Advising Clients since 1980
Private Investments
Alternative investment vehicles such as hedge funds and private equity are often offered exclusively to high-net-worth individuals. In fact, it is the high-net-worth investor for whom this type of financial investment plan is best suited.
Barriers to entry are both legal and structural. The Securities and Exchange Commission (SEC), which does not scrutinize these investments, has clear guidelines about who may invest in them. Minimum investments are high, making it impossible for all but the most affluent to gain access. In most cases, profits or losses are not realized for five to ten years, so these vehicles are only appropriate for those who do not need their money for that amount of time.
Participation in Private Investments
Those who qualify as private investors fall into one of two general categories: accredited investors, who must have a net worth of more than $1 million or annual income of at least $200,000 for each of the past two years; and qualified purchasers, who must have a minimum of $5 million in investments not including property used for business or as a primary residence.
Most alternative investments are structured as private limited partnerships. Partnerships are open to no more than 100 accredited investors, and those open to more affluent qualified purchasers can accept up to 500 investors.
Investment managers overseeing alternative portfolios must believe that individuals from whom they accept money meet minimum investing requirements. Prospective clients are asked to fill out an exhaustive questionnaire outlining their financial holdings. Although managers are not required to gather supporting documentation, such as tax returns, they may request a financial reference from an advisor.
How Private Investments are Managed
Not all vehicles are available to individuals who attain private investor status, even though the SEC allows access. Because the best managers have no trouble raising capital due to their excellent reputations, they can require initial investments between $5 million and $10 million. They also frequently give preference to individuals and organizations who have previously invested with them.
Investing in private limited partnerships is not a simple process even for those who exceed minimum net worth requirements. It can be difficult to locate partnerships, because those who manage them are prohibited from advertising or soliciting business. Referrals from trusted contacts are often the only way to uncover quality investment opportunities.
It is also not easy to determine how and in which securities an investment manager invests because many are reluctant to disclose their strategies. Disclosure can make it difficult for managers to execute complex strategies, and it gives others the opportunity to copy their moves. In the absence of such required disclosure, it is left to managers to determine whether the risks they are taking are prudent.
A possible vehicle for the high-net-worth investor is the fund of funds, which operates in much the same way as a mutual fund. Funds of funds pool investor assets and invest in multiple hedge funds, either across various styles or within a niche such as technology or emerging markets. Funds of funds, which generally have lower minimum investment requirements than individual hedge funds, have somewhat democratized private investing during the past several years by providing services that help less affluent private investors access alternative investments. Fund of funds also charge fees that are in addition to the fees charged by the funds in which they invest.
The financial services industry has attempted to further democratize this type of investing by creating mass-market alternative vehicles. For example, closed-end mutual funds that make venture capital investments have been created, but for the most part, successful alternative investing remains the domain of those who can afford the highest quality deals.
Managing Risks
Of course, alternative investments do carry risks, the degree of which varies within each asset class. For example, hedge funds that have strategically protected against a market downturn through the prudent use of short sales and options contracts can be safer than traditional long-only stock investments.
Hedge funds that use leverage, a strategy designed to enhance returns without increasing the size of an investment, can significantly increase risk. Hedge funds achieve leverage through various methods, including the purchase of securities with borrowed money, or the use of derivatives. Leverage can dramatically increase the velocity and size of gains or losses in a portfolio and any borrowings must also be repaid if the financial investment increases or decreases in value.
Despite some high-profile blowups, such as that of Long Term Capital Management, the heavily leveraged hedge fund that failed in 1998, alternative investments are often worth the risk and hefty price of admission, having generally delivered appealing compound annual returns.
For most private equity investments, the expected return includes an illiquidity premium. The illiquidity premium is that portion of the return that rewards investors who have the patience to wait five to ten years to realize gains. Because of the long time frame, private investments are less impacted by market volatility than traditional investments. Another benefit is the tax-free compounding that occurs while the funds are invested and the favorable tax treatment that the gains receive when they are realized.
Unlike private equity investments, the expected return for hedge funds does not include an illiquidity premium. Hedge funds are typically invested in marketable securities and offer quarterly or annual liquidity. Hedge funds can also be less tax efficient for individuals than private equity investments, given the high turnover of the portfolio.
Taxation
For investors in income tax brackets of 28% or higher, a capital gains tax law enacted early in 2001 reduced the maximum capital gains tax rate to 18% for assets acquired after 1 January 2001 and held for at least five years. The top capital gains tax rate for assets held between one and five years remains 20%.
One Final Thought
Investing in alternative assets is a responsible way for high-net-worth investors to diversify a portfolio heavily weighted toward traditional investments such as stocks and bonds. These investments often have a low correlation with traditional equity and fixed income investments, and any investor must carefully consider the expected reward versus risk with any of these private investment partnerships.
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Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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