Alternative investments have become more influential in portfolios, especially since the onset of the Covid-19 pandemic in 2020. Over the last two years, equity valuations have become stretched and bond yields have fallen considerably. This has led to lower expected returns going forward and forced investors to look at areas such as private equity, private debt, real estate, real assets, and hedge funds to enhance return and mitigate risk.

The results of utilizing some of these asset classes over the last few years have been beneficial. They have been able to mitigate rising inflation, higher energy prices, and lower bond yields while further diversifying portfolios. However, the range in performance between the various alternative managers in each of these areas has been dramatic. For example, the difference in return between a top and bottom quartile private equity manager is approximately 20%. Therefore, when allocating to alternative strategies, it is paramount to get access to funds managed with a proven process that can generate top tier performance.

In order to identify the most reputable managers in the alternative investment space, it is important to focus on the following characteristics:
1. Team—the key decision makers within an alternative investment firm must have a sound relationship where they are identifying unique opportunities within their particular asset class while retaining talent, evolving their business, and instilling a culture of collegiality and competition.

2. Track Record—the firm must show a history of consistent performance in different market environments while continuing to act as a diversifier to equities and fixed income. For example, a sought-after hedge fund strategy is able to generate strong returns with minimal volatility, correlation, and beta to public markets.

3. Investor Base—reputable alternative managers have a large number of institutional investors that include pension plans, endowments, foundations, family offices, and high net worth individuals. If a strategy is not heavily diversified among these different investors, it could lead to issues, particularly during times of underperformance when redemptions are more prevalent.

4. Capacity—respected alternative managers are thoughtful about their assets under management (AUM) and too many assets could potentially hinder their ability to generate consistent long-term returns. If any alternative investment manager becomes too large, it is important to ask whether they can execute their strategy with even more capital. If AUM becomes an issue, many strategies will close their fund to new dollars in order to avoid any risk of return degradation.

5. Fee Arrangements—there are typically two types of fees in the alternative space. First, there is a management fee, which is charged by the strategy to operate the fund. Second, there is a potential incentive fee which is rewarded to the strategy if they achieve a particular return threshold (i.e. above 10%). Highly regarded managers do not share their fee with any outside vendors or service providers. For example, in some cases private banks and other institutions will take a piece of the management fee to assist with marketing and distribution. Top tier alternative managers do not need to follow this exercise since they are comfortable with their asset and investor base.

6. Deal Flow—the ability to source a sufficient volume of high-quality investment opportunities is key. Strong alternative managers have robust networks and can identify unique ideas that enhance the risk and return profile of their funds. This item is especially critical in the private equity and private debt space where return dispersion is significant. If capital is consistently invested in strong deals, then returns can be substantial.

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