Understanding Alternative Investment Assets in Detail

Imagine you’ve gone on a vacation in the mountains. But this is quite an active trip, where you’re going on long hikes for the most magical views.

Many a time, there are several different routes that one can take for different types of views. One route can take you through a path hugging the cliff, for instance. Another can lead you through a forest and a third can lead you by a waterfall.

Each path is similar, of course. But it is the slight variations, especially in the approach and the intention, that make all the difference.

When it comes to alternative investments, private equity funds and hedge funds are two of the most popular asset classes. While they share some common ground as alternatives to traditional stock and bond investments, their strategies, target investments, and approaches to value creation markedly differ. In this chapter, we’re going to delve into these differences and understand them in detail.

Private equity funds, as the name suggests, refer to investment funds that directly invest in private companies.

Imagine a group of seasoned investors, each bringing a wealth of experience and capital. They band together and form a private equity fund with a specific goal — to find companies with untapped potential or those in need of a turnaround. They’re not interested in just being passive investors; they’re more like strategic partners. They often take a more hands-on approach in guiding the companies they invest in.

Once they identify a suitable company, the fund can buy a major stake or even acquire the company outright. This is where the real work begins.

Unlike public equity, which focuses more on the identification of value, private equity focuses more on outright creation.

The PE fund isn’t going to wait for the company to grow on its own and capture a market share. No, the fund experts actively participate in the company’s operations and look for ways to improve efficiency. They explore operational improvements, expansion into new markets and a variety of other strategies.

The story of a private equity investment culminates in an ‘exit’, where the fund seeks to sell its stake in the company for a significant profit. This could be through an initial public offering (IPO), selling to another private equity firm, or finding a strategic buyer.

From a boutique bank to a financial powerhouse — The growth of Blackstone

Blackstone first forayed into private equity in 1987, just two years after its inception. The firm raised its first fund, totalling $800 million, quite a significant sum at the time.

Over the years, Blackstone’s private equity division grew exponentially, both in terms of assets under management and the diversity of its investments. One of the key strategies is the focus on distressed assets and companies with high potential for operational improvements.

Feathers in Blackstone’s Cap:

1. Hilton Hotels Corporation:

In 2007, Blackstone acquired Hilton for $26 billion, in what was then the largest hotel buyout. Blackstone transformed Hilton through strategic management changes, expansion, and debt restructuring. When Hilton went public again in 2013, its value had increased significantly, resulting in substantial profits for Blackstone.

2. Equity Office Properties:

Acquired in 2007 for $39 billion, this was one of the largest leveraged buyouts in history. Blackstone skilfully navigated the pre-recession real estate market, selling numerous properties from the portfolio at a profit.

3. Versace:

In 2014, Blackstone acquired a 20% stake in the luxury fashion brand, helping to revitalise its operations and expand globally. The investment paid off when Michael Kors bought Versace for $2.12 billion in 2018.

Hedge funds pool capital from various HNIs and institutional investors and deploy them across a range of different assets. They’re quite similar to mutual funds but can take on more complex investment strategies.

Hedge funds work on a very simple premise — to achieve the highest possible returns for its investors, regardless of the market conditions. To achieve these ambitious targets, hedge funds use a wide range of investment strategies.

Some funds engage in long/short equity strategies. This means that they buy stocks that they consider undervalued and short stocks they deem overvalued.

Others can focus on global macro strategies and make bets on economic trends across different countries and asset classes. We can even have hedge funds that focus on event-driven strategies and aim to capitalise on corporate events like mergers, acquisitions, or even bankruptcies.

One of the defining characteristics of hedge funds is their use of leverage – borrowing capital to amplify their investment potential. This can allow them to tap into higher returns. However, it also increases the risk and makes hedge funds a double-edged sword.

Additionally, hedge funds often trade in derivatives – financial instruments whose value is derived from underlying assets like stocks, bonds, currencies, or interest rates. This allows them to hedge against potential losses in their other investments, a strategy from which the term ‘hedge fund’ originates.

Historical Growth in Hedge Funds

The Cautionary Tale of Using Too Much Leverage

Let’s explore the story of Archegos Capital Management, which collapsed in 2021.

The Rise

Archegos was a family office run by Bill Hwang, a former hedge fund manager. The firm’s strategy involved taking large positions in a small number of companies, using total return swaps. These swaps are agreements to exchange the returns on a stock or other asset for cash flows based on a predetermined rate. They allowed Archegos to gain exposure to stocks without actually owning them, thereby sidestepping typical disclosure requirements.

The Storms Start Brewing

The trouble began in March 2021, when the share prices of some companies Archegos was heavily invested in started to fall. This decline triggered margin calls from the banks that had lent to Archegos, requiring the firm to provide additional capital to cover its leveraged positions.

However, due to the size of the positions and the amount of leverage used, Archegos was unable to meet these margin calls. This forced the banks to start selling the stocks tied to Archegos’ positions, leading to a further decline in their prices and exacerbating the situation.

The Collapse

The collapse of Archegos had significant repercussions. The firm’s losses were estimated to be around $20 billion, making it one of the most significant losses in the history of Wall Street. Major global banks that had dealings with Archegos, like Credit Suisse and Nomura, reported billions of dollars in losses due to their exposure to the firm.

1. Investment Time Horizon

   Hedge funds typically aim for short-term returns.

   They focus more on investments that can yield good ROI within a shorter period. The fund managers prefer liquid assets as this allows them to rapidly move from one investment to another, in response to the changing market conditions.

   As for the investment duration, that can range from mere seconds to a couple of years, with a primary focus on quickly realising profits.

   Private Equity funds, on the other hand, are more oriented towards long-term investments.
   They are not just looking for quick gains but substantial profits over a longer time period, usually 5 to 7 years. Because of the nature of their investment strategy, quick exits aren’t really in the cards. After all, to acquire a controlling interest in a company and then help it create value from scratch is quite a time-consuming process, as you can imagine.

   It is only after the improvements have been made and valuations have increased that PE funds can consider selling their stake for a significant profit.

2. Capital Investment

   Limited Partners in PE funds commit their capital beforehand but are only called upon to invest it as needed. This generally happens after the General Partners identify the target companies and complete their due diligence process.

   The fund capital is then invested as a whole for a certain period, typically ranging from 3 to 10 years. Failure to meet a capital call can result in penalties for the LPs.

   Hedge funds work differently. Investors place their money all at once. There are also no restrictions on the time commitment, which means that investors can liquidate their holdings more freely.

3. Legal Structure

   Hedge funds are generally structured as open-ended funds. This means, investors can enter and exit at their convenience. In comparison, PE funds are typically closed-ended, with restrictions on transferability over a set period.

4. Fee Structure and Compensation

   Hedge funds base their fee structure on the high-water mark principle.
   Consider an investor who decides to invest ₹1 million in a hedge fund at the beginning of the year. The fund performs well initially, and by the end of the year, the investment has grown to ₹1.2 million.

   This is great news for both the investor and the hedge fund as it can charge a performance fee, generally around 20% of the profits. The high-water mark is set at ₹1.2 million. This ensures that the fund only receives a performance fee for the profits that exceed this level in the future. Essentially, it’s a benchmark that prevents the investor from paying performance fees on the same profit twice.

   In the next year, the market dips and the investment value falls back to ₹1 million. In the third subsequent year, the performance picks up again and the fund closes the year at ₹1.3 million.

   Here’s where the high-water mark plays an important role. The fund earns a performance fee only on the ₹1,00,000 profit above the ₹1.2 million mark, not on the entire ₹3,00,000 gain from the original investment.

   PE funds usually charge a management fee and a carried interest. They also employ a hurdle rate system, where the fund earns incentive fees only after surpassing a predetermined return threshold.

   Consider an investor who invests ₹1 million in a PE fund. They will have to pay about 2% of this amount as the management fee and a separate amount, generally 20%, as the carried interest. This means the PE fund will retain 20% of the profits.

   However, the carry is only applicable after a certain threshold return is achieved, known as the hurdle rate. Suppose the hurdle rate is set at 8%. The PE fund must generate returns exceeding this rate before it can claim its 20% share of the profits.