Understanding Alternative Investment Assets in Detail

In our daily lives, we’re all natural-born detectives when it comes to due diligence. Think about it: you wouldn’t buy a shirt without checking its fit, or pick a smartphone without scrolling through its specs. We poke, prod, and scrutinise everything from avocados in the grocery store to the reviews of the latest binge-worthy show. It’s in our DNA to be thorough, especially when our hard-earned money is involved.

Now, take that Sherlock Holmes spirit and apply it to alternative investments. Private investors need to assess the risks and do ample research to figure out the possible pitfalls before investing.

Throughout this module, we’ve journeyed through the nuts and bolts of alternative assets. Now, in this final chapter, we’re zeroing in on the critical skills of risk assessment and due diligence.

In the private markets, hazards can crop up at any time. Investors are essentially in danger of two things. Firstly, the danger of losing their capital on the whole and secondly, the ambiguity surrounding the nature of returns.

We can broadly group the hazards into three main categories — market risk, liquidity risk and funding or cashflow risk.

1. Market Risk

   Market risk, as the name suggests, includes external economic factors that affect the alternative investment space on the whole.

   These risks are ever-present, reflecting the ebb and flow of economic conditions. Just as a sudden storm can transform a landscape, economic downturns, political instability, or changing market sentiments can significantly impact investment outcomes.

   Add to that the fact that private investments are innately illiquid in nature, and we have quite a Catch-22 situation on our hands!

2. Liquidity Risk

   Private markets are not so easy to convert into quick cash. This is why many private funds have a ‘no-exit’ sign for a while, a “lock-in” period where investors can’t pull out their money. It’s like fund managers saying, “Please keep your hands and feet inside the vehicle at all times.” They don’t want hasty withdrawals causing a domino effect on everyone else’s investments.

   And even when there’s a light at the end of the tunnel, an exit strategy, it’s no walk in the park. Selling your stake in a private company isn’t a click-of-a-button affair like in the stock market.

3. Funding or Cashflow Risk

   There are two separate angles to this.

   First is the risk arising from the unpredictable timing of capital calls in private equity funds. Investors might need to keep their funds liquid for extended periods and this can have an impact on returns.

   Private investors generally don’t provide all their capital to the GPs right at the beginning. Instead, only a portion of the capital is taken upfront. Then, the GPs evaluate their deal pipeline and finalise the portfolio companies. Once due diligence is completed and the fund is ready to acquire the asset, the GP calls for the remaining capital. This can, however, take months or even years at times!

   While they’re waiting, investors can’t allocate these funds to other investments. Instead, it stays idle and this decreases the returns on that capital.

   Secondly is the risk from the uncertainty of when and how much return the investment will yield. It’s as if you’re driving down a dark road without your headlights — you don’t know when you will reach your destination.

   Unlike more liquid assets, where returns can be more predictable and consistent, private market investments can have varied and sometimes delayed cash returns.

What is the best way to understand the risks?

The due diligence process is a meticulous expedition to ensure the investment ship, in this case the alternative investment fund, is seaworthy. Every single nook and cranny has to be checked to make sure there is no possibility of a leak springing on the voyage.

It begins with a deep dive into the management team of potential investment funds, assessing their stability and potential for growth. Next, the composition of the fund portfolio is scrutinised — evaluating the companies and their contribution to the fund’s performance. Understanding the fund’s structure and the investment’s position within its industry helps in gauging its potential to succeed consistently.

Let’s explore this in detail:

1. Performance Excellence

   The importance of the management team in the success of the fund is central. This step involves a deep dive into the their abilities and the relevance of their experience in ensuring consistent fund performance.

   The goal? To prioritise those funds where the management team has a strong track record. After all, nothing speaks louder than steady growth.

2. Quartile Performance

   Here, the focus is on consistent top quartile rankings in comparison to market indices like CRISIL and Prequin. Regular rankings in Quartiles 1 and 2, for instance, can be indicative of future success.

3. Distribution of Performance of Investee Companies

   This step assesses the strategy of evenly distributing investee company performance to reduce the reliance on a few companies. After all, if just a few companies are pulling the weight of the entire portfolio, it can be quite risky.

   This stage is about discovering how diversified the fund’s portfolio is. The aim is to understand whether the fund’s performance will be impacted if a few portfolio companies suffer.

4. Strength and Resilience of Fund Managers’ Franchise

   This step assesses the effectiveness of the fund managers in deal flow, support for scaling companies and exit strategies. It’s about evaluating the markers with the objective of identifying robust and resilient franchise.

5. Replicating Success

   Almost anybody in the investment markets can execute successful investment strategies once or twice. After all, it could be anything ranging from beginners’ luck to the sheer balance of probabilities. The true skill lies in replicating success over and over again.

   This step involves exploring factors like staff retention, carried interest distribution and strategy adaptability. The aim is to identify funds that can consistently execute successful investment strategies, no matter what the market conditions are.

6. Robust Governance

   The last step is to ensure that the fee structures and the composition of the investment committee are aligned with the industry standards. This is key to ensuring ethical and effective fund management.