Before you invest your hard-earned money in an alternative investment, there are three basic, but powerful due diligence steps to check off. You already know them, but it’s always good to have a reminder. This list is like your mom telling you to put your jacket on because it’s cold outside. Common sense, but something important that we don’t always follow through on.
#1: Know Who You’re Dealing With
The first step is getting to know who you are dealing with. Nothing will make an investment sour faster than dealing with an alternative investment manager who doesn’t have high integrity or doesn’t understand their product within the market. That may be a duh, but it isn’t always the easiest to really know someone.
If you are dealing with someone who doesn’t tell the truth or doesn’t do the right thing, it will only end badly. So, when something isn’t feeling right, trust your gut. It’s probably more reliable than whatever conversations are going on in your head.
If the alternative investment manager has inaccurate information or lack of experience with the product or market, we all know that can be a recipe for disaster. The problem with an inexperienced or ill-informed manager is: They don’t know what they don’t know. No one is experienced on day one, but there are ways to overcome some of the initial deficiencies.
When we started going down to the courthouse steps ten years ago, I didn’t know anything about it. It had always fascinated me, but I didn’t even know where to begin. So, I started by attending the auctions every day, talking to the people down there who would talk to me, and finding patterns in how it all functioned. I spent 90 days learning the process before we bought our first foreclosure.
As an example, one of the things you don’t know that you don’t know is they sell Deeds of Trusts that are 2nds on the steps (A 2nd position Deed of Trust is created after a 1st position Deed of Trust on a property, and the 1st has seniority and different privileges.). If you buy a Deed of Trust that is a 2nd, you just bought nothing. Rarely does the property have enough equity in it to take it over through a foreclosure. We had a title company search the titles before every auction for every property we were interested in buying. That’s the only way to know and even then, it’s not foolproof. As with anything, experience is a big indicator for success.
#2: Ask About the Downsides
The second step is finding out the downsides of the investment. Everyone wants to tell you the good stuff and nobody wants to share the bad. But you didn’t get to where you are in life without some knocks and bruises along the way. Realistically, we all know there are downsides to every investment. Find out what those are and compare them to the rewards you’ll be receiving. The rewards should always outweigh the risks. Always. If not… move on.
Ask the question, “What can go wrong and what will that mean for my investment?” The investment manager should answer in two ways: (1) an easy-to-understand explanation of what the downside is and (2) a clarification of what type of market forces can make that happen.
What you don’t want to hear is a false answer; a manager who says the downside is actually the upside. It reminds me of conducting job interviews. When you ask a candidate to tell you about their weaknesses and they reply, “Oh, people tell me I work too much and I should take more time off.” That is not a weakness. That is BS!
There are always real downsides to an investment, even if they are unlikely to happen. As we all know, things do happen. Unfortunately, those longshot downsides can, in rare cases, become a reality. Know them and understand them.
You will also want to know the different severity levels of the downside and how that will affect your investment. The answer should be as specific as possible. An example might sound like this: “The breakeven point for your investment is X. If the downturn is more severe, you could sustain a loss of Y, and if it lasts beyond 3 years you probably will be at Z.” No one has a crystal ball, but this demonstrates that the investment manager has modeled out multiple scenarios and understands some key metrics of his product or portfolio. He knows how it’s affected by outside forces and what to be keenly aware of in order to avoid that worst-case scenario.
One of the key metrics for our buy and hold fund is the rent. We can easily stress test our rental homes by leaving all the expenses at the same amount and reducing the rent. We find that if the rent was reduced by 20%, we would be somewhere in the 4% to 5% return range. If the rent was reduced by 40%, we expect to break even or have a small positive return. Both of those scenarios are drastic, and we don’t expect them to happen, but they could.
Running these stress tests quantifies our risk and helps us understand what our downside could look like. Next you have to ask, “What are the situations in which we could encounter reduced rents and what are the chances of that happening?” For our buy and hold fund, we know that our biggest risks are a natural disaster destroying a city or many large employers leaving a city. Although these events are unlikely, both situations could reduce rents in a single city which is why we have created more safety for our portfolio by purchasing homes in diverse geographical locations.
#3: Require Transparency and Accessibility
The final step is to make sure you have complete accessibility and transparency within the investment. I know most people don’t want to study profit and loss statements, balance sheets, property directories, etc. But make sure those, along with other important materials, are accessible to you. An example of this would be the online Data Room we have created for our investors and potential investors. You can check out our Data Room for the buy and hold fund here: www.HughesCapital.com/data-room/
These are items that should be provided to you by any investment manager. If they are not, you should be nervous. Again, trust your gut and move on.
Even if you don’t have the desire or skillset to review the information provided, just having this information available means there are others who will examine it in detail. At the very least, this may give you some assurance that the fund manager is not hiding anything.
I have been doing some due diligence on a liquidity fund for the past few months. It’s been a slow process because I’ve been too busy to give it my full attention. It takes time to make sure I would, first, personally do business with them and second, feel comfortable providing their information to our investors as a possible investment opportunity. Here’s the deal. Every time I’ve asked them for more due diligence items, they have provided them without question, even if what I’ve asked for isn’t that easy to provide. That is absolutely essential for me to continue moving forward with them. This is what you should expect as well.
This is actually one of the biggest key benefits of investing in alternative investments. You can be in control. Think about investing in Apple stocks vs. investing in real estate with someone you know. When Steve Jobs was alive you couldn’t call him up and ask him to explain why last month’s statement shows a dip in revenue. However, with many alternative investment managers, you can go meet with them face to face, call them, go golfing or out to lunch with them and check in on how your investment is doing. Alternative investments usually allow for more accessibility, transparency, and control. Isn’t that what everyone wants? Don’t accept anything less.