How to Invest in Alternatives Like a Pro?
From the last OpenAlt conversation, I talked about the basics of Due Diligence and identified the key areas that you need to take a look at before making an investment. In this webinar, I dive into areas you need to look at for potential red flags so you can invest like how the pro’s do it.
Hosted by OpenAlt, Chris Carsley - CFA, CAIA, Chief Investment Officer & Managing Partner at Kirkland Capital Group continues the series on alternative investments.
“Throughout history, a ton of people have grossly mismanaged asset-liability matching. Are you able to get your money back in accordance with the assets the fund is investing in?”
“You’ve gotta obtain a level of transparency so you can see the trades and how are they being allocated. Look at both current and historical trades.”
“One of the big problems that I’m always worried about, and it doesn’t mean anything’s being done nefariously, but it is something you gotta keep your eye on is, if all the valuations are done internally and the manager is valuing the portfolio. There’s a major conflict of interest there.”
Watch the discussion below.
Transcript
Nikita: All right. Good morning everyone. Once again. Welcome to the final webinar of this series, OpenAlt series, on due diligence of the private market alternatives. Welcome to Open Alt, Private Market Alternative Investment custody and due diligence platform. My name is Nikita Brodsky and I am introducing our speaker guest, Chris Carsley.
Who was the author and presenter on all three previous webinars of this series. Chris, please take over.
Chris: Yeah, sure. Thanks, Nikita. Welcome everybody. And hopefully, you got a chance to watch the other three webinars that we covered. What are alternatives? We then went in and discussed diversification.
What does that mean and how do alternatives impact the diversification of your portfolio? And in the last webinar, we had the daunting task of Hey, let's cover some due diligence. But before we dive into that let's move forward into what we're gonna be talking about today.
A lot of these people will come on and they'll talk about a number of different things and educate you, and you walk away going, Hey, that's great. I really need to do that. I should get better at doing due diligence, but you're not really sure where to start, or what questions to ask.
There's some that you might think are quite logical and hopefully, we can now walk through this webinar and really address a number of different questions that you can add to your list if you don't already have them in there. And I'll give you some different examples and actions to take afterward and as fitting, I'll have a few stories from my experience of some of the things that had occurred in my life of investing in doing due diligence.
But the agenda today, is we'll do a little recap on, what was due diligence. then we're gonna walk through and I like using this term as red flags. I wanna be clear. the items and the aspects that we're gonna be talking about, they themselves are not problems.
They're just areas where you need to be sure to ask questions because they have caused problems in the past repeatedly with a lot of different funds across a lot of different investment structures. So we'll be touching on that. And I wanna be clear, there are literally hundreds and hundreds of questions to ask.
And then even more that can be idiosyncratic to a particular investment fund. all investments are slightly different in the Alternative space. So you need to understand whether you're looking at venture or real estate, or I'm gonna be looking at a long, short hedge fund, or I have a special sit trade.
It's legal arbitrage or something of that nature. There are very specific things you need to ask and understand about those. We're not gonna be going into that deep, but I'm gonna try and hit some of the key areas that do affect a majority of different funds. and then lastly, once we walk through, what are these red flags,
we're gonna dive into some of these, and come up with some of the questions. So I'm gonna give you some things that you can add, like I said earlier, and then some action points. you can ask a question, but how am I making sure I'm getting the right answer? and because we live in a world of trust, but verify.
So some of these action points will walk you through some of the steps that you could help in verifying the answer that a manager gives you. So yeah, let's move on to the next slide. A recap on due diligence. Nikita, you got control? Perfect. Real high level. There were three levels of due diligence.
The one that most people spend most of their time on for right or wrong, was the investment due diligence side where you're asking questions, what markets and assets did the fund manager invest in, what's their investment strategy, how do they enact their investment strategy and make it repeatable?
And then, do they have benchmarks? If we're gonna do an analysis of, is this manager adding value, which I always believe you should. you're paying fees. Sometimes these fees can be rather large. Wanna make sure that the manager is adding value above their fees. Next was operational due diligence, which, out of 2008, a lot of people were doing operational due diligence, but out of '08, a lot more people were considering, Hey, what's the impact to this investment If I understand the operations that affect the investment strategy directly. And then lastly, you are looking at business due diligence. Chris, how is that any different than operational? The simple definition there, again for a recap was business due diligence was the due diligence around things that don't directly relate to the strategy. So you're not sitting on the trading desk and understanding what software they're doing, what kind of cash movement controls do they have.
It's more about facilities and office equipment and, controls of, physical security, maybe even business continuity. Yeah, and we covered that. There's information and networking systems. So let's dive in. and at any time anyone has questions, please put 'em in chat, raise your hand.
We'll have a section at the end if people want to dive into something in particular, I'd love to. But red flags, or as I said earlier, areas to look for red flags. and I'm not gonna dive into too much of the definition cuz we got a lot of slides that we'll cover and define these a bit more, but allocations, how's the fund manager allocated things, related party transactions.
Okay that always sounds good if I can build a vertical integration, but actually, historically, unfortunately, that's actually caused more problems for funds than it has created benefits for investors. Then you've got external operations and partners and advisors. it's a little bit more particular to certain types of funds, but you're seeing a trend where people are outsourcing some functionality that they might have normally had within the manager, and we'll walk through some of the problems with that.
Asset and liability duration. I used to call it asset-liability matching. Also, a classic error that you see in a variety of different areas of funds where people, they're investing in an asset, and their natural liability is your money. They owe it back to you, they owe you a return. So how are they matching and are there liquidity terms matching and able to get your money back, in accordance with the assets they're investing in?
I know it sounds weird but throughout history, a ton of people have grossly mismanaged this between the illiquid nature of what they're investing in and the liquidity that they're giving investors. Another big one is valuations. This is really hitting everybody and should be something that's extremely important to a number of different people because this is your entry point.
This is your exit point. Everything that you're doing from an investment standpoint is based on some level of valuation. Cross-fund trades. A lot of PPMs you'll read through they'll have the ability to move assets from one fund to another. Now if you're in a smaller manager that only has one fund, obviously that's not a real problem. But when you're working with bigger managers that might have a lot of funds that have an overlapping capacity of investment. Okay, you need to understand if they can move things from one fund or another and you know what they have in place. And then service providers. Again, this is falling a little bit more into that operational due diligence side, but people are not doing good enough research and taking the time to understand the service providers that are protecting your dollars as an investor or increasing the efficiency of the fund itself.
So let's dive into the first one, allocations. Some of the questions you can ask, and I hate to read off slides, but, we're gonna read these questions. What funds exist under the manager's control? It's a really simple question, but you may be focused on only one fund in particular to your investment, what you're thinking about putting into your portfolio.
How many other funds do they manage? And this is not a matter of oh, are they stretched too thin? Kind of a question. That's not what we're going after here. Although that can be a concern. It's something that you've gotta think about. Wait, what are overlapping circles?
Can they move assets from fund to fund? How are they allocating between those funds? Do they have a partner's fund and an investor's fund? and I kid you not, I was working on a paper, with a fellow cohort of mine and there's a number of SEC indictments against a couple of different funds that were investing in a partner's fund, and then two or three days later investing in the investor's fund. That's basically a way of almost like front-running. and so best ideas were going into one fund and then they were following on with other ideas that didn't fit the partner's fund, or they were picking up scraps they didn't have the capacity in the partner's fund kind of thing.
A number of different problems. Obviously what occurred in that situation was the investors' fund, their returns were monumentally lower than the partners' fund. and it wasn't marketed that way. There was a great deal of misrepresentation, but for some investors who took the time to ask that question and understand how things were allocated. They recognized that problem and so that's why, that's an important question. I know this is, sometimes these will appear like nitpicky, but there again, not a fraud, just not something you may want to invest in as an investor, cuz you're gonna get inferior returns given, maybe the fees you're paying.
And the partners for the fund were actually getting the best deals. Next question is, how are trades allocated? We covered a little bit of that. And how are you gonna do that? Here's some of the actions. You need to get the documents. This will be a recurring theme.
Read your documents. You gotta get the PPM, you gotta get the OA, the operating agreement. You've gotta obtain a level of transparency so you can see where trades are, how they are being allocated. So one of the things I used to do when I was doing due diligence on managers is, Hey, let's look at a current trade that you're just putting in place.
How did you come up with that trade? How did you analyze that? What's the sizing and how is that then allocated across a number of different funds? And is that in line with what you've told investors? That's life of the trade is what I called it. Follow from the beginning to the end of, how an old trade put it in the book and worked out and sold. And how is the current trade? If you have that opportunity to walk through a most recent trade with a manager, I think it's always valuable information. Lastly, check with the fund administrator. I know that, historically, the fund administrators weren't always doing what they needed to do from a dive and control aspect.
But I think things have gotten a lot cleaner. There are a lot more strict rules and operations around how fund administrators operate today. So check with them and get their understanding. Does their understanding match the document that matches maybe your in-person verification?
If there's a break in any of those, you probably have an allocation problem. And there might be something wrong. It's something you might wanna dive deeper into, and make sure there's no misrepresentation. next one we're gonna dive into is, from allocations?
The big one is valuations. We could have an entire hour's conversation just on this subject. Valuations, some of the questions, how are valuations calculated? Is it an exchange base? If it's an exchange based, great. What's, when are they pulling closing prices? How do they manage that or differentials?
So it's a lot easier because you're dealing with something that's publicly traded. But in private investments, you're obviously looking at a situation where they're not on an exchange, they don't have regular pricing. So you need to understand what is the mandate of how valuations are performed, and who calculates them.
One of the big problems that I'm always worried about, and it doesn't mean anything's being done nefariously, but it is something you gotta keep your eye on, is if all the valuations are done internally, the manager is valuing the portfolio. Okay. there's a major conflict of interest there.
and what is the timing of their valuations? When an investor comes in, do they mark the portfolio intermittently? Is there a schedule to it? you wanna make sure that there is a repeatable pattern that is best practices for the valuation of the asset that's in that private manager cause it's entry and exit for a lot of people. It also goes into, affecting performance as you can see there. Does your performance match the valuation policy? That's a check on the math, and why that's important. that's how a lot of funds if they charge an incentive fee, you gotta understand, are they crystallizing annually, quarterly, how often are they pulling fees based on performance?
And so it's really important to understand, how are they marking that portfolio at the end of a quarter? And, then they're gonna charge fees. And that gets into other questions of, do they have clawbacks? If there was a mistake? some do these days, Here's one that if you're dealing with, a fund that is mostly marketing based on IRR you should look at past funds.
Now, obviously that's hard to do if you're dealing with an emerging manager. doesn't mean there's anything wrong with the emerging manager. They just don't have another fund to show you, or they don't have a light fund. Maybe they're doing something different. So there's nothing wrong with that but if you have the opportunity to ask this question from a fund that has. similar funds in the past go in really, check what was that unrealized IRR and what was the drift or the difference between actual IRR because in a lot of investments like venture and some, long haul real estate you can run into a situation where those numbers might be monumentally different, given occurrences during the life of that investment. Last question is, what is the fund's volatility and the correlation statistics? I'm a big numbers guy. I love statistics. How much of these numbers are driven by the valuation policy?
You can actually affect the statistics around and the tracking numbers behind a fund by timing and altering valuation. . and so it's something you should be aware of. It's like when are they marking their timing? It's going back to those earlier questions and following that flow of when you understand the first questions of how it's done and who's doing it.
What has it been affecting? some of the action points you can take. Obtain and review policy and procedures manual. if you're working with a larger fund, they should have one of these. This should be in place. There should be an entire description of valuation.
It should also be duplicative, perhaps in their PPM. you should see their policy in multiple places and it should be something that's well ingrained in their mid-office and back office. And like I said earlier, check with the fund administrator, there again, what are the valuation policies, how are things treated?
They should know as well cuz they're shadowing and running books, review the valuations of investments there again, walk through and part of that life of the trade. If it's not exchange based, how are you valuing it? How do you maintain, how often do you value it? and understand that and walk through some past investments and try to grab some present ones.
I don't let the manager usually choose the investment they want to show. I like to pick randomly and then have them fumble around and see if they can find the paperwork. backing their valuation. and I say that jokingly, but I have been in the manager's office where they're scrambling to find the files that support the assumptions they've made around an investment, an awkward situation for them.
I talked with a third-party valuation provider. Now here's the real key thing is a lot of times some of your bigger funds are trying to be much more institutional class, and I'll put that in quotes cuz that's not really a defined term by a lot of people and it's open to interpretation.
Do they have a third party valuing their assets and double-checking everything? I think that's extremely valuable if they have the size and they cannot absorb that cost. And it costs tremendous money to the investors. but it's something that's very valuable and you should take the time to understand how they're doing it and how they integrate that valuation into the fund. Does the fund and the manager always accept the third-party valuation, or is it just considered? I've seen both of those happen, and I always prefer that, within a level of reason. And as long as the third-party valuation company really understands this asset, which hopefully they do, you're accepting the valuation.
The manager's not able to supersede the valuation without a lot of written notes and announcements about doing so. And then there again, Obtain audited financials, and you know the return stats of previous funds. And that kind of goes towards that last two questions did unrealized IRR Match realized, walk through those financials, walk through the actual numbers there again, from a third party auditor so that you can understand, hey, they have been pretty good, they have actually been fairly tight. There's not a lot of variance in the valuations. and then you can move forward from there. But this one's really important. and there's, like I said, there's other questions you can ask that are related to valuations, particular to the fund and some other actions you'll have to take—related party transactions. Here again, I've seen this as marketed as, wow, look, I've got this entire vertical integration and I'm seeing tons of fees. be careful. Sometimes it doesn't actually work out that way, but you also have a conflict of interest here where does the manager have related, or fully owned companies that support the functionality of the fund.
Okay. You can see why there can be some variety of different problems. If I own three companies wholly, they're all related to the functionality of the fund I'm managing and you're an investor in it. you really want to dive in and understand what are the engagements, what are the agreements for those entities to work together.
What aspects are supported by these companies? Understand what these companies are actually doing? What fee agreements are in place? Like I said, I've run into, unfortunately, a lot of funds that don't really pass on any kind of cost savings by controlling all these different pieces.
You're paying full freight all the way. The only value of vertical integration might be the seamless capability of expediting a variety of different processes all in house quickly, cuz communication, hopefully, is quick. But there again, Are you getting fair pricing?
Have these people gone outside and looked at outside providers? Do they have their process and procedures manual? Hey, I do own this company, but we go out and we check three people externally, and if I'm always beating 'em, then great. What efforts are they taking to make sure they're doing their best efforts for your investment dollars? If you're actually the one paying the fee for that service you're sure you're not being overcharged.
How much is the fund paying for these services? And this gets back to my point, you're probably carrying the bill for this as the investor, they're billing into the fund, not the manager. There's a section we'll talk a little bit later, that also deals with making sure you understand what's being billed to the fund and you can get that itemized out. Some of the actions there, I said, Again and again, you'll see this, get your PPM, get your operating agreement, obtain those disclosure related, party agreements and the engagements, understand how they relate. then, if they did get external bids, can you see those? I know this sounds like a lot, but you gotta get in there and trust, but verify.
You gotta go that extra mile to make sure you're really understanding. so there's no surprise in the future when something goes wrong. Listen, the world deals us some ups and down markets. So when and if it goes wrong, you want to make sure you really understand, operationally and structurally, and through all these different questions that your fund is gonna be able to, whether that and you're not gonna be inadvertently hurt from an investment standpoint. Obtain an itemized breakdown of fees.
It amazes me to this day that people think two and 20 is the only thing you're paying. If you actually believe that you should readjust your thinking. there's a lot of fees embedded in a lot of moving pieces of funds that have nothing to do with the management fee and the incentive fee.
You really should have someone map that out. Now, with that said, nothing is an absolute. There are funds that streamline their fees, effectively. So it's very transparent. You just wanna make sure you're verifying that. So in this related party transaction, it's very important that you just don't take it.
Someone's, face value of, wow, he's vertically integrated, all these aspects, and I'm capturing all this value by having this in place. go in and check, and make sure there's not a conflict of interest that you know the manager's not, collecting money at four different levels and you're paying the full freight for all of that.
Next one, cross fund trades. A lot of funds have this written into their documents. therefore you've gotta go in and understand I'll kind of do this one a little bit reverse to explain this. Most people are not too exposed to this function unless you've really dealt with a lot of Alternative investments is read through the PPM and the OA. They'll talk about the ability to cross trades between one fund and another. it's usually required by regulators to have. very specific policies and write ups in relations to a lot of the things we've talked about. valuation procedures, marking and timing, the timing of transfer, justification of suitability between the funds.
A lot of different aspects they go through. And they should itemize that out on what they're going in, what they're talking about. And that should be, if it's not written up separately, it'll be embedded in the PPM. Here again, what funds are owned by the manager and do they allow cross fund trades?
They may not even allow them. and this question may not have even come up. Again, this question may not be an issue if you're dealing with a manager that's only running one fund or they run two funds that don't do like trades. This is just an area to consider that can be a red flag and has caused some problems in the past.
What's the valuation policies? What third parties are involved in monitoring these transfers and ensure fair treatment? That's probably gonna be a third party valuation. Definitely will be a fund administrator. They're gonna be monitoring and having to book that between the funds. is the administrator the same, do they have the same fund administrator for both funds that's taking on the transfer?
That could add some extra complexity. If you've got two fund administrators, okay, it's an extra phone call for you to complete the loop of due diligence, on, historic cross trades. Walk me through a past cross trades.
So I can see a live example of how this was treated and how it was fair to both funds, and the justification of that. And lastly are there third parties utilized to obtain external approval for transfers? Less common, but a good question to ask just so you close the loop on everyone that might be involved in this process.
And then some of the actions we already said, Hey, read your PPM's. Double check and see where it's written in. It's usually required by the regulators. if transfers are allowed, obtain a complete list of the transfers. you may not be able to find a recent trade cuz it's not something that might happen commonly but you can walk through historical crosses and understand how they've been fair about those so that you're just comfortable on anything that they do in the future as well. And then obtain access to those third parties, call those fund administrators, that's the real, important aspect. always check with those third parties.
Always verify outside of the manager. A lot of the SEC indictments that I've walked through occurred because people just stayed within the manager's loop. And I know this sounds scary, cuz this is not the norm, but there are a number of occurrences over history we're talking 30 years, where people have lied.
They've just snowballed. On a number of these points, if you don't double check and really go after every point and close the loop through the third parties, you might be one of the people that they pull the wool over. you're dealing with some pretty smart people and if they have the intent to, deceive you, that's sad
But it does happen. you can look up SEC indictments as public information. You can find a number of things where people have been indicted for valuation, been indicted for cross funds, improper allocation, like I was explaining. The example I was giving earlier was a London based fund, that was misrepresenting investments to investors.
Next slide. External operating partners. It's been more recent problems and I, maybe I shouldn't use the word problem, it's just been, a challenge. You need to understand the new fee structures that can occur. And, I've seen this a fair amount in venture where a number of people have been siloing a number of different projects because it is a very complex process, in, startups and, venture and private equity. Does the manager utilize external operating partners and advisors? That's your first question. Are you using external people to get work done for your fund?
It sounds like a simple question. but most people listening to this have not asked that question. it's just something that's overlooked. or they don't understand how it can turn around and be a conflict. And what is the policy and procedure on fees? Okay, this is where it gets a little tricky to use external partners.
Are these partners and advisors paid by the fund, or the manager. Is the fund paying the bill or is the manager paying the bill? And what I mean by this is the fund paying the bill? you may pay a management fee, so you got your 2% management fee and you're thinking, oh, this might have been work that was done by the manager, but they've outsourced this to an external partner now.
But that's actually not covered by the manager. So now there's an extra fee in related to the fund that you're paying as an investor, and that's where this has caught a lot of people off guard is you're still paying the management fee and you wrongly assume that these external partners providing a number of different, important, don't get me wrong, they're important processes.
It's not that it's not valuable, it's just that you're unaware of it. The cost of operating it just went up because the manager didn't absorb that work. They took a piece of their work and outsourced it. So here again, what are the all in expenses to the fund? You gotta have that itemized out.
You gotta understand that and here's another important fact that you can mention in multiple things that I've already talked about is just because you did this due diligence on day one, doesn't mean you can just stop watching. One of the number one things that has occurred in, multiple frauds and other funds that have had problems is people stop watching.
They didn't do the ongoing monitoring, so that's super important. So you may ask all these questions when you get into a fund, and oddly enough, you should probably turn around if you've been in a fund for a while and turn around and ask all these questions again. Maybe a procedure has changed. We've been through some pretty dynamic times.
A lot of outsourcing. This is where one gets picked up and, oh, no one's showing up in the office, so I'm gonna outsource this to an external operating partner. Okay, wait. There was a dynamic shift that, maybe the fund manager doesn't fall under the purview that they have to notify everybody that was done, should be written in there.
And that's an important piece of information that investors should know about. But this is one where you gotta understand What you're paying for, and like I said earlier, we're not on a hunt for frauds. Everyone always thinks due diligence is, I'm just trying to hunt frauds.
I always view due diligence and in my job in due diligence is I'm trying to identify an inefficiency that's run by a team that has a solid edge and that investment wise, operationally wise and business structure wise, and asking the right questions has an efficient method of fulfilling and taking advantage of that inefficiency, with their existing team.
That's really my view of due diligence. We just want to supply some of these questions so you can ask the right questions and determine not really is it a fraud? It's more, is this a fund I want to invest in? Is it something I'm comfortable with the fees I'm paying? Is the net of fee number still good?
And, have they been through a cycle? meaning have they seen a down cycle? If they've seen a down cycle, and the fee structure and all these questions we walked through, still pan out and still provide a solid net return that's maybe not very correlated with your other investments.
Great. That's what we're going for. That's the angle that we want to attack. I just wanna be clear about that and not drive people down this, there's a lot of negativity unfortunately, and a lot of these questions cuz we're hunting for people who are making mistakes. But I just wanna be clear what we're really driving. Most people who are running funds are trying to do the best they can. they're not trying to be nefarious. some of the actions that you can take on this, obtain a list of external partners. I did this for one venture group that was looking at it that they had outsourced some, and it was all good. There weren't any real problems.
It was just something you needed to make sure that there was some extra cost to the operations of it. And, was that gonna, hurt the return, obtain engagement agreements of these partners. You're looking to write a large check to this, you should understand, if that external partner is performing, an important function, you should understand the level of engagement and what type of, risk do they carry if something goes wrong, and check with the fund administrator here again. Check with those third parties. Get in there. Understand the other people who are looking over the manager's shoulders. What do they understand? What do they think is going on? everything should match. If everything doesn't match well, you have a problem.
All right, next one. We talked a little bit about this earlier. This is one that has shown up repeatedly throughout history. I think one of the biggest ones that most people will remember is, some people call it the great financial crisis. I just call it 2008 cuz that's the year that occurred and does the duration of the fund’s assets match the withdrawal terms of the fund.
They don't have to match perfectly. But you want to be aware that in a time of stress and everyone's trying to get through the same door, what's the likelihood of me being able to get liquidity? and that leads you to the next question is what's the gate provisions? I have so many investors.
I don't like gate provisions or I don't like the limitations on liquidity that's available. In '08 I'll tell you, there were a number of great funds that didn't have any provisions and they became an atm. The people who lost the most in that action of not having the ability to control liquidity and protect investors within a fund weren't the investors you basically sold at the bottom.
Okay, congratulations. You realized a loss. for some of the funds that I knew that actually gated, they weren't popular, no one liked them, but by the end of '09, all the investors were back in the black and everyone was happy. So you had a number of different occurrences where, sometimes you gotta understand what the duration and the liquidity nature of the fund and are they matched, but also understanding and diving in a little bit further and saying, am I going into an investment that matches liquidity?
And I understand that if the world turns upside down, is this an investment that I'm content holding in a massively stressful period. and there again, if you've got your own planning, what other investments do I have that are liquid? Do I have enough liquidity capability? And, what's my cash reserves?
What's my other options? those are, that's proper management. Whether you're running your own portfolio or you're running a small family office or something like that, those are things that you should be thinking about. But moving on, if the fund's underlying assets are not exchange traded, how does the manager accurately strike NAV to determine the price investors pay to enter and exit the fund?
This kind of goes back to a little bit of the valuation aspect and, the liquidity of the asset will sometimes affect, when they're striking, valuations. But if they're actually using stale pricing and the world turns upside down in some type of, gap event, Okay, can I actually get out and what's the price I'm getting out at?
You gotta understand and put all these pieces together after asking all these questions of, wait a second, they're using a valuation that might be a little stale. That's not really to my advantage. Do I really want to get out, even if I have the ability to, have the liquidity. During times of stress and heightened redemption requests, can the manager implement fund level gates?
We already covered that. a lot of people view that as a negative. I can understand why. I've just hopefully tried to provide you with a number of aspects of how in the illiquid Alternative Investment space, that's always not a negative. The manager has an obligation and a duty to protect the investors' principal, the best they possibly can, given the risks of the investment.
And part of that is, If you really liked me and you're my last investor, but everyone else redeemed, the old saying, you don't wanna be the last money out. how does that look if that actually occurs? and understanding how the fund operates, can give you some insight into that.
But, If they have the ability to structure a little bit of their asset and liability mismatch if it exists, then, maybe that protects a broader base of investors from being hurt by people emotionally reacting and trying to get out of a fund quickly. on the other side of the asset mismatch was you had a ton of people in five year locks with quarterly liquidity.
There's a day when hedge funds were trying to get into venture and then people were doing direct private investments in fund to funds. And so you had a fund to fund that was a quarterly liquidity. But then they had a five year lock instrument. Okay. That's horrific. That is a massive mismatch.
What really made it versus, I'm giving a real example, that wasn't disclosed to investors that they had that asset in there. So people thought that they had the ability to obtain liquidity, within a quarterly basis, because they understood the nature of what they thought they were invested in, but they had a component of their portfolio that was a massive mismatch and caused a number of lawsuits. So not good for investors, not good for managers. But as an investor, you should be aware of it. And I say also to managers, you should be watching this yourself. you do not want to be on the bad end of this.
Actions, understand what you're investing in there. Again, do that ongoing monitoring. Cuz in that last example I gave you, everything was fine until all of a sudden the manager decided to go into something that was massively illiquid and really didn't disclose it to investors. Perhaps you could have, through an ongoing monitoring aspect in a more regular time period, you could have determined that with your PPM, your OA. And then check with the service providers. Make sure that the documents you're reading and the message you're hearing from the manager matches what the service providers understand. I know that's a constant theme, but that's a good way to keep yourself out of trouble, making sure those three people are all saying the same thing.
Next, Service providers. Who are the service providers? not every fund's gonna have a prime broker. So if you're dealing with something that's got market level securities in it, Great. Then they'll probably have a prime brokerage relationship. But if you're dealing with venture, they don't have prime brokers, a lot of your real estate, they don't have prime brokers.
So understand what service providers should be in a fund. And so you need to ask that question, see what the lineup is, who's their bank? If they need a prime broker, obviously, your larger funds will have fund administrators. Do they have a third party evaluation company?
Walk through that list. If they need legal assistance in their trade, who is, maybe securities legal, who is corporate legal, understand all the moving pieces that require this fund to really operate efficiently, given any occurrence that may come its way, that's extremely important.
You should understand who they are. I know in my time of dealing with very large funds and your large pensions and endowments, Sometimes service providers, for your very big funds can be kind of, Hey, I need to work with the biggest and best names. you're doing due diligence on mid-sized or small funds.
There's a number of other providers that are not the big names, that do a perfectly wonderful job. . so don't get myopic in your view of, oh my God, you're not using, top three fund administrators. then you must not be a really good fund. That's just not a correct statement. there's a lot of mid-tier and administrators that work with smaller funds that are top-notch, they're great.
Are they reputable? If you're dealing with an auditor, one of the classic things is, if you're gonna go get on a custodial platform or you're gonna have certain access to other investment platforms, they're gonna require that auditor to be approved and on the list for, public company accounting oversight board.
They're gonna have to be reviewed. You can do the same thing. If you're gonna go, like I said, work with a large custodian and try to get on their investment platform. They're gonna have that as a requirement. Make it a requirement of the questions you're asking.
Make it one of your requirements. And if it's not and they're not using an auditor that's on PCAOB, the next question is, why are they doing it? And I have run into managed futures funds. I've run into a ton of different smaller funds, that when you dive in, and it all sounds like a fancy name, but you end up like, oh, this is a guy, Running on an audit, a little tiny one-man auditing firm, and you're like, okay, that's a little scary.
I'm not saying that those can't be good. You just need to dive deeper and really understand, is that something you're comfortable with or is this, am I working with a shop that has, a hundred, a thousand different funds that they're working with and They may not be on an oversight board, but are they still reputable?
Are they getting the job done and do they have the experience? Is the fund a majority of service provider's business? Okay. Very interesting question. This is what came out of, for a little bit of history for people who may not have been around and been doing private investments before 2008, it was very common to be self-administered or to own your own administrator.
And be the administrator for the fund you're running and also administer other people's funds. Tons of these combinations. I saw at least a dozen of them. '08 changed. wait a second. That's a conflict of interest. The person looking over your shoulder and shadowing your books. you own them.
I'm writing their paycheck. obviously if I'm gonna choose to do something that's close to the line of wrong. I might be able to strong arm my third party service provider into doing something that's maybe not right, because I'm the one writing their paychecks. so now in a post 2008 world most of the service providers, especially your fund administrators are separate. they are not associated and, they're a totally separate company and they truly act on their own and they don't have a lot of cross ownership and certainly not, the fund paying the paychecks for the individuals that work at, say the fund administrator or some other service provider.
So it's an important question, is there again, if that is too large of a monetary link, now you're dealing with a related party and that is a direct problem. Especially if that service provider is running a function that's supposed to be, risk and oversight. so some of the actions ask for list service providers, smaller funds may not have a DDQ.
That's a due diligence questionnaire. It's a document created by a number of different funds. I generally found it to be an operational and structural document for operational due diligence supplied by larger funds. so I do know some mid-tier people who actually have one. ask if the fund you're working with has put something together like that.
It can be a good document that can really cover a lot of questions you might have operationally. It will definitely list out all the service providers, a contact name, an email, and DDQ that I used to develop. I always put in a question, can the service provider be contacted?
And the answer should be yes, you should be able to send emails and reach out and call that person for reference. And double check on some of the questions that we even asked earlier. perform an internet check on the service riders go in. Who are they? Do they show up?
have they made mistakes? Are there any indictments against them? You don't have to dive in, with a full corporate background check. But, do a cursory check. Where do they show up in the news? trust me, a lot of 'em were showing up in the news in 2009 and 10. You wanted to definitely check at that time period. If needed. You can't really find the information. You're just really not sure, and you're writing a big check. Do obtain a full, business background. and then this is one of those trust but verify actions is, make sure you get a chance to interview them. Often not, you'll need endorsement to get this, if I'm gonna call someone, these people will not just answer your questions blindly about a fund. they are under agreement. so you'll have to get prior approval from the manager, which shouldn't be an issue if they won't give you approval to talk to their service providers. There's a real red flag right there. You might wanna back away if someone's not offering transparency. That's a big red flag in my world today. Now with that said, there are some funds certain things have to be kept secret. Maybe they're in a particular trade, what we call a zero sum, they can't really divulge too much, cuz it could hurt their trade.
But for most funds, you should be able to obtain just transparency and you ask these questions, you should be able to get access to their service providers and be able to do verification. yeah. And that could be a long list. Maybe they've got eight service providers. So this is not a small amount of work that you're verifying.
And sometimes it doesn't have to be in depth. Like you don't have to dive into a degree of banking and just be like, oh, I just wanna verify you actually bank here. I know that sounds really weird and super simple, but there have been funds historically that had all these grand presentations and you called one of the service providers up and they didn't even have an account there.
They weren't a client. And that's really low hanging fruit to take the five, 10 minutes to just try to verify, do these people actually work with the people that they said they are? You can find a fraud pretty quick on that one. cuz if someone's outwardly lying and creating false marketing material then, you can pack that book up.
It's a no and move on I think that's the last of the questions and like I said, there are hundreds more questions. There's a number of different subjects you've gotta cover. and in the previous webinar someone was asking about checklists and I said, don't get into a habit of checking boxes, but a checklist can be helpful to just organize your thoughts.
You need to be going in and asking these next level questions beyond checking boxes, you need to go in and do the verification that we've discussed in some of these actions. I'm a proponent of checklists to organize the process cuz it is daunting. There's a lot of things to cover, a lot of things that we just didn't even have time to cover today. But don't hang your hat on wow, I checked all my boxes this must be great. that'll get you in trouble. There's a lot of people who were doing that, in '06 and '07 and when everything fell apart, they're just wondering, wow, I checked all my boxes. How did this possibly fall apart? So learn from their lessons.
They ran face first into a wall, made that mistake. Don't be one of those people, do the work, ask the questions, get the information and if you can't get it, I always say, get to your no quickly. Due diligence is all about how fast do I get to a, hey, I want to go to the next level, or how do I get to a no?
And you'll find often not, you get the No's a lot faster. if you ask these questions, and just move on from there. And I think the next slide is, Diving in for questions. So please, I know we went through this rather quickly. Obviously this deck, we've always shared the deck, so you didn't need to take screenshots or snapshots with your phone on the screen.
We'll send you all these questions and the actions. if people want to. and if you've got others, Hey, I've run into this situation, what kind of question could I ask? If I don't know off the top of my head. I'm very fortunate. I have a very large network of people who still do very in depth due diligence on a number of different funds.
Especially in this dynamic world where we've gone in and looked at a number of things in crypto, some of these things will cover crypto, but there's a whole slew of other questions and other issues that go into that level of investment that we just didn't have time to cover. But if you do have questions on that,
Nikita: Chris, I think we have a couple of questions here on the panel.
Chris: Sure. What have we got?
Nikita: So one is, let me read out. So due diligence aspects of investing in operational businesses, my understanding is when you are entering LP or LLC as a partner or subscribe, subscribing for a private offering, how is it different from, investing in private funds. And due diligence over the investment and private funds.
I think it may require a separate, public webinar or meeting to discuss direct participation investments.
Chris: Yeah. We covered a lot of the questions I was supplying were, Hey, I'm gonna be an LP position if you're taking direct, Oh God. yeah, there's a lot to cover.’
If there's what level of involvement? What's, are you sitting on the board? Are you involved in the functionality of the business? Are you a passive investor in the functioning business? That is a whole ‘nother level of questions because you're now at the granular level. you're not dealing with a fund manager who might be investing in these operating companies.
You're now saying, Hey, I'm gonna go direct to this operating company, and maybe you're doing a direct investment in a startup or something of that nature there Again, what's your involvement? Understanding the team is immensely important. I've always believed spending an immense amount of time on the team for an operating company is probably the most important.
I think this is not my quote, but someone said, you can have an A idea with a B team and fail. You can have a B idea with an A team and succeed. And they were pushing the probability of success was higher with the A team when you're dealing directly, in operating companies and investments like that, what's your level of transparency?
How do you obtain transparency? How often are they actually meeting if you're on the board, what subjects and what agendas are being, do you have, the ability to, influence, agenda, I, and then you're diving into all the metrics of the business. you got a full financial review.
You gotta go through all the financials and understand, you gotta understand market space. It's due diligence. It's just asking a different set of questions, and there's a lot of 'em. I've done that. I've worked with a lot of different startups and, I'm currently working on, even, a company that's, looking at potential mergers and yeah, it's just, You're dealing with a more complex question of teams and team integration.
And then you've got nuances in idiosyncratic natures to particular industries. and then you still got valuation. How are things being valued and what's the future plan? Cuz if you're an investor, What's my liquidity? How am I getting out of this trade? What's my exit? Or is there an income component? There again, all leads back to, how's that being valued and who do we have on the team or what service provider we're using to facilitate that process, if, that's needed for exit.
Nikita: But yeah. Perfect. Yeah. We can probably do a series of webinars related to direct participation of subscription. Yeah. Direct participation. Quickly, we have a few more moments left. Importance of networking with other investors. We're working with an advisor when choosing the private market, investment, angel groups and so on.
In other words, is it a common practice to collaborate with other investors over due diligence?
Chris: Oh, completely. Let's back up from that question a little bit. How am I even sourcing the investments? You gotta have a network. It's almost impossible. Hey, Nikita, you and I are gonna come together and we're gonna, we're gonna pool our money to go find investments.
How do we even begin? Okay, wait, let's go out and find Angel Networks. Let's find other venture groups. There's a ton of investment groups in real estate. Let's go out and join network groups. The NBCA is one group that I belong to.
And get into those webinars, go to those conferences, network, meet other people, develop those relationships as a level of sourcing. and then you can understand and learn from them. Especially if you've got someone in your network now with someone who's been doing it for a multitude of years, they probably have a great process.
Can you participate and learn and walk through some of the trades in their process. and then you can expand out and then hopefully as a member you can ask questions and if, say some of the questions we walked through weren't part of their process. okay. Maybe you have an opportunity to add that to the process.
But yes, networking is important for deal sourcing. It's important for due diligence cuz you're getting other eyes on a deal. I don't think I've ever done an investment where it was just me all alone doing due diligence. You'll find that I always say that after I've done something, I trust myself the least.
I always want other people's eyes on it cuz they're going to think about something different. They're gonna see something different, they're gonna ask a different question. Cuz there are so many things to go after. you need to build that network. You need to build that trust. I work with a couple of family offices.
They work off each other. Hey, here's the dealer. Oh, hey, did you run into this problem? How did you solve that? I always say don't run into every wall as a source of knowledge. Learn from somebody else who've already hit that wall. and then hopefully you can absorb that information and avoid that problem in the future for yourself.
And so yeah, that's imperative. You've gotta network. And then from the education standpoint, like what we're doing here, you've become part of a network of like-minded investors. You gotta get in there and that's all about the education.
Awesome. There's just, there's too much to know. So you need help.
Nikita: Awesome, Chris, thank you so much. It was great. It was, again, the last webinar on the series of doing due diligence on private funds and Alternative investments, and we'll go on with our educational, resources, webinars, articles.
Please subscribe and follow our website for more information. Thank you. Thank you very much everyone. Thank you very much Chris.
Chris: Thanks everybody. Have a good one. Bye-bye.
