Even after the declines of 2022, the disparity between stock prices and fundamentals continues to be a topic of discussion among investors. As Jeremy Grantham eloquently put it, we find ourselves in a situation where stock market valuations are at the top 1%, while economic outcomes are at the bottom 1%. With continued volatility in the stock market and longer-term yields rising despite the Fed lowering the short end of the curve, investors are increasingly turning to non-correlated alternative asset classes. A survey conducted by Peltz International revealed that alternative investments constituted the largest portion and performed the best among typical family office portfolios in 2018. An objective of diversifying portfolios with alternative investments is to maintain positive returns during market downturns, an increasing possibility as the market continues to make new all-time highs and the Shiller P/E approaches 40.

Asset management experts at a recent Milken Global Institute Conference suggested that the traditional 60/40 portfolio (60% stocks and 40% bonds) is becoming outdated, with alternatives expected to play a larger role in investors' portfolios over the next decade. GMO, headed by Jeremy Grantham, advises its clients to deviate from the conventional 60/40 mix, similar to their approach in 1999. GMO forecasts an average return of -5.7% for US Large Cap Equities over the next seven years. David Rosenberg, former chief economist at Merrill Lynch, recommends shifting portfolios toward real or tangible assets that generate reliable cash flows, given the era of financial engineering and central bank manipulation. In November 2019, Morgan Stanley Wealth Management predicted a 2.8% return for the 60/40 portfolio over the next 10 years, when the market was at a lower level than today. Research Affiliates' forecast for a 60/40 portfolio over a decade is -0.4%. A Bank of America's report titled "The End of 60/40" confirms the diminishing role of bonds as a hedge to equities. Citibank's Chief Economist states that there is a 100% historical probability of market downturns in the next 12 months at current levels. John Hussman of Hussman Funds expects a significant decline of 65-70% in the S&P 500 during the current market cycle.

Traditionally investors have allocated to hedge funds for their alternative’s exposure, yet these did poorly in 2008 and lackluster since. Amadeus Wealth Alternatives has conducted due diligence on a number of alternative asset classes and recommend investors consider the following:

Private debt, private equity and real estate on a primary and secondary basis, direct and co-investments, venture investing, direct secondaries, helicopter leasing, multi-alternative, general partner interests, litigation finance, energy, and other special situations.

Discussing private credit, it is essential to mention business development companies (BDCs). In 1980, the Small Business Investment Act was passed to increase capital flow to privately owned U.S. companies, resulting in the formation of BDCs. These investment vehicles allow investors to pool capital in a tax-advantaged manner for investing in the debt and equity of privately held American businesses. BDCs are exempt from entity-level taxation as long as they meet certain regulatory and IRS guidelines. They distribute 90% of their income and capital gains to investors and can be publicly traded or non-traded. BDCs typically offer returns between 8% and 12%, but since they can add leverage, higher returns are possible. They exist in publicly traded and non-traded forms, the latter experiencing liquidity via an IPO or merger at some point in their lifecycle. 

Another form of private debt comes from Small Business Investment Companies (SBICs). These privately-owned investment companies are licensed by the Small Business Administration (SBA) and provide financing to small businesses in both the equity and debt arenas. SBICs offer an alternative to venture capital firms for small enterprises seeking startup capital. These funds raise between $50 million and $100 million from private investors and can borrow a multiple of this amount from the SBA. The interest rate charged by the SBA are relatively low compared to what the funds subsequently charge borrowers, creating an inherent leveraged return. SBICs often pay investors between 8% and 12% and have a preferred return (see below for a definition) of 8%.

Mezzanine or 'mezz' funds represent another type of private debt. Mezzanine debt is subordinated to another debt issued by the same issuer and often have equity instruments, such as warrants, attached. Mezzanine debt is commonly associated with acquisitions and buyouts. Embedded options in mezzanine debt can include stock call options, rights, and warrants. These funds have generated returns between 10% and 15%, particularly when warrants have played a role.

Real Estate Investment Trusts (REITs) are excellent diversifiers. Equity REITs invest in and own properties, generating revenue mainly from rents. Mortgage REITs involve property mortgages, either by loaning money to real estate owners or by purchasing existing mortgages or mortgage-backed securities. Hybrid REITs combine strategies from equity and mortgage REITs. Non-traded REITs are preferred due to their lower correlation with the S&P 500, providing non-correlated return streams. REITs can be well diversified or concentrated in specific sectors such as health care, residential, global, industrial, or city-specific real estate. Like BDCs, non-traded REITs typically offer liquidity when the IPO market is favorable. 

Multi-family housing is another popular real estate investment option. Investors can participate in new developments or acquire existing projects. Renovating older properties, known as "value-add", can lead to price appreciation. Rental income is often distributed, and sponsors can generate cash-on-cash returns of 6% and higher. Selling the property can result in internal rates of return (IRR) in the high teens or even '20s.

Private equity (PE) is a popular alternative investment that involves purchasing an interest in a privately held company. These investments have less liquidity than traditional investments and typically follow the so-called "J-Curve" cash flow pattern. Institutional investors sometimes sell their private equity interests into a secondary market, creating opportunities for secondary funds to purchase illiquid partnerships. Secondary funds can offer outsized returns by reducing the holding period and bypassing the early years' negative returns. Preferred returns for secondary funds are often around 8%. There are even so-called ’40 Act’ secondaries, investments that are registered with the SEC and structured to offer liquidity with 90 days’ notice, rather than require a ten-year hold, as is typical with primary funds.

Venture investing focuses on newly formed companies. Angel investors and venture capital funds typically invest in venture rounds, which are categorized as A, B, C, etc., with each round representing a different stage of funding. Some funds target specific rounds, seed and A for example, while others focus on later-stages, just before an IPO. Venture funds often target IRRs above 25%.

Co-investment opportunities are sometimes offered by private equity firms funds. Co-investment strategies involve making direct investments alongside a fund, enabling investors to avoid management fees and carried interest. These opportunities arise when a fund requires additional capital for an existing portfolio company or when a new acquisition opportunity arises. Co-investments can be offered by PE, Credit and Venture funds or funds specializing exclusively in co-investments.

Direct secondaries, also known as Pre-IPO investments, involve acquiring equity ownership positions in unlisted private companies through privately negotiated transactions. These investments anticipate an IPO within a few years, potentially offering significant returns. Funds in this category have a target return between 25% and 30%.

Helicopter leasing funds focus on a diversified portfolio of global commercial aviation investments, particularly those backed by commercial helicopters rather than fixed-wing assets. These funds aim for 12%-14% net returns and high single-digit quarterly distributions.

Apart from traditional investment options such as mutual funds, ETFs, and individual equities, there are several alternatives that provide direct exposure to the energy markets. Limited partnerships, working interests, master limited partnerships (MLPs), and unit investment trusts (UITs) offer pass-through treatment of both income and deductions derived from oil and gas investments. Investors can participate in the industry up-, mid-, or down-stream. Upstream operations involve the exploration stages, midstream activities focus on processing and transporting oil and gas, and downstream operations can include refining and distributing by-products to the retail level. Funds that diversify across various alternative categories are preferred, combining riskier aspects with more conservative ones. For example, a fund could develop a diversified portfolio of mezzanine capital investments, combined with investments in independent producers, and also invest in midstream assets. These managers can also participate in oil and gas exploitation and development projects. Such funds typically offer an 8% preferred return and target an IRR in the high teens.

Investors interested in tax benefits associated with oil and gas drilling partnerships can benefit from deductions that include tangible and intangible drilling costs (75%-85%) and a depletion allowance (15%) on a portion of income received from partnership wells. Limited partner interests are often sought by investors looking to offset a portion of their passive income. Alternatively, investing as an Investor General Partner provides different tax benefits, such as deducting losses described earlier (intangible/tangible/depletion) against active income reported on a tax return, a so-called “above the line deduction”.

Litigation finance funds offer asset-backed capital investments in mature litigation cases with established liability of the defendant and precedent regarding settlement. These funds invest in various legal proceedings and can achieve target returns in the high teens. They also make loans to firms and can therefore be bucketed in the private credit space.

Lastly, there are unique funds that acquire minority interests in private equity and real estate funds, so-called “co-GP” funds, that allow limited partners to participate in the general partner's 2% & 20% fee structure.

Litigation finance funds offer asset-backed capital investments in mature litigation cases with established liability of the defendant and precedent regarding settlement. These funds invest in various legal proceedings and can achieve target returns in the high teens. They also make loans to firms so can also be bucketed in the private credit space.

Lastly, there are unique funds that acquire a minority interest in private equity funds, allowing limited partners to participate in the general partner's 2% & 20% fee structure. These funds provide another avenue for investors to explore alternative investment opportunities.

The “preferred return” or "hurdle rate" (“Pref”) is a term used in the world of private Limited Partnerships. It refers to the threshold return that the Limited Partners of a fund must receive, prior to the General Partner receiving its share of profits, often referred to as carried interest or "carry." The former is often 8% and the latter 20%. The so-called “2 & 20” fee structure consists of an annual 2% management as well as the 20% carried interest. Occasionally a fund will offer a higher Pref; 10%, 12% or even 15%, as an incentive for investors to participate in the early stages of fund raising.

In addition to the more traditional investment options like mutual funds, ETFs, and individual stocks and bonds, alternative investments provide avenues for more direct exposure to various markets. Amadeus Wealth Alternatives recommends diversifying across different alternative asset classes, combining more conservative with riskier asset classes to achieve a well-rounded portfolio. These investments offer the potential for non-correlated returns, which can help mitigate volatility and provide a hedge against market downturns. It is important to conduct thorough due diligence and consult with a financial professional before making any investment decisions.

 

Here is a summary of common terms related to alternative investments:

  • 2&20: Private funds often charge a 2% management fee and take 20% of the profits, often called the “carried interest” or “carry”.
  • 40 Act: The securities act of 1940. We use the term to describe alternative investments which are registered with the SEC. They often have quarterly liquidity because they come in the form of an Interval Fund or BDC and can be custodied at a brokerage house.
  • Asset Class: Broad category of investments. Alternative asset classes include: Private debt, private equity and real estate on a primary and secondary basis, promissory notes, equipment and aircraft leasing, direct and co-investments, venture investing, energy, options trading, multi-alternative, GP (General Partner) interests, litigation finance, mineral royalties, and other special situations.
  • BDC: A business development company is a fund that invests in small and medium-sized companies as well as distressed companies. A BDC helps the small and medium-sized firms grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain sound financial footing. Set up similarly to closed-end fund, , many BDCs are typically public companies whose shares trade on major stock exchanges however they can be illiquid as well.
  • Capital Calls: Many private funds frequently ask investors to send the commitment they’ve made to the fund over a period of years, ranging from all at once to up to 4-5 years.
  • Co-investment: Where a private equity fund offers investors the opportunity to invest alongside the fund in a company they are acquiring, or lending to, but not through the fund, rather, as a direct investment, so often no fund level fees apply, like the 2&20 for example.
  • Correlation: Refers to the behavior or one security or class of securities to another. If Stock A goes up 10% and stock B does the same, they are perfectly correlated and behave the same, a 100% correlation. If Stock A goes up 10% and Stock B goes down 10%, they are perfectly negatively correlated, so they do the opposite. Correlations range from -1 to +1, with a zero representing no correlation. The more non-correlated investments you have in a portfolio, the less volatile it will be. Alternative investments have low correlation to the stock market.
  • Illiquidity Premium: Investors of illiquid assets require compensation for the added risk of investing their funds in assets that may not be able to be sold for an extended period. Accordingly, illiquid investments can have higher returns than liquid ones over similar time horizons.
  • Interval Fund: An interval fund is a type of pooled investment vehicle similar to a mutual fund that allows the issuer to repurchase fund shares from its shareholders at certain points in time, or intervals, allowing the investor to sell an otherwise illiquid investment, usually on a quarterly basis.
  • J-Curve: The early years of a private equity investment are often negative, so the shape of the investment return looks like the letter “J”. A fund will acquire companies in years 1-3 of the fund’s life, improve them in years 4-7 and sell them in years 5-10, so the investor’s profits don’t materialize until later on. Meanwhile the 2% management fee is charged every year, so the returns are negative early on.
  • Opportunity Zone: A Qualified Opportunity Zone (QOZ) is an economically distressed community where private investments, under certain conditions, may be eligible for capital gain tax incentives, in particular, the deferral of capital gains until 2026. Opportunity Zones were created under the 2017 Tax Cuts and Jobs Act , signed into law by President Donald J. Trump on December 22, 2017, to stimulate economic development and job.
  • Options: Options can be a CALL or a PUT. A CALL is a right to buy a security at a specific price and a PUT is a right to SELL. CALLs go up in value if the associated stock price rises and PUTs go up in value if they fall, similar to going “short”. Combinations of options in a “spread” are often used to hedge stock exposure in anticipation of a market decline.
  • Private Credit: Like a private equity fund but using debt. A private debt fund will make loans to private companies.
  • Preferred Return: Often 8%, although sometimes higher or lower, which the limited partner (LP) investor must earn before the general partner (GP) can take their carried interest.
  • SBIC: A small business investment company is a type of privately-owned investment company that is licensed by the Small Business Administration (SBA). They have the potential to outperform owing to the leverage associated with the low interest loan the SBA provides to the fund.
  • Secondary Investments: The purchase of a limited partnership from an investor who bought it years ago. For example, if the Yale University Endowment invested in a private equity fund years ago, and then decided they wanted to sell it today, how do they accomplish this given the fact the fund requires a ten-year commitment and is illiquid? There is a secondary market for these interests and many funds are established for the very purpose of buying these illiquid shares.
  • Standard Deviation: a measure of the volatility of data including a portfolio’s return. It measures the extent to which returns vary above and below its average 68% of the time (one standard deviation) and 95% of the time (2 standard deviations). Given two portfolios with the same average return, the less volatile it is, the higher the value over time.
  • UBTI: Unrelated business taxable income is income earned by a tax-exempt entity, such as an IRA, that is not related to the exempt purpose of the tax-exempt entity, thereby causing the IRA to have taxable income. This tax can be avoided by investing in an offshore vehicle sometimes offered by private funds since the offshore entity can block the UBTI.
  • Waterfall: In the traditional waterfall structure, the GP receives carried interest after the invested capital and preferred returns have been paid back. This assures the GP will receive its carry early in the life of the fund. However, in the "European style" waterfall, GPs must pay back the invested capital on the investments liquidated as well as the invested capital on investments that have not been sold yet. This precludes the carry from being paid to the GP until the later years of the fund when all invested capital has been repaid back first.
  • Warrants: Warrants are a derivative that give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration. They are sometimes issued to debt funds alongside their loans to private companies so the fund can participate in the appreciation of the company’s private stock.

 

While historically made available only to institutional investors, Amadeus Wealth Alternatives often has access to these funds at lower minimums for individual investors. Please do not hesitate to contact us at 212-697-3930 should you wish to consider investing in alternatives. Our opinions are subject to change without notice and are not intended as investment advice or a solicitation for the purchase or sale of any investment or security. Please consult your financial professional before making any investment decision.

*Potential investors should be aware that an investment in Limited Partnerships involves a significant degree of risk and, therefore, should be undertaken only by investors capable of evaluating the risks of a Fund and bearing the risks they represent. In addition, there may be occasions when the Principals, General Partner, Advisor, Sub-Advisor and their respective affiliates may encounter actual and potential conflicts of interest with respect to a Fund. Prospective investors in a Fund should carefully read the Risks Section of a Fund’s Private Placement Memorandum and consider the information discussed therein which enumerates certain material risk factors and conflicts with respect to the Fund. If any of the events discussed in these sections occur, the Fund’s business, financial condition, results of operations and prospects could be materially adversely affected. In such case, performance could decline, the Fund’s ability to achieve its investment objective could be negatively impacted and investors may lose all or part of their investment.