Module 2
Alternative asset classes: hedge funds, private equity, private credit
Gurus-in-training, you have made it to the next step of your journey. Module 2 will focus on three different types of asset classes: Hedge funds, Private equity, Private credit.
5 MINUTE READ
Getting to know the alternative asset classes
After building a foundation of key terminology and mastering the differences between traditional and alternative investments, the next step is to dive deeper into the asset classes that are the building blocks of alternative investing.
Learn about what each strategy entails and how these asset classes contribute to building strong and resilient portfolios.
Did you know?
While these alternative strategies were historically only accessible through private funds, there is now a movement to democratize access to private markets for accredited investors as new products emerge. Watch this space, gurus.
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First stop: hedge funds
What do hedge funds do?
Hedge funds are pooled investment funds that trade relatively liquid assets and can be used as a diversification tool. The investment strategies can vary but typically seek to produce return while mitigating downside risk. Hedge funds often invest in public markets, and have the flexibility to employ alternative trading techniques to manage overall exposure, such as “short-selling”. By deploying various financial instruments or market strategies, hedge funds offset risks and provide downside protection1.
Some example strategies include:
Long/short equity: This strategy focuses on buying and selling stocks based on fundamental valuations. An example strategy is “paired trades”. Post crisis regulation in the US favors large banks over small banks, so a long position in a large bank and a short position in a small bank results in low/zero exposure to banks and a profit if the large bank outperforms and the small bank underperforms.
Event-driven: Event driven strategies, which can include special situations, opportunistic or other sub-strategies, look to capitalize on corporate events, such as announced mergers.
Multi-strategy hedge funds: Apply various strategies and implement diversification to smooth returns, reduce volatility, and decrease asset-class and single-strategy risks.
Extra credit for alts gurus:
The primary source of risk and return for traditional, actively-managed portfolios are market risk, and security selection. Hedge funds utilize market inefficiencies as their main source of return. Their primary source of risk is idiosyncratic risk, or the inherent risk involved in investing in a specific asset, such as a stock.
Next stop: private equity
What is a private equity investment?
Private equity (PE) generally refers to an investment into a private, non-listed company with the aim to bring about some sort of change in a private business. Private equity represents investments in different stages across a company life-cycle, from early-stage venture capital to later-stage growth investing and corporate finance.
Private equity investing may offer key advantages over public equity investing. Some benefits of PE include: company-specific selection, intensive due diligence, active participating in driving the business, alignment of interests with company management, and extended holding periods.
Glossary update before we get technical:
A private equity firm/manager is called a general partner (GPs) and its investors that commit capital are called limited partners (LPs).
There are multiple ways of gaining private equity exposure
The private equity toolkit consists of several approaches that offer investors exposure to equity through the following:
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Main features: Raised and managed by a private equity firm to invest in underlying companies.
Potential benefits: Direct access to GPs, and the ability to diversify across GPs and strategies.
Considerations: Investors are responsible for manager due diligence, and direct PE funds typically have high minimum investments.
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Main features: Pools capital to invest in several other direct private equity funds and co-investments.
Potential fenefits: Greatest diversification and smaller investment requirements.
Keep this in mind: Potential for over-diversification and limited contact with GPs of underlying funds. This can be mitigated by delegating control to an experienced PE manager.
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Main features: Executes minority investments directly in companies alongside lead sponsors.
Potential benefits: Greater diversification vs. a direct PE fund and potential for higher returns and fee savings.
Keep this in mind: Quality of the co-investment manager’s deal flow and transaction expertise of the manager.
Final stop: private credit
Glossary update before we get technical:
The credit market consists of participants borrowing and lending using bonds, loans or other structured products. These instruments typically charge an interest rate based upon a borrower’s financial profile.
In other words, you might lend $10 to a friend without asking for much in return knowing they will likely repay you. But would you do the same for a stranger that you were less sure would pay you back? As mentioned above, there are many types of credit products across the public and private markets (including corporate bonds, bank loans and structured products) that provide a wide range of investment options for investors.
We will focus on Private Credit, which represents the broader private market’s alternatives universe. Private Credit encompasses non-traditional investments relying on an illiquidity premium and a complexity premium to help drive excess returns.
Extra credit for alts gurus:
Private credit can also be referred to as direct lending or private lending.
Benefits of investing in private credit include:
- The diversification of an investor’s capital base
- Yield enhancement to a portfolio
- Opportunities to take advantage of cyclical changes in the market
- Attractive risk premia generated by illiquidity and complexity
- Decreased risk on enhanced yields as a result of negotiated structural protections
Let’s recap
Hedge funds, private equity and private credit are three key asset classes in the alternatives universe. They provide portfolio diversification, help tap potential for growth and enable financing opportunities for investors and businesses.
Test your knowledge
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