Last Updated on 25 November 2025

Alternative Investments surveys asset classes outside public markets- private equity, real estate, venture capital, hedge funds, infrastructure and private debt- highlighting their illiquidity, complexity, and longer investment horizons. These assets typically offer illiquidity premium, making them suitable for long-term holding.

This text defines core concepts, examines the unique risks and return drivers of these assets, and explains how incorporating alternative investments can strengthen any portfolio, while requiring tailored due diligence and large allocations.

Foreword

In today’s rapidly evolving financial landscape, traditional investments such as stocks, bonds, and cash are no longer sufficient to meet the needs of many sophisticated investors. As global markets become more interconnected and traditional asset classes face increased volatility and lower returns, alternative investments have emerged as a crucial component of modern portfolio management. Institutional investors, high-net-worth individuals, and even retail investors are increasingly looking to alternative assets for their ability to generate higher returns, provide diversification, and offer unique risk-reward profiles.

Alternative investments, which encompass asset classes such as private equity, real estate, venture capital, hedge funds, infrastructure, and private debt, provide access to opportunities that are often less correlated with public markets. These assets offer the potential for higher returns, though they come with unique risks, such as illiquidity, complexity, and longer investment horizons. Despite these challenges, the growing demand for alternative investments reflects their importance in delivering alpha and managing risk in a low-interest-rate environment.

In this paper, we will explore the various types of alternative investments, their unique characteristics, and the reasons behind their growing popularity. We will also delve into the key risks associated with these asset classes, the frameworks used to evaluate their performance, and the practical considerations that investors must weigh when incorporating alternatives into their portfolios. Whether you are an institutional investor seeking higher returns or a portfolio manager looking for diversification, understanding the complexities and benefits of alternative investments is essential for long-term success in the financial markets.

Introduction

While this family of asset classes has been in existence since the 19th century^◆, it truly took off in the 1970s: first, with new institutional investor capital flows that came thanks to the US Government’s legislation of the 1974 Employee Retirement Income Security Act (ERISA), and then in the 1980s due to the reduction of US capital gains tax^◆.

In more recent times, allocation to alternative investments has also risen tremendously. The following chart shows the total Assets Under Management (AUM) that institutional investors allocated to 5 major groups of alternative investments (shown in USD billions), since 2010:

^{Source: Preqin Global Report 2023: Alternative Assets. 2022 shows annualized data.}

The sums, that have recently reached about 11 trillion dollars, are enormous.

Some General Investment Definitions

Let’s start by going over some basic definitions from the world of investing. This will give us the base for a more sophisticated discussion.

Alternative Investments, at the very basic level, can be defined as all the economic objects and entities that are not publicly traded in a stock market. While this definition has its exceptions, it serves to clearly distinct between those assets that are easily accessible to an individual investor, and those that are beyond immediate reach, making them “alternative”. This market is characterized by thorough due-diligence when buying and selling assets, since there is no publicly available information to assist in valuation. It is therefore mostly accessible to large, sophisticated institutional investors. For an in-depth discussion about valuations, see my text Asset Valuation.

An asset, in an economic and investment meaning, can be defined as an object or entity which grants its owner economic benefit in the future. This benefit can be measured as periodic cash flows (also referred to as “yield”, or “the fruit”) and capital appreciation (i.e. the rise of the asset’s value in the market, also referred to as “the tree”). For a deeper discussion about assets, see the “What is an Asset” section in my text Asset Valuation.

Investing can be defined as the action of obtaining an asset using current resources in order to gain economic value in the future. You let go of value (as measured by currency) in return for an asset that you expect will get you more value in the future. The more you perceive the asset to be “risky”, i.e. there is a wider range of outcomes regarding its future economic benefit, the more value you would expect to receive if all goes well, or else you would not choose to invest in the asset.

Institutional investors can be defined as large entities that invest capital on behalf of their clients for the long term. This includes pension savings schemes, life insurance providers, sovereign wealth funds, endowments and foundations, which are the most suited to invest in illiquid assets. It can be extended to include family offices and high net worth individuals (HNWI), since they are also patient and sophisticated investors. In the cryptocurrency industry this definition is further extended to banks and large investment managers, but these are not major players in alternative assets.

Institutional investors and family offices are the main players in the alternative asset field: it was stated that almost all the investment in alternative assets comes from these types of investors^◆. I will therefore focus on these investors in this text.

Capital is basically value in the shape of money that was saved and became significant, ready to be spent with the intention of obtaining ownership rights in an asset and generating a return.

Return is the phenomenon when we put our capital to use at something other than consumption, and after some time receive our capital plus extra value, which a compensation for taking on risk. Return can come as yield, meaning ongoing payments such as dividends or rent, and it can come as capital appreciation, when the value of our asset increased due to both internal and external factors.

Liquidity is a term that describes how fast one can transform his asset into cash without a major influence on the price. Low liquidity means that in order to buy or sell an asset, the investor needs to work harder and compromise on the price. Alternative investments are illiquid, meaning it is not easy to buy and sell them.

Secondary market- this is the general term for all deals done outside the public stock markets. Since alternative investments are illiquid, buying and selling such assets result in varying prices, as usually sellers have to sell at a discount, since there are usually not many adequate buyers waiting in line. Usually, secondary deals are made using intermediaries that connect buyers and sellers for a fee. There are investment funds that specialize in deals in the secondary market, called “secondary funds”.

Leverage describes the use of debt to finance a deal. Investors usually use leverage to enhance their equity returns, but it also just helps getting more capital to be able to afford a deal. When used to enhance returns, debt helps get more exposure to risk, but debt holders expect to receive only the principal and periodic interest payments, which are calculated periodically based on outstanding principal. So when investors use debt, they can keep most upside potential to themselves.

Using debt increases default risk exponentially, as it requires periodic servicing and a regime of limiting covenants, so any use of leverage should be prudent. Investment fund managers often use leverage to increase the return to their investors. It’s important to emphasize that default relates to the situation when the borrower doesn’t meet any of its contractual obligations to pay the lender, and bankruptcy relates to the formal, legal process that takes place when the borrower is unable to pay.

It’s important to mention that default doesn’t mean certain losses for debt holders, since in case of liquidation, they can recover some or all of their capital, depending on their position in the capital structure and whether they were secured by assets. The rate of capital recovered is called the “recovery rate”. The proportion of loans issued by a lender that have been classified as bad debt, and were written off due to non-payment by the borrowers, is called the “default rate”.

Covenants are the terms and conditions borrowers agree to adhere to in the loan agreement, with the purpose of protecting the lender’s interests. Usually, loan agreements that are made in arms-length contain covenants. A default event can be triggered when a borrower misses a covenant, allowing the lender to apply remedies as stipulated in the loan agreement.

Covenants can be affirmative, which stipulate the borrower’s commitment on what to do, and negative, which stipulate what the borrower can’t do. It’s important to note that usually, missing a covenant is a less severe case of default than missing an interest or principal payment. Missing a covenant can be a warning sign that more financial trouble is ahead for the borrower, and this informs and incentives the lender to step in and get a closer look.

A Publicly Traded Asset is an asset that can be bought and sold in an exchange by the public, like stocks and bonds. In the public markets, many people are exposed to an offer and the information revolving it and the deal goes to the highest bidder. However, many assets exist that are not publicly traded, and when an investor seeks to buy or sell such assets, they need to find someone to buy from, or sell to, by themselves. They also need to ask the seller for all the relevant information, as there is no obligation to share anything to the public. These are called privately held assets.

A Portfolio is a group of assets owned by the same entity. At the basic level it mostly refers to traded assets (i.e. “portfolio management” of publicly traded assets), but it fits all asset types. When deciding what investment to take on, an investor examines his or her existing portfolio and tries to judge whether and how the new investment fits with the rest, in regards to total exposure to risks. Investors seek to create portfolios that are both well-diversified, meaning they are comprised of assets whose returns are projected to show little correlation to each other, and are well-thought, meaning that the assets will generate good returns for the risk of holding them through time.

The Efficient Frontier is a part of the Modern Portfolio Theory, which was developed by Harry Markowitz and his peers in the 1950s, and was part of the reasons he received a Nobel Prize in 1990. This concept basically means that in an uncertain environment, when we can’t know what will happen in the future with certainty, there are some combinations of portfolios that are expected to perform better than others in regards to expected return for a given level of expected risk. These days, this analysis is usually performed ex-post, on historical asset data. Alternative investments serve as a means of “expanding” the efficient frontier due to their unique exposure to risks and smoothed connection to the public markets.

Alternative Investments Classification

Before we dig deeper into alternative investments, see here their classification by asset class:

The main asset classes are presented from left to right in order of their presentation in this text. I will focus here on Private Capital and Real Assets.

The Main Idea

The main idea behind “investing” is to channel capital and satisfy demand for goods and services in the economy, mostly in the medium term of several years. Since the first “stock market” was established in Amsterdam in 1611 around the East India Company, traditional capital markets helped channel private capital to industries and companies that investors identified as acting efficiently in growing markets.

Being humanity’s largest “wisdom of the crowds” platform, entire capitalist economies were successfully built around the information stock markets gave society about its own needs and preferences, through the minds of millions of individual investors. When investors identified industries that they thought were going to enjoy higher, unfilled demand, they poured capital into them, raising valuations and making it easier for traded companies to finance and invest in supply-generating assets.

The stock markets were, and still are despite all their shortcomings, capitalist societies’ best tool for distributing value and resources in the economy, and fill anticipated demand. The superiority of this tool shines against the inability of controlled economies to efficiently distribute value, which eventually brings to their demise. Governments can never gather and process all the information needed for this efficient distribution, as no number of bureaucrats can never compete with millions of minds that constantly analyze their immediate environment, trying to discover where there is unmet need.

One major shortcoming that prevails in the public markets is “the market beta”. This is the phenomenon when often times, the general “mood” investors feel affect financial assets even when they have little to do with it. This brings to exaggerations, “herd mentality”, higher correlations in distress and a general instability that all together hurt the efficient distribution of value. With all the noise investors experience in our modern society, together with the increase in trading volume performed by machines, it can be argued that these inefficiencies only grow stronger. This hurts both the efficient distribution of value and institutional investors, which manage other people’s money for the longer term and prefer a less volatile ride.

This is where alternative investments come in. As I show hereunder, they bring many advantages to those investors that are willing to invest for the long term in illiquid assets.

With the huge amounts of capital allocated to these asset classes in the recent decade, alternative investments have been creating true economic growth. Smart fund managers have been replacing retail investors in trying to figure out where the demand is, and this is a positive development.

Benefits of Alternative Investments

Alternative investments offer several benefits to investors:

1. Illiquidity premium- this is the compensation investors expect to receive for getting exposure to privately-held assets, i.e. where there is no public market with willing buyers and sellers. In illiquid environments, the actual deal price can vary significantly from any fair value achieved by performing a valuation. Since alternative assets are not part of any exchange, their ownership can only be sold in the secondary market, between negotiating parties. This means that it can take time and require flexibility in order to close a deal. It also means that there is no publicly available “fair price” for each deal. Investors expect to be compensated for this risk.
   
2. Distance from the “market beta”– since alternative investments are not traded in an exchange, they don’t get continuous price quotes from deals made in arms-length. Their valuation arrives usually once per quarter, effectively smoothing the markets’ influence on asset pricing. This sporadic valuation serves as a barrier from the “market beta”, or all those influences that originate from people’s psychology and result in erratic shifts in asset prices. Also referred to as “low correlation to public markets”, it can therefore take time for the market’s beta to penetrate alternative asset valuations, usually between 3 to 6 months, depending on the severity of the public markets’ disruption.
   
3. Direct exposure to risks (diversification)- on top of alternative investments’ disconnection from the market’s beta, alternative investments offer investors a pure, direct exposure to the assets and therefore to their various risks, without the layer of a publicly traded company that brings its own risks. As mentioned above, there’s little connection to the market beta.
   
   Unlike publicly traded assets, alternative investments are often managed by private entities, that themselves are far from the market’s beta and the investor is the direct owner of the asset. An example for a direct risk exposure is a toll road in Brazil, that gives investors an exposure to the area’s economy and dynamics. Investors have a direct stake in the road and they are entitled for a share of its profits.
   
4. Hedge against inflation- some alternative assets, especially those that contain inflation protection clauses in their agreements, offer investors protection against inflation. This is especially prominent for infrastructure, when the counterparty is the government and inflation is not excessive. Real-estate is also considered a hedge against inflation, as rents tend to rise along with prices, at least when there is enough demand.
   
5. Access to unique opportunities- alternative investments are often unique opportunities that are not available in the public markets, such as residential buildings or districts in New York City or a group of distribution centers that are rented to Amazon in California.
   
6. Tax advantages- alternative investments offer various tax advantages, such as pass-through depreciation and long-term capital gains treatment^◆.
   
7. Top talent- since alternative investments are large assets and investors invest a lot of capital, there is a great incentive for asset or fund managers to outperform. Unlike in public markets, where an “incentive to perform” often means “taking higher risk”, in the alternative investment world the incentive for managers is usually to apply their skills and talents, to implement their strategy successfully and make the most out of the asset in the long-term.
   
8. Passive investing- alternative investments can be considered “passive”, in that investors always need to have employ someone to manage the assets and implement the strategy. As long as returns justify the fees, there will always be someone to create sustainable returns for investors.

Exposure to Alternative Investments

Before we move to speak about alternative asset classes, we should mention the ways we have to get exposure to such assets.

As investors, we want to get exposure to various systematic risks, since we get compensated for that with return. According to the Modern Portfolio Theory, investors only get compensated for taking on systematic risks, i.e. risks that are a part of the economic system and can’t be diversified away. They don’t get compensated for taking on company or asset-specific, idiosyncratic risks, which can be diversified away. Therefore, we would like to get exposure to a decent amount of assets that get affected by different types of systematic risks.

Alternative investments offer us a very good way of achieving this diversification, both through the different asset classes and through each asset’s capital structure.

Basically, we can either have an equity or a debt exposure to an asset. Equity is the stock: ownership and sometimes control of the asset. Debt is a contractual right to receive payments (principal and interest) at certain conditions. Debt owners get control over the asset only when these contractual obligations are not met. Both types of exposures contain various sub-classes that offer somewhat different exposures to an asset’s risks. We will further discuss these classes in this text.

An exposure to an asset is usually made through a legal entity that is entitled to its cash flows and can obtain financing, and often times protects investors from personal financial liability.

In traditional investments, an investor gets exposure to an asset through the stock or bond of a publicly traded entity, where financial assets are publicly traded. In alternative investments, there is no easy way to buy and sell holdings. While there are publicly traded entities that deal with alternative investments, they are still publicly traded themselves and are therefore exposed to the “market beta”, and all the noise and randomness it brings with it. This misses some point of alternative investments.

So, investors can get exposure to alternative assets in public markets through several means:

1. Publicly held investment funds or companies– this includes various asset managers such as private equity firms, REITS (Real Estate Development Trusts) and BDCs (Business Development Companies).
2. Publicly held groups of assets (i.e. assets that were grouped together and marketed as an instrument).
3. Exchange Traded Funds and Notes (ETFs and ETNs)– these can hold alternative assets, letting an investor buy a share of the asset pool (for example physically held gold and oil).

In the privately-held space, investors can get exposure to alternative assets in the following ways:

1. Direct investing in an asset, such as buying real-estate and then finding someone to manage the asset. This is a must, since without a management mechanism around them, assets degrade and their economic output plummets.
2. Privately held investment funds or companies- through joining as Limited Partners (LPs) or equity holders to entities that pool capital from various investors and invest and manage the assets on their behalf.

Basically, alternative assets are perfect for Institutional Investors who invest for the long-term. However, their direct holding of such assets is limited since their analysis teams, the ones in charge of checking and monitoring the firm’s investments, are usually small and can’t control a vast array of alternative investments the organization could own.

For this reason, the best exposure to alternative investments is gained through limited partnerships that pool capital from many investors. These are called “investment funds”. These entities ensure that capable individuals take on the work of implementing investment strategies, maintaining assets and making an exit on behalf of their investors.

Due to this reason, in this text I will mostly focus on accessing alternative investments through investment funds, as this is the smartest and most prominent way of doing so.

Assessing an Investment

When investors try to assess whether to pursue investment in an alternative asset or an investment fund strategy, they do so in the following stages:

1. They make a quick analysis of the opportunity, extracting its basic characteristics such as asset type, strategy, main risks, required investment size, fees, required capital commitment timing and others.
   
2. They check and see if the asset’s risk and return factors fit their investment goals. In the case of institutional investors, these goals are set once a year for the coming 12 months by the organization’s investment committee. These include the target allocation to the various asset classes.
   
   As a side note: allocation to alternative investments by institutional investors have seen a great rise in the past decade. The most prominent example to institutional allocation to alternative investments is the Yale University Endowment, where the late David Swensen, who became the Endowment’s CIO in 1985, and Dean Takahashi, pioneered a diversified portfolio model consisting in large part alternative investments. As of 2019, alternative investments made about 60% of Yale’s total Endowment portfolio^◆. On average, as of 2022, institutional investors allocate about 23% of their assets to alternative investments^◆.
   
3. The most difficult part of the task come in case the opportunity fits the organizational goals. When it does, the organization’s analysis team takes a deeper look at the offer. They perform due diligence to form a deep understanding of the opportunity’s potential risks and return and measure how it fits with the other opportunities they examine. They also meet the team that brought the offer and try to assess their ability to realize their promise for yield generation and capital appreciation through the holding period, which usually lasts more than several years. When the opportunity is an investment through a fund, the fund manager’s (officially the partnership’s “general partner” or GP) team, which includes senior members of the fund. The analysis team meets the fund management and tries to assess whether they are a good partner for a long-term relationship.
   
   The analysis team usually checks the following subjects, among others:
   
   • Manager Experience- the managers’ experience in their professional lives and former funds, including past results, if applicable. The management’s expertise is the most important indicator of its ability to reduce risk and enhance return.
   • Manager Co-Investment- the managers’ own capital investment in the fund (a good tool for aligning manager-investor interests).
   • Market Research- the general attractiveness of the market and asset class as reflected in the investment strategy. The analysis team tries to understand where the strategy fits in their allocation goals and whether this opportunity is better than the others.
   • Projected Risk and Return Analysis- how the GP is planning to reduce risk while maximizing return, such as investment diversification. The team reviews the fund’s target gross and net IRR, among any current yield (also called “cash-on-cash”) if applicable, and the hurdle rate.
   • Existing Investors- any existing well-known and large institutional investors as LPs, if applicable.
   • Case Studies- past investment case studies.
   • Constraints- check for compliance with any constraints on investing in certain geographies (usually that nations need to have at least “investment grade” credit rating) or industries (such as ESG principles).
   • Terms and Conditions- fees, investor co-investment opportunities and any other perks and benefits.
     
4. If the analysis team thinks that the opportunity is a good fit, they pass it on to the investment committee for a “go/no-go” investment decision and a capital commitment amount.

Basically, investors assess an investment at both the model level and the team level:

• Model- the asset needs to promise a decent return relative to the risks of this promise not fulfilling. This is done at the model level, since the model shows the details of the asset’s projected path. The “decency” of the promised return is measured against the investor’s alternatives, what promises he can get from other assets and for what risks.
  
• Team- the asset management team should have the necessary skills and experience to fulfill the asset’s potential. They need to be able to generate at least the promised return and be able to efficiently tackle all possible risks.

If an asset promises a return-risk ratio that is considered good both objectively and subjectively (i.e. both when measured against the investor’s own needs and relative to other assets he can reach), when the asset management team is strong, and if all his other requirements are met, the investor should pursue the investment.

Investment Funds

Basically, an “investment fund” is an entity that combines investors, a pool of committed capital and a talented management team. Capital is collected from investors who are referred to as Limited Partners and managed by a legal entity called the General Partner, which is the fund manager.

A fund is usually structured as a Limited Partnership, where the active manager is the General Partner (GP) and the investors, which are passive and have limited liability to their capital contributions, are therefore Limited Partners (LPs). The GP manages the fund and implements its strategy. It collects fees as pay for its work.

Every fund produces legal documents that contain all the terms and stipulations regarding all sides to its activity. The main document is the Private Placement Memorandum (PPM), that provides a detailed explanation about the fund’s investment strategy, the GP, its fees, risks, and terms. Another important document is the Limited Partner Agreement (LPA), signed between the GP and each LP and governs their relationship. These are legally binding documents that are used within the institutional investors’ internal mechanisms for decision making.

The overall lifecycle of a fund includes 4 stages: Formation, Investment, Harvesting and Extension (optional and usually not preferred).

During the Formation period, the management team, which has a unique set of skills, forms an investment strategy it wants to execute. The team speaks with investors and tries to get them to commit to allocate capital to the fund. If they succeed, they get commitments and get access to a large pool of capital. They use this money to buy assets and execute their strategy to manage risks and create return.

Committed capital is governed by the Subscription Agreement, which is a document signed by the investor, and details all aspects of money transfers to the fund. Commitments can be divided into two types: Soft Commitments and Hard Commitments-

• A Soft Commitment is a non-legally binding commitment an investor makes towards the fund. It’s a little more than a show of interest.
• A Hard Commitment is a legally binding commitment an investor makes towards the fund, which states the amount of capital to be provided to the fund on a specific future date.

Committed capital is gradually called by the GP in increments during the next stage, the Investment Period, to make investments. This period can take 3-4 years, depending on the strategy, and this is the time when the GP looks for investment opportunities. This is a complex process of seeing many opportunities, analyzing and making due diligence, with the goal of trying to pinpoint the best ones, the ones that will make the highest return for a given risk.

The Investment Process

When deciding upon their strategy, fund managers choose their target asset qualities, such as size, industry and geography, and then choose where in the capital structure to focus, before moving on to find a prospective deal pipeline. Their investment process generally looks like this:

1. Investment sourcing- prospective investments are sourced from various connections and businesses in the industry, such as banks, hedge funds, other private equity firms, industry participants, restructuring advisors, law firms and other businesses.
2. Investment screening- the team identifies key drivers of investment thesis and checks whether an investment matches the fund’s criteria. This process often includes several people from the GPs team.
3. Investment analysis, due diligence- the GP’s team performs a thorough due diligence: they check the target investment’s financial position, review its documents, speak with suppliers, consultants and employees. They leverage their knowledge base and connections to consult.
4. Structuring an offer- following an approval by the fund’s investment committee, creating the deal structure and pricing, and then closing.
5. Monitoring and exiting- the GP’s team monitors the target investment’s financial positioning. Some teams seek to add value and help the business/asset grow and improve, like adding board members, helping recruit management, finding potential customers and more.

Next, during the Harvesting period which spans for some more years (7-15 for a fund, depending on the strategy), the manager works to enhance and improve the assets, with the goal of selling them at a profit at some point in the future. Depending on the strategy, yield is generated during this period and distributed to investors, and capital appreciation is slowly created due to both the manager’s actions and hopefully benign external conditions as well. After several years, investors may start becoming impatient and push for faster realization of the fund’s holdings. Investors measure their returns both in IRR terms, where the time value of money comes into play, and as a multiple on invested capital (MOIC)- both explained hereunder.

Lastly, a manager can ask to extend the holding of some assets, if they believe there is still value they can extract from them, a value that is higher than what investors can get in other investment opportunities. This is the Extension period, and it is largely not preferred, as investors would like to get the highest return as early as possible.

As time goes by, considering the time value of money, the longer it takes to generate a return from an asset, the lower the return is relative to the initial invested capital. This results a lower IRR (internal rate of return), which is a measure of overall return that does consider the time value of money. The faster the manager creates value, the higher the IRR and the happier the investors. A fund manager always looks ahead to raise capital for the next fund, and having a good reputation and satisfied investors is essential.

Funds’ maximum fees are mentioned in the PPM and actual fees are agreed upon in the LPA. They are divided into two main types:

1. Management fee- this is an annual fee that is meant to sustain the GP’s mechanism and cover its overhead expenses such as team salaries, travel and office rents. It is paid by the LPs based either on their committed capital or invested capital (either on total commitments or on capital actually invested by the GP). The terms are negotiated and agreed upon based on the investors’ dominance and market conditions. It’s typically 2% a year, but it differs between strategies, fund size and reputation.
   
2. Performance fee (also called “preferred return”, “carried interest” or just “carry”)- this is a performance-based compensation that comes to incentivize the fund managers to employ their full time and talent for creating value.
   
   The payment of carried interest is subject to the fund generating a certain cumulative, annual return (calculated as IRR) to the LPs, which is agreed upon in advance. This rate of return is called the “hurdle rate” or “preferred return”, and it includes the investors’ initial commitment and an extra annual return.
   
   Only after the GP was able to generate the preferred return to its LPs, it can start collecting its performance fee. Since we only know for sure if a manager was able to deliver the hurdle rate when the fund dissolves, the amounts a GP is entitled to receive gets accumulated, or “carried” over the years until it is paid, and thus its name.
   
   Carried interest is usually set at 20% of the annual return, but this depends on the GPs reputation and market conditions. It is calculated either in a European-style or American-style payment schemes:
   
   • European-style: this is when the carried interest is calculated on the whole fund, i.e. on its total performance, regardless of whether some investments failed to generate profits.
     
   • American-style: this is when the carried interest is calculated on a deal-by-deal basis. This means that carry is calculated only on the deals that generated a profit, ignoring the losing ones on which the GP is undue. Bad performance of some assets do not leak to the successful investments. This results in a faster carry distribution. Under this method, the GP is entitled for a carried interest payment when the fund realizes a profits from single assets, such as in the event of an asset sale, and subject to the LPs receiving their preferred return. GPs prefer this type of carry payment scheme.

Each payment scheme entails different incentives for the GP, and each has its own advantages and disadvantages. Once the hurdle rate is reached, carry is calculated on each cash distribution, regardless of the payment scheme.

GP Catch-up is another term that relates to carried interest. It quantifies the share of the GP in the periodic capital distributions once the LPs reached their hurdle rate, and is calculated on all fund distributions from its inception. The catch-up is given as a percent, and it measures the share of relative carried interest payments the GP gets, out of the fund’s proceeds, until it receives its entitled 20%.

For example, a full catch-up means that the GP is now entitled to receive all capital distributions above the hurdle rate until it reaches its stated 20% of the total fund return, meaning all return up to the hurdle rate as well. A 50% catch-up means that after the hurdle rate is reached, the LPs and GP share the proceeds at 50-50 until the 20% target is met. After the GP receives its entitled carried interest, it maintains its 20% share of all incoming fund profits. A detailed example of catch-up can be viewed here.

A Clawback clause basically means that upon fund liquidation, the GP is obliged to return capital to LPs in case it was discovered that its carry payments were too high. This can happen, for example, when carry was paid at a certain point but the fund’s following performance disappointed, lowering LPs IRR below the hurdle rate. Clawback is mostly a complementary to the American (“deal-by-deal”) carry payment distribution, since it is most prone to carried interest exaggerations.

Due to the low liquidity and complex nature of private investments, investors in investment funds must be at least “accredited”, as defined in each jurisdiction. This means that they must have enough capital and must be sophisticated. However, the managers’ most favorite investors are institutional investors, since generally every investor takes the same attention, but institutional investors are able to commit to much larger sums than Family Offices of HNWIs.

Some more important definitions regarding investment funds

At this point we should make a short stop and explain some more important terms from the world of investment funds.

J-Curve- this important term in fund investing describes the phenomenon that the most of the times, first few years of a fund’s operations show negative net cash flows to their investors, as the funds draw commitments, charge management fees (usually about 2% a year from either invested or committed capital) and try to make investments, while no revenue is generated.

After several years, if all goes well, the funds start to enjoy the fruits of their labor and get cash payments. They make distributions to their investors, gradually reaching strong positive quarterly cash flows. When the cash distribution from the funds pass the investors’ committed capital, the investors start having net positive returns on their investment.

During the “bottom period”, the fund managers are under the most stress to employ the capital and start generating returns. The J-curve is well-known and mostly unavoidable when investing through funds.

J-curve charts show the cumulative cash distribution to the fund’s investors.

This is the J-Curve of a real fund X, 2008 vintage. Notice how it gets positive after almost 8 years of since its inception:

This PE fund was very successful and up to that point achieved a gross IRR of about 29% and a net IRR of about 20%.

Gross/Net gap- every fund operates and makes investments. Some funds work with their target investments to create more value. The cost of this operation is charged to the investors that pay management fees. So the gross return a fund makes is simple: its a return on invested capital. The net return is gross return minus various fees that investors pay the GP over the years. We can say that the gross return is the basic fund performance return, and the “net” return is net to the investor, after fees but before tax.

Internal Rate of Return (IRR)- this is a tool for measuring investment results and for choosing between investment opportunities.

Practically, it is the discount rate that brings all future cash flows from an investment equal to the initial investment amount (and thus brings the net present value, NPV, of the investment to zero). The IRR therefore takes into account the time value of money. Once the IRR for an investment is determined, we can compare it with our hurdle rate (i.e. the minimal return we would like to get for the risk we are taking when making an investment. This is based on the other opportunities that are available to us and on our own cost of capital). Most importantly, we can explain IRR as the expected compound annual rate of return that will be earned on a project or investment, and make judgement if it properly compensates us for the risk^◆.

IRR is used by LPs and GPs to asses their decisions and compare them to other investment options that exist in the market, and compare the expected/realized return to the perceived risk of each investment. When analyzed ex-ante (looking forward), it is a tool for choosing between investment opportunities. When analyzed ex-post (looking back), it is a means for judging the quality of our past decisions.

Generally, higher IRR relative to the other investment options or relative to the risk in an investment, means success.

The time value of money- a dollar in our hands today is worth more than a dollar promised to us in the future. The reason is that there is a risk that the promise will not be kept, and also there is the missed return we could have gained if we invested that dollar today. The higher any of these factors is, the lower the promise is worth to us. We would prefer to receive payments as early as possible.

Multiple on Invested Capital (MOIC)- this is a return metric that measures the ratio between total cash returned from an investment and total investment. The higher this ratio- the better. An MOIC larger than 1 indicates that the investment has generated a positive return. While the MOIC is a simple metric, unlike IRR, it doesn’t take into account the time value of money.

Vintage- this is the year when a fund made its first investment. At that point it can be said that the fund truly started to operate.

Co-Investments- these are investment opportunities that some fund managers offer their investors as a means to give them more exposure to the strategy, keep them satisfied and enhance their returns. Co-investment is made alongside the fund and can help it get financing quickly to close good deals. The fees on co-investments are usually lower than those within the fund, as they are made on an opportunistic basis, help the manager close deals and bypass the fund structure.

Separately Managed Accounts (SMAs)- some fund managers offer personal investment management services to specific investors, alongside their main investment fund activities. Under such arrangement, a large investor grants the manager with varying authority to invest on their behalf, under predetermined conditions, in his area of expertise. This arrangement provides the investor with flexible, tailor-made risk exposure, direct ownership stake in the assets and also flexible tax planning^◆.

Dry Powder- in the 1600s, this term meant “the gunpowder armies carried with them for firepower, which soldiers had to keep dry at all times”^◆. In the realm of private capital, dry powder is the amount of committed but yet unused capital. This is capital that is available for the GP to use almost immediately, a reserve that can be dipped into as needed.

Funds of Funds- these are investment vehicles that pool capital from investors and invest as LPs in multiple other investment funds. They provide investors with quick and smart diversification across multiple investment teams, strategies and geographies, but there is a double-layer of fees involved.

Closed and Open-Ended Funds- investment funds can be structured as either “closed-ended” or “open-ended”:

• Closed-ended funds are vehicles that have a fixed term, typically up to 15 years, in which they raise capital, invest, grow and distribute capital. After the fund’s subscription period is over, it becomes closed to new capital and all existing capital is locked. This makes this structure stable and lets managers stay focused on their long-term strategy. Investors in closed-ended funds can only trade their share interests in the secondary markets for a discount. Closed-ended fund managers are not responsible for creating liquidity to their investors, which comes at a price.
  
• Open-ended funds are vehicles without a fixed term. They can continue operating to infinity or until they are actively shut down. They offer investors regular “liquidity windows” and facilitate the ongoing subscriptions and redemptions of their partnership’s share interests: when an investor sells its stake, the fund must have cash on hand to buy it back at current net asset value (NAV), which is the fund’s latest asset worth after subtracting its liabilities. These funds don’t have lock-in periods and often maintain large cash reserves as a portion of their portfolios to meet shareholder redemptions (this is called “cash drag”). Open-ended funds often have a larger focus on income and regular distributions than closed-ended funds.

Alternative Asset Classes

Private Capital

Private Capital includes all investments in the capital structure of privately owned companies. We will start with describing the main Private Equity strategies such as Venture Capital, Growth Equity and Leveraged Buyout, and then move to describe the main Private Debt strategies: Direct Lending, Venture Debt, Mezzanine and Distressed.

A Company’s Capital Structure

Before explaining what the private capital strategies are about, lets have a short discussion on a company’s capital structure.

A company is a superb tool for creating value while sharing risks. It is a legal entity that is created in order to distance its owners, the shareholders from its business debts and obligations. It is a way to limit the business risks the company owners face and incentivize people to start businesses. It also allows a market for the sharing and trading of risk, such when the business owners want limited risk but the overall risk still exists, so other people and entities can take some of the overall risks in return for a fee and make the business work. This is the base of our entire financial system.

Sometimes, business activity can be incorporated in other forms than a “company”, such as a Partnership in the case of investment funds. The decision about the nature of the legal incorporation of the business depends on several factors, where the most prominent ones are risk exposure and tax considerations.

The company’s purpose is to hold and create value while sharing the risks in doing so.

The company funds its activity with various means, which basically differ from each other in the risk-return profile they offer to the financing providers, which have their own risk-return preferences and needs. The company then uses the funding to obtain assets and create value.

The company’s capital structure is made of all those who funded its activity, and it is depicted on the “obligations” side of its balance sheet, i.e. all those that the company needs to repay at some point.

The company’s obligations can be ordered by their overall “risk” exposure to the company’s business, i.e. the chances that the holders of the obligations will not receive their full investment + expected return back. They are divided such that the most “safe” exposure to the company’s business risks, senior debt (often backed by assets) is first to receive payments, both in normal times and in case of liquidation and bankruptcy. Then the various subordinated debt instruments get their share and so forth all the way down to the common equity, which are the last ones to receive compensation when the company is liquidated, meaning when the toughest risks materialized, but their return is potentially infinite if everything goes well.

It is more likely that upon liquidation, after paying out its debts, a company will not have sufficient funds to compensate its common equity investors, which expect the highest return on their investment. Sometimes, in the most unfortunate cases, they can even take personal liability towards some of the financing and end up having to pay debt holders from their own pocket.

This order of payment is referred to as “cash flow waterfall” (or “payment waterfall”), and is shown in the following figure, where the “safer” exposure to the company’s risks is at the top, moving down the ladder to the more “risky”:

^{Source: Axial.}

As I mentioned earlier, various entities can share the company’s risks for a fee. They provide funding for the company and get something in return: either a promise to be paid back principal + interest, or be eligible to receive dividends and enjoy capital appreciation.

Each of these segments of the company’s funding sources offers different risk and return characteristics to their providers, and this is why the senior debt attracts different kinds of investors than mezzanine and equity.

As any investor seeks to be properly compensated for the risk they are taking in financing the company, the higher, safer segments offer a lower return than the lower, riskier parts, but also a lower risk exposure.

Just to explain since this word was mentioned above, Liquidation is the process of selling off assets to repay creditors and dissolve a business.

Private Equity

Private Equity includes all investment in the equity of companies that are not traded in a stock market and therefore do not share information with the public: they are not obliged to publish their financial reports to the public and are therefore referred to as “private”.

This type of investment can either be done directly, such as the case of Angel Investors, or through external managers (i.e. funds). The investor’s goal is to achieve both yield and capital appreciation as the target company hopefully distributes dividends and increases in value over time.

Private Equity Investment Strategies

As mentioned above, private equity activity is basically dealing with privately-held companies with the goal of creating value. These investors take on the risks that are involved with owning a company’s equity and expect to make a return that will more than adequately compensate them for the risks.

A brief overview of the PE fund types, from the most risky:

1. Growth Equity- this is a type of private equity investment that provides equity financing to companies that have already achieved market traction (sales), but have not yet “matured”- they are still growing rapidly and thus not earning profits.
   
   These strategies obtain a minority stake in the target company, meaning that the fund manager does not have control over the company’s operations. The purpose of this financing is to provide the company with capital for further business expansion. The goal is to accelerate the company’s growth and increase its market share.
   
   This type of private equity investing is interesting (also) because it includes specialized fund managers that focus on specific types of target companies. For example, there are growth equity investment funds that acquire minority stakes in well-established GPs, granting investors access to the GP’s cash flows that come from a diversified group of LPs and portfolio companies in multiple funds (that is also diversification of vintage). Another example includes a fund that specializes in US small regional banks, applies its extensive know-how, creates value and exits. It is also a major player in the US distressed banks market. Other funds combine equity and debt investing, and others focus on sports teams.
   
2. Venture Capital- venture capital is a source of equity financing to young start-up companies. This strategy seeks to acquire minority stakes in young companies, starting from the “pre-seed” round and forward. It provides finance to technologically-oriented companies through series of “investment rounds”, typically A to E, all the way to pre-IPO (initial public offering- a type of exit through selling equity to the public), in order to finance its growth and expansion.
   
   Venture capital funds differ in many areas and there are many types of such funds. They may differ in the following main fields:
   
   – Target company stage: from an entrepreneur with an idea to “late-stage” companies getting ready for an exit.
   – Industry focus: funds usually focus on few areas of expertise.
   – Investment size: this depends on the size of companies the fund targets.
   – Other differentiations: such as geographic focus, level of involvement in the company’s management and more.
   
   The stake the fund prefers to take in a target company differs according to its strategy. When financing entrepreneurs, it’s important to leave them with enough equity stake to incentivize them to work hard. It’s also important to remember that every following investment round dilutes all existing shareholders, so a fund needs to leave itself enough equity to still have a meaningful amount after several rounds.
   
   This private equity strategy usually involves the fund manager investing in up to several dozens of young companies and helping them grow over the years. Fund managers hope that at least one company in each fund will reach a significant exit. Most portfolio companies will most likely end up in small exits or liquidation. In this strategy, one star is enough to compensate investors for the long years that pass until value is returned. It’s important to remember that since these companies are often young and are far from reaching net profitability, investors usually don’t see a significant yield when investing in venture. Their main source of revenue are successful exits. This puts a lot of pressure on VC fund managers.
   
3. Buyout- also called Leveraged Buyout (LBO), these strategies obtain a controlling stake in the target company, in order to be able to control its activities. They seek mature, successful businesses where there may yet be potential for getting extra value, given new managerial attention. They improve the company’s operations, by either increasing revenue and decreasing costs (i.e. increasing efficiency), in order to increase its revenue, its cash and allow for dividend distribution and capital appreciation.
   
   Usually, these kinds of deals are made using leverage, meaning the fund manager takes on debt in order to buy a stake in the target company, which is usually well established and has a stable market positioning. This debt is secured by the target company’s assets and expected cash flows. While this debt is taken by the fund, upon deal completion it is transferred to the target company and becomes its liability. In other words, the legal obligation to service this debt is transferred to the target company.
   
   So basically, the buyout fund’s strategy typically involves improving the target company’s financial performance and cash flows to ensure it can meet its debt obligations and generate returns for the equity investors. This type of investment results in higher debt levels for the target company and this introduces new risks to its business- “financial leverage risk” and a slightly higher chance for bankruptcy.

The types of PE investing according to the target company’s stage can be summarized in the following chart:

The difficulty in private equity is first finding investment opportunities, second identifying the most promising ones, then adding value and finally preparing for an exit. These are difficult tasks.

Median Risk/Return Figures

These are the median risk/return figures for private equity funds, vintages 2009-2018:

While venture capital is not mentioned in this figure, it is centered around the risk/return 26%/23% point for funds vintage 2009-2019 (source: Preqin Global Report 2023: Venture Capital).

Private Debt

Moving up a company’s capital structure, we reach the region of debt. These funds lend capital directly to legal entities such as companies and offer access to the generally less risky part of the capital structure, since debt-holders are the first ones to collect payments from an asset. The most secure debt is protected by assets with economic value, that serve as collateral in case payments don’t go through as planned.

It’s important to note that at the point when business entities turn to debt funds, the most secure debt is usually already taken by banks. So investment funds take the lower parts of the capital structure for a higher price due to the increased risk.

Debt strategies provide further diversification to investors, since they offer a smart and direct access to corporate or various asset holders’ debt.

When implementing its strategy, the lender analyzes the target borrower’s risk and tries to quantify the probability of default, which is when the borrower doesn’t fulfill its obligations. It then comes up with an offer, stipulating the proposed interest rate, various fees and collateral, and what happens when default occurs. The last part of the sentence is the most interesting and complicated in this relationship, since a lot can happen when a borrower fails to meet its commitments.

Due to their astute nature, lenders come up with various ways to get compensated when this happens, ways that banks and traditional lenders were not built to employ.

Types of Debt Securities

There are various types of debt securities that form the debt part of a company or an asset’s capital structure:

1. Senior Secured Debt- secured debt instruments are backed by specific assets, so in the event of default, debt-holders have a claim on these specific assets. Because it has tangible assets supporting it, this debt type is considered the safest.
   
   Debt can be both senior and secured by specific assets, enjoying the best of both worlds. Senior secured debt is often divided between first and second-lien debt, with first lien debt having the first claim on the specific collateral and second lien debt having the second priority. First and second-lien debt generally have equal rights to principal and interest payments.
   
2. Senior Unsecured Debt- these are debt instruments have a higher priority than other forms of debt in the event of bankruptcy or liquidation, but these instruments are not secured by specific collateral. In case of default, these debt-holders are entitled to receive their outstanding principal before junior debt holders and equity investors. Senior debt that is not secured by specific assets is secured by a general claim against the company’s assets, meaning all assets that are not subordinated specifically for specific loans.
   
3. Subordinated Debt- as its name suggests, the holders of these debt instruments are entitled to receive what cash remains after the senior debt holders get their share in the payment waterfall. Therefore, it is considered more risky than senior debt, and thus it offers higher interest rates to compensate for the increased risk. This is often referred to as “high-yield bonds”.
   
4. Convertible Debt- these types of debt securities can be converted into the company’s equity, usually common stock, at predetermined price or conversion ratio. The holders of this type of debt are ranked lower in the payment waterfall and are entitled to payments only after the subordinated debt tranche holders got their share. The option these instruments have, that allows the holder to convert some of the debt to the company’s equity, provides an upside potential but the lower rank in the payment waterfall makes these debt instruments more risky.
   
5. Mezzanine Debt- mezzanine debt, which is considered junior subordinated, is a hybrid security that combines both debt and equity characteristics. It is subordinated to most kinds of debt, but may have warrants or any other kind or “equity kickers” attached.
   
6. Preferred Stock- these instruments are considered a combination of debt and equity, or a less risky type of equity. Preferred equity holders have a preferred, first right claim on dividends, and therefore share similarities with bonds, but they still enjoy all the possible upside that comes with holding equity. Some types of preferred equity have a fixed end date in which, much like a bond, the original capital contributed is returned to the shareholders. However, most types are perpetual.

Every debt fund strategy focuses on different parts of the capital structure, each offers different exposures to risk and expected return.

A security is a financial instrument that represents a claim on assets or cash flows of an entity. Securities are basically tradable financial assets.

Sources of Return

Lenders try to maximize their return both when times are good, using benign interest rates and various fees, and when a default occurs. When times are good, lenders make returns through the following channels:

1. Interest rate- the most basic form of payment for a loan, this rate is paid on a monthly or quarterly basis on the current loan principal. The lender sets this rate first in accordance to the perceived risk, and second in accordance to other lenders, and try to remain competitive.
   
2. Fees- lenders charge borrowers various fees in order to enhance return on top of the agreed-upon interest rate. Fees can take the following forms: “origination fee”, “loan servicing fee”, “due diligence fee”, “cash commitment fee”, “exit fee”, various “prepayment penalties” and more. Borrowers can also be asked to pay for the legal and closing costs.
   
3. Warrants- some loan agreements can contain an option (i.e. not an obligation) granted to the lender, allowing them to purchase a given amount of the borrower’s stock equity at a set price within a specific time period. If the lender chooses to exercise their warrant, they can get equity-like upside potential. These warrants are often referred to as a kind of “sweetener” for the lender.
   
4. Payment in Kind (PIK)- this term describes the situation when a borrower pays interest on debt instruments and preferred securities in means other than cash. This allows borrowers who wish to do so, to avoid paying cash financing costs either during the growth phase of their business or in times of stress. PIK can take the form of the company’s equity, additional debt instruments or an increase in the principal of the existing debt. Usually, a PIK instrument has a higher interest rate than non-PIK equivalents.

Lenders calculate their return based on all the payments they receive from their borrowers, so everything adds up to total performance, which they try to maximize for their investors.

Sometimes, negative scenarios realize and borrowers miss a condition in their borrowing agreement, triggering a default. If their relationship with the lender is good and the default is insignificant, some lenders can show flexibility and not immediately impose fees and fines which will make things harder for the borrower. However, some lenders’ strategies look forward to such events in order to gain a controlling stake in the company, restructure its capital structure and enhance returns.

It’s important to mention that unlike equity investing, debt investing can also include municipalities and government debt, as they are significant players in the debt market.

Private Debt Investment Strategies

A brief overview of private debt investment strategies, from the least risky:

1. Direct Lending (Senior Debt)- this involves the direct provision of senior credit from one entity to another, without using an intermediary such as a bank. These loans are often granted to mid-size companies or directly linked to assets, usually because banks prefer to deal with larger clients due to regulation since the financial crisis of 2008. The loans are often given at an adjustable interest rate.
   
2. Venture Debt (Venture Lending)- this direct lending strategy is aimed at venture-backed, smaller high-tech or high-growth companies. For entrepreneurs, this strategy offers to extend the runway without further diluting ownership. This is a type of short to medium-term debt financing, and it’s provided to the target companies to fund growth and capital expenses.
   
3. Distressed Debt (Special Situations)- this is an event-driven strategy where the fund manager locates companies that are in financial distress and acquires some of their debt securities. This strategies usually involve the purchase of the target company’s debt securities at a significant discount to face value. The goal is one of two: either assist the borrower to stand on its feet and collect the high loan interest rates, or see the borrower fail to make payments, get equity at default and perform debt restructuring, perhaps even getting a controlling stake in the restructured company or asset.
   
   Fund managers can also seek to bet on the outcomes of special situations regarding the company, such as litigation, a merger and others, through the purchase of its debt securities at a discount.
   
4. Mezzanine- this direct lending is focused on the lower tranches of the company/asset’s capital structure. Coming from the Latin word for “middle”, these are the subordinated types of debt in the capital structure, situated bellow all the safer debt types and above preferred equity. Mezzanine is more complex than the other types of debt strategies, in that it is the most flexible strategy, often holding the right to convert to an equity interest in the company in case of default, generally after senior lenders are paid.

Some debt/credit facilities (loans) are given as Unitranche Facilities. These debt securities combine senior and junior risk tranches of debt into one instrument, and are usually used to help fund acquisitions or ownership transitions. It carries a single interest rate paid by the borrower, comprising blended senior and junior rates and even equity. Unitranche facilities simplify the borrower’s capital structure in that they replace the alternative, where each loan operates separately with its own credit agreement, security and covenants.

The difficulty in private debt is to accurately assess the borrower’s default risk and upside potential, and then to come and price these assessments into a competitive loan agreement proposition.

Default Rate Statistics

Debt default data, and specifically regarding private debt, is a good barometer of the overall health of the economy. Rising default rates indicate worsening economic conditions, as more borrowers face difficulties in generating enough revenue to service their loans.

Usually, macroeconomic influences such as higher interest rates, lower supply of capital to borrow and generally tougher economic conditions change the nature of the debt markets, increasing overall risk. When this happens, senior debt holders find comfort in their high rank in the payment waterfall, and subordinated debt holders start looking at equity kickers and PIK.

A research made in 2022 analyzed over 30 lenders of private debt with an aggregate AUM of about 1 trillion dollars, found how default rates tend to change in dedifferent economic scenarios for sectors varied by risk:

The report defines the following sectors as high risk: health care, materials, real-estate, capital goods and others. Medium risk sectors include technology hardware and equipment, software & services, automobiles, telecommunications and more. Low risk sectors include mostly banks, but also other financials, energy, utilities, insurance and more.

Like all markets, the private debt market is also changing rapidly. The aforementioned study also found that in 2021, about 33% of private debt deals in the US were “covenant-lite”, which means a more loose environment for borrowers. This is more than double the amount in 2020, which stood at about 15%. This hints about the intensity of competition on the lending side.

Private Debt and the Credit Cycle

Like most asset classes, private debt is influenced by the credit cycle (or the “business cycle”). The credit cycle is a natural phenomena in an economy where debt is used. It describes the cyclical pattern of expansion and contraction in the availability of credit in the economy. It’s what Ray Dalio calls “the short-term debt cycle”. It is closely linked with the overall economic cycle, which is represented by long periods of growth that are followed by short periods of contraction.

Each stage of the cycle creates a different credit environment and brings different opportunities, as the demand for capital changes. The following chart shows the four parts of the economic cycle, the suggested private debt strategy (middle part) and default and credit spreads situations (bottom):

Generally, credit enjoys the highest rewards early in the economic cycle, as the overall demand for capital increases in the economy in order to facilitate investing in supply-generating assets. Credit risks are highest in the later stages of the cycle, as businesses and individuals realize they over-borrowed and demand for credit reduces. This is often accompanied by rising interest rates in the entire economy, sustaining the cycle.

A credit spread is the difference in yield between a more risky debt asset and a less risky one, usually a sovereign bond, of the same debt maturity.

According to the US-based National Bureau of Economic Research (NBER), there have been 11 credit cycles since World War II with an average length of 69 months^◆.

Projection and Median Risk/Return Figures

Private debt is predicted to show growth in the coming years. According to Preqin, asset allocation to private debt assets is projected to reach around 2.25 trillion dollars in 2027, growing at an annual rate of about 8.7% since 2020:

And these are the median risk/return figures for private debt fund strategies, vintages 2009-2018:

The following chart shows the expected gross returns of various public and private debt assets, together with a general mentioning of private equity:

This chart is from 2017, but can serve as an indication to the different rewards investors expect to receive for exposing themselves to various types of credit risks.

Real Assets

Real Assets are tangible, pyisical possessions that hold and produce value. This includes Real-Estate, Infrastructure, Natural Resources, Farmland and Art.

Investing in real assets can be put onto an axis, according to the general risks of development vs. management. Here from most risky to least:

1. Opportunistic (Development)- this is the most “risky” part of real asset investing, since it includes development risk (i.e. the creation of new assets). This type of investing often deals with Greenfield assets, i.e. empty plots of land, they require development and various local government approvals.
   
   The enhanced risk in this strategy is the requirement to deal with local governments and to create something from nothing, which is always the hardest. More things can go wrong in the process, deferring, diminishing or even cancelling future cash flows. The risk is enhanced since during construction no yield is generated by the asset, since it is not yet complete. The yield part of the total return from this strategy is lower than the capital appreciation part.
   
   Land also falls under opportunistic investing, since it’s even pre-development and usually generates no yield. Land investment is a call option on development.
   
   Usually, fund managers who deal with opportunistic real-estate investing seeks to mostly take development risks, i.e. sell the asset at or near completion and move to create the next asset. When things go well, the overall return that arises from this strategy is highest due to the highest risk involved.
   
   What can go bad? Many things: from problems in construction, through local council regulatory obstacles, to the cooling of the economy.
   
2. Value Add- this strategy includes the purchase of older real assets, renovating them and renting them out at higher rents. This type of investing deals with Brownfield assets, i.e. existing properties that need renovation. In this strategy, the yield part is higher and there is less room for capital appreciation than opportunistic investing.
   
3. Core- this strategy includes the buying and holding of mature and established assets that are projected to generate a relatively safe yield over a long period of time. In other words, there is little room for capital appreciation in this strategy, and more room for yield, which is what investors in this strategy want through a long-term holding. The overall return from this strategy is lower but more predictable. Usually, investors of this strategy seek strong tenants that have long leases. For example: a toll road in a stable region with a reliable regulatory environment.
   
   Core can be sub-divided into “core-plus”, which refers to real-estate assets that are perceived to be very safe. Core-plus indicates well-known assets that are situated in “Tier 1”, “gateway” cities with strong tenants. For example, the Flatiron building in Manhattan or the Plaza.

Real asset investment strategies also differ in the type of exposure to the capital structure: ownership (equity) or debt. As in the other asset types, investors can invest in both owning the properties or lending to them, getting direct exposure to the risks and potential returns they are comfortable with. For example, investors can get direct stakes in real-estate and infrastructure assets through owning equity, but they can also get exposure through owning these assets’ debts.

Real-Estate

Real-estate investing is the exposure to the physical assets where people live, trade and work. Investors can get exposure to either real-estate equity or debt, as discussed above.

There are several real-estate asset classes that investors can access, each with its own risk-return characteristics:

1. Residential- this real-estate segment includes the creation and maintenance of homes and apartments. The target customers are people and the service is living.
   
   Residential real-estate investors generate returns by renting or selling their properties to people.
   
   Residential real-estate assets can either be single homes, sole buildings, or whole neighborhoods. Any dwelling that hosts more than one tenant is called “multifamily”.
   
2. Commercial- this segment includes the creation and maintenance of offices and other commercial assets, such as malls or hotels. The target customers are businesses that rent these spaces in order to perform their work and create revenue.
   
   Commercial real-estate investors generate returns by renting or selling their properties to companies that use the assets to generate revenues for themselves.
   
   Commercial real-estate can be divided into the following main groups:
   
   • Office buildings.
   • Retail compounds.
   • Hospitality (hotels and accommodation).
   • Student housing.
   • Senior housing.
   • Self storage.
     
3. Industrial- this segment includes the creation and maintenance of industrial buildings, such as light industry or distribution centers. This rarely includes heavy industrial compounds.
   
   Industrial real-estate investors also generate returns by renting or selling their properties to companies that use the assets to generate revenues for themselves. However this classification relates more to physical products and logistics chains.
   
   Industrial real-estate can be divided into the following groups:
   
   • Factories and various manufacturing and production plants.
   • Distribution and supply chain, including cold storage, fulfillment centers, last-mile distribution centers and more.

Each of these 3 real-estate asset classes also falls on the development vs. management axis, providing a more specific risk exposure.

Real-estate assets are also differentiated by their condition into 3 main classifications:

1. Class A- these are premium buildings in central areas. These are the highest-quality buildings on a market, and are usually relatively new, and always well maintained. They are typically occupied by strong, creditworthy tenants, which makes them the lowest-risk property class. They usually offer high quality amenities and are often managed by professional property managers. These assets usually charge the highest possible rents in the market.
   
2. Class B- these are older assets that are general in the middle of the quality axis. They are a step down from class A in terms of building quality, location and amenities. These assets are situated in benign areas, however not the most central areas. There is room for value-add strategies to renovate class B assets and collect higher rents. These assets can be brought to class “B+” levels or even class A.
   
3. Class C- these are older, lower quality buildings that charge the lowest rents. Usually, class C buildings require substantial renovations to bring them to modern standards.

There is demand for all 3 types of property in the economy. Also, these categories can vary between regions, as a class B building in a Tier 1 region can be considered class A in a tertiary region. Properties can move up or down these classifications as they get older or get renovated.

As with all other assets, real-estate asset return is comprised of both varying degrees of current yield and capital appreciation.

The Cap Rate

Real-estate investors often use of the term “cap rate” to refer to the return an asset is projected to generate, on an annual basis, through its economic life. The cap rate can either include expected or realized proceeds from an exit, or only the current yield received during the holding of the asset.

The cap rate is calculated in the following way:

Where Net Operating Income (NOI) is the projected net annual profit generated by the property, after deducting all operational expenses from the asset’s revenue but not financing costs. Current Market Value is the asset’s price, as executed in the purchase deal, or its appraised value as calculated from time to time.

The cap rate is basically an inverse “price to earnings ratio” used in the public markets, and just like the PE ratio it is used to estimate over or under-valuation and compare between multiple opportunities. It’s also similar to a dividend yield calculation, in that it calculates the ratio between annual cash flow and amount paid for the asset. The relative predictability of the NOI and the unfrequent nature of valuations make it possible to use of cap rate in such broad array of use cases.

A higher cap rate generally indicates both greater risk and return.

It was said that “Cap rate levels are generally a reflection of other larger economic factors”^◆. It is affected by both macroeconomic factors such as inflation, interest rates and unemployment, but also by asset-specific factors that affect this asset’s ability to generate revenue. Generally, macroeconomic factors are well represented in the cap rate calculation, as they directly influence the NOI and a couple of months later, also valuations.

The Absorption Rate

Absorption rate is another important term in real-estate investing. Investors use it to measure the speed at which real-estate assets are either sold or rented in a specific market and a specific time frame. It offers an estimate of the supply and demand dynamics in a regional market.

The absorption rate is calculated in the following way:

Where the nominator represents the total deals made in the period, and the denominator refers to the total assets that were listed for sale/rent in the relevant market during the period.

A high rate represents strong demand relative to supply. It’s a “seller’s market” where assets are sold or rented quickly, indicating rising property prices.

A low rate represents weak demand relative to supply. It’s a “buyer’s market” and it takes longer for assets to be sold or rented, signaling an oversupply of assets in the region. This can indicate stagnating or dropping prices.

Practitioners use the absorption rate as a decision-support tool, helping them better understand supply/demand dynamics, validate appraisals and time investments, i.e. buy when absorption rate is low and sell when it’s high.

Real-Estate and the Economic cycle

Like most assets, real-estate assets are also influenced by the dynamics of the economic cycle. The following chart shows the main real-estate-related characteristics within each of the cycle stages:

In the diagram above, the y-axis is the real-estate occupancy rate and the x-axis is time.

It was argued that the average real-estate cycle spans around 18 years. However, this is the average, and these unpredictable cycles can last for either longer or shorter periods^◆.

Real-Estate Returns and Risks

The following table shows the annual returns for various real-estate asset classes in the US and the NCREIF Property Index (NPI), from 2012 through March 2023:

The NPI is a US-based quarterly, unleveraged composite total return index of private commercial real estate properties held for investment purposes only^◆.

All real-estate investing offers the investor exposure to the following main, unique risks:

1. Development risks- this depends on the construction stage the asset is at, as mentioned above.
2. Market risks- the unpredictable changing market conditions that affect demand for real-estate assets. This includes interest rate changes, inflation and unemployment.
3. Location risk- since real-estate is stationary, it is deeply connected to its local environment. This risk is specifically connected with changing local consumer preferences.
4. Vacancy risk- the risk of having some or all parts of the property idle and not rented.
5. Tenant risks- these cases when tenants are unable or unwilling to pay rent.
6. Structural risks- such as unidentified defects that require extra payment for fixing and maintenance.
7. Environmental risks- in some regions, there is a real threat of damage due to extreme environmental event.
8. Illiquidity risks- as in all alternative investments, real-estate is an illiquid investment, making buying and selling a difficult task. An asset owner should have an exit plan.

Infrastructure

Infrastructure is another type of real asset: it includes all structures that support society and life, and can vastly differ from one another. Be it roads, power stations, hospitals, prisons, data centers, data cables, heat distribution and more.

Like real-estate, this asset class can also have different exposures to the development-management risk axis: opportunistic (development), value-add and core. Furthermore, investors can get exposure to either infrastructure equity or debt, as discussed above.

In his book, Alternative Assets: Investments for a Post-Crisis World, Guy Fraser-Sampson divides the infrastructure asset universe by several branches. The following figure shows his classification, together with several modern additions:

As infrastructure assets provide essential services to society, when attracting private investment they are often involved with the government, as it is the main body that is in charge of facilitating orderly life within its jurisdiction on behalf of its citizens. Governments provide the sets of rules that govern infrastructure assets, such as the regulatory, legal and tax environments. They welcome private investment in infrastructure as a means to create economic development without directly spending public capital, and also as a means to enjoy a higher standard of service as usually offered by private ownership.

In infrastructure, regulation is a natural force that influences an asset’s attractiveness as an investment, in that it can serve as both protection, such as from competition or losses, but also as a cap on rates and profits. By itself, regulation is not “good” or “bad” when it comes to infrastructure investing. What’s important is its clarity and consistency, as it provides investors with certainty on which they can calculate their exposures.

Some examples of regulation when referring to infrastructure: when governments commit to buy the output of an energy generation facility at a predetermined price for a certain period, when they pay a mass transit operator by predefined metrics such as distance travelled, or pay an operator to run a prison.

Some definitions regarding infrastructure investments

Public-Private Partnership (PPP)- this is a funding model for public infrastructure projects. This is a broad term that can include either short-term or long-term contracts between public and private entities. They can also include only the development part, the management part, or both. PPPs can involve a concession agreement, but not necessarily. PPPs allow for risk sharing between the public and private sectors, but also allow direct government oversight, the creation of long-term asset management contracts and most importantly- to use specialized talent found in the private markets.

PPPs are often complex, with multiple stakeholders involved in the decision-making process. The involvement of the public sector can bring political influences on the project, that can harm the project and its economic benefit to society. These are long-term agreements that bound the private partner for many years. Due to the complexity and size of the projects that induce PPPs, they include a high risk of cost overruns and schedule delays. Nevertheless, their benefit is often able to compensate for the difficulties, both to investors and society.

There are various PPP contract models that differ on funding and responsibility for controlling and maintaining the assets at different stages of the project. For example:

• Design-build (DB)- where the private partner designs and builds the infrastructure according the the government’s specifications, often for a fixed price, and assumes all the construction risk.
• Design-build-finance-operate (DBFO)- where the private partner both designs, finances and develops a new infrastructure asset and controls its operation and maintenance under a long-term lease. The asset is transferred to the government once the lease is up.
• Build-own-operate (BOO)- where the private partner finances, develops, operates and controls the infrastructure asset perpetually. The government’s constraints on the asset’s management are stated in the PPP agreement, and the asset undergoes ongoing regulatory audits.
• Build-own-operate-transfer (BOOT)- where the private partner finances, designs, develops, operates and controls the infrastructure asset for a predetermined period of time, after which it transfers the ownership of the asset back to the government.
• Build-lease-operate-transfer (BLOT)- where the private partner designs, finances and develops the infrastructure asset on leased public land. The private partner then operates the asset for the duration of the land lease. When the lease expires, the private partner transfers the ownership of the asset back to the government.
• Buy-build-operate (BBO)- where the control over an existing publicly owned asset is transferred to a private partner for it to manage for a designated period.
• Operation and maintenance contract (O&M)- where the private partner operates a publicly owned assets for a specific period, while the government retains ownership of the asset.
• Operation license- where the private partner is granted legal permission to operate a public service, usually for a specified term.
• Finance only- where the private partner, usually a financial services company, finances the infrastructure component of a project and charges the government interest payments.

Concession Agreement- this is the agreement upon which the government or a public authority grants a private entity the right to control and operate an infrastructure asset for a given period. Such agreements are required, since the government has a monopoly over the life-supporting assets in its jurisdiction, and specific agreements are required to concede parts of this monopoly.

Under such agreements, the private entity is required to meet various financial obligations or performance standards. These agreements are granted to private investors where governments either believe private owners will do a better job at developing, maintaining and managing an infrastructure asset, or when they don’t want or can’t directly spend public funds to fund a project.

Such agreements allow the private management and control of public assets for a predefined period and predefined terms and conditions. Basically, it’s a government’s decision to pay more for a service and get a better value in return, in those cases when private management and control creates much more value than a public one. This extra value should be higher than the extra cost that comes with private investors’ requirement for a premium, profits, over other investment opportunities.

Such agreements can be used for infrastructure assets of any point on the development-management risk axis. When they facilitate the creation of new infrastructure assets by private investors, there is no need to spend public resources. In such cases, the concession agreement will offer compensation to investors accordingly for taking development risk. In a free market, if the offer will not be desirable, no private investor will take it.

Concession Asset- this is an infrastructure asset that is owned by a private entity but used to provide a public service or infrastructure, based on a concession agreement signed with the government or a public authority. The right of ownership was granted by the government for a predefined period (such as 20+ years). During that period, asset owners enjoy regulatory protection along with regulatory requirements, that result in more stable cash flows for the long-term.

Asset Concession Value- this is the financial value of a concession asset, as assessed by taking all relevant matters into account and performing a professional valuation. This value determines the deal’s return on investment and the investors’ ownership stake under the concession agreement, among other important parameters.

What Makes A Good Infrastructure Asset

When assessing infrastructure investment opportunities, investors analyze the following dimensions:

1. Barriers to entry- high barriers to entry allow for a stronger pricing power and lower price elasticity. This brings to more stable cash flows and lower risk.
2. Pricing- assessing the asset’s importance in the region and the owner’s ability to influence the price from time to time.
3. Operations- if this is an existing asset, investors assess its condition by a making thorough technical and structural evaluation and by going over its maintenance history. Investors further asses if there is any room to increase operating efficiency such as through better procedures, better pricing mechanisms, using technology or implementing capital improvements.
4. Governance- assessing the quality of the asset’s management and existing shareholders if applicable, as it is key to a strong performance over the long-term.
5. Leverage- assessing the outstanding debt amount linked with the asset. Higher debt will make it harder to refinance in a volatile environment and make the asset vulnerable over the business cycles.
6. Growth- if the region is projected to grow in economic activity and population, the infrastructure asset will benefit.
7. Liquidity- assessing the various possible exit options.
8. Government and regulation- assessing all aspects of government intervention in the asset, such that affect the legal framework and rules that regulate the asset, or its concession value. This includes taxation, capital controls, breach of contractual obligations, environmental requirements and the risk of expropriation.
   Governments can and do change regulations from time to time. They also sometimes fail to fulfill their contractual obligations, such as happened in Spain between 2012 and 2014, when the government canceled past incentives it granted to renewable energy projects^◆.
9. Business cycle- analyzing the influence of short-term fluctuation in macroeconomic variables, such as interest rates, use volume and price changes.
10. Inflation- assessing the pricing exposure to inflation. Investors will prefer assets that provide pricing power and the ability to at least meet inflation.
11. Environment- assessing the possible environmental implications of the asset’s development or operation, and its possible influence on the asset’s profitability over the long-term.
12. Economies of scale and synergy– assessing whether there are any complementary assets in the regions that can work together, either under single management and operations teams or provide together a more complete service to the region’s inhabitants.

What Infrastructure Assets Offer Investors

To investors, and specifically large institutional investors, infrastructure assets can offer various benefits:

1. Strong market positioning- a long-term, monopolistic or quasi-monopolistic position with low risk of obsolescence. Many times this includes limited competition.
2. Inflation protection- either when included in the deal terms or through monopolistic position.
3. Stable and predictable cash flows- low volatility of return.
4. Long duration- the long-term horizon of infrastructure asset investment suits the long-term liabilities of most institutional investors.
5. Large scale- infrastructure assets tend to be large investments, offering institutional investors an easy route to deploy capital.

Infrastructure Asset Returns and Risks

The following chart shows the projected gross, levered return of various infrastructure asset types. The x-axis shows each asset type’s position on the development-management risk axis, as of 2021:

It is visible that the regulated, core infrastructure assets offer a lower return for a lower risk. Core+, value add and onward to opportunistic infrastructure assets show higher risk-reward ratios.

Levered (or leveraged) return refers to the use of borrowed capital to amplify returns on investments.

Performance and Conclusion

Alternative investments have grown to become a vital element of modern portfolio management, offering investors a pathway to diversification, higher returns, and the ability to hedge against the uncertainties of public markets. As we have explored, asset classes such as private equity, real estate, venture capital, hedge funds, and infrastructure provide unique opportunities that are often less correlated with traditional investments, making them particularly valuable in today’s volatile and low-yield environment.

While the potential for outsized returns makes alternative assets attractive, investors must also be mindful of the complexities and risks inherent in these asset classes. Issues such as illiquidity, longer investment horizons, and limited transparency require careful evaluation, especially when compared to the relative simplicity of traditional assets. Nevertheless, for investors willing to accept these risks and navigate the complexities, alternative investments offer access to a broad range of opportunities that are not available in the public markets.

What about performance? According to Preqin, the various asset classes differ greatly in performance, at least when viewed from 31 December 2007 to 31 March 2023:

Another way to show returns is with annual returns in the past 1, 3, 5 and 10 years, as of 31 December 2022:

While not easily noticeable due to some similar colors, private equity shows the best performance through time.

Looking at the spectacular performance charts above, that show the great returns of several alternative investments strategies, we should keep in mind the historical flow of capital these asset classes have seen in the past 10 years. As visible in the chart above, since 2010 about 10 trillion dollars found their way to alternative investments in the form of investments by institutional investors.

More specifically, during the boom period of 2019 to 2021, 3 to 4 trillion dollars poured into alternatives. Coincidentally or not, we can also notice a leap private equity performance between 2019 and 2021.

So, what happens when more capital enters a market, chases assets and empowers deal making? Does the subsequent selling and reselling of assets to newer investors with new institutional capital, brings to increases in asset pricing? Is this pouring of new capital connected to the great results of some alternative investment strategies?

I believe so. The quick and smart investors who quickly got into alternatives got, on top of illiquidity premium, a significant “first mover” premium that slowly diminishes. This trend should continue until the “first mover” premium completely fades. When that happens, alternative investments would see lower upside potential and lower yields. Alternatives will probably not be as appealing as they were since before the 2010s, but will still hold more than enough value to justify large commitments by institutional investors.

As the global financial environment continues to shift, the strategic importance of alternative investments is only set to grow. Investors who are equipped with a deep understanding of these assets, and who actively integrate them into their portfolios, will be better positioned to achieve sustainable long-term growth and risk mitigation.

I encourage readers to explore the areas of alternative investing that resonate most with their goals and to dig deeper into the evolving tools and opportunities available today. The deeper you go, the more potential you unlock in an ever-expanding landscape of alternative assets.

By continuing to adapt and learn, investors can fully leverage the potential of alternative investments, ensuring that their portfolios are not only diversified but also positioned to thrive in a rapidly changing financial world.

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