the past two years. You also need to indicate that you can maintain this for the current year.
Net worth over $1 million, whether you are single or married and file a joint return. The net worth is the value of all your assets – which includes your vested employee stock options as well as property not held jointly with your spouse – minus your liabilities. This excludes the value of your principal residence. There is also a 60-day lookback rule. That is, if you take a loan against the value of your home during these last 60 days, you must include this in your liabilities for your net worth. This is a way to avoid inflating assets.
You are a general partner, executive, or director for the company that is issuing the private securities.
You are a registered broker or investment advisor.
You have certain professional certifications or credentials, or you are a knowledgeable employee of a private fund.
The reason for the accredited investor rules is that there is less regulation for alternative investments. Thus, the SEC wants investors to be wealthier or have more investment experience to deal with the potential risks.
A trust is a common structure used to own assets. Thus it can qualify as an accredited investor. This is the case for both revocable and irrevocable trusts – if there is more than $5 million in assets, the trust was not formed for the sole purpose to invest in a fund, and the trustee is considered a sophisticated investor. A “sophisticated investor” is a person who has knowledge and experience in financial and business matters.
Revocable trust: Each grantor is an accredited investor and the tax benefits flow through directly to the grantors.
Irrevocable trust: Each grantor is an accredited investor, the trust is a grantor trust, the grantor is the trustee, and the grantor is the sole source of the funding.
Access To Alternative Investors
Top Wealth Management Firms
Firms |
UBS Global Wealth Management Credit Suisse Morgan Stanley Wealth Management Goldman Sachs J.P. Morgan Private Bank Charles Schwab Bank of America GWIM Citi Private Bank Julius Baer Northern Trust Wealth Management BNY Mellon Wealth Management |
Smaller wealth management firms may also provide access to alternative investments. They do this by using outsourced platforms like CAIS, Griffin Capital, and iCapital Network.
Regardless of the type of firm, there will be a minimum investment requirement. For the larger firms, this can be $1 million to $50 million. But the smaller wealth management firms may have thresholds at $25,000. Such an investment can then be integrated into an overall financial plan.
According to the CEO of CAIS, independent financial advisors have anywhere from 1% to 2% of the portfolios invested in alternative investments.4 But for large wealth management firms, the average is about 15% and institutions have allocations that range from 30% to 40%.
Conclusion
While stocks and bonds should be a part of any portfolio, there is also a need for alternative investments. They can help reduce volatility, provide diversification, and allow for the opportunity of higher returns.
But alternative investments can be complex and expensive. And yes, there have been notable cases of frauds. In other words, it’s important to do your own due diligence before making an investment.
As for the next chapter, we’ll look at hedge funds.