Financial advisors frequently recommend alternative investments to provide diversity in an investment portfolio, but finding a cost efficient way to get this diversity is challenging.
Alternative investments generally include assets like private equity, real estate, hedge funds, and commodities. These investments are “alternatives” to stocks and bonds.
A portfolio with exposure to alternatives (typically advisors recommend at least 20%) may outperform and/or experience less volatility than a conventional portfolio of stocks and bonds.
Unfortunately, alternative investments have become synonymous with high fees (2 to 5%) and high investment minimums ($500,000 to $5,000,000).
Many alternative investments are structured as a fund with management fees of “2&20”—meaning 2% in an annual asset management fee and 20% of the profit share. Many studies of this fee structure have concluded that the lofty fees aren’t justified as the vast majority of these funds do not beat the market. Ironically, this research shows what, in retrospect, is obvious: over the long term, the higher the fees, the lower the net performance.
Mutual funds and exchange traded funds (ETFs) have evolved into a “poor man’s” alternative—open to all—while hedge funds and private equity funds have targeted the wealthy with promises of high returns and “inside edge” exclusivity via high minimums.
The high-touch nature of these investments combined with the opacity of their fee structures have made many revere and assume projected alpha, undeservedly. Private equity funds in particular have boasted above average returns. Yet on an after-fee basis, one might be surprised to learn the real take-home returns for a passive investor. We’ll explain below.
What’s Private Equity?
As the public markets have become more regulated in the wake of the 2008 financial collapse, private investment has become an exclusive way for businesses to raise necessary capital while avoiding the cost of regulation. Private equity funds have grown rapidly in this environment, becoming an “investment club” dominated by large investors like university endowments, insurance companies, banks, ultra high net worth family offices, and pension funds.
In addition to complicated fees and high minimum investment amounts ($250,000+ for some, $5,000,000+ for others), these investment funds are highly illiquid, typically with terms of approximately 10 years. The contracts creating the investments may have extension provisions, which may lead to illiquidity over a life beyond the originally expected 10 year term.
Private Equity Fees: Not So Pretty
As is the case with most traditional funds, private equity managers tend to make significant profits at the expense of their investors, or limited partners (LPs).
However, 2 and 20 isn’t always the case. Fund managers may charge management fees of 1.5 - 3.0% levied against the amount of the investment (one of Carlyle’s funds famously charged 3.68%). The larger the amount of capital they are able to raise, the greater their total income. Of course, fees pay operating costs, however any excess revenue after costs is distributed to fund managers.
Management fees are collected regardless of the fund’s performance, meaning an investor could lose a significant amount of money from both poor fund performance and a burdensome fee structure.
Carried Interest & Upside Participation
Frequently private equity funds are structured so distributions of returns go to managers and then to investors. There is often a “waterfall” that has a “preferred return” distributed to the managers first. After satisfying the “preferred return”, additional earnings are distributed 20% to the manager and 80% to the investors.
Some funds will have provisions for “high water marks” so that if there is a distributable gain in one year and a loss the next year, the manager won’t earn any carried interest until the high water mark set in the prior year is once again surpassed. However, not all private equity investments are structured this way.
The Bottom Line
You can quickly see how an investor’s ability to profit from a private equity fund is significantly less attractive than that of the manager. In the instance of a fund that charges a flat 2.5% management fee per year, even a good year means earning returns much lower than might have been realized otherwise - and that isn’t counting the fact that upside is fractional.
Private equity funds are not alone in this model. Hedge funds, non-traded Real Estate Investment Trusts, and other private investment vehicles have been known to charge exorbitantly for their management services, while failing to deliver market returns.
Education is key to learning what this means for an investor’s ability to profit. Investments where a manager and middlemen can be avoided typically mean reduced fees and improved transparency around real take-home returns.
The Fundrise eREITs give anyone in the US direct online access to real estate investments. We strive to increase access to real estate investment with lower fees and higher transparency than other vehicles for alternative investments.