A Primer on Private Investments

First, of course, the legal disclaimer

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The Article

Private investments are the most exciting, secretive, and lucrative investments in the finance world. The high premiums (usually a one million dollar minimum investment) and complicated strategies make private investment partnerships extremely exclusive. If you follow investment news then you may have come across headlines telling about hedge funds, private equity, or venture capital firms. These funds are designed for wealthy individuals and companies. There are many restrictions on who can invest in these products so only those with unspeakable wealth have access to the very best managers in this field. This chapter will deviate from our current discourse in strategy and will focus on the higher echelon of finance. I feel that having an understanding of how financial companies operate will provide you with a more clear understanding of the finance world.

Hedge funds are the fastest growing segment of the financial services industry. Many experts estimate that over $800 billion dollars are invested in alternative assets. The term hedge fund can often be misleading. Sometimes, the use of the term ‘hedge fund’ is simply making reference to a private investment partnership that invests in marketable securities. A true hedge refers to a defensive position created by a money manager so that the risks associated with an investment are decreased. Much of this text has explained several ways that risk can be reduced in the stock market, and many hedge fund managers employ the techniques that you have seen in order to make a profit. However, some managers exploit the private partnership vehicle so that they can take risks not usually allowed by mutual funds or other registered investment firms.

A traditional hedge fund is an unregistered private investment vehicle. A minority of these funds are registered with the Securities and Exchange Commission. Unregulated partnerships are not illegal. Regulation D of the SEC code allows investment companies to operate outside of the normal provisions that usually apply to securities investment firms. Only accredited and certain non-accredited investors may invest in hedge funds. At the time of this writing, a person must have a net worth of over one million dollars or an income greater than two hundred thousand dollars per year in order to be eligible for private investment partnerships. Very few hedge funds cater to the ‘low-end’ of high net worth individuals. The average hedge fund investment minimum is one million dollars. A hedge fund may accept a certain number of people that do not meet these requirements assuming that they are deemed “sophisticated investors.” The ‘sophistication’ requirement is somewhat vague, but it usually applies to people that work in higher levels of finance and have an understanding of complicated investments, but do not necessarily meet the requirements to be considered an accredited investor.

Hedge funds often have access to higher amounts of leverage. Earlier in the text we discussed the nature of professional trading, and hedge funds often use many of the tactics described in the second chapter in order to have access to both leverage and lower commissions. Some hedge funds register as brokerage firms (also known as broker-dealers) so that they can employ some of their strategies with higher leverage. Strategies such as delta hedging demand that large amounts of leverage be used in order to make the strategy economically feasible. 

Private investment partnerships have been around for quite sometime, but it was not until Alfred W. Jones created the first hedge fund in 1949. His investment strategy was to short sell overvalued companies, and purchase undervalued ones. The performance of his funds was well beyond the average market return. In the late 1960’s, his investment programs came to prominence, and the term “hedge fund” was coined.

Private equity and venture capital investment funds are other examples of SEC exempt investment businesses. These funds use the same provisions granted to hedge funds in order to escape the long, expensive, and frustrating process of registering securities. Large private investment vehicles are owned by insurance companies, banks, wealthy individuals, and charitable foundations. Companies that deal with financial services are automatically considered to be accredited investors. Venture capital became a buzz word in the late 1990’s as the dot com era came to peak. These funds invest in the very early stages of businesses in the hope that they will become very large and profitable companies. Generally, a venture capital fund seeks to have one to two great successes, four or five average businesses, and three to four business failures. It is a very difficult and cutthroat business. It is also extremely risky. Their counterpart is the private equity firm. These funds invest in mature companies that seek to expand. Unlike venture capital firms, private equity is a much lower risk investment. The businesses that private equity firms deal with have proven track records and product lines. Other examples of private investments involve leveraged buyouts (LBO) and real estate. The corporate raiders of the 1980’s used leveraged buyout firms to take over public companies. The practices involved with LBO’s have changed significantly over the past decade and a half. Often, LBO firms were granted nine to one leverage for a typical deal. Today, only half of the leverage that was once available may be used. Real estate funds pool large amounts of funds to use as down payments on apartment complexes, commercial real estate, etc.

Private equity and merchant banking firms almost act in the same capacity as a commercial bank. Instead of granting a loan to a company, a private equity firm will invest equity capital. The returns demanded by these firms are extremely high, and so companies that have excellent growth prospects are only accepted for investment by private equity and merchant banking investors.

Unlike hedge funds, many venture capital and private equity firms do not accept the capital they raise in bulk. The investors that they solicit are asked to commit a certain amount of capital over a period of time. This is to ensure that the rate of return achieved on their investor’s money is sufficiently high. This also allows investors to hold other investments while they wait for a “capital call.”

Often, comparisons are made between mutual funds and hedge funds. However, these two investment vehicles are only similar in the sense that they both invest in marketable securities. The largest difference between the two funds is the fees associated with hedge funds are drastically different from their mutual fund counterparts. A mutual fund will typically charge between .5%-2% of assets per year as their management fee. On the other hand, a hedge fund usually charges 1% of assets and 20% of all trading profits. The potential for creating enormous wealth draws many of the better investment minds toward hedge funds. Redemption of shares in a hedge fund differs from that of a mutual fund as well. Typically, there is a lock-up period for a hedge fund where as a mutual fund has no lock up period and can be redeemed for cash at any time. Liquidity is a large concern among hedge fund investors, and some of these funds offer credit services so that money can be withdrawn from a partner’s capital account at anytime.

Hedge funds are allowed to operate in a much broader scope than mutual funds. Higher amounts of leverage and short selling are common practices in hedge funds, but mutual funds are bound by much tighter restraints. The SEC carefully monitors all of the investments made by mutual funds. Minimum amounts of leverage may be used by a mutual fund. Public investment funds also tend to invest for a longer period of time than hedge funds. Hedge fund managers sometimes hold positions very briefly in order to make quicker profits. The SEC exemption allows these managers to use exotic and complicated strategies.

The way that these two entities raise capital is also very different. A mutual fund may publicly announce the sale of investment securities using any form of medium. If you have flipped through an investment periodical then I am certain that you have seen advertisements for mutual funds. These ads typically showcase the past returns of the fund, and they provide contact information. Most mutual funds may also solicit funds on an on-going basis. Their initial public offering never ceases to expire, and they may accept an unlimited amount of money for investment. Hedge funds are not allowed to advertise publicly. The restraints that hedge funds have for raising capital are tremendous. A new hedge fund many only issue an offering memorandum to clients that already are associated with the managing firm, or to people that the firm knows are accredited investors (banks, insurance companies, trusts, etc).

Limited partnerships are the most common form of business entity that is used by hedge funds and private equity firms. Under this agreement, the general partner (the manager) takes a 1% ownership of the fund and sells the remaining 99% to other investors. The operating agreement of the limited partnership allows the fund manager to receive 20% of the profits on a quarterly or yearly basis (occasionally monthly). The incentive fee varies by fund, and some managers may take a much larger percentage. I have seen instances where the manager receives half of the profits produced, although these occurrences are rare. Mutual funds are registered as regular corporations with a tax status that allows profits to flow directly to the investor. Unlike other regular corporations, mutual fund profits are passed through to the investor without double taxation. Limited partner interests are only taxed on the investor level and not on the corporate level. When determining if a hedge fund is an appropriate investment, it is important to understand the tax consequences. There is a distinct difference between ordinary income and passive income, and a tax specialist should be consulted before purchasing restricted securities. Additionally, the limited partner structure provides limited liability for the investors. This is an extremely important component to hedge funds because managers that use short selling and leverage take an unlimited risk in doing so. In the event that the manager’s positions fail, the investor’s loss is only limited to the amount of money that they invested. This can create a problem because the manager may take excessive risks that a prudent investor would not normally assume.

Hedge fund managers operate in many different ways. Some funds take a macroeconomic look at an economy and make investments based on predictions of the performance of the economy. Long/short equity funds take positions in undervalued and overvalued securities and attempt to make a profit on both the downside and upside of the market. Arbitrage funds practice several types of arbitrage. Other funds capitalize on one time events like mergers and acquisitions.

Unlike mutual funds, hedge fund managers generally have a sizeable portion of their net worth invested in the fund. Mutual fund managers tend to not invest their own money in their funds. There is a general rule of thumb that a hedge fund manager should “eat their own cooking.” If you are making investments in alternative vehicles, it is important to know what percentage of the manager’s net worth is invested in the fund or related funds. The higher the percentage of net worth invested, the more confident an investor feels about the prospective fund.

A relatively new product in the private investment world is the fund of funds. Instead of investing in just one type of strategy, a fund of funds manager selects several managers to trade in different styles. The minimum investment amount for these funds is dramatically lower than their single strategy relatives. In some instances, a $25,000 minimum may be the key to investing with hedge funds. However, the fees associated with funds of funds are extremely high. You will be charged fees from the fund of funds manager in addition to the fees from the limited partnerships. It is very difficult to make a large profit from these investments because of the fees levied on your returns. In the event that the fund does not post a positive return, you will still be charged at least 2-3% of the net asset value per year. Publicly available mutual funds are beginning to act in the fund of funds capacity so that the average investor can have access to a once forbidden investment. Again, the fees on these mutual funds can be enormous so it is important to carefully inspect any prospective investment’s fee structure. There may also be a lock-out period on these investments where you are not allowed to remove your money from the fund for a specified period of time.

Today, there are over 6000 known hedge funds. Several hundred new private investment partnerships are formed every year. There is a high turn over rate among hedge funds as their limited partnerships do not run in perpetuity. Limited partnership investments tend to have a lifespan of seven to ten years. After the investment period is over, all of the proceeds are returned to the investors.

The business media has focused a lot of attention on hedge funds. The funds and their respective fund managers are often shrouded in secrecy. Very few fund managers enjoy popularity. Some of the more well known investors include George Soros, Victor Neiderhoffer, and Julian Robertson. The minimum investment in their respective funds tends to run into the tens of millions of dollars. The media has also focused on the disasters within the hedge fund community. Several hedge funds have imploded as a result of extreme risk taking combined with the use of heavy margin. These funds often have access to leverage outside of the standard 50% borrowing limit, and so the potential for financial disaster is always looming. Long Term Capital Management became an international financial spectacle with its catastrophic collapse in 1998. This hedge fund was run by one of the most prominent Salmon Brother’s bond traders John Meriwether. Additionally, Fisher Black (from the Black-Scholes model) was on the board of LCTM’s management team. This fund took highly leveraged speculative risks, and when the Russian debt crisis occurred the hedge fund was left bankrupt. It is suspected that the fund controlled over 1.25 trillion dollars of financial instruments. In addition, they borrowed a tremendous amount of gold in an attempt to sell short the gold market. Experts believe that over 400 tons of gold were borrowed from money center banks. Many broker-dealers did not require LCTM to put up the required margin for these transactions. Under certain conditions, a brokerage firm or investment bank may lend the hedge fund money in excess of federal requirements. LCTM often placed no equity in their trades thus exposing the brokerages to several financial risks. The collapse of LCTM prompted the Federal Reserve to bail out the fund. At the time it was believed that the fund meltdown could have serious worldwide financial consequences. This move was criticized because it created the illusion that a hedge fund could take very large speculative positions, and in the event that there is a problem, the Fed would bail then out.

The hedge fund world is constantly undergoing several changes. Currently, the SEC is determining whether or not hedge fund managers should register their investment companies. In all likelihood there will be some form of regulation in the future. As the assets in hedge fund near one trillion dollars, there is the concern that these private investments could wield too much financial power. The LCTM debacle has prompted several debates on the financial power that hedge funds control. The leverage and ability of these fund managers allows them to have a much greater control over markets, and thus some regulation is certainly needed.

When a hedge fund company acts with fiduciary responsibility, the funds can be an excellent alternative investment vehicle. If you decide that you would like to invest in a hedge fund then it is important to make sure that you understand the fee structure of the fund. If you are not an accredited investor then the choices you will have for hedge fund investing will be severely limited. In these instances, the funds available to you will most likely charge fees that are not congruous to the performance of the fund manager. Fund of funds for the non-accredited investor are very expensive. Better fund managers tend to cater directly to their clients, and so the fund of funds structure may have a difficult time gaining access to top level investment talent. It is very possible to emulate a lot of the strategies offered by hedge fund managers. Many of the strategies that have presented thus far are commonly used tactics. The only field that you may not have access to in a retail brokerage account is the foreign currency exchange. The currency markets are extremely complex, and they are not similar at all to their equity exchange counterparts. Currency trading is also a very volatile market. In order to be successful in currency trading, you must take a macroeconomic look at the world’s economy. Only trained economists are qualified to make correct assumptions about the overall economy, and it is my recommendation that you avoid currency trading. However, if you have the resources to work directly with talented investment managers then it certainly is in your best interest to do so.

Investment banks act as an intermediary and service provider for all of these players in the finance world. For hedge funds, the investment bank provides invaluable research, execution, and financing so that returns can be enhanced without having to accept a higher capital risk. The job of the investment bank is to raise capital, provide advice, perform IPO’s, and assist with trading operations for companies within every sector of the business world. In short, investment banks bring companies and investors together so that investments can be made. However, there is a great distinction between an investment bank and a commercial bank. A commercial bank accepts deposits and makes loans using those deposits. If you need a credit card, car loan, or mortgage loan then you would go to your local branch of your bank and apply for these financial products. Investment banks do not solicit deposits nor are they allowed to accept them. In rare instances they will invest their own capital in a project, but this is usually very unlikely. On the other hand, merchant banks act in the same capacity as the investment bank, but they use their own capital to finance investment projects. The law has changed significantly over the last ten years concerning the governance of investment banking. It used to be that a commercial bank was forbidden from engaging in investment banking activity because regulators feared that depositors’ money would be used for risky investment projects and not risk-averse loans. Since the law has changed, almost every large commercial bank has developed an investment banking arm.

Most people associate the work of an investment bank with initial public offerings. When a company decides to raise money by selling shares of a company, an investment bank is used to underwrite and sell the issue. These financial institutions reap enormous fees for their work, and so the competition among banks is very high. In a typical IPO, the underwriting investment bank purchases all of the shares that a company offers at a deep discount. This is the fee taken by the investment bank for bringing the new shares to market. There are many ways that the banker’s fee is calculated, but the industry standard is to receive seven percent of the total offering. You can now see why there is much competition among investment bankers for deals. In other dealings, such as merger and acquisition advisories, fees are calculated on a different basis, but the revenue generated for the banks is just as lucrative.

The investment banking industry has come under scrutiny amid the corporate scandals over the last few years. In this instance, the investment bankers were pressuring stock analysts to raise their opinion about certain issues so that those companies would continue to use that investment bank for its corporate finance projects. Unfortunately, those who purchase shares that are rated with a biased opinion suffer. Conflicts of interests exist because it is the investment banks objective to sell a new issue of shares as quickly as possible. They do not like having their capital tied up for extended periods of time. Stockbrokers that work for these firms have pressured their clients to buy shares of a newly public company because they receive large commissions for each sale despite the risks involved with buying IPO shares. I do not recommend that you purchase shares of a newly public company because the risks seem to always outweigh the benefits. Very little information is usually available for a new issue of shares, and nor is there a past stock performance to gauge past results against possible future outcomes.

Recent changes to the law seeks to prevent more conflict of interest scandals like we saw earlier in this decade, but all advice and opinions given by professionals should always be take with a grain of salt. People in the finance industry seek to gain wealth just like the rest of us, and on occasion people engage in illegal activity to further their own personal agendas. Salaries and bonuses paid to investment bankers are calculated on their work over the past year, which creates an incentive for bankers to do as many deals as possible. In the investment banking industry, a good investment banker can easily make a seven figure salary. In some instances, salaries have reached into the tens of millions of dollars per year. The majority of these bankers are extremely well educated and ambitious, and the atmosphere among bankers is usually clouted with arrogance. Bankers work ungodly hours. It is not uncommon for a financier to work over 100 hours per week during a busy period.

 The investment banking business is a very interesting but guarded world. The inner workings of most investment banks are only known by a small clique of managers that run the operations. These institutions are privy to information that is not generally released to the public; a certain shroud of secrecy is often one of the more prominent attributes of investment banks today.

These institutions create a great impact on our daily lives. They organize and arrange the finance for the companies that produce the goods and services that we enjoy. Additionally, they help to lower the overall cost of new products by constantly financing competing businesses. I’m sure that you can recall when a new computer cost well over $3,000. The reason that you can purchase one for a lot less money now is because investment bankers have financed the competition. The same applies to the telecommunications industry. It used to be that you would pay over a dollar per minute for your cell phone usage. Now, cell phone minutes cost just a few cents during peak hours and at night cell phone usage is almost always free. Investment banking firms also act as a way for investors to weed out bad investments. The most established banks have a reputation that tells investors that these firms have searched, analyzed, and decided which investments are suitable and so ideas and companies that do not have a real chance of becoming profitable never waste an investor’s money in the first place.

Financial institutions, for the most part, simply act as intermediaries between people that have capital to invest and people that need capital to make purchases. Commercial banks accept deposits and make loans, and investment banks bring together equity money and equity investments.