CommonLounge Archive

Investing with Futures and Alternatives — Hedge Funds, Private Equity and Venture Capital

February 21, 2018

Investing in Futures (Future Contracts)

As the name indicates, a future contract entails an obligation to do something in the future, which is usually to buy or sell a commodity at a certain price in the market in the future.

Types of Futures

  • US treasury futures — contracts to buy or sell US treasuries at a certain price in the future.
  • Swap futures— two parties agree to exchange periodic interest payments
  • Forex futures — futures contracts on any forex pair to hedge against exchange rate fluctuations
  • Single stock futures — future contracts on a certain stock
  • Index futures — future contracts on a certain index such as the Dow Jones Industrial Average.
  • Metals — metal futures include copper, gold, platinum, and other futures.
  • Energy futures — including crude oil futures, heating oil, and natural gas, among other futures.
  • Grain and oil seeds futures
  • Livestock futures — including futures on live cattle, feeder cattle, lean hogs, and pork bellies
  • Food and fiber futures — including coffee, cocoa, cotton, and other futures

Investors need to have an account with a broker that offers future contracts to be able to buy and sell them.

Example: Below is a table showing prices for future contracts on EUR/CAD with different expiration dates.

Investing in Hedge Funds

Hedge funds are professionally managed investment funds.

They consist of fund managers, known as general partners, and the investors, who provide the capital for investment — they are known as limited partners.

By design, hedge funds are supposed to make money regardless of whether the markets are rising or declining.

Hedge funds are similar to mutual funds in that their purpose is to maximize return while reducing risk to the minimum. However, hedge funds are different from mutual funds in many points:

  1. For investors to be able to join a hedge fund, they have to have a net worth of at least $1 million without including their primary residence.
  2. More versatile investment portfolio: the mandate of the hedge funds outlines the rules under which the management constructs its portfolio. The investments can include commodities, currencies, stocks, bonds, depending on the strategy.
  3. They use leverage: hedge funds may borrow money to invest with bigger capital. This can maximize returns or maximize losses quickly.
  4. They have a different fee structure: hedge funds often charge fees as a percentage of assets under management as well as a percentage of the returns generated. A common rule is the two-twenty rule (2% of assets under management, and 20% of returns generated).

Hedge funds may be attractive to investors who want to protect themselves from risk. However, there are certain points that investors should be aware of regarding hedge funds.

  1. The taxes may be high, depending on the portfolio of the hedge funds and its trading activity.
  2. The leverage that hedge funds use may increase risk significantly.
  3. Investors have to commit their funds for a certain period of time, and often there are restrictions on withdrawals.

Example of hedge funds with high returns: Paulson & Co., Lone Pine Capital, Bridgewater Pure Alpha.

Most hedge funds specialize in certain types of investments based on their expertise. For example, some hedge funds may invest more in emerging markets and others in renewable energies.

Hedge funds often have their own strategies that they use, some of which are not revealed so that they maintain their edge. They may focus in their strategies on aggressive growth, or income, or macroeconomic changes, among other strategies.

Investing in Private Equity

Investors can invest directly in private equity by investing in private equity (PE) firms. Private equity firms are firms that gather capital and invest this capital directly in other companies, rather than buying their share. PE firms often buy the whole company they want to invest in. This gives them control over its key decisions. The aim of PE firms is often to sell the companies they bought at a higher price.

There are certain conditions, however, for investors to be able to join a private equity firm. Today, the minimum capital that any investor can contribute with is $250,000, although it used to be much higher than that.

Among the biggest buyout deals done by PE firms are:

  • Energy Future Holdings; Deal value in 2007: $44.37 billion; Buyers: KKR, TPG and Goldman Sachs
  • RJR Nabisco; Deal value in 1989: $31.1 billion;
    Buyers: KKR

Usually, PE firms have a single fund or many funds for investment. The firm is managed by someone with expertise, and he/she is called the general partner (GP). The other partners who contribute with capital are called “limited partners”. Partners can include institutional investors as well.

PE firms charge different types of fees:

  • Management fee — payment to managers for their money management efforts regardless of profit or loss
  • Incentive fees — given to managers for profitable investments
  • Ancillary fees — these are normally paid to the general manager by portfolio companies. Well-versed limited partners often request to deduce these costs from the management fees of the manager.

Investing in Venture Capital

Venture capital firms usually provide capital to startup companies with successful prospects. In exchange, investors receive equity in the companies they invest in. Venture capital firms help entrepreneurs obtain the capital they need for their businesses to grow.

This type of investment can be associated with risk if the financed startups fail. Furthermore, usually it takes time for a company to grow and for its cash flow to turn positive, so it is a medium to long term investment. However, it is important for economic growth since it supports businesses in their early stages.

Crowdfunding is also a similar way of financing startup businesses with promising ideas but is suitable for investors who have a smaller amount of capital. Investors also get equity rights in exchange for their capital investment.

There are mainly three types of venture capital financing or investments. First, early stage financing, where startups receive initial investments to cover their capital costs. Second, expansion financing, which helps startups scale up their business. And third, there is acquisition financing, to help a company acquire another company.

Venture capital firms usually vet many applications with business ideas to fund, and eventually choose the ones they deem to be least risky and most promising.

Examples of VC companies: Sequoia, Greylock Ventures, New Enterprise Associates.

Examples of VC-backed companies include: Facebook, Twitter, Salesforce, Whatsapp, etc.

The fees of VC firms include the following:

  • Organizational and fund expenses — including legal and marketing fees, and fees of establishing the firm.
  • Management fees, as a percentage of the capital commitments of the fund.

Strategy

The main strategy of venture capital firms is to finance early promising companies, and then sell their shares later with an exit strategy. There are many exit strategies such as making an initial public offering, merger of the startup with another company, private offering to investors, and maintaining the companies with large market shares and consistent income (cash cows).


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