Suitability Considerations

Investment Horizon

Private real estate investments, private real assets, and private equity investments are generally unsuitable for investors with less than a 15-year time horizon. Assuming no new investments are made after the 7-year mark, an investment can take five to seven years to fully mature and another ten to twelve years to unwind. Even a 10-year horizon may be too short to develop a solid investment program of this nature. Investing in hedge funds related to public equities may take less time but still may be unsuccessful without lengthy lockup periods.

Expertise

Managers in the alts space need much expertise to beat the market and deliver alpha. Understanding the spectrum of alternative investment opportunities and the complexity of strategies within each alternative class requires a high level of investment expertise from an investor who is looking for the appropriate manager. Even if the investor is highly experienced, the risk of information asymmetry between the investor and the fund is always there. Handling an alternative investment program often requires full-time professional staff, such as that which would be offered by a FOF.

Another important point is that the investor needs to believe the markets lack efficiency for the manager to earn alpha via the active management that alternative investments inherently entail.

Governance

The design of an alternative investment program must meet investor needs using a strong investment governance framework. The following are hallmarks of a strong governance framework for an alternative investment program:

• An investment program’s long- and short-term goals are clearly outlined.
• Those with the knowledge, capacity, and time to evaluate possible courses of action receive appropriate decision-making responsibilities.
• A formal investment policy is in place.
• A reporting framework is in place, this helps monitor progress toward the agreed-on goals and objectives.

The chances of successfully developing an alternative investment program are lower for investors without a strong governance program.

Transparency

Investing in alternative assets often means accepting less than full transparency. Blind pools, common in real estate, private equity, and real asset funds, involve investing in assets that haven’t been pre-identified. Hedge funds rarely disclose their entire portfolio to investors, making it challenging to gauge true risk exposures even with access to the complete portfolio.

Compared to stocks and bonds, alternative fund reporting is typically less transparent. Hedge fund reports, usually quarterly, offer information on performance, top holdings, and market commentary. However, various hedge funds provide different risk reporting, complicating an investor’s ability to assess overall risk exposure. Separately managed account clients may generate their own risk reports using common metrics.

Private equity fund reports provide more transparency into portfolio holdings but don’t break down exposures by geography, sector, or industry. To fully understand their investments, investors must gather additional information.

Although recent studies and lawsuits have improved transparency, the alternative investment industry remains opaque at many levels.

Private real estate fund reports detail the fund’s size, drawdown progress, realizations, unrealized valuations, and market commentary. Each report includes investment information like original cost, square footage, borrowing details, and fundamental metrics.

Calculating the fund and limited partner’s Net Asset Value (NAV) requires using independent administrators, as they process cash flows and comply with fund documentation. Funds without outsourced administration have significant discretion in valuing assets.

Alternative investments’ lack of transparency complicates risk management and performance evaluation. LPs of high-quality alternative investment funds can review the audit report performed annually by an independent accounting firm.

Regulations for mutual and UCITS funds mandate standard information like costs, expected risks, and performance data, with additional periodic disclosures.

Question

For what minimum time horizon should investors avoid committing capital to alternative investment funds?

1. 5 years.
2. 7 years.
3. 15 years.

Solution

The correct answer is C.

Investors should generally avoid committing capital to alternative investment funds, such as private real estate, private assets, and private equity funds, if they have a time horizon of less than 15 years.

A and B are incorrect. Developing and unwinding an alternative investment program in private markets may take:

• 5 to 7 years for development.
• An additional 10 to 12 years for unwinding.

This timeline assumes no new investments are made after the 7-year mark.

Portfolio Construction: Learning Module 3: Asset Allocation to Alternative Investments; Los 3(e) Discuss suitability considerations in allocating to alternative investments