Understanding Structured Equity Investments - The Complete Guide
September 26, 2022
Structured equity is a form of investment that's all about flexibility. It's an excellent option for investors who want to maximize their return while minimizing their risk, and it's one of the most creative forms of investing in recent history.
We'll look at structured equity, why it was created, and how you can start investing in it now!
Structured Equity Overview
Structured equity allows investors to purchase pieces of an asset or business without having to own it outright.
Instead, they can spread their money across multiple companies and industries, giving them more growth opportunities and protection from losses if any asset doesn't work out as planned.
What Is Structured Equity?
Structured equity is a financial product that combines the features of equities with those of debt. Investors can use structured equity for various purposes, including as an investment or part of an investment strategy.
The main appeal of structured investments is that they offer investors access to opportunities that might not otherwise be available on the open market. They can also protect against losses if the value of one's investments declines over time—a situation known as downside risk management.
Why Was Structured Equity Created?
A significant contributor to the rise of structured equity may be seen in the development of the private equity industry in recent decades. Control buyouts and venture capital/minority growth equity were the two most common forms of private equity investment.
Many alternative asset managers anticipated growth in private lending as an opportunity following the 2008 financial crisis. Due to banks' reluctance to lend, this group of investors came in to fill the resulting hole.
Private equity firms, in particular, began to offer debt investments to generate returns and compensate for the lack of opportunity in traditional lending markets.
Structured equity was developed as a tool by which private equity managers could raise capital from investors who could not participate in control buyouts or minority growth equity deals.
Structured equity products are contracts that derive their value from the performance of underlying equity security. Structured equity products typically have a fixed maturity date and provide interest or a coupon.
In addition, structured products sometimes include upside participation caps or limits, primarily if the underlying security provides principal protection or a higher interest rate.
Structured Equity Examples
Structured equity can be applied in a wide variety of contexts. The reduced cost of equity financing for developing or monetizing an asset with cash flow and equity cushion qualities makes structured equity attractive to sponsor-backed and management-owned organizations.
Structured equity examples include:
- Loans secured by a share of the company's future earnings for start-ups with significant growth potential.
- Capital for a mature business that is either already heavily laden or unwilling to take on further debt
- When a corporation has too much debt, it may need to refinance
- Assisting an acquirer to "stretch" a value in the market through acquisition financing, such as arranging an additional turn of leverage or preferred stock.
- Profiting from, or recapitalizing, existing shareholders through a process that minimizes their exposure to market risk and improves corporate oversight.
Flexible for both businesses and investors, structured equity offers a compelling option to traditional private equity and credit solutions.
Types of Structured Products
There are many types of structured equities available for investors. Structured equity products have become widely accepted by institutional investors and regulators due to their ability to offer a wide range of risk-adjusted returns.
The four most common types of structured products are yield enhancement, capital protection, participation, and leverage.
Despite yield-enhanced instruments' similarities to bonds on the surface—they pay monthly and are typically issued at par or a discount—their risk profile is significantly different from traditional fixed-income products. These coupon-paying instruments are not bonds and should not be treated as such.
Structured products can include variable capital protection levels in a given instrument. In some cases, investors in structured products may count on getting back their entire initial investment.
With a total capital protection mechanism, even if the market goes against the investor's expectations, they will still receive their initial investment amount back at maturity.
Several instruments offer capital protection. However, it is often contingent on the asset's performance.
The investor's cash is at risk. There is no guarantee of a return at maturity if certain circumstances are satisfied, such as if the underlying asset's price falls below a certain level throughout the investment period.
These products often offer limited or no protection of principle and a heightened chance for gain or loss through leverage. These instruments are not provided at a discount and do not pay a coupon.
Certificates are a typical term for these securities, which various assets besides only stocks may back. The final payout on specific tools is determined by taking the underlying asset's value and multiplying it by a certain percentage, known as the participation rate.
As the market for structured solutions develops, more cutting-edge offerings appear, each with its unique set of conditions and framework. Some instruments will have properties that make them suitable for more than one of the categories.
Before putting money into any tool, a buyer must fully comprehend its terms, payments, and risk profile.
Investing in structured products is a great way to spread risk across various asset classes and tactical market approaches. Each type provides investors with different risk and rewards profiles depending on the underlying asset class or index it tracks.
Structured Equity vs Preferred Equity
Structured equity is a derivative of equity. It pays out based on the performance of an index or basket of indices and not on a company's performance.
Preferred equity, however, does not pay out based on an index. Instead, it pays out based on the cash flows stemming from your investment in a particular company's stock as that company distributes them over time.
The dividends you receive from preferred equity should be treated like any other dividend payment (i.e., taxed at ordinary income rates).
Who Should Invest in Structured Equity
Structured equity is an attractive investment for people who want to make a bet on the stock market but don't want to do so directly. It allows you to invest in a basket of stocks or other assets without worrying about picking individual stocks that may or may not perform well over time.
Structured equity is suitable for a wide range of investors, including:
- Individual investors who invest on their own or have the capacity to manage the investment through the life of the fund.
- Hedge funds interested in diversifying their portfolio with a non-correlated asset class.
- Investment managers who want to include structured equity as part of their product offering.
- Institutional investors looking for alternative investments that can provide risk-adjusted returns and diversification.
Structured equity is not for everyone, but the right investor will find it a valuable addition to their portfolio.
Structured Equity FAQ
Here are some answers to commonly asked questions about structured equity.
What Are The Disadvantages of Investing in a Structured Product?
While there are many benefits to investing in a structured product, there are also some drawbacks that investors should be aware of.
One of the most significant disadvantages is that structured products can be very complex and challenging to understand. These complexities mean that you may not fully understand what you're investing in or how the underlying assets work together.
Investors in SIPs sometimes have to accept the price quoted by the investment bank or risk being unable to sell their holdings before maturity.
Another disadvantage is that structured products sometimes have high fees and commissions, making them more expensive than other investment options.
The investment bank guaranteeing the structured product is subject to credit risk. If the investment bank fails, you could lose part or all of your investment.
Is a CD a Structured Product?
A CD (certificate of deposit) is a form of structured product. A CD is a deposit account that locks you in for a set period and offers interest rates higher than those on traditional savings accounts.
Unlike some other types of structured products, CDs are relatively direct investments. You buy them from a bank or credit union, choose the time you want to hold them (usually between three months and five years), and then get paid interest on the amount you invested at the end of your term.
Is an ETF a Structured Product?
An ETF (exchange-traded fund) is a mutual fund traded on an exchange. It's not a structured product but has some of the same characteristics. ETFs can be volatile and risky because they don't have a guaranteed return and are often based on a basket of assets such as stocks, bonds, or commodities.
Structured Equity Explained: Closing Thoughts
The structured equity market is relatively new, and it's growing in popularity. It can be a good option for some investors who want to pursue higher returns without the added risk of traditional equity investments.
However, structured equity isn't suitable for everyone. It tends to offer a higher level of volatility than other types of investments, so you'll need to weigh the pros and cons before deciding whether or not this kind of investment is right for you.
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