When Researching Alternative Products, Look For ‘Red Flags,’ Experts Say

Sarti said advisors should perform operational due diligence and watch for structural issues, including:

● Liquidity mismatches between fund terms and underlying assets, especially in downside scenarios.
● Fee structures that fail to align manager and investor interests.
● Inadequate operational controls, both internal and external, such as lack of third-party oversight on large cash wire transfers.

Sarti was particularly blunt about fee structures, citing excessive real estate acquisition and disposition fees that can incentivize managers to churn portfolios at the expense of potential long-term returns. He also warned of waterfall structures with outsized fees in upside scenarios. “Are you incentivizing general partners to go for home runs by taking on extra leverage?,” he asked the audience.

Other red flags include inappropriate preferred return structures and general partners with little or no skin in the game. “It’s important for the general partner to have a lot of money invested side by side with you,” said Sarti. For some fund managers, a 10 percent stake might not be enough. “They have to feel pain in a nasty environment. People make a lot of money in this space. They come and go. When things turn bad, they have to ride it out and fix the problems.”

Sarti also suggested that advisors tailor their due diligence based on the asset class and experience with the fund manager. For example in real estate, “With newer relationships, we’ll typically visit the property. We’ll always look at leverage and look to stress test the manager’s projections,” he said.

After the buy decision, an advisor’s work is just beginning, said Jeff Whitmoyer, head of fixed-income, asset allocation and alternative investments at Wells Fargo Fund Management Group. “Everybody’s familiar with the pitfalls of manager selection—making sure you hire the right people to manage the portfolios—but once you build a portfolio, the job isn’t over. The problem becomes ongoing monitoring,” Whitmoyer said. Management teams can be impacted by additions and deletions of personnel, while funds can be affected by changes in economies and markets.  

Wells Fargo runs scenario analyses of how its funds could be affected over time and through various past events, such as the 9/11 attack on the U.S. in 2001, the Asian financial crisis in 1997 and 1998, and the emerging markets rally from January to May 1999. A future risk the firm is modeling is a potential rise in interest rates.

Access to portfolio managers is also key to risk reduction. “There’s no way we would ever buy an investment product where we didn’t have access to the portfolio managers, not just in the presale, but a commitment from the shop on an ongoing basis that we can have access to the pullers of the triggers,” Whitmoyer said.

The relative importance of access to managers may depend on the liquidity of the investment, said panel moderator Brian Haskin, founder and chief executive officer of Los Angeles-based RIA firm Alternative Strategy Partners. If you’re investing in an illiquid asset that’s tied up for a number of years, you’ll likely want direct contact with fund managers, Haskin said. “If you’re investing in something where you can liquidate your investment tomorrow, it may be a little less worrisome.”