Investors are often attracted to alternative investments when seeking greater diversification and/or higher expected returns in exchange for what are often longer-term, illiquid investments in less efficient markets. The features of these investments necessitate specific skills and information to evaluate their performance and include unique factors investors must consider if adding them to a portfolio.
Alternative Investments: Features and Categories
Features that may distinguish alternative investments include the following:
- The need for specialised 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
These features lead to the following alternative investment characteristics:
- Different investment structures due to the challenges of direct investment
- Incentive-based fees to address/minimise information asymmetry between managers and investors
- Performance appraisal challenges
Private Capital
Private Capital is a broad term for funding provided to companies that is sourced from neither the public equity nor the public 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. In general, private equity is used in the mature life cycle stage or for firms in decline, with leveraged buyouts being a key approach.
Venture capital is a specialised form of private equity whereby ownership capital is used for non-public companies in the early life cycle or startup phase, where often an idea or business plan exists with a limited operation or customer base.
Private debt, in addition to private loans or bonds, venture debt is extended to early-stage firms with little or no cash flow, while distressed debt (introduced in a separate fixed-income lesson) 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.
Real assets generally are tangible physical assets, such as real estate (for example, land or buildings) and natural resources, but also include such intangibles as patents, intellectual property, and goodwill. Real assets either generate current or expected future cash flows and/or are considered a store of value.
Real estate includes borrowed or ownership capital in buildings or land. Developed land includes commercial and industrial real estate, residential real estate, and infrastructure.
Infrastructure is a 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.
Infrastructure may be developed either solely by governments or through a public–private partnership (PPP)in which private investors also have a stake.
When private investors are involved, a contract known as a concession agreement 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.
Natural resources involve either less developed land, which itself is the source of economic value, or naturally occurring standardised 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.
Standardised, traded goods known as commodities include plant, animal, energy, and mineral products used in goods and services production.
Other real alternative assets include tangible collectible assets, such as fine art, wine, rare coins, watches, and other rare assets, as well as intangible assets, such as patents, and litigation, and so-called digital assets. “Digital assets” is the umbrella term covering assets that can be created, stored, and transmitted electronically and have associated ownership or use rights.
Hedge Funds
Hedge funds are private investment vehicles that may invest in public equities or publicly traded fixed-income assets, private capital, and/or real assets, but they are distinguished by their investment approach rather than by the investments themselves. Hedge funds make frequent use of leverage, derivatives, short selling, and other investment strategies, which often results in a substantially different risk and return profile from that of merely buying and holding the underlying assets in an investment portfolio. Investors may also invest in a portfolio of hedge funds, often referred to as a fund of funds.
