Alternative Investments. Hossein Kazemi
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The Buy Side
Buy side refers to the institutions and entities that buy large quantities of securities for the portfolios they manage. Buy side entities include asset owners and asset managers. The buy side contrasts with the sell side (detailed in section 2.1.2), which focuses on distributing securities to the public. Examples of buy-side institutions follow, with an emphasis on the perspective of alternative investing.
PLAN SPONSORS: A plan sponsor is a designated party, such as a company or an employer, that establishes a health care or retirement plan (pension) that has special legal or taxation status, such as a 401(k) retirement plan in the United States for employees. Plan sponsors are companies or other collectives that establish the health care and retirement plans for the benefit of the organization's employees or members. Plan sponsors are responsible for determining membership parameters and investment choices and, in some cases, providing contribution payments in the form of cash or stock (or both). In many cases, one individual, the plan trustee, is designated with overall responsibility for managing the plan's assets, whereas the plan administrator is charged with overseeing the plan's day-to-day operations. Both the trustee and the administrator are identified in the plan's summary plan description.
FOUNDATIONS AND ENDOWMENTS: A foundation is a not-for-profit organization that donates funds and support to other organizations for its own charitable purposes. An endowment is a fund bestowed on an individual or institution (e.g., a museum, university, hospital, or foundation) to be used by that entity for specific purposes and with principal preservation in mind.
FAMILY OFFICE AND PRIVATE WEALTH: Family office and private wealth institutions are private management advisory firms that serve ultra high-net-worth investors. A family office is a group of investors joined by familial or other ties who manage their personal investments as a single entity, usually hiring professionals to manage money for members of the office.
SOVEREIGN WEALTH FUNDS: Sovereign wealth funds are state-owned investment funds held by that state's central bank for the purpose of future generations and/or to stabilize the state currency. These funds may emanate from budgetary and trade surpluses, perhaps through exportation of natural resources and raw materials such as oil, copper, or diamonds. Because of the high volatility of resource prices, unpredictability of extraction, and exhaustibility of resources, sovereign wealth funds are accumulated to help provide financial stability and future opportunities for citizens and governments.
PRIVATE LIMITED PARTNERSHIPS: Private limited partnerships are a form of business organization that potentially offers the benefit of limited liability to the organization's limited partners (similar to that enjoyed by shareholders of corporations) but not to its general partner. For tax purposes, limited partnerships tend to flow taxable revenue and expenses directly through to their partners rather than being taxed at the partnership level.
PRIVATE INVESTMENT POOLS: Hedge funds, funds of funds, private equity funds, managed futures funds, commodity trading advisers (CTAs), and the like are private investment pools that focus on serving as intermediaries between investors and alternative investments. Most U.S. funds are structured as limited partnerships and offer incentive-based compensation schemes to their managers. These limited partnerships are usually managed by the general partner, while most of the invested funds are provided by the limited partners. Exhibit 2.1 illustrates the basic structure used for most private alternative investment vehicles. The general partner manages the assets in the fund. Hedge funds tend to use sophisticated trading strategies, funds of funds invest in other funds, private equity funds tend to invest in stock of nonpublic companies, and managed futures funds and CTAs are asset managers who, instead of focusing on traditional stock and bond investments, focus on currency or commodity futures markets.
Exhibit 2.1 Structure of a Limited Partnership Investment Vehicle
SEPARATELY MANAGED ACCOUNTS: Separately managed accounts (SMAs) are individual investment accounts offered by a brokerage firm and managed by independent investment management firms. The relationship between an investment adviser and a client to which it provides advice is typically documented by a written investment management agreement. SMAs can be thought of as being similar to pooled investment arrangements, such as mutual funds, in that a customer pays a fee to a money manager for managing the customer's investment, but SMAs tend to be differentiated from funds in five major ways:
1. A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record.
2. A fund invests for the common purposes of multiple investors, whereas an SMA may have objectives tailored to suit the specific needs of its only investor, such as tax efficiency.
3. A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investor.
4. Fund investors may suffer adverse consequences from other investors' redemptions (withdrawals) and subscriptions (deposits), but an SMA provides protection from these liquidity issues for its only investor.
5. Whereas the fund structure may allow investors to have limited liability, the SMA format may allow losses to be greater than the capital contribution when leverage or derivatives are used.
From an investor's perspective, the advantages of the first four distinctions typically outweigh the disadvantages of the last distinction. However, fund managers prefer the simplicity and convenience of pooled arrangements (funds).
MUTUAL FUNDS (’40 ACT FUNDS): Mutual funds, or ’40 Act funds, are registered investment pools offering their shareholders pro rata claims on the fund's portfolio of assets. In the United States, mutual funds that offer their shares for sale to the public are known as ’40 Act funds due to the regulations that permit their offering by registered investment advisers: the U.S. Investment Company Act of 1940. In recent years, ’40 Act funds have increasingly offered alternative asset exposures through these retail fund structures. A general discussion is provided in section 2.4, along with more specific discussions throughout Parts 2 through 5.
MASTER LIMITED PARTNERSHIPS: Master limited partnerships (MLPs) are publicly traded investment pools that are structured as limited partnerships and that offer their owners pro rata claims. Like equities, MLP units are traded on major stock exchanges, but they have legal and tax structures similar to those of private limited partnerships.
2.1.2 The Sell Side
In contrast to buy-side institutions, sell-side institutions, such as large dealer banks, act as agents for investors when they trade securities. Sell-side institutions make their research available to their clients and are more focused on facilitating transactions than on managing money.
LARGE DEALER BANKS: Large dealer banks are major financial institutions, such as Goldman Sachs, Deutsche Bank, and the Barclays Group, that deal in securities and derivatives. Although based on the same economic principles as typical retail banks, large dealer banks are much bigger and more complex. The macroeconomic impact of a large dealer bank failure may be more widespread because of the central role this type of bank plays in the economic system at large. Generally, most large dealer banks act as intermediaries in the markets for securities, repurchase agreements, securities lending, and over-the-counter (OTC) derivatives. In addition, large dealer banks are often engaged in proprietary trading and brokering hedge funds.
Large dealer banks also have large asset management divisions that cater to the investment management needs of institutional and wealthy individual clients. This involves custody of securities, cash management, brokerage, and investment in alternative investment vehicles, such as hedge funds and private equity partnerships that are then managed by the same banks. Some of these types of banks operate internal hedge funds and take on private equity partnerships as part of their business management service. In this role, the bank acts as a general partner with limited-partner clients.
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