Even after the declines of 2022, the disconnect between stock prices and economic fundamentals remains a critical topic among investors. As Jeremy Grantham aptly noted, stock market valuations are in the top 1% of historical levels, while economic conditions sit in the bottom 1%. With ongoing market volatility and rising long-term yields, despite the Federal Reserve's efforts to lower short-term rates, investors are increasingly seeking non-correlated alternative asset classes.

A survey by Peltz International found that alternative investments constituted the largest allocation and delivered the strongest performance among typical family office portfolios in 2018. The primary objective of diversifying with alternative investments is to generate positive returns during market downturns, a growing concern as equities continue to reach new highs and the Shiller P/E ratio nears 40.

At a recent Milken Global Institute Conference, asset management experts suggested that the traditional 60/40 portfolio (60% stocks, 40% bonds) is becoming outdated, with alternatives expected to play a larger role in portfolios over the next decade. GMO, led by Jeremy Grantham, advises deviating from the conventional 60/40 allocation, as it did in 1999. GMO forecasts an average return of -5.7% for U.S. large-cap equities over the next seven years. Similarly, David Rosenberg, former chief economist at Merrill Lynch, advocates for a shift toward tangible assets that generate steady cash flows, given the prevalence of financial engineering and central bank intervention.

In November 2019, Morgan Stanley Wealth Management projected a 2.8% annual return for the 60/40 portfolio over the next decade—when market levels were lower than today. Research Affiliates forecasts a -0.4% return for a similar portfolio, while Bank of America’s report, "The End of 60/40," highlights the diminishing role of bonds as an equity hedge. Citibank’s Chief Economist has noted a 100% historical probability of market downturns within 12 months at current valuation levels. Meanwhile, John Hussman of Hussman Funds predicts a 65-70% decline in the S&P 500 during this market cycle.

Traditionally, investors have turned to hedge funds for alternative exposure, though these performed poorly in 2008 and have delivered lackluster returns since. Amadeus Wealth Alternatives has conducted extensive due diligence on a range of alternative asset classes and recommends that 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, leasing funds, promissory notes, multi-alternative, general partner interests, litigation finance, energy, and other special situations.

Private Credit: A Key Component of Alternative Investments

Business Development Companies (BDCs)
Established under the Small Business Investment Act of 1980, BDCs were designed to increase capital access for privately held U.S. companies. These tax-advantaged investment vehicles allow investors to pool capital into debt and equity opportunities, provided they distribute at least 90% of their income to shareholders. BDCs, which can be publicly traded or non-traded, typically yield returns between 8% and 12%, with potential for higher returns through leverage.

Small Business Investment Companies (SBICs)
Licensed by the Small Business Administration (SBA), SBICs provide financing to small businesses in both equity and debt forms. These funds raise $50-100 million from private investors and can borrow a multiple of that amount from the SBA at relatively low rates. SBICs generally offer investors returns between 8% and 12%, with an 8% preferred return.

Mezzanine Debt
Mezzanine or "mezz" funds provide subordinated debt, often with equity-linked instruments like warrants. Commonly used in acquisitions and buyouts, these funds have historically generated returns between 10% and 15%.

Real Estate: Diversification Beyond Traditional Markets

Real Estate Investment Trusts (REITs)
Equity REITs own properties and generate revenue through rents, while mortgage REITs focus on financing real estate through loans and mortgage-backed securities. Hybrid REITs blend both strategies. Non-traded REITs are particularly attractive due to their lower correlation with the S&P 500.

Multi-Family Housing
Investors can participate in new developments or acquire existing projects, often using a "value-add" approach to renovate properties for appreciation. Rental income distributions and property sales can yield IRRs in the high teens or 20s.

Private Equity and Venture Capital

Private Equity (PE)
PE investments involve acquiring interests in privately held companies, which often follow a "J-Curve" cash flow pattern. Secondary PE markets create opportunities to buy illiquid partnerships at a discount, reducing holding periods and early-stage losses. Secondary funds typically offer preferred returns around 8%.

Venture Investing
Venture capital investments focus on startups, with rounds categorized as Series A, B, C, etc. Venture funds often target IRRs above 25%, and pre-IPO direct secondary investments can yield 25-30% returns.

Unique Alternative Investment Opportunities

Co-Investments
Co-investments allow investors to participate alongside PE, credit, or venture capital funds without paying management fees or carried interest.

Helicopter Leasing
These funds focus on commercial aviation investments, specifically helicopters, targeting net returns of 12-14% with steady quarterly distributions.

Energy Investments
Investors can gain exposure to energy markets through limited partnerships, master limited partnerships (MLPs), and unit investment trusts (UITs). These structures provide pass-through tax treatment and allow participation across the energy supply chain (upstream, midstream, and downstream). Preferred returns in energy-focused funds are typically around 8%, with IRRs targeting the high teens.

Litigation Finance
Litigation finance funds invest in legal claims where liability is well-established. These funds can yield high teen returns and may be considered part of the private credit space. These funds also make loans to law firms and can therefore be considered a form of private credit.

Co-GP Funds
Co-GP funds acquire minority interests in PE and real estate funds, allowing limited partners to share in general partners' management fees and carried interest (the 20% of profits).

The Role of the Preferred Return

The preferred return (or "hurdle rate") is the minimum return that limited partners must receive before the general partner earns its share of profits (carried interest). A standard structure is "2 & 20", a 2% annual management fee and 20% carried interest. Some funds offer higher preferred returns, ranging from 10% to 15%, to attract early investors.

Conclusion

Beyond traditional investments like mutual funds, ETFs, and individual equities, alternative investments offer a path to enhanced diversification and non-correlated returns. Amadeus Wealth Alternatives advises a balanced approach that blends conservative and high-growth alternative asset classes. However, thorough due diligence and consultation with financial professionals are essential before making 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.
  • Distribution to Paid-In Capital (DPI). A metric used to measure the return on investment for limited partners in a private equity fund, calculated by dividing the total amount distributed to investors by the total amount of capital they have paid into the fund.
  • 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 like 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.  Meanwhile the 2% management fee is charged every year, so the returns are negative early on.
  • Multiple On Invested Capital (MOIC). It is a metric used to measure the return on investment for a private equity fund or investment, calculated by dividing the total value of the investment (including any remaining unrealized value) by the initial amount invested. MOIC is often expressed as a multiple, such as 2x or 3x, indicating that the investment has returned two or three times its initial value.
  • 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, particularly 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, like 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.

*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.