New Rules for the Alternative Investment Landscape

January 30, 2011
5min read

Investors often turn to alternative investments to provide diversification beyond the traditional avenues of equities and fixed income. Alternative investments are known for being complex products, usually open only to institutional and accredited investors. The financial services arena has long been focused on the mass affluent, but new alternative asset classes are widening the playing field for other investors.

Alternative investing is complex, but worth parsing -- savvy professionals as well as novice investors will benefit from understanding the nuances of the field. This is true of any financial opportunity, of course, but the unconventional structures of alternative investments merit a deeper examination.

Investing in Anything

Alternative investment is an umbrella term for a vast array of options: these range from private equity to commodities and derivatives; from classic artwork to classic automobiles; from timberland and oil/gas partnerships to your breakfast -- that is, to wheat, orange, and lean hog futures.

Oranges are nature's oranges.

The 90%

Legal funding is a newcomer to the alternative investment field, but it has proven as lucrative as any other asset class. While there are three main types of legal funding - consumer, attorney, and commercial - the latter is probably the most commonly-known to investors.

The returns are impressive: in two years, commercial legal funding firm Burford Capital saw a 90% return on its short-duration portfolio, while Juridica Investments paid a 5% dividend to its investors in its first year of operation. This goes to show that alternative investments can not only provide competitive returns in a short timeframe, but they can do so in a relatively non-volatile way. Investors can also take advantage of alternative investments in order to pursue personal passions or hobbies.

Take classic automobiles: just as collectors of fine art might curate a collection, investors can finance whole or fractional ownership of classic vehicles. Famous collectors such as Jay Leno, Jerry Seinfeld or Ralph Lauren act as testament to an investment class that offers huge returns: the most expensive automobile sold at public auction was a 1963 Ferrari 250GTO, sold for over $38 million in August 2014.

That this was a public auction is quite noteworthy -- private auctions typically fetch much higher.

Toy Ferraris, however, usually only go for a couple hundred thousand.

Portal Processing: How Investors Can Channel Capital

The ability to channel liquidity quickly and efficiently is one of the hallmarks of today's investment landscape. Alternative assets reflect this by permitting diversification for not only a portfolio but also for portals that channel funding and provide capital.

The Growth of Emerging Growth

President Obama's Jumpstart Our Business Startups (JOBS) Act exempted so-called emerging growth companies - defined as having less than $1 billion in revenue in their most recent fiscal year - from certain corporate governance requirements. It further allowed them to solicit investment directly from pools of small investors in the general public.

This is known as general solicitation, but also goes by a more recognizable title: crowdfunding.

The World Bank commissioned a study on crowdfunding in 2013 and found that the market has the potential to grow to $93 billion by 2025. By channeling capital directly into structures like Funding Circle, Symbid, or GoFundMe, investors allow companies to raise money in a cost-effective, compliant manner. Conversely, larger investors seeking strategic partnerships and advisory services in the crowdfunding market can benefit from partnerships with organizations like Crowdfund Capital Advisors or BoardSuite.

As the saying goes, it takes a village to raise a startup.

Do the Due: Why Due Diligence is Critical

Of course, all this activity is possible only because of the confidence in the legitimacy and efficiency of capital markets. Take away that confidence and those same markets might not be as strong. Due diligence must be performed before any investment -- alternative investments are certainly no exception.

Six Degrees, Zero Assets

Famous actor Kevin Bacon has enjoyed a successful Hollywood acting career that would not leave anyone financially wanting, but unfortunately a significant portion of his assets were invested in the hedge fund of one Bernard Madoff. After Madoff's hedge fund spectacularly imploded in December 2008, Bacon had few demonstrable assets.

Though Madoff's scheme and its cover were elaborate, this is a case where insufficient due diligence resulted in one of the greatest disasters in financial history. Even when an alternative investment -- such as a hedge fund or the commodities market -- does have compliance controls in place, utmost due diligence is a matter of rule, not of exception.

Before investing in fine wine, make sure it comes with only the finest fish.

Consider the rare wines market, an alternative asset class where no such compliance controls exist. Here the potential for fraud and duplicity is ripe. Between 2004 and 2012, wine investors, including William Koch and Quest software co-founder David Doyle, found themselves victim to a multi-million dollar counterfeit wine scheme. The perpetrator, Rudy Kurniawan, concocted counterfeit French vintage wines to the tune of over $20 million dollars.

The victims consulted with not only a wine expert who attested to the false authenticity of the wine, but also with a printing expert who determined that the labels -- supposedly 1940s vintage -- were rather made by an inkjet printer. Although Kurniawan has since been arrested, convicted, and ordered to pay restitution, this case demonstrates the importance of due diligence. Investors need to be as unconventional in obtaining their information as the asset classes they are exploring.

Consideration Differentiation: Debt vs. Equity

Alternative assets by themselves represent a different asset class, but the alternatives themselves are just as differentiated. A company may issue more shares of common stock and the result is straightforward: shareholders are diluted, the stock price will decline and of course, more shares are left outstanding. But for a private placement floated to institutional investors and accredited investors, the transaction itself can be structured in numerous ways to provide equity, debt, and for any contingencies.

The most alternative investment of all: peace and joy on this earth.

Contingencies can range anywhere from a clause specifically to work around an over-subscription to the private placement, to special classes of stock that may benefit certain shareholders, all the way to clauses that open the door to litigation should certain milestones not be achieved. Derivatives are well-known for being as differentiated on their own merits as they are among other asset classes.

A call or a put means that an investor is betting on a stock going up or down, respectively. However, what if an investor wants to bet that it can go either way?  Try a straddle. Betting on how the markets will perform in any given day?

The futures market could be the place to be. Want to bet on the Dollar being stronger than the Yen, Yuan or Euro on any given day? That is referred to as ForEx, or Foreign Exchange. The wide variance of derivatives alone attests to the scope of the alternative asset market.

Why the Fundamentals Still Matter

The alternative asset market is complex enough for professionals -- for everyday investors it can be downright befuddling. But to assess a strategy's potential, one must understand how alternative investments fit into the overall picture. Purchasing the investment du jour is not just dangerous; it confounds common sense.  Old sayings such as ''Don't put your eggs in one basket'' hold as much water for traditional and alternative investments alike.

Of course, adages are a poor substitute for the counsel of professionals such as a tax adviser or a financial planner - in addition to the investor's own expertise.

A disaster waiting to happen.

Factors such as risk tolerance, taxes, investment objectives, and special situations should also be considered. There are times where an alternative investment may not be as liquid as other investments and could force undue hardship and inconvenience for an investor at the very least. It is not often said that due diligence should be performed on the investor as much as the investment, but in the case of alternatives it should be stated as a matter of fact.

The world of alternatives boils down to the simple truth that good business is where you find it. Investors might not believe at first that there is money to be made in lawsuits, classic cars, alcohol, and Broadway musicals, but these classes are in fact widely accessible. They have different rules, yes, but the fundamentals are the same - and just as important.

Photo credits: scottwills, The Rocketeer, LEGO Bro, Vinoth Chandar, capn madd malt, KawaiiCloud, jronaldlee, via Compfight.

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