Sense Financial Alternative Due Diligence
Watch the full interview below.
Have you ever wondered how to invest in alternative assets like hedge funds, private credit or commercial real estate? If so, you’re not alone. Many investors are looking for ways to diversify their portfolio and generate higher returns outside of traditional investments. But how do you evaluate these opportunities? Chris Carsley, our Chief Investment Officer, joins Sense Financial for a webinar. He talks about how to perform alternative investment due diligence that is applicable to different types of funds or investments.
Video Highlights:
What are the different types of Due Diligence?
What are the non-negotiables of professionals?
What are investment mandates?
“When performing Investment Due Diligence, do not get swayed by the performance numbers. Performance is a tool to lead you to ask more questions.”
“Understand what’s going on in the world that might actually hurt the trade and how can it break the investment strategy.”
Watch the full video below.
Transcript
Dmitriy: Well, good evening and welcome to another, uh, series of webinars, uh, with Sense Financial. Today's topic is Alternative Investments Due Diligence. My name is Dmitriy Formichenko, uh, with Sense Financial Services. I will be your host today, and we do have a special guest presenter who's gonna go ahead and join.
And, uh, do his share of presentation in just a moment, but I wanted to just, uh, quickly tell you about, uh, Sense Financial. Those of you that are new, uh, we are a boutique financial firm specializing in self-directed retirement accounts with checkbook control. We've been serving our clients since 2010. We, uh, assisted over 3, 000 clients, established over 4,000 self-directed retirement plans.
Our clients love us. We have hundreds of five star reviews on Google, Better Business Bureau, Yelp, LinkedIn, and Bigger Pockets. And most of our business comes through referrals. We don't do marketing or advertisement, so we are a little bit unique in that way. Our mission as a company is to help our clients obtain control and protect their retirement accounts.
Proverbs 21:5 says that good planning and hard work leads to prosperity and we want to come along your side. We know that you work hard for your money and we want to make sure that your money is working hard for you. That's actually where we have the synergy with today's presenter. Uh, we, uh, enable you to use your retirement accounts to invest in alternative assets, and that will be just one of the options that you may consider, uh, for you.
But, uh, with self-directed, uh, IRA and 401k, you have virtually unlimited investment options. You can invest in, uh, things like real estate. Uh, residential, commercial, you can invest in promissory notes, in tax liens, uh, uh, precious metals, uh, cryptocurrency, uh, you can use your, uh, 401k or an IRA as a bank and do private loans, uh, so the, uh, Options are virtually unlimited.
Benefits of a Self-Directed IRA and a Solo 401k that it allows you to have true diversification because you have virtually unlimited investment options. The returns that you generate inside of your retirement account are tax deferred if you're using the traditional or pre-tax money or in the case of a Roth, it can be tax free which can be very, very powerful. You can also leverage your funds inside of your retirement account and use a non-recourse loan and purchase a property, investment property. Uh, what sets us apart from, uh, others out there is that we offer our clients ability to have checkbook control over their, uh, uh, retirement accounts so you can, um, avoid or bypass the middleman and make investments directly.
And Solo 401k is a great tax shelter that allows you to contribute up to 73, 000, uh, into, uh, your retirement account per year, per participant. So you can potentially double that if you are, uh, um, also enabling your spouse to participate. So it can save you tens of thousands of dollars on taxes. But, um, while there is almost unlimited investment, uh, uh, choices for you, there is few restrictions that you need to be aware of.
And the Internal Revenue Code 4975 talks about those prohibited transactions. So basically, it's two investments that are not allowed, and that is Collectables and Life Insurance and in addition to that the IRS prohibit, uh, a disqualified person to be involved in any capacity in any way, uh, with, uh, uh, qualified retirement plan and disqualified person, that's, uh, yourself, the account holder and immediate family members. Uh, true diversification means that you, uh, Minimize the risk and you actually able to grow your bottom line much quicker.
In this cartoon, Craig goes to my daughter for this, man holds the basket, which represents a stock market and the bottom fell off, all the eggs are broken. And wife says, well, I thought that our investments were diversified. Well, guess what? If you are in just one asset class, you don't have a true diversification.
You may have a few sections in that basket. If the bottom falls off, all the eggs are at risk, unfortunately. Chris is going to show you one of the ways how you can diversify. Ecclesiastes 11:2 says that you should divide your portion to seven or even eight, for you do not know what misfortune may occur on earth.
And I'm, I'm sure all of you live through that. You don't have to go far, uh, back, just... Look at the just a few years ago in 2000, beginning of the pandemic, what happened with the stock market and then back to 2007 or 8, another crash prior to that. So, uh, certainly you have the opportunity to minimize your risk by applying diversification.
Well, with that, I'm gonna go ahead and, uh, uh, bring, uh, uh, Chris and uh, uh, Chris is actually his, uh, uh, CIO and uh, uh, managing partner of, uh, Kirkland Capital Group. And, uh, he's responsible for portfolio management. Risk Assessment and Fund Operation with the Kirkland Income Fund, which is a micro balance commercial real estate bridge financing fund.
He brings over 27 years of investment industry experience. And, uh, Chris, if you can go ahead and share your, uh, beginning slide, that will be great. Uh, he, uh, co-founded the Seattle Alternative Investment Association in 2004. And, uh, he's a member of. The executive board of the, uh, C I CAIA Pacific Northwest chapter that was launched in 2007.
Uh, Chris earned his CFA designation in 1998. Uh, also certified alternative Investment Analyst in 2011 and he holds a bachelor's degree in business administration from the University of Portland. And Chris is also a client. So, um, and, uh, I think, uh, They're doing a great thing there and I wanted to, uh, introduce you guys to Chris.
So Chris, um, go ahead and take it away.
Chris: All right. Well, hey, Dimitriy, thanks for having me. Um, love coming in and talking about this extremely important subject because You know, for about 10 to 12 years, uh, being an alternative investment, uh, specialist, no one cared to really talk to you, but, uh, we're back in favor, uh, now that people have really seen what's capable when money is no longer free and, uh, prolific.
Um, so, uh, back to a little bit of a norm of, you know, what I saw before. Uh, the times of, you know, 2008 and 2009. But, um, and that's the main reason, you know, I think this is a super timely subject is to come in and talk about Alternative Investment due diligence because so many people haven't been monitoring this or haven't been terribly involved.
And if you have, that's great. But what I'm running into is a lot of people, they need sort of a trifecta of, you know, education. What are the alternate investments to what we're going to talk a little bit about today is how to maybe structure and think about due diligence, um, as you're looking at funds or different, uh, you know, special purpose vehicles.
And then lastly is maybe even some, some access. So today we're going to kind of kind of split it right down the middle and talk about some of this due diligence. Um, let's move forward here. Well, we already talked about that guy, so that's enough. But, um, one of the things I'll add to that is, and what we'll sort of lean on is a fair amount of, uh, due diligence that I had to do.
Working as a hedge fund trader, obviously looking at a number of different trades and then working for a fund to fund for a number of years, my primary job was to go in and perform end to end due diligence, uh, on a variety of different esoteric trades, uh, that, you know, mostly would fit into the hedge fund category, but we did look at a number of different venture trades, some real estate, um, And so, you know, if you've got any questions during this, I am totally okay, you know, put it in chat and You know, I can answer it in hopefully a timely fashion.
So I'm totally okay being interrupted. It sometimes I enjoy it But so the agenda we have here. Let's talk about types of due diligence Um, I'm going to go into something that, uh, I found very useful for a lot of people who don't have a team of research analysts or big systems helping them perform due diligence is, uh, something sort of, uh, I sort of deemed non negotiables and that's something that every individual has to define for themselves and really the reason to create non negotiables is Identifying your, in yourself, what you're looking for, not only from a strategy standpoint, but particularly a risk and structure standpoint, you might run into things that your friend introduces you to, or your broker introduced, or some financial advisor, and it just It immediately hits a non-negotiable for you, and that allows you to stop reading an 80 page PPM and move on to something that might be far more interesting.
Um, and so we'll talk a little bit about that and, uh, dive in to some professionals that I actually asked them across a spectrum of non-negotiables what they thought. So I'll share some of their thoughts and what they viewed as non-negotiables. And then, some aspects about, uh, allocations. And so, that's, uh, it's an important aspect to think about.
Most of you are already invested. Some of you might have alternatives, and now you're looking for something new to add, and what does that really mean, and how should you think about allocation and sort of portfolio creation, um, all right, so simply, what is due diligence? I'm not going to read this, but I'm Anytime we perform due diligence on anything today, we're talking about investment management, uh, you know, in funds, uh, you're performing a series of analysis and steps to better understand what you're going to spend your time on or eventually deploy capital to, um, and the important thing that I always found because I did work in venture for about eight years and I worked with a lot of startups, ran a venture fund, and I quickly realized that there was a lot of overlap between You know, due diligence of, say, a hedge fund and due diligence of a venture company, or even how venture companies look at their portfolio companies, because one of the things you need to get into your head is you are a limited partner coming into a company, this company that you're due diligencing, i.e. this fund, really, I mean, it's, you've got to understand The people that work there, the process of the company and the investment product or the return that they provide is the product. So something to think about. You might be able to change your mindset that when you're really thinking about looking at a fund, you're looking at a company.
All right. Uh, types of due diligence. You know, I always say in other things of when you're going through and you finish one piece of this due diligence, and this kind of goes back to some of the non-negotiables that were hit is get to your no quicker. I mean, you really, there's so many things to look at.
There's lots of interesting investments. So how do you weed through? You just got to define through the due diligence. We're going to talk about some of the non-negotiables, how you get to your no faster. Well, the first type of due diligence is what probably most people spend their time on. Um, and unfortunately, most people only spend their time on this, which is the investment due diligence.
It's the far more fascinating and interesting aspect. You're learning how the trade works. Um, you're seeing a unique investment structure and, you know, You get, uh, hopefully not too wowed by the performance numbers, and I will make a note that, uh, performance is a whole other deep dive that you do under the investment analysis piece, um, I just created a webinar a few days ago, um, on some of the nuances of performance measurement, um, and so if you reach out to me or I can share it with Dimitri, if you want to know more about some of the things I had to say about the specific, uh, nuances of performance measurement, Uh, within the investment due diligence class, I'd love to send you a link for that.
Um, but there's far more to a, you know, just investment due diligence. You've got to move on to the operational due diligence. Now, what, wait a second. We got business due diligence, we got operational due diligence. What's the real difference? And the actual definition, at least from the professionals who perform due diligence is Operational is an assessment of anything from the qualitative aspect or the functions that deal directly with the investment product.
So say, you know, the actual people on a trading desk, something of that nature, um, or a specialized system or network that directly relates to the investment. And the business due diligence side is dealing with all the operational structures or solid facilities and things that just don't have a, they're indirectly related to the investment process.
And one thing that I think a lot of people do subconsciously, um, but should be far more conscious about it is the economic due diligence side. That's really involving what's going on in the world that could affect, uh, the particular investment. that I'm looking at, uh, you know, going into. And obviously it's very tough to do a thorough economic without completing your investment due diligence.
But it's important to mesh all four of these together in a process so that you have a full picture of, you know, what you're going to write your check to. So, investment due diligence. Well, this is really understanding that investment process of the fund manager. You know, what, what, what are they trading?
Are they in stocks? Are they in, you know, bonds? Are they in options? Are they a combination of the above? Do they do direct real estate? Is it a venture fund? What type of venture fund? What subclass of, you know, asset are they investing in? What market are they using to, uh, create this product for you to invest in?
And what is the particular strategy? I mean, there's always a subclass, even within Venture, it's not as simple as just, Hey, I'm going to invest in some startup companies. You know, there's dedicated B2B SaaS, there's enterprise SaaS, there's, um, you know, maybe I'm looking for the latest AI, maybe I'm biotech.
Um, so in Venture, you've got to take it one step further and understand that specific strategy. And a key word that I say there is inefficiency. This is the time in the assessment of where if you're going to create an excess return anything you're doing it has to be in an inefficient market now that's just you know if it's not an inefficient market and it's Not fragmented and it's easily accessible with no barriers.
What you generally find is excess return is worked out of it. And then that looks a lot like the general market level return. So it has to be an inefficient space and continually inefficient. Now, wait a second. There's one section over on the other side of the slide there. It says repeatability. So if you have a very inefficient and fragmented space, well, how repeatable is it?
Is this a one hit wonder? Is this a short term investment that, you know, I'm going to invest in a fund that maybe is an evergreen structure, but once I really understand what the investment manager is doing, um, this trade is way too cyclical and the life of the trade may be only six months. Um, or rotating in and out of a certain time period.
I've seen lots of those types of strategies over my career. And then the next part of this is really diving in, and this is where we start to get a blend into the operational side, is the edge, the team. So we've identified what they're doing, the strategy. Is it repeatable? Well, why them? Why the company?
Why, why, why this particular manager? Who's on his team? Um, do they have a network advantage? An informational advantage? Is it a particular system? Um, it's very important for you to understand how and why they're able to generate the returns that They're generating. Um, and the manager, if they can't really explain this in really easy terms, and you kind of walk away from a discussion with them, and you still don't understand their edge and why them, that might be a good indicator, you know, this is not something you want to pursue.
Um, a manager should be quite specific. And his ability to define what they're doing and how they're doing it and why they're going to be able to continue to do it. And then the last sort of question I always like there's no Holy grail in investment world. Um, everyone who's been in this for a while has always tried to find something that works no matter what.
Um, everything can break. Um, I'll tell you a short story when I was, um, you know, working for a hedge fund and we did true arbitrage. Um, literally we could contractually get into a trade and, you know, it was, it was free money. Um, you just, the only thing that we found that could possibly break, and we used to joke about it, is there's nothing that can stop us unless A major Wall Street bank goes out of business and well, that's never going to happen.
We literally used to sit around and in 2003, 4, 5, 6, we felt we were masters of the universe. We had found something that was unbreakable. Well, we all know what happened in 2008. Well, we had a series of banks that failed and the greatest one that kind of created the final collapse and actually closed and hurt a lot of trades that we were in was Lehman.
Um, so even if something sounds absurd. It still can happen. And so you should understand, well, how is that manager mitigating even the absurd, you know, is he even aware of it? Um, you know, and that's where that kind of comes back to that economic due diligence standpoint. What's going on in the world that might actually hurt the trade and how does it break?
I'm sorry, if a manager can't identify. What can hurt his trade or at least talk around it or talk about you know And some trades may have more than one thing that need to break to you know, cause a mass failure You know, they should be able to explain that to you and walk through that with you And now let's not stop just there because that's honestly it's kind of scary a lot of people stop right there because the next parts of due Diligence start to get more difficult Um, you know, except minus in this part.
I think a lot of people don't do justice to performance measurement. You really need to look through the performance and tell a deeper story. And performance measurement really can create a lot of very interesting questions for you to ask managers, um, and really pin them, uh, sometimes how much do they actually know their own fund, um, And like, as you're going into edge, you kind of start branching into operational due diligence.
Now, this was something that pre 08, a lot of people didn't really do. A lot of people didn't think about it. It wasn't glamorous or fancy. And this was really sort of looking at, you know, accounting and back office and treasury management and process and procedure. And it sort of falls into, you know, a number of these sections here you can see on the slide is, well, what technology do they have in place?
You know, what is it that allows them to efficiently engineer their trade? What do they have in place? And technology has become more and more important, but it's also created a situation of where there's a new risk in play and that's where cybersecurity has raised its head. Um, back when I first started doing due diligence, even when I was tearing the company apart, I mean, if they had basic firewall capability, that was really all you had.
And that's all you really required, and the world has become far more complex in the protection of information and security of, uh, of, you know, the information that this fund has, particularly on its investors. Um, you also need to dive into process and procedure. This is, um. This has been a pretty important one of late in the operational due diligence side is cash controls.
Who's monitoring money? Do this kind of bleeds into the service provider world of like, well, in that process and procedure that you're diving into is do you have third party oversight? Are you audited? Um, of late, you're seeing more and more often in the news where, you know, you had fintech platforms that were allowing, you know, money to be moved to where it shouldn't have been moved and then it was misappropriated, um, and you had no checks and balances on what happened to that money.
Um, and you know, I'm a big proponent of really having those third party people in place, asking those checks and balance, asking those questions of, Hey, uh, you know, an 8 million wire just went out to this account. Can you please verify that and where that went and why, and why did it go to this account that's not registered as, you know, a proper account for, you know, performing the trade. Um, I mean, it sounds all simple, but it has been going on, um, for, for years and now it's coming to light, um, where a lot of these companies are getting over their skis or failing or outright fraudulent activity, unfortunately, um, and people.
You know, do they have the right people? I'll tell you a particular story. I went to go see a hedge fund in New York and they were actually running a trade very similar to what I was trading um, when I was at a hedge fund and it was a tender offer trade that involved the borrow of securities. And it was very, very important in tender offers that you had to have the right election for the shares that you were going to utilize for the trade.
And it required a certain person, a corporate actions person, to really have the right network and be able to negotiate for the right shares to pull off an effective tender trade. Knowing the investment leads you to that next level of operational due diligence of where, wait a second, do I have the right people?
Um, and, and if I need to talk to a very specific person that is important to the trade, you want to make sure that you get some of that person's time and you do a verification call of the person who's actually a key element. Um, so very important. I mean, in external events, we kind of talked about the cybersecurity aspect of, you know, the new front of operational due diligence.
You can actually have external factors now more often than we had seen historically, um, you know, for funds as, you know, technology expands and we become even more of a, a global market space, you know, these attacks can come in from multiple countries. So, business due diligence, as I stated earlier, is anything, you know, sort of operational that's not directly related to the investment itself.
Um, still very important now, I joke because this is actually still a process of business due diligence is the physical facility and office. Well, that aspect of due diligence might have changed. Because of COVID, we have multiple funds and, and organizations that they have might have people all over the place.
They might have a central office or they might have no office at all. Um, and so there's positives and negatives to that. I mean, when everyone's centralized in one place and something catastrophic happens to that office then that can sort of be a major event for the fund and trigger a number of different things about redemptions and other things that might be in the PPM.
Having dispersed office space or no central hub, you know, does offer a little bit of, uh, you know, physical uh, facility safety, but you've got to understand also what controls are they putting in place through software and do they have the proper office equipment and infrastructure to ensure that these people in various office spaces are still controlled and monitored and have limited access to information that they don't need, um, and are unable to perform actions that they shouldn't be doing.
Um, so, I mean, there's, there's a new, new level of due diligence that needs to be assessed and it's a little bit more difficult, um. You know, to, uh, to complete that. And I think, yeah, Dimitri, you had, uh, You had a couple poll questions. I know we're gonna walk through, so, you know, Dimitri, if you want to throw up one of the poll questions, that'd be great.
Dmitriy: There's been a couple already initiated, so.
Chris: Oh, okay, great, good. I didn't even see them. Um, my screen's not showing me that, so. Yeah. Apologize. Um. Yeah. So, um, so yeah, just let me know if you need me to, you know, stop and wait for certain answers on poll questions. Um, so, and then obviously we circle back around to, you know, on the business side, you have that bleed of, you know, technology and IT support.
There again, cyber security. Um, it's, it's a huge, huge issue. Um, I can tell you from our standpoint, we get some of the craziest emails and craziest things of people trying to get access to systems, even in our business. Um, some of them are super obvious. Some of them are, uh, super tricky. Um, today I got one that told me my partner, um, needed a new bank account for his paychecks. So that was kind of an easy one for me to catch. But, um, if we're a bigger organization, you know, someone might have accidentally clicked on that. Um, but it is, uh, it's everywhere. Um, so really understanding how people are protecting and what are the policies and procedures around that is more important than ever.
And then human resources. Um, do the new background checks on people. Um, what information can be shared about those background checks and you know, the bios of the key people within the company. Um, obviously have you, you know, double checked as the owner of the business or, you know, the prime manager of the fund.
Um, you know. Nobody has any felonies. No one's been indicted for securities related issues. You know, a number of different things. Those are things you want to check on. You want to ask those questions. You want to get that information. So to make sure that, you know, the manager hasn't, you know, hired somebody who's already been brought up on multiple securities charges.
I mean, that would be a huge red flag. I mean, you're, you're, you're literally, um, in the securities business and you've hired someone who's been, you know, brought up in a case whether they've been Found guilty or not, um, it's equally concerning. To see if someone was, you know, whether you were charged or not, that you were being brought up, you know, more than once, um, in, in securities related issues.
Um, you know, that would give me a huge red flag. Um, and then economic due diligence. Um, like I said earlier, well, Here's some that I've just kind of threw up here. And this is, this is not a set list, you know, there's tons of things that go on in our, in our global economy now. So we need to understand, you know, and what's going on recently is, okay, we've got some interest rate issues.
You know, the Fed just, you know, handed us the fastest increase in interest rates in history. Um, it's having a catastrophic effect on a number of different investments, but it's also helping others. Um, are you looking at the investments or thinking about the investments that interest rates and rising interest rates or more, you know, stable interest rates at a higher level could be benefiting from, you know, then there's inflation.
Well, it's, it's obviously going to be pretty sticky. Um, the Fed has done a fairly good job at fighting what they can. Um, but I think everyone out there can kind of understand that their goal of 2 percent inflation, given a number of different economic factors, um, is becoming, Quite a, you know, unachievable number.
Um, and then we got geopolitical risk, wars, uh, economic failure of other countries. I mean, you know, everyone's like, oh, well, China's going to have some massive economic issues. You know, what you're trading in does, will you be affected with that? Those are something that you need to ask the manager. You need to ask those questions of, hey, here's a series of major events that are going on.
How does that affect what you do? Um, and, and, you know, what safety protocols have you put in place? What risk mitigations have you taken to offset some of that risk? Now, obviously you have to be open to some level of risk to make a return. You can't have a perfect hedge. Um, I remember, um, in '09 and '10 people would ask me, well, I need you to build a portfolio that's 08 proof.
And I said, well, okay. Um, you're basically asking me to build a product that will produce almost no return and might in some instances produce a negative return simply because the safety measures I have to put in and the cost of that insurance. Um, you know, so you do realize managers have to be open to some level of risk.
Um, if they're going to make any level of return. Um, it's just a matter of you being comfortable and wanting exposure to that risk and the access to that particular return. And they've mitigated ones that you do not want access to. Um, and then elections. Um, there's always a lot of regulatory changes, saber rattling, and a variety of other things that can create, you know, volatility, whether that be good or bad.
There again, depending on the trade around, you know, an election period. And, you know, we could go on and on about a number of different economic occurrences, but those are some of the big ones that are going on now. But it's important for you to ask those questions because this is also one of those key aspects, as I said earlier, one of these factors could be a cycle that would create a negative return and break the trade for a manager.
And, If you hit on that, um, then you need to really, you know, go after that and really understand how that manager is mitigating that or are they at all. And now you understand that you're exposed and so that that type of event, if it does come to fruition, you know, could send you in a position to where maybe the duration of the trade is extended or there's an outright loss.
All right, moving on. Um, as I said earlier, Um, I think it's very important in a due diligence process to come up with for yourself. Uh, and like I said, this is, this is individualistic. Um, each one of you has your own liquidity needs, your own risk aversion levels. You have your, you know, your own playbook.
Um, you already own a series of assets, so you might be looking for, you know, one asset and not another. Um, and you need to come up with non-negotiables. Now they can cover a variety of different Aspects of what a fund does. And so I asked a series of professionals. These were, uh, family offices that invest in alts.
These were RIAs that have internal alt platforms. And some of these were just, uh, you know, wealthy individuals that have been doing alts for, you know, 10, 20 years. Um, and I just kind of asked across the board and you'll see, you know, they're quite differentiated. Um, one person was saying, well, I need to, and obviously he's referencing something in private debt here.
Um, You know, I need to be first position. I, he needs to be in a preferred position. So he is not, you know, He's more at the first of the feeding trough rather than down the line. He wants to make sure if something goes wrong I've got the right to be paid out first or any other returns or accrued and unpaid interest in the case of private debt He wants to make sure he's first Um, and maybe that's something if you're looking at private debt, that would be something you would want as well.
Um, others wanted a short term. They didn't want duration now, obviously in a rising interest rate environment you certainly do not, you don't want duration. Duration is the implied of, well, the, the term of the, uh, how long the trade may go. Um, you don't want to be in a long, uh, dated trade. You want to be in something short so that you can, you know, not be affected by rising interest rates, but be able to recycle money quickly and capture interest rates as they rise.
So, this particular person wanted to be only in instruments that were relatively short term. Um, and some people wanted backed by real assets. Um, so obviously, perhaps, you know, they've got, um, you know, actual value and functionality and participation of ongoing value of a corporation and venture debt or in real estate, uh, You know, I, you know, I want to invest in, you know, the actual physical building.
I, you know, I want it to be an LP in a fund or a GP structure, or maybe you're going to do a direct ownership of your own property. So you want an investment where there is an asset you can, you know, you can go kick, or you're looking at, you know, a timber fund, something of that nature. You, you want something tangible.
Um, you know, that's been, uh, an important aspect for the last couple of years, for sure. Um, Some people were going after like, well, particular natures of the fund manager. Um, they want the fund manager to really be able to articulate the differentiated opportunity. Well, this goes back to what I was saying about the inefficiency and the manager being transparent and being able to understand what inefficiency are they capturing?
Um, and obviously is, is it still repeatable? Um, they want a definable niche. Um, so, um, they want people to talk about how things failed. I loved that. I mean, how many people, how many marketing decks do you look at and it's in the last few pages are nothing but all the great trades that person did and how he's done somehow nothing wrong and he shows you all the best.
That is just ridiculous. I mean, I, we do not learn from successes. We learn from making mistakes. So it is super important in your due diligence aspect. Go out there and really, um, you know, ask for the failures. And the natural, the natural next question is, okay, you walked me through how that trade failed.
Well, what are you doing differently? Um, or do you understand why that failed and you've changed, you know, some type of operational structure or something of that nature within the trade? I mean, those are the, those are the things you really want to understand. Um, and it also, as you can see here, you know, success and recession, really the way to better say that, I think, is How did they do when cyclically they were in a downswing, uh, you know, within their particular trading strategy, you know, did they still perform? Um, you know, some people, you know, might, if they're in a long short hedge fund, you might be where dispersion is minimal. Wow. For the last 10 years, hedge funds have really had a tough time until the last couple of years.
Well, how did they do in that time? What did they change in their portfolio to deal with? Hey, the shorts are not going to perform. Okay. That's a, that's a great question. Um, you know, and some people, and this is something that's a lot of people don't talk about because, you know, you know, it doesn't always apply to everyone.
Um, but there's a lot of apprehension about people who are like, well, I've been doing this for the last 10 years. Well, somebody who says that nowadays is basically telling you, I've only been investing and running and doing this trade when times were good. Um, until recently now they've been kind of punched in the face and this is a perfect time to be doing due diligence around well, how did your trade do in the last couple of years?
Not so much, you know, the time period before that, um, it'll give you insight into how do they deal with adversity? Um, because, uh, I know a lot of people who are doing due diligence and, you know, 20 and 21 and well, things still were going relatively okay even during COVID. Um, so it was hard to see how people might fail in a truly tough time because they just hadn't seen that before.
Um, and it's important to understand not only how the trade works, but how the team works in times of adversity. Uh, trust me, I mean, in 2008, you saw a lot of teams crumble. They just had no idea. They were frozen in fear of like, well, I have no idea. My, my credit line is being pulled. My trades are all down.
They haven't recognized anything, hopefully. Um, but it was a time where no matter where you turned, um, something was broken. And how are you going to deal with that? Um, it was an important time, sort of a test for people, and a lot of people in the investment world haven't, haven't seen that in a, in a material way.
Um, and then some people went after personnel. Uh, it was important for, for them to write money they need to see gender diversity within the management team. Um, You know, they need to see this is obviously a venture related that the CEO had successfully launched and exited, you know, previous companies, you know, they wanted to see previous success if they're going to write another check into a startup company.
Um, and then the core team's previous successes. So you might have veterans that have been around for 30 years and maybe this is a new fund strategy for them. Um, but how did they do and what were their successes, you know, previous to this fund? Um, it, it may not be directly related to, oh, what would you return in this strategy, but it could give you in that, like I said, that earlier insight into, well, how did they deal with 08?
You know, walk me through some of the stories of the things you had to deal with and how you managed those. I mean, I think that's a great question, um, for those people who were, that had to go through that. Um, some of the other non-negotiables, fund size. You know, they want, um, it's kind of both these sort of under fund size, I think are kind of related because I think they deal with what is capacity.
It's a great question. You need to understand and ask, well, does the manager understand the capacity of what they're investing in? You know, if they're dealing with something that's very inefficient and fragmented, well, the other side of that coin is you're probably not going to be able to run billions of dollars doing it.
Um, so that's something you should ask and you should understand of, well, what do they think the capacity for the trade is? Um, and how are they going to manage that as they grow? Um, and so these people were kind of going after, you know, particular size and making sure that they could stay nimble. Um, that a lot of the mega funds, which is true, you know, was true 10, 20 years ago, still true today.
A lot of the mega funds, people run to safety of size, but when those people need to move, that's like turning a battleship. It doesn't turn quickly. So if something goes wrong in one of those funds, it's very difficult to, to be nimble. Um, and you know, you get so many different people with so many different cross objectives in that fund, you know, you may still like the fund and then, you know, the other half of the people are all trying to get out.
So you're going to be left in a situation where, you know, 50 percent of the fund redeemed. Um, that's not always the best position to be in. Um, money matters. Um, some investors needed to have transparency. They needed to understand pricing and valuation. I think that's huge. In today's age, there are certain trades you can't get transparency.
Um, You know, that's just a fact. And if that's one of your non negotiables of, hey, I can't get it. Well, then that's not a trade for you. Um, but I will tell you there, there are particular trades, they call them zero sums. There's only a dollar in the trade, um, true arbitrage and event driven aspects. You know, they if they told you what's going on, um, it could, you know damage their ability to make money.
Um, but for the most part, I think you should be able to receive a great deal of transparency across a number of different, um, Alternative Investments. And then I, this person obviously mentioned pricing. I sort of changed that word into valuation, who values what, how are things valued? Um, that's super important.
And if the manager is the one valuing it, what's their process and procedure of doing so? Um, low leverage. I know some people who want no leverage. I mean, if you have leverage in your fund, they don't invest. I mean, um, I don't think leverage is as bad as most people are making it out to be. Um, if it's put in the right hands, uh, your job is doing your due diligence is to understand if they're using leverage.
Is it in the right hands? And have they thought through the various risks that come with leverage? Because leverage is not just a risk of volatility within the investment. It's also an operational risk because you're taking counterparty risk. Um, something could happen at the lender that has nothing to do with your trade and they wake up and say you got to return all the money.
You didn't do anything wrong, but you're now in a forced situation, uh, at least the fund is in a forced situation, um, that they will now have to de lever themselves. Um, so that's something you, you know, that a lot of people kind of forget about leverage. People tend to focus on, you know, the leveragability of the investment, but it's also an operational risk.
Um, this other person wanted, uh, no crypto. Oh, okay. That probably worked out. That was probably a good decision over the last, uh, couple years. Um, what the future brings, we have yet to see. Um, and as I said earlier, one of my favorites is, and I think a lot of things could be mitigated with proper third party independent valuation and oversight.
Um, you know, really monitoring, you know, cash movements and control of cash movements and pre negotiation of where, what accounts can be used and what they're used for. Um, I think that could mitigate a lot of the problems we've seen, um, where funds have been misappropriated in large dollar amounts. Um, I don't know if anyone saw the recent news about, you know, I'll not mention names.
I think everyone can figure out who it is. Um, moved money, um, to a manager in the real estate space. There's a FinTech platform that moved money, uh, to a, uh, a manager and the manager didn't buy a property at all. He went in and bought shares and options of, um, First Republic, because he was making a huge bet that it was going to be saved.
Um, and obviously that didn't work out well for him. So that money literally almost completely disappeared and it was a massive misappropriation of funds. Um, and there was no oversight checking of what, what and where he could do with that money. So he had, he received the money from the FinTech and then moved that money into a trading account.
Okay, if a fund administrator was on that and had transparency down to the transaction, which they usually do, uh, they would have been immediately like, where did that money go? And why? I mean, it would have been an immediate red flag. Um, that would have been noted. Um, but nothing was in place. So, um. This person was no sin related.
So obviously they're not a friend of, you know, cannabis or alcohol, alcohol, fire and tobacco, tobacco and firearms. So, okay. Um, that's, uh, and then, you know, one of the big things that people are pushing for is, you know, ESG focused initiatives. Um, the, you know, this was a family office that wanted to have a lot of their investments in one way or another, according to their definition of ESG, um, that that's what they were focused on.
Um, and here's a really specific one. One person just said, Hey. Anything that deals with the privatization of the prison system. Um, I thought that was fairly interesting. Um, I'd never heard that one before, but that was their personal preference. Um, and, and that's okay. You can have your personal preferences.
That's literally the part of building up your non negotiables because you want to have a list of these where you can just get to your no quickly and move on to the next investment, uh, that will, you know, match what you're looking for. Um, in the allocation section, um, once you've completed your due diligence and really understand all these moving pieces, um, now this is something that is really used for large institutions.
They will have minimum investment dollar amounts. They will have maximum ownership of funds. Um, not everyone's in that situation. Um, but if you're looking at emerging managers that, you know, maybe they only have 10 or 15 and they're in a really, really niche trade, if that's something you, you know, you, you're interested in because a lot of those people can really truly create, you know, amazing returns. Um, you might want to develop like, okay, hey, how does this affect the portfolio of what I own? And, you know, with that, what minimum investment dollar amounts would I want to deploy? And what's my maximum ownership level of a particular fund or individual company?
It's something that you should probably develop for yourself and start thinking about the greater aspect on the back end of due diligence of, well, how does this due diligence and all this work affect what I'm adding to my portfolio? Um, and so I just wanted to add that note, because I think that's an important aspect of when somebody does all this due diligence, it's not just about, do I write the check or not in the fund?
I think people need to think broader about, well, how does that really, you know, affect what else I own? Um, some people get caught up on the fascination of the individual investment, and you know, I just want to make sure people, hey, take that time to sort of, is this the same risk that I'm taking in five other investments, or is it differentiated?
And how do I want to structure that? Um, that's, I mean, if people have any specific questions about due diligence, I mean, please, you know, This is your opportunity. Uh, you know, ask away. Um, if there's something like, oh, hey, Chris, do you have a particular question you ask about this? Um, you know, let me know.
I'm, I know that a lot of these, you know, webinars, you get introduced to a number of different ideas and sometimes the application is difficult. I mean, how do I apply this? You know, what, what question would I actually ask? So, um, if you have one of those, you think about it now, um, certainly ask, if not later on, you can always reach out to me.
Thank you. Um, I just left this up here. This is, uh, a little bit about what I work on. I, we run the Kirkland Income Fund, which is, you know, a microbalance commercial real estate fund. Um, and so, uh, it's focused on principal preservation. It is an alternative fixed income. So, I mean, that's really if you're thinking about the access of, hey, why would I invest in this?
It's, hey, I'm trying to find something alternative for the fixed income aspect of my portfolio. Um, so certainly if you have any questions about the fund, you have questions about due diligence, please ask now or you can reach out to me via my email. There's my website. Um, I am not difficult to find on LinkedIn if you want to connect with me via that as well.
Um, I connect with a lot of people through LinkedIn and then Um, you know, allows us sort of that avenue to, you know, have a one off conversation that might be more directed toward, you know, what you're looking for.
Dmitriy: Uh, Chris, we do have a couple of questions. So first one, um, among the types of due diligence, which one should I focus on when I get started performing due diligence?
Chris: I actually, I actually go after the team first. I start with a little bit more on the operational side because I want to understand who's doing what, what their background is. And I want to understand, you know, some of the edge of the team. Um, I, I don't like to be led by performance. Um, It's just something I know that's not normal for a lot of people.
A lot of people are driven to look at performance first. Um, but we found is in the research, especially from an institutional shop, if you're too focused on the investment management or the investment return aspect, it can... It can actually affect how you view other aspects of due diligence. You can, you can kind of sort of almost trick yourself.
Um, we're like, oh yeah, that kind of is questionable, but man, he really did a great return profile during that time period. Okay, so now you're, instead of asking the questions of, Hey, how did you do well in that performance given what you operationally put in place? You know, that'd be a better way to attack it.
I mean at the end of the day I guess the better way to think about that that answer and you can kind of start anywhere you want that where your passion is and go from there, but you really should cover all the aspects because they are not mutually exclusive from each other. They all overlap each other.
Um, cause everything comes around to that fund is creating a product and that product is a percentage return. And so if you need to understand, I mean, how many times would you do analysis of a, of a manufacturing company and only look at the product? Well, of course you'd go look at the assembly line and you'd look at all the pieces and the, and the raw materials and everything else that goes into create the product.
I mean, That would be crazy to not, but a lot of people, when they look at an investment fund, they usually start with investments and end there, and they kind of forget, wait a second, I actually didn't go look at the assembly line. I'm one of those people that, hey, look at the, look at the assembly line first, understand the materials and the, and the management team that's running it.
And then, then obviously you have to go back and look at numbers. And like I said, the performance measurement due diligence is pretty involved. Um, It's, it's not as, to do it right is not as easy as just looking at a return stream and going, oh wow, they really did good.
Dmitriy: Uh, Chris, one more question here. Um, what are the, some of the example, couple of questions that, uh, I should start asking when performing due diligence?
Chris: I'm just gonna, you know, gonna just broadside me there. Uh, not, not specific, but, um, you know, okay. Um, Like I said, I like to go after or right off the bat, um, tell me what you do. Okay, great. Walk me through the trades that didn't work. Um, that's one of the first things I like to go for is put people on guard of like, I want to talk about how you failed, not how you succeeded.
Um, that makes some, a lot of people uneasy, um, but you'll realize if the person is very accepting to that and is like, Oh, great question and they go right into one or two things and how they dealt with it. Okay, well, now maybe you've got a manager that is a little bit, um, you know, understanding that. Not everything goes great.
I mean, if you're running a portfolio of any investment, you're going to have some of them go wrong. I mean, I've never seen any fund who's ever had anything, everything go right. There's always things that don't work out. And that is important to understand why they didn't work out or how the decision was made to invest in it.
I mean, it happens. I mean, you know, if you're on this phone call, you've never invested in anything that went wrong. Well, then you are better than every professional investor that I've ever met, and I've met a lot of them. Um, it just, it just happens, but that's what you want to go after. So that's one of my first questions I like to go after is like, great, I've read through your marketing deck, super, now let's talk about the other side of the coin.
That's one of my first questions. Um, You know, another important question for me is, um, I immediately go after service providers and I immediately start verifying those references. I want to understand you said you worked with these people, um, Go verify it. I was just having lunch the other day with a professional investor and he kind of laughed how professional he, I don't think he was like, Oh, I don't know if I'm really professional.
I got into a startup and the guy said he was doing business with XYZ company. Um, and he's talking about, uh, obviously a fraudulent situation where he lost money. And my first question was, well, didn't you go, the guy basically showed you invoices that he was working with this company. Did you call the company and verify that he's actually working with them?
And of course, Well, he didn't. Um, and sometimes it really can be that easy. You can strike very quickly, um, on references. Um, Oh, I do business with these people or, and you just call them. And if that guy's like, well, I've never heard of this person. Well, well, yeah, no, you're done talking to that guy. Um, so that's another one I go after quick.
I try to get to the no quickly. And I've, I've discovered a few jugglers over the years. of where, you know.
Dmitriy: All right. Thank you so much, uh, uh, Chris, uh, for the insightful presentation and, uh, the, the answers to the question. Yeah. If you guys have any questions for Chris, reach out to him on his website or via email. And if you guys have any questions about how to utilize your retirement account to invest, reach out to our office.
We will be happy to chat with you and see what best solution fits you. Thank you again for joining us and wish you everyone a good night. See you at the next webinar.
