alternate investment
& carried interest
What is an Alternative Investment?
An alternative investment is a financial asset that doesn’t fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.
Key Aspects
- An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
- Private equity or venture capital, hedge funds, real property, commodities, and other tangible assets are all examples of alternative investments.
- Most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
- While traditionally aimed at institutional or accredited investors, alternative investments have become feasible for retail investors via alternative funds.
- Common forms of alternative investments include real estate, commodities, cryptocurrency, and collectibles.
Understanding Alternative Investments
Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and risk. Many alternative investments have high minimum investments and fee structures, especially when compared with mutual and exchange-traded funds (ETFs).
These investments also have fewer opportunities to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets because of lower levels of turnover.
Most alternative assets are fairly illiquid, especially compared with their conventional counterparts. For example, investors are likely to find it considerably more challenging to sell an 80-year-old bottle of wine than 1,000 shares of Apple Inc. (AAPL) because of the limited number of buyers.
Investors may have difficulty valuing alternative investments since the assets and transactions involving them are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as only 11 are known to exist, and only one can be legally owned.
Carried Interest
Carried interest, often referred to as “carry,” is a share of the profits from an investment fund that is paid to the fund manager, typically in alternative investments like private equity or venture capital. It serves as an incentive for the manager to generate strong returns for the investors in the fund. Essentially, it’s a performance-based fee where the manager only earns a percentage of the profits once the fund achieves a certain pre-agreed rate of return, often called a hurdle rate.
Here’s more detailed breakdown:
Incentive for Fund Managers:
Carried interest is a key component of a fund manager’s compensation, motivating them to maximize returns for investors.
How it Works:
If the fund performs well and exceeds a predetermined hurdle rate, the fund manager receives a percentage of the profits (often 20%) above that hurdle.
Tax Implications:
Historically, carried interest has been taxed at the lower capital gains tax rate rather than the higher ordinary income tax rate, which has been a subject of debate and legislative efforts to change the tax treatment.
Example:
If a fund has a hurdle rate of 8% and generates a 20% profit, the fund manager would receive 20% of the 12% profit exceeding the hurdle rate.
Not a Salary or Bonus:
Carried interest is separate from the management fees a fund may charge, which cover the fund’s operating expenses and the managers’ base salaries.