INSIGHTS FROM ADAM GORLYN

Adam Gorlyn is an investment management professional hired by Fountainhead to consult on its alternatives investing approach as we continue to enhance our OCIO services and offerings.

Alternative investments provide a myriad of potentially valuable benefits for investors, balanced with a cost of complexity and illiquidity. In a series of articles, we will explore the increasing popularity of alternative investing. We focus on how investors can analyze and utilize alts as part of their overall strategic asset allocation in order to increase the likelihood of achieving desired outcomes.

In our previous article on alternative investments, we covered some of the reasons for the significant asset growth in the space and the potential opportunities we see across multiple strategies.  In this article, we focus on the many time-intensive steps necessary to thoroughly evaluate alternative strategies. For illustrative context, we will focus on the screening and analysis of private equity funds, including growth, buyout, and venture capital strategies.

EFFECTIVE DUE DILIGENCE 

A due diligence process for traditional long-only investment strategies is an effective means to assess whether the portfolio manager is employing an investment process that is methodical, repeatable and can generate its stated goals on an ongoing basis relative to its appropriate benchmark. For instance, attribution analysis of historical performance offers insights into past results. However, was outperformance relative to a benchmark simply the result of the strategy having a different goal and different underlying exposure? Or is it a sign of true manager alpha? An analysis of historical underlying holdings is key to fully appreciating a strategy’s exposure relative to its goals. Finally, since most long-only strategies are offered in highly regulated investment structures[1], less time and resources may be necessary to evaluate operational or legal aspects of the vehicle itself.

HIGH LEVEL MANAGER DUE DILIGENCE CHECKLIST: 

• Clearly stated goals align with historical exposure
• Institutional level, established processes
• Experienced management team
• Strong performance attribution of past performance relative to an appropriate benchmark
• Competitive fees relative to peers
• Strong legal and regulatory compliance
• Proven risk management expertise
• Approach to exit strategies

While the above checklist is applicable to evaluating alternative managers as well, the process is more complicated and time consuming due to the non-standard characteristics and potentially complex securities in the underlying strategy. In the case of private equity, many funds have unique, esoteric investment characteristics which need to be sufficiently vetted and can only be understood by thoroughly interviewing management. In addition, the evaluation process requires additional time to perform operational due diligence, including an assessment of the integrity of the firm, its overall professionalism and stability of key personnel. A well-defined month-end portfolio valuation process is integral as fair value assessments cannot be taken for granted as they often can with liquid public securities. Detailed analysis of the fund’s legal structure and offering terms is another important component of the alternative due diligence process given the lower level of regulatory scrutiny of private funds.

CASE STUDY: PRIVATE EQUITY

Private equity is an investment strategy where a fund acquires equity ownership in companies that are not listed on a public stock exchange. Given the broad definition of the category, it is imperative to identify and be comfortable with the risk and potential return profile of the private equity fund’s underlying exposure, and to make sure that’s consistent with what the investor is seeking to achieve for their own portfolio. Private equity funds can invest in a broad range of companies, from early-stage start-ups within the venture capital space, to more established businesses in a growth stage, or strategies which focus on the buyout of companies or underlying business lines. And all of these different stage companies can be different sizes and in a wide range of industries.

Private equity fund managers often take an active role in the management of portfolio companies as the strategy generally focuses on creating value through strategic initiatives and operational improvements. This is meaningfully different from investing in the common equity of publicly traded companies where portfolio managers do not generally have an active role in day-to-day management decisions of portfolio companies. Private equity firms typically work alongside the company management team, providing guidance and support. This may involve operational improvements, expanding the business, or implementing restructuring processes to potentially increase profitability. This hands-on approach to private equity investing places importance on the capability, proficiency, and skill of the management team. Understanding their prior experience and track record of success within a particular sector or industry, as well as evaluating their ability to navigate through various economic cycles, is an important part of the evaluation process. In addition to operational prowess, smart financial management is a key component of a successful private equity manager.

CHARACTERISTICS MORE RELEVANT TO DUE DILIGENCE OF PRIVATE EQUITY:

• Specialization: Given the added value that a management team potentially adds to the company they invest in, it is critical to understand their level and area of expertise.
• Access: Not every manager has the opportunity to invest in every company (as is the case in public markets). The pedigree and connections of a given manager may be key depending on the strategy.
• Leverage: The degree of financial leverage employed can potentially contribute to increasing a portfolio company’s value and rate of growth. However, leverage can work both ways, as interest rate costs can create strains on a balance sheet and be a potential headwind as well.
• Concentration (Vintage/Business): We will touch a bit more on this topic within our next article, but it is important to understand timing of investments and how narrow and concentrated a manager may go. Especially within early-stage venture capital, there can be many losers alongside any single winner.
• Scale: Private equity is biased towards larger sized firms and more senior management given the need for specialization and access. It is important to understand their full capabilities as well as longer term management team plans.

CHALLENGES AND RISKS ASSOCIATED WITH PRIVATE EQUITY INVESTMENTS:

• Illiquidity: Unlike public equities, alternative investments are not often traded at all or are traded infrequently, making it difficult to publish a daily price on the portfolio. Due to a lack of a strong secondary market, investors must hold assets for an extended period of time. An “illiquidity premium”—additional return to compensate for this limitation—is often associated with private equity strategies due to this characteristic.
• And, of course, not all private equity will end up having positive returns or even make it past those first years of negative returns.
• Complexity:  Assets may be invested in complex vehicles which utilize leverage or specialized investment strategies. It may be challenging for investors to understand and be comfortable with the fund and to evaluate the potential risks and prospective returns.

VEHICLE SELECTION

Traditionally, private equity funds were available only through limited partner “LP” structures available to qualified purchasers, and rarely, qualified clients.[2] Investors accessing private equity through traditional drawdown LP structures would expect to have some portion of their overall commitment invested for over 10 years.

More recently, as the private equity space has begun to mature, there has been a proliferation of semi-liquid strategies available in interval and evergreen structures which have become available to Accredited Investors. Additional diligence is needed to understand if these vehicles are truly feasible, especially for private equity strategies where time is required for underlying portfolio companies to grow and, ideally, achieve the top of the J curve before they can be harvested. As these structures are relatively new to market, it will take time to determine how much of the illiquidity premium is still available to be harvested in these types of funds.

CONCLUSION

As we have highlighted, alternative investing typically encompasses two sets of due diligence lists, one universal to general public investments and a second more tailored to a specific approach or exposure. Hopefully, this article provides some context about the time commitment and necessary expertise required to conduct proper due diligence. It is worth noting that many vehicles are not available directly to clients and may necessitate a high firm minimum investment which both benefit larger advisor groups or alternatively, the use of an OCIO, where one’s assets are combined with many others in scaling a practice, inclusive of access and appropriate due diligence.

From our extensive network of external asset managers, we provide our clients with access to a broad range of potential strategies to meet bespoke investment needs. Our ability to curate a list of strategies from managers both large and small differentiate our approach relative to peers.

In the next paper of our series, we discuss how to position alternative strategies to increase the likelihood of achieving the best investment outcome within each client’s personalized investment objective. This includes understanding the appetite for an alternative weighting in a client’s strategic asset allocation, as well as underlying strategy selection and, finally, proper position sizing.

Disclosure

Alternative investments are not appropriate for all investors. Some alternatives, including private placements, have minimum investor qualifications. Private placements are generally offered only through a private placement memorandum or other offering documents provided by the issuer and may be purchased only by accredited investors. In some cases, in addition to being accredited, investors must also meet the definition of “qualified purchaser” and/or “qualified client.” This paper is not intended as investment advice or the recommendation of any security or class of securities. Fountainhead provides investment advice only to clients, and only after assessing individual client needs, objectives, risk profile, and investment profile. This paper describes general risks and opportunities of investing in alternatives. The actual risks and opportunities of any specific investment must be carefully reviewed before being employed in a client portfolio. Fees associated with alternative investments are separate from and in addition to the advisory fees charged by Fountainhead. No investment can guarantee positive returns or the prevention of all loss.

[1] For example, registered mutual funds and ETFs are highly regulated vehicles.

[2] Investors are placed into 1 of 4 categories in an attempt to protect them from overly complex product and potential investment scams. These categories are basically segregated based on wealth characteristics as detailed in the following link with the categories being (1) None (2) Accredited (3) Qualified Client and (4) Qualified Purchaser: Accredited Investors vs. Qualified Clients vs. Qualified Purchasers (strictlybusinesslawblog.com)