Due Diligence for Private Alternative Investments: Key Considerations and Checklist

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Key Takeaways

• While alternative investments can provide diversification and outsized returns, they present their own unique set of risks including illiquidity and volatility.
• Do the obvious due diligence — deep dive into the manager, strategy, structure, performance, and vetting claims.
• Knowing fee structures, liquidity terms and governance curbs investor enthusiasm and shields against hidden fees.
• Considering the human elements like manager incentives, culture and succession planning promotes long-term investment viability.
• Conductor your own due diligence, not just using marketing materials, but doing channel checks, stress tests and scenario analysis to expose risk and check assumptions.
• Continued oversight and periodic performance reviews are critical to adapting strategies and keeping investments aligned with financial objectives.

To do due diligence on private alternative investments is to verify key information about the asset, its management team, fees, risks and historical performance.

Reviewing legal documents, interviewing management, analyzing third-party audits figure into the process. Most investors employ checklists and external assistance to reduce risk.

Being aware of these steps assists in making informed, prudent decisions. The main text explains each critical step in plain language.

Understanding Alternatives

Alternative investments are all the investments other than stocks, bonds, or cash. These are real estate, hedge funds, private equity, venture capital and other alternative vehicles. Investors turn to alternatives for diversification, the opportunity to earn enhanced returns, and to reduce exposure to the volatility of traditional markets.

These investments carry their own risks, such as liquidity and valuation challenges, and the lack of transparency. Today, alternatives constitute an increasing portion of worldwide money flows, and due diligence has never been more important.

The Appeal

Options outside of the usual investment portfolio can yield unusually high returns. This pull is particularly strong when rates on bank deposits or government bonds are low.

Including alternatives in a portfolio helps diversify risk. If conventional markets sink, assets such as real estate or startup equity or asset leasing could remain flat or even rise. Certain alternatives, such as private debt or infrastructure, possess income streams that don’t behave in the same way as stocks or bonds.

Investors gain access to things not available on public exchanges, such as direct startup investments or specialty real estate. These decisions can assist in realizing very targeted financial objectives, like consistent income, capital appreciation, or even tax considerations.

The Risks

They have actual downsides. One of the biggest is liquidity risk — these assets tend to be difficult to sell fast. Some funds lock up money for years, so investors can’t cash out whenever they please.

Market risk is a separate concern. The prices of alternative assets can fluctuate drastically, particularly in stressed markets. A lot of alternatives are less transparent than stocks or bonds.

It’s not always obvious what you possess or how it’s handled. This ignorance can result in big losses if things do go awry. Before investing, they should thoroughly research all potential hazards and investigate any conflicts between managers and investors.

The Landscape

The realm of alternatives is vast. It includes private equity, where they invest in private companies, hedge funds, which employ hundreds of strategies, real estate, from office buildings to farmland, and newer alternatives such as invoice discounting or asset leasing.

Private equity and venture capital are particularly in vogue at the moment, with increasing numbers seeking growth beyond public markets. The guidelines for alternatives vary by country, but the majority need certain legal and tax scrutiny.

Crowdfunding platforms have opened up access, allowing even jumbos to get in on the game. Trends indicate an increasing flow of global capital into alternatives—by 2024, they could account for 17% of assets worldwide.

The Diligence Process

Due diligence on private alternative investments is about more than box ticking. It aims to identify risks, inefficiencies, and growth opportunities and to ensure that each opportunity aligns with your risk tolerance and financial goals. Most investments won’t make the cut—diligent diligence means just a few clear the bar.

An intricate checklist and a multi-tiered review process maintain high standards and weed out anything less than excellent. It spans financials and leadership to legal structure, ESG factors and beyond.

1. The Manager

Begin by drilling down into the manager’s background. Search for a proven track record in similar markets and asset classes. A manager with a strong background in your target area is unlikely to make rookie errors, but it’s wise to look for gaps or red flags.

Look into the team’s expertise and experience. Are they finance, operations, or niche-sector qualified? Have they worked together on prior deals as a team? These particulars assist when gauging constancy and mastery.

See how much of their own money the managers have put in. This demonstrates that they have skin in the game, which creates an incentive for them to act in the investor’s best interest. Get a sense of their investment philosophy, their risk tolerance, if they utilize external advisors for governance.

2. The Strategy

Evaluate what type of methodology the manager has. Is it a value play or trade? For instance, certain plays depend on bargains, others depend on growth or at least reliable revenue.

Benchmark the strategy’s historical performance to its peers and to indices. If the fund’s returns are significantly greater or lesser, explore the reasons. Question if this plan fits your objectives.

For example, a high-risk, high-return approach may be effective for some and not others. See how the methodology adjusts as markets change. Flexible strategies tend to fare better in bust.

3. The Structure

Fund Legal Structure A fund’s legal structure is important from a tax, liability, and transparency perspective. Most private funds are limited partnerships or LLCs. Review the operating agreement.

What rights as an investor? Are there lock-ups or early withdrawal penalties? See how the structure impacts your taxes. Some vehicles are tax advantages, others complicate things.

Confirm that the structure complies with local and international legislation. Request annual audited financials and SOC reports to verify controls function as advertised.

4. The Performance

Examine the fund’s returns over time. Benchmark against something appropriate. Research what contributed to previous returns or declines. Remember to include fees.

5. The Verification

Verify all assertions from the manager. Check financials with independent audits and third parties. Search for red flags in the documentation. Flag anything that doesn’t make sense.

The Fine Print

Alternative investments tend to have complicated terms and conditions that require close examination. The fine print in investment prospectuses can offer important insights into risks, fees and exit opportunities. Overlooking these details can lead to surprise fees, liquidity problems, or conflicts of interest.

For institutional investors, the fine print is part of due diligence; for retail investors, they can miss key points. Here’s why understanding the fine print matters:

• Cybersecurity or complicated strategies, these hidden risks are usually revealed in the fine print.
• Real fees are 1–2% higher, and annual returns can be as high as 3–4%.
• It’s fee structures and liquidity terms that form the actual investment experience.
• Governance and decision-making can reveal conflicts of interest or weak oversight.

Fees

Management fees, often a fixed percentage of AUM, can significantly impact overall returns. Carried interest, typically on net gains over a hurdle, is another important consideration. Additionally, administrative and operational charges, like audit or legal fees, can add up.

Exit or redemption fees are applied when withdrawing capital, and there may be potential undisclosed costs embedded in transactions or services. Even tiny fee disparities can significantly affect net returns.

For instance, a 1% fee on a €10,000,000 investment means €100,000 less per year, plus compounding. Real costs for hedge funds can be 3-4% a year, not including trading costs. Fee structures that you can compare to similar funds or on a platform help you identify a fair deal and avoid overpaying for the same strategy.

Fee transparency is fundamental. Everything must be clear in the offering documentation, and investors need to insist on getting full explanations before investing.

Liquidity

Other funds only allow redemptions on quarterly or even annual windows. Others might have lock-up periods of multiple years. Being aware of the liquidity profile assists investors in managing their cash flow requirements and preventing unexpected situations.

Illiquidity can be risky if you need capital during market stress or for other opportunities. Illiquidity can provide greater returns—an illiquidity premium—but there are tradeoffs. If an investor needs to get out early, they’re penalized or forced to sell at a discount.

In turbulent markets, exit options can close even more. The fine print needs to explain all the withdrawal terms, such as notice periods and any gates or suspensions. Liquidity risk impacts portfolio management as well. Huge illiquid positions can hamstring your ability to pivot, particularly when rebalancing or adjusting to shifting objectives.

Governance

A robust governance structure should specify who makes major decisions and how supervision is managed. The papers ought to describe the positions and obligations of managers, boards as well as any advisory committees. Decision-making rules, like voting rights or veto power, ought to be well-defined.

Best practices say checks and balances. Investors should seek alignment with global norms, not just local regulations. Weak governance can lead to conflicts of interest or even fraud.

Conflicts of interest often lurk in the fine print, such as fee arrangements with related parties.

The Human Factor

Human factors define the essence of private alternative investments. Beyond the digits, it’s the individuals, their culture and their collaboration that can make or mar results. Human rights risks, leadership and workplace culture all factor into how an investment performs over the long term and how trustworthy it is.

When you consider private deals, these elements require close examination in addition to financial criteria.

Incentives

Incentive structures tell you a lot about how a fund is going to operate. When fund managers get paid based on performance, the idea is to align their interests with those of investors. The typical version is the “carried interest” arrangement, where managers receive a profit share once reaching an established return.

This can work well, but it can push managers to take bigger risks for quick wins if not checked. For example, short-term bonus plans might encourage you to chase quick profits rather than creating long-term value. It’s crucial to verify that incentives extend beyond the next quarter and instead reward prudent, sustainable growth.

Anyway, just notice how these rewards are distributed among everyone in the group. If only top managers gain, key staff might not stick around or work as hard. Remember, incentive plans can influence more than just monetary decisions — they can influence how we deal with human rights risks as well.

If the reward system discounts such risks, managers may overlook them. A smart incentive plan will span financial performance and good corporate citizenship, particularly in industries such as farming, retail or clothing, that have large workforces and inherent human rights problems.

Culture

Culture is sneaky but profoundly powerful. An open, transparent culture enables teams to identify issues early and control risks more effectively. Take, for instance, companies that have transparent values and open doors — they tend to experience lower turnover and are able to attract employees who are passionate about conducting business the right way.

Conversely, influence, a secretive, high-stress culture buries issues — including those related to human rights or mismanagement — until it’s too late. How a firm speaks and behaves on human rights matters a great deal, too.

In these high-risk sectors and countries, companies that take the time to train staff on human rights issues and establish specific benchmarks for their suppliers experience fewer expensive scandals or interruptions in their business. Mapping where a firm operates, its supply chain and the risks of each country or sector helps investors know where to look closer.

As an example, agriculture companies operating in nations with weak labor laws require rigorous audits and an ethical company culture.

Succession

Succession planning is its backbone. Teams that have an explicit, documented leadership succession plan are more likely to maintain stability when senior personnel exit or retire. It’s not merely about having a successor-in-place—organizations must demonstrate they’ve developed leaders for tomorrow and established a process that is effective in reality.

Good succession plans appear in the day-to-day behavior, not just in print. When firms communicate these plans to investors, it establishes credibility and communicates long-term orientation.

Unclear planning can erode investor confidence and disturb employees, endangering abrupt departures or panicked decisions that damage productivity.

Beyond The Pitchbook

Private alternative investments are complicated and high-risk. It’s all too easy to hide behind pitchbooks and marketing materials. Due diligence goes beyond, using third-party sources and real-world verification to empower investors.

Channel Checks

Channel checks are for contacting third parties for a broader perspective. Industry contacts can provide direct opinion on a startup’s maturity, the tech it uses or its reputation with customers and suppliers.

Nothing illuminates actual performance and happiness like feedback straight from current investors, and it seldom aligns with what a pitchbook asserts. Brief surveys or individual calls can uncover problems such as delayed reporting or underperformance.

Third-party research, such as industry reports or analyst notes, assist in validating or undermining the manager’s figures. Custom benchmarking is important, too. Selecting a like-minded peer group—perhaps by sector, geography, or strategy—an investor can determine whether a fund’s historical returns stand up to the rest.

Indeed, dealmakers deploy this kind of benchmarking all the time to ensure fund managers come through on their commitments. Channel checks can help highlight hidden risks. A tech startup, for instance, may appear paper-sound, but due diligence with customers or vendors might reveal that adoption is weak or the tech isn’t as useful as advertised.

Counterfactuals

Being a counterfactual thinker means thinking about what might happen in various scenarios. Investors imagine different futures—what if sales decline by 30%? What if the core offering gets regulated?

This is deeper than what’s on the pitchbook. It helps catch core assumptions, such as expected growth rates or market share. By asking “what if,” investors can identify vulnerabilities in the business case.

It’s crucial to calibrate these scenarios to the company’s maturity. A high-growth startup, for instance, can be more susceptible to shifts in tech or market trends than an established firm. Thinking through best- to worst-case outcomes helps prepare for surprises.

Stress Tests

Stress tests take the model to its extreme. Investors simulate how the company or fund would fare if markets tumble, if a critical customer suddenly disappears, or if financing dries up.

Strong stress testing verifies not just cash flow or debt, but risks associated with operations, law and IT systems. This is where dealmakers review portfolio company valuations, ensuring stress test results remain up-to-date as conditions shift.

Everything you learn from these tests should be documented. This not only helps steer future decisions, but makes for a more robust diligence process. It’s a best practice for HNWI investors, still under-allocated to alternatives (5%ish on average), to close the information gap.

Other Key Considerations

Timing matters—being quick without skipping steps gives an edge. Financial due diligence means reviewing the basics: statements, debts, assets, cash flows.

Cover the full picture: legal, regulatory, IP, HR, operational, and market risks.

Ongoing Oversight

Ongoing oversight is not merely a check-in. It’s a rigorous process that monitors private alternative investments against objectives, risk tolerance and evolving market dynamics. This strategy aids risk identification and promotes sustained success.

Robust structure for continuous oversight begins with defined roles and establish review times. Our elected leaders bear primary responsibility for this oversight. They have to ensure each step reaches fiduciary levels. Establishing a hard schedule, like quarterly and annual reviews, keeps the process on track and ensures nothing slips through the cracks.

Going over your stats and closing numbers is crucial. Extract yearly audited financial statements for every investment. These indicate whether the figures align with what was pledged and assist in identifying unusual patterns or omissions.

Compare benchmarks, risk measures and cash flow reports to see if the fund is hitting its numbers. Talk through assumptions and valuation methodologies with auditors. This prevents errors in reporting, like over- or under-valued assets. Getting independent checks on year-end balances can slow down the audit but brings more trust to the numbers.

To keep things under control, request a manager’s SOC reports each year. These demonstrate whether the manager has robust controls for security, processing and reporting. Be sure to implement user entity controls, which are things your team has to do to keep the process healthy.

Don’t leave it there with the figures. Sense the manager’s style and how they operate. Qualitative review of their staff, systems and key processes is just as important as return reviews. For instance, if a fund’s team churns or they employ legacy technology, then it might be riskier.

Be aware of market trends and news that may impact your investments. For example, new regulations in finance or a change in trade flows can alter the risk profile for a fund. Modify the strategy if necessary — for example, rebalancing or switching funds — based on what you discover in these reviews.

Request that third-party managers approve your investment policy annually. This step confirms that their activities remain aligned with your objectives. Receive data direct from third-party service providers, not just the fund manager, for complete transparency.

Conclusion

Smart due diligence gives you a real shot at safer private investments. Pose straightforward questions, get into the fundamentals, and verify the details. Getting beneath the deal to the people behind it helps identify genuine risks, not just slick pitches. Look beyond the pitchbook. Dig into the specifics and observe how it unfolds. Keep up your checks, even after you put your money in. Too many skip this step and miss key shifts. Small steps now can imply fewer bumps down the road. So, before you dive in, take time to slow down and look closer. Want to learn more or share your own advice? Leave your comments or get in touch for more resources and guides.

Frequently Asked Questions

What are private alternative investments?

Private alternative investments are not publicly traded. Think private equity, real estate, hedge funds and private debt. They provide diversification but usually need deep due diligence before buying.

Why is due diligence important for alternative investments?

Due diligence assists you in understanding the risk, verifying the claims and evaluating the real value of an investment. It safeguards investors against fraud, incompetence, and sub-par results.

What steps are involved in the due diligence process?

Common procedures involve checking financials, strategy, legal documents and the management team.

What legal documents should I review during due diligence?

Read offering memorandums, partnership agreements, subscription documents and any regulatory filings. They describe your rights, responsibilities, fees, and risks.

How can the management team affect my investment?

A savvy management team can propel growth and handle risks. Evaluate their track record, expertise, and alignment of interests with investors.

What is the significance of ongoing oversight after investing?

Ongoing monitoring keeps the investment in line. Track performance reports, financial updates, and changes in strategy or personnel.

Where can I find reliable data beyond the pitchbook?

Look for independent third-party reports, ask for audited financials, compare against industry benchmarks, talk to references or past investors. This assists corroborate information provided by the manager.