A public company might turn to the financial markets and issue the kinds of debt and equity securities that are discussed in the Debt Securities and Equity Securities chapters if it requires funds to invest in a project, such as building a new production facility or expanding its operations abroad. However, what if an entrepreneur requires funding to launch a promising new venture? Or what if a young business needs money to grow but isn't well-established enough to apply for an IPO?
The young company and the entrepreneur are not sufficiently established to issue equity or debt securities to the general public. Additionally, they may apply for loans from banks, but the amount they can borrow is frequently restricted. Because of the high risk of not receiving the money back, banks frequently do not lend money to young businesses. As a result, the venture capital industry may be a source of funding for new businesses or entrepreneurs. Venture capitalists are experts in financing start-ups and small businesses. They provide young businesses and entrepreneurs with the expertise and capital they need to start and expand their businesses. Private equity, which is itself a type of alternative investment, is a subset of venture capital. Alternative investments are diverse from the perspective of investors and typically include the following:
Venture capital: investments in private businesses, also known as businesses that do not trade on a stock exchange Real estate: commodities: direct or indirect investments in land and buildings investments in physical products like precious and base metals like gold and copper, energy products like oil, and agricultural products that are typically consumed (like corn, cattle, and wheat) or used in the production of goods (like lumber, cotton, and sugar) are all considered alternatives because they offer an alternative to investing exclusively in "traditional" asset classes like debt and equity securities. Private equity, real estate, and commodities are also considered alternatives. Alternative investments are not new, even though they have gained popularity in recent years; in point of fact, commodities and real estate are two of the oldest types of investments. Diversification is the practice of combining various types of assets or securities in a portfolio to reduce risk. Alternative investments present an opportunity to potentially enhance returns and reap the benefits of diversification.
Alternative investments are now a crucial part of the portfolios of many investors who see private equity, real estate, and/or commodities as opportunities to deliver both. This is because investors are looking for higher returns at lower risk.
Why invest in alternative options?
It's common for alternative investments to appear to have no connection to one another. However, they may share advantages: By providing advantages of diversification, they may assist in enhancing returns and lowering risk. Additionally, they have similar limitations: Compared to debt and equity investments, they are typically less regulated, transparent, liquid, and simpler to value. Advantages of Alternative Investments
There are two primary reasons why investors include alternative investments in their portfolios: to take advantage of the benefits of diversification to boost returns and lower risk.
Why put money into alternatives?
Increasing Profits. Between 1990 and 2009, historical returns for various asset classes It indicates that private equity and real estate investments have outperformed equity and debt securities investments over the past 20 years. However, this exhibit should not lead you to believe that alternative investments always provide higher returns than other asset classes. During the global financial crisis that began in 2008, many investors lost money on their real estate and private equity investments, some of which were worse than losses on traditional investments like publicly traded equity.
Limitations of Alternative Investments Despite the fact that alternative investments have the potential to increase returns while simultaneously lowering risk, they also have some drawbacks. Alternative investments typically lack liquidity, are difficult to value, and are less regulated and transparent than traditional investments. Individual investors are less likely to invest in alternative investments because they are less regulated and transparent than traditional investments like equity and debt securities. This may be viewed as an opportunity by institutional investors to profit from market inefficiencies.
Additionally, the majority of alternative investments are illiquid, making it challenging to quickly sell them without accepting a lower price. Compared to private company shares, land, or buildings, selling shares of a public company listed on a stock exchange is much simpler. Liquidity may not be as important to some institutional investors as it is to individuals or institutional investors with liquidity constraints for some institutional investors, depending on their cash flow requirements. Due to the lack of data available to determine their value, alternative investments are also challenging to value. Since there aren't many sales or purchases of new businesses, buildings, or land, valuation is often based on an appraisal. An appraisal is an estimate or assessment of an asset's value based on certain assumptions that may not always be true. Based on its location, square footage, and the price per square foot paid in similar transactions, a property might be valued at £100,000, for instance. However, the assumption regarding the price per square foot may prove to be overly optimistic, and the property may be worth less than anticipated.
PRIVATE EQUITY- When the entrepreneur started her new business, she got the money she needed from her friends and neighbours. After five years, her business was successful. Through an initial public offering (IPO), the company could issue shares to the general public to obtain the additional capital required to support its growth strategies. However, in the interim, the company was not yet ready to go public and probably required more funding to expand than the entrepreneur, her friends, neighbours, and banks were able or willing to provide. Who could possibly have funded such a young, inexperienced business? Venture capitalists are the answer. To obtain the additional capital she required to expand her business, the entrepreneur could have offered to sell some of the shares of her company to a private equity firm. Private equity firms make investments in privately held businesses that do not trade on a stock exchange. Although the term "private equity" is frequently used, investments can include both equity and debt securities. However, debt investments are more uncommon than equity investments.
Strategies for Private Equity Private equity refers to a number of different approaches that have the potential to assist in funding businesses at various stages of development. Buyouts, distressed, venture capital, and growth equity are the most commonly employed strategies.
Secondary is a different type of private equity investment strategy that has nothing to do with the stage of a company's development.
Venture Capital Venture capital is a type of private equity investment that focuses on financing early-stage businesses with novel business concepts. Venture capitalists frequently make investments in businesses that are just an idea or a business plan away from being established. It's possible that the business only has a few employees, generates little or no revenue, and is still working on developing its product or business model. A lot of the time, business owners are looking for more than just capital to get their company off the ground. They are also seeking expert guidance on how to set up and run their company. Due to the fact that more businesses fail than succeed, venture capital is considered the most risky form of private equity investment strategy. A company's success can take many years to achieve, and the majority of venture capital-funded businesses experience years of non-profit activity before reaching profitability. Therefore, investing in venture capital requires patience. However, successful businesses frequently provide substantial returns to their investors.
Growth Equity Growth equity is a type of private equity investment that typically focuses on financing businesses that have established business models, loyal clientele, positive cash flows or profits, and other favourable factors. These businesses frequently have opportunities to expand through acquisitions or the construction of new production facilities; however, the cash flows generated by their operations are insufficient to support their plans for expansion. Growth equity investors aid these businesses in expanding and establishing themselves by providing additional funding in exchange for equity in the business.
Some growth equity investors specialize in assisting businesses with initial public offering preparation. When compared to venture capitalists or early-stage growth equity investors, these investors provide additional funding at a later stage of a company's development. Because more investors share in the company's cash flows, additional equity reduces the ownership of existing shareholders. However, the benefits of dilution may outweigh the drawbacks because later-stage growth equity investors typically have experience organizing initial public offerings. An opportunity for founders and existing shareholders to convert some or all of their investment in the company into cash is provided by an initial public offering, such as those offered by Microsoft, Google, and Facebook. As a result, founders and current shareholders may benefit from the late addition of equity investors with successful track records organizing initial public offerings.
Buyouts are a form of private equity investment that involve financing established businesses that require funds to restructure and facilitate a change of ownership. Buyouts are a type of buyout. Sometimes, a buyout involves privatizing a publicly traded company.
Financial leverage is the ratio of debt to equity in a company's capital structure, as explained in the Debt Securities chapter. Leveraged buyouts (LBOs) are buyouts for which the financing of the transaction involves a high proportion of debt. Companies going through an LBO need to be able to generate strong and sustainable cash flows due to the high level of debt, which means high interest payments and principal repayments. As a result, they frequently represent well-established businesses with advantageous competitive positions in their sector. Companies that have recently performed poorly but offer opportunities to increase revenues and margins are frequently the focus of buyout investors.
Distressed When businesses face financial difficulties, they may be unable to pay their interest and/or principal in full and on time. The Debt Securities chapter discussed this risk, also known as credit or default risk. Purchasing the debt of troubled businesses that may have defaulted or are on the verge of defaulting is the primary focus of distressed investing. Investments are frequently made at a substantial discount to par value, or the amount owed to lenders at maturity. For instance, if an investor purchases a troubled company's debt, they may only offer the existing lenders 20% or 30% of the debt. The investor will gain significant value and the debt value of the company will rise if the business is able to survive and prosper. A company's cash flow is typically absent from distressed investing.
Secondary Another strategy that does not require the company to generate cash is referred to as secondary. Secondary are not determined by a company's development stage. Buy or sell existing private equity investments as part of this strategy. Partnership-managed funds typically organize private equity investments. A private equity fund usually lasts about ten years, but it can last longer. It involves investing for three to four years, then developing investments for five to seven years and returning invested capital to investors in the private equity fund. Venture capital, growth equity, buyouts, and distressed investments may not be able or willing to be held by all private equity partnerships. Therefore, in the so-called secondary market, a partnership may wish to sell one or more of its investments to another private equity partnership. Secondary transactions include purchases and sales between private equity partnerships.
The structure and workings of private equity partnership funds are typically where private equity investments are organized. There are typically two types of partners in a private equity partnership: The private equity firm that establishes the partnership is typically the general partner. It is in charge of raising money, choosing investments, and making decisions. Because general partners have unlimited personal liability for the partnership's debts, they could lose more than their investment because their personal assets could be used to pay the partnership's debts if necessary. Investors who contribute capital to the partnership are limited partners. They are not involved in the investment selection or management. The personal liability of limited partners is limited, meaning that they cannot lose more than the capital they contributed to the partnership.
For various types of investments, a private equity firm may establish various private equity funds. The investments are typically managed by professional fund managers hired by the general partner rather than by the general partner itself. It's possible that each private equity fund has its own fund manager, who is in charge of managing the investments in the funds on a day-to-day basis.
There are two ways the private equity firm makes money: management fees, which limited partners are required to pay general partners in order to compensate them for managing the investments in private equity. Instead of being based on the amount that has been invested, management fees are typically set as a percentage of the amount that the limited partners have committed. In addition, limited partners are obligated to pay management fees regardless of whether an investment is performing poorly or succeeding. Carried interest, or a portion of a private equity investment's profit. Before distributing the investment profit to the limited partners, general partners deduct this type of incentive fee. The purpose of carried interest is to guarantee that the interests of limited partners and general partners are in line with one another. Private equity partnership investments typically lack liquidity. That is, it is difficult, if not impossible, for the limited partners to exit the investment before the commitment term ends once they have committed capital to the partnership.
There are four businesses in which the private equity firm invests. A professional fund manager typically oversees these investments and charges the private equity firm a fixed fee and an incentive fee for his or her services. In order to cover fund manager fees and other administrative costs, the private equity firm charges limited partners management fees. As an illustration, let's say that the management fee is 1% of the committed capital each year. The limited partners of the fund experience negative cash flows in the early years due to the fact that they must pay management fees on the committed capital and receive multiple capital calls to fund investments. The limited partners receive cash payments from the private equity firm when investments pay dividends or are sold. The limited partners experience positive cash flows when cash distributions net of carried interest exceed capital calls and management fees.
A typical pattern of a limited partner's cash flows. It represents a fictitious ten-year investment of $1 million in a private equity fund. It is presumptuous to assume that the private equity firm makes ten investments in businesses between the first and sixth years. These investments begin paying dividends in the fourth year, and they are then sold between the sixth and tenth years. The sum of the capital calls and management fees, which are assumed to amount to 1.5% of the committed capital, is depicted in the blue bars. The cash distributions, omitting carried interest, are depicted by the green bars. The line represents the limited partner's cumulative net cash flow, or the difference between the cash distributions and the capital calls and management fees. Real estate investments come in a variety of forms. The purchase of a home may represent a significant portion of a person's net worth for many. Many people's financial plans are based on own-occupied homes, apartments, and other types of residential properties. However, the majority of residential real estate is not included in individuals' investment portfolios, despite the fact that it is considered part of their financial strategy.
Owner-occupiers (people who live in the home they own) are typically involved in residential real estate transactions, which are not solely for investment purposes. Residential real estate can be invested in by individuals or groups for investment-related purposes, like renting out vacation homes.
Real Estate- A lot of investors focus on investing in what's known as "commercial real estate," also known as "income-generating real estate." In terms of value, a select few nations hold the majority of commercial real estate.
Segments of Commercial Real Estate- There are numerous segments of commercial real estate, each with its own set of characteristics, benefits, and drawbacks. Land, offices, multifamily homes, retail and industrial properties, hotels, and multifamily residential homes make up the majority of the market. Each is explained in turn in the sections that follow.
Land Known as raw land, undeveloped land can be highly speculative due to the absence of tenant or occupant cash inflows and the presence of real estate taxes and other costs associated with holding the land. The land becomes more developed and its value rises based on a projected stream of future cash flows as improvements are made, such as obtaining building permits and installing roads, utilities, and other services. It is risky to invest in undeveloped land because values can quickly fall when there is less demand for housing.
One of the largest segments of commercial real estate are offices. They are typically owned by real estate investment firms that lease space to tenants on a variety of lease terms, ranging from monthly leases with shorter terms to multiyear leases with longer terms. Office rents are fairly predictable over the course of a lease because tenants are responsible for paying their leases regardless of whether they occupy the space. Additionally, office rents typically adjust in line with inflation, making them an appealing investment for people looking to safeguard their real estate income from inflation.
Multifamily Residential Dwellings- The market for investable commercial real estate is dominated by multifamily residential dwellings, which are also referred to as apartments or flats. They are commercial properties that are part of a single development or property and contain multiple units. These apartments are rented to singles and families. The multifamily residential dwellings segment is sensitive to supply and demand dynamics in the local market because the majority of leases last no longer than one year. Shopping malls, commercial shopping centres, and other buildings intended for retail use are examples of assets in the retail segment. The space is leased to a retailer by the owner, or investor, for a period of time ranging from a few weeks to several years. Manufacturing facilities, research and development space, and warehouse/distribution space are examples of properties in the industrial segment. Again, the length of lease terms varies.
Hotels- Hotels include boutique and independent establishments as well as branded short-term and longer-term accommodations for contract workers in remote locations. Other Segments There may be additional commercial real estate segments based on the nation. Senior housing for people over 55 and post-secondary student housing, for instance, have both received significant investments in many developed markets.
How Does Real Estate Investing Work? Direct real estate acquisition is available to investors with sufficient funds. If not, they can become familiar with real estate by participating in either the public or private market. Investments in the Private Market- Real estate limited partnerships and equity funds are the most common means of investing in the private market. Partnerships that concentrate on real estate investments are known as real estate limited partnerships. They are similar to private equity partnerships in terms of structure and operation.
A real estate development company that becomes the general partner frequently establishes the partnership. After that, the general partner raises money from investors, who then become limited partners in the real estate limited partnership. Real estate projects receive the raised funds. The construction of an apartment complex or office tower are two examples of real estate projects. Real estate projects may be managed by the general partner if it is a real estate development company. A real estate limited partnership, like private equity partnerships, requires its limited partners to pay general partner management fees on committed capital as well as carried interest on real estate asset profits.
Real estate limited partnership investments are illiquid, just like those in private equity partnerships. Additionally, the general partner may not distribute cash until the real estate assets—such as the apartment complex or office building—are sold, which could result in years of negative cash flows for the limited partners. In most cases, investments in hundreds of commercial properties are held by real estate equity funds. Geographical location, property type, and vintage year all play a role in the diversity of these properties. Real estate equity funds are frequently open-end mutual funds, which means that investors can buy or sell shares at any time. Either on demand or at regular intervals, like quarterly, redemptions occur. They are made from the cash flows of the real estate equity funds, such as rent and property sale proceeds. Therefore, in theory, real estate equity funds are more liquid than real estate limited partnerships. However, investors' requests for redemption cannot be guaranteed to be satisfied by the cash flows.
Public Market Investments- Real estate investment trusts (REITs), in contrast to real estate limited partnerships and real estate equity funds, are investments made through public markets. REIT shares, like other equity securities, are traded on exchanges, making them more liquid than real estate equity funds and real estate limited partnerships. Companies that primarily own and typically manage income-generating real estate are known as REITs. The majority of REITs are involved in every stage of the real estate process, from land development to building construction and property management.
COMMERCIES- The prices of commodities like energy products, agricultural goods, and precious and base metals typically follow inflation. so that they can safeguard a portfolio against inflation. Investors can gain exposure to commodities in a variety of ways. They can buy the actual commodity, shares in companies that deal in natural resources or commodities, or commodity derivatives. The actual purchase of the product. An investor could theoretically purchase a barrel of oil, a head of cattle, or a bushel of wheat. However, investors rarely have access to commodities in this way due to the difficulties with transportation and storage that come with purchasing a physical commodity.
Purchase of shares in companies that deal with natural resources or commodities. Shares of businesses that focus primarily on the exploration, recovery, production, and processing of commodities can be purchased by investors. Commodity derivatives are purchased. Derivatives with a commodity or commodity index as the underlying asset are available for purchase by investors. Options, forwards, futures, swaps, and forwards are all common commodity derivatives. Keep in mind that forwards, swaps, and other types of options are privately negotiated agreements, whereas futures and some types of options are traded on exchanges.
If you want to expand your business or looking for mentoring and investment support please be in touch.