The Risks of Alternative Investments

Posted by Craig Burrows

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craigburrowsIf you’re a keen follower of Michael Campbell’s Money Talks, than you probably understand the missed opportunity by solely investing in public markets like stocks, bonds and funds. Last week’s article explained the basics of alternative investments and the three main areas that retail investors can likely invest in: real estate, private companies and commodities. Before investing one should know the risks as salespeople will always show you the reward – but a real advisor takes the time to explain the risk. I can tell you that at TriView we’ve reviewed hundreds of Business Plans and my partners probably thousands, and to this date we’ve never seen a pro forma that doesn’t make money! So why do so many fail?

Alternative investments can improve your portfolio diversification, can be profitable in any economic environment, can improve long-term risk adjusted returns and can preserve capital in volatile markets. So based on the above factors, why wouldn’t you invest all of your wealth into alternative investments? The above is only one side of the sword, the other side that should concern you is less liquidity than public markets, valuation based on book value than market value, less regulation that can lead to fraud and longer capital lockout periods that can extend your investment more than anticipated.

Simply put, alternative investments should be a piece of your portfolio pie and the size of that piece depends on your own risk tolerance and timeframe.

What are five risks that a retail investor should consider before making an investment:

–  Management risk

–  Financial risk

–  Transparency risk

–   Liquidity risk

–   Less Regulatory risk

Management risk is probably the biggest with alternative investments as you’re investing in a private company that is generally controlled by one or a few people. Hundreds of millions of dollars have been raised and lost due to the lack of experience, knowledge and integrity of management in alternative investments. Many of these failures tend to be gifted sales or marketers that are very good at selling an idea but have no experience to execute their idea. They tend to see a trend and take advantage of investor greed to pry money out of their hands. The old saying is “even turkeys can fly in hurricanes”. But once the wind stops, there’s a giant thud when your investment hits insolvency. Before investing in any company, try and get a background check on the management team (google them). Another thing to look for is “investor alignment”. Investor alignment is comparing how management get compensated (front is bad, back is good), and how do you get paid (front is good, back is bad). Also find out what penalties management face if they don’t hit targets on time and on budget?

Financial risk is an important factor when investing in a private company that can’t raise money on the public markets. Many deals have failed due to lack of capital. For example, what happens if a company needs to raise $10 million to complete their business plan and only raise $7 million? Sometimes they can get some bridge money (borrowed money at high interest) or need to dilute shares to vulture capitalist that reduce the original investors significantly. The worst case scenario – the business fails and the investors’ money disappears entirely to insolvency or bankruptcy. How confident are you in the company completing their capital raise in order to execute their business plan? Some companies like to raise the price of their stock / units in order to reward earlier investors but also allow more conservative investors to invest at the end of the capital raise at a higher premium.

Transparency risk relates to how well you can vet the deal prior to investing as well as tools to continue vetting the business to ensure your investment is safe. Many private companies refuse to provide audits as they believe, as a private company, it’s confidential. That may be an OK attitude when it’s your own business but once you ask people to invest in your company, it’s no longer fully “private”. Stay away from anyone that gives you the “Trust Me” line. If they are not prepared to provide you audited financials on a yearly basis, you should not be prepared to invest.

Liquidity risk describes how and when you can get your money back. Many alternative investments have clauses that don’t allow you to transfer your stocks / units without management approval. They also generally have provisions that can postpone the liquidity event if the company does not have the money, or a return of capital could expose the company to financial risk. Invest money in alternative investments that you can afford to have tied up for an extended period of time (years).

Less regulatory risk is becoming less of a risk as most of the regulators across the country are improving their monitoring of alternative investments. Over the last two years, more money has been raised in the alternative / private markets than the public markets. While most of this money is institutional investors, knowledge slowly trickles down to accredited investors than to retail investors. Investors need to understand the difference between prospectus, Offering Memorandums (OM) and Confidential Information Memorandum (CIM).

The alternative markets are an incredible opportunity to provide additional yield and diversity to your portfolio but probably the most forgotten risk is trying to invest on your own. In some cases, there might not be a big difference from using a broker to conduct public trades to e-trading. In fact, I would argue that with the internet and basic knowledge of valuation of public companies, many sophisticated investors are more knowledgeable than their stock brokers. For example, I was looking to buy Alibaba prior to their IPO but when I spoke to my broker about the largest IPO in history, he knew very little while I’ve been following this company for two years. In fact, I shut down my account the very next day!

I’d be very cautious on buying alternative investments without an advisor as it’s can be very complicated and there is little information on the internet to help you understand if the investment is valued properly. You should obviously investigate your advisor as there are good and bad ones.

Hopefully this has helped you look at the risks of investing in alternative investments. At TriView, we tend to focus on private real estate opportunities as it’s less complicated than hedge funds or some of the morecomplex investment strategies. We feel real estate is something that people can relate to as we’ve all either owned or rented a property. The more educated and comfortable our clients are about an investment sector, the better the investor.

Happy Investing!