Alternative Investments

Alternative Investment Features

Compared with Traditional Investments

• More specialized knowledge required of investment managers

• Relatively low correlations with returns of traditional investments

• Less liquidity of assets held

• Longer time horizons for investors

• Larger size of investment commitments

Unique Features

• Investment structures that facilitate direct investment by managers

• Information asymmetry between fund managers and investors, which funds typically address by means of incentive-based fee structures

• Difficulty in appraising performance, such as more problematic and less available historical returns and volatility data

Private Equity

Private equity invests in non-public companies or public companies taken private.
Main types:

• Leveraged Buyouts (LBOs): Use debt to buy mature companies.

• Venture Capital (VC): Invests in early-stage, unproven companies.

• Private Debt: may make loans directly to companies

• Distressed Debt: loans to struggling companies

Real Assets

Real assets are tangible or physical assets used for income and inflation protection.
Types include:

• Real Estate (properties, RE-backed debt)

• Natural Resources (commodities, farmland, timberland)

• Infrastructure (roads, utilities, airports, schools)

• Other Assets (art, patents, cryptocurrencies)

Hedge Funds

Hedge funds are investment firms for qualified investors, using flexible strategies.
They may use:

• Leverage

• Long/short positions

• Derivatives

• Illiquid assets
  Despite the name, they do not always hedge risk.

Fund Investing

Using funds to invest following an agreed-upon strategy

• Manager gains

  • Management Fees

  • Investment gains

Term Sheet

Describes

• Investment Policy

• Fee structure (higher than normal)

• Requirements for investors to participate

Co-investing

Investor contributes to a pool of investment funds but has right to invest with fund manager

• Reduces overall fees (while benefit from manager’s expertise)

• Learn/experience to direct investing

For a fund manager, permitting co-investing may increase the availability of investment funds and expand scope/diversification

Direct Investing

Direct investing means an investor purchases assets directly (e.g., companies, real estate) rather than using funds or outside managers.

✅ Advantages:

• No fees to outside managers

• Greater control over investment decisions

❌ Disadvantages:

• Requires more expertise and due diligence

• Higher minimum investment amounts

• Less diversification

Alternative investment structure

Limited Partnerships

• GP

  • fund manager

  • makes all investment choices

• LP

  • investors

  • own partnership share proportional to investment amount

Accredited Investors

LP shares that are only available to those with sufficient wealth to bear significant risk and enough investment sophistication to understand risk

Limited Partnership Agreement

Rules and operational details contained here:

• Side Letters: Special terms that apply to one limited partner but not to others

• Excusal Right: withhold capital contribution that GP would otherwise require

• Most-favored-nation clause: Side letters applied to others should also be applied to them

Master Limited Partnership (MLP)

Can be publicly traded

• Most commonly specialize in natural resources or real estate

Committed Capital

Committed capital is the total amount that investors (LPs) agree to invest in a private equity fund.

• It is not all invested upfront.

• Funds are "drawn down" over time as investment opportunities arise.

• The management fee is usually based on committed capital.

• Undrawn capital is called dry powder.

Soft/Hard Hurdle Rate

• Soft

  • Performance fees are percentage of total increase in value of each partner’s investment

• Hard

  • Only on gains above the hurdle rate

Catch-up clause

• LP

  • Take off of hurdle rate

• GP

  • If excess, get performance fee of hurdle rate

• Residual

  • Split using performance fee

High-water mark

A high-water mark ensures that performance fees are only charged on new net gains, not on recoveries of prior losses.

• Fees are paid only if the fund value exceeds the previous highest net-of-fee value.

• Prevents charging investors twice for the same gains.

• Each investor may have a different high-water mark if they enter the fund at different times.

Waterfalls

A waterfall defines how profits are split between the GP and LPs.

• Deal-by-Deal (American):
  GP can take performance fees from each profitable deal, even if other deals lose money.
  → Favors the GP.

• Whole-of-Fund (European):
  LPs must first receive all invested capital + hurdle rate from the entire fund before the GP earns carry.
  → Favors the LPs.

Clawback Provision

A clawback provision allows LPs to recover excess performance fees from the GP if earlier gains (on which carry was paid) are offset by later losses.

• Protects LPs in deal-by-deal waterfalls

• Ensures GP doesn’t keep carry if the fund underperforms overall

Alternative Investment Additional Risks

• Timing of cash flows over an investment's life cycle

• Use of leverage by fund managers

• Valuation of investments that may or may not have observable market prices

• Complexity of fees, taxes, and accounting

Timing of Cash Flow

• Capital Commitment Phase: Managers issue capital calls; LPs commit capital gradually.

  • Returns: Typically negative due to cash outflows without immediate gains.

• Capital Deployment Phase: Managers fund and manage investments (e.g., start-ups or turnarounds).

  • Returns: Often still negative due to risk and development costs.

• Capital Distribution Phase: Investments mature and generate income/cash flows.

  • Returns: Turn positive and typically accelerate as profits are realized.

Multiple of invested capital (money multiple)

Ratio of total capital returned plus the value of any remaining assets

• does not consider timing of cash flows

  • affect annual returns on invested capital significant

Prime brokers

People that arrange margin financing with hedge funds

Leverage Purposes

• Purpose: Leverage amplifies returns, especially when exploiting small pricing inefficiencies.

• Risks:

  • Margin calls if equity falls below thresholds → forced sales at a loss.

  • Fire sale risk: Large liquidations can depress asset prices further.

  • Borrowing limits: Lenders may restrict further access to capital.

Fair Value Hierarchy

• Level 1. The assets trade in active markets and have quoted prices readily available, such as exchange-traded securities.

• Level 2. The assets do not have readily available quoted prices, but they can be valued based on directly or indirectly observable inputs, such as many derivatives that can be priced using models.

• Level 3. The assets require unobservable inputs to establish a fair value, such as real estate or private equity investments, for which there have been few or no market transactions.

Investor Redemptions

Investors ask managers to redeem their positions

• Typically take measures to restrict early redemptions

Lockup period/ Notice period

• Lockup Period

  • Time after initial investment over which limited partners either cannot request redemptions or incur significant fees for redemptions

• Notice Period

  • Amount of time a fund has to fulfill redemption request

Redemption fees/Gate

• Redemption fee

  • Redemption costs

  • Can counteract transaction costs

• Gate

  • Restricts redemptions for a temp period

Founders class shares

Early investors receive lower fees or better liquidity terms

Either-of-fees

Maximum of management fee or incentive fee (excess return fee)

Vintage year

Compare funds that originated in the same vintage year

• Each fund’s structure is unique

• Can be in different phase of life cycle

Survivorship/Backfill Bias

• Survivorship

  • Index only includes those who have not failed

• Backfill

  • Managers only select their successful funds for inclusion in index

Portfolio Companies

Companies PE funds invests in

Management Buyouts/Buy-ins

• Buyouts

  • Existing management team participates in purchase

• Buy-in

  • PE replaces portfolio company’s current team

Stages of Venture Capital

• Formative Stage: earliest period

  • Pre-seed (Angel): Idea-stage funding from individuals for planning and market potential.

  • Seed-stage: Funds for product development, research, and marketing—first VC involvement.

  • Early-stage: Supports operations before production and sales begin.

• Later-stage: For companies with sales—used for growth, expansion, or improvement. Often involves giving up control to VCs.

• Mezzanine-stage: Pre-IPO funding to prepare for public offering; typically equity or short-term debt.

Minority Equity Investing

Buy a less than controlling interest in public companies that are looking for capital

Private investment in public equity

Allows publicly traded firm to raise capital more quickly and cost effectively than IPO

Main PE exit strategies

• Trade Sale: Sell to a strategic buyer; often at a premium. Faster and cheaper than IPOs, but may face internal resistance and few buyers.

• Public Listing:

  • IPO: Most common, higher valuation, visibility; costly and complex. Best for large, stable, growing firms.

  • Direct Listing: Lower cost, no capital raised.

  • SPAC: Flexible, less valuation uncertainty, but dilution and regulatory risks.

• Recapitalization: Take on debt to pay dividends; not a full exit but returns capital to investors.

• Secondary Sale: Sell to another PE firm or investor group.

• Write-off/Liquidation: Recognize loss from failed investments.

Private debt categories

• Direct Lending: Senior, secured loans made directly to companies—often with covenants.

• Leveraged Loans: Fund's portfolio of loans is itself financed with debt to amplify returns.

• Venture Debt: Convertible or warrant-linked loans to VC-backed start-ups; preserves founder ownership.

• Mezzanine Debt: Subordinated debt with higher risk and return; may include equity features like warrants.

• Distressed Debt: Acquired from troubled firms; investors may engage in restructuring or turnaround strategies.

  • Most typical in mature companies

• Unitranche Debt: Blends senior and subordinated debt into one facility with a blended interest rate.

Vintage year investments

• Vintage year: The year a private equity fund makes its first investment.

• Importance: Performance is influenced by the economic cycle at that time.

  • Expansion phase: Favors early-stage investments.

  • Contraction phase: Favors distressed investments.

• Investor strategy: Diversify across vintage years to manage cycle risk.

Private capital ranking (high to low risk)

1. Private Equity

2. Mezzanine debt

3. Unitranche debt

4. Senior direct lending

5. Senior real estate debt

6. Infrastructure debt

Private/Public RE Investments

• Private

  • Usually direct investments

  • Can be solely owned or indirect owned through partnerships

    • GP provides property management services

    • LP provides investments

• Public

  • REITS

  • MBS

  • ETF

Basic Forms of RE Investments

• Pros

  • Control. The owner can decide on what to purchase, how to finance it, what improvements to make, to which segment of tenants to market the property, and when to sell.

  • Diversification. Real estate returns are less than perfectly correlated with the returns of stocks and bonds. Thus, adding private real estate investment to a portfolio can reduce risk relative to the expected portfolio return.

  • Tax benefits. Real estate can provide deductions for noncash depreciation (even as properties typically appreciate) as well as interest expense.

• Cons

  • Illiquidity and price opacity

  • Complexity of managing property

  • Need for specialized knowledge about current market conditions

  • High initial investment/capital needed

  • Concentration risk if a portfolio has one or few properties

Equity/Mortgage REITs

• Equity

  • Invest RE directly or via partnerships

• Mortgage

  • Lend money for RE or invest in MBS/CMBS

REITS investment strategies

• First Mortgages or investment grade CMBS

• Core real estate strategies, invests in high-quality commercial and residential properties with stable returns

• Core-plus real estate strategies, which accept a bit more risk than core strategies by undertaking modest development and redevelopment.

• Value-add real estate strategies, which undertake development and redevelopment on a somewhat larger scale than core-plus strategies.

• Opportunistic real estate strategies, which pursue large-scale redevelopment and repurposing of assets, invest in distressed properties, or speculate on upturns in real estate markets.

REIT Equity correlation

REITs correlation with equity is higher than that for direct investment

• increase during steep market downturns

Infrastructure Investments

• Transportation assets

  • Roads/airports/ports/railways

• Utility

  • Gas/electricity/waste

• Information and communication

  • telecom/cable

• Social

  • prisons/schools/healthcare

Cash flows generated from infrastructure Investments

• Availability payments

  • making infrastructure available

• Usage-base payments

  • highways tolls

• Take-or-pay arrangements

  • require minimum purchase price for an agreed-upon volume

Greenfield investments

Infrastructure to be constructed

• build operate transfer BOT

  • greenfield life cycle

    • cash outflows during building phase

    • increase cash inflows when begin operating

    • transfer of facility to a gov or third party

Brownfield investments

Expand or privatize an existing infrastructure

• secondary stage investments

  • sale leaseback arrangement where asset is purchased from and leased back to government

Infrastructure correlation with equities

Long term contracts and barriers to entry

• CF from equity investments in infrastructure are stable

• low correlation with public equities

Safer and less affected by economic cycles

Infrastructure investments investors

Longer term investors

• Pension

• Life insurance

• Sovereign wealth funds

Timberland Investment management organizations TIMOs

Investment for those who lack expertise

Commodity major sectors

• Metals

• Agricultural

• Energy

Other ways to invest commodities

• Exchange-Traded Products (ETPs): Include ETFs and ETNs; trade like stocks; suitable for investors limited to equity purchases.

• ETFs: Can hold commodities or futures; passively track prices or indexes.

• ETNs: Unsecured debt notes that track commodity indexes; carry credit risk.

• Managed Futures Funds: Actively managed by CTAs; structured as hedge fund-like partnerships (with high minimums and restrictions) or mutual fund-like vehicles (more accessible, liquid).

• Separately Managed Accounts (SMAs): Customized for high-net-worth individuals.

• Specialized Funds: Can focus on specific sectors (e.g., oil, metals) and use any of the structures above.

Contango/Backwardation

• Contango

  • Futures > spot

  • decrease return of long only

• Backwardation

  • Futures < spot

  • increases return of long only

When are commodities prices volatile

Supply is inelastic in short run due to long lead times

• Volatile when demand changes significantly over economic cycle

• supply shocks like natural disasters

• weather

Commodity Risk Return

• High Return Potential: Commodities and real assets like timberland/farmland have historically offered higher average returns than global stocks and bonds.

• Volatility: Commodities are more volatile than stocks and bonds; timberland/farmland have lower volatility.

• Diversification: Low correlation with global equities and bonds provides portfolio diversification benefits.

• Inflation Hedge: Commodity prices tend to rise with inflation, offering protection against inflation risk.

• Risk Sensitivity: Prices are sensitive to geopolitical events and weather.

• Investor Analysis Focus: Includes inventory, supply/demand forecasts, and economic/policy expectations.

Farmland vs Timberland vs Raw land

• Farmland

  • steadiest CF form leasing or selling crops

• Timberland

  • More discretion over timing

  • Can choose to let timber grows or harvest for sale

• Raw Land

  • no CF

Mutual vs Hedge Funds

• Hedge funds lightly regulated

• Managers have great freedom in selecting investment strategies

Hedge Fund Strategies

Hedge fund strategies aim to profit from market inefficiencies:

• Equity Hedge: Long/short positions in equities.

  • Fundamental Long/Short: Long undervalued, short overvalued (net long).

  • Growth: Long high-growth, short low-growth (net long).

  • Value: Long undervalued, short overvalued (value vs. growth).

  • Market Neutral: Equal long/short to reduce market exposure.

  • Short Bias: Predominantly short positions.

• Event-Driven: Linked to corporate actions (typically long biased).

  • Merger Arbitrage: Long target, short acquirer.

  • Distressed: Long distressed, short overvalued.

  • Activist: Buy to influence management.

  • Special Situations: Capital structure changes (e.g., spinoffs).

• Relative Value: Exploit price discrepancies.

  • Convertible Arbitrage: Bonds vs. stock/options.

  • Fixed Income: ABS/MBS/high yield or across issuers.

  • Multistrategy: Across assets/markets.

• Opportunistic: Macro trends or commodities.

  • Macro: Positions across asset classes based on global trends.

  • Managed Futures (CTAs): Trade commodity/financial futures.

Separately managed accounts

Single large investor fund

• customized portfolio to meet investor’s objectives

• no manger stake - no interest

• require more operational oversight

• lower negotiated fees offset by disadvantage of receiving allocations of only the fund’s most liquid trades

Master-feeder strcuture

• Tax efficient, Economies of scale, allows funding from global investors

• bypasses regional regulatory requirements

Hedge Funds structure

• GP

  • fund manager

• Private Placement Memorandum: contractual relationships between GP and LPs laid out in documents

• Recent push from 2/20 to 1/30

Fund of funds

investment company that invests in hedge funds

• gives investors diversification among hedge fund strategies

• charge additional layer of fees beyond the fees charged by the individual hedge funds in the portfolio

  • 1/10

Hedge Fund Return sources

1. Market beta. This is the return attributable to the broad market index. Investors can get this from passive investments in index funds.

2. Strategy beta. This is the return attributable to specific sectors in which a fund has exposure.

3. Alpha. This is the additional return that is delivered by the manager through security selection.

Why Hedge fund index overstated

Hedge fund indexes may overstate performance due to:

• Voluntary Reporting: Poor performers may not report.

• Survivorship Bias: Excludes failed/short-lived funds.

• Selection Bias: Inconsistent category assignment.

• Backfill Bias: Adds prior strong returns when funds join index.

  • Including only successful funds’ prior returns inflates historical index performance.

Despite biases, hedge funds offer diversification, with higher equity correlation than fixed income.

Distributed Ledger Technology DLT

Digital asset is secured and validated

• Blockchain

• Cryptocurrencies have their own blockchains

  • crypto tokens are built on blockchains that already exist

Distributed Ledger

Database among participants

• stored record of all transactions, allows each participant to have an identical copy

Smart Contracts

Computer program self-executes based on predetermined terms and conditions

• Automate contingent claims and collateral transfers during default events ie.

Blockchain

Digital ledger that records information sequentially within blocks

• linked together and secured using cryptographic techniques

Consensus Protocols

Determine how blocks are chained together

• Structured to protect against market manipulation

• Proof of work (PoW)

• Proof of Stake (PoS)

PoW/PoS

• Proof of Work (PoW):

  • Miners solve cryptographic puzzles using powerful computers.

  • High energy consumption due to intensive computation.

  • Security depends on controlling >50% of the network’s computing power.

  • Rewards go to the first miner to solve the puzzle.

  • Most widely used in early blockchains (e.g., Bitcoin).

• Proof of Stake (PoS):

  • Validators stake cryptocurrency to earn the right to validate blocks.

  • Much lower energy use; no complex computations required.

  • Security relies on economic incentives and majority stake control.

  • Validators are rewarded based on stake and participation.

  • Emerging mechanism used by newer blockchains (e.g., Ethereum 2.0).

Permission(less) Networks

Forms of DLT networks

• Permissionless

  • Transactions are visible to all users within the network

  • Confirmed or denied through consensus mechanisms rather than centralized authority

• Permission

  • May be restricted from some network activities

  • Permissions can modify level of ledger accessibility

  • more cost effective due to stronger restrictions

Types of Digital Assets

ryptocurrencies	Tokens
Bitcoin Altcoins Other cryptocurrencies (e.g., Ether) Stablecoins (e.g., Tether) Meme coins (e.g., Dogecoin) Central bank digital currencies (CBDCs)	Nonfungible tokens (NFTs) Security tokens Initial coin offerings (ICOs) Utility tokens Governance tokens

Utility/Governance Tokens

• Utility Tokens:

  • Provide access to services within a blockchain network.

  • Used for payments, transaction fees, or subscriptions.

  • Do not represent ownership or offer dividends.

  • Reward users for participating in the network.

• Governance Tokens:

  • Represent voting rights in decentralized protocols.

  • Allow holders to vote on upgrades, fees, or policies.

  • Offered mainly on permissionless networks.

  • Empower users to help shape the network’s future.

Digital Assets v Traditional Assets

• Inherent Value:

  • Digital assets lack cash flows (e.g., interest/dividends) → no fundamental value

  • Valued based on scarcity and future utility

• Transaction Validation:

  • Traditional assets recorded by central intermediaries

  • Digital assets recorded on decentralized blockchains

• Medium of Exchange:

  • Traditional assets priced in fiat currencies

  • Digital assets act as fiat alternatives, but face legal and cost barriers

• Regulation:

  • Traditional markets are well-regulated

  • Digital assets face unclear, evolving rules and often unregulated exchanges

Indirect Investments in Crypto

• Coin Trusts:

  • Trade over-the-counter like closed-end funds

  • Hold large crypto positions; no need for wallets or keys

  • Offer transparency but often charge high fees

• Futures Contracts:

  • Cash-settled contracts to buy/sell crypto at a future date

  • Traded on exchanges (e.g., CME)

  • Use leverage; more volatile and less liquid than traditional futures

• Exchange-Traded Products (ETPs):

  • ETFs and similar products that mimic crypto returns

  • Use spot holdings or derivatives for exposure

• Cryptocurrency Stocks:

  • Companies connected to digital assets (e.g., exchanges, miners, payment firms)

  • Exposure via business operations or crypto holdings

• Hedge Funds:

  • Use active strategies (e.g., long/short, quant) to invest in crypto

  • Some also engage in mining to enhance returns