This piece originally appeared on Forbes.com.
When people hear “hedge fund” or “alternative investments,” many conjure up exotic strategies aimed at amazingly high returns. Well, as Sportin’ Life sang, it ain’t necessarily so. As discussed in earlier columns, some alternatives aim for higher current income; others, to avoid losses; and as we’ll see tomorrow, many are designed to protect against inflation and currency devaluation.
But, yes, some do swing for the fences… or at least for extra base hits. Today, we take a quick look at a few of these; and in future entries we’ll dive deeply into these and many more. If you just can’t wait (and I hope you can’t!), please pick up a copy of my new book, The Alternative Answer.
The perception that hedge fund managers are always swashbuckling gamblers — as Fred Gwynne is always Herman Munster– was fixed by the breaking of the Bank of England by George Soros and Julian Roberston in 1992. The UK was trying to keep the value of the pound in line with German mark (foreshadowing today’s problems with a single EU currency). Soros and Robertson saw that as unsustainable and led an impudent assault on the currency, eventually forcing the Bank to let the pound’s value fall. Soros netted over $1 billion at a time when that was real money.
But savvy investors rarely take such dramatic risks when trying to multiply returns. (John Paulsen demonstrates why: up hugely on subprime, but then down hugely on gold). Instead, they look to distressed investing, startups, corporate turnarounds, natural resource development, and a host other strategies that are hard to replicate in traditional stocks. Let’s look at a few.
Very ironically, bankruptcy court — where distressed investors play– is actually a powerful incubator of great wealth. Many companies with still-valuable assets wind up there because of misfit financial structures and poor management. Smart fund managers await, buying up the bonds of the sickly companies so they can control the restructuring process and then extract the hidden value. Not as cool as breaking the Bank of England, I guess, but it can be even more profitable: Bill Ackman earned eighty times his investment when he vacuumed up General Growth Properties as it entered bankruptcy in 2009.
A related strategy is activist investing, where managers take a stake in a company they feel is undervalued, and then push it to improve shareholder value– Apple , Sony , and Yahoo have all created very nice returns to activists recently.
Probably the most successful strategy for institutional investors over the past few years has been “private equity.” Now, this is yet another alternative term that has many meanings– visit altanswer.com for video explanations of the various flavors. But the signature deal of the field is the corporate version of a home fixer-upper. The idea is to buy a somewhat distressed company with as much debt as possible (just like you’d like to put down as little cash as you can when you flip a house). Then, the PE firm tries to improve things: sometimes with better equipment or distribution; sometimes by cutting fat; sometimes with new strategic partnerships; but nearly always with a new management team. Once it’s all shiny, it’s time to re-sell. Because of the heavy use of debt in the original acquisition, the economic benefit of the improvements flows to a relatively small amount of invested equity… with luck, producing profits of many times that amount. PE firms, and their investors, hope for 2 to 5 times their money back… a homer by any definition.
Startup investing is often considered a branch of private equity, but it’s a wholly different beast. These investors know a bunch of their bets will be complete flops, so they shoot for huge returns in each deal (5 to 10X or more) so that the portfolio average will be respectable. We’ll have lots more to say on this subject in future articles, because various developments — including some great new web platforms — have made this one of the most interesting options for individuals seeking outsized gains.
Just one more for today: oil and gas partnerships, which are definitely not your grandfathers’ drilling deals. Technology advances have taken an awful lot of the guesswork out, and the number of true dry holes is way down for experienced drillers and management teams. Horizontal drilling, fracking, and new lubricants that ease extraction have increased production dramatically, and better seismic and survey methods help identify promising areas much more reliably. Surprisingly, it sure looks like the US is headed for hydrocarbon independence over then next many years; and direct investments in this space might provide outstanding returns along the way.
So there are a few of the ways alternatives can really juice up portfolio returns. When mixed in properly with many other strategies and asset classes for diversification and risk reduction, these can make a lot of sense. And there are now many ways for average investors to participate… more details in future columns (and in that book).