Advising Clients since 1980
Alternative Investments
Economic and financial market booms created an enormous amount of wealth for people heavily invested during the bull market. These high-net-worth individuals are now turning with increasing frequency to diversified investment advisors for alternative asset classes to further increase their wealth or protect it.
Alternative assets classes, which include hedge funds, private equity, and real estate, among others, can be used to increase or protect assets from inflation. For example, hedge funds that protect against market downturns can reduce the volatility and risk associated with a portfolio of stocks and bonds. By contrast, a venture capital investment in a startup increases portfolio risk as well as potential returns.
These asset classes are considered “alternative” because, unlike traditional stock and bond investments, they generally seek absolute rather than relative rates of return. Alternative investments attempt to provide compound annual returns, which may include an illiquidity premium that compensates investors for their patience in waiting five to ten years to realize returns.
Why the Affluent Invest
TAlthough the returns can be impressive, high-net-worth individuals often choose alternative assets for reasons that are not strictly financial. Many find this form of investing to be more enjoyable and intellectually rigorous than choosing stocks, and believe that it is an appropriate way to provide for non-essential lifestyle choices, descendants, and charities.
Private investors who have amassed considerable wealth are no longer pre-occupied with meeting their own lifestyle expenses. They can turn their attention to providing for succeeding generations.
Because the expectation is that funds earmarked for beneficiaries will not be needed for a few years, high-net-worth individuals are typically comfortable investing in what are often illiquid vehicles if such investments have the potential to help them achieve their long-term goals. Professionalinvestment advisors can help them with these long-term goals.
Private Equity
The term “private equity” refers to securities that are issued to a small number of individuals and are not yet traded publicly. This asset class includes venture capital, leveraged buyouts, corporate restructuring, and mezzanine financing. A closer look at how each security is structured and the potential rewards provides insight into why many high-net-worth individuals choose to include them in investment portfolios.
Venture capital, a high-profile form of private equity, is an investment in a private company in the early stages of its launch that gives investors equity in exchange for cash. In the late 1990s, venture capitalists were particularly attracted to early-phase technology and biotechnology companies because of the public’s appetite for shares of these businesses. Initial public offerings from such companies sometimes provided a profitable exit strategy to early investors.
Venture capital investing can provide more than financial rewards. This form of investing can allow entrepreneurs who have achieved success to mentor individuals with similar interests. For example, the founder of a successful technology company might wish to invest in a fledgling technology company by providing its executives with advice as well as money. To the executives whose companies are receiving capital infusions, the wisdom provided by experts can be as important as the cash.
Leveraged buyouts, another form of private equity, can involve turning corporate divisions into freestanding companies, acquiring private companies from founders, and/or taking public companies private using borrowed money. Although these moves can be risky, as some investors discovered during the boom-and-bust 1980s, they provide the opportunity for exceptional investment returns.
Corporate restructuring, or investing in distressed securities, involves purchasing stakes in companies facing enormous financial problems, including bankruptcy. Investors in such deals believe these troubled companies have turnaround potential.
Mezzanine financing is a form of private equity that provides investors with senior or subordinated debt, as well as equity in the form of warrants and options, in exchange for their investment. Some companies seek mezzanine financing in the final stage of financing before going public. Investors providing mezzanine financing generally take on less risk than earlier investors and may enjoy early asset appreciation as a result of a public offering.
Hedge Funds
A hedge fund is any private limited partnership permitted to take short positions and use leverage. Although they are called “hedge” funds, they do not necessarily protect against investment risk.
Hedge funds are often likened to mutual funds, but they differ in key ways. The Securities and Exchange Commission (SEC), charged with protecting the investing public, regulates mutual funds, which are open to all investors. By contrast, hedge funds, which are only available to accredited investors, do not have to register with the SEC, and they operate under fewer restrictions.
For example, mutual funds cannot use leverage or make extensive use of short positions. Mutual funds also have disclosure requirements; hedge funds are free to operate in relative secrecy. Mutual funds raise money from the general public. Hedge funds raise capital from a limited number of partners who have invested in the fund, and hedge fund managers usually have a significant portion of their own money invested in their funds.
It is important to keep in mind that not all hedge funds are created equal. Domestic hedge funds frequently have offshore counterparts, called “mirror funds,” domiciled in international tax havens to provide tax benefits for investors not subject to U.S. tax laws. Mirror funds are only open to non-U.S. investors.
Real Estate
An additional alternative asset class that high-net-worth individuals can consider is real estate, which provides protection against inflation as well as the potential for high returns.
High-net-worth individuals can invest in real estate through the outright purchase of properties or through portfolios of holdings structured much like private equity and hedge fund private partnerships.
A Real Estate Investment Trust (REIT) is another option. Although a REIT is very much like a real estate partnership, most REITs are publicly traded instruments, functioning somewhat like a mutual fund. A REIT’s underlying assets are generally property or real estate management operations.
Plan Your Investments by Determining Objectives
Before investing in alternative assets, it is important to align your investment objectives with what you are likely to achieve. Expected returns and the risks must be carefully considered before investing. Once goals are well understood, you and your advisor can determine which vehicles are appropriate and how much, if any, of your wealth you wish to commit to them.
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Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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