Alternative Investment Funds (AIFs)- Derivatives

Alternative Investment Funds (AIFs): Hedge Funds and Private Equity

I. Hedge Funds

Overview

• Reputation: Often perceived as high-risk investments, but strategies vary widely.
• Original Purpose: To reduce or eliminate market risk.
• Current Landscape: Diverse range of strategies, some focused on risk control, others on high-geared returns.

Strategies

• Traditional ‘Absolute Return’ Hedge Funds:
  • Aim to profit regardless of market movements.
  • Use a mix of asset classes, including derivatives.
  • Employ long and short positions (selling borrowed shares to profit if prices fall).
• Modern Strategies:
  • Focus on generating highly leveraged returns.
  • Can involve higher levels of risk, sometimes with less emphasis on controlling market risk.

Key Characteristics

• Structure: Typically established as unauthorized and unregulated Collective Investment Schemes (CISs).
  • Not generally marketed to private individuals due to perceived risk.
• High Investment Entry Levels: Require minimum investments often exceeding US$500,000 (sometimes over US$1 million).
• Investment Flexibility:
  • Unrestricted by regulation, can invest in any assets.
  • Can take long and short positions in securities, commodities, and currencies.
  • Aimed at producing absolute returns (positive returns regardless of market conditions).
• Gearing/Leverage:
  • Many hedge funds borrow funds and use derivatives to enhance returns.
• Liquidity Restrictions:
  • Initial 'lock-in' period (1-3 months) before investors can sell.
    • This increases risk exposure and the multiple of cash value of an investment.
• Fees:
  • Performance-related fees (paid if specific performance levels are achieved)
  • Fees for all investments which are comparable to other growth funds. *Performance fees can be substantial - 20% or more of the net new highs.

II. Private Equity

Overview

• Definition: Medium to long-term finance invested in potentially high-growth companies in exchange for an equity stake.
• Forms: Can range from venture capital to buy-outs.

Nature of Private Equity Investment

• Equity Stake: Investment in exchange for a share in the company.
• Risk Sharing: Private equity firms face similar risks to other shareholders, dependent on the growth and profitability of the business.
• Return: Private equity firms primarily make returns through capital gains on exit.

Exit Strategies

• Sale Back to Management: Selling shares back to the investee company's management.
• Sale to Another Investor: Selling shares to another private equity firm.
• Trade Sale: Selling company shares to another firm.
• Stock Market Listing: Taking the company public.

Funding

• Sources: Private equity firms raise capital from large investing institutions.
• Investor Confidence: Institutions are happy to entrust money due to private equity firms' expertise in finding high-potential businesses.

Investment Vehicles

• Direct investment: Few individuals or institutions are able to invest directly due to high levels of risk.
• Pooled Vehicles: Investment through pooled vehicles reduces risk and increases diversification.
  • Historically, investment trusts were a common option.
• Modern Methods:
  • Structured as limited partnerships with high minimum investment levels.
  • Private placement funds are now a common way of structuring the investment.
• Liquidity Restrictions: Generally, restrictions on when investors can withdraw their investments.

III. Comparison

In Summary

Hedge funds and private equity are alternative investment vehicles with distinct strategies and risk profiles. Hedge funds seek absolute returns through diverse strategies and the use of derivatives, but are typically high risk, illiquid and have high fees. Private equity provides longer-term financing for companies with the potential for growth, and primarily seeks capital gains upon exit. While both offer diversification benefits to institutional investors, they usually have significant barriers to entry for retail investors.