Alternative Investments: Sophistication Required

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Finance Industry Series Part 2 of 5

What do hedge funds, private equity, and venture capital have in common? Quite a bit, actually. Today we will look at five things they share.

1. Lightly regulated

While public companies are highly regulated, in the US and most other countries, alternative investments are not. Most of the regulation you are likely to find is how a country defines each category of alternative investment. There might be restrictions around the total dollars in a fund, the size of individual investments, broadly how a fund invests, or other structural requirements.

You might be able to learn how the fund operates – things like investment strategy, fees, and maybe returns – but you most probably won’t be able to find out the names of the investors.

And yet, the lure of high returns is compelling.

“But on January 23rd it emerged that Citadel, a secretive investment firm based in Miami, had generated $16bn in net profits for its clients in 2022, breaking the record for the largest annual gain in dollar terms. Its main hedge fund posted a 38% return—while MSCI’s broadest index of global stocks declined by 18%.” (Source: When professional stockpickers beat the algorithms, The Economist, 1/26/2023)

Doesn’t it seem counterintuitive to under-regulate an industry that is producing gobs of money with extraordinarily high rates of return? I’m so glad you asked!

2. Sophisticated investors only

The theory behind this lack of regulatory oversight is that these high return investment vehicles are available only to the sophisticated investor, also known as an accredited investor. Who are accredited investors? Why, the people and organizations that already have a lot of money, of course!

Investors in alternative investment funds typically include the following:

  • High net worth individuals (HNWIs);
  • Institutional Investors (e.g., pension funds, insurance companies);
  • and Family Offices.

For individuals in the US, this means that they must meet the following requirements:

  • Minimum yearly income of $200,000 or $300,000 joint income, for two documented years and an expectation that such income level will continue;
  • Net worth of more than $1 million; and
  • Significant amount of investment knowledge.

Note: The US uses the term “Accredited Investor,” but other countries have similar definitions using different terms.

3. Pooled investment funds

Even though alternative investment funds are exclusive to the sophisticated investor, the structure of the funds is similar to something you might be invested in – mutual funds. If you are an unsophisticated or “retail” investor (in other words, you don’t have much money), you don’t want to buy four shares of stock worth $300 a share. Instead, you invest your money together with lots of other investors in a mutual fund.

The mutual fund takes this pool of money, and on the advice of a fund manager, invests it in the stock market based on certain investment strategies that match your appetite for risk. You own shares of the fund, and the fund owns shares of stock. You receive gains based on the number of shares of the fund that you own.

Very similar to mutual funds, alternative investment funds are also pooled investment funds.

4. Favorable tax treatment

In the US, but not in all countries – India being a notable exception – alternative investment funds also receive favorable tax treatment.

The key favorable tax treatment is that the fund is considered a “pass-through” entity. If you missed out on the US Trump-era tax break for pass-through entities, here’s a refresher. Typically an entity, such as a corporation, must pay tax on income and gains. The investors in that corporation must then also pay tax on their individual income and gains. But alternative investment funds avoid this double-tax.

  • Alternative investment funds pass the income and gains through to the investors who must pay tax.

This is a really good deal for the fund managers. If they had to pay a tax on the total gains of the fund this would be a deep cut into their profits. After all, the goal is to have very high gains!

5. Hefty fees

And just when you think it couldn’t get any better for alternative investment funds, it does! The owners and operators of alternative investment funds – broadly the fund managers – typically charge two kinds of fees.

  • Management Fee. For every dollar they manage, they charge a management fee. This management fee is due regardless of how the fund performs and is frequently 1%-2%.
  • Performance Fee. If the fund performs well and there is a return on the investment, the fund manager frequently charges 15%-20% of the return on investment.

Now you understand why the pass-through tax treatment is so delicious for the fund managers. They do not owe tax on the returns, but receive a percent of that return in addition to an unfailing management fee. The fund is only taxed on what it receives, not the full return of the fund.

Since The Great Recession, investors have pushed back against these high fees and what used to be fees of “2 and 20” are now more usually “1 and 15.” Other restrictions on performance fees include items such as hurdle rates and high-water marks.

On the downside, if the fund incurs debt and its investments do not make a return, the fund is liable for the debt in its name, while its limited partner investors are not.

Why do we care so much about Alternative Investments?

Money. Yes, it really is that simple. The finance and investment industry generates extraordinary wealth and if your prospect is employed in the field you want to be able to ballpark that prospect’s capacity to make a gift.

And if your prospect is an alternative fund management owner, then the potential for incredible wealth is difficult for us retail investors to imagine.

So, don’t leave it to your limited imagination. You’ve taken the first step to learning more about this kind of wealth. Why not attend a Master Class and learn more, in a safe environment with your prospect research peers?

Additional Resources

Finance 5 Blog Series