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Dan Hallett is vice-president and principal of Highview Financial Group

Skinny bond yields have prompted investors to replace high-quality but low-yield bonds and to sometimes expect too much from their chosen bond substitutes. But increasingly, investors are also responding to low yields by stepping further out on the risk spectrum by allocating slices of their portfolios to private-market investments. These products hold a lot of allure – i.e. attractive returns; higher yields and uncorrelated returns. But it’s incumbent on investors and, in particular, advisory firms to put those alluring traits into context by getting a clear picture of both risk and return before even considering an investment.

Guilty until proven innocent

One of the greatest illusions of private investments is the high level of price stability. Many pay generous yields and have prices that appear very stable. Since the academic definition of investment risk is defined as how wildly prices swing up and down, private-market investments can appear to be “low risk”.

But it is an investment truism that any investment offering a return significantly higher than government bonds involves a level of risk that is aligned with the claimed excess-return potential. With most financial assets – e.g., stocks – the risk is apparent in quoted prices during periods of distress. But if an investment claims to offer returns of, for example, 8 per cent to 10 per cent a year, you must start digging to uncover an investment’s risks.

If risk isn’t apparent in volatile prices or returns, then you need to look more closely. I’ve often described our due-diligence process as “guilty until proven innocent." Promoters will put all of an investment’s positive characteristics in your face. So it’s incumbent on investors (or their advisers) to dig up the bad stuff to make sure you’re looking at a full picture.

Complexity is your enemy

“Complexity is your enemy. Any fool can make something complicated. It is hard to keep things simple,” Richard Branson once said.

The more complex an investment’s strategy or structure, the less likely you are to fully grasp it, and the more likely you are to make an error in judgement. The business of private lending is simple at a high level, but, when putting lending funds through our due-diligence process, we encounter a range of complexities.

Some are part of a tangled web of legal entities between the investor and the borrowers. Others have a long list of fees and charges. Our preference is for a sensible and simple strategy, a very straightforward legal structure and reasonable costs. It’s not a coincidence that some of the most poorly performing private investments are also the most complicated.

Principals’ and investors’ interests must align

Alignment or conflicts of interest can show up in governance structures, fee structures or legal structures. Sometimes this is more obvious. Most private investments are more similar to operating businesses than traditional investments. The investment fund you’re considering may pay an external company for services (e.g., loan brokering/origination for a private mortgage fund). That triggers several obvious questions pertaining to common ownership, fees charged and many other factors.

Other times, governance worries are more subtle. Some of these private-investment funds started as a single individual’s business activities. Often such enterprising and smart investors are asked to invest for others. And when they “roll” their personal investments into a fund structure that takes in capital from others, the founders still sometimes treat the fund as their own personal business. This is tougher to detect but requires as much diligence as more obvious governance shortcomings.

Always do a gross-to-net analysis

To avoid getting seduced by private investments’ promise of high returns, we perform a gross-to-net analysis on every product. In other words, we create a financial model to understand what level of gross return is required to deliver the minimum rate of return we expect from an investment. That clarifies the impact of the fee structure and allows us to assess whether the gross return required is realistic.

One product we examined a few years ago involved three legal entities and a handful of different fees across all entities. Once we understood the strategy, we determined that we would need a net-of-fee total return of at least 9 per cent a year to even consider this. Our gross-to-net analysis showed that the managers would need to generate a return of 15 per cent each year – before fees – to leave our clients with a net return of 9 per cent a year.

Nowhere was it obvious that this product’s fee structure would create “friction” of 6 per cent a year. This was only clear after completing this analysis; and that was enough for us to conclude that we had no interest.

Every private-market investment that I’ve ever reviewed had at least one negative characteristic. They’re not necessarily deal breakers. Rigorous due diligence is a must to get a full picture of each investment’s pros and cons. Only then can investors make good and informed decisions.

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