Although opportunities can exist, high fees and low liquidity keep the investment hurdle high for alternative investments.
For hedge funds, any measurable “alpha” is disputable, often include leverage and lack much real diversification. Yet, the average fees as reported by the AIMA are close to 1.75% annually and 17.5% of the upside performance. Also, liquidity is highly restricted.
With that said, we do acknowledge that hedge funds can offer access to certain markets otherwise closed to investors and many profit by providing liquidity in times of stress. Some that employ short strategies can also offset risk in other areas of a portfolio. Still, to overcome their fee structure, tax inefficiency, illiquidity, etc., the opportunity needs to be glaring for us to consider a hedge fund.
Private equity shares a similar fee structure with hedge funds. And it is hard to see how leveraged buyout (LBO) firms buying publicly traded companies at premiums offer much diversification benefit to a balanced stock portfolio. Many firms, though, operate almost exclusively in the private markets, buying smaller, often mismanaged companies, often from second generation families or firms exiting lines of business. These acquired companies can offer synergies to other companies in a private equity firm’s portfolio and can be more readily restructured than with prior owners. In these circumstances, the risk around the investment is often around execution, a risk uncorrelated to other assets and thus a worthy diversifier.
Private equity firms themselves capture much of this ability to restructure companies via a fee structure often as high as those at hedge funds. But in addition, many private equity firms charge transaction, “monitoring” and additional fees back to their acquired companies. These fees can add multiple percentage points to the costs of the investment. The question from us isn’t so much does private equity create value, but rather who really benefits given the high fees and often small diversification advantages?
Venture Capital and Start-Up Investments
Venture Capital performance data is more limited, but intuitively, appears to be very cyclical exhibiting very strong performance through the 1990s and more mediocre performance since then. Start-ups, or “seed capital”, have even less performance data to parse, but likely mirror that of venture capital. In both, the success of even one investment can skew the performance of the most broadly invested fund or portfolio of start-ups. This further limits the ability to separate the lucky from the skilled early-stage investor. And similar to if not even more so than private equity, execution drives success which in turn is largely uncorrelated to other assets by its very nature. With seed capital, investors can also avoid many of the fees associated with other alternative investments which makes us favor that particular asset, at least when capital for the sector is scarce.