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Alternative investments include various types of investments that fall outside the scope of traditional investments — long-only positions in cash or publicly traded stocks and bonds. Common structures include hedge funds, private equity funds, and real estate vehicles, and they typically are actively managed and may include exposure to commodities, infrastructure, and illiquid securities.

The perceived benefits of including alternatives in a portfolio are:

• Risk reduction via diversification — historically low correlations with traditional assets.
• Higher potential returns — from illiquidity premia and from less-efficient markets for some alternative assets.

Compared with traditional investments, alternatives typically exhibit:

• More specialized manager knowledge required.
• Relatively low correlations with traditional asset returns.
• Less liquid assets held.
• Longer investor time horizons.
• Larger capital commitments from investors.

As a consequence, alternative investments display these characteristics:

• Structures that facilitate direct investment by managers (alignment of interests).
• Information asymmetry between managers and investors, addressed via incentive-based fee structures.
• Difficulty appraising performance — historical returns and volatility data are problematic and less available.

Alternative investments may be classified into three broad categories: private capital, real assets, and hedge funds.

Private capital — details:

• Private equity (PE) invests in equity of non-public firms, or takes public firms private. Leveraged buyout (LBO) funds — most of PE — use debt to buy mature companies. Venture capital (VC) funds back young, unproven firms in start-up or early life-cycle stages.
• Private debt includes direct lending to companies, venture debt for early-stage firms, and distressed debt in firms struggling with payments or in bankruptcy.

Real assets — details:

• Real estate: residential / commercial properties and real-estate-backed debt; held directly, via leveraged ownership, individual mortgages, pooled public/private securities, or limited partnerships.
• Natural resources: commodities (physical, derivatives, equity of producers, or index-tracking futures), farmland (lease income or harvest sales), and timberland (harvest cash flows).
• Infrastructure: long-lived assets providing public services — economic (roads, airports, utility grids) and social (schools, hospitals). Often financed via public-private partnerships; the asset may revert to public ownership at a future date.
• Other real assets: collectibles (art), intangibles (patents), and digital assets (cryptocurrencies).

Hedge funds are investment companies typically open only to qualified investors. They may use leverage, hold long and short positions, employ derivatives, and invest in illiquid assets. Despite the name, they do not necessarily hedge risk.

Fund investing — investors pool capital with others, and a fund manager selects and manages assets according to an agreed-upon strategy. Investors do not control asset selection, management, or sale. The manager typically receives a management fee (a % of investable funds) plus an incentive fee (a % of investment gains). A fund's term sheet describes its investment policy, fee structure, and participation requirements.

Compared with traditional-asset funds, alternative-investment funds typically require larger capital commitments, longer lock-up periods, provide less information on holdings and returns, and charge higher management fees.

Co-investing — investors contribute to a fund (as in fund investing) and have the right to invest directly alongside the manager in some of the same assets. Versus pure fund investing, co-investing can:

• Reduce overall fees paid by the investor.
• Still benefit from the manager's deal expertise.
• Build investor skills and experience for eventual direct investing.
• For the manager, increase available capital and broaden diversification.

Direct investing — the investor purchases assets independently, with no pooled vehicle or outside specialist manager. Typical of large, sophisticated investors (e.g., a sovereign wealth fund with in-house specialists buying real estate, farmland, or VC-stage companies).

Alternative investments are often structured as limited partnerships:

• The general partner (GP) is the fund manager and makes all investment decisions. The GP takes on the partnership liabilities, including repayment of partnership debt.
• The limited partners (LPs) are the investors. They own partnership shares proportional to their commitments, typically have no say in management, and have no liability beyond their investment.
• Partnerships typically set a maximum number of LPs.

LPs commit to an investment amount; in some cases they contribute only a portion initially and provide the remainder over time as the GP calls capital. General partnerships are less regulated than publicly traded companies, and LP shares are typically only available to accredited investors (those with sufficient wealth and sophistication).

Operational details are governed by the limited partnership agreement. Special terms applying to a particular LP appear in side letters. Examples:

• Excusal right — an LP may withhold a capital contribution that the GP would otherwise require.
• Most-favored-nation (MFN) clause — special terms granted to other LPs must also be offered to this LP.

While most alternative limited-partnership holdings are illiquid, a fund may be structured as a master limited partnership (MLP), which can be publicly traded. MLPs are most common in funds specializing in natural resources or real estate.

Fee Structures

Total fees typically consist of a management fee (often 1%–2% of assets) plus a performance / incentive fee (sometimes called carried interest).

Committed capital is typically drawn down over three to five years at the GP's discretion as deals are identified. Committed but un-drawn capital is called dry powder.

Performance fees (a portion of profits) are usually paid only after a hurdle rate (a.k.a. preferred return) is met or exceeded. Two flavors:

• Soft hurdle — once met, the performance fee is computed on the entire increase in value.
• Hard hurdle — the performance fee is computed only on gains above the hurdle.

Performance fees are typically paid at year-end based on the increase in fund value after management fees and other charges (e.g., consulting and monitoring fees billed to portfolio companies).

A catch-up clause works similarly to a soft hurdle. With a hurdle of 8%, a 20% performance fee, and an annual return of 14%: the first 8% goes to the LPs, the next 2% goes to the GP (so the GP "catches up" to receiving 20% of the first 10% of gains), and additional gains are split 80/20 LP/GP.

A high-water mark means no performance fee is paid on gains that merely offset prior losses. Performance fees are charged only when the current value exceeds the highest net-of-fees value previously recorded (at the end of a payment period). Because investors enter a fund at different times, each may have a different high-water mark.

Waterfall & Clawback

A partnership's waterfall describes how proceeds from realized deals are allocated between the GP and LPs.

A clawback provision stipulates that if the GP has accrued or received incentive payments on gains that are subsequently reversed as the partnership exits later deals, the LPs can recover those previously paid (excess) incentive fees. This is especially important under a deal-by-deal waterfall.