Alternative Investments: A Guide to Due Diligence for Investors
Alternative investments have emerged as a promising avenue for enhancing returns and diversifying beyond traditional stocks and bonds. These range from real estate, private debt, private equity to hedge funds and more unconventional options like cryptocurrency. However, venturing into these realms normally requires a comprehensive understanding and meticulous due diligence. As I share insights from decades in the investment industry, my goal is to empower you to conduct better due diligence when considering these opportunities.
The Importance of Due Diligence
Before we delve into the intricacies of alternative investments, it’s vital to appreciate why due diligence matters. Your due‑diligence toolkit should include a structured series of analyses and steps to understand an opportunity fully. It’s akin to inspecting every component on a factory floor—scrutinizing operations, management, and product quality. This discipline helps you avoid costly pitfalls and ensures each allocation aligns with your financial goals and risk tolerance.
Types of Due Diligence
Investment Due Diligence: This is the most enticing aspect for many investors, focusing on the trade mechanics, investment strategy, and performance measurement. It examines the processes that underlie investment decisions and strategies, spanning across various asset classes like equities, bonds, derivatives, or venture capital.
Operational Due Diligence: This area's emphasis is on the aspects that directly touch the investment product or are directly related to the trade, such as technology, people, and process. Understanding the operational backbone of an investment is crucial to assessing its potential success. An estimated 50 to 66% of fund failures occur due to operational failure.
Business Due Diligence: This examines the broader organizational aspects that might indirectly affect the investment, such as corporate governance, IT Support, and physical facilities, if applicable.
Economic Due Diligence: This involves understanding external global factors that could influence your investment, such as interest rate changes, geopolitical events, inflation, and regulatory environments.
Conducting Effective Due Diligence
Identify Non-Negotiables
Every investor has unique preferences and thresholds for risk. Establishing personal non-negotiables—a list of deal-breakers that resonate with your financial principles and goals—allows you to swiftly filter through unsuitable opportunities based on your situation. Common non-negotiables include risk exposure, leverage levels, asset-backed investments, and ethical considerations such as avoiding industries like firearms or tobacco.
To help you create your non-negotiables, watch our short webinar on “Investing for Success: Determining Your Non-Negotiables”.
Strategy and Team
Investors should understand the strategy of the investment team early in the due diligence process. Once you've thoroughly understood the investment strategy, it's crucial to assess the team members' backgrounds and expertise to determine their ability to effectively implement the strategy and ensure it is repeatable. Years ago, during a due diligence trip with a New York hedge fund, I was discussing an event driven trade that hinged on the team’s ability to negotiate with custodial corporate actions groups and discovered a gap in their team's expertise that highlighted an operational inefficiency. This emphasized how vital it is to understand the operational nuances that could make or break a strategy. You should also look for people who can clearly articulate what their edge is and the risks of the investment, which speaks volumes about their competence and transparency.
Watch our webinar on “How to Identify Market Inefficiency and Manager Edge”.
Assess Performance Metric with Caution
Performance metrics often tell the story of past success but rarely depict future potential. Early in my career, while working at a hedge fund, I learned a valuable lesson from the 2008 financial crisis. We had developed what we thought was an unassailable approach, confident that our contractual trades were “risk-free”—unless a major Wall Street bank failed. In a twist of irony and reality, we saw the collapse of Lehman Brothers, a pivotal moment that taught me the real-world impact of systemic failures and the importance of looking beyond returns. Aside from this, you also need to understand the contextual conditions that contribute to these assets’ returns. In our next article, we will talk about how to evaluate investment performance in a little more detail.
Get started on evaluating investment performance better by watching our video on “How to Assess Performance Like a Pro”.
Operational and Business Related Considerations
As mentioned, operational due diligence extends to evaluating efficiency in technology, people and processes. While business due diligence relates to aspects of the company that are not related to the trade. A personal experience underscores the importance of simple verification checks in uncovering critical insights. During our review, a quick phone call revealed that a claimed association with a significant business partner was nonexistent, thereby safeguarding our investment from potential fraud. The presence of robust third-party oversight can also provide added security and reliability.
Economic Factors and Market Conditions
In today's dynamic market landscape, staying informed about economic indicators is critical. Monitor movements in interest rates, inflation, and geopolitical tensions, and understand their implications for your investment portfolio. These factors can dramatically alter the landscape and performance of alternative investments, thus proactive management of such risks is essential.
Structuring and Allocations
Once due diligence is complete, the next step is effectively structuring your portfolio with these alternative investments. Consider factors like the fund’s size, your percentage of ownership of that fund, and the potential impact of your investment on the broader portfolio. This involves understanding whether your investment might create undue stress or push the fund beyond its capacity limits. Additionally, you need to assess your allocation parameter to ensure that this investment contributes to a more diversified portfolio, with a focus on achieving balanced exposure to different sectors and asset classes.
Conclusion
Conducting due diligence in alternative investments is an exhaustive, but indispensable process. For investors, it is a blend of art and science—requiring both quantitative and qualitative evaluation. By focusing on the key aspects discussed in this guide, you may be able to navigate this complex landscape better. To help you get started, download our short guide on How To Perform Due Diligence.
