Due Diligence in the World of Alternative Investments
Due diligence is the most important aspect of making an investment. Though an institutional level investment firm has a massive system for making sure everything checks out, it pays to know how these things are going from the perspective of an expert.
Join us in this episode of the Purpose-Driven Wealth podcast, as Mo Bina interviews Chris Carsley, our Chief Investment Officer at Kirkland Capital Group. This is a must-see, must-listen episode for aspiring investors, as well as those who have already established themselves in investing. Learn about the importance of due diligence, and how pros like Chris get it done the right way.
Here’s what you will expect in this episode:
What are alternative investments and what are the major types?
Advantages and potential disadvantages in alternative investments
Major categories of due diligence on alternatives investments
How institutional level firms perform alternative investment due diligence.
Recurring potential "red flags" in alternative investments.
“ When you’re looking at alternative investments, you are generally looking at two things. One, can I enhance my return or two, am I reducing a risk? You should be able to answer either of these two questions.”
“Find an investment that you can understand, and be aware of the risks associated with it that you’re taking on for your portfolio.”
Listen to the full interview below.
Transcript
Voice Over: Welcome, you are listening to Purpose Driven Wealth, the podcast for empowered investors. If you're an investor who is tired of playing the Wall Street Casino, stay tuned. On this show, we bring on industry experts to discuss leading strategies to help you make empowered decisions with your hard earned capital.
And now, here is your host, Mo Bina.
Mo: Welcome to Purpose Driven Wealth. I'm your host, Mo Bina. Today on the show, we have Chris Carsley. Chris has over 25 years of investment industry expertise in various areas, such as corporate and venture finance, business valuation, portfolio management, arbitrage trading, and hedging.
He's the Chief Investment Officer and Managing Partner of Kirkland Capital Group. Chris, welcome to the show.
Chris: Hey Mo, thanks. And thanks for reminding me just how long I've been around. I'm trying, I'm trying to stay young.
Mo: You are very experienced for sure. Uh, just for the sake of the, uh, the listeners today, uh, today's discussion with Chris is actually going to be a two part series on performing due diligence of alternative investments.
Uh, so there'll be a second part to this, uh, to this interview that we'll release at some point, uh, uh, after this one goes live. Uh, but Chris, uh, could you please kind of start us off by talking about your background? and your experience working with Alternative Investments and performing due diligence.
Chris: Sure. Actually, um, I got my, uh, my start, uh, dealing with just traditional investments. I was a money manager, um, for roughly eight years, just managing high net worth, small company money. Um, now, interestingly enough, sort of the first introduction to Alternative Investments and having to do analysis on things that weren't public related was you had a lot of clients come in with private holdings.
And they needed, uh, share valuations. They needed assessments. So that was sort of my first intro of being thrown to the wolves of, Hey, we don't know how you're going to value this or what we really need to do or how, where are you going to get your information from? Because you got to remember when I first started, uh, this will date me.
A lot of your research was done through the newspaper and this cool invention called Microfiche. So, um, you literally had to sit there for hours going through micro print trying to, you know, find case studies or things like that that could be used as proper valuation. Um, so that was sort of my first intro, but got started in pure traditional.
Um, my specialty was derivatives. Uh, just lucky, met the right person at the right time. Got an opportunity to jump over and work for a hedge fund for a number of years. And obviously, part of that job there again is you're running a series of trade books, and some of this was event driven arbitrage, and you have to come up with your own trades.
And as we were talking before the show, Mo, there's due diligence has a lot of names, you know, it's underwriting, it's securities analysis. I mean, you're basically doing research to determine, you know, some number of factors so that you can make an educated, uh, you know, based investment. And so as I was joining the hedge fund, you now had to put together entire trades end to end.
Um, and it was a different kind of due diligence as you're, um, walking through something that hasn't been built yet. You're the one building it. You're going to see if you can actually make money doing this trade. Um, and then after working for a hedge fund, um, that was back on East Coast, um, came back, you know, spent most of my time West Coast, had an opportunity to join a great group right here, uh, in Washington at a, uh, at a fund to fund and then it switched into where I really went full bore into what most of what we'll talk about today and what I think most people are thinking this discussion is going to be about is the due diligence of alternate investments, primarily funds.
Um, so we worked at a large fund to fund, we invested in a number of different esoteric, um, you know, special situation trades, hedge funds, you know, covering a variety of different strategies. So you had to come up the curve on a lot of different, uh, types of investments. Um, and we'll talk a little bit about that later, because that's just one piece of due diligence.
Um, one of the other tasks I had at the fund to fund, because this was, uh, 2000, you know, into 2007 and into 2008. So things were just about to get really, really interesting. Um, we didn't know it at that time, but, um, this shop was one of the things they brought me into is to build an entire operational due diligence program.
So I did that for them as well. Um, they had a top notch, uh, ability to understand the investments, but they needed to dive in a little bit more on the operational and business side of due diligence. So that's one of the things that I built for the fund to fund. So that really, um, Gave me a lot of iterations to look at a lot of different structures, um, in due diligence.
And then, after the fund to funds, uh, I, I went out and did a number of things, uh, on the venture and startup side. Um, so there again, a little different way to think about analysis as you're trying to build a company from scratch. Uh, and you're putting everything together to understand, you know, market.
You know, it's going to be your, you know, go to market plan, how that company is going to efficiently run that, um, and I, it made sense because most of the thought process you're going to was very similar to other due diligence I had actually already done, but it did give me a different way to look at things.
Um, so I was invited in the room because I didn't have a traditional startup or venture background, so they're like, let's bring the guy in who, you know, didn't come from Venture, but he's looking at things differently. Um, so some of the teams I worked with, they recognized I was gonna, you know, Have a differentiated view.
Um, so if you're ever putting together a due diligence team, don't put a team of people who all think the same. Um, you want some differentiated thought. Um, and then after running a small seed angel fund and working in that space, uh, I was then approached by my now partner Brock Freeman, uh, in 2019, and then we launched, uh, a private debt fund in commercial real estate, which I'm still running to this day.
Mo: When you were talking about, like, when you were working as, um, uh, your previous role working and investing in fund to funds, um, were those funds primarily, like, very specialized, or were they kind of, or some of the funds investing in very kind of broad assets? Because it seems like the amount of due diligence you would have to perform in order to invest in a fund that's kind of investing in various types of assets versus one that's more specialized probably takes a lot more work, right?
Chris: Oh yeah, no, if you're going to look down and, and I'll put a word to it, it's a really a single trade type fund, uh, versus a multi-strat. A multi-strat is a lot of work and you really need to break down the attribution of all the different Types of trades they're doing and really understand, um, how they're controlling their portfolio because you're looking at one company and one operating team.
So that saves some work, but from the investment standpoint, you could look at eight or nine different silos of actual investment theory. So yeah, you're right. I mean, if you're looking at somebody who has a lot of tricks in their bag, it's a lot of work. Um, rather than someone who's like, Hey, I'm, I'm a muni bond trader, or I do, you know, relative value arbitrage in Asia.
I mean, you could. You know, okay. Now I'm only looking at one sort of sector. I really just have to understand the risk profiles and what's occurring in that one trade. So yeah, I mean, it's, it's, it's a lot of work. So, you know, if you're out there doing due diligence on, on, on a fund and you run into somebody, well, whether it's real estate or hedge funds or anything else, and they, they've got a lot of things they can do.
They've got a lot of style flexibility. You got a lot of work in front of you. I'm not going to lie. It's, you know, I may be the lead on some of that due diligence, but at the institutional level, you're not out there by yourself. I mean, you got, you got a team, you're not, you're not running end to end. You may be in charge of running that particular fund's due diligence.
But, you know, at, at the fund to fund, you know, we had nine people, you had a lot of peer review. Which I mean, one of the things that, uh, you know, if we run into that question, we can circle back to, you know, some of the problems that I think people are having in today's world is, Hey, it's just me investing my dollars.
I don't have a team. Where do I find peer review? It's a problem.
Mo: Yeah, that's actually a good point. Let's, let's, let's kind of, uh, make a mental note of that and circle back with that, uh, either in this discussion or when we do part two, um, because, you know, investors, retail investors, or, or, you know, someone who's just kind of investing on behalf of themselves or their family, they're going to run into that situation.
So let's, let's circle back. That's a great.
Chris: Yeah. You're a doctor all day. I mean, and then all of a sudden you got to put on a whole ‘nother hat and do due diligence on a, uh, on a fund. Well, I mean, how many hours do you have to actually effectively pull that off? And there's, there's some ways you can organize your thought to, to, to help you achieve that as a sort of a single person doing, uh, due diligence.
But yeah, we can, we can definitely circle back.
Mo: Yeah. Um, since we're going to, today's topic is about due diligence of alternative investments, perhaps we should define, you know, what alternative, what are alternative investments and, and what are the major types out there?
Chris: Oh, oh God, do we have enough time?
Um, I always tell people it's easier to define what an alternative investment is by telling you what it isn't. Um, in a broad scale, everything that's traditional long stock, long bond, um, maybe, you know, what your financial advisor is putting together for you. That, that's your traditional side. Anything else is really alternative.
And, and there's some gray areas, depending on who you talk to, of, you know, what, what's alternative. But you've got, you know, hedge funds, Venture, I mean, what should venture is sort of if you want to talk broad categories, private equity. So private equity comes in a variety of different forms. Buy out, large private equity, you know, down to venture.
Maybe you're, you know, early on the curve, you want to do angel and seed investing. So that's all kind of that view under private equity. And then you've got real estate. You know, you can do direct real estate. You can do equity or debt. Um, there's a lot of different ways to even approach real estate. Um, and then you've got, um, hedge funds.
Last time I counted, there's 26 different kinds of hedge funds. Um, you know, some of the biggest are like your convert ARBs, your merger ARB, uh, relative value. Like we'd mentioned earlier, there's a number of multi strat and probably the biggest out there, um, that I think there's like 7, 000 of them exist just in, uh, North America is the long short equity.
Um, there's lots of ways to play long short equity. Um, I'm not sure that, uh, There's a need for 7, 000 of them, but, um, it's, uh, I was told by, uh, my manager at the, at the hedge fund I worked at is, is, you know, the world doesn't need another fund. Um, if you're going to do something, try to create something that's not done by 50 other people.
Easier said than done sometimes, but, um, yeah, lots of different, and in that, in that gray area. I hear some people sort of say, okay, well, are REITs really an alternative? And I know some people you'll run into they talk about them as alternatives because they do focus on real estate but I would say no and that's just my opinion.
Um, because of the nature that they are publicly Public REITs is what I'm going to talk about is public REITs really don't act like an alternative because they actually have some pretty high correlation to other public, you know, markets. You know, the last time I was, you know, looking at, um, like MSCI REIT correlation to S& P 500 was like 0.
88. I mean, it's a huge correlation. They tend to move in lockstep. So, And one of the things when you're looking at alternatives is you're either looking for, hey, can I enhance a return or am I reducing a risk? Um, what is this alternative doing for me? And I kind of view that, and that's sort of my reason why I don't sort of put public REITs in the alt spaces.
I don't, yeah, you're taking on a different risk factor of getting a variety of different real estate exposure, but you're not really reducing any risk. You're not, you're taking a risk factor that is very similar to what you would get in just a public market investment.
Mo: Yeah, you can.
Chris: Oh, sorry. Go ahead. Go ahead.
Yeah, no, go ahead.
Mo: No, I was just going to ask a follow up question. You kind of mentioned about, you know, one of the reasons or two of the reasons, I guess, why people primarily look at alts is enhancing return or reducing risk. Um, are there any other advantages, uh, in terms of trying to include alternative investment within one's investment portfolio, um, other than those two?
Chris: Those are the two I focus on. 'cause then I think any other derivatives sort of fall under those two broad categories. Um, you know, you, you're, and you can break it down into a lot of people. Um, especially, you know, recently in 20, you know, 2022, there was a big, big push and, and a lot of people. Sort of going after how do I add alts on the equity side?
It seemed to be the biggest bang for the buck and most what people were going there was They were trying to Enhance a return because they were thinking hey public equities are not going to actually have The return that I might see in private equities and there's a lot of math and a lot of institutions have data on this where generally You know, you know, private equity does outperform public equity over time.
Um, and so there was a big push for people to try because they were realizing, wait, am I going to be able, if you're a large pensioner endowment, you, you know, you have a certain amount of liquidity you need. Uh, you need to make sure you're maintaining a certain return and you got to have that required return.
And they were looking at a situation that they might fall below required return if public equity was not going to enter the return. So there's a very big push into private equity. But one thing that 2022. brought to light was also was the worst performing year for fixed income. And fixed income is a little boring.
It's not very exciting. Um, no one goes over to their neighbor's house and drinks champagne and brags about their fixed income fund. I mean, it's just not, you know, no one does that. I mean, but you do have the opportunity where, um, In the alt space, you can have actually some interesting bragging rights because there's a number of instruments out there in private debt that actually do have the capability to generate a nice excess return, um, and really truly create an equity like return with debt level debt, are debt level risk. And so, um, you might have some bragging in fixed income. Uh, who knows? Depends on, uh, you know, what your portfolio looks like. But yeah, to answer your question, that shift, in one way or another was people were either trying to capture a greater return or they're looking and saying wait a second Can I maintain a return or capture a return that wasn't prevalent in fixed income yet I can still have the diversification factor because that was the big problem with fixed income It's just supposed to be a diversifier supposed to be that Hey lower the overall volatility of my portfolio so that interim liquidity I need I don't need to pull from equity I can pull it from fixed income if needed Well that kind of all disappeared when you're down 14 percent on your fixed income portfolio It really got everyone's attention of, wait a second, can I actually, you know, add alts to mitigate risk?
And a lot of people don't think about that. And I laugh because I talk to a lot of people on the retail side. They think, hey, I'm going into hedge funds. And so I really want to crank out this really big return. And I'm like, okay, the word hedge does not actually mean. massive 50 percent return. I mean, there are, there are speculation funds that, yeah, they will do that and they might fall under the category of hedge, but a true hedge fund is really trying to just target a, the best risk adjusted return they can create.
Keyword risk adjusted. They are trying to control risk. They are hedging pieces of their portfolio to limit that volatility. And if they're effective at doing that, you usually don't see these massive outsized returns of, you know, big double digits that people kind of expect hedge funds to do. Um, you know, true hedge funds really have an amazing risk mitigator on a portfolio if deployed correctly.
Mo: Yeah, totally makes sense. What are some of the disadvantages, uh, or potential disadvantages when, uh, investing in alternatives?
Chris: Yeah, you've got to, you got to, I always tell investors, you got to understand what's your liquidity requirements, understand your suitability, because if you're going to go into alts, um, one of the biggest things that usually people complain about, and it varies between which alt category you're in, is liquidity.
Um, you know, a lot of these investments are capturing assets returns because they're in an investment that requires some level of, uh, illiquidity. I mean, one of the best that people are looking at and trying to solve right now is, is, is Venture Private Equity. You got this whole 7 to 15 year time period.
Um, well, I mean, that might work for a part of your portfolio, but you got to size that correctly. Um, depending on... the restraints in your own portfolio. If you have a high liquidity need, well then that's not going to be an investment you want to oversize. Um, and I know a ton of people who ran into that problem in 08, 09, you know, they, they thought they had enough going on and they went into five year investments and the world turned upside down and they needed their cash.
And you're like, well, You're not getting it for a while. Um, if it's, you know, actually still even there. Um, so that's one of the big things is, you know, you've got liquidity, liquidity issues. The other one is, um, I think a lot of people go in and they don't really understand the nature of the trade and the risks they're actually exposed to.
Um, some of these trades and some of these alternatives can be quite complex. And I generally tell people, if you ask a manager, what do you do? And how are you generating this excess return? What's your inefficiency? What's your edge? If you can't get clear, understandable answers, and you walk away from the table after asking that, you still don't know what that manager is doing.
Or it just had so many legs to what you know, maybe that's not the right trade for you. Maybe, maybe you should just kind of walk away or spend more time trying to educate yourself on what that trade is. And, and I've run into those. I mean, I work in this industry. I was a trader and I have sat in front of people and they explained to me what they're doing.
And I'm like, I'm not an idiot. And I have no idea what you said. I mean, I've literally said that to a manager. I'm like, you're going to have to walk me through actual trades. And of course they didn't want to do that and we didn't write a check. Um, you know, so that's, that's one of the other problems I run in or I see for people looking to go into alts is really, really find something you can understand and understand the risks you're taking for your portfolio.
I mean, understand how the trade breaks and if the manager can't explain it to you or they tell you something like, Oh, you know, this, you know, this always works. Yeah, nothing always works. There's no holy grail. I've tried to find it for a long time, and I know other people who've tried to find it.
Something always breaks a trade. You know, we, in the relative value sort of event driven trades that we did, um, for years, we used to sit back, put our feet up on the table and say, Hey, you know what? Um, nothing can possibly, you know, cause us to lose money unless a major, global financial partner goes out of business.
That's the only thing that could, and that's never going to happen. Yeah. We were, we were talking about this in like 07 and early 08 and well, we were wrong. And we saw our trade break, even as absurd as everyone thought that was, it happened.
Mo: Yeah, I like your, the question that you kind of posed too is, you know, just boil it down as simply as what is your edge?
What type of inefficiency out there are you taking advantage of, or planning on taking advantage of? And you're right, if they can't articulate that in a very kind of simple way, um, then, and it's, Very complicated. There's a lot of moving parts. Then that in itself, I guess, makes it more risk prone, right?
Because there's a lot more moving parts, more things potentially to go wrong with the trade. Oh, yeah. Or particular type of asset or whatever it is that they're, that they're trying to do. Um, and that in itself, I guess is just a really great kind of due diligence question to, to maybe pose or to even think about.
Uh, when someone's doing, uh, their research or doing their, I guess, underwriting or whatever phrase or whatever industry you're in, where they basically are researching and trying to find the merits of an investment.
Chris: Oh yeah, you'll, you'll, there's a continuous theme you'll hear from me, no matter what I'm talking about.
Benefits and investments is inefficiency and edge. Because you can't create an excess return without some level of inefficiency that's sustainable and repeatable. And here's the other, I guess, I don't want to call them negatives. They're just challenges of alts. It's not just about the investments. It's the due diligence is actually much deeper because you are, you are investing in a, in a company.
At the end of the day, you may think, Oh, no, I'm investing in a fund that's doing this investment. Okay. Well, who runs that? You got the manager. That's the company you're invested in as well. You're invested in that manager. And that's that edge part. Um, and that's where I think a lot of people, they do the investment research and they go really heavy on that because one, that's the far more interesting part.
But the other problem is, is then they kind of stop or they go super light on the operational side and they don't dive into the other exposure and risks they're taking is they have a risk and exposure to the team that's managing the fund. Um, and what most people. Have maybe heard or have not heard most failures actually occur in the operational side, not actually the investment side.
About 66 percent of fund failures is, uh, operational mistakes, team mistakes, um, not actually in the investments.
Mo: So it sounds like you're now getting into kind of the different types of due diligence. Can you kind of maybe take a step back and kind of define what are the major categories or areas of due diligence and maybe a little bit about each one of those areas?
Chris: Yeah. Um, I break it down into four pieces. One, the most exciting and what everyone loves to do is the investment due diligence, diving in and understanding the nuances of this amazing trade that's going to generate excess returns. It's super exciting. That's where people tend to spend most of their time.
Um, but moving on, as I just said, there's a lot of other important aspects that, you know, You know, investors new to alts are gonna have to think about. One of the big ones is the operational due diligence side. Now, the definition of operational due diligence is anything operationally at the manager or at the fund that directly relates to the trade.
So, um, that can be, well, who's your traders, uh, allocation policies, uh, you know, down to cash controls. I mean, a number of different things fall into operational due diligence. Um, next is. Business due diligence. Now that sounds like, well, what's the difference between operations and business? Well, business is more the operations around running the actual business that don't have anything to do with the trade.
So it could be like facilities, you know, security systems and software, things like that. So how do they build their business? And how does that increase the efficiency or secure the operations of the fund? Um, but it doesn't have anything to do with the actual trade. So, um, so, you know, In the early days, when we were sitting around with AIMA and everybody else in 2009, trying to figure out what the new world of due diligence was going to look like, they didn't have business separated out.
They just kind of shoved it all into operational. But more recently, people have realized, wait a second, with cyber security issues and a number of other things, it's kind of becoming its own class. And it's actually pretty large and pretty important and requires a different number of skill sets to, you know, complete that level of due diligence.
And lastly is, you know, economic due diligence. After you understand the trade and you understand what breaks it, one of the things that you might want to understand is, well, is there a cyclicality to the trade? When does this perform well? When does it perform poorly? And then you're doing some level of economic assessment of like, well, Is this the right time to think about this trade, you know, is this, you know, is everything breaking because we've got rising interest rates and this trade doesn't do well in the rising interest rates.
I mean, these are the kinds of things you need to start thinking about of, well, what is the, and I'll use a term here, the, the macro events that are occurring of, you know, they're, they're not directly related to the trade or the fund, but there are events that can definitely affect, um, you know, the company's operations.
Well, I'll give you one example there is you use a leverage line. Well, if leverage is hard to get and free capital dries up and someone calls and calls in your leverage line. Well, okay, you now have, um, an operational problem. You know, depending on how much leverage you're using, um, you could be in a situation where you've got to start selling things in your portfolio or find someone else to, you know, finance it for you that might cost more.
So now the return to the investors is lower because it's a tighter spread between the cost of leverage and, you know, the actual return on the trade. There could be a number of problems. And then obviously, there's things, you know, in the macro world that can affect, you know, the direct investments as well.
Mo: When I was, uh, thinking about your kind of examples you were giving with the economic, I... In my mind, I've always kind of articulated and kind of like combine that with the actual investment itself. But I can see why you probably want to separate and kind of like have it on its own. I guess with the investment, that is specifically just the investment itself.
But with the economic, you're kind of looking at the more broader global macro picture of how that investment fits with what's going on a kind of bigger picture level, right?
Chris: Yeah, bigger picture. And there again, no one really, you're dating yourself because economic was really embedded mostly in investment, but they realized there were actual economic occurrences that could affect the business as well.
So they're kind of like, Hey, let's make it our own section and really understand these macro events. How could they affect the manager, the fund, and the investments?
Mo: Yeah, that makes sense. When you were talking about kind of the operational stuff as well, too, um, in your experience, did you run into situations where fund managers, and you probably know, I could see Smiley, you know where I'm going to go with this, where they probably were very guarded or perhaps didn't want to share operational type information?
Um, and, and, and what do you do in that case? Do you just kind of walk away and say, well, if they're not willing to be transparent, then we're not willing to invest or move forward. And how do you kind of deal with that? Or even for like, I know I'm kind of asking a number of different things now. How about a retail investor?
If they're doing that operational due diligence and they get in, they run into roadblocks or they run into managers that don't want to share information. And basically say, well, that's, that's our proprietary intellectual property, and we can't share that with you. Have these things come up in your experience and have you kind of dealt with them?
Chris: I, I have a very, I mean, don't necessarily use this, but I have said this to many managers. If you can't disclose what I'm asking, then it means you don't actually really have a defensible trade. And if you think I can actually learn whatever you're doing operationally or investment wise and reverse engineer you in one conversation, then I'm not writing you a check anyways.
I need an inefficient trade that I see sustainability and repeatability to where there's some level of moat, some level of difficulty. Because if everyone can just step into your trade and it's that easy to understand, then I'm going to be here for a very short period of time and I'm not really actually sure, um, when the break will occur and my ongoing monitoring becomes extremely intensive.
So one thing that we've kind of not really talked about is everyone does a ton of due diligence up front. And if you ask anybody who's in the due diligence businesses, yeah, that's a lot of work. But it's equally as much work for the ongoing monitoring, so you need to stay on what's happening, and if these, if these funds have certain level of allowable drift, or sometimes they don't, um, you've got to watch style drift, where all of a sudden, the trade they said they were doing is not working, and then you wake up a year later, and you look in, and you're like, what are you doing?
You're doing a completely different trade. That's not what I invested in. That's not what I assumed was right for my portfolio. Um, and unfortunately we ran into some of that style drift, uh, you know, when it was too late. Some of the funds that we had invested in had massive style drift and when 08 hit and we kind of like took a deeper dive.
Well, we're wondering how in the world did you guys lose money? You shouldn't have lost this kind of money. And you realize they were actually doing something different than what you thought they were. Um, so, um, I, I have, I've run into a lot of people that, um, usually not so much on the operational side.
You will, you will run into some people like compliance manuals and things like that. If you, and that's not really a retail level, but from an institutional level, if I visit your office, I'm going to be there for four to eight hours. I'm there for, I'm there for the day. Um, and pretty much every document you have that pertains to the operations of your fund, I'm going to read it.
And so, um, some people did run into problems where people walked away with certain documentation and turned around to use documentation in a lawsuit against them. And so now you have a lot of funds that won't let you walk away with things. You can review it. While you're sitting there, if that's what you want to do, and some of these documents, 80, 100 pages.
I mean, you better read quick, you better know what you're looking for. Um, because otherwise it's going to be a multi-day on site, uh, verification. From a retail standpoint, um, and I don't want to go too far into this because there's a number of things that you can kind of do to, to help guide you in this huge process.
But, I, I've had people are like, Oh, I can't show you certain software. A lot, a lot of people on the quant side, if they truly have like a black box, it's got some unique programming. And if you want to invest in that fund, and they can't really tell you what it is, cause that's their proprietary tech as an investor, you just got to be comfortable with, well, do I trust that person and do I trust what they're doing?
And then other ways you can kind of, or don't and just walk away. If you need full transparency in every moving piece, and you can't get it, you walk. There's no lack of investment opportunities out there. And someone says, Oh, there's no one doing it. I was just reading a website and it was really funny because people always say, we're the only ones that do this.
Okay, really? The world's a very big place. I've never seen anybody doing something that someone else isn't doing in one form or another. There's always somebody competing. I mean, even in the space that I'm working in with our debt fund, it's small, it's niche, and we don't run into a lot of people that do it consistently, but there are people that come in and out of it.
I mean, so there is competition. Um, but as an investor, and we used to do this all the time. I mean, it's a very, very famous fund now. We'll leave names out of it because it's a small world. I sat down when they were just getting started and we were going to be one of the first checks. And, uh, one of the things is I have to sit on your trade floor and walk through what I call the life of a trade.
Walk me through how you came up with the idea, how you executed the idea, how you monitor that particular position in your portfolio, and, um, the exit. and why you made the exit decision. Or if you haven't made an exit decision, what's your pro, you know, what's your assessment of when you think you're going to exit?
What's your target exit? And so I would sit and I would pick a trade randomly. I wouldn't let you pick a trade or like, oh, hey, look at my deck and here's a trade that I did. That, that can be gamified. I need to sit down. Here's your book. These are all the things. Now point to the screen. What about that one?
Let's talk about that trade. Um, and I had a fund that was like, well, no one sits on our trade desk. And I'll be honest with you, I was like, okay, thanks for the coffee, appreciate the donut, started packing up my papers, and they looked at me like, well, what? And I go, meeting's over. I. If I don't get the transparency, you got to remember I worked at a fairly large shop.
So when I'm going to write a check for you, it's not some 100, 000 check. It's, you know, I'm writing a $25 million check. So it's kind of one of those where, you know, it's material what I'm about to do. So, um, and they were like, well, wait a second. Let me ask around, let me check. And so after about 20 minutes of them getting authorizations, I went and spent about an hour and a half with the traders on their trading desk.
And got to walk through a few trades and we ended up making an investment. It was, it was a great investment because it was a great fund. But that's not always going to happen. You know, when you're, when you're a retail investor, you probably don't have, you're not writing $25 million checks. And so you might get a lot of pushback.
And in my opinion, I'd walk. If you just can't get what you feel comfortable with, you'll find something else.
Mo: Yeah, exactly. Um, other than having a team, which you've alluded to, being able to sit down for four to eight hours or more, um, at, you know, the hedge funds or the funds, you know, offices, um, in your experience, how do institutional level investment firms perform, um, or approach due diligence differently than retail investors?
Chris: Well, you stole some of my thunder there, because that's really some of the bigger differences is, um, they'll have institution guys, everyone's got a checklist, and I'm, I'm a fan of checklists, and I'm not a fan of checklists, it depends on how you want to use it, organize your thoughts, because there's a lot to cover, and institutions will have a very, very thorough checklist, but at every checklist spot, of something that can be verified.
Institutions would take the time, whether it's on site or a request for materials ahead of time. And, you know, our checklists were always two, two boxes for every line item, not one box. It wasn't, I asked you a question of, do you have, you know, cash controls? Yes, we do. Check. What did I, I didn't, I didn't do anything.
I asked you a question and you said yes. That's not, that's not, that's checking boxes. That's not actually achieving any type of due diligence. The second box is great, now that you've answered yes, let's walk through exactly the process and procedure in your process and procedure manual or you go show me how it's done.
Um, and I can't say this for all institutions because I did have people come in and do due diligence on us and I ran all the future string. Um, a lot of hedging and you know, creating a synthetic exposure for clients that wanted it. And I sat with one group that, I mean, they had a fair amount of money with us and they asked, Oh, you're, you run trading.
And I gave them this short little spiel about what I do in futures. And they literally, I kid you not, checked the box. I moved on to the next question and I kind of was like, well, we're trying to get more money out of you. I was like, well, do you want to go to my computer and I can actually show it to you?
And the guy looked at me like, no, that's, that's not necessary. That's like, I'm literally trying to help you do your due diligence better. And the guy was saying no. Um, so my point being there is don't be that guy checking a box. and just moving on. If you ask a question that you think, Hey, whatever it is, is really important.
Um, you know, how are you going to verify it? And understand how you can verify those ahead of times. And if you got questions like, Hey, I love this question. I'm not really sure how to verify that. Great. Ask a question. Put a question in the bottom. I mean, after you watch this video, reach out to me and I'll see if I can come up with what I've done.
Or if I don't have an answer, I'll reach out to other people who are still working for major billion dollar funds, allocating the hedge funds and wherever and say, how do you guys verify that question? And I'll get the answer. Um, but that's the thing you got to do is that and that's what the institutions most of the big institutions They will take that extra step.
Um now as you alluded earlier, we talked about the big difference is that teams, resources, Software they have so many things That help them achieve due diligence en masse because you got to remember I’m not looking at one or two funds. I'm looking at 100, 200 a year I mean, you're going through a ton of different, I mean, that's your job.
Um, and so, you know, as a retail investor, um, I wouldn't try to boil the ocean. Identify what you want in your portfolio, go after that sector, get the education you need, identify what the important factors are, which, I mean, I actually call, there's two levels to that. There's non negotiables, and then, oh, hey, what do I actually need to verify?
Um, investment wise, operationally wise, business wise, and you know, then obviously the economic side of it's, you know, that due diligence purely on you and you can ask the fund manager about when they've performed and what the risks are in different economies, which I think is a great question, but a lot of that research kind of lands on you and, you know, your opinions.
Um, so, I mean, that's the biggest difference. The institutional side has is extremely procedural. They've already mapped it all out and they have people and systems that are trained to carry that procedure out like Clockwork.
Mo: When you were talking earlier about the ongoing due diligence, um, that you and your team would do, um, and then you kind of mentioned drift.
So what would you do when you experienced drift? Because at that point, have you not already mobilized capital? You've already, you've already made your investment. And what recourse do you have at that point, other than to tell a fund manager or tell a management team, hey, you're doing something differently than what you told us, or what was in your procedure manual or whatever.
Um, but you've already made that investment. What, what would be, I guess somebody may listen to this and wonder, well, what's the point of doing on, what's the point of doing ongoing due diligence? You've already given them your money.
Chris: Depends on the liquidity of the fund. Um, you know, if you've got something that's got quarterly liquidity and they're not doing what you want anymore, redeem.
If you've got something that's got like a, hey, I'll get your money back to when the deal comes due something like in venture where that could be five. I mean, uh,
there's not a lot you can do to create liquidity in the situation. Um, you can certainly cause a ruckus of point out the fact that, Hey, these guys said they were doing AI tech, and now we're doing consumer good. I mean, start, I mean, it's like, Whoa. Um, I mean, and then you probably actually have a breach of, you know, contract, depending on how they wrote their document, you know, there might be a lawsuit to create liquidity if they've just gone off the cliff, you know, um, and it's a lockout, I mean, there could be a number of things to take from that standpoint, but you're correct.
I mean, you're not able to just get out tomorrow once your manager is doing something you don't like. Um, and you know, and one of those things is this gets down to also read your documents because Most managers, at least the good ones, they've built some level of flexibility into their PPMs and their documents that allow them some level of movement.
And it may not be something that you like as an investor, but it's maybe they see an opportunity set or they think it's a better risk adjusted return for the portfolio given a current change. Um, and that's something you'll, you'll have to assess at that time. And, you know, before you go cry wolf. Really make sure you understand the PPM and the operations of the fund to understand what type of drift they can have Because I have you know, I have you know, haven't run into it But I know other people that were complaining about some stuff in you know, more tumultuous left tail event type times And you know, it was right there in the PPM That they could do that.
They could do those trades and so it's like well, okay. You just didn't read your documents
Mo: I guess this also kind of ties into when we're talking about 1 of the disadvantages of, uh, alternatives and private investments is the liquidity aspect. Right? And so when you have, you have your money into or invested in a 7 to 15 year hold period, and you've already mobilized capital.
This is kind of one of those potential disadvantages that investors, I guess, should be aware of because once you mobilize that money, even, even with doing ongoing due diligence, uh, you may have, you may be very limited or you may have no ability really to do anything. Um, if the fund or its strategy, you know, is drifting from where you thought or where you were told it would be.
Chris: And yeah, that's definitely, I mean, and one of the things also, there's some recent articles about the re-emergence of zombie funds. So this is a zombie fund is basically you've got a private equity level fund that has a number of assets, you know, or portfolio companies that are being held that, um, aren't performing and you've got money locked into them and they're not really performing well, but they're not dying. So your money is locked up. You have no access to liquidity. You can't get your money out, but they haven't really breached anything. So you're just stuck. And so, Yeah, the CAIA and um, a couple other guys did some research of just current data of what's going on, you know, in, in, in the private equity space and they're seeing a lot of the factors that created, you know, zombie funds.
So they're like, well, we might be coming into an era where we've got a lot of private equity funds that you just, you're going to be in them a lot longer than you think.
Mo: Or you could have a situation where it's lost money, but you can't take a loss and realize that loss for like tax harvesting or to offset maybe gains in other parts of your portfolio.
And so essentially, there probably is a loss that you can't realize because someone know that the fund just keeps going, right? It's just, it can be technically dead, but it's still kind of like still moving forward.
Chris: Definitely. Yeah, you can definitely get locked up into a number of different occurrences.
Which is, you know, where I, I go back and I say, well, before you start, your due diligence is really understanding what is it you want to add to your portfolio and why, and then really be honest with yourself about the sizing. Hey, if this was, if this occurs, you know, it's not 80 percent of my portfolio, it's 10.
Whatever. I mean, you got to size, you got to understand the risk factors and size accordingly to what you think you want to achieve. And, and, and these are all different for every individual. I mean, your, your objectives and constraints are different than mine. And, you know, and different from someone else's.
So there's no real, you know, Oh, this is what you should do. This is how you should size things. This is the amount of alts you should have. That's different for every single person. And I've actually had that question. Well, how many alts should I have? I'm like, Hey, I'm not really your financial advisor. I mean I You know, it's a great question, but that's a question you have to ask for yourself.
And you got to, you got to build that and understand that as you're building out your portfolio and looking at alts. Um, you should do that before you put your feet in the water.
Mo: Yeah, I totally agree. Uh, Chris, from your experience, uh, what are some recurring red flags, uh, that arise when, uh, when you perform a due diligence?
Chris: Uh, yeah, well, um, recurring red flags. Um, I always say follow the money, so cash controls. Um, I know this really is a scary idea in today's world where people may not understand this, how it goes on, and it may be common in smaller funds, but pre 08, um, I would go visit some funds and they had a special computer in a room that was just on and it was a, it was, it was a computer dedicated to wiring funds.
And anybody could sit down and wire money. I know it sounds ludicrous, but that, I mean, pre 08, well, it was, it was efficient. Hey, we got to wire funds. We got to do this. Okay. So this guy goes over here and there was a reason for wiring funds on a multiple different aspects across trading desks. So you have these larger hedge funds and it definitely created efficiency, but it also created a huge open like gap of like, wait a second.
Um, You know, you've got a team of people who can just sit at this computer and it's always on. Um, I don't think anybody's doing that today, but what I'm getting at is, are there dual cash controls? Are there, I mean, who actually has authorization to move money and walk me through various occurrences of, you know, how, how things are moved between the fund and the manager?
How are things moved from the fund to external? Um, Walk me through those pieces. So cash controls is, is a big red flag. Um, you know, even in the latest situation with, um, you know, the Nightingale people, it's like money came into an account and then in short order it was moved out, but it was not supposed to be moved out to the actual manager.
It was like, okay, wait a second, who breached cash controls there? So if you had a procedure. And I'm not, and I'm not saying they did. I have not read through the documents or anything else, but I was just reading the article about, wait a second, money went into CrowdStreet and then it got moved out and it wasn't supposed to, and it was said that that wasn't supposed to happen.
Well, that's one of those things where cash control, it's like, well, listen, as an investor, what's your biggest concern? I'm losing my money. Well, losing your money doesn't actually always just happen in the investment side. I can also just move it off somewhere where it's not supposed to be. And I know that sounds ludicrous, but it literally just happened.
It happens all the time. This one just happened to be, you know, in the front page of the news. Um, so cash controls, huge red flag. Um, third party oversight, another huge, I mean, and this is, this is one where, you know, who's looking over the shoulder of the manager? Who's, watching things that is not part of the company.
Who's monitoring transactions? Who's maybe calculating management fees? Who's, um, you know, doing external books and records? I mean, there's a number of, uh, third party companies. One of the biggest ones that I'm sort of, the things I listed there is kind of a fund administrator. You know, do you have a third party fund administrator in place and what do they do and how do they integrate, um, and what's the check and balance there?
And there's, there's actually a variety of different checks and balances where, you know, even to make a wire occur, I've seen some funds that it's not just say you and I run a fund, you got to have your signature, my signature, well the third party's actually got to have a play on that too. Now, if you're high volatility, you can't have a third party involved.
It just, you know, you won't be able to get your done if you've got low latency trading and things like that. But if you've got infrequent trades, I've seen some people, you know, writing big checks. They want that third party approval also of, Hey, I've got documentation. I've collected all the documentation.
I've got all the authorizations. I've double checked wire details and now I can sign. Okay, great. It's moving to the right place, everyone has checked off, it's moving to the right place, and we've got all the supporting documentation in place. Um, smaller funds, you're, maybe you won't see that level, uh, of, of controls, but they should be on some path where there's third party oversight.
Um, another one is valuations. Always a big red flag. Um, there's tons of SEC indictments and everything else that deal with, um, you know, people running their own valuations or, and I'm not talking, you know, for people who don't know this, there's different tiers of valuation, um, and the more esoteric non-public instruments that are not valued every single day.
Um, that's where there's either a third party valuation or some very, very defined process. That is explained in nauseating detail in the PPM of how it's run, maybe in conjunction with a third party and internal. Um, and I'm not saying it's wrong, and sometimes you'll have people run valuations just internally.
I'm not necessarily saying anything's wrong, it's not fraudulent or anything else, but that's something you gotta dive in on then. That's, that's okay. Wait, you're valuing everything inside the manager. Okay. Well, there's a lot of potential conflicts of interest by you having that kind of control and power.
Great. I can value something really big so that, you know, when you come in, you're getting, you know, if they do a unit base or something like that. Okay, great. You're getting, you know, less percentage because it was, or, oh, wait, you're getting out. Oh, this is really low value. So I'm going to send you less money.
And there's lots of little things people can do from an accounting Uh, Gamification Standpoint and Valuation. Um, Oh, I'm going to charge my fees. Ah, well, everything's worth a ton. Crystallize and charge my fees. I mean, I know this sounds like I'm giving, like, some ridiculous scenarios, but this stuff has actually happened in the real world.
Um, so valuations is a red flag. Um, we talked about it earlier. Uh, transparency. The ability to obtain transparency. If you can't get transparency, that's, that's a problem. I mean, that's, that's a pretty big one. Um, in today's world. And I will say this, not, especially in hedge fund space, there is some esoteric trade structures that really, if I told you how I'm doing it.
It's like letting the cat out of the bag. Um, you, you, depending on who you are, you could go do it. Um, I did some of those trades, um, when I was, uh, you know, working for Paloma, and you, the value of your trade went down. As soon as the information went out, and all of a sudden, the prop desk, Goldman, Morgan, all these guys are coming in and taking your trade.
So, here I am making 7 million one year, and now I'm barely making 100, 000 on the same trade, two years later. And that happens. I mean, there are trades where there's very limited barrier of entry, and it's an intelligence and network thing. And you got to keep it pretty quiet. So if someone's like, Hey, I really can't tell you how I'm doing this, um, identify and understand the nuances of how the trade works.
And maybe that transparency is something legitimate. They can't give it to you. Um, but in general, you should be able to achieve transparency. That's, that's another one that we've seen. If someone can't introduce you to something, or somebody can't share information. You got to really think to yourself, Hmm, I now have a dark hole that I can't check any boxes or do any verification.
Um, and I'll tell you, one of the biggest losses I ever had was 49 stars, all perfect, verification, all perfect, one box left open. And I made the trade anyways, because I was like, okay, guy seems smart. And that actually broke the trade. That one box, my inability to understand that one factor and get the, that was the breach.
Um, and yeah. I lost money. So I'm pretty draconian of where, you know, if you can't answer things and I feel like there's an important piece to the trade that I can't verify and I have a nice day, I won't do it again. You know, it's kind of one of those I'm a once bitten, you know, shy immediately. Um, so, and then, um, the other one that I see also that everyone thinks if I go with a really large platform, or I go with, um, you know, some big name something can't go wrong.
Things can go wrong anywhere. Don't, don't get sucked into the, Oh, the big guy running a billion dollars is somehow, you know, better than maybe the mid-sized or smaller guy. Um, you still got to do your due diligence. You still got to understand all the moving pieces and, you know, I've been co-writing some different papers about red flags in due diligence, um, with a friend of mine who, John Canaro, um, and you'd be amazed, almost all the SEC indictments are these major big funds that have breached all kinds of things.
Um, so that's one of the things I also is like, I tell people, it's like, I don't know, it's not a, it's not a red flag as in, but it's a don't get swayed by the, you know, Oh, I should always just go to the big name. Because somehow that'll be safer. Maybe, but not always.
Mo: Yeah, that's a good point. Yeah, these are all, uh, all the red flags identified.
These are all great ones for people to kind of keep in mind. Especially like, you know, especially if you're, whether you're institutional or retail level.
Chris: There's, there's, there's more, but we could go on and on. I mean, I've got an eight paper series that we're busy writing and it's, it just, you got in all kinds of nuances.
They get pretty institutional, like structure of investment allocation. Okay. What that means is you're investing with somebody who's got multiple funds. You know, okay, well, who gets the trade out of all the funds and how are the trades allocated between the various funds, especially if they have overlaps.
It's very, very common, very, very common structure. Um, And you see a lot of problems in very large shops that run multiple funds that have overlap in trade style. So certain funds with certain clients that are not you are getting the better trades. I mean, here again, sounds ludicrous that anybody would purposely do that.
Go read my last paper that I posted on the CAI blog, and there's an actual SEC indictment that we actually cite, because it's public information, where a UK based fund manager did exactly that. He literally took all the best trades and put it in a fund for large premier clients and the employees and partners of the fund and then created a sub fund for all his investors that really invested after they had already made their investments.
So you got an investment allocation problem and you also have a front running problem.
Mo: Wow, interesting.
Chris: I mean, that's a real trade. So you can go, go to the CAIA and you can. org, and you can look up that paper. It's, it's a pretty, like I said, it's, it sounds like, wow, that would never happen. Why would someone purposely do that?
And it happens all the time.
Mo: Uh, well, in our next discussion, we'll get into it, take a deeper dive into due diligence, and we'll kind of get into the weeds more than we did in this discussion. Uh, but until, until that next discussion, that next interview that we do, Chris, um, how can people find out more about you and also about Kirkland Capital Group?
Chris: Yeah, certainly. Um, obviously you can, um, go to our website, KirklandCapitalGroup.com. Um, you can, you know, find information about the fund there. Um, you can, you know, set up meetings, whatever you want it to do. Um, for me directly, if you, you know, you just want to talk more about due diligence or alts or whatever, um, you can find me on LinkedIn.
Um, I'm the only Chris Carsley other than I think there's a professional soccer player that's listed there. So yeah, if you find the professional soccer player. Go to the other guy.
Yeah, you'll see my picture there. CFA, CAIA, um, you know, love to connect with you and, um, cover a number of different subjects, whatever you want to talk about.
Mo: Okay, great. Well, and we'll include a link to the website and also to your LinkedIn profile in the show notes for this episode when it goes live.
Chris, thank you for coming on to the show today.
Chris: Well, Mo, thanks for having me. I mean, I, yeah, I love this stuff. I mean, some of it can get long and dreary, but, uh, it's all important, especially now that people are a little bit more focused on alts. It's, uh, you know, I've been spending a lot of time trying to get education and thought out there.
So I appreciate the opportunity to coming in and, you know, you know, talking with you.
Mo: Yeah, definitely. Thank you for coming on. And like you said, because the alt space continues to grow, that's one of the major reasons was one of the big reasons why I love to, uh, reached out to you to have you come on and to kind of do this two part series to kind of help people out there when they're doing due diligence, when they're trying to figure out, you know, what am I looking for?
What am I supposed to be doing? Uh, so hopefully this discussion and the next one that we do kind of provides a good roadmap and foundation for people out there when they're doing due diligence.
Chris: I hope so. Yeah. And I look forward to the next discussion. We can dive a little bit deeper.
Mo: Yeah, definitely. I really appreciate you sharing your insights with the audience today, Chris, and that's all for today.
Thank you everyone for tuning in and until next time, have a great week.
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