Managing the Risks of Alternative Investments

In an era when traditional investment vehicles are experiencing price fluctuations and slender margins, the allure of alternative investments has surged, underscoring a significant recalibration in firms’ portfolio management strategies.

This increased interest marks a strategic shift for firms that recognize the unique value proposition offered by alternatives, which include private equity, hedge funds, real estate, and commodities. Alternatives provide diversification and a potential hedge against inflation and market volatility, positioning them as an indispensable part of today’s modern investment arsenal.

However, the alternative investing landscape is fraught with complexities ─ from valuation challenges to regulatory conundrums and liquidity constraints, and they require a sophisticated understanding and strategic approach. This blog post examines alternative investments’ complexities and considerations. We explore valuations, regulatory environments, risks, and the balancing act required when dealing with these assets.

Alternative Valuation Considerations

A significant challenge for firms is the rigorous valuation process for alternatives. Unlike their publicly traded counterparts, these assets often lack an easily ascertainable market value. Therefore, valuation becomes both an art and a science. This opacity necessitates a disciplined valuation framework that is not only robust and transparent but also adaptable to the unique characteristics and market conditions of each asset. It’s crucial that firms adopt such a framework ─ incorporating market comparables, discount cash flow analysis, and third-party appraisals. This structured approach will help your firm navigate the complexities of alternative investments, ensuring accuracy, fairness, and compliance with accounting standards and regulations.

Regulatory Dynamics: Navigating the Maze

The regulatory landscape surrounding alternatives is both intricate and dynamic. Jurisdictions around the world each have their own regulatory architecture designed to protect investors and ensure market integrity. This complexity requires that fund managers and investors develop a granular understanding of the applicable regulations that span AIFMD in Europe, SEC oversight in the United States, and evolving frameworks in Asia-Pacific markets. Compliance is not merely a legal requisite but a cornerstone of operational excellence and investor confidence. It mandates continuous surveillance of regulatory developments and an agile adjustment of investment and operational strategies.

Ownership Complexities

Alternative assets are wide ranging. They can be equity or debt stakes, small minority stakes to full ownership, and owned through various investment structures. These factors affect the risk profile of the investments, access to information, and ease of valuation or verification. Responsibilities also differ when GPs are primarily responsible for managing the valuation process with LPs focusing on validating and monitoring the valuations provided by the GP. These dynamics are critical in determining the extent of valuation risk, and therefore firms must consider them in their valuation policies.

Expectations Are Ramping Up

Expectations are increasing, with investors looking to GPs for more frequent and detailed data, out-of-cycle valuations, and greater access to valuation methodology and inputs, to name a few. Investment managers and GPs will need to consider their operating models to ensure they are sufficiently scalable to respond to changing expectations.

Moving Forward

Incorporating alternative investments into portfolio strategies marks a significant shift driven by the quest for diversification and enhanced returns against the backdrop of increasingly volatile global markets. This shift, however, brings a host of challenges, from the intricacies of asset valuation and regulatory navigation to the imperatives of risk management. Addressing these challenges requires an astute strategic approach, underscored by rigorous methodologies, regulatory foresight, and a comprehensive risk management framework.

Cutter Associates can serve as an important resource in the evolving alternative investing landscape. We offer the latest research and comprehensive consulting services that empower our clients to navigate the complexities of alternative investments with expertise and strategic acumen.

Want to learn more? Read the full report, Are Alternatives Risky Business?