What happens when clients want "something different" than typical investment vehicles?
Well, as the saying goes, if you have to ask ...
Alternative investments such as private equity deals or hedge funds are not for average clients. Salomon Smith Barney, for example, requires a minimum of 5 million dollars in investable assets before its "qualified" clients can pursue an alternative investment. Ed Cunningham, senior vice president and director of alternative investments at the firm, calls this select group of investors penta-millionaires.
PaineWebber also has an Alternative Investment Group, billed as providing services for "qualified, high-net-worth individuals." That means a minimum net worth of 1.5 million dollars. Products include investment partnerships, hedge funds and private equity funds.
"[Such offerings are] certainly not for the run-of-the-mill investor," says a PaineWebber spokesperson. "Alternative investing is something our reps would not usually advise."
That's because most clients wouldn't qualify. "Studies show that there are probably 600,000 households in the entire country that have what we call 'the ability to invest where others cannot,'" says Gerry Kuschuk, head of Prudential Securities Alternative Investments Group. Translation: Tying up money in illiquid private deals is not a problem.
"It's not heads, but dollars" that make alternative investments an interesting market, Kuschuk says. About 80 billion dollars has been placed in alternative investment vehicles in each of the past two years, he adds.
No Angels Most firms offer clients private deals at the mezzanine level. This is the stage prior to an IPO. Investors cash out when their holdings go public or are acquired.
Clients don't usually participate at the venture capital stage. This "angel" money is used in initial rounds of financing a start-up. Most investors don't want to be in the business of providing seed money.
"You need a lot of religion to try angel funding," Kuschuk says. "There is a large potential, but the failure rate is even larger."
Private mezzanine deals are risky enough. Fund managers may have to be actively involved in helping a start-up company achieve profitability. And there can be significant withdrawal penalties for an early exit. Most deals are structured as a limited partnership or limited liability company. There are no specific rules on either valuation or pricing. Their most appealing feature is the potential for higher returns than publicly traded securities, along with low correlation to the public markets.
A hedge fund is a private investment partnership that invests in many types of products and markets. The funds are usually structured as limited partnerships, typically with more liquidity than private equity. They can provide diversification benefits, depending on the hedge of the portfolios. Typically, a hedge fund investor is a wealthy individual or institution who ponies up at least a 1 million dollars.
Slicing the Pie In many private equity deals, firms partner with extremely high-net-worth clients and divvy up pieces for the average millionaire as well.
Mark Panfil, a Rolling Hills, Calif.-based SSB broker, cites a case in which the venture capital company of Dell Computer founder Michael Dell invested 100 million dollars in a European mezzanine-level private equity endeavor. Citigroup invested 250 million dollars in the same opportunity, and then sold pieces of that investment to its high-net-worth clients.
"We opened it up to our institutional investors, then we opened it up to our high-net-worth clients for [smaller investments like] 500,000 dollars," Panfil says.
Merrill Lynch also pools assets and allows its investors to purchase portions of selected private equity ventures, says Matt Kraft, a Merrill Lynch rep in Montvale, N.J. "All the major firms approaching these big private equity investments are doing this."
Panfil points out that firms try to limit clients' investments to no more than 10 percent of their private equity portfolio in any one specific venture.
Brokers agree that there is a certain cachet to having alternative investments.
"It's almost like having the ability to join a certain country club," Kuschuk says. "Anyone can play golf, but not everyone can play at an exclusive country club."
