“First master the fundamentals.” -Larry Bird
It doesn’t get simpler than that. This is but the second edition of Alt Blend, and we are continuing to examine the basics, with today’s focus being on alternative investment funds. When one spends time contemplating the advent of alternative investment funds (which I have just done), it’s almost surprisingly obvious why they exist. However, it’s also a topic worth spending some time on because it will help us cover some alternative investment essentials.
Imagine you and some of your long-time friends decide to all pitch-in money and buy a few investment properties. Even if you could afford to buy some property individually, there may be appeal in doing this as a group, for several reasons:
- You can buy more properties than you’d be able to on your own (more financial resources, more diversification of risk)
- Each member has a different skill set that will be useful to the group (more expertise); perhaps your group even includes a real estate professional who can source promising off-market deals (more/better access)
- The workload will be more manageable for each member (more human capital)
To help keep track of everything and provide some liability protection, you create a simple legal entity, BFFs Real Estate Partners LLC (aka “BFF LLC”), and you agree to meet regularly to review progress. Depending on how actively involved the group wants to be, BFF LLC may even think it makes sense to hire some additional help – e.g., a handyman/landscaper to maintain the properties or a property manager to ensure tenants are following rules and paying rent on time. It all comes down to whether the expected benefit outweighs the anticipated cost.
Congratulations! By pooling resources and expertise to share in risks (and hopefully rewards), based on what seems to be a good investment thesis, you’ve just created an elementary version of a real estate investment fund. You may be able to make a greater return on your own by concentrating your investment on only one property and being your own handyman/property manager, but it would come with far greater risk and time commitment. Therefore, BFF LLC is a likely option for you.
The above is a convenient simplification of why investors utilize alternative investment funds but, importantly, it highlights the overall premise: To invest in seemingly beneficial areas that we can’t, shouldn’t, or don’t want to invest in ourselves, due to lack of access, experience, desire, resources, or ability to manage risk adequately.
But how do I get my money back?
Now fast forward. BFF LLC has purchased some properties, and things are going well. The tenants are paying rent on time, there have been no major issues, and the value of the properties has appreciated. You then own an asset technically worth more than the money you invested, but what do you do with it? What we haven’t touched on is how you might get your money back out of BFF LLC; i.e., how liquid is it?
“Liquidity” simply refers to how quickly and at what cost investments can be turned into cash. The liquidity spectrum of assets ranges from highly liquid (e.g., short-term, high-quality bonds) to liquid-but-potentially-more-volatile (e.g., stocks, daily-liquid mutual funds, ETFs) to intermittently liquid (e.g., quarterly, semi-annual, annual liquid hedge funds), to illiquid (e.g., private real estate).
One of the first considerations of investing in alts is if, when, or under what circumstances investors can access their funds. But why might liquidity be limited in the first place? Going back to our previous example, if you suddenly decide you want to get your original investment back out of BFF LLC, consider what would need to happen to make this possible. There are a few options: Sell one or more of the properties to help raise the cash; Borrow money against the houses to buy your share of the fund; or, Replace you with a new investor who wants to buy your share.
Each of the above options can have either positive or negative implications for you and the remaining BFF partners. Quickly selling a property could mean doing so at an unattractive price – meaning you may get less money than you thought, and your partners could lose money as well. Taking on additional debt could result in magnified returns (either more positive or more negative) for the remaining partners; it will also involve debt service (i.e., loan payments) that affects the LLC’s cash flow. A new partner would likely want to pay you less than the market value of your investment because it’s in their best interest to do so, and you may find this to be acceptable because you need the cash.
Applying this to the broader world of alternatives, a given fund may restrict liquidity for a number of reasons:
- Because the underlying investments themselves are illiquid
- Even for funds with liquid underlying positions (e.g., stocks/bonds), investment theses can take time to play out, and forced-selling of a position to raise cash can lock-in losses for remaining investors.
- There may be no desire to either:
- Expend the resources required trying to match new investors with outgoing investors, effectively keeping the overall assets of the fund stable, OR
- Take on additional leverage to provide liquidity, as it inherently alters the risk/return profile and may not be possible per the fund’s mandate/terms.
Now that we understand why funds exist and why they may require investors to sacrifice liquidity to participate, we can take a closer look at common structures and uses in our next edition.
Until next time, this is the end of alt.BLEND.
Thanks for reading,
Steve
