What Are Alternative Investments? Alternative investments refer to any asset class other than stocks, bonds or real estate. It includes private equity, venture capital, hedge funds, collateralized loan obligations (CLOs), real estate or other non-traditional investment vehicles. What Is Private Equity? Private equity investments are those that are made in private companies, as opposed to those available on public exchanges. The goal of private equity investments is to generate the best possible returns, which may be through capital appreciation, dividend payments or an eventual liquidation of the investment at a profit. Private equity can be used to finance company growth or to facilitate a corporate restructuring, such as a leveraged buyout (LBO). The financing typically comes in the form of senior debt or senior credit facility, mezzanine debt, or equity. What is Venture Capital? Venture capital investments are made in early-stage companies. These are start-ups that have yet to become profitable, or in some cases, companies that have been operating profitably but are not yet public. Because of the high risk involved, venture capital investments come with a high reward, provided the investor has the patience to hold until the company receives an exit. The exit could be an initial public offering (IPO), a sale of the company, or the generation of a significant amount of cash through debt financing. There are many venture capital funds, and they tend to be large, institutional funds with a high minimum investment requirement. They generally focus on the technology sector, but there are also funds that specialize in a variety of sectors. What Is Hedge Funds? Hedge funds are investment vehicles that use a variety of strategies, including short selling, derivatives, arbitrage, and credit arbitrage, as well as other esoteric investment strategies that are often proprietary to the fund. They are generally open only to large investors and institutions with minimum initial investments ranging into the millions, depending on the fund. They have a high level of risk and can fail catastrophically, as was the case with Long Term Capital Management in the 1990s. What Are Collateralized Loan Obligations (CLO)? The CLO structure is often used to finance real estate investments, as well as other asset types such as corporate debt. The CLO is a securitization of a pool of debt, in this case, a portfolio of loans that finances the purchase of the real estate. The loans are pooled together and sliced into different risk levels, with the riskiest tranches receiving a higher payment than the less risky tranches. Investors in the CLO receive a return based on the performance of the underlying loans, but the return is often lower than the one on the underlying real estate itself. What Is a Real Estate Investment Trust (REIT)? A real estate investment trust (REIT) is a publicly traded company that owns commercial real estate assets like office buildings, malls, hotels, hospitals and apartments. REITs are structured as a pass-through entity, meaning they do not pay corporate taxes. Instead, they distribute most of their income to the shareholders in the form of dividends. REITs are a common alternative investment in taxable accounts, as they do not have special tax treatment like real estate held in a retirement account would. They come in different sizes, with the larger ones generally being more diversified, having lower management costs and a lower risk profile. REITs are subject to significant volatility and are not a good investment for someone who does not have a high-risk tolerance. Additionally, They have low yields, so their primary benefit is in providing tax-efficient income, but investors must be willing to accept the high volatility.
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