Alternative Investments
Evaluate private equity, venture capital, hedge funds, and private credit illiquidity premiums and fee hurdle waterfalls.
TL;DR
- Access non-correlated portfolio returns by deploying into institutional
alternative-asset-classes. - Demand substantial
illiquidity-premiumswhen locking up private capital. - Scrutinize steep
two-and-twentymanagement and incentive fee hurdles.
Private Equity And Venture Capital
Leveraged Buyouts (LBO)Acquiring mature private companies using substantial debt leverage.
Set leveraged buyouts (lbo) to enterprise value minus debt financing.Venture Capital Power LawA tiny minority of breakout startups generate the vast majority of fund returns.
Check whether portfolio company return is greater than 50.Capital Call ScheduleCapital drawn down gradually over a 3 to 5 year investment period.
Capital drawn down gradually over a 3 to 5 year investment period.Hedge Fund Strategies
Long-Short EquityBalancing long undervalued positions with short overvalued positions.
Set long-short equity to long exposure minus short exposure.Global MacroTrading interest rates, currencies, and sovereign debt globally.
Trading interest rates, currencies, and sovereign debt globally.Market Neutral ArbitrageExploiting pricing discrepancies while maintaining zero market beta.
Set market neutral arbitrage to 0.00.Private Credit And Direct Lending
Direct Corporate LoansNon-bank private financing for middle-market corporate borrowers.
Set direct corporate loans to sofr benchmark plus credit spread.Senior Secured PriorityFirst lien claims on physical collateral protecting against defaults.
Check whether lien priority equals 1.Illiquidity Premium SpreadExcess yield earned over public high-yield corporate bonds.
Set illiquidity premium spread to private yield minus public high yield.Fee Waterfalls And Liquidity Risks
Preferred Return HurdleInvestors receive baseline return before managers earn carried interest.
Set preferred return hurdle to invested capital times 0.08.Carried Interest (Carry)Performance fee of 20% of net profits above hurdle rate.
Performance fee of 20% of net profits above hurdle rate.Secondary Market LiquiditySelling locked-up partnership stakes at steep secondary discounts.
Selling locked-up partnership stakes at steep secondary discounts.Tips
- Require a minimum 3% annual
illiquidity-premiumover public stock benchmarks before committing money to 10-year private equity lockups. - Utilize interval funds or liquid alternative
ETFsif you desire alternative asset exposure without accredited investor wealth minimums.
Warnings
- Beware of private equity reported returns that look artificially smooth because assets rely on subjective
internal-appraisals. - Do not invest money needed within five years into
venture-capitalpartnerships that enforce strict decade-long capital lockup periods.
In Practice
Calculate net investor returns after deducting management fees and carried interest with an 8% hurdle rate.
An institutional investor evaluates net returns on a $1,000,000 private equity commitment under a 2-and-20 fee structure with an 8% hurdle rate.
- 1. Gross capital return is 15.0% over 1 year: Gross Profit = $1,000,000 * 0.15 = $150,000.
- 2. Deduct 2.0% annual management fee on capital: $1,000,000 * 0.02 = $20,000 fee.
- 3. Calculate preferred return hurdle: $1,000,000 * 0.08 = $80,000 hurdle.
- 4. Calculate carried interest on profits exceeding hurdle: ($150,000 - $80,000) * 0.20 = $14,000 carry.
- 5. Calculate net investor return: $150,000 gross - $20,000 mgmt - $14,000 carry = $116,000 (11.6% net).
Private equity fund yields 11.6% net after $34,000 in management and incentive fees.
High 2-and-20 fee structures consume nearly a quarter of gross private market gains.
FAQ
Alternative investments encompass any financial asset that falls outside traditional long-only stocks, bonds, and cash. Common categories include private equity, venture capital, hedge funds, private credit, and real assets.
The classic hedge fund and private equity fee model charges a 2% annual management fee on committed or invested capital, plus a 20% performance fee (carried interest) on net profits generated above a hurdle rate.
In the United States, an accredited investor is an individual with annual income exceeding $200,000 ($300,000 for couples) or a net worth over $1,000,000 excluding primary residence, granting legal access to unregistered private funds.