The 5-minute rule for evaluating alternative investments

Advisors evaluating alts for their clients should focus on what clients want to achieve as part of a well-diversified portfolio and understand their clients' cash flow requirements.

April 10, 2023 By Jenny Zhan

Inflation, banking safety and soundness, and recession fears all are contributing to investor jitters while nudging others to take a fresh look at alternative investments. As banks tighten lending as a result of recent banking news, it will push quality companies and entrepreneurs looking for alternative financing to go to the private market for capital, and the private market will play a more significant role. This will translate into a number of investment opportunities within the alternative investment space.

For financial advisors evaluating a wide array of alternative investments on behalf of their clients, the research process may seem overwhelming at times. It doesn’t have to be if you focus your investment process on what your client wants to achieve as part of a well-diversified portfolio and understand your client’s cash flow requirements to cover their daily expenses, including travel and their children’s education, for example. Knowing a specific client’s cash flow needs will help guide the type of alternative investments that are suited for them and help you avoid any type of forced selling situation, which we have witnessed in the wake of Silicon Valley Bank’s risk management woes.

Alternative investments, once only for the super wealthy, are now becoming more available to the mass affluent. It is expected that total alternative investments under management may reach $17.2 trillion by 2025, based on Preqin data. This further supports the need for investment professionals to enhance their understanding of alternative investments. Below are some key criteria I look at when evaluating our own alternative investments:  

Valuation: Assessing the valuation of any alternative investment is key. Is the valuation accurate? In a lending situation, it’s important to understand the value of the collateral the borrower has provided. The portfolio manager should easily tell you how they assess the value of each investment and quickly answer your valuation questions.

How big is this market? Before diving in, it’s critical to know how big the market is for the particular investment. This will help with understanding liquidity within that particular pool of assets. And ask yourself, what is the worst-case scenario for this strategy?

Secured lender, senior position: It’s also important to understand the structure of each deal within a fund. In a debt situation, it’s vital to understand the position your clients, as lenders, would fall into. Are they considered secured lenders, so that they would receive priority if something went wrong? Opting for investments where you are in first senior position is good, especially if something goes wrong.  

Time horizon: Alternative investments continue to evolve and now you can find investment structures with lockups of one year or perhaps even shorter.  When looking at the time horizon for alternative assets, you can pick investments with different time horizons that align with each client’s cash flow needs per month, per quarter, and after their children graduate from college.

To make the evaluation of alternative investments less daunting, I use a five-minute rule. As a financial advisor, you are well-educated, so if you don’t understand an alternative investment strategy within five minutes, don’t suggest it to your clients and move on to the next opportunity. This will save you time and enhance your review process to evaluate the number of opportunities that may land on our desks in the coming months.

Jenny Zhan is CEO at Beyond International, an alternative investment management firm.

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