Subsequent installments in the series will dive into specific subcategories within the “alternative asset” asset classes. Think of those installments as the trees. This installment looks at the forest.
There are many different ways of categorizing the alternative assets; no universally accepted approach exists. In this series, we group them into the following four, overarching categories:
Most authorities distinguish between angel investing and venture capital investing. We agree that there is a distinction, but the line separating them is not stark.
This series addresses angel investing and venture capital investing in tandem, briefly in installment 5 and then more thoroughly in Installment 6, which is titled “Venture Capital.” While we recognize the distinction (which we elaborate on below, in the section titled “Investment Stages”) we consider angel investing to be a subcategory of venture capital.
[Editor’s Note: For more on venture capital, please see A Brief History of Venture Capital.]
The term “private equity,” in its broadest sense, could encompass everything from angel investments to venture capital to leveraged buyouts. More common definitions, however, distinguish between venture capital and private equity. The Business Dictionary defines private equity to mean:
“Money invested in firms which have not ‘gone public’ and therefore are not listed on any stock exchange. Private equity is highly illiquid because sellers of private stocks (called private securities) must first locate willing buyers. Investors in private equity are generally compensated when: (1) the firm goes public, (2) it is sold or merges with another firm, or (3) it is recapitalized.”
An individual investor can make a private equity investment along the lines described above and, technically, that investment would meet the definition. However, most private equity investments have historically been made by private equity funds and when the financial literature refers to private equity, it usually means private equity investments conducted by private equity funds.
We define a “private equity fund,” in turn, as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund, or venture capital fund and which does not provide investors with redemption rights in the ordinary course. This last point is very important and is characteristic of many alternative assets: most are not liquid; you cannot simply go online or call your investment advisor and sell your investment immediately.
Hedge funds, like venture capital and private equity funds, are actively managed, pooled investment vehicles that invest the funds of several types of investors, including individual accredited investors. Unlike venture capital and private equity funds, hedge funds invest in a range of assets classes, including public and private securities and derivative instruments, with most hedge funds typically focusing on assets that are free from restrictions on transfer and which have fairly liquid trading markets.
Structurally, hedge funds differ from private equity and venture capital funds in a number of important ways. For starters, hedge funds are, strictly speaking, open-ended funds. Meaning that, subject to limitations set forth in their organizational documents (and there are always limitations), hedge funds can accept new investors and redeem the interests of existing investors at any time. What’s more, open-ended funds are not typically subject to a specific term, so once formed, a hedge fund exists indefinitely.
Another important structural difference is in the way investors contribute funds. A hedge fund investor makes her entire capital contribution when she is admitted to the fund, rather than committing or pledging to contribute capital in the future, when a “capital call” is made, as with a private equity or venture capital fund.
We mentioned examples of “hard” (aka “tangible”) assets in installment 1: art and antiques, precious metals, fine wines, rare stamps and physical coins, and sports cards and other collectibles. Other examples include: apple orchards, banana farms, comic books, date farms, emus, and probably 10,000 other things.
But wait, you don’t have to be an accredited investor to buy any of these things. So why are we mentioning them in a series intended for accredited investors?
Well, while you do not need to be an accredited investor to invest in “hard” alternative assets directly, you do need to be an accredited investor to invest in a private equity fund or hedge fund that invests in “hard” alternative assets. And, for all the reasons discussed in installment 3, you will undoubtedly become aware of opportunities to invest in such funds.
Having sketched out the major categories of alternative assets in the prior section, we want to dive in slightly deeper with respect to the inter-relationship between two of them, venture capital and private equity, and discuss how they relate to investments in the stock market.
Rob Slee, in his book Private Capital Markets (Wiley, 2011), recognizes five stages of company growth, from an investment perspective: (1) seed, (2) startup, (3) early, (4) expansion, and (5) later or mature.
The following table provides a brief overview of each stage:
|Seed stage||Concept or product development||Personal savings, family, friends|
|Startup stage||Operational but still developing product or service; no revenue; less than 18 months||Personal, family, friends, crowdfunding; small angels|
|Early stage||Product or service in testing/pilot production; maybe revenue; less than 3 years||Angels, VCs, equity crowdfunding|
|Expansion stage||Significant revenue growth, maybe profit; more than 3 years||VCs and VC funds|
|Later or mature stage||Positive cash flow, profit; typically more than 10 years||PE groups and funds, family offices|
A publication by investment banking firm Madison Park Group, does an excellent job of summarizing the various investment stages:
Take a moment to tie these five stages to the differences between venture capital (“VC”) and private equity (“PE”). The critical point for you to understand is this: today’s VC investment is tomorrow’s PE investment.
We mentioned earlier that some authorities view angel investing differently than VC investing. And, as the chart above suggests, we do too.
In a nutshell, and as the chart also suggests, the newest start-ups have tended to be self-funded and/or are funded by investments by “friends and family.” As a start-up progresses and gets closer and closer to becoming profitable, it can look to different types investors; younger start-ups have tended to look for money from angel investors whereas VC funds tend to invest in slightly more proven start-ups. But the line of demarcation, which was never that bright, is getting duller all the time and will soon become downright hard to see because of the changes the JOBS Act has brought (See installment 3).
If you are interested in investing some money in “start-ups,” there are a number of ways you can do that:
You should also understand that “crowdfunding” sites and platforms are also a way to invest in PE. More on this in installment 5.
Recall our discussion in Section 4.1 about how one can invest in various tangible assets through a fund? Well, before you can do that, unless the offering is a registered offering with the Securities and Exchange Commission, the fund (that is, the “issuer”) will typically provide you with a “private placement memorandum” or “PPM” or with other disclosure materials designed to alert you to the risks of investing in their fund. This is because your investment constitutes a purchase of a “security” (see Section 3.1).
The same is true of any other security. If you invest directly in a start-up (or any company, for that matter) other than by doing so on a public exchange (i.e. the NYSE, NASDAQ, etc.) then you are most likely buying a security and doing so through a private placement.
And, if you are investing through a fund that, in turn, invests in one or more companies (or assets of any kind) then- unless you are investing in the fund by purchasing its securities on a publicly traded exchange then the issuer of that security (that is, the fund) is selling to you in a private placement.
In either case, you should be given a PPM. If the issuer doesn’t do this, then something may be very wrong and you should consider very carefully whether this is the investment for you.
The terms “alternative mutual fund” and “liquid alternative” refer to a publicly offered, SEC-registered fund that uses investment strategies that differ from the buy-and-hold strategy typical in the mutual fund industry. One does not need to be an accredited investor to invest in one. The past few years have seen a proliferation of them.
There are a number of factors to consider before investing in any alternative asset (and for that matter, like any potential investment). These include understanding the strategy of the fund, the track record of the manager, and how the investment fits into your overall investment portfolio.
An alt mutual fund is not a hedge fund. Like any mutual fund, alt mutual funds are regulated under the Investment Company Act of 1940. Hedge funds are not. This limits what an alt mutual fund can do. Among other things, an alt mutual fund is subject to:
One final note: if you decide to look into alt mutual funds, you will see that there are two major types of managers: (a) managers of traditional hedge funds that have decided to move into the mutual fund space; and (b) managers of traditional mutual funds that have decided to move into using hedge fund-like strategies. Click here for an interesting discussion of this subject by Barron’s writer Beverly Goodman.
While we encourage you to read this series in order, you certainly don’t need to. Each installment is designed so it can be read as a stand-alone article. Here they are in case you want to skip around:
You will notice that throughout this series, I use the term “we.” This is done to acknowledge the great editorial assistance of the Financial Poise Editorial Team. This series is based on my book The Investor’s Guide to Alternative Assets: The JOBS Act, “Accredited” Investing, and You.
©2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a senior partner in Sugar Felsenthal Grais & Helsinger LLP’s Chicago office. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts…
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