Alternative Investments: Common Challenges to Know Before Investing

19 Apr 2018·In Alternative Investment Tips

We get calls every week about another alternative investment opportunity. Maybe you do, too.

Before investing in alternative investments, it might help to understand certain limitations and challenges that these present.

Complexity of Alternative Investments

Alternative investments are not cookie cutter securities. Yes, many hedge funds look alike. So might managed futures contracts, or liquid alternative funds, or even debt or equity investments into single companies.

But each offering can be complex on its own. That is one of their advantages – the structure might be perfect for a small audience, unlike most public securities that need to cast a broad net. Each might have its own characteristics, e.g. can the issuer pre-pay and retire the security? Can the fund make “capital calls” and collect the money you pledged anytime? What happens if the issuer declares bankruptcy? Do you have some protections?

Before moving forward, an investor should plan to conduct his or her own due diligence.

Determining Fair Value

For the most part, these are private investments. Determining what is the operating company’s true value, or the value of the pool of operating companies, is more of an art form than a science. While most investment banks will try to identify companies with which to compare the one raising private capital, finding one may be hard to find, if possible at all. In addition to CFG’s investment bankers’ experience in a number of industries, we also draw on professional resources that aggregate data on public and private transactions for a more educated stab at a company’s value.

Why is this important? When a company seeks to be sold, a current valuation, often provided by a certified valuation advisor, gives the buyer a range to make a realistic offer and the seller a clear sense of what the company is worth.

To an equity investor, a fair valuation is also important, as determining what is the investor’s share of the company depends on the funds invested as well as the overall business value. Note, however, that the smaller the company, the more difficult it is to determine a realistic value.

Illiquidity

Speaking broadly, there is no secondary market for most alternative investment vehicles. An investor lends money to a credit fund, or makes a private equity investment in a fund or a private company, and that money stays in the investment either until maturity of the investment or it is redeemed by the issuer. A hedge fund, for instance, often limits the time when investors can sell, and they often face a lockup after initially investing that prohibits them from selling for a period. As an asset class, alternative investments like private equity, real estate and others are long-term investments by nature.

However, there is a growing market that provides investors with the ability to buy and sell interests in private equity funds (and others) called the “private equity secondary market.” This type of trading was first introduced in the 1980’s and has grown considerably due to the credit crisis that began in 2008. Investors, primarily institutions, were seeking means of selling their investments whose value had dropped considerably (think pools of real estate mortgages). The distressed market has stabilized, and, while still a major category of alternative investments, the distressed sector has fallen in size.

Additionally, there has been a rapid growth in the last decade of liquid alternative investment vehicles such as mutual funds, ETFs and closed-end funds that provide daily liquidity.
So, what used to be a 99.9% illiquid market -- at least for individual investors (an institution sometimes could find a buyer of its private investment) – is still largely illiquid, but the market is changing.

Reporting - or lack thereof..

You’ve read this in other articles (see “Differences Between Public and Private Securities”) – under a Reg D offering, the reporting requirements are less stringent than are those that public companies follow. So, expect limited disclosure when evaluating the investment and less thorough reporting of the progress of the investment over time than with a standard investment.

Purchase and Sale Costs

Minimum investments typically have been much higher for alternatives than their traditional security equivalents (CFG’s minimum investment size is $25,000), and, where an investment can be sold, there may be associated fees.

Finally, most alternative investors are required to be “accredited investors,” despite the recent entry of crowdfunding into the private capital marketplace See “Are You Eligible to Make Private Investments?” and “Crowdfunding and the Jobs Act of 2012.”

Having noted these challenges, remember that alternative investments frequently offer low correlation to traditional stocks and bonds, which can help manage the risk that volatility poses while potentially increasing return (see “Alternative Investments: Why Would You Consider Investing?”) when compared to standard investments.

If you’d like to learn more about alternative investments, please, please read more of our articles, such as “Alternative Investment Categories.” Our Library is filled with additional related topics.

As always, contact us with any questions you have.