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Advisors need to recognize the unique risks that alternative investments pose to their clients and sharpen their due diligence on these products as they become more popular, several experts in this space say.
Total assets under management in Canada’s alternative market have risen by approximately 67 per cent over the past year to about $20-billion today from roughly $12-billion at the start of 2021, according to data from the Canadian division of the Alternative Investment Management Association (AIMA).
Claire Van Wyk-Allan, AIMA Canada’s managing director, says the “democratization” of alternatives is set to continue as roughly 10 per cent of retail asset allocations in the U.S. are already in alternatives compared to an estimated 1 per cent in Canada.
Yet, amid a reckoning spawned by surprise redemption freezes at some of Canada’s most popular private debt funds, advisors need to place greater emphasis on the illiquid nature of alternatives, experts say, while also making it clear to clients that not all products in the nascent asset class are created equally from a risk perspective.
The first step in a proper due diligence process for an alternative investment is being selective about choosing a manager, says Belle Kaura, vice-president, legal, and chief compliance officer at Third Eye Capital Corp. in Toronto and AIMA Canada’s current chair.
Whoever is running the fund being considered for investment must be judged on how they source, assess, and monitor the load, quality, and variety of their deal pipeline, along with the strength of their credit underwriting and their loss rate, she says.
Ms. Van Wyk Allan adds that “advisors need to take great care in [looking at] the manager’s pedigree,” particularly when it comes to assessing whether they’re invested personally in the fund – and to what degree.
One nuance that’s especially important in the process is direct access to the manager, says Ethan Astaneh, wealth advisor at Nicola Wealth Management Ltd. in Vancouver.
“If you don’t have access to that information, then what’s your ability to gauge the suitability risk for your client?” he says. “An extra effort is going to be required if advisors don’t yet have direct access [because] that’s where you can end up with unexpected things occurring.”
Ms. Kaura adds that advisors should have the same access to transparency as the institutional investors that still dominate the alternative investment space in order to level the playing field.
How to assess private investment risk
The sheer diversity of products that fall under the alternative umbrella makes the diligence process more difficult, but also much more important, Mr. Astaneh says.
“It is very hard, as an investor, when you’re assessing one alternative investment from another, [to figure out] where they land on the risk scale,” he says. “If I say private debt to someone who isn’t informed about these things, they might think that all private debt or private mortgages are created equally, but the reality is that you’re always dealing with a risk spectrum.”
The potential risks are much more difficult to determine than in more traditional asset classes because investors are drawing from their knowledge of the public markets, Mr. Astaneh says. But the reality is that private markets have different considerations.
While some of the lessons from working in public markets do transfer over to the alternatives space, some don’t, and that can lead to false assumptions about how things work, he says.
For example, assessing the risks in publicly traded infrastructure-related equities is relatively straightforward. In contrast, a private infrastructure investment such as a public-private partnership for a new toll road carries unique political risks such as unexpected election results upending a project.
“The challenge is there are going to be some that will stick their necks out into the alternatives space when maybe the risk isn’t being understood fully,” Mr. Astaneh says. “Then, if there’s a situation in which the dynamics of the market come under pressure, you could end up with liquidity issues or displeased investors.”
Promises of easy redemptions brought that challenge to a head earlier this month when Ninepoint Partners LP – one of the best-known names in the Canadian private debt market – halted redemptions on four of its funds. One of them, Alternative Income Fund, was frozen indefinitely despite assurances of “30-day liquidity” in its marketing materials.
Manny DaSilva, president of Canfin Magellan Investments Inc. in Oakville, Ont. and chair of the Association of Canadian Compliance Professionals, says that disconnect reinforces the need for advisors to fulfil their know-your-product (KYP) obligations.
While some of those KYP rules – which require advisors to analyze a fund’s underlying liquidity and compare it to other similar-like products before investing on behalf of clients – were only formalized as part of client-focused reforms at the beginning of the year, Mr. DaSilva says the expectation was always there.
“Marketing [to the advisor] does not replace the know-your-product obligation,” he says. “There’s an onus on the advisor to fully understand, they have to drill down, especially when they’re dealing with an alternative investment.”
Mr. Astaneh says the first way he contextualizes the risk profile of most alternative investments to clients is by explaining that they’re buying something that’s probably illiquid because tempering expectations is very important.
“If there is a push toward more private and more alternative investments, that means your due diligence has to sharpen as the marketplace gets larger,” he says. “Otherwise, you run the risk of buying something and complacency dealing you an unpleasant surprise.”