Alternative investments explained: Types, benefits, and risks

What are alternative investments?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories like public stocks, bonds, or cash. These investments exist outside of the public markets and form the foundation of private markets, where new companies are built and value is created away from the daily fluctuations of the stock exchange.

These assets are "alternative" because they offer a different approach to investing, often with different goals, timelines, and risk profiles compared to what you might find on a public stock exchange. They represent a world of investment opportunities that operate on its own terms, powering innovation and growth in ways that traditional assets typically do not.

Understanding these alternative asset classes is key to understanding how a significant portion of the modern economy is funded and grown. The scale of this ecosystem is immense: Private investment funds are the backbone of the private markets, and Carta’s latest VC fund performance data analyzes benchmarks for more than 2,000 funds across recent vintages, illustrating how large and institutionally driven this segment of the market has become.

How alternatives differ from traditional investments

To understand alternative investing, it’s helpful to see how it contrasts with the traditional investment products most people are familiar with. These differences are precisely why investors turn to alternatives—to find growth opportunities and diversification that the public markets may not offer. The core distinctions often revolve around liquidity, regulation, access, and correlation to broader market trends.

Understanding liquidity events is a measure of how quickly you can convert an investment back into cash. Public stocks are highly liquid because you can sell them on an exchange almost instantly. Alternative investments are generally illiquid, meaning your money is committed for a long time, often for several years, before you can get it back.

Traditional investments are also heavily regulated to protect the public, while private funds often operate under exemptions like Regulation D that have different rules about financial reporting and transparency. While alternative investments are also subject to regulation, the rules are different and generally assume more sophisticated investors or high-net-worth individuals can handle higher risk and require less protection. This difference in regulation and risk is why access to many alternative investments is restricted for individual investors.

Types of alternative investments

The world of alternative investments is vast, but a few key types form the core of the professional investment landscape. These categories represent the primary engines of the private markets, where fund managers and institutional investors operate to fund everything from brand-new startups to established, mature companies. Each type has its own unique strategy and plays a different role in the ecosystem.

Private equity and venture capital

Private equity (PE) is the practice of taking an ownership stake in a company that is not publicly listed on a stock exchange. This can involve buyouts of a mature business to improve its operations or providing growth equity to help a growing company expand. The goal is to increase the company's value over time and then sell the stake for a profit.

Venture capital (VC) is a specific type of PE that focuses on providing capital to startups and early-stage companies with high growth potential. In both PE and VC, the key participants are general partners (GP), who are the professional investors that manage the fund, and limited partners (LP), who are the various types of investors that provide the capital for the fund to invest. Think of the GP as the driver of the car and the LPs as the passengers who have trusted the driver to get them to their destination.

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Private credit

Private credit involves providing privately negotiated loans to companies, serving as an alternative to traditional bank financing or public debt markets. The goal for the investor is not to gain ownership but to earn returns from contractually agreed-upon payment-in-kind (PIK) interest payments and the eventual repayment of the loan.

This alternative strategy offers a different risk and return profile, similar to mezzanine debt and distressed debt, focusing on generating steady income rather than capital appreciation from an exit. It's like being a landlord for money; you're not trying to own the building (the company), but you want to collect the rent (interest payments) reliably.

Real assets

Real assets are investments in physical assets that have intrinsic value. These are tangible assets you can often see and touch, and they play a critical role in the economy by providing essential services and resources.

• Real estate: This includes commercial properties like office buildings, industrial warehouses, and large-scale residential apartment complexes.

• Infrastructure: These are investments in long-term projects essential to a society's function, such as toll roads and airports, with research showing that performance metrics for infrastructure investments can be drawn from nearly 9,500 unique deals.

• Commodities: This category covers raw materials or agricultural products, such as crude oil, precious metals like gold, or agricultural goods like grain.

Hedge funds

Hedge funds are alternative funds that use a wide variety of complex investment strategies to generate returns for their investors. These strategies can include taking long and short positions in stocks, trading derivatives, and investing across different asset classes.

The primary goal of a hedge fund is to produce positive returns regardless of whether the broader stock market is moving up or down. They aim to hedge or protect against market downturns, providing a source of returns that is not dependent on the overall market's performance.

Other alternative assets

Beyond the main institutional categories, the universe of alternative assets is broad and includes more niche investments. These can include collectibles like fine art, rare wine, and classic cars, as well as intellectual property such as film rights, music royalties, and patents.

While these are part of the alternative landscape, the core of the professional alternative investment industry revolves around PE, private credit, and real assets. These more niche assets often require highly specialized knowledge and due diligence to value and manage.

Benefits and risks of alternative investing

The unique characteristics of alternative investments create a distinct set of potential advantages and disadvantages. Every investor and fund manager must carefully weigh these factors before allocating capital to this asset class, as the potential for high rewards is balanced by significant risks.

Benefits: Portfolio diversification and return potential

Investors are drawn to alternatives for several key reasons that set them apart from traditional stocks and bonds. These benefits can help build a more resilient and growth-oriented investment portfolio over the long term.

• Portfolio diversification: Because effective asset allocation ensures the performance of alternative assets often has a low correlation with the public stock and bond markets, they can help cushion a portfolio during periods of market volatility. This means they don't always move in the same direction as the stock market; when your stocks are having a bad day, your alternative investments might be doing just fine, which helps balance things out.

• Return potential: Investing in private companies provides access to businesses in their early and high-growth phases. This offers the potential for significant capital appreciation that occurs long before a company becomes publicly known, allowing investors to participate in its earliest growth stages and mitigate the J-curve (initial periods of negative return).

Risks: Illiquidity, complexity, and fees

The potential for higher returns comes with a unique set of risks that are important to understand. These challenges are fundamental to the nature of private market investing.

• Illiquidity: This is a key characteristic of most alternative investments. Illiquidity means that an investor's capital is typically committed for a long period—often many years, with an early-stage venture fund operating on a long lifespan of around 10 years—and they cannot easily execute secondary market transactions to sell their stake and get their cash back.

• Complexity and transparency: Valuing a private alternative asset is more complex than checking a public stock price, as it can involve analyzing data from tens of thousands of transaction documents to benchmark terms. Effective portfolio monitoring is required because information about a private company's performance may be less readily available, requiring deep expertise to assess its true value and risk.

• Fees: Alternative investment funds typically have a different fee structure than mutual funds. A common model is the 2 and 20 structure, but LPs need continuous fee oversight to safeguard their negotiated terms and ensure accuracy.

How to invest in alternative assets

Understanding the what and why of alternatives naturally leads to the question of how. Participation in this market looks very different depending on whether you are an investor providing capital or a manager deploying it. Each role has a distinct path and set of responsibilities within the private capital ecosystem.

Accessing alternatives as an LP

For most investors, participating involves understanding private investment funds and becoming an LP in one. In this role, an LP commits capital to a fund, which the GP then invests on their behalf according to the fund's strategy.

Direct investment in these private funds is often limited by regulators to accredited investors, a designation for individuals and institutions who meet certain income or net worth thresholds, and institutional investors including pension plans, endowments, and family offices. This is to ensure they have the financial sophistication and capacity to bear the associated risks of private investing.

Creating investment vehicles as a GP

For aspiring fund managers, the journey begins with creating an alternative investment vehicle to pool capital from LPs. This is typically structured as a fund for making multiple investments or as a special purpose vehicle (SPV) for a single deal.

Many emerging managers use SPVs to build a track record before launching a full fund, a path made more accessible by their lower capital requirement and relative ease of management, which make SPVs appealing to emerging managers. Firms like High Circle Ventures used SPVs to launch its firm and demonstrate its investment thesis to future LPs. This allows them to build a track record and prove their ability to source good deals and manage investments on a smaller scale.

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The operational engine of alternative funds

Beyond a winning investment strategy, running an alternative investment fund requires a complex operational machine. This back-office engine is responsible for managing the fund, its investors, and its assets. From this perspective, fund administration is not just an operational task but a strategic function that enables the fund to operate efficiently and maintain trust with its stakeholders.

Fund formation and investor onboarding

The fund lifecycle begins with critical back-office work. This includes drafting legal documents, handling fund formation, and performing integrated AML/KYC onboarding checks on all incoming LPs to ensure compliance.

This administrative work is essential, but it can often bog down GPs, taking their focus away from fundraising and deal sourcing. This is a key challenge that solutions like Carta Fund Formations and Carta Closings are designed to solve by streamlining these foundational processes.

Capital calls and distributions

A capital call is the process a GP uses to collect committed capital from LPs when it's time to make an investment. Later in the fund's life, a distribution is the process of returning profits to LPs after a successful investment exit, and modern platforms help managers handle distributions to hundreds of investors at once.

Manually managing investor reporting and these cash flows with spreadsheets can be prone to errors and delays, creating operational risk and potentially damaging investor relationships. An integrated platform automates these workflows, ensuring accuracy and timeliness in moving money between the fund and its investors.

Portfolio valuation and audit readiness

Unlike public stocks with constantly updated prices, private company investments must be assessed via portfolio valuation on a recurring basis, a process governed by accounting standards like ASC 820. This process is critical for accurate reporting and is closely examined during a fund's required annual audit, which is why firms rely on systems that produce accurate, audit-ready books.

As Michelle Keyes, partner at Withum, explained during Carta’s ASC 820 Valuations for Funds webinar, a fund's valuation policy is the foundational framework for communicating with investors: "You want to make sure that you are consistent and clear with how you're performing the valuations, who is going to perform them, [and] how frequently they'll be performed." This highlights the need for a rigorous and well-documented process. The pain point of tedious data collection can be addressed by solutions like Carta Portfolio Valuations, which streamlines the process by connecting directly to portfolio company data, while a dedicated Auditor Portal can simplify the audit itself.

LP reporting and communications

Keeping LPs informed with timely and accurate reports on fund performance is a crucial responsibility for any fund manager, who can use platforms with built-in reporting to make it easier to answer questions and produce reports. This goes beyond simple financial statements to include deep insights into the portfolio's health and progress.

For many firms, providing this level of transparency is a key differentiator. For example, when social impact firm Kapor Capital was looking for a fund administrator, they chose Carta because they needed the "great insights that their previous platform couldn't provide.” A modern solution like the Carta LP Portal gives investors a clear, on-demand view of their investments.

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Why a modern technology stack is essential for fund management

The growing complexity of the alternative investment industry has outgrown outdated tools like spreadsheets and disconnected systems. Data from Carta shows that SPVs are getting bigger: The median SPV grew from $1.18 million in assets in 2016 to $2.17 million by 2023. A fragmented approach that relies on manual processes creates hidden risk and drag in private markets, slowing down fund forecasting and decision-making, and ultimately holding a fund back from reaching its full potential.

A modern, integrated alternative investment platform centralizes all fund activity and data. By automating routine tasks, centralizing data, and providing real-time visibility, a modern platform can deliver faster valuations than traditional methods and enable fund professionals to elevate their role. They can move from being consumed by administrative tasks to mastering portfolio management and becoming strategic partners who surface insights, drive efficiency, and contribute directly to the fund's success.

To see how a modern platform can transform your fund operations, request a demo.

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Frequently asked questions about alternative investments

What is an alternative investment vehicle?

An alternative investment vehicle is the legal structure that pools capital from investors to make investments in assets like private companies.

Are alternative investments only for accredited investors?

While direct investment in private alternative funds like PE and VC is generally limited to accredited investors, some types of alternative assets can be accessed by retail investors through publicly traded vehicles like Real Estate Investment Trusts (REITs).

What is the difference between private equity and venture capital?

VC is a type of PE that focuses specifically on funding high-growth, early-stage startups. The broader category of PE investment strategies also includes investing in and acquiring more mature, established companies.