Before understanding alternative investments, we need to understand conventional investments. Investments in securities like stocks, bonds, and cash are known as conventional investments. Investments outside these categories such as Private Equity (PE), Venture Capital (VC), Hedge Funds, Real Estate, Commodities, Derivatives, Art, and Antiques are known as Alternative Investments. Alternative Investments can also include investments in Certificate of Deposits or investments in PPF or chit funds in India.
Private Equity Funds
Private Equity funds are pooled investment funds managed by PE firms that make large investments in private companies with huge growth potential which have exited their startup phase and have become more stable companies. A private equity fund attracts investment from institutions and high-net worth individuals (HNIs) who wish to invest in private companies before they go public.
A Private Equity firm acts as both investor and fund manager of the fund. They are usually required to invest at least 2% of the entire fund size to show their commitment to managing the fund successfully.
Before starting any PE fund, PE firms are supposed to attract investors for their funds. To do so, PE firms prepare a prospectus where they talk about the management team, the risk involved, tax implications, and most importantly the investment strategy of the fund. PE firms are required to show the prospectus to all potential investors. After understanding the document properly the investors may choose to invest in the PE fund. This fund is then used to invest in companies. The type of investment the fund makes must match the prospectus mandate.
They usually buy a large stake in these private companies and have significant control over the board meetings and are actively involved in the company’s decision-making process. They do this to take care of their investments and to make sure that the companies do not make any decisions that could devalue their investments. Some PE funds also invest in early-stage startups, such funds are called venture capital funds. Venture capital funds are a subcategory of PE funds, however, there are a few differences that have been explained later in the article.
PE funds are also involved in buyouts of distressed companies that have the potential to be valuable but are being held back due to bad decisions made by the management or because the companies have run out of money. The PE firms buy these companies and restructure the whole business to make them profitable and hence more valuable and then exit the investment making a huge profit in the process. Another type of buyout PE funds are involved in are Leveraged Buyouts (LBO). In an LBO, PE firms buy companies with zero or next to zero debt using very little equity and a large amount of debt. In doing so, the PE funds get a large return on their investment as they had put up very little equity in the investment. LBOs are very popular in the USA, however, the company laws in India are structured in such a way that PE funds executing a leveraged buyout is next to impossible.
The PE firms generally follow a fee structure of 2 & 20, where they charge an annual 2% fee of the total AUM and a 20% share of the profit earned by the investment. However, some PE firms reduce the management fee to attract more investment.
Venture capital funds
As we know a venture capital firm is a firm that invests in innovative startups. A venture capital fund is a pooled investment fund managed by the venture capital firm which invests in innovative early-stage ventures in any growth industry. A venture capital fund attracts investment from institutions and high-net worth individuals (HNIs) who wish to make early investments in growth industries.
The structure of the VC fund is similar to that of the PE fund where the VC firms have to prepare an investment prospectus based on which investors invest money in their fund. The VC firms then use this fund to invest in early-stage startups in innovative growing industries.
The nature of the VC fund is such that all the investments made by the fund are high-risk and high-return investments. The companies they invest in have the potential to be very successful unicorns if run efficiently by the management. However, most startups fail even after receiving large investments due to bad management of funds, or several external reasons. Therefore VCs take an active interest in the companies and sit on the board of directors and get involved in the company’s decision-making process so that they can reduce the risk of the startups failing.
The VC firms earn revenue by charging an annual management fee of 1-2% of the total asset under management (AUM). After exiting an investment, they take 20% of the profit over the hurdle rate. The hurdle rate is the predetermined minimum benchmark returns the VCs are expected to earn for their investors.
Hedge Funds are also pooled investment funds that employ complex trading and investment strategies often by using leverage, trade in various financial instruments including equity, debt, commodities, currencies, and other complex financial instruments to generate superior returns for their investors. Hedge funds invest in both public and private companies and can employ any kind of strategy like taking a majority stake in the company and take management decisions like cutting costs, restructuring the management structure, or even replacing the board of directors to boost the stock price of the company. Hedge funds are also involved in Management Buyouts (MBO) and Leverage Buyouts (LBO) if they could earn profits.
Hedge Funds are also involved in the active trading of stocks, commodities, fixed-income securities, derivatives, and other types of complex instruments. They take both long and short positions in the market and profit from the spread. They also employ high-frequency algorithmic trading where they profit from small variations in stock prices.
Hedge funds engage in high-risk investments and they disclose the same to the investors. Due to the high-risk nature of hedge funds, only Institutional investors and HNIs invest in them. Hedge Fund managers earn revenue through a management fee and an incentive fee. The annual management fee is usually 1-2% of the AUM and the incentive fee is 20-25% of the profits over the hurdle rate.
To understand more about the regulatory environment of these alternative investments in India, read our insight ‘Regulatory environment and Classification’.