Navigating the Challenges: A Closer Look at the Pitfalls of Alternative Investments

Investing in alternative assets can mean going out on your own to look for opportunities in private markets. There are no public notice boards; alternatives are ad hoc and they are not commoditised, which makes them initially complex to understand. While this complexity unlocks opportunity, it also unlocks risk.

Investing with the wrong people is the number one reason things can go wrong. But you are also at risk if you don’t understand the documentation involved. Here are a few things to watch out for before you invest and what to consider carefully when your offer arrives.?

Know who are you dealing with

Before researching an investment opportunity, research who is involved in raising the capital. Do you know them? If you’ve never heard of them, it’s a red flag. You might not have a wide network in the industry, which means you need to thoroughly investigate the backgrounds of the CEO and CIO (chief investment officer in charge of investments). Is their experience relevant to the asset you are investing in? This is important because each asset class has unique characteristics, and when something goes wrong, you need someone who

knows what they’re doing.?

It’s also important to know who will be doing the legal work, so you can be confident that if something does go wrong, you are in a financially sound position to take legal action. Also, know who the auditor is and who is responsible for the financial accounting. Are they reputable and reliable?

Risks and security?

Before investing, you will typically receive an information memorandum, prospectus or other form of offer or disclosure document that specifies the details of the transaction. You will need to review that document carefully to make sure you understand what you’re buying, and the risks involved. Go straight to the ‘risks part’ of the offer document and understand what they are. If you can’t find the risk section or if it’s a short section, then it’s

a red flag. Either they don’t understand the risks, or they do understand them but haven’t bothered to disclose them.?

Another key thing to watch out for is security. If you think you are buying a senior secured position, but later discover it’s a junior secured position (or even worse, no security), you will have a significantly higher risk trade than you wanted.

Fees and conflicts

If the fees seem too high, that’s a bad sign. If you, as the investor, are paying all the fees (instead of the capital raiser), it will eat a large chunk of your return. Although it is appropriate for financial service providers to generate revenue, a scan of the fees section will show you if they aim to benefit investors through building positive long-term relationships or if they tend to benefit themselves.?

If these are the fees you do see, what about the ones you don’t? The other key element to understanding fees is knowing the ones that are not clearly disclosed. In some trades, there can be conflicts. A conflict can exist when the capital raiser is making money through equity on top of the disclosed fee. These types of investments and capital raisers are a major concern because they are dipping into a ‘fee well’ multiple times.?

Extensions, maturities and exits

Maturity can be the length of the loan or the timing of the expected exit. It can be a fixed maturity loan or callable, which means you or the capital raiser can initiate the end to the investment sooner. Watch out for terms like ‘potential extension’ where the capital raiser has the right to extend the maturity, meaning you could be in the trade for a lot longer than you thought.?

An exit strategy is one of the most critical parts of investing and involves knowing upfront how you will exit the investment and how you will get your money back. When you receive the offer documentation, review the section on maturity to find out if it is a refinance, which can be difficult in a distressed market; or sale to a third party, which is market and performance dependent; or an IPO (initial public offering) where the timing is volatile. Whatever the exit strategy, you want to understand the probability of the exit occurring. A clean, highly predictable exit typically suggests a lower risk.

When investing in alternatives, consider who you are partnering with and providing capital to. Alternative investments are skewed towards larger investors where the minimum investment can be $1–5 million; therefore, you will need to review the documentation carefully for red flags to make sure you understand what you’re buying, what return to expect and the risks involved.

Edited extract from Grow Your Wealth Faster with Alternative Assets (Wiley $34.95) by Travis Miller . Travis is co-founder and CEO of iPartners, a leading Australian alternative asset marketplace with approximately $5B in funds under management. He is passionate about improving access to alternative asset investments and educating everyday investors about a broader range of investment options.