Understanding Characteristics, Methods, and Structures
Alternative investments are a class of assets outside of traditional investments like stocks, bonds, and cash. They are distinguished by a unique set of characteristics.
Unlike traditional investments, alternatives typically offer diversification benefits, require specialized knowledge, and involve longer time horizons with limited liquidity.
Investors can access alternative investments in three primary ways, each with different levels of control, cost, and required expertise.
The most common method, where investors pool their capital in a fund managed by a professional manager (the General Partner).
Best for: Investors with limited resources or experience.
Investing in a specific deal alongside a fund manager. This offers lower fees and more direct involvement.
Benefits: Lower fees, direct involvement, learning experience.
Investors make all decisions independently without a fund manager. Provides maximum control but requires substantial resources.
Typical investors: Large institutions like pension funds.
The structure of an alternative investment fund is crucial for aligning the interests of the investors and the managers.
This is the dominant structure for alternative investments. It involves two types of partners:
Important: The relationship is governed by the Limited Partnership Agreement (LPA), a detailed legal document outlining the fund's operations.
The typical compensation structure is designed to reward the GP for successful performance.
of AUM annually
An annual fee, typically 1% to 2% of assets under management (AUM) or committed capital. It covers the day-to-day operational costs of the fund.
of profits
A share of the fund's profits, typically 20%, that is paid to the GP. This is the primary incentive for the manager to generate high returns.
Several features are used to refine the compensation structure and further align GP and LP interests.
Important Terms to Know
A minimum rate of return (e.g., 8%) that the fund must earn before the GP can receive a performance fee.
Allows the GP to receive a larger share of the profits after the LPs have received their initial investment back plus the hurdle rate, until the GP "catches up" to their agreed-upon 20% share.
Ensures that if a fund loses money, the GP cannot earn a performance fee until the fund's value has recovered past its previous high.
A safety net for LPs. If a GP earns performance fees on early successful deals, but the fund later performs poorly overall, this provision requires the GP to return the excess fees.
The method for distributing profits: