Alternative investments live outside public stocks and bonds. They use unique access methods, distinctive fee structures, and ownership vehicles that look nothing like a mutual fund. Master the features, then the access methods, then the compensation math.
Alternative investments share distinctive features that separate them from public markets:
- Illiquidity. Lock-ups run 10 to 12 years in private equity. Investors demand an illiquidity premium.
- Low traditional-market correlation. Useful for diversification, though correlations rise during crises.
- Specialized, skill-dependent strategies. Return depends on manager alpha, not beta.
- Limited transparency and lighter regulation versus mutual funds.
- High minimums, typically $1M+ for institutional vehicles.
- Complex fees with both management and performance components.
KEY: Reported alternative returns are smoothed because positions are marked infrequently. Smoothing understates volatility and inflates risk-adjusted returns. Adjust before comparing to public markets.
Three ways to access alternatives. The trade-off is control versus fees versus operational burden.
Fund Investment. You commit capital to a pooled vehicle. The GP picks the underlying deals. Simplest access, highest fees, least control over deal selection.
Common mistakes
- Confusing co-investment with secondaries. Co-investment is alongside a fund in a new deal. Secondaries are buying existing LP interests. Trap answer: "co-investment is a discounted purchase of fund stakes."
- Charging carry on distributions instead of profits. Carry applies to profit above return of capital, not to gross distributions. Trap: 20% × $180M = $36M on Example 2. The correct base is $80M of profit, yielding $16M carry.
- Forgetting the catch-up. With catch-up, carry applies to ALL profit once the catch-up completes. Without catch-up (hard hurdle), carry applies only above the hurdle. Trap: applying 20% only above the hurdle when the LPA includes catch-up.
Bottom line
- Shared features: illiquidity (illiquidity premium), low correlation, skill-dependent returns, limited transparency, and complex fees
- Five categories: hedge funds, private capital (PE + private debt), real estate, infrastructure/natural resources, commodities
- Three access methods: fund (easy, high fees), co-investment (selective deals, reduced fees), direct (full control, full operational burden)
- "2 and 20" = 2% management fee plus 20% carry above a hurdle
Exam shortcut
Memorize five categories: hedge, private capital, real estate, infra/natural resources, commodities. Map method to investor size: small to fund, mid to co-invest, sovereign to direct. Walk the waterfall in four steps (capital, hurdle, catch-up, split) and verify GP carry equals 20% of total profit at the end. If it doesn't, you skipped a step.
The full lesson (about 1,921 words, 13 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- features methods and structures
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