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What are alternative investments?
Alternative investments – also known as alternative assets, alternatives, or “alts” – are any investment in an asset class that falls outside of the traditional investments – those being, namely, stocks, bonds, and cash. As a result, alternative investments offer risk/return profiles that differ from traditional investments, thus adding diversity to an investment portfolio.
The most significant differentiator between traditional and alternative assets is that, unlike traditional assets, alternatives are not traded on public exchanges, such as the NYSE, NASDAQ, FTSE, etc.
Instead, alternative investments, or else known as “private investments” have generally been invested through more exclusive channels, such as, private equity and private debt. This gives alternative investments a different liquidity profile than traditional investments, another key characteristic for the asset.
Finally, despite their increased complexity compared to stocks and bonds, alternative assets are also usually less regulated than traditional assets. This, combined with their illiquidity – which often requires a relatively high minimum investment –is why they are generally only held by institutional investors – such as pension funds, endowments, etc. – or an accredited investor such as a family office.
|Highly regulated||Less regulated|
|Open to the general public||Only open to accredited investors|
|Highly correlated to the markets||Less correlated|
Alternative assets access a range of unique asset classes and durations. They can be tangible assets or intangible assets. The wide diversity of asset types is part of what gives alternatives its low correlation to public markets.
The following are examples of intangible (or financial) alternative asset classes:
The following are examples of tangible alternatives (also known as “real assets”):
Private equity and private debt are prominent segments within the realm of alternative investments, each with distinct characteristics and opportunities that set them apart from traditional asset classes.
Private equity involves investing in privately-held companies that are not publicly traded on the stock market. In this alternative investing strategy, capital is provided to companies with the goal of enhancing their value over time and ultimately generating substantial returns. Private equity investors typically take an active role in the companies they invest in, influencing strategic decisions and operational improvements.
One of the key advantages of investing in a private equity fund is the potential for higher returns compared to public equities. By participating in the growth and development of companies in their early stages or undergoing restructuring, private equity investors can capitalize on significant value creation. Moreover, private equity investments often have a longer time horizon, with capital typically locked up for several years.
Private debt refers to the provision of loans or fixed income instruments to non-publicly traded entities. Unlike traditional debt instruments, such as bonds or bank loans, private debt is typically sourced from non-bank lenders or institutional investors. Private debt can take various forms, including senior secured loans, mezzanine debt, distressed debt, or direct lending arrangements.
Private debt investments offer several advantages to both borrowers and lenders. For borrowers, private debt can provide alternative financing options outside the traditional banking system, allowing greater flexibility in terms of structure, collateral, and covenants. Lenders, on the other hand, can benefit from potentially higher yields compared to traditional fixed income securities while diversifying their investment strategy and portfolios.
An alternative investment fund is an investment vehicle that allows for institutional investors to front capital and pay management feeds in exchange for having alternative investment fund managers invest their capital via specific intangible investment strategies.
Investors see their capital locked up for about seven to 10 years within the fund while the fund managers invest it according to the specific fund’s strategy, then exit those investments before the fund winds down. The return of a given fund to its investors over its lifetime is defined by the agreement between them and the manager.
Today the alternatives industry includes a multitude of industry participants in distinct categories:
General partners (GPs): General partners are the alternative investment fund managers. They invest and manage asset owners’ capital. The managers generate fees from investors in the form of a management fee and a performance fee that rewards them for strong performance. GPs manage funds which typically follow one or more private capital investment strategies, including private equity, private credit, venture capital, real estate, or infrastructure.
Limited partners (LPs): An LP is a partner in a private company, venture, or high-net-worth individual who receives profits from the business and whose liability toward its debts is legally limited to the extent of the investment. They are also known as asset owners, asset allocators, or institutional investors.
In terms of alternative assets, LPs are the investors – the source of capital. They make capital commitments to alternative funds and undertake due diligence to determine which fund managers to invest with. This process can be extensive and typically includes both quantitative and qualitative analysis, an assessment of fund manager performance track record, and legal compliance.
Types of LPs include:
Other parties offer services to help GPs and LPs with their investment operations:
Investment consultants and gatekeepers: Investment consultants assist asset owners with the management and planning of their investment portfolios and provide investment recommendations. They charge a fee that is sometimes linked by their recommendations rather than fund performance.
Service providers: Service Providers cover the various entities that provide services to a fund. They include:
Investing in alternative assets has many advantages, such as the following:
Just as every coin has its flip side, alternatives also come with their own risks, including the following:
The Global Financial Crisis (GFC) of 2008 led to a handful of industry responses and investor reactions that ultimately laid the groundwork for the substantial growth we’ve seen since in the alternative investment fund industry. Among those factors involved:
As a result, alternatives have become a bigger piece of the portfolio for pension funds, family offices, and everyone in between.
This trend can be seen broadly across the alternatives industry as well as within specific asset classes. As a case study: direct lending.
Direct lending was created as an asset class in 2008, as a direct response to the GFC. Since then, it has become the largest area of growth in private investments. Originally focused on small and medium-sized enterprises (SMEs), it grew in importance when banks reduced lending activities to SMEs, and non-bank lenders stepped in to bridge the gap.
Now, with non-bank lenders seeking better returns, direct lending has been expanded to include all types of private and public companies, helping to significantly boost AUM allocated to private debt while also meaningfully increasing the type of loan structures that investors must manage and reconcile.
Many of the characteristics that define alternative asset classes, and set them apart from traditional assets, also make them more challenging to manage. Among those challenges:
As with fund managers, investors also face unique challenges when dealing with alts. One of the most significant is benchmarking.
As investors expand their allocation to alternative strategies in private markets, benchmarking can quickly become a difficult task to manage. In order to accurately benchmark an investment, investors need to compare their return to benchmarks most relevant to their portfolio. The range of potential benchmarks and methods, from internal rate of return (IRR) and modified IRR (MIRR) to cash multiples (which compare fund value to capital that has already been called) is expansive.
The effort required to benchmark grows exponentially as LPs expand the range of asset classes they invest in, such as hedge funds, private debt funds, and real estate investments. Benchmarking data is necessarily vast: it is calculated every quarter and broken down by asset class, strategy, geography, and other characteristics. In addition, performance benchmarking is not limited to private benchmarks but may also utilize public market data, drawn from the daily closing values of an array of indices.
These figures are then used to calculate public market equivalent (PME) and PME+ benchmarks. Managing such huge volumes of data can easily overwhelm an LP’s resources and increase operational risk, especially if done manually and without the proper tools.
These challenges, in conjunction with the significant growth the alternative assets market has seen in the last decade plus, have left GPs without comprehensive technology solutions that can handle information from across multiple asset classes and currencies. As a result, GPs often find themselves trying to manually reconcile large amounts of data and information.
While some GPs have implemented a stop gap solution of adding more resources and full-time employees to resolve the issue, this is not a viable, long-term substitute for being able to reconcile, consolidate, and aggregate different asset types into a single multi-asset class solution.
GPs need to onboard technology that can allow them to keep up with increasing investor demands, make quick and accurate decisions based on shifting market information, and continue to grow their business.
Specifically, GPs should look for providers who can offer the following:
Allvue Systems offers both GPs and LPs a comprehensive, end-to-end solution designed specifically for the challenges of alternatives.
Allvue’s cloud-based software is purpose-built to address the needs of private capital investors, facilitating operational efficiency, improved accuracy, and providing a superior investor experience across multi-asset class and multi-currency portfolios.
From smaller start-ups and boutiques to the world’s largest asset managers, from pension funds and family offices to private equity and private debt managers, we provide the tools to manage workflow, integration, and reporting needs.
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At Allvue, we’re committed to harnessing technology and expertise to tackle the biggest challenges facing the private capital space. Our Resources hub, offering blog articles, whitepapers, case studies, videos, and more, shares industry best practices and reflects the experience and learnings of top Allvue experts and our partners motivated to see this industry continue to grow and thrive.
Our goal is to provide guidance as well as food for thought for anyone interested in the private equity, venture capital, private debt, and public credit spaces – whether you’re learning the fundamentals or getting ready to raise your fifth fund. Many of our articles contain links to trusted third-party resources to support our takes, and all our content is regularly reviewed and updated to keep current with the fast pace of alternative investment innovation.