A Primer on Private Investments
First, of course, the legal disclaimer
Please note that the information
in this article is not to be used as consulting, accounting, or legal advice. The
following information is provided with the understanding that this article is not
a substitute for professional advice, and is merely for informational purposes.
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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
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
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
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
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.