“You can’t get second things by putting them first. You get second things only by putting first things first.”-C.S. Lewis
Before we get into what will surely be a riveting discussion, I first want to express my gratitude for being welcomed to the Thoughts on Money family as a regular contributor. As some of you know, I’ve been writing consistently as a solo artist for the past six years under Alt Blend, which primarily focused on Alternative Investments.
Alts seemed like the best way to complement other thought leadership from my colleagues at TBG, but joining TOM is an opportunity to expand the range of topics, which is exciting. If I can create greater utility for more readers (while not letting the team down), I will consider this endeavor a success.
That being said, someday I may actually venture into topics outside the realm of Alts, but today it seems only appropriate to cover the basic structures of Alts, as it’s a subject yet to be covered in TOM. And, after all, we need to put first things first. Here we go!
Come for the Why, but stay for the How and What
David Bahnsen has written about Why and How We Use Alternatives, which is a useful read for understanding the How and Why of Alts from the TBG perspective (aptly titled, eh?). TLDR: Alternatives are investments that offer us idiosyncratic (i.e., different) risks from one another and from what we are exposed to in public markets. As David puts it, these risks are largely tied to “the execution, talent, and specific risks of a given manager.”
In other words, Alts let us incorporate different income, return, risk, and volatility profiles into portfolios vs. what is possible in the publicly traded realm, therefore providing true diversification. Moreover, much of our (i.e., TBG’s) alternative investment exposure focuses on private markets (e.g., private equity, private credit, private real estate), and it doesn’t hurt that there are over 9x more private companies than public companies; to ignore private markets is to ignore much of the global investable universe.
What better way to build on the above than to discuss Alts from a mechanical perspective? By covering the basics, I hope to leave you feeling more confident in understanding Alts structures – especially if they’re already held in your portfolio.
Setting the (non-liquid) Alts table
I’ll be very upfront in saying that Liquid Alts do not get a seat at the table for today’s discussion; these are where investment companies attempt to package Alts strategies in regular (daily liquid) mutual funds or ETFs. There is nothing structurally “alternative” about them, and today we are focusing on structures (not strategies).
Fundamentals
For most investors, an alternative investment will come in the form of a fund. Like in a mutual fund or ETF, the idea is to pool together money from investors to outsource the allocation/investment process to a manager. That can help end-investors diversify their portfolios and (often) access investments they would otherwise be unable to. For instance, I may not be able to buy and manage a large commercial building on my own, but I could invest in a fund that owns many large commercial buildings and employs professionals to manage them on my behalf. Such “funds” can come in many different forms.
Looking back on the investment industry and Alts in particular, fund structures have been a natural evolution to help solve for obvious hurdles, like:
- Diversification: Both for investors and for the underlying portfolio/strategy (more money buys more investments).
- Illiquidity/Fractional Interests: As above, the bar to own a share of a fund is far lower than it is to buy a whole building or private business, let alone a portfolio of them.
- Division of Labor: Yes, there’s the cool job of identifying investments, but there are many other necessary roles to manage a fund, including raising capital, accounting/finances, reporting, legal, investor relations, and more.
- Institutional Audience: for institutional investors (including large wealth management firms), scale and institutional-grade infrastructure are vital components of investment funds. An institutional investment committee won’t approve a “Two Guys, One Building” strategy, as it falls outside acceptable risk parameters. Large minimum investments (e.g., $20M) may be required to justify the time and expense of proper due-diligence processes, and risk-management policies may not allow for being more than 20% of a given investment strategy; quick math of those numbers means a fund size of at least $100M would be needed for larger investors to even take a look.
And now the real fund stuff
Have you ever wondered about fund jargon like GPs, sponsors, open (end), closed (end), subscriptions, partnerships, hedge funds, lockups, gates, SPVs, evergreen, or drawdown structures…or do you have a life? These terms could easily be worthy of a TOM edition on their own, but I will do my best to succinctly cover them at a high level.
Know your role
GPs are the general partners who build and run the investment fund; they are also known as “sponsors” because they manage (aka sponsor) the end-to-end process of raising capital, identifying investments, structuring deals/funds, and running projects/companies to make the investments work.
LPs are the limited partners who invest in the fund; they take on a limited/passive role in terms of both daily operations and liabilities, as compared to GPs.
Thus, GP/manager/sponsor and LP/investor are largely interchangeable terms in Alts “fund speak.”
Open vs. closed: Not the same as open-ended vs. closed-end
If a fund is open, that means it is accepting new money/investors (aka new subscriptions). If a fund is closed, it is not accepting new subscriptions.
- In publicly traded investments: open-ended funds are ongoing; familiar examples include mutual funds and ETFs. Money can flow into and out of those funds daily (or even intraday). When an investor buys shares, their money goes into the pool of capital. In a closed-end fund, however, no new money goes into the pool; instead, investors merely trade shares of the fund (more like a stock) and its existing pool of money. If I were in charge, we would call these “open-pool funds” and “closed-pool funds,” but I’m not, and we don’t. But considering whether the “pool” is open or closed can help you keep them straight.
- In private investments: The open-ended and closed-end nomenclature is more aptly applied here. Open-ended funds are those that are ongoing or perpetual in nature. These are also called evergreen funds, and they have no predefined end date or timeframe. On the other hand, closed-end funds have a finite life – usually expressed as a target timeframe (years) for the underlying strategy to run its course.
Open-ended: Interval Funds and Hedge Funds
As above, our open-ended fund examples will be ongoing/evergreen; however, they still may limit inflows and outflows with respect to both amounts and timing (intervals). Here are common examples:
- Interval Mutual Funds: the most client-friendly of the bunch, as they look the same as any other mutual fund in your account – complete with a 5-letter ticker symbol and daily price adjustments. Most of them can be purchased daily but limit redemptions to one day per calendar quarter, and they are bought and sold by entering standard trade orders (i.e., no additional paperwork is needed). They are also available to retail investors. I’d say these are mainly focused on private investments, but they could also be used for public securities/hedge funds (more on that below). It’s worth noting that there aren’t GPs and LPs in these mutual funds, but rather plain old “managers” and “investors” (just like any other mutual fund).
- Interval/Evergreen Funds: these differ from Interval Mutual funds in a few ways. First, paperwork is needed to buy (subscription documents) or sell (tender offers) these, as investors are formally entering/exiting a partnership. Money is wired from an investor’s account to the GP for purchase. At least partially due to those operational hurdles, they typically only accept subscriptions monthly (or quarterly) and allow redemptions/tenders monthly or quarterly. The net asset value (price) is also only updated monthly or quarterly. The main use case is for private investments, like private equity, private credit, and private real estate.
- Hedge Funds: For general purposes, “hedge fund” simply means an open-ended alternative investment fund, but they technically should be “hedging” (limiting) risk in some way. Unlike the above evergreen/interval funds, the underlying holdings are usually public securities, rather than private investments (but the GP/LP relationship and subscription/redemption process is similar). Perhaps the most standard example is a fund that buys (“goes long”) some stocks and concurrently short-sells (“shorts”) other stocks; this is known as a long/short equity hedge fund.
Closed-end: Drawdown Structures
Private closed-end funds are referred to as “drawdown funds” because capital is “drawn down” as it is deployed. They are very standard for private equity strategies and consist of four main stages/phases:
- Fund Raise Period: LPs commit capital (yes, these are called “capital commitments”) and then wait for it to be called by the GP; it may be called all at once or over several years (or anything in between).
- Drawdown Period: the manager calls capital over time as they make investments to build the portfolio)
- Investment Period: continuing to make investments and often “recycle” capital from completed investments to new investments)
- Distribution Period: as investments complete their lifecycle, capital (ideally with a gain) is returned to LPs. Examples are businesses being sold in Private Equity, properties being sold in private Real Estate, or loans being repaid in Private Credit.
As a GP successfully raises and begins deployment of a fund (e.g., “ABC Fund I”), they will begin raising their next fund (e.g., “ABC Fund II”); even if the underlying strategy is largely the same, each fund may perform very differently than the prior/next fund, as it will fall within a different timeframe of markets; these are known as “vintages.” If a GP does well (or even if they don’t), their hope is that investors from prior funds will commit to future funds, and they will attempt to align distributions with future fund raises.
Unlike semi-liquid evergreen funds, the hallmark traits of drawdown funds are that they are completely illiquid and self-liquidating. The above capital call/deployment/distribution process is dictated by the manager, and that could last several years or 15+ years (in the more extreme cases).
Funds of Funds
Packaging together any number of the above structures within another fund creates a “fund of funds” (FoF); the name couldn’t be more appropriate. FoFs may focus on a particular asset class (e.g., a fund of hedge funds), simplified access (e.g., a core Alts solution of many asset classes within a single fund), providing exposure to highly desirable managers otherwise closed to investors, or anything else the manager thinks will appeal to investors.
The operational convenience of FoFs is a big selling point (many strategies with one subscription and a single tax form). However, the (understandable) gripe with these is the extra layer of fees; some can be egregious, as the FoF manager may add another layer of management AND incentive fees on top of what the underlying managers already charge (more on fees below). On behalf of TBG, it’s worth pointing out that our in-house FoF solutions add neither of the above fee layers; they’re all about improved operational processes and risk-management.
Lock-ups and Gates
To help the GP have a more predictable timeframe during which it can invest money on behalf of LPs, a fund may incorporate a “lockup” period – or an initial period where liquidity is limited. A “hard lockup” means no liquidity, while a “soft lockup” imposes a penalty (e.g., 3% of an LP’s investment) if funds are withdrawn during the lockup period.
After the lockup period, then other liquidity provisions come into play. To avoid forced-selling of underlying holdings at potentially unattractive prices, the value of redemptions may be restricted. An example would be to limit redemptions to 5% of the fund’s assets in a given calendar quarter – a practice known as “gating.” If a couple of smaller investors want to redeem their holdings, it’s usually not a problem. However, when redemption requests exceed the gate, proceeds are distributed systematically (typically pro-rata), and the process for an investor to fully redeem can drag on for years.
Gating is a protection mechanism (“a feature, not a bug,” as David Bahnsen would say).
Taxes
I’ll keep this short and sweet. The differences are largely whether a given fund results in 1099 or K-1 tax reporting for investors. That may largely depend on the structure of the fund (interval funds typically provide 1099s and drawdown funds issue a K-1 in every instance I can think of), but the fund structure is often a function of the underlying strategy and what type of tax benefits the manager can pass through to the investors). Some 1099 reporting is seamlessly included into a custodian’s annual tax documents, while others may issue a separate form 1099.
Fees
Again, keeping this very high level, but some of the main considerations here are:
- Management fees: charged as a percentage of assets on an ongoing basis (applies to almost every fund in existence). In drawdown funds, it’s vitally important to understand whether this is on committed capital (your money that hasn’t even been invested yet!) or only on invested capital (the morally correct way to do it, but who am I to judge?).
- Incentive fees: charged as a percentage of the gains – often with a minimum return “hurdle.” For example, if a fund returns 10% in a given year, they take 20% of that return (i.e., investors would get 8% of the 10%). Incentive fees may also include a “high watermark” requirement, which means the fund has to be at a positive return overall to be able to collect the incentive fee. Without the high watermark, the fund could lose 50% one year, make back 10% the next year, and still collect an incentive fee – even though LPs would be at a loss of over 40%.
- Carry: this is simply an incentive fee, but it’s a term that is associated with drawdown structures, which base their incentive fees on total return over the life of the fund. For instance, once a fund returns an LPs full original investment and then generates another XX% of return, they start participating in a share of the returns thereafter; it can take
- Fee Jargon: Putting the above together, a fund with a 2% management fee and 20% incentive fee, is where the term “two and twenty” comes from. A lot of funds now are closer to “one-twenty-five and twelve-and-a-half” (1.25% management fee and 12.5% incentive fee) with a 5% minimum return hurdle and high watermark. That all doesn’t quite roll off the tongue like the old “2-and-20,” but it’s better for investors. In drawdown funds, GPs are focused on “getting carry” or “getting into the carry” of funds they manage. It often takes years to get into the carry participation. GPs will tell you that management fees “keep the lights on,” but carry is where the real money is made.
I’ve gone on long enough (and easily a thousand words longer than intended, so I apologize), so we’ll end it here. I know I’ve thrown a lot at you, but my hope is now you have a better sense of why funds are used so extensively in the Alts world and what the basic fund structures are. And if you need a place to refresh yourself on the basics, we’ll keep this on file for you.
At the same time, this was meant to put first things first. We’ve only to scratched the surface of what it means to invest in Alts, but it will provide the foundation we can build on in future editions of TOM.
Thanks for reading,
Steve Tresnan
Private Wealth Advisor
Trevor Cummings
PWA Group Director, Partner
