The World of Alternative Investments

In the vast universe that is investing, there are an overwhelming number of options for investors to place their hard-earned cash. Most are aware of the traditional asset classes, including stocks, bonds, and cash, and the importance of diversification among these classes, but there are a handful of other alternative options that are lesser known and less understood. If you are categorized as an accredited investor and are looking for even greater diversification in your portfolio, knowing what is available is crucial to making the most appropriate decision for your situation. This article is meant to be a broad overview of alternative investments available to accredited investors, and should not be viewed as professional investment advice.

Before diving into the options accredited investors have in the world of alternatives, it is necessary to know how an accredited investor is defined. The following criteria must be met to be deemed an accredited investor:

  • Have a net worth of at least $1 million, excluding the value of personal primary residence, or
  • Have an income of at least $200,000 for the last two years with an expectation of making the same amount in the current year ($300,000 for joint income if married)

The SEC set apart these individuals as eligible to participate in alternatives because of the nature of these investment options. Although alternatives may offer a greater range of diversification for investors, they are typically much higher risk than traditional asset classes, are generally illiquid, and the initial investment minimum can be quite high. In other words, they are not well suited for non-professional investors or those with minimal experience.

Now, let’s discuss what constitutes an alternative investment.

Alternative investments are those defined as investment vehicles that do not fall under the umbrella of public stocks, corporate (high-quality) bonds, money market or cash accounts, or real estate purchased for residential purposes. Instead, alternatives include private equity offerings, venture capital opportunities, hedge funds and some hard assets. The JOBS Act of 2012 added an additional option for accredited investors that includes equity crowdfunding as an investment alternative; however, because final rules have yet to be established, these platforms available only to accredited investors are operating on previously laid out regulation and interpretation of state and federal guidelines.

Private Equity

Put very simply, private equity investments in the realm of alternatives refer to those where investors pool funding for the purpose of purchasing all or a controlling portion of a private and established company. Private equity investments are easily understood when compared to retail mutual funds, except not just anyone can invest in private equity funds, and mutual funds are pooled investor funds for the purpose of purchasing publicly traded companies, not private entities. These transactions can be leveraged also, utilizing the money borrowed from investors to pay for the acquisition, making them more complex than their mutual fund retail counterpart. Private equity funds are typically offered only to institutional clients and accredited investors, as the minimum buy-in amounts are fairly high and the investments are not considered liquid. These aspects of private equity make the investment high-risk to even the most advanced investor.

Venture Capital

Similar to private equity funds, venture capital refers to an actively managed group investment in the equity of a private entity. In contrast, venture capital is used in pursuit of start-up companies or those in a phase of rapid growth, and is typically a minority investment as opposed to a full acquisition. A venture capital investment is often paid back to investors in preferred stock, but with advanced control and inherent downside protection that typical stockholders are not afforded. Just like with private equity, venture capital investments are high in risk because they require hefty upfront cash and getting any principal back is not guaranteed due to the nature of start-up or growth companies.

In both private equity and venture capital investments, accredited investors are expected to leave funds invested for an extended period of time – typically 10 to 12 years. Both are considered close-ended funds that are professionally managed by a management team or appointed sponsor. This team or individual works to raise pledged capital from accredited investors, endowments, pension funds and/or insurance companies, and once the appropriate amount of capital is committed, they begin the search for attractive acquisition or investment opportunities. This process, known as the investment period, can last anywhere from three to five years of the close-ended fund’s lifetime.

Once private entities are found and investment is made, the holding period begins. This is exactly what it sounds like – the fund’s management team holds the purchased interests in the selected companies for a period of five to seven years in order for the companies to appreciate in value. During the holding period, additional company interests can be purchased, known as a follow-on investments, but no new investors are permitted into the offering. Once the fund has come to maturity, deemed by the management team or sponsor, the investments are sold so that proceeds can be distributed back to investors proportionately.

Both private placements and angel investor options fall under these categories, and vary slightly in terms of number of investors, time frame, and use of management teams or sponsors. A private placement generally describes the process of selling equity or debt securities of a company to an individual accredited investor or a small group of accredited investors. It is done without the assistance of a fund or manager, and can be a viable way for private companies to raise necessary capital. Angel investing, on the other hand, is a subset of venture capital investing, and involves providing capital formation for seed companies, or those just getting out of the gate. These investments are smaller than the other categories, usually falling between $50,000 and $1 million total.

Hedge Funds

Although hedge funds are also pooled investments that are actively managed, this alternative varies from both private equity and venture capital options. Hedge funds gather capital from a number of accredited investors but are not restricted to investing in only private entities; instead, hedge funds are typically spread across a variety of asset classes, including derivatives, private and publicly traded securities. These are less restrictive in terms of trading in the market, and therefore may hold less risk than private equity or venture capital investments.

Also in contrast to the previous alternatives, hedge funds are considered open-ended, which means new investors are allowed to participate during any point in the lifetime of the fund, and distribution of proportionate ownership in the fund can be done at any time. Additionally, instead of working on an initial pledge system like private equity or venture capital investments, hedge funds require the full buy-in contribution when admitted to the fund.

Hard Assets

Hard assets as alternative investments are most similar to private equity offerings, except they are pooled investments from accredited investors in often rare tangible assets that are highly appreciated. This can include fine art, rare coins, real estate investment trusts (REITs), or other commodity pooled funds. The price of the underlying assets can fluctuate greatly, and as with the other alternative options, entry into these funds can be is high. These investments are also fairly illiquid as they require a longer holding period for appreciation to occur.

Crowdfunding

The JOBS Act brought to light the newest wave of alternative investment strategies, including, most notably, the option for accredited investors to participate in the different phases of start-up and growth companies in need of capital formation. Crowdfunding in the sense of alternative investments can be done through crowdfunding or lending platforms available to accredited investors through the Internet, either for the purpose of funding a start-up company in return for a small percentage of equity in the business, or by participating in a lending option, with a potential return on the borrowed investor funds. In either case, the SEC has yet to determine the final rules under the JOBS Act that will clarify regulation surrounding this alternative option for investors. For now, only accredited investors are allowed to participate with the hope that retail investors will be able to join the mix in the near future.

No matter what investment selection an investor makes, it is crucial to understand the direct correlation between risk and reward—the greater the potential for reward, the greater the risk. The alternatives listed here require a great deal of capital in order to participate, are generally best suited for those who plan to be in the investment for an extended period of time, and may not offer any real return once the underlying asset is liquidated. However, for accredited investors willing to take the time to understand these options and the associated risk, each of the alternatives listed here offer a way to diversify an already well-rounded portfolio, and can, in some instances, offer stability in an otherwise unstable market.

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