An ALM First Investment Perspective
As forward-thinking institutions seek new ways to enhance their balance sheets, more financial professionals are being pitched opportunities that fall outside the traditional investment universe. Many of these alternative assets are advertised with promises of a high yield/return and low volatility. However, it’s important for institutions to do their due diligence and ensure they understand both the asset and its true risk/reward potential.
An alternative asset is typically classified as any investment that falls outside of public stocks, bonds, or cash. Private credit/equity would be a popular example of an alternative asset. Other examples include real estate, life insurance settlements, real assets (e.g., solar), and some hedge fund investments.
Some are advertised as having low correlation to large cap equity indices like the S&P 500. In other words, an equity-like return without the day-to-day volatility of public equities.
Here are four key areas we encourage institutions to work through when evaluating any alternative asset investment opportunity:
1) What are the sources of the promised/expected return?
Start with the mechanics. How is the expected return derived? When there are underlying cashflows, how are they being modeled — and what are the model assumptions?
Perhaps more importantly, what risk factors are those cashflows exposed to, and how sensitive are they to each under stress scenarios? Understanding the sources of return, cashflows and associated risks should be the first step in the evaluation process.
2) Is it actually enough return?
Often attractive on the surface relative to other options, is the return of this alternative asset commensurate with the level of risk you’re taking on? And second — assuming it clears that hurdle — is this the best risk-adjusted return available within the asset class? High-performing institutions ensure that investments don’t only clear the first test but also pass the second before moving on to the next phase of evaluation.
3) How are the valuations derived?
Many alternative assets are illiquid, which means there’s no observable market price for the underlying holdings. To value them, managers often rely on a “mark-to-model” approach — and that model-based value can look very different from what the asset would actually bring in a liquidation.
In many market environments, investors may view using a model-based value favorably, because it limits the periodic price volatility exhibited in other more on-the-run assets. However, smoother does not necessarily mean “uncorrelated”.
For example, a private equity fund’s price can appear much less volatile than a broad public equity index like the Russell 2000, but is that private equity return truly uncorrelated to the market? For mark-to-model pricing, are we comfortable with the assumptions driving those valuations? What conditions could force a mark-to-market event?
4) What’s the right position size?
Suppose an alternative investment opportunity clears the evaluation process above and your institution decides to move forward. The most important decision may still be ahead of you: how much to allocate.
As with any credit allocation, relative investment size should account for liquidity and unexpected risks to capital — the scenarios your base case didn’t include. Disciplined risk budgeting is an essential component of any sophisticated investment process.
The bottom line
Alternative investments will rarely offer the same volume of information and pre-purchase transparency as more traditional, on-the-run assets. However, that doesn’t mean an institution can’t work through a reasonable evaluation process and answer these types of questions to determine whether it’s an appropriate opportunity to pursue.
In addition to the above considerations, using more straightforward common sense can also be an effective safeguard. As the old maxim goes: if it’s too good to be true, it probably is.
ALM First helps banks and credit unions evaluate investment opportunities and mange their balance sheets. To talk through your portfolio strategy, visit almfirst.com.
