Top Alternative Investment Due Diligence Best Practices

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The market volatility and unprecedented disruption seen in the wake of the COVID-19 pandemic once again reminded our industry of the importance of a diversified investment portfolio. The most diversified portfolios include alternative assets (alts), in addition to traditional ones.

The “Pro List” for alternative investments includes potential tax benefits, as well as protection from market turbulence. While investors are attracted to these elements as well as the potential for receiving a higher return than what typically comes from traditional investments, alts come with their own share of risks as well. For individual investors and institutional investment allocators—such as pensions, endowments, foundations, and family offices—considering different alts as part of a broad investment strategy, due diligence is critical.

The Greenwich Roundtable’s 2010 white paper, titled “Best Practices in Alternative Investments: Due Diligence,” puts it quite bluntly:

Alternative assets are founded on trust, as we give managers an essentially free hand to do as they wish. Alternative assets are less regulated than traditional investment options, and such flexibility can help by allowing the manager to be more adaptive and to pursue more creative strategies. But it can hurt, as the high fee structures attract investment managers of all levels of competence and integrity and can give them heightened incentive to take undue risks, or even to cheat. 

Firms can fail not only as a result of poor investment performance or fraud, but also for non-investment-related reasons, such as poor risk management, weak operations, compliance gaps, and promising too much liquidity to investors. 

Our only defense is due diligence—the tremendous amount of research that we should do before deciding to make an investment.

Of course, each alt opportunity is unique. Therefore, the proper due diligence strategy should be created according to the specifics of each investment option. It should typically include an initial evaluation phase, as well as ongoing monitoring throughout the lifecycle of the investment.

“Expect that the vetting process will take time … Don’t rush through due diligence because if you do, inevitably, you will miss something,” warns a FactRight blog titled “Top 7 Alternative Investment Due Diligence Considerations.”

In 2017, the Alternative Investment Management Association (AIMA) published a new edition of its flagship due diligence questionnaire (DDQ). The original version of the “AIMA DDQ,” which was published in 1997, aimed to help standardize the due diligence process for alternative investment managers and investors.

According to AIMA, the latest version of its Illustrative Questionnaire for the Due Diligence of Investment Managers is used by investors assessing hedge fund, private credit, and private equity managers.

When launching the updated version in 2017, AIMA’s CEO Jack Inglis said in a statement: “The due diligence process has evolved significantly since the first AIMA DDQ was published in 1997. Ever more investors are undertaking significant due diligence processes prior to making an investment. Many alternative investment fund managers have transformed into diversified multi-strategy, multi-product firms seeking investments from a wide range of investors. These factors have created challenges for investment managers and for investors alike. Reacting to these pressures, AIMA has modernized its suite of DDQs, making them more flexible, easier to complete and more data-driven than before.”

Here are some key topics to consider during due diligence and ongoing monitoring of alternative investments:

Due Diligence

  • Potential tax liabilities and consequences
  • Cost of regulatory compliance
  • Fee structure
  • Liquidity and/or illiquidity

Ongoing Monitoring

  • Compare investments return to benchmarks
  • Review periodic communications
  • Stay aware of, and prepared for, potentially changing circumstances

AltsAxis has centralized the vast alternative investment universe on one secure, proprietary mobile ecosystem. Pensions, endowments, foundations, family offices, and other institutional investors can access robust, dynamic, and unbiased data on a broad spectrum of alternative asset managers, as well as cutting-edge data modeling and visualization features, to make informed decisions on alternative investments. The Axis platform meets all sourcing needs for allocators, and enables them to securely facilitate virtual and in-person introductions to the alternative asset managers they follow and track. By allowing allocators and managers to continuously communicate and share information, the AltsAxis social network strengthens engagement within, and adds much-needed transparency to, the historically fragmented alternative investment universe.

To learn more about how you can make informed investment decisions, reach out to us today.