Alternative Investments: An Overview

Alternative Investments: An Overview
Alternative Investments: An Overview

In recent years, and particularly following the ethical questions that have arisen since the 2007/8 financial crisis, people have been questioning the financial system. This has led people to consider more carefully the investments they are making, and where that money actually goes. Alternative investments have risen more to the forefront, but there is a limited understanding of the benefits and risks associated with these. In July 2015, the World Economic Forum published a comprehensive report that helps to pinpoint and better understand the implications of such types of investments, for the benefit of the industry overall.

The World Economic Forum defines alternative investments as:

“Those which are not part of traditional asset classes such as cash, stocks or bonds that retail investors are most familiar with.”

This is explained to include private equity real estate, private equity infrastructure funds, secondary funds and private debt funds. The report especially focuses on hedge funds, venture capital and private equity buyouts.

While private investment has occurred for decades, it is argued that the alternative investment industry began to merge in the latter half of the last century. Initially this began with just a few US companies managing a relatively small amount, to a great many companies worldwide managing what is estimated to be $7 trillion for investors. Indeed, it is estimated that there are 10,000 firms that contribute towards managing this massive figure. There have been regulatory changes that have driven the growth of the industry, and laws that have had an impact include the US Small Business Investment act of 1958 among others.

It is anticipated that going forward the alternative investments industry will continue being impacted by regulation and change in this area. Regulation is thought to have the potential to impact on innovation and returns, and potentially to create barriers to entry for new businesses.

Alternative investment structures have different legal structures from traditional funds, leading to fee structures that also differ, different lengths of investment (lifespans usually range between 10 to 15 years), different levels of freedom and liquidity. In many cases it is argued that governments will only allow the very wealthy to access such types of investments, on the basis that it is thought that they will best understand the complexity and deal with the level of risk concerned.

Cash flow size and timings may vary more than that with traditional funds. There may also sometimes be a sizeable delay between the time when the money is committed and when it is actually invested. There are also different performance metrics used compared to traditional funds. While traditional funds rely on the time weighted method, considering the returns based on two points in time, the alternative investment approach is more commonly to use the internal rate of return method.

Turning to the types of investments available, hedge funds comprise a considerable proportion of alternative capital, making up 40% of the total, or more than three trillion dollars. The majority of this activity occurs in the USA (70%), but 21% also happens in Europe. There are thought to be more than 8,000 hedge funds in total. One of the reasons for choosing hedge funds is the fact that that they can lead to risk-adjusted absolute returns in any market, which is an attribute that investors value highly.

Private equity buyouts are another form of alternative investment, and this is currently thought to account for $1.4 trillion of alternative investment. The US is the location of 50% of the companies that facilitate these types of investments, and Europe accounts for 26%. Private equity buyout firms have been around since the 1980s, and investors place their money in many different industries, using the services of any of 1,000 firms that operate in this area. One of the major benefits of this type of investment is high returns.

Meanwhile, venture capital is an alternative source of investment that has been utilised since directly after the Second World War, and today there are thought to be $400 billion in assets. There are estimated to be almost 1,500 venture capital firms worldwide. The biggest incentive for taking on this type of alternative investment is the “outsized returns relative to traditional public equity”. Those that invest through such organisations hope to make money by investing in the next big thing, like Facebook or Uber. These types of investments are largely concentrated in the technology industry.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.