Other Considerations of Alternative Investments
Alternative investments are often misunderstood, and that naturally follows from their complexity. Beyond just risk and return features, you might wonder how alternative investments are actually structured. The most common answer is a limited partnership.
The general partner is the organization running the investment, like a hedge fund manager. Investors are limited partners. What would a general partner have that a limited partner would not?
Exactly.
Each investor is a limited partner (LP) and risks just what is invested; no more. It's the general partner (GP) that takes on all of the risk. Both get returns, and both can suffer losses, but those losses are *limited* for a *limited* partner. This is easily the most popular structure for alternative investments.
Not really. If the investment declines in value, there are losses for all partners.
Not really. All partners get returns based on how well the investment performs.
A large investor can often purchase a limited partnership interest directly from the GP; when this is done, what is the investor sure to have?
Not necessarily. There are many unknowns with alternative investments, and a high return is far from certain.
Right. The investor will likely invest in multiple limited partnership stakes in order to diversify this risk. The simplest way of doing this is choosing a fund of funds (FOF). There is significantly more diversification with this choice, but of course that second layer of fees as well.
Probably not. Investments like this are fairly illiquid.
Separately managed accounts (SMAs) are popular for very wealthy investors. A manager will simply manage the client's wealth individually, allowing full customization of the portfolio. How could this be performed with a special sort of limited partnership?
That's always the case. The SMA would be like having a single limited partner. This is then called a "fund of one."
Precisely. This is then called a "fund of one."
The main difference is that an asset manager in an SMA says, "I'll do my best to grow your money, and hope I don't lose it," without having a personal stake. But a fund of one, as in any limited partnership, has the capital of the GP invested right with the capital of the LP. In this structure, the interests are aligned for sure.
What would need to be in place for this to be assured?
Right.
Hedge funds often accept subscriptions monthly or quarterly and allow redemptions quarterly or annually with one-to-three months' notice. That suggests about a year of lock up so that capital is fairly stable.
No, that would be problematic for the manager of the fund pursuing a multi-year strategy.
Not really. Subscriptions are letting money into the fund; some extra money can sit around without too much of a problem.
How would you expect a lock-up period for private equity or private credit to compare to this?
Of course.
No, it is usually a longer lock-up period.
Often these don't have any redemption provisions at all; you'll get your money when it's available, or you can sell your interest to someone else if the GP approves. That's pretty restrictive. If you put your money with private equity or private credit, expect something like a 10-year lock-up period. The capital is returned as the investment proceeds (the capital drawdown), but there's plenty of uncertainty with this, and investors can get their money back more quickly or more slowly than anticipated.
What risk is really being identified here?
Not really. Of course that's present in a private credit deal, but that's not related to lock-up periods.
Exactly. Liquidity is a big issue with these types of investments. Equity oriented hedge funds are often fairly liquid, although some equities may be considered as being in a "side pocket" and not available for sale as other equities, making that pocket illiquid. Event-driven hedge funds are waiting for events that can take years, and are less liquid. This is similar to relative value strategies: the GP may be right on a pairing, but then the market has to eventually agree and reprice the pair, which takes time.
Not really. Of course that affects various investments, but that's not related to lock-up periods.
Imagine a fund that uses significant leverage, but then markets move against the strategy. Who do you think will get their money back first?
No, the provider of leverage will.
Absolutely.
Debt interests are nearly always prior to equity interests, and so deleveraging is required first. If this is during a bad period (think about 2008 as a real example), then the limited partners' liquidity can vanish while leverage providers are repaid—and often at the worst possible time.
That's when some investors are left shaking their heads, unfortunately realizing just how misunderstood alternative assets really are.
To summarize:
[[summary]]
Many pooled investments are trying to take advantage of opportunities that may take years to materialize. So in order to succeed, they need to know that capital will remain available for that time period.
Liability for debts
Returns based on performance
Potential for losses
High returns
Idiosyncratic risk
A fairly liquid asset
Have a single GP
Have a single LP
A lock-up period
Infrequent subscriptions
Daily redemptions
Longer lock-up period
Shorter lock-up period
Liquidity risk
Interest rate risk
Credit risk
The limited partners
The provider of leverage
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