Alternative Investment Features, Methods, and Structures

Alternative investments now make up a large share of many institutional portfolios, but they come with features, access routes and fee terms that differ sharply from listed stocks and bonds. This module explains what makes an investment 'alternative', compares the three ways of investing (through a fund, alongside a fund and directly), and shows how partnership terms such as hurdle rates, catch-ups, high-water marks and waterfalls decide who earns what.

Start this lesson free Practice questions

What you will learn

1. Describe the features that set alternative investments apart from traditional investments and identify the main categories of alternatives.

Main categories: private capital, real estate, infrastructure, natural resources and hedge funds; digital assets are a newer category.
Typical features: illiquidity, reliance on manager skill, low correlation, limited regulation and transparency, high fees, leverage, scarce and biased data.
Two motives for investing: diversification and return enhancement (illiquidity premium and manager skill).
Appraisal-based valuations smooth returns and understate true volatility and correlation.
Dispersion of manager returns is wide, so manager selection drives results.

2. Compare fund investing, co-investing and direct investing in alternatives in terms of fees, control, diversification and due diligence.

Fund investing: diversification and expertise, but layered fees, little control and blind-pool risk.
Co-investing: lower fees and more selection, but adverse selection and rushed due diligence.
Direct investing: full control and no external fees, but needs a large in-house team and is concentrated.
Due diligence shifts from the manager (fund investing) to the individual asset (co-investing and direct investing).
More control and fee savings come with higher internal costs and concentration risk.

3. Describe the ownership and compensation structures of alternative investment funds, including management and performance fees, hurdle rates, catch-up provisions, high-water marks, clawbacks and distribution waterfalls.

The GP manages the fund with unlimited liability; LPs' liability is limited to their commitment. Terms sit in the LPA and side letters.
Management fee of about 1% to 2% (committed capital in private equity, AUM in hedge funds); performance fee or carry of about 10% to 20% of profits.
Hard hurdle: fee only on profit above the hurdle. Soft hurdle: fee on all profit once the hurdle is met.
Catch-up lets the GP reach its full share of profit after LPs receive the preferred return.
High-water marks prevent double charging; clawbacks reverse excess carry; a European waterfall is more LP-friendly than an American one.

Module at a glance

Alternatives share illiquidity, reliance on manager skill, low correlation, limited transparency, high fees and frequent use of leverage.
Main categories: private capital, real estate, infrastructure, natural resources and hedge funds, plus the newer digital assets.
Diversification works when correlation is below 1, but smoothed appraisal data can overstate the benefit.
Fund investing buys expertise and diversification at the cost of fees and control.
Co-investing cuts fees but brings adverse selection; direct investing needs a large in-house team.
Hard hurdle: fee on profit above the hurdle only. Soft hurdle with full catch-up: fee on all profit.
High-water marks stop double charging, clawbacks correct excess carry, and a European waterfall favors LPs.

This free module has 3 lessons, 13 practice questions with full explanations.

Start the lesson