Hedge Funds and Other Alternatives
Beyond DPPs and REITs, alternative investments include hedge funds, private equity, and venture capital. These are typically limited to accredited and institutional investors.
Accredited Investor Definition
To invest in most alternative investments, investors must meet accredited investor standards:
Individual Qualifications
| Criteria | Requirement |
|---|---|
| Net Worth | Over $1 million (excluding primary residence) |
| Income | Over $200,000 individually ($300,000 with spouse) for past 2 years |
| Professional | Series 7, Series 65, or Series 82 license holder in good standing |
Entity Qualifications
- Assets exceeding $5 million
- All equity owners are accredited investors
- Bank, insurance company, or investment company
Hedge Funds
Hedge funds are private investment pools that use various strategies to generate returns, often employing leverage, short selling, and derivatives.
Characteristics
| Feature | Description |
|---|---|
| Structure | Limited partnership or LLC |
| Regulation | Less regulated than mutual funds (Reg D exemption) |
| Investors | Accredited investors and institutions only |
| Liquidity | Limited (lock-up periods common) |
| Minimum investment | Typically $100,000 to $1 million+ |
Fee Structure: "2 and 20"
- 2% management fee - Annual fee on assets under management
- 20% performance fee - Percentage of profits (incentive fee)
- High-water mark - Only earn performance fee on new gains
Common Strategies
- Long/Short Equity - Buy undervalued, short overvalued stocks
- Global Macro - Bet on macroeconomic trends
- Event-Driven - Trade around corporate events (mergers, bankruptcies)
- Arbitrage - Exploit price differences between related securities
Key Risks
- Lack of transparency - Limited disclosure requirements
- Lock-up periods - Cannot withdraw funds for months/years
- Leverage risk - Amplified losses
- Manager risk - Heavy reliance on fund manager
Private Equity
Private equity involves investing in private companies not traded on public exchanges.
Types of Private Equity
| Type | Description |
|---|---|
| Buyout Funds | Acquire controlling stakes in mature companies |
| Growth Capital | Invest in expanding companies |
| Distressed | Invest in troubled companies |
| Venture Capital | Fund early-stage startups |
Characteristics
- Long holding periods (7-10 years typical)
- J-curve returns (negative early, positive later)
- Illiquid until exit event (IPO or sale)
- Capital calls over time (not all invested upfront)
Venture Capital
Venture capital (VC) focuses on early-stage companies with high growth potential.
Stages of VC Investment
| Stage | Description |
|---|---|
| Seed | Initial funding for concept/prototype |
| Series A | First significant funding round |
| Series B/C/D | Growth and expansion funding |
| Late Stage | Pre-IPO or mature company funding |
Risk Profile
- High failure rate - Most startups fail
- High potential returns - Successful investments can return 10x-100x
- Illiquid - No public market for shares
- Long time horizon - 5-10 years to exit
Alternative Investment Risks Summary
| Investment | Liquidity Risk | Leverage Risk | Manager Risk | Regulatory Oversight |
|---|---|---|---|---|
| DPPs | Very High | Moderate | High | FINRA Rule 2310 |
| REITs (Public) | Low | Moderate | Moderate | SEC Registered |
| Hedge Funds | High | Very High | Very High | Limited |
| Private Equity | Very High | High | High | Limited |
| Venture Capital | Very High | Low | Very High | Limited |
Important: Due Diligence All alternative investments require extensive due diligence. Investors should thoroughly understand the strategy, fees, risks, and liquidity constraints before investing.
In a limited partnership, which party has unlimited liability for partnership debts?
Income and losses from a DPP investment are classified as:
Which type of oil and gas program carries the HIGHEST risk?
Intangible drilling costs (IDCs) are:
What is the liquidation priority order for a limited partnership?
Which type of REIT invests primarily in mortgages and mortgage-backed securities?
To qualify as a REIT, how much of taxable income must be distributed to shareholders?
REIT dividends are generally taxed as:
Which of the following can pass through LOSSES to investors?
An individual qualifies as an accredited investor if they have income exceeding:
The typical fee structure for hedge funds is described as:
Which is the MOST significant risk associated with DPP investments?
A limited partner who actively participates in partnership management may:
Real estate DPPs that invest in raw land have:
Excess intangible drilling costs and excess depletion from oil and gas DPPs are:
Which statement about REITs is TRUE?
8.1 Options Basics
Chapter 8: Options