Diving Deeper - Due Diligence in the World of Alternative Investments
Understanding due diligence goes beyond knowing what’s going on. You have to be willing to do the work no matter how mundane it is and be willing to take the time to ensure your investment and investors are in good hands.
Join Chris Carsley, our Chief Investment Officer at Kirkland Capital Group, on another episode of the Purpose-Driven Wealth podcast, with Mo Bina. In this second episode of a two-part series (listen to part one here) on the Purpose-Driven Wealth podcast, Mo Bina welcomes back Chris Carsley in a continuation of their discussion on due diligence in alternative investments. Diving deeper, they discuss specific areas to focus on, inefficiencies, repeatability, and risk management, to name a few.
Here’s what you will expect in this episode:
Core areas of due diligence: investment, operations, economic and business.
Important areas of focus on investment, operational and business due diligence.
Inefficiencies, repeatability, and government regulation.
Key items when analyzing an investment strategy.
Portfolio risk, correlation of assets, and counterparty risk.
Investment monitoring and internal risk management.
Valuable suggestions for doing due diligence.
“In Investment Due Diligence, you need to know the products being used. Are they trading equity or debt? Is it public or private? Are they using derivatives?”
“If a manager claims they will generate extra returns, they must clarify why these returns exist, how they will continue, and how they will consistently capture them.”
“If you create a portfolio with similar risk characteristics, you will likely discover that your portfolio is highly correlated and not diversified, even if these are different asset classes.”
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 is the Chief Investment Officer and Managing Partner of Kirkland Capital Group. He has over 25 years of investment industry expertise specializing in corporate and venture finance, business valuation, Regulatory Compliance Practices, Securities Research, and Portfolio Management. Today's discussion with Chris is the second of a two-part series on performing due diligence of alternative investments. Chris, welcome to the show.
Chris: Hey Mo, thanks for having me back. Happy to be here.
Mo: Yeah, thank you for coming on.
Uh, in our previous discussion, uh, in part one of this interview, uh, we covered due diligence and kind of like the core areas being investment, operational, and, uh, business. Can you please kind of just start off today's discussion by just kind of providing a quick recap of these three areas?
Chris: Yeah, super quick.
Um, yeah, the, those are the three. I've got a, I've got a fourth one that I've been talking about lately too, uh, seeing as we've had a lot of dynamic changes that may not be very specific to the fund, but we'll cover that. So, the investment due diligence, you're really kind of going after investment strategy, objectives.
Trying to understand risks and, you know, and obviously you'll be looking at, you know, the performance of the fund during that phase of due diligence. Operational is where you start getting into a little bit more of the qualitative nature of due diligence. You're trying to assess the operations that really directly relate to the investment process.
Uh, you know, and so that's the big difference everyone always asks me is like, what's the difference between operational and businesses. that operational is related to the trade. You know, that might be third party oversight aspects, cash controls, um, various treasury management, uh, type questions. And on the business side of the, uh, due diligence, those are maybe hard assets, facilities, different operational structures or equipment that really is not directly related to, uh, the, uh, trade that the, that sort of fills the strategy, but obviously is super important. It allows people and the business to, you know, say the manager to effectively manage the fund. Um, but the fourth one that we've been talking about, because there's just been just one punch after another. I mean, it's been kind of interesting from a new standpoint, um, is economic, the economic due diligence. And once you really understand the investment, one of the aspects of the investment due diligence, and it's been pretty important, is well, in today's market, what is the economy and some of the global macro events, or maybe even some, you know, you know, micro events in some areas, if you're very regional in your, in your base of investment, um, what's affecting that investment and It may adjust the sizing or the timing of what you're looking at.
Um, I was just at a conference, and someone asked a question of, well, if I was looking at doing something in, uh, real estate, what, what properties would I probably want to avoid? Well, everyone kind of laughed. The easy one was office. I mean, so it's, it's, you know, during COVID it was, you avoided hospitality.
That was the, the punching bag of that time period, but now you're looking at, you know, economically given a number of different occurrences and things that are going on, you, I'm sure there's opportunities in office, um, but it's approach with caution. So that's another level of due diligence that, you know, all these are overlapping circles.
So those are sort of the, the, the now four aspects that people really need to be thinking about.
Mo: Yeah, that fourth one, you know, we did not mention, or we did not get into that, uh, in part one. This economic due diligence, um, I guess maybe a good way to kind of summarize it would be just kind of like the bigger picture and the kind of like the bigger macro setting.
Um, would you include within that for example, like Um, interest rates.
Chris: Oh, yeah. That's, that's one of the, you just hit one of the big ones. That's, uh, that's one of the, you know, that's a big factor that people really have to think are interest rates a headwind or a tailwind. So, like for me, being in private debt, interest rates are actually, you know, a tailwind.
Um, I'm able actually to go charge more and capture more return per unit of risk for my investors, where if you're on the equity side, Well, okay. Rising interest rates and effective inflation. Well, that's generally, you know, a headwind for anything on the equity side. I mean, that's, you know, that, that's a broad, uh, brush stroke there, but a lot of details go into that.
But that would be one for sure is, you know, interest rates, inflation, a lot of your geopolitical problems. Um, you know, depending on if your trade involves other countries. Well, okay, you have got to understand the political risks and the nature of what's going on in that country. And would that. Affect your trade.
Mo: Hmm. Um, I've always kind of, uh, maybe innately, um, I've always kind of thought about, um, some of the components of this economic due diligence. I've always kind of thought of them as kind of part of the investment due diligence, but, um, do you kind of feel that this point, maybe either where we are right now, or do you think that it's just better to classify these things in its whole, in a whole new category?
Chris: I, I've really been sort of, it, it, like I said, they're all overlapping circles. Um, nothing is mutually exclusive in your due diligence process, but there's so much going on now. Um, it, it's become big enough where a lot of people I've been talking to have been saying, okay, hey, what are these factors that are going on?
And some may not affect today, but one of the things like changing regulation aspects that could, you know, affect something. Okay, well, that may not actually be in place yet. Um, but when it does get in place, is that something you should really be thinking about? You know, you know, there's a lot of bank regulations coming down.
That's sort of going to have a greater economic impact. Well, there's been a lot of whispers and rumors and some numbers thrown out, but nothing's been hard lined yet of, well, how much are banks going to be able to lend? And how much are they going to have to hold in reserves? Okay, that's coming. Um, and it will have a massive impact on a lot of things.
Um, and so you should be prepared. Well, how's that going to affect what I look to go do? If I know I need financing in the future for whatever I'm doing, well, okay, wait, am I going to be able to get that financing? Am I going to, you know, what's going to happen at the bank level if I'm, you know, and I'm in my world?
Hey, maybe an SBA loan is a takeout for one of my bridge loans. Well, okay, when I'm looking at a property, um, and adding something, it's like, oh, there's the probability of that particular borrower being able to get an SBA loan in the future as things tighten down. Okay, maybe I should reassess that risk of something that really hasn't happened yet as I'm even doing a loan today.
Mo: Yeah, that's true, because to me, it kind of would have an effect on liquidity, it seems like, right?
Chris: Totally. So, yeah, it's, it's, there's enough going on that it's kind of become its own little beast in the, uh, in the due diligence process, but you're totally correct. I mean, at the end of the day, you're using this information in this assessment of due diligence and keeping up on economic factors and occurrences as an impact to the research and the due diligence you've done on the investment side.
Mo: I mean, clearly. Uh, investment due diligence is probably the error, the one area that most retail level, um, investors kind of focus on, uh, as compared to operational and business, uh, due diligence. Um, what are some common areas of focus when performing investment due diligence?
Chris: Yeah. I mean, you really want to understand what products are being used.
I mean, are they trading equity debt? Is it public? Is it private? Are they using derivatives? You know, you have got to understand what are the tools in their tool bag. Um, and then also understanding, okay, what is. How do all those tools help complete the strategy and the objective of the fund? Um, you know, are they using the right things, and does it make sense to you?
Um, I always think about this entire, uh, sector as two main categories. And you've heard me say this before most, the inefficiencies and the edge. You've really got to understand when you're looking at the investment due diligence, what inefficiency are they taking advantage of and is it repeatable? Uh, it, if you're going to create an excess return, or you run into a manager that says they're going to create an excess return, they should be able to explain why that excess return exists, why it's going to persist, and how they're going to be able to capture that repeatedly.
So that repeatability factor, that actually comes back around into the second place, the edge. And the edge is really, look, well, why the team, why this team, why this manager, um, what do they have in place, um, that is going to allow them to be efficient in carrying out their investment objectives and also, like I said, make this repeatable.
Um, do they have the network? Do they have the access to get the right instruments? Do they have the systems in place to do the correct analysis? Um, and you know, has that been proven over time? Um, and then, you know, thirdly is, uh, risks. You need to understand, well, how does this trade break? Um, how has this trade gone through certain cycles?
Um, and this is something you should definitely ask the manager. You know, I always love looking at pitch decks because at the end they always talk about all the great trades they've had and all the money they've made. And I really just don't see the point in looking at those. I like to kind of negate those pages.
I don't really care how you made money in the past because I wasn't an investor then. Um, I want to know what broke and how did you deal with that and how did that trade get in the book? And, you know, those are far more important inflection points. that really dive into the risks and how this manager is going to deal with, you know, the problems.
And it also gives you insight into, well, when did those problems occur? You know, is this particular trade cyclical? Does it do well in certain times and poorly in others? Um, and a lot of trades are. Um, you know, have some kind of cyclicality to it. Um, and that'll give you an idea of how it might do in a certain cycle.
You know, a lot of people right now are looking like, oh, man, we're going to go into this recession. Now, whether it's going to be a soft landing or hard landing, I'm not going to get into, you know, pontification of what's going to happen in the future. But that understanding of risk can understand, like, wait a second.
Historically, when we ran into these economic, um, situations, um, this trade didn't do so well. And it's a tough one in today's world because you might be looking at a lot of funds that have been around for eight, nine, 10 years. They may not have seen one cycle or another. They might not have been, I mean, so you might have tons of data and it's you, you know, you might not actually have an occurrence to dive into.
But sometimes you just have idiosyncratic impacts to certain level of trades. Those are the ones you really want to go after, uh, and sort of say, okay, how did you deal with that? And some of that, I, I, you know, you and I were talking offline before we started this mode, but I just did a webinar on performance.
Um, and it kind of came to me as kind of, this is a really important piece of the investment side of due diligence and everyone looks at it, but I think most people look at it as like, you Wow. Okay. They've had good performance or not. And it, and it kind of just stops there. There is an entire story that can be told from performance.
You've got to think, okay, how has measurement done on performance? Really understand how this is measured? How is it reported? Um, and every investment, whether you get your venture private debt, your hedge funds, there's going to be some differentiations of some of the numbers in the way it's measured. So, it's important to understand how that's done.
But then the next phase is Go into the attribution and what that really means is dive in and understand uh, a little bit about well, what drove the returns? What generated the positive or negative return? Um, and so you might have 10 things in a portfolio. Well, did one item of that generate all the return and the other nine didn't or do we have a good breadth of return across?
Um, and this gets pretty interesting when you start dealing with long short portfolios and hedge funds. Well, how much came from longs? How much came from shorts? Um, you know, so you can really get an interesting story of what drove the return. Now, once you have that attribution and you understand measurement, the final phase is the analysis of the, you know, now you're into the story of like, what are these numbers showing me?
And how do they mesh with the story that I understand from the other due diligence of understanding the products, the inefficiency that we're taking advantage of, uh, and the risks. Does it all make sense? And, and, I'm not going to lie, it's a fair amount of work, um, and you just got to find the right way for yourself to kind of complete that last phase.
But performance is more than just a list of numbers that show monthly performance. There's an entire story underneath those numbers. And, um, in my previous careers where I was tearing, you know, funds apart, you really, you really got some interesting moments that, you know, caught managers off guard of how much you could know about what happened in various months.
So that's one thing that I've really been diving in more and trying to educate people on is the performance. And it's definitely a piece to the investment due diligence side. Oh, definitely.
Mo: When you mentioned earlier about kind of like looking at investment due diligence under the lens of like, inefficiency or edge, and then, but when you kind of like also incorporate the repeatability aspect of it.
Are you basically saying that at times, there may be some inefficiencies, but others in the industry may catch on and basically take advantage of those, of those inefficiencies and, and therefore, therefore, I guess maybe that portfolio manager or whoever's running the fund may now lose that edge. And so, the repeatability becomes important, I guess, or having a track record.
Chris: You hit it right on the nose. I mean, that's exactly one of the big concerns and that's actually a big concern in, you know, certain trades that, um, you're not creating new value. It's a value that might be related to, um, a tender offer or something like that, where there's only a certain amount of money in the trade to be captured a true arbitrage.
Well, if I know about it, I get all the money. I get the, I get the whole dollar. Okay. Well, Mo, you figure it out. Okay. Well, maybe you get a piece of my dollar. There's no new dollar. There's only one dollar in the trade. So, the more people and the growth of information and the knowledge around a particular trade, you can definitely see trades wax and wane where things will just disappear.
Um, it might be back in one form or another, or it may never be back. Um, and that's one thing to really understand about, you know, especially in the hedge fund space. Um, you know, it's, you're not always creating, you know, a new, a new dollar. You're just capturing the same dollar that everyone else is going after.
Um, and those are just, they call them zero sum trades. Um, but, you know, the other aspect, you know, is, you know, inefficiencies. Well, you could have, maybe it's based on a regulation. You know, let's just take, you know, private debt, for example, you know, we had a lot of things change in Dodd Frank and that kind of opened the doors now that's always been around, but that was a huge tailwind that really allowed it to explode, you know, out of 2010.
And now we have another tailwind that could have private debt grow even further, but let's just jump into an alternate universe here and the regulation goes the other way and banks are allowed to go do whatever they want. Whoa, okay, the world of private debt is going to disappear pretty quick if all of a sudden, the chains are taken off and banks are able to do whatever they want and lend anything they want, um, without a lot of stipulations.
So, understanding what is the driver behind the inefficiency and the stability towards it, um, that's super important because things can disappear. It's a fact. You know, a lot of things that are like different tax arbitrages or tax benefits to certain trades, you know, the government wakes up one day and all of a sudden doesn't want to give tax breaks to oil and gas.
Well, the pitch on oil and gas funds that is really going on right now, uh, that's going to change. I'm not saying that's going to happen. I'm just saying that would be the occurrence. I mean, that's something you'd have to be really aware of. Like, well, you know, is the government going to change regulations?
Because government regulations can create a lot of inefficiencies to where there's money to be made. Or saved in that case from, you know, tax benefits.
Mo: Yeah, and I guess there's some that would even argue that some corporations, right, utilize government, you know, to pass certain regulations to kill competition and to kill and to make, create, I guess, maybe barriers.
Chris: Yeah.
Mo: Um, to basically entering a particular market or a particular industry, um, you know, uh, people sometimes call that corporatism, or perhaps in some cases, you may even call it fascism, right? Where government and corporations, big, powerful corporations, that is, essentially kind of merge into one. And so, they can use it as a means of basically killing off and making it so difficult for any new entrants into the market.
Chris: Yeah, I mean, in some of those instances, some of your event driven style trades that are related to M& A or something of that nature could have a big upside or downside, depending on, you know, how that relationship between government rules and regulations, uh, and corporate activity, you know, plays out.
Mo: Um, most retail investors probably, uh, retail investors, sorry, probably focus less on operational due diligence and business due diligence, but do you have any suggestions for kind of things that investors probably should not ignore when it comes to these two areas of due diligence?
Chris: Um, Operational, things not to have, things to pay attention to in operational. I think one of the biggest things that's right now in the operational due diligence side. Um, there's been a lot of companies, there's been some misappropriation of funds. Um, and a number of different things. I always say on the operational side, you really have got to follow the money.
It's very, very important. And some of that really means, wait a second, we've got to go in and understand, do they have third party oversight? Do they have a fund administrator in place? Um, on the back end of that is there, uh, further eyes through an audit of the fund. Um, now really tricky, smart people have found a number of ways to get around some of these things, but you can't, Stop everybody.
Um, if you got someone really smart trying to outsmart you 100 percent of the time and you're spending 20 percent 20 percent of your time trying to catch them, you know, eventually you might get caught. Um, but with that said, I have really just noticed, you know, a lot of the recent problems that we've seen in a lot of funds, a lot of fintech platforms.
It's just that people weren't following the money. People were not, You know, didn't have the transparency into what they should have with some of these funds and so money went places it shouldn't have gone or money was moved out of accounts that it shouldn't have been moved out of. It just, you got to have that oversight in place.
And that's one of the key angles on the operational side is really understanding what the cash control is. Is everything dual controlled or can one guy walk in and wire 10 million wherever he wants? I know that sounds absurd. I guarantee you there's a lot of fund structures out there that have that capability. They don't have any kind of dual control or oversight. It's one of the things that you've seen in some of the real estate areas of late where, you know, you know, the idea of having a fund admin, people are like, why would I have that?
That's an extra cost. And it's like, well, they're really there to, you know, if set up correctly to be that looking over your shoulder, that, that, you know, that third party oversight of watching all your transactions and questioning kind of what you're doing. And making sure you're saying your do match to the, to the investment documents that you've supplied to the investor.
So that's one of the, you know, that's one of the biggest areas on the, um, on the, you know, operational due diligence side that is, is pretty important. The other one is, um, you know, references. Make sure you go verify things. Um, I had a guy I sat down with lunch just recently and he said, hey, I got into this trade and, um, the fund said that he did business with XYZ company.
And I said, well, did you go call XYZ company and see if they were a client? I mean, that sounds like a really simple idea to go do that. But you'd be amazed how many people like, duh. I, no, I didn't. Um, and it turned out that that company wasn't a client. Um, so I mean, sometimes it's really just low hanging fruit.
Um, in hindsight, it's 2020. I mean, of course he was buying me lunch, so I couldn't be too mean to him. Um, but I did give him kind of look like, well, that probably would have been an easy phone call. Um, but yeah, so get your references, do your verification. If they say they're using a service provider, it may sound ridiculous of like, well, why would they lie to me about using this?
Just call, you know, you know, I put together an entire due diligence questionnaire that goes through every single operation I have. And in there is an entire reference section of every service provider. I use the contact's name, their email and their phone number. And I've already got verification from all my service providers that if anybody is doing due diligence, wanting to contact them, you should go right ahead.
Verify that that person is really working with me. You should. Um, now I will tell you, if you want to go to the nth degree and start diving in and asking all kinds of specific numbers, a lot of these service providers, because the protection of their customer, they're not going to share a ton with you, but they will be able to at least verify, yes, we work with that person.
Now it gets a little worrisome when they're like, well, we did, but we don't anymore. That, okay, now you've run into a problem. Um, either documentation or story wasn't updated, but you probably definitely found a verification issue. So those are the things in the operational is like that third party oversight.
That's a huge, huge deal. I mean, I, I just tell everybody, and I know this may be draconian in a way, if someone doesn't have a fund admin and doesn't have third-party oversight and they're not audited, it's your money. I mean, do you, do you want to work with someone who's not going to give you that kind of transparency?
You know, people say, well, not all the great deals have that structure and I go, well, you're going to miss out on a lot of great deals. That's just life of investing. But I think the safety of your principal is probably more important than missing out on an opportunity that maybe, you know, had an outsized return.
That's just my view. Um, so yeah, yeah. Cash controls, audits, references, do your verification.
Mo: That's all of that basically to get the extra peace of mind, right? I mean, we're talking about ways of mitigating or reducing risk, right? You know, I mean, all these things basically pile on top of each other and, you know, at the end of the day, like you said, sometimes you just have to walk away.
Chris: Yeah. Yeah. Be willing to walk away. Don't get sold the amazing story of this is going to make you rich. If that's their key angle of what they're selling. That makes me suspect right off the bat.
Mo: Yeah. Yeah, I agree. Chris, when analyzing an investment strategy, um, what do you think are some key items that people should evaluate or look at?
Chris: Um,
well, I mean, like I, like I was saying, it's just like the key angles of what you should analyze. Let's see. Well, I hate to be a broken record here. It's a little bit of, well, one, understand the team and the manager in the background, you know, in venture, I always. You know, they, they always go after the team first and then kind of like, okay, this is a really novel idea, but who's running the show?
It's the old adage of, you know, give me an A idea with a B team. I'm suspect. Give me a B idea with an A team. Okay. You've got my attention. Um, so team's really a big deal. What is their particular edge? I mean, it's just, it really comes down to these two factors, you know, over and over again, you'll see that your due diligence process rotates through.
And then is it, is it something that you can understand? Like when I, when I tell you the trade and I walk you through the inefficiency I'm taking advantage of, and if you look at me like, I have no idea what you just said, that's probably something you should go back, educate yourself further, but certainly not write a check at this time.
And there again, oh no, if you don't get in in the next month, it'll be closed. Oh, that's okay. That's fine. I obviously need more education. And you know what? I may miss out on this event, but if it's something that was repeatable, it'll be back. And so, I've got time to deploy my money more intelligently, um, and collect more information.
So. You know, there again, understand that inefficiency, understand that trade. And if you don't, you know, wait, um, you know, don't, don't be in a hurry. I always tell people, I said, listen, as so many people are piling into alternative investments, find something you're, you have a knowledge base in, or something that you're passionate about, because if you're passionate about something, you'll be driven to learn.
Um, if you like could care, absolutely nothing about, um, you know, real estate, well, yeah. Okay, then it's going to be hard for you to have the motivation to come up the curve and have the desire to learn the information you need to understand the trade. Um, so if you're getting into this, I always say, listen, find something you have a background in, find something that you're passionate about, that will help you move in the right direction to where you can deploy.
Some of your own knowledge into the discussion you might be having with the management about, you know, a particular trade because, you know, it's like you say you're in biotech and, hey, I'm going to go look at, you know, a fund that's doing, you know, pre IPO work in biotechs. Okay, you have probably a pretty good knowledge base.
You might even have a network that you can go, hey, I saw this company posting X, Y, Z drug. I'm not in that field, but I know someone who is. And you can call and use your own network to do further due diligence of like, what's the real viability? What's the competitive landscape of that particular investment?
I mean, that's, you know, that's some of the things I usually try to get people to focus on.
Mo: Yeah. Um, we talked about, uh, risk, uh, earlier. Um, what does portfolio risk typically consist of? What components?
Chris: Oh, wow. Uh, do we have enough time for this? Um, um, all right. What does portfolio risk consist of? Well, diving past a little bit of, you know, the big four categories that we already talked about in our due diligence.
Um, a portfolio, it's a culmination of risks in individual pieces. And so, you've got to understand how do all these individual pieces work together. Um, and, you know, I'll use, um, talk maybe a little bit more about, like I said, about a portfolio. So, it's a mix of assets that are not going to be the same asset.
Maybe some are stocks, some are debt, some are real estate, some are venture. You've got to understand Well, wait, all these have individual risk characteristics that we've actually already, hopefully ascertained in our due diligence process. Now we're going to think about putting a portfolio of these together.
Well, what's the cross correlation of these assets? How do they interrelate to each other? Because, you know, this will get a little bit deep, but to get a return, you have to take a risk. There's no free lunch. Um, even in arbitrage, it's not free. You've got to have the right networks and phone numbers and capabilities to pull some of that off.
Um, so when you are putting these together, what's the, what's the correlation across these, you know, how volatile is each individual piece of your portfolio that you're putting together? Um, these are sort of that, like, I'm sort of going on what you said specifically portfolio risk. Um, and so now it's like, hey, I've got all these aspects that maybe are correlated and what I wanted to say there is that you get, um, you got to take a risk to get a return.
Well, some of those, you'll hear some people say, oh, there's various risk factors. And what risk factors are you exposed to? Well, what they really are saying there is, hey, I took a certain kind of risk. I took equity risk, or I took interest rate risk and I'm earning a return off of that. Well, if you put a portfolio together, that has all the same risk characteristics, you'll probably find that your portfolio is very, very correlated.
Um, and when something, you know, a cycle or something hits that particular, um, factor, um, say I need interest rates to go up and interest rates go down. Um, well, my portfolio is going to lose across the entire array of assets that I've put together. Um, and so that's one thing to think about with regards to, you know, portfolio risk is I'm building all these different alternatives is.
How do they interrelate? Um, I also kind of dove in and had someone ask me like, well, everyone keeps on saying the 60 40 is broken. I said, I really don't think that's a really simple term. 60 40 is not broken. That's just an allocation of equity and debt. It's a little bit more complex than that. And what I think most people are getting at and what they're really trying to say is, um, maybe 60 percent and the 40 percent are not all just traditional assets.
You're looking at some aspects of alternative assets that might be an alternative fixed income instrument or an alternative, you know, equity instrument. So, you might have your S& P 500 index as a, as an investment. But alongside of that, you might have a private equity fund instead of some individual stocks that might be highly correlated to that index.
Um, in the fixed income world, it's kind of more nuanced, you know, most people focus on equity. But now people are realizing, wait a second, 2022 really had a pretty nasty impact on fixed income. You know, we had, you know, down double digits and diversification just disappeared. It all headed in the same direction.
Maybe we should rethink about Oh, maybe I just don't have treasuries, corporates, and some munis here if I'm tax sensitive or saying some junk ETF or something like that. I think about alternative fixed income. Maybe that's private debt in real estate. Maybe that's private debt in venture. Maybe that's, you know, consumer private debt fund or, you know, something on, you know, the business private debt side. You can look at an array of other different alternatives in that that might have lower correlations to the things you already own. So even within fixed income equity, you can actually look at those as individual portfolios and assess the risks. I know this is getting kind of complicated, but you did bring it up while you brought up portfolio and risk.
Mo: No, I do.
Chris: I mean, this is what a lot of you know, your financial advisor and everybody else should really be thinking about that. And as you go into alts, you know, hopefully your financial advisor, wealth manager can really assess and say, wait, I do understand how these alts affects your entire portfolio.
And I can understand the risks. Um, but, um, and then we talked about impact of, you know, various cycles, understand. the cyclical nature, you know, given, you know, the volatility of the instrument, what, what, what could I potentially lose? Um, if I looked at this historically, I mean, and I say that a lot of your risk assessments, especially from a quantitative standpoint, are really backward looking.
And sometimes you don't always know where something new can happen and create a gap that we've never seen before. So, you can prepare as best as you can and sometimes, um, you'll still get, you know, some nice sideways, sideways movements, even though you try to diversify as best as possible. Um, you know, there's an old adage of like, oh, when you get a huge gap event, say like a 2008, you know, you'll hear someone say all correlations go to one.
You know, historically your correlations might have been low, but in high stress periods, things that are historically not correlated might end up being far more correlated than you thought that does happen. Um, you know, so, uh, it's, it's, it's a realization that that. That is, that is a risk in a portfolio, but you're not really trying to build a portfolio for the end of the world events.
You're trying to build a portfolio that's going to meet your risk levels and obtain your, you know, required rate of return that you're trying to, you know, create in this portfolio. Because at the end of the day, you're trying to create the best. risk adjusted return for your portfolio. I need to get an 8 percent return.
How much risk can I possibly take? The lowest amount of risk I can take to achieve that. I mean, that's really what you're trying to shoot for when you're, you're talking about, you know, portfolio risks. Um, there's obviously other, you know, sizing, um, leverage use. Uh, is another form of risk within it, within a portfolio, either you use leverage or the other underlying assets use leverage, you got to really dive in and understand, um, you know, how's that affecting, you know, it's like, if you've got a fund that uses derivatives, that is inherent leverage, you should understand, okay, well, how much do they use it?
Why do they use it? Um, and, you know, what's been the impact to the portfolio, your manager should be able to answer these questions if they can't, that's a good point to walk away, and if they can't understand and really explain in simple terms what they're doing. Um, and then here's the one that I always love that everyone seems to forget about, and this shows up a little bit more on your, your operational due diligence side is counterparty risk.
That is a part of a portfolio, especially when you're in the alts world, it, you can't run a fund in isolation of where I've just got one little account and I'm just trading some stocks. It's usually more complicated than that. You've got multiple people that could help facilitate, you know, like in hedge fund, you need a prime broker, um, in some aspects that require leverage.
Well, you're going to have that provider of leverage that, that bank or something of that nature. Now in today's world. you know, go talk to the venture funds that had First Republic and Silicon Valley Bank as their primary lender and their banker for their fund. Well, they got a real quick dose of counterparty risk.
I mean, it was, and it was real. It was like, wow, I can't get my money out to make payroll. I can't make an investment that I wanted because all of a sudden, I'm temporarily frozen. And that's something that counterparty risk is always there, but it just rears its head every so often, just long enough for everybody to forget about it.
And then, you know, and then all of a sudden people get hit by it and they're like, oh my God, I couldn't have possibly seen that happen. Well, if you find every piece of your business is in one place, and that the entire day, if that, that company went out of business tomorrow in a flash, well, how would that impact you and your fund?
That's a question the manager should be asking, and as you're doing your due diligence as an investor, you need to assess that. Um, because, you know, go talk to anybody who is using leverage. It's, it's getting kind of interesting because that's real counterparty risk. And one of the examples that, you know, I saw multiple times was, I've got a fund.
I use leverage. Uh, my line gets cut. Okay. I, I have a decent amount of equity, but here's the problem. I have to get their money back. So, I might be in some form of forced selling at a time I don't want to sell. So, I'm actually walking in losses or making trades that I wouldn't necessarily, um, like to do.
But as I'm trying to meet these demands of a counterparty, it inadvertently is hurting my investors. Okay, that's now did the fund manager do anything wrong? Did the investments do anything wrong? No. A counterparty had a problem, and that counterparty had a direct effect on the fund. And that's what really is the simple aspect of counterparty risk.
So, when you're talking about portfolio risk, I always like to mention that one because people seem to forget about that one. And it's, it's just one of those risks that you take, but you're not rewarded for. There's no return metric of like, well, how much do I get paid for taking counterparty risk? That's just a part of the game of how it's played, but it can have an impact on your portfolio.
Go talk to anybody who lived through 2008. It was a big deal, you know, trying to mitigate. Um, everyone was on a war path to get every dollar they could. as fast as they could out of the system. That type of action is going to cause a lot of damage to people who technically didn't do anything wrong.
I saw entire funds ground up to zero. They had a great performance, didn't do anything wrong, but they were still completely destroyed.
I mean, that's, hopefully those investors, I don't think that I know that particular fund investors didn't do poorly, but it was a great investment and a great team that was supplying a great, you know, service to a number of investors. And, you know, that's how drastic counterparty risk can be. Now that's, that's the far, the far tail type event, but you know.
A lot of venture funds, they obviously survived and, you know, everything kind of worked out. But let me tell you, there's about three or four days that, um, there's a lot of people sweating around, you know, some of the bank failures that was very, very centered on, you know, the venture space.
Mo: Yeah. How can an investor know, um, or make sure that, uh, an investment manager is properly monitoring and measuring risks involved with the investment?
Um, how can an investor figure out and know that the manager is doing this appropriately and doing it consistently as well?
Chris: That's a, that's a tough one because it requires two things. Um, I see this a lot and I'll, I'll drill this and then I'll kind of come back to the rest of the meat of the question is, um, a lot of people do a lot of due diligence up front.
And then they kind of go away and they don't do a level of ongoing monitoring. Um, and that's, that's a real key factor is maybe one day that manager was doing everything right and had all the bells and whistles in place. Um, but you need to make sure it's maintained, and it stays in place. You know, maybe I, I mentioned, um, a whole bunch of people I was working with, and I didn't send out a newsletter. This should be pretty common practice that if I change my fund admin or I change my prime broker, okay, that's a pretty material operational event to the fund. You should probably have let every investor know that occurred and why it occurred and how it's advantageous to them.
Um, and so, but you may only get that if you're asking these questions on a regular basis for ongoing monitoring. Um, for that internal risk management, I mean, identify those key aspects, some of them we talked about here, or, or others you've identified particular to the, to the fund and build sort of a tracking sheet. I'm not a big, well, actually I can't say that. I'm a huge fan of checklists, but don't get into the mode of just checking a, you know, checking a box.
Um, you want to check those boxes, but you want to make sure that, oh, oh, you have a new, um, fund admin that's checking everything. Oh, okay. Um, what's their contact information? Then take that next step of, hey, I checked the box. That's great. Now verify. Don't forget that second step. You've got to get in there and you've got to, you know, do what you did day one when you were raking them over the coals, make sure you're still doing those steps and you've got a procedure to it that allows you to make sure that, hey, what I invested in three years ago is still the same thing.
Um, because we did run into a number of different things that certain funds have style drift. Um, they, they, the trade they were originally doing, and they told you they were doing, well, all of a sudden, they didn't really tell you that 50 percent of the portfolio moved into some other strategy. Well, okay, that's kind of material because if you thought they were doing A and you wake up and the fund that you're in is now doing, you know, B.
Um, well, that might change how it impacts your entire portfolio. I mean, for someone who's got a fair amount of money or is running a family office and has a number of different moving pieces. Yeah, that could have a material impact. Um, so, um, I would say develop a process of how you're going to complete all this and stick to that and create, you know, some, some checklists.
Um, And I always tell people, if you're not sure, did I miss anything, um, develop a network of people in the due diligence space, ask them, you can go to the ILPA, and they've got some different, you know, questionnaires you can pull down that can give you some other ideas of, hey, what other questions could I possibly ask managers, um, some of those lists are massive overkill, you've got to cut them down for who you're talking to, because not all questions pertain to certain types of funds.
Like sometimes I'll just get some weird questions. I'm like, okay, that's a great question if I was running a hedge fund, but that's not what I do. Um, I mean, obviously they're reading off a list of questions. Um, so, um, you know, but that goes back to, if you've really taken the time to understand the strategy, you'll know, and sort of be led towards the right questions to ask. And then, you know, like I said, build that process and procedure and be sure to do ongoing monitoring.
Mo: Yeah. Yeah. Great points about the ongoing monitoring because you're right. A lot of people do the due diligence up front, but after that, they just kind of forget about it. And, you know, they just hope that, you know, at the end of the 3, 4, 5, 7-year hold period, whatever it happens to be. Right. That, you know, everything happened the way I was told it was going to. And like you said, you also mentioned about style drift and sometimes things are changing with time, and you know, you probably won't be told, you know, if that that is the case and all of a sudden, this strategy's change and so forth.
So, um, there's,
Chris: yeah, I'm not, and, and I'm saying it's like, you know, in some funds when you read their documents. They may be, have some good capability for, you know, moving from one strategy to another. Um, it's not always a bad thing. It's just, you should know.
Mo: Yeah, exactly. You should know that if that's something that may potentially happen, right.
That it may be shifting if market conditions change, or, you know, we talked about it, the macro environment changes, and then they're going to be shifting to doing something, you know, in response to that. Cause at the end of the day, you know, we're all beholden to central bankers and interest rates, right?
Ultimately, we can't control that. Uh, but if an investment manager basically has a plan in place for inflation and for interest rates, and if they move one way versus another, then they can plan and make, uh, take action accordingly. Yeah. Uh, Chris, any final thoughts that you'd like to share? Uh, anything that perhaps we didn't talk about either in part one or part two of our discussion, or maybe some suggestions for investors or for people out there doing due diligence on alternative investments?
Chris: Yeah. I mean, I'll, I'll just address, listen, it, it's a lot of work, um, to do this, but don't be in a hurry. Um, as an institutional investor, we would often spend months reviewing one fund before we pulled the trigger. We would watch a number of different cycles or when we did our economic due diligence, we might like a manager and we like a strategy.
But we didn't think it was timely. So, we might let them walk through a time period where it might be hard for them. So, um, you're obtaining, you know, that attribution level performance and having conversations with them. So, you're, you're really diving in deep and maintaining that connection with them.
But Be willing to watch for a while, um, if there's something that makes you feel uncomfortable, um, you never need to be in a hurry, uh, that's, that's, I, I see so many people and I see so many pitches, um, I, I will raise the money for, you know, the next two weeks, you don't get in now, you're out, okay, well, that person is probably doing multiple deals, great, give me the transparency on this deal, let me walk through that deal and then maybe I'll get you on the next one.
I mean, it's just, you know, I see so many people getting pressured, um, as, as you're trying to get in, don't, don't be what they call, you know, the, the fear of missing out the FOMO, don't, don't do that. I've seen a lot of people get into some tight positions. Um, um, the other one is, you know, like I said, one of the processes I always use for my due diligence is, you know, build a set process, follow through on it, um, don't cut corners.
You know, some things like, oh, this is so mundane, this is so much work, um, that's where things get dangerous and you're like, oh man, if I'd really just asked that question, I would have seen that. So that's kind of the biggest point of, you know, due diligence and alternatives. Um, and network, network, network.
I mean, find people who've done similar investments or know that manager. Um, what problems have they had with that manager? What, what, what, you know, everyone can do something a little different. I mean, or a little better. I mean, no one's, no one's running a perfect show. Um, but you, you know, find other people who are existing investors.
And to tell you the truth, it's part of my process. I have, uh, I have references that I offer people and I've already, um, usually most funds won't share investors, but I have a few investors that are like, hey, I'm Yeah, I'm totally willing to talk to a new investor. And I try to differentiate it. Um, some of my investors knew me before I started this fund.
Some of my investors in my fund, I didn't know until afterwards. So, I tried to provide a mix, you know, don't, don't, you know, you want to see that manager that's proactive. Like, I, I know what I would ask, so I'm going to give you what you should ask for, whether you even ask for it or not, I want to give you those different people to go through, because if I just gave you a whole bunch of people who already know me, you're going to get kind of the same story, and who knows, maybe that's biased in a certain way, um, but giving you somebody who only met me after I built this, and they've only made me known, known me for a year, okay, they'll give you a different perspective.
Um, hopefully, so those are the things you're looking for is the managers who've put in the thought of how they want to showcase information to you so that you feel and you can build, um, a comfort level with what's occurring and, you know, make sure that, you know, already you've probably made the decision.
That's the type of investment you're looking for in your portfolio.
Mo: Yeah. Yeah, great suggestions, especially avoiding the FOMO. That's one that I, that sometimes even I've kind of experienced as well too. It's like, your kind of just like, I got to get it now that, right. It's like, otherwise that window will close.
Chris: And everyone does, even the professionals. Anyone who tells you, I don't get sucked in by like, oh my God, that sounds great. Of course you do. It's, it's human nature. Just try to overcome it.
Mo: It really is. Uh, Chris, uh, Great suggestions. And I also like some of the earlier stuff you said as well, too, about, uh, having a passion, you know, there's so many alternative investments out there and if you have a passion for something, you're going to want to learn more about it.
And on top of it as well, too, you probably already know quite a bit already. And if you don't, then you're going to have that. If you have that passion, you're going to take the time to develop, uh, the work ethic and, and, you know, the, the get into the details and the weeds of trying to really understand it inside and out.
Uh, you're more likely to do that if you've got passion for something or a particular asset class than if you don't...
Chris: Yeah, it's there again. That's just human nature. I mean, come on. We all went to school, you know, the course you loved, you always aced it because it wasn't work.
Mo: Of course.
Chris: You know, the course you hated. You're like, oh, God, I'm going to put that off as long as possible. It's the same idea. You know.
Mo: Yeah. Chris, how can people find out more about you and, uh, Kirkland Capital Group?
Chris: Yeah, no, easiest way is, you know, you can hit me up on LinkedIn. Uh, love to connect with people and, you know, answer any kind of questions, whether it's something we talked about today or something else in alts, uh, or related to my fund.
Uh, I'm not tough to find. I'm the Chris Carsley with about six letters after my name. I don't think there's many others on there. Um, and then the other one is our website. You know, you can go to KirklandCapitalGroup.com. That will, you know, give you access to more information about me, the team, my partner Brock, what we do, uh, and then you can dive into a number of links and look at, you know, things that we, what we're doing in our fund.
So, you can read more, more about what we're doing in the Alternative Fixed Income Space.
Mo: Yeah. Thank you, Chris. Thank you for coming onto the show today. And also thank you for really getting into the weeds of the discussion and, you know, making this into a two-part series. Uh, I hope the investors are going to get a lot of good advice and tidbits out of this.
So, uh, thank you again for sharing all your insights with the audience.
Chris: Always. Love it, Mo. Thanks for having me.
Mo: Yeah, thank you. And that's all for today. And thank you everyone else for tuning in. And until next time, have a great week.
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