Key Takeaways
- Alternative investments can enhance portfolio diversification by delivering returns that move independently of stocks and bonds.
- Alternative investments carry a higher risk than traditional investments, due to factors such as complexity, illiquidity and limited oversight.
- Compliance issues are common, with many alternative fund managers reporting fines or sanctions in recent years.
- Performing alternative investment due diligence is essential to help prevent fraud, protect capital and optimize long-term portfolio performance.
Many of us have a friend, family member, neighbor or old classmate who’s always reaching out with a “can’t lose, you’ve got to get in on the ground floor” investment opportunity. These are often alternative investments that could include a new business venture, a real estate opportunity or a type of loan, for instance.
Alternative investments can provide a helpful way to diversify your portfolio, with many offering a buffer against market downturns. However, there are some drawbacks — and these investments typically carry higher risk than their traditional counterparts.
Some of these opportunities can be valid, but there are many historical examples of investment opportunities that weren’t in investors’ best interests. In fact, a 2024 Ocorian report found that approximately 67% of alternative fund managers said their organizations had faced compliance fines or sanctions within the past two years.
The main takeaway here, especially for high-net-worth and ultra-high-net worth investors, is that the right alternative investments can strengthen your portfolio, but not all will. To protect your capital, it’s essential to perform thorough due diligence before moving forward with an investment.
At Creative Planning, we take alternative investment due diligence very seriously. Let’s take a closer look at what investors need to know.
Why Alternative Investments Require Enhanced Due Diligence
Alternative investment strategies require more rigorous vetting than traditional investments for a variety of reasons, from illiquidity and complexity to higher fees, limited regulations and manager skill dispersion.
Still, alternative investment opportunities have the potential to be lucrative additions to your investment portfolio, thanks to their higher earning potential. However, with that potential comes increased risk that demands enhanced due diligence.
Understanding Investment Due Diligence vs. Operational Due Diligence
When performing due diligence on alternative investments, it’s important to understand the two distinct components of the overall assessment process: investment due diligence (IDD) and operational due diligence (ODD).
IDD focuses on reviewing the investment-related functions of a fund or asset. The primary goal is to assess the potential returns, investment risks and suitability of the investment strategy for your broader portfolio. Key steps include a strategy analysis, performance evaluation, risk assessment, portfolio analysis and market opportunity assessment.
ODD, on the other hand, focuses on assessing the operational risks associated with an alternative investment. The purpose of this is to determine if an investment’s operations are sound enough to avoid losses due to issues such as failure, fraud or weak internal controls. Key steps include reviewing back-office operations, third-party service providers, compliance infrastructure, conflict management and cybersecurity protocols.
Today, a thorough alternative investment due diligence process requires both IDD and ODD. Historically, IDD was more common, but ODD is just as crucial now. In fact, many investor losses now come from operational rather than investment strategy failures.
Key Areas to Evaluate During Alternative Investment Due Diligence
To help you better understand what to look for before investing, here’s an alternative investment due diligence checklist you can keep on hand.
Investment strategy and philosophy
Before investing, make sure you clearly understand how the alternative investment generates returns and what gives it a competitive edge. If the explanation feels overly complex or unclear, that’s reason to pause. Also, be sure to confirm that the strategy aligns with your broader investment goals and risk tolerance.
Manager track record and performance
Ask to see how the manager’s previous investments have performed — and not just in bull markets. Look for consistency across market cycles. If their success story sounds too perfect or relies on cherry-picked numbers, dig deeper. According to CAIS, top-quartile alternative managers can outperform median peers by more than 10% annually, compounding dramatically over time.
Background checks and manager verification
Verify the manager’s credentials and confirm they’re properly registered with the SEC or FINRA. Watch out for past litigations, bankruptcies or disciplinary actions. A reputable manager will welcome your requests.
Fee structures and total cost analysis
Fees can quietly eat away at your returns. Investigate the full fee structure of investments. These can include management fees, incentive-based compensation for the asset manager, ongoing service fees and redemption fees. You want to have a clear understanding of the total cost.
Legal structure and third-party service providers
Make sure the investment is properly structured with trusted third parties, like auditors, administrators and custodians. These checks and balances help protect you. If one person or firm seems to control everything, that’s a red flag worth heeding.
Valuation methodology and transparency
Ask how the fund’s assets are valued and who’s doing the valuing. For illiquid investments, the process should be consistent, well-documented and independently verified. Regular third-party audits and clear reporting help ensure the numbers are more than optimistic estimates.
Conflicts of interest and alignment
It’s important to know whether the recommended investment has any conflicts of interest. This could include money invested by the person recommending the opportunity or conflicts within the firm’s management that prioritize firm managers over investors.
Cybersecurity and technology infrastructure
Even the strongest investments can be compromised by weak cybersecurity. Ask how the manager protects client data, guards against breaches and backs up records. A modern, secure infrastructure protects both your personal information and your investment.
Legal and regulatory compliance
Review all offering documents, contracts, licenses, permits and past/pending lawsuits. Ensure compliance with all relevant laws and regulations to identify hidden liabilities. Check Form ADV filings and any SEC examination history.
Risk management framework
Every investment carries risk, but smart managers plan for it. Ask how they identify and manage market, liquidity, credit, counterparty and operational risks. A solid manager can explain how they monitor exposures, stress test scenarios and prepare for downturns.
Liquidity terms and lock-up periods
Some investments can tie up your money for years, so it’s crucial to understand when and how you’ll be able to access your funds. Ask about the expected holding period, redemption terms, lock-up periods and the manager’s exit plan. Clear timelines help to prevent unwanted surprises later.
ESG and sustainability factors
Consider environmental, social and governance (ESG) factors, including sustainability practices and ethical policies, as these can impact long-term value and reputation.
Exit strategy and realization track record
Research how and when investors typically exit. A manager with a proven track record of successful realizations shows they can close the loop.
When it comes to alternative investments, you don’t want to rush the process or get swept up in hype. At Creative Planning, we help our clients evaluate opportunities and ensure they’re legitimate options to add to your portfolio.
Integrating Due Diligence Insights Into Your Portfolio Strategy
Our wealth managers complete a rigorous due diligence process on alternative investments and have recommended options available for your portfolio. This means the next decision for you is whether to move forward. If you decide to move forward, your wealth manager will advise you on how much of your portfolio to allocate to the investment and how long to hold it for.
At Creative Planning, we evaluate each alternative investment opportunity by assessing its correlation benefits, diversification impact, structure, governance and manager skill. The result is a personalized allocation strategy designed to fit your goals, manage risk and help support lasting growth.
We know that investments in public markets would only access around 13% of high-revenue diversification opportunities, which is why we provide access to alternative investments through private markets in four main pillars (private equity, private credit, private real estate and private infrastructure funds).
Our investment managers are well-versed in the benefits of alternative investments, as well as the due diligence needed to help ensure a match for your values and portfolio.
Frequently Asked Questions About Alternative Investment Due Diligence
What is alternative investment due diligence, and why is it important?
Alternative investment due diligence is a thorough, investigative process that assesses the risks, potential returns and viability of investments outside of traditional investments. It’s crucial to do your homework, because alternative investments tend to carry more risk than traditional investments and lack the transparency and regulatory oversight of public markets.
What should be included in an alternative investment due diligence checklist?
A thorough alternative investment due diligence checklist is lengthy but should include steps such as investigating the manager’s background and performance, investment strategy, fees, legal structure and risk controls. It also evaluates valuation methods, conflicts of interest, liquidity terms and compliance. Comprehensive checklists used by institutional investors often contain 50-100 (or more!) verification points.
How long does the due diligence process usually take?
The due diligence process for alternative investments typically takes 45-60 days for thorough institutional-quality reviews, though timelines can range from a few weeks to several months, depending on the complexity of the investment and the availability of information. Simpler opportunities may be reviewed in four to six weeks, while more complicated ones can take three to six months. Rushing due diligence to meet fund closing deadlines is a red flag.
Can due diligence improve portfolio performance over time?
Yes, effective due diligence can improve portfolio performance over time. By identifying high-quality managers (top-quartile managers can outperform median peers by more than 10% annually), competitive fee structures and well-aligned strategies, you can reduce the likelihood of investing in underperforming or poorly managed funds. The compounding effect of proper manager selection dramatically impacts long-term wealth accumulation.
What red flags should I watch for during alternative investment due diligence?
Key red flags vary by category. On the performance and financial front, for example, watch out for unrealistic or guaranteed returns, inconsistent or incomplete financial data, growing debt levels, and negative cash flow. Operationally, red flags include evasive responses, a lack of transparency, an unclear investment strategy, self-administered funds or unknown service providers, a lack of independent auditors, and a lack of an exit strategy.
What are the tax implications of alternative investments?
The tax implications of alternative investments are complex and highly dependent on the specific asset type, investment structure, holding period and investor’s tax status. Many alternative investments generate K-1 tax forms instead of 1099s, which often arrive late (March–April) and can delay tax filing. Some investments may trigger unrelated business taxable income (UBTI) for tax-exempt accounts or IRAs as well as multi-state filing requirements. Income can be taxed as ordinary income, taxed at capital gains rates or, in some cases, enjoy tax-deferred growth. Work with a tax professional experienced in alternative investments to navigate these complexities.
What qualifications should I look for in an alternative investment manager?
Look for a manager with a verifiable track record (ideally 10 or more years, including full market cycles), professional credentials (like a CFA charterholder or CFP® professional), a sound investment philosophy, strong risk management discipline and experience navigating multiple market cycles. They should have transparent reporting, reputable third-party relationships and clear alignment with investors.
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