History of Alternative Investing
Saturday, May 22, 2010 at 04:35PM
The concept of alternative investing began in Europe in the 1800’s with the idea of “pooling” money for investing purposes. This “pooling” concept came to the United States in 1924 with the launch of the first official mutual fund by Massachusetts Investors Trust. With just $50,000 in assets to start, the concept of “pooling,” now known as the $7 trillion mutual fund industry, quickly became an accepted investment option, as evidenced by the astonishing increase in assets under management in our country’s first mutual fund by more than $300,000 in the first year.
Just five years later in 1929, the crash of the stock market underscored the importance of what has become one of the most essential investment strategies today – diversification. At the time, mutual funds were one of the only investment options that allowed investors to minimize risk by enabling them to hold more than one equity at a time – for the same initial investment.
After the crash in 1929, Congress passed a series of laws, known as the Securities Acts of 1933 and 1934, to structure the process and protect investors by requiring each fund to register with the Securities Exchange Commission (SEC). Under these laws, each fund was required to provide potential investors with what is now known as a prospectus. This prospectus remains one of the most useful tools available to investors today.
By 1969, the world’s first alternative investment product – mutual funds – had gained traction with 270 funds in the marketplace and more than $48 billion in assets under management. Experts feared that the market was becoming saturated and mutual fund returns had “peaked.” Yet, seven years later, the nation welcomed a new type of mutual fund when Vanguard launched the first index mutual fund – the Vanguard 500 Index. Nearly three decades later, in November of 2000, the Vanguard 500 was named the country’s largest mutual fund with more than $100 billion in assets under management.
It was in the early 1980’s that the mutual fund industry received its most substantial validations. The Individual Retirement Account (IRA) was created and Johnson & Johnson successfully persuaded the IRS to allow part of the Revenue Act of 1978, called IRC Section 401(k), to be used as a benefit structure for individual employees. In 1982, Johnson & Johnson employees were the first to enjoy the freedom of a customized benefit plan. The mutual fund industry has become a trusted investment retirement vehicle for individual investors ever since.
Today, more than 83 million individual investors have contributed $7 trillion to the nation’s 10,000 mutual funds.
A New Fund Alternative
With mutual funds well underway, it was only a matter of time before the next alternative investment idea was developed. In 1949, former United States diplomat, financier, and Fortune Magazine reporter Alfred Winslow Jones introduced the concept of hedge funds – based on the theory of hedging long stock positions by selling other short stock positions to protect against market risk. With an initial investment of $100,000, Winslow set out to prove that this new concept of borrowing or leveraging to enhance the potential return on partnership assets would produce high returns for investors. The method that he called “speculative tools” is known today as shorting.
In 1952, Mr. Jones transformed his general partnership into a limited partnership and began collecting management fees of 20%. In 1966, Fortune Magazine featured its former colleague’s resounding hedge fund success when he outperformed the leading mutual fund by 44% and beat the best mutual fund five-year return by 85%. Returns like these naturally garnered investor interest, thus validating the concept of the world’s newest investment product – hedge funds. Unlike mutual funds, hedge funds are classified as “private investment vehicles” and are not required to register with the SEC and are, therefore, unregulated products. Today, hedge funds and private equity remain among a small group of unregistered investment products.
The quest for superior returns always has and always will remain the top priority for investors, and this new hedge fund product seemed promising in helping to achieve that goal. However, the unregulated nature of hedge funds, coupled with high minimum investments and fees, made this alternative investment product one for institutions and high net worth individuals – leaving the average individual investor behind.
The industry steadily progressed until the early 1990’s. At that time the number of hedge funds surged as many managers left long-time posts at established investment firms to start or join hedge funds. By the end of the decade investors were fleeing the stock market after years of disappointing returns, primarily due to the technology bubble, and hedge funds quickly became the happy recipients of large amounts of capital. With experienced managers on board and wealthy investors lined up with capital, hedge funds were well poised for success.
By the beginning of the millennium, there were more than 4,000 hedge funds. But the major validation for this asset class happened in 2001 when long-only mutual funds lost 45% of their value sending hedge fund profits soaring.
Today, there are more than 8,000 hedge funds and assets totaling more than $1 trillion. A steep increase in investor demand and the resulting deployable capital have further bolstered the status of the hedge fund industry. In the interest of diversification, investors remain on the lookout for another credible investment opportunity capable of producing high returns with managed risk.
Private Equity: Venture Capital to Leveraged Buyouts
The concept of angel investing or venture capital has been widely used in the investment community for some time. Wealthy families such as the Rockefellers and the Whitneys had long practiced an early form of “private equity” by buying shares in small or fast growing private companies in hopes of selling them at a profit. Such wealthy investors were dubbed angel investors, and their goal was to uncover meagerly funded companies that exhibited strong and quick growth potential.
However, venture capital did not become a professionally managed industry until the late 1950’s with the passage of the Small Business Investment Act (SBIA) of 1958. This act allowed the government to license private "Small Business Investment Companies" (SBICs) that would, in turn, provide financing and management assistance to small entrepreneurial businesses in the United States.
The SBIA helped to institutionalize the practice of venture capital, extending the investment and business opportunities to a broader group of investors and early stage companies. In addition to delivering high returns, venture capitalists also worked toward the goal of stimulating the U.S. economy in general by facilitating the flow of capital to pioneering small concerns. Venture capital has grown to become a dominant force in the U.S. economy, responsible for more than 10 million jobs in 2004 alone.
The alternative investment sector further evolved with the introduction of the modern day private equity firm. In 1966, investment bank E.M. Warburg and venture capital firm Lionel I. Pincus merged and focused on dealing with securities of private vs. public companies.
As this concept was gaining ground in the investment community, in 1976 there was a small group of investment managers at Bear Stearns who believed in a new breed of private equity in the form of an investment transaction called leveraged buyouts (LBO). The idea was considered too “alternative” for the historically conservative firm Bear Stearns so the group of investment managers formed what would soon become one of the most successful private equity firms, Kohlberg Kravis and Roberts (KKR).
Private Equity and LBOs certainly gained the attention of several financial institutions and notable individuals and in 1985, former Secretary of Commerce Pete Peterson (under Richard Nixon) and Lehman Brothers M&A specialist Stephen Schwarzman founded the now renowned Blackstone Group.
In the 1980’s KKR surprised the market with several notable and historical deals such as: the 1984 completion of the company’s first billion dollar LBO transaction with the purchase of Wometco Enterprises; the 1986 purchase of Safeway supermarkets where it borrowed 97% of the $4.8 billion cost of the deal; and what is still the largest and perhaps most famous buyout of all time, the 1989 purchase of RJR Nabisco for $24.5 billion. During this time, KKR also demonstrated that it could build up companies and showed the industry the first established leveraged buyout build-up with the success and turn around of PRIMEDIA.
History shows us that new (and successful) turnaround concepts typically incite competition within the marketplace and the LBO transaction model was well underway as evidenced by the formation of another formidable competitor in 1987 – The Carlyle Group. Other well-established companies like Forstmann Little and Texas Pacific began to emulate the LBO transaction model. By the 1990’s, the caliber of followers helped the industry to evolve its image from the “buy and bust” reputation of the 1980’s to the “buy and build” success strategy of the 1990’s.
LBOs had finally become a vastly accepted alternative investment transaction. Venture capitalists were commended for the development of hugely successful start-ups like Google and Intel and investors poured more than $10 billion into private equity firms.
The LBO industry that was once seen as a risky “alternative” investment has evolved into a viable and well-respected business model known today as private equity. Some of the world’s most successful private equity companies like KKR and the Carlyle Group continue to lead the industry they helped establish in the 1980’s with the “buy and build” approach perfected in the 1990’s. Furthermore, LBO funds are now one of the most sought after hybrid investment models. The introduction of “mega funds” – billion dollar LBO funds – is an indication of the continued validation of this model.
2000 was a peak year for private equity when investors committed more than $160 billion to various deals, and private equity accounted for nearly 4% of all global merger and acquisition activity. In 2004, that number increased and private equity was responsible for more than 14% of all global merger and acquisition activity.
In continuing their evolved resurgence, buyout funds raised $54 billion in the first quarter of 2005. Currently, there are approximately 5,000 private equity firms and in the first quarter of 2005 the average LBO fund had nearly $750 million in assets under management. Ten funds are larger than $5 billion, and in May of 2005 the Carlyle Group broke the world record raising $10 billion for two new buyout funds.
Private equity firms continue to deliver much higher returns than the stock market. The three main pioneers of the private equity sector have revenues in the billions (Carlyle, Blackstone, and KKR) and have stated that they will continue to focus on the private equity model. However, Carlyle and Blackstone will add new areas of focus to their business such as property funds and merger and acquisition advice.
A New Alternative Investing Model for the 21st Century
Reflecting on the history of alternative investing over the years, there are several key conclusions that can be drawn:
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Alternative investments in high-growth sectors have become a proven opportunity for superior performance |
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A successful concept may bring healthy competition which is always in the interest of investors |
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Investors follow returns, thus there will be on-going investor demand for alternative investment products |
The most innovative and effective investing concepts generally build on preceding ones, but with new forms of returns and risk management. Alternative investment options have been an evolution rather than a revolution.
Based on investment lessons from the past and the ability to look to the future, Punja Investment Inc. is a new breed of private equity and a new investment model for the 21st century. Punja Investment Inc's unique business model combines the best of private equity, fund-of-funds, and asset classes to provide investors with a new level of diversification to seek potential returns superior to traditional alternative investment products. Punja Investments Inc. invests in talented fund managers at the fund company level which enables investors to profit the same way fund managers do: through asset management fees and fund performance.
Post Millennial Milestones
| Mutual Funds | |
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More than 10,000 funds in the U.S. |
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$7 trillion industry |
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83 million individual investors |
| Hedge Funds | |
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More than 8,000 funds in the U.S. |
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$1 trillion industry |
| Private Equity | |
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More than 5,000 private equity firms in the U.S. |
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Responsible for more than 14% of all global M& A activity
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