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Traditional investments are long-only positions in cash and publicly traded stocks and bonds.
Anything outside that is an alternative investment: hedge funds, private equity, real estate, commodities, infrastructure and other, often illiquid, assets. Alternatives are usually actively managed.
Investors add them for two reasons:
Compared with traditional investments, alternatives usually involve:
One warning: the low correlations can rise sharply in periods of economic stress, just when diversification is needed most.
The features above shape how alternatives are run:
A leveraged buyout (LBO) fund uses borrowed money to buy established companies; LBO funds are most of private equity. Venture capital funds back young, unproven companies. Hedge funds don't necessarily hedge.
Infrastructure is long-lived assets that provide public services:
Governments often build it, but public-private partnerships are increasingly common, and the asset may revert to public ownership later.
Natural resources cover commodities (held physically, through futures or through producers' shares), farmland (leasing or harvest income) and timberland (income from harvesting trees).
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In fund investing, you pool money with other investors and a fund manager selects and manages the investments under an agreed strategy.
Compared with traditional funds, alternative funds need larger, longer commitments, disclose less and charge more.
Invest in the fund and also have the right to invest directly alongside the manager in some of its deals. Builds skills for direct investing. For the manager, it adds capital and widens diversification.
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Most alternative funds are limited partnerships:
LPs commit an amount but may pay in only part of it at first. The GP calls the rest as it finds investments.
LP shares are usually sold only to accredited investors, who can bear the risk and understand it. A master limited partnership (MLP) is publicly traded, common in natural resources and real estate.
The management fee, typically 1% to 2% a year, is earned whatever the performance.
Committed capital is drawn down over 3 to 5 years, at the GP's discretion. Capital not yet drawn down is dry powder.
Why committed capital? Otherwise the GP would profit from investing quickly instead of selectively.
Our running example: a private equity fund with USD 100 million of committed capital and a 2% management fee. In year 1 the GP draws down USD 40 million.
The fee is 2.0, because it's based on committed capital.
The performance fee (or incentive fee, sometimes called carried interest) is a share of the profits, often 20%.
It's usually paid only once a hurdle rate (or preferred return) is met. There are two kinds:
Below the hurdle, neither pays a fee.
The fund earns 12% in a year. The hurdle rate is 8% and the performance fee is 20%. To keep it clean, ignore the management fee.
Once the hurdle is cleared, the GP earns its share of the entire gain.
A catch-up clause works like a soft hurdle. LPs take all gains up to the hurdle. The GP then takes all the next gains until it has 20% of everything so far. After that, gains split 80/20.
Gain of 14% on USD 100 million, 8% hurdle, 20% fee:
USD million. The GP's 2.8 is exactly 20% of 14.
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A high-water mark means no performance fee is paid on gains that only make up for earlier losses. The fee applies only to value above the highest net-of-fees value recorded at the end of a fee period.
So investors never pay twice for the same gain. Investors who joined at different times can have different high-water marks.
A hedge fund starts at USD 100 million and charges a 20% performance fee with no hurdle. Ignore the management fee.
USD million. After year 1 the high-water mark is 116. Without it, year 3's fee would be 20% × (125 − 100) = 5.0.
A waterfall sets how payments are shared between the GP and the LPs as deals are sold.
LPs put USD 50 million into each of two deals. Deal A sells for 70 (a 20 gain), then deal B sells for 40 (a 10 loss). Fee: 20%, no hurdle.
USD million. The American GP was paid on deal A's gain before deal B's loss was known.
A clawback provision lets LPs recover performance fees paid on gains that later reverse as the fund exits deals.
In the waterfall example, the American GP received 4.0, but the whole fund only earned 10, which supports a fee of 2.0. A clawback lets the LPs recover the 2.0 excess.
So a deal-by-deal waterfall with a clawback can end with the same total fee as a whole-of-fund waterfall.
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That's the reading.
Now test it on exam-style questions while it's fresh.