Not All Alternative Investments are Cut from the Same Cloth
Updated: Feb 24, 2021
The term alternative investments evolved to become a catch-all phrase for investment products whose returns are unlike those of traditional stocks and bonds. This area of the investment universe has been a focus at Northland Wealth due to the potential for improved consistency of returns, something that is hard to achieve with today’s 24-hour news cycle and constantly changing narratives.
The popularity of alternative investments has encouraged many new entrants into the marketplace and the quality has been watered down. Our Research and Portfolio Management team spends a lot of time identifying, performing due diligence and continuously monitoring the solutions from around the world in order to find the best managers in their respective asset classes.
Each asset class has its unique quirks and unless you have an in-depth understanding of its unique attributes, you as an investor may be misled by the quoted performance of the asset. The following will highlight some of the risks that Northland identifies in our industry leading due diligence process. (Northland was Shortlisted at the 2020 Private Asset Manager Awards held in NYC for the category of Best Due Diligence, where we were recognized as one of the best firms in North America).
During Northland’s due diligence process, we examine over 50 areas to better understand potential risks. Below are some insights:
1. In private debt, not marking loans to market keeps price volatility muted and artificially inflates risk-adjusted returns.
Private debt assets have grown significantly because investors are not satisfied by low interest rates in government and corporate bonds. Private debt managers took the place of traditional banks after the 2008 recession to lend monies and provide lines of credit to private companies.
Like any other portfolio, these assets must be valued periodically. Unlike listed instruments where values change daily, these assets are not actively traded, and they are usually held to maturity. These managers follow the IFRS or ACS1200 valuation principles, which dictate that if a loan is going to be held to maturity and is relatively short in duration, then there is no need to constantly reprice the loans. The lack of price fluctuations understates the true risk of the loan portfolio.
2. The rising trend of using lines of credit (LOC) against limited partners’ (LP) undrawn commitments inflates the internal rate of return (IRR) performance.
A major feature of a certain subset of alternative investments is that investors first make a commitment to invest in a fund, then the fund searches for appropriate investments, and as allocations are made the fund makes ‘capital calls’ on commitments made by investors. This is different than traditional investments, whereby the entire intended amount can be invested right away. Commitments complicate the process, because it often takes 2-3 years before funds are fully called and the intended exposure is gained. Rather than calling capital, asset managers often make investments using a LOC provided by the banks and backed by the legally binding commitments of the investors.
The managers utilizing LOCs will argue that this is to the benefit of the investors because it saves administrative costs and allows them to act quickly. The reality is that the use of a LOC boosts IRR, which is a common performance measure by which those same managers are compensated and it is used for comparative purposes.
3. The rising trend of using general partner (GP) led secondary trades for orphan/single positions artificially shortens the life of funds.
This follows the trend of private equity managers trying to manipulate the IRR measure, as it enables them to have the ability to fundraise for future funds and is the main measuring stick used to compare funds.
A fund would usually invest across 10-20 separate positions to diversify its risk. Often a small number of holdings under-perform and what often happens is that after all the investments are liquidated and returned to investors, there are 2-4 laggards that remain. The GP wants to provide liquidity to encourage investors to commit to their next fund and investors want to eliminate small holdings and simplify portfolios. There has been a trend towards selling those orphan holdings or spinning them off to another investment vehicle. This shortens the life of the fund and improves IRR.
As most alternative investments are not regulated entities, it’s imperative to understand the nuances of reporting by asset managers; doing so allows Northland to properly understand the risks we are taking for our families. To conclude, our team devotes many resources to stay on top of trends in the growing alternative investment industry. We are dedicated to our mandate to identify, access and invest in the best institutional quality solutions on behalf of our families.