Alternative Investment Due Diligence

Hosted by Rocket Dollar, Chris Carsley - CFA, CAIA, Chief Investment Officer & Managing Partner at Kirkland Capital Group discusses his playbook on Due Diligence

This is an in-depth discussion on that steps you need to take BEFORE you invest across any asset class.

He discusses the following:

• What is DUE DILIGENCE?

• Areas where you need to FOCUS

• Possible RED FLAGS, QUESTIONS and ACTIONS

Watch the discussion below

Download the Full Presentation.

Transcript

Brendan: All right. Welcome everyone to another Rocket Dollar webinar today. We really have an amazing educational opportunity today from Chris Carsley about a lot of topics on due diligence. I've always liked talking with Chris. I've been impressed with his experience. And, just here at Rocket Dollar, we work with a variety of partners.

And why do those partners come to Rocket Dollar? Mainly so that they, their clients can get into an alternative fund that they've struggled to get access to on, one of the major stock brokers. What I was really impressed with, not only Chris's experiences, he's actually gotten some alternative funds on these bigger stock brokers and into their alternative departments.

Chris, why don't you tell us a little bit about yourself and know, I know you don't like talking about yourself too much, and then we'll pull up your slides here and get started.

Chris: Sure. Yeah, just real quick on my background, I started off as an asset manager running discretionary accounts, primarily long only.

And then one of my specialties was derivative structuring. I got very fortunate, tapped on the shoulder to go work for a hedge fund and do a variety of different trades for a number of years for a Connecticut hedge fund. And then came back, worked for a fund to fund, and that's where.

You were doing due diligence and certainly doing analysis while working at a hedge fund to put together trades. But really working for the fund to fund is where I started to hone in and really develop. My due diligence aspects of how to look at alternative investments, and we'll talk a lot about some of those pieces now.

After working for a fund to fund I branched out, did a lot of different work in startups in technology, ran a small seed angel fund, still, if anybody's ever done that or involved in angel companies, it takes a long time to get out of those. So still working through some of those.

But more recently I partnered with my now business partner Brock Freeman, and we created the Kirkland Income Fund, which is a bridge financing fund where our particular niche is we're, originating first lien, full recourse mortgages against commercial real estate. So that five plus door multifamily, your mixed.

Light industrial, but that particular niche that we're focusing on is the 1.2 million loan and below. And it's a very underserved market in your secondary and tertiary markets. and that has actually worked very well. Even though we launched in January of 2020, which was not the best timing.

When your anchor calls you in March and says yeah, I'm not gonna be able to anchor the fund, but we had a fair amount of our own money in it, and so we launched anyways, and that's really worked out to be a great product. And I'm very fortunate to say that, a lot of our investors have been very happy.

And I think almost every one of our investors is, anted up additional money over the few years that we've been operating. But yeah, we can skip that. Who wants to see that guy? But yeah, the agenda today is let's talk a little bit about what's in the face that we're dealing with here.

Alternative investments have been mostly ignored. By many investors for years, and rightfully you could basically be in a liquid instrument long equity risk on type mentality, and you performed very well. I'm not gonna argue that point, even though I've been in alternatives for most of my career the last 10 to 12 years has been difficult to watch most of what, many people are doing in alternatives ignored.

But that has certainly changed. This year has been monumentally different. We are now looking at an opportunity set for a variety of different alternative investment providers to be there for investors as they look to broaden out their portfolios. One of the problems is, sometimes when I get invited to go talk to students at colleges in the Pacific Northwest I'll ask a question of, what is an alternative investment?

And, the crowd struggles to answer that question as, as best as they can. And I always tell 'em, I say the easier way to answer that question is just tell me what it is not. And what it is not is traditional investments. Your traditional, long stock, long bonds, everything else falls in one category.

Another of alternatives, which is a ton. There's hedge funds, there's venture funds, there's venture debt, there's now crypto, there's various aspects of private debt. There's real estate. It just, the list goes on and on. You can break hedge funds down into 25 different subcategories of strategy.

It is very complex. And so one of the things that I want to dive into, we obviously will not have the time to cover anything in massive granular detail, but what is that due diligence? What is it and why do we do it? And then we're gonna hit some areas of. The key metrics that you should be at minimum focusing on as you look at an alternate investment.

And then lastly, we'll just talk a little bit about some of the red flags and questions and actions. We're gonna not talk too much about that, but I will provide information of actual questions and actions that professional due diligence people take. People who work for multi-billion dollar shops that do this for a living.

We will actually have some of those questions and actions available to you. So let's with that, let's dive in. So due diligence, why do we even do this? It's not the fun part of it. We just wanna find a great investment. We want that to turn around. We wanted to make a lot of money and, or, offset a risk in our portfolio, whatever we invested in.

I usually say that the real key is you gotta get to your no quickly, some of these documents that you have to read, 80 pages, if not more. And there's multiple levels of legal documents to assess, and that's outside of understanding maybe the investment that this fund or platform is bringing you.

So you really, the key aspect of due diligence is honing in on what you want to go after, what is driving your “No’s”, and get to that quickly so that you can read 20 pages of that 80 page document, get to your No, and pass and go to the next one. Now of course, if you read the 20 pages, you come up to a yes you're on a, you're on a journey.

Hopefully that will end in a great investment, but you gotta read the rest of your information and complete your due diligence. What are we trying to identify? And you'll hear me if you ever hear me talk about anything. There's two key aspects that we're always trying to identify in an alternative investment.

We're paying so many money to provide an investment that I can't easily get myself. And then maybe there's a particular aspect that's gonna create an excess return. Excess returns come from identifying what is the inefficiency of this alternative investment? What are they doing? How are they creating an excess return?

You need to understand what is that inefficiency they're gonna take advantage of. Secondly, the key aspect is what's this team's edge? Is it network? Maybe they're in venture network's super important. You gotta have the right network to basically make sure a startup company is gonna go from, A to Z and you can create an exit.

Maybe it is an informational edge so that they have access to, or a trading partner that can create a true arbitrage. You've gotta understand what that edge is and why that team has that, and how that's gonna be deployed consistently. And then lastly, this is the one that most people they forget is really focusing on.

The investment. I'm looking at how does it fit my portfolio? What am I looking for? Am I looking for income? Am I looking for, absolute return? Am I looking for a risk off offset? In today's world, like the fund that I create created, it's a fixed income alternative. I don't tell people that you should go invest in, real estate fixed income, with an equity allocation unless you're gonna change the allocation of your portfolio.

So identifying what that is and what you're trying to find and what that fit is. I see often not you, you got one investor, they come in and they say, Hey, my best friend, they invested in this and they love it, so I'm gonna go in and buy it. Maybe that's a good investment, but maybe it wasn't a fit for what you have.

Maybe you already have that risk in your portfolio. Maybe you already have that exposure and maybe you got a great. You just doubled up on your exposure, and if something happens to that particular area, some idiosyncratic hit to that type of strategy you're gonna get hit twice. So that's that last little piece that I like to throw in there that, most people forget is not every alternative investment is really right for you, per se.

So let's dive in. Types of due diligence. First is, the one that most people spend most of their time on is the investment side. You really want to go in, you wanna understand what are these people investing in, what's their objective? How do they actually carry through their objective via the a particular strategy?

That's always important, but don't get bogged down in that. There's two other aspects that you really need to understand, and one of 'em came around pretty heavily in 2008. And I was involved in a lot of different panels and talking with AMA and a lot of other people trying to figure out what is the future of operational due diligence.

And operational due diligence has now been split into two pieces. It's still named operational. And then you've got the business due diligence side. Operational due diligence is any of the funds operations that are directly related to the trade. Trade desk aspects types of traders.

Do they have different counterparties that they're working with for, do they short a lot? Do they have all the borrow that they can basically get if they're an event driven, dealing with corporate actions, do they have access to corporate actions, desks, and the people who run those at various custodial houses?

That operational aspect that's directly related to the investment. The next one is business. You're now looking at the business activities of you are investing in a fund, but that fund is a company. And just like you would assess any type of startup company, It's the same thing when you're looking at an investment fund.

There is a business behind offering you the product of a percentage return. So you need to go in and understand how did they build that business? Do they have the right, people working there? What's their technological capabilities? What's their infrastructure, their office space? Is it safe?

I knew during Covid we had a number of companies that their physical office space wasn't even safe for the employees. Then that led to, working from home. How did they work with that from, safety of information and technology to ensure that the company can continue to move forward.

So those are the three big areas that you'd need to think about. Don't be one of those people that just focuses on the investment side, falls in love with what's going on there and makes that decision. And omits the two other aspects you really should understand, and I know I'll be jumping forward and I might repeat a few things throughout this seminar, but most failures of alternative investments don't actually happen on the investment side.

It happens structurally and it oscillates. I don't know what the current number and data is, but it used to be high as 66% of alternative investment fund failures was some level of operational in business. , it wasn't actually the investment failed.

Brendan: Wow.

Chris: And most failures don't actually deal with the fraud that everyone thinks they're seeing.

Brendan: Yeah. And I think this is, these are three really good points. We have partners at Rocket Dollar that I can see are, they excel at two of these very well, and then one of them is definitely like a weaker side. How big is the firm? Is it maybe concentrated, they have no succession plan.

It's one person that could be an amazing investor, but it's really just driven by one person for a really long investment that you'll hold

for a long time.

Chris: Yeah. And that would fall in the operational side of where it's a keyman risk,

Brendan: Yeah.

Chris: We used to joke back in the day, it was two guys, a dog and a Bloomberg could run a hedge fund.

And usually the dog was the smartest one. But that, that key man aspect that Brenda brought up is super key. You need to dive into those facts. You need to understand that this guy gets hit by the proverbial bus. What is the liquidation plan? Who's actually still standing that can ensure that the investment is liquidated and returned in the most timely fashion to investors.

That's a huge, important question, especially for what, even myself we have two managing partners. We get that question a lot. It's something that, you should ask and there should be something in the PPM or the legal documents dealing with that event and there should be a plan to how that's gonna, be carried out.

Brendan: Yeah. And when, Rocket Dollar first starts working with the partner too, we are always looking at the operational and the business side a lot cuz we are communicating almost directly with these different partners and seeing, hey, are they passing these tasks? Are they, really sloppy on a couple concerning things.

As far as the investment side, we are a self-directed IRA provider, so we do not recommend investments. We pretty much never step in unless we see something extremely blatant, like basically fraud for the clients. So our clients are really the ones that, they sometimes give us feedback, Hey, this team managed my previous investments incredibly.

That was a great experience. I'm investing with them again. Or they might just say that, last investment blew up. I'm never going back to them, or, our partnership teams runs at the operational business side all the time. We can't really give any recommendations as an investment advisor.

Just as a client. You have to be informed on all three of these. Yeah. Make sure that you're protecting yourself as well.

Chris: Gotta do your work. Alright. Areas of focus. Break these into multiple different pieces. This is just an overview of you need to be paying attention to at least these areas.

I get asked a lot of times hey Chris, would you create a checklist? I'm a fan of checklists, only from the fact that there's just so much to cover when you're doing your due diligence of an alternative investment. But don't hang your hat on a checklist. Don't get blind and say oh, I checked all my boxes.

It must be okay. You gotta get in there, you gotta verify. I know that on sites are not as common. I know the big shops are back doing it. What has an individual investor, how are you gonna do an onsite when you, maybe this fund is not, in your town. I get it. I understand. It, it does have a level of importance and you gotta be able to deploy what you can.

Given your resources because due diligence actually costs a lot of money. I know that there's due diligence shops that charge upwards of 150,000 to do a complete due diligence review of a fund. That kind of gives you an idea of what people are willing to pay to have this done. So it's valuable.

 There's real value in proper due diligence. But let's dive in. You got fund structure, you got investment strategy. Everyone loves that one. We'll talk about that, that there's a lot of points to think about under investment strategy. There's the administration, which is where you start to get into that operational side.

Chris: There's risk, portfolio risk, understanding that risk. Legal references. And then I put performance last for a reason. We actually were trained to look at performance last, take you, you have the numbers, but don't hang your hat on 'em. Don't be swayed by shiny objects. And that's where, some of your bigger shops, you are aware of their performance.

You understand that they've at least performed well, in the past. But we would try to focus on everything else first and then dive into does everything we just assessed about this company match the numbers? And we'll talk a little bit about that. 'cuz a lot of people in this due diligence process, you think you're on a witch hunt to find a fraud.

That's actually not what you're doing. That's stop listening to the news, stop listening to the reading, the newspapers that are just all about the negativity of frauds. It happens, they're out there, but it's actually fairly infrequent. There is a number of people out there trying to do a great job in the alternative investment space.

But a combination of all three of these and like I said, I'll mention it a little bit later, is how you actually will run into a fraud. And I'm thinking, however, the thousands of companies I've dove into, there's only. Two or three that I really thought, wait, something's not right. And that might have been a fraud.

Of course they went out of business regardless without being labeled as a fraud. Maybe they were smart and realized, they couldn't run that, legitimately. But let's dive into the first one. Fun structure. Probably the least fun to do, but you gotta start with the foundation.

You gotta, like what have they built, what have has this team built to facilitate the investment? Understand where are the complexities of the structure they've built to pull off that trade. If things get too complex right or wrong, I've usually just walked away if I can't understand what you're doing in a high level assessment.

Okay next. It, if it's super complex, it's probably gonna break in about two or three different ways that you'll never even find. And that's pretty much, I won't say that for everything, for a lot of the due diligence shops, I know they'll just pass on somebody that can't explain what they do simplistically and have it really easily followed.

That obviously leads to understanding, okay, what conflicts come out of this structure. There's always a conflict of interest between a manager and their investors. It's a given section in a PM, just deal with it. That's where the trust comes in. You've gotta do that further due diligence on the team.

Understand their history. Are they trustworthy? Do you have the right transparency to double check them? Are their service providers in place for further transparency? There's gotta be conflicts of interest. It's just the way the world works. You just gotta make sure that there's checks and balances in place that gets you to a level of comfort.

How much does it cost to run their fund? That's one thing is you know, and then they do, they have the proper regulatory structure. I know this sounds weird, but you've had people spin up funds and I've got some friends that work for the Washington Department of Financial Institutions, and if you heard some of the stories they had about people who spin up funds, They walk in to do an exam on them and they just haven't done anything.

It's what kind of triggered their exam. You really need to make sure you're working with a group that has run a fund, understands the compliance aspects, understands the regulations the next is, and this has become less important in the Covid era, is, okay, where's their home office?

Where's their satellites? Who controls what? That's been, like I said, there, it's complications with post pandemic. Even myself, we had an office in Kirkland since that was the name of the fund, and then we realized we don't really need an office. So Brock and I run extremely virtual.

We have a WeWork office that we have downtown Seattle, but it's not something that, we'll just go live in every single day. Fees. Are they in line with the strategy? I know this is a big hang-up for a lot of people. And I just remember sitting with one investor. And we were talking about fees, and you need to look at the net impact of fees to the return you're getting and the risk you're taking.

You can't just say two and 20 is wrong. Heck, you can't even say five and 50 is wrong. If I have a fund that's making five and 50 and I'm beating all my competition and still giving you a return that meets all your goals, then is five and 50 wrong? If it is, then Citadel, Renaissance, and some of those big guys are probably not right for you.

But there's still some of the best performing funds. Something to think about. Don't, so don't get hung up on what you think is right or wrong for fees or what's the norm? You need to dive a little bit deeper.

Brendan: And I would also just, if this is, if you've only done a few alternative investments, some of our investors can be a little bit intimidated, is they're jumping into an entirely new fund that they have invested in that area before or that it's just their first time.

They might be used to fees in another fund and they go, wow, this is an entirely different world. So I think, starting to compare the quality of manager, their fee they're charging and what's in their niche, what are all their competitors and similar offerings charging. Once you understand that, then you can better analyze that fee, that specific manager.

Chris: Totally agree. You gotta compare apples to apples and some strategies are more complicated and take more resources and are more expensive. So maybe that fee is commensurate with the strategy in the complexities of it. . I've run into that as well. Personnel, very important. This is a human business.

People run this. You're assessing that edge, get your background checks. You'd be amazed. I Obviously it's pretty standard. When we're underwriting alone, we do background checks on the borrowers all the time. It's pretty amazing, especially when you're dealing with microbiomes commercially. You run into a fair amount of questionable backgrounds.

We just don't lend the money. Move on. We got plenty of deal flow. Maybe he was a perfectly great property. Maybe the guy's turned over the right stone. The leverage changed his spots. But there's so many opportunities out there to invest your money. There's no lack of places for you to look and deploy money.

If that's one of your hang-ups, just move on. But get your background checks, make sure they've done it, and then really understand their particular skillset. Do they have the knowledge and the capability to pull off the strategy? Service providers Do they have everybody they need in place? Not everybody needs a prime broker, not everybody maybe they just need a custodian or, in the debt world you don't even have a custodial capability.

The, it's just a mortgage document that, that's basically stored title at escrow and, the fund's account, understand what they need and who those people are and who they're working with and don't get hung up on. I know a lot of people get the bigger funds and it becomes a name drop.

I got a top level admin, I got a top level prime broker. I've got the big names. I can drop all names. I'm not saying that's wrong for certain level, but don't be shied away if you're looking at smaller funds that they're using, mid-tier, service providers because it's much more cost efficient for a smaller fund to do and there's plenty of great providers out there that aren't your, big Wall Street names. They do a great job.

Let's move on to the strategy, everyone's favorite. This is where everyone really goes bonkers and really tries to jump in and understand. Cuz this is the fun part, really understanding what they do and the fascination of this unique alternative investment that you're about to embark on.

Chris: But there's a lot of moving pieces underneath it. And some of 'em I list here markets, what are they trading, what securities are they trading? Are you on a long short hedge fund? Are you originating debt? What are they doing and what is the, the exchange or there is no exchange where these securities might be held.

Identify exactly what products they do trade or what they have the ability to trade in. A lot of managers I know, have a very wide swath of things they can trade in. You should understand what they're currently doing and what they can do in the future cuz one of the problems we used to run into a lot of times is as dynamic markets change, You get some style drift and so you invested in a fund and all of a sudden three years later, you wake up and you look at that fund and it's not even remotely what you've thought it was.

It's got an entirely different exposure base. So understand what they can do and make sure you do that ongoing monitoring as well. Counterparts, like I mentioned earlier, what kind of counterparts do they need to pull off their strategy? Like I mentioned earlier, some, a lot of event-driven trades that I was doing, when I was a Trader was it required access to corporate actions groups.

You had to have very large relationships with custodians to borrow securities on a global basis. Do you have that capability? Understand what it takes for them to pull their trade off and understand how they're utilizing that network in those counterparties to facilitate the trade in your best interest.

Trade examples you'll probably see these in a deck. Everyone loves to tout all the money they made on their last 10 trades. Great. What were the trades that broke and why'd they break? Get the other side of the coin, ask for things that didn't work. Go after those things cuz that will show you two things.

One, it, the strategy is not, it is not infallible. It breaks why it might have broken and it might lead to one of the other things that we'll talk about here is okay, are we going into a market cycle that you might see that as a higher probability of having things break? It also shows you how did the team deal with it?

Was it a panic issue? They sweep it under the carpet, did they bring it to the front and make everyone aware of, hey, this is a, this is an issue and this is how we deal with this cuz we told you upfront this could happen. Have they been upfront and honest about, how things are going to break and how they deal with it.

It's pretty important. Obviously in my business we have things that can go to an operational default. It goes out of an operational default, goes to a foreclosure situation. It was nice. We told before it even went to a foreclosure, we were telling our investors, Hey, this might actually come around.

It hasn't happened yet, but when it does happen, I don't want you to be surprised. And when we actually moved to a full foreclosure process and brought in legal none of the investors were surprised. Of course I wanted them to know about it. I want to people to understand that it's not a matter of if it'll happen as a matter of when.

This just happens. And so you deal with it and that's, why have your legal counterparties in place and you have your people ready to deal with those problems. And you can showcase that, from a process procedure standpoint, but also live when it does happen.

I mentioned market cycles. I'm gonna skip benchmarking for a little bit. I'll come back to benchmarking cuz that's kind of its own little unique sector there that can be rather difficult for people to pull off. But market cycles. When does this thing break? Is this a cyclical trade?

Or am I dealing with a global macro hedge fund that, it's gonna be average for a while until all of a sudden ball spikes? And that's why I have it. It's that shortfall strategy that I've got in play. Know when things work and why you own them.

Sourcing understand, hey, how do they come up with these trades? And is it repeatable? AUM in capacity? If you're dealing with an alternate investment that's doing something that's in an inefficient, fragmented space. The other side of that coin is usually capacity. They can't go run a billion dollars doing it.

And so you need to understand, ask that question of what do you think the capacity of this fund is? Why do you think that is? What's their ability to go beyond that capacity? If, if there's, a vote to do or are they, hard stopped? And understand a little bit of if a u m goes up, how does that affect my return?

Do I have a cash drag situation or a u m drops? And okay, how does that affect, are they using maybe a revolving line of credit to meet redemptions? And so there's now an increased cost in some leverage component to the fund. Or you had some forced selling, that, they had to sell when they didn't want to.

So understand that that's happened to a lot of different funds, especially, over the last 15 years or so leverage. I don't use any leverage in my fund and a lot of people look down on leverage. I'll be honest with you, I think that's a bunch of bull. I think you need to find a team that understands their trade and if leverage is even needed.

And if they are using it, how is it effectively used to the best interest of the investor? Is it something to where I'm just ripping and roaring because I'm trying to maximize return in a short period until I blow up? Or is it, hey, there's a real structural reason where I'm a very low-vol fund and I need a little bit of leverage to really capture and move myself into an acceptable risk profile for my investors?

And I use that as an example. The fund to fund I worked for, we had very low vol cuz we hedged a lot of different aspects of the underlying investments. And so we used leverage to go from like a two vol to a four. Because most of our large clients that were on the institutional level, they wanted to take more risk.

And it wasn't something one do directly in the portfolio, but we could do it indirectly through leverage. So it was something that the investors were aware of. It was something that was accepted and desired by the investor. So I mean it can be a very powerful tool if you are one of these shops that's gonna go out and say, Hey, I'm gonna go 10 x myself in the face of a storm.

Okay, that's probably dangerous. You don't wanna deal with that person cuz they may make it through the storm, but they may not because anytime there's a liquidity crisis, two aspects come in. We'll talk about one of 'em. Once the asset liability mismatch, the other one's leverage. When things start to go upside down, lines start to get.

And you wanna make sure that there's a plan in place and that's not too far a reach for your fund manager to deal with that kind of leverage. Now onto valuation and benchmarking. Valuation, I'll just say one thing cuz this I could talk another hour and a half just on valuation.

Understand who's valuing it. Is it internal? Is it external? Walk through real examples. Reach out to the third party provider evaluation and get record that they are at what values they have on certain assets that are in the fund. I know there's a lot of funds out there that maybe they're just market equities.

So it's market to market on a day-to-day basis. That's the easiest aspect to do. There's not much that the, the fund manager might be doing cuz it is a public equity. But if you're dealing with something that's not public, it's private, you really need to understand the mechanism of how it's valued, who's valuing it, how often it's valued because valuation is determined and is important at the point of your entry, the point of your exit, and the point often not if they charge an incentive fee when you're crystallizing and paying an incentive fee. So it's pretty darn important to understand how that is done and who's doing it. Now, a lot of managers, I've read PPMS and they say, oh, we totally accept the third party marks all the time.

And when you dive in, you see there's multiple occurrences of where they disagreed with the third party and they used their own internal valuation and they marked it themselves. So it does happen. I know it sounds crazy, but people can get away with it. Often not. They'll try it. Benchmarking, super important.

I love benchmarking. It is far more complex than most people give it credit to because it's very hard to what they find, what they call a best fit benchmark. is great for you to get an idea of. How is this fund lined up against maybe a public investible index or a series of them?

A combination of them. And that's why I say benchmarking can get rather complex is sometimes it's not just, I'm gonna comparison myself to the S&P 500 or the Russell two or something like, it could be a combination of three or four that's a best fit. And I'm not saying, there again, that takes a team and it takes a knowledge of doing that and maybe you don't have that capacity, but perhaps you can find a third party or a shop that can, help you walk through that aspect of benchmarking.

And it's important to understand here again, you are paying a fee for this manager to provide this investment to you. You need to make sure that on a after fee basis, your net return, Is beating a benchmark that's acceptable to you? And sometimes, and there is an argument out there of oh, does it always have to be an investible benchmark?

Obviously that's a superior analysis. But sometimes you'll find, I'm just comparing myself to other alternative investments within that universe to get an understanding of the risk they've taken, given the return, and then run that benchmark that way. There are services out there, I know, like Pre Quinn and a lot of other guys.

They try to create those sometimes non investible, private benchmarks. Not always exact. , but can give you an idea. But don't be don't be fooled when someone says benchmarking is simple. It's not, it's a lot of math and it can be very complicated in the alternate investment world.

Brendan: A very simple question you can ask is, why did you select this specific benchmark back to the manager? Then you will get a very good answer of why. If they don't frankly have a very good answer, maybe that was sloppy, carry on very quickly. if they have an answer that impresses you and you feel is sufficient of why they selected that specific benchmark.

And again, a lot of our clients, if they're not to experienced in alternatives, the S&P 500 is the only benchmark they've really ever worked with in any big capacity. Just know that is a moderate aggressive strategy in the public markets. So it's not a bad benchmark, just know it is moderately aggressive and sometimes certain funds have an aim to do something else or go in separate ways than the S&P 500,

Chris: Correct. The S&P 500 is an equity index. That is primarily growth and less so on the tech side now, but mostly technology names. So that's really important, Brendan. Calling out the S&P 500 cuz people try to compare me to that and I said okay I'll compare myself to it, but I'm a fixed income fund comparing against an equity.

And over my time of inception of April, 2020. Yeah. You actually had a higher return in the S&P 500. I would expect over a 31 month period even in this downturn. But if you look at just this last I crushed it this year. Obviously it wasn't that tough. But the thing is that's another aspect is when someone's benchmarking something , I see this.

All the time, and it's a big no-no and to do this in the professional, like the high level world you'll get dinged pretty hard is they show you the benchmark that shows the time period that they're beating. They don't show you the whole time period of Hey, when the S&P 500 did well, how did you do against it then?

Yeah, of course when the S&P 500 going up 15, 16% a year, maybe more, of course a fixed income in instrument's, not gonna keep up with that. But it's a matter of your comparing apples and oranges a little bit and unless, like I said, you're shifting out of equity to increase your fixed income allocation for one, maybe it's a lifestyle change or something, you just need more income or something of that nature, then you can make those kinds of assessments.

But Brendan's totally correct, you gotta make sure you're comparing yourself to the right bench.

Brendan: And so that if you're actually reading through like a certain page, that would be looking at the axes of the chart, like what's the month and the year down there? And is this opportunity that you're trying to pick, is this more like a stock equity replacement or is it more like a bond replacement or are you trying to, as Chris was going through I want the best hedge fund or this specific area "how does that compete against all competitors?"

Chris: Yeah. So let's move on from here. I know that it took a while, but that's always a big one and there's a lot of moving pieces to investment strategy. Next, going into a little bit more of the operational you'll see something thrown around operational efficiencies, creating actual alpha.

I have seen this in multiple funds. They have a structure or a network or a process that actually cuts costs or allows them to access investments cheaper than perhaps their competitors. And that is a true operational alpha. That is a real return to the investment flows to the investor that wasn't created in the basis of the investment.

It was created in particular, their particular edge and their network. Those are really important to identify. See if they have some of that. I know that a lot of operational efficiencies are being created, from a technological standpoint nowadays. So really understanding what they do from a technology standpoint.

Perhaps even as simple as save time on repeatable, mundane tasks that allow them to spend more time on, like in our case, hey, we spend more time on underwriting. We spend more time on taking that next step of due diligence, make sure we don't miss any moving piece instead of oh, hey, did I get these emails out cuz it wasn't automatic. I know that sounds simple, but all that is now available. And there's some amazing systems out there to create all kinds of efficiencies. Staffing and turnover. We talked a little bit about that. It's is this a revolving door? And it's dangerous to be investing in a shop that's got a lot of movement.

You wanna see people that are happy working there that they enjoy what they do which means they're gonna be motivated to, do the best they can. For your investment process and procedure. You might not see this too much in smaller funds, but I think it should probably change.

I know a lot of smaller guys that I've talked to, it's like they should develop a process and procedure manual. You should be able to go through and understand a lot of what they do and how they do it and why and how it affects the business because all of that affects you. The business operations, it really does affect, your return.

Business continuity, we talked a little bit about some of that's around keyman issues, but you also have, power outages floods, storms, what do they have in place and do they have multiple office sites? Do they have the ability to be mobile and, still manage and take care of your investments depending on the investments.

A lot of companies will have an actual business, continuity plan, A disaster recovery plan is what D R P stands for. They'll have that document. I already mentioned background checks cause we're not gonna really spend much more time on that. And then like I mentioned earlier, technology, amazingly.

Understand the technology, understand the efforts that they're taking to always be on the forefront because it is an area that, finance and investment management has been a little bit behind the curve when it comes to technology. But that is changing on a rapid rate. So technology really can affect all of the other five things on this page.

Brendan: So how are they doing that? Two, two quick suggestions for people. Go to LinkedIn. A lot of people that are not salespeople are just not fans of it. I get it. It's a little spammy, but just going there and scrolling through all the people on there. How do they display?

Where did they go to school? This is not a bad thing of anywhere they went, but just does, do they display well? Are you seeing some red flags in there, the turnover, stuff like that. Are there employees that have been leaving in droves that no longer work there? These are things that we pop on and look at.

Crunchbase is a great website for really startup-y venture style firms. You'll see how much money they have raised. There's other websites you can do research in, more private funds. Sometimes you have to pay for access to those, but just Google the fund. Google the people. Maybe a social media profile pops up that looks fine or looks frankly a little bit weird or suspicious or gives you bad vibes.

These are things that you can take that anxiety. Form it into a real question when you're having an investment meeting and just casually bring something up. Oh, I see that person's no longer working here. What happens? Things that can help you give a bigger picture of who's running your fund and your money.

Chris: Yeah, that's a good point. Sometimes a simple Google search can bring up some really interesting stuff. And there you get, like I said earlier, the whole point of doing all this is how do I get to my know quicker? I'm always a little uneasy when I go into someone's website and it's not functional or it looks like it was built in 1990.

mean it's okay, what's going on here cuz if that's the kind of care they have of their outward appearance okay, it doesn't mean they're not necessarily running a great fund, but it's not a good sign.

Brendan: Any previous business names they used to do business under. That's a big one. And LC records are public as well.

So if someone says they own an LC, you can typically go look that up in that state and you can see is that name as you expect or is there some partner that's like no longer there. These are things that you can just, if you get a bit deeper, if you have an anxiety, there's a lot of work you can just do through Google and a couple pages, Steve.

Chris: Yep. Totally agree. Yeah, there's never have we been, had more opportunities to do due diligence in, in many different ways. Just by sitting in front of your computer.

Brendan: Personal referrals, calling, asking usually every fund will have what I would call like a VIP investor. This is someone that likes them personally and has invested with 'em a lot of times they're of course biased, but what is usually nice is that the fund administration will refer you to that investor and say, Hey, You can't take all their time, you can't talk their ear off for an hour, but maybe you can talk to them for five minutes over phone or a couple emails back and forth, if that helps you get a better picture. That's always a great strategy.

Chris: Yeah. One of the things I do is I offer anyone who wants references from existing investors. I'll give you an investor I knew before I started the fund and I'll give you an investor that I met after I started the fund. We've only had one person redeem and I'll offer you that one too. Get a little view of a little bit of everything.

Brendan: Yeah, and I would always suggest a little bit of the interpersonal side too, because on alternatives, they're just not as big as names as the big three or five stockbrokers. They have less of a brand name.

So you could have, five totally fine funds all next to each other and one very rotten one. But you don't recognize any of their brand names or any of the people. So just going out and asking a few of the community, some people in investors, people that you trust, maybe it's someone you don't know super well, but you know that they know all those six managers and that person immediately is just do not invest with c and d.

Chris: Yeah.

Brendan: All the rest are great people. And all of a sudden you have that answer that you did not have a day before.

Chris: Yeah. You just eliminated somebody.

Brendan: Yeah.

Chris: Risk, let's talk about risk when you're assessing risk. You've got, Brendan mentioned this earlier, , this is exactly what I was stating here, is, hey, Ask the manager sometimes, Hey, what's your benchmark?

What do you think your risk is? Get them to answer the question and see how they think about it. It's pretty important to understand how they think their trade can break. All trades can break. There's no holy grail. Anyone who says otherwise is fooling themselves. Something always has a way, it doesn't mean it goes to a zero, but it just means, oh, maybe it won't be paying interest.

Or maybe, oh, it goes down and stays down for a while. So you're stuck in an investment that might come back eventually, but maybe you don't want the liquidity right now. But what risks are the manager monitoring. How are they tracking it? What are they looking at? And is there, external risk?

Is there events that may not be actually at the fund level? There's lots of different people who are reliant on, various weather and other aspects. There's all kinds of different special sits trading out there. And I know that if a hurricane hits this area, I, we could lose it all.

Okay. Understand that. And what's the probability of that? And is that something you're comfortable with? Understanding that variance of Hey, it's great, but I could lose because of one weather pattern. Counterparty risks these are risks you're not paid for. These are things that can go on and I'll give you an example that we had to deal with one of the shops I was working at, we had.

It used to be the Lehman Aggregate Bond Index. Before then it was the Barclays, now is the Bloomberg Aggregate Bond Index. It's the most common sort of index viewed across, a broad, pool of fixed income. But it used to be the Lehman aggregate bond index. And to create exposure to it, you had to do it by a swap.

And so it's a derivative product. You had to post money. And so you had a real exposure to Lehman. They had, two, four, 10 million of your money sitting there. And. Never ever thought that a major Wall Street counterparty would go out of business. But it happened.

We now know that's possible. And it's something to be at least aware of and say, okay, great. Where are those counterparty risks? And what do I think the real probability of that occurring is if we do feel there's pressure, how fast can I get out of that? Or how fast can the manager unwind that?

It's something to understand. Counterparty risk is real. I also know that I've known hedge funds that their counterparties were, I'm not gonna name names, but their counterparties were actually the beginning of their demise. I know the prop tests are gone, but historically there was a large hedge fund that, prop desk figured out what the trade was, took the other side, and squeezed them out and caused the hedge fund to go outta business.

It's okay, wait a second. That's messed up. Aren't these people supposed to be helping my business? Not always. So understanding those possibilities can happen. Not so much more, it is just something to be aware of. So counterparty risk is real. It's important.

Know who they're dealing with.

Brendan: Yeah.

So we're at a 10 minute warning. Chris. I think we're,

Chris: Yeah, let's go because we're the rest of these get pretty, pretty quick.

Brendan: Yeah.

And last thing is our crypto investors certainly know about counterparty risk outta any out of any community. I hear them bringing up those words the most and they are looking at, all right, my investment has three partners or counterparties.

What are all three? They can usually name all three. And I think that's a great, it should also extend to other assets as well.

Chris: Oh yeah. If you're in a new nascent forming industry, counterparty risk is bigger than you think. Legal Pretty quick. This is, one of the things I wanna talk about is the you're going through and you're doing your due diligence.

There's a lot of, as you do more and more of this, you're gonna run into PPMs and operating agreements and other documents that are very similar to other things you've read. Hopefully that makes your life easier. By now. It makes my life easier cuz if you read enough of these, you do see a lot of similarities and it allows you to really hone in on what's the differences and are those the problems that I want to, drive to my no.

The one other side of that coin is if you're investing across a lot of different alternative asset classes, there is no real standardized format for legal documents across strategy. So venture funds are gonna be different than hedge funds that are gonna be different than real estate. It's gonna be different than a, syndication versus private debt different than a crypto fund.

You're gonna have some pretty material differences in those documents and you're just gonna have to deal with that. And educate yourself if you're gonna be one of those investors and you have the money and the capacity to invest across all of those different spectrums.

Okay you got some work in front of you, I'm not gonna lie. But, so just be aware of that. Don't assume, oh, I've read this PPM in real estate, that's gonna be the same as, you know this hedge fund. It's not the case. Key documents. Get your PM, get your operating agreement obviously they'll have a marketing deck that'll be super biased.

A lot of people ask for it. I tend to ignore those things and unless I can't figure out what they're doing. DDQ, it's very uncommon to have this document for small fund. It's a due diligence questionnaire. It's diving into pretty heavy aspects of having the manager write out in material detail their operational structure by answering a series of questions.

It's a great document if they have one. Super. But don't be surprised if you run into kind of a smaller manager, they may not even be aware that document, or even know how to form it. It's a very institutional level document. You're gonna go for bigger money. And you're a fund manager, you better have that.

Compliance manual. Here, again, smaller funds may not have a fully formed compliance manual, but some kind of code of ethics, something that will give you the idea that these people are trying to operate and educating their employees to operate on an ethical basis with the investor first mentality. As Brendan mentioned this earlier, entity verification.

Do your LLCs checks, do, dive in and understand? Do these entities actually exist? If certain levels of licensing are required, make sure they have their licenses and they're listed. Double check, a lot of funds to get their ADVs double check on, their securities filings. The, that's all information you should be able to obtain from the manager.

And in some cases you can actually, check right through the internet. And as I mentioned earlier, policies and procedures. , it's a document that you know they should have in one form or another or be able to talk your ear off about it.

Let's move on. We were coming to the end of this.

Brendan: Just so everyone knows that PPM is a private placement memorandum.

You'll hear everyone who's experienced in this space just say ppm, private placement memorandum. It's one of the first documents you're signing.

Chris: Or you'll, some people call it an offering memorandum. They'll say an OM is the other one. But same document.

Alright, references. We already talked a little bit about this. Get your investor references. The other thing I like is check with your service provides. Get the authorization, get the link from the manager to go call the fund admin to go call their prime broker. And, have a few questions ready and even if it's as simple, just verify they're a client.

I'll let you know there's a very famous person named Bernie that when you did this type of reference check The people that would've been able to facilitate his options trading weren't actually clients of his. That was actually one of the biggest things that was discovered about in the early days that he maybe wasn't doing what he said he was doing.

And it was really just a reference check with the service providers. You called the largest options houses and we're like, oh, I know you can't tell me if he's a client or this or that, but you can ask the right questions to get a general idea. Are they even moving the volumes that Madoff was running and you found out not quickly, but with a little bit of work they weren't.

Do your reference checks. Like I said last is performance. I put it last here. It can be rather complicated. There's a number of different funds that will run through quantitative. They'll have a bunch of statistics on their fund. That's great. If you don't understand something, ask. Either ask the fund manager or go to and build a network of people that can, help you out in understanding some of the quantitative aspects of performance that they're talking about.

There's lots of ratios that people throw around out there, and there's good and bad to all of them. That's why I laugh about a lot of your financial ratios and your risk adjusted return metrics is, You gotta understand what it's actually telling you. It's not just some number that, oh, this one's better than this one.

There's a lot of moving pieces. Get your if possible, get an attribution breakdown. One of the things I used to do with long, short hedge funds all the time is I don't want your net. I'll take your net performance, but I want your long performance only.

I want your short performance separated, and I want the attribution. I want to understand how much net long were you. Those are the number of things you can break down. And I admit it gets very complicated, but, get everything you can and then ask the questions of what you don't understand.

I mentioned things here like herd behavior, performance review. Don't be swayed by numbers. Don't follow shiny objects. It's okay to be aware of the numbers, but complete everything that we've talked about today before you just make a bet because, oh yeah, this guy puts up a huge IRR. You can find yourself in trouble doing that.

You might get lucky you, this is all about getting the, skewing that probability to a positive probability that you found the right investment. And these are the steps you gotta take. And I mentioned down at the bottom here, you're not on a witch hunt to find frauds.

Finding a fraud is extremely difficult and it requires literally a deep dive on everything we've talked about today and a combination of understanding the investment, understanding the returns, and then effectively having the knowledge base to say, wait a second, the guy told me what he did and I'm looking at his return stream and the timing, and I've got the benchmarks in place and it just doesn't mesh.

And then that leads you to like, Hey, let's go to a deeper dive and follow what I used to call the life of a trade. Walk in. How did you come up with this idea? How did you execute this idea? How did you maintain the position? How did you exit? And then have, you might need to do that a dozen times and then all of a sudden you can really start to realize, wait a second, something's broken here.

This guy's good, but something's not meshing. And if you really don't feel comfortable, walk away.

Brendan: And no one is ever gonna be hurt by you stopping and sending one more email or one more question. Us sales guys might get a little flustered, but it's our job to answer questions. Anyone selling you investment? It's their job to answer your questions.

Chris: Totally. Yeah. If you're not getting the answers, you're not getting the transparency you want, don't do it. I'm warning you there's better things to do than crawl out of a hole.

Lastly, now we're not gonna dive too much into this. These are the red flags.

These are areas that I, I couldn't come up with a better name than red flags. These are not like, oh my God, these are problems. These are areas that historically you've seen SEC indictments, you've seen funds have problems and they're not acting in a moral way or putting their investor first.

We don't have time to dive into this obviously, cause we only have minutes, but we will send out the deck and there's other slides that will walk through actual questions and actions taken across, how do managers choose allocations between multiple funds? There again, valuations related party transactions.

Everyone loves to see vertical integration of Hey, I've got this project and I've got all these people that support the project. That's good. In one way. But you gotta do your verifications and understand that you're being treated fairly and there's not undue expenses buried into those related parties.

Cuz the manager technically might own the entire chain. And there's, like I said, nothing bad. Doesn't mean there's fraud, there's not anything else. It's just you, something you need to be aware of. Cross fund trades this is much more of a larger fund house. If you've got the guy's, got multiple managers and they have like strategies sometimes the funds are allowed to trade with themselves.

You need to really dive into that because that. How's that valued and who has the right to do that. External operating partners, this has become more and more popular in venture and some other areas where the fund manager is not actually performing some duties. They've outsourced a duty directly to an external party.

You better understand what the cost of that is cuz I have heard from a few people. I have not run into it personally, but those external partner fees are not part of the management fee. So you need to understand management fee, fund expenses, external partner fees. Okay, what does that really look like?

What am I really paying at the end of the day?

So.

Brendan: Are they secretly related to that external partner? Maybe they make some money off that partner too?

Chris: Totally, yeah. If there's a kickback. Okay. That's just bad. The most con one of the biggest and always a failure, anytime there's a liquidity crisis asset and liability mismatch, has this manager matched up their liquidity profile with the product they're investing in?

I know it sounds like that would be super easy to do Like clockwork it happens across a large spectrum of alternate investments every time there's a liquidity crisis. So be aware, work with a manager that understands what they own and what they owe. And the timing of when things might need, needed to do that.

And then there again, service providers dive in. There's been a lot of issues where they don't have proper service providers they don't have any don't have the right people in place because the right service providers are really looking over their shoulder. One of the things with the fund administrator, not only are they doing accounting for mid and back office for a lot of funds, they should also be looking over the shoulder and questioning transactions.

Hey, I saw this come through. What is this? If they're not, you need to get that time with the service provider. Understand how they integrate with the fund and how they're acting in your best interest as a, another pair of eyes. Keeping the manager in check.

Brendan: Always feel free to give the Rocket Dollar sales line a call. We cannot give investment advice, but if you are having a concern related to the operational business side that has maybe hit a red flag, feel free to call us. That's also valuable information as us, as well as more clients come in, are excited to invest in a fund.

Maybe they were not aware of this certain red flag. We'd be happy to communicate that to other investors as well. And that, the clients have been frontline often of telling us when something is up or off, we immediately say, Hey, is it right for Rocket Dollar to be working with a specific investment because there's something potentially really concerning.

So always feel free to call our sales line and bring that up. We cannot be your financial advisor, but if we see a red flag, we are happy to try and step in and see how can we maybe stop working with this particular individual or fund.

Chris: Yep. And always on the next slide there's my email.

I know this was super fast, this was very high level. You got some questions on any of this stuff. I love this stuff. I love tearing funds apart for better or worse. But if you got any questions or any other follow ups like I said, this was super fast. And we're, three minutes over already, don't hesitate to reach out.

Brendan: Great.

Chris: Love to talk to you and answer any questions you have.

Brendan: We had one solid question, and then we're gonna close out here for the day. So someone asked what about an independent financial audit? How many small funds have these?

Chris: Kinda alluded to your earlier comment. If you want to move forward and raise larger dollars, it's pretty much required to be an audit.

It is not very common in smaller funds. I say that tongue in cheek because if you have the right network and the knowledge to do this, you can actually have your fund audited and it'd be very small. And it does, it's not really cost prohibitive to the fund itself. One of the things that we did is we got audited day one from our fund.

So I have two years of audited financials. And it was a low enough cost that Brock and I just paid for the first year. But then we actually got enough AUM in place to where rolling a cost of a full audit to the fund cuz it is a fund expense. It was de minimis. It was literally down to like basis points of impact to return to the investors.

Brendan: So funds gotta do their homework. They gotta get out there and understand that you're not gonna go to your big four to get an audit done because you're gonna be paying a lot of money for just their fixed cost of running their entire empire. There are a number of smaller firms out there that will actually provide great tax and audit, that's actually very cost effective. And it's something as an investor you need to be aware of because it is a fund expense. You're paying that bill. I would say that information is not available immediately. Try and go to references and, they can tell.

Chris: Yeah.

Brendan: They can probably give you that reference might have been around the fund longer than an auditor who's just coming new into this situation, day one, that, that can give you some great information about that.

Chris: But the short answer is not too common. But in today's age, I'd like to see it, more common. And actually if the fund does have an, a admiration through sort of an aspiration to grow they're gonna have to get there sooner rather than later cuz most of your service providers and large platforms that Brendan was asking about or stating about, was like, Hey, how do I get on the big broker dealer custodial platforms? All of them require you to be audited. You cannot be on there and not be audited.

Brendan: Got it. Thank you Chris. I know we're a little over time, but this is amazing information. Sometimes it could be a lot to sit through all of this, but this is awesome for an alternative investor to really get a full scope of how to analyze their opportunities, red flags and even their trusted issuers. How do they more holistically look at those and how they operate? So thank you for coming on today.

Chris: No, thank you for having me. And be sure to request the deck cuz then you can get the slides. We did not get to that. Really walk through those questions and actions you can take on the due diligence side.

Brendan: So you'll see a follow up. There'll be, this will be open in the YouTube channel later tonight. And then we'll also put Chris's contact up there. And Kirkland Capital Group is also on our partners page and they have some opportunities that you can look through our partners page.

So thank you. Appreciate that You've coming on here today, Chris.

Chris: Yeah. Thank you again.

Brendan: All right.