Private Equity? Hedge Funds? What's My Alternative?

In the world of investing, it's all too common these days to hear your advisor talk about "Alternative Investments".  Just what are these and what exactly are they an alternative to? In today's world of investing, nearly everything trades in the public markets. Simply put, those investments outside of the public markets are broadly called alternatives. Some of these are true private investments that have nothing to do with the public markets while others are simply private market wrappers on public market investments.

Before we dive too deeply into all of this, let’s reflect on how my granddad taught me to invest. The world was much simpler then and the general rule was 1/3 in stocks, 1/3 in bonds and 1/3 in real estate. In a sense, the old school way was to have a third in alts, except that real estate wasn't considered an alternative investment back then. Strangely enough, it is considered so today even though it has been around as an investment class longer than stocks or bonds!

Let's knock out one of the most common alts first:  Hedge Funds. A sympathetic view of hedge funds is that they are the investment vehicles that attract the most talented money managers in the business and they have the tools and incentives to maximize returns for their investors. The skeptical view is that they are a transfer tool to move investor money to the manager’s pocket through exorbitant fees. The simple reality is that only a tiny minority of hedge funds are able to outperform a simple passive index. Just ask Warren Buffett (http://blogs.wsj.com/moneybeat/2016/05/02/warren-buffetts-epic-rant-against-wall-street/)

The bottom line is that you should avoid hedge funds as a general rule for 3 basic reasons:

1. No Transparency - You have no idea what they are really doing because their trades and holdings are hidden.

2. Leverage - Many hedge strategies generate their returns through borrowed money. These strategies work great until they don't. When that game of musical chairs stops you don't want to be the one left standing.

3. Fees and expenses - Most funds charge 2% of the assets plus 20% of the gains, plus the administrative expenses of running the fund. This basically means if the market earns 10%, the hedge fund manager needs to earn about 15% just so the investors break even with the market.

So, do hedge funds ever make sense?  Sometimes, they do when you find a manager with a true value added approach where they bring a proven skill set to the table that is not otherwise available. Once in a rare moon, you will find a manager that will have an incentive fee that is properly aligned with the investors’ interest by only kicking in once they have exceeded a benchmark return. It is fair to pay an incentive for excess performance, just not for underperformance as is often the case with most funds.

Private Equity (PE) is the next most common alternative. PE can come in many forms such as venture capital, growth capital, mezzanine, buyout, seed, etc. but it all has essentially the same thing in common. It is investing directly into privately held companies that are not publicly traded. For an investor, the advantage is the ability to access an opportunity set that is not available to the general public.

When analyzing most PE funds, the results for the top quartile performers in each category always stand head and shoulders above the rest. Put another way, if you are not in the top quartile, then you most likely have a pretty lousy investment. Oh, by the way, you are probably locked up in that lousy investment for 10 to 15 years.

When reviewing PE funds I am always reminded of Garrison Keillor and the Tales of Lake Wobegon, where all of the children are above average. It seems that every fund I see assures me they are a true top quartile manager!  This is definitely an area where caveat emptor applies because if you don't know how to recognize the potholes on the road ahead you will be doomed to wreck.

Private Equity can be a very strong investment but it requires having the right partners in your corner to help identify the right managers with which to invest. These are long term investments and the fees are high, so make sure the manager has a distinct advantage and a proven track record of execution.

Let me go back to Granddad.  Sometimes the simplest things get lost in the shuffle. If you take a step back and look around at much of the generational wealth in your community, chances are it is significantly invested in real estate. There are pretty simple reasons for this. First, real estate values are generally stable (or at least a heck of a lot more stable than the stock market) and secondly, there are serious tax advantages to owning real estate, such as the ability to deduct depreciation, tax free re-financings and tax free exchanges when it's time to sell.

From an investment standpoint, owning cash flowing real estate is a way to generate equity-like returns through a combination of steady cash flow, equity build-up through debt amortization and, if you are fortunate, appreciation in the value of the property. To use a baseball analogy, most successful real estate investors are steady singles hitters, targeting modest but predictable properties where they can generate steady income over many years. As a non-professional investor, you should leave the development projects and speculative investments to the pros. Once you own that cash flowing property, you can hold it for many years and the really great properties can be held for generations.

There are a number of tax strategies to further enhance your returns and enable you to keep the majority of your return tax free. That's another whole subject and we will explore that further in another post.

In the world of alts, we have touched on the basics here. There are many other niche strategies that can be very rewarding such as distressed debt, secured lending, secondary market strategies, royalty stream buyouts, and more.

The bottom line is that we live in an investing world where the public markets are extremely volatile, unpredictable and, for the average investor, completely nerve rattling. A carefully selected portfolio of alternative strategies is a prudent way to protect and grow your assets in a much more predictable way.

IMPORTANT DISCLOSURES