What to consider when evaluating an alternative investment

December 16, 20207 min read
What to consider when evaluating an alternative investment
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Here are six important questions to consider when evaluating private market investments.

1. What are the underlying assets of the investment?

When it comes to evaluating an investment, understanding the underlying assets helps address several considerations: what types of risks and returns an investor could expect, and whether the investment can provide diversification within an investor’s portfolio.

A business’ underlying assets can also hint at its risks and opportunities. Assets that create or hold value in many different scenarios may carry less risk than assets whose value may fluctuate or deteriorate in certain scenarios. Investors should also consider how underlying assets may or may not contribute to the diversification of their portfolios. For instance, adding an investment in art to a portfolio that already holds a lot of art investments won’t add the same diversification benefit as an investment that’s exposed to other markets, such as real estate.

Another consideration related to the underlying assets is when an investor is evaluating opportunities in the debt or lending space. For example, some private debt investments are secured by collateral. Collateral may help reduce the risk a lender has by giving the lender a claim on the assets if, for example, a borrower has trouble meeting the terms of their borrowing. (There are many types of collateral—we’ve broken down the different types of collateral used in real estate, art finance, and litigation.)

Steps to consider:

  • Get a clear idea of how an investment’s underlying assets might generate cash flows or drive future value.
  • Evaluate scenarios where those assets might become more, or less, valuable or vulnerable.
  • Consider whether those assets are similar or different compared to the rest of your portfolio. Varying assets help contribute to greater diversification.

2. What is the target yield (interest rate) of this investment?

It’s critical that investors evaluate an investment’s target yield, which is the expected percentage of principal returned on your initial investment. Yield can apply to both equity and debt investments, however it is typically a much larger proportion of returns in debt investments.

Here’s a quick debt example:

Say a hypothetical borrower takes out a loan of $10M to finance the construction of a new office building. The lender expects the borrower to pay back the $10M in principal, plus $0.8M in interest. Dividing $0.8M by $10M gets you 8%, or the yield on the loan. Target yield, together with return of principal, is an important consideration for investors.

Gross yield is the top-line amount an investment is expected to produce. Net yield or annual interest rate to investors is the investment’s return after the deduction of a management fee and other expenses (if any). In our hypothetical example, if the management fee is 1%, the net yield for the investor will be 7%—the gross yield of 8% minus the management fee of 1%.

Timing of payments also affects how we think about yield. Investments on the Yieldstreet platform have varying target maturities, ranging from a few months to a few years. Investors can compare target yields on investments with different target maturities by annualizing the target yield, calculating what the target yield would be for an investment assuming it produced the same returns for a single year. You can read more on measuring investment performance in our guide on internal rate of return vs. return on investment.

Think of yield not just in absolute terms, but also as a way to compensate investors for risk. All else equal, investors typically can expect higher yields for investments with a greater perceived risk. To evaluate whether the target yield on an investment justifies the risk, investors should consider the credit quality of the underlying loan, where the underlying loan sits in the capital stack, the liquidity of the underlying collateral, the underlying loan’s term and the likelihood of a default or other adverse events, among other considerations.

Steps to consider:

  • Account for the timing of interest payments by calculating a standardized target yield measure, such as the internal rate of return.
  • Consider the risks that may drive whether the target yield is relatively high or relatively low with respect to the risks only. Note that target yields are affected by other considerations as well.
  • Compare target yields in alternative investments with those of traditional investments for a sense of the potential risk/reward.

3. When may you expect to get paid?

Unlike traditional investments that tend to be highly standardized, private debt investments are more customized to the unique circumstances of both the lender and borrower of the underlying loan. This means some additional research on your part may be necessary to become comfortable with a specific loan’s unique structure and its timing of cash flows.

For example, Yieldstreet investments have a variety of payment structures and schedules, while the timing of final payments are expected shortly after a loan’s final maturity. Some investments pay interest before the principal is returned, typically on a monthly or quarterly cycle, and others pay all interest at maturity. Because each investment is unique, it’s important to review the relevant offering documents, such as the Private Placement Memorandum and Series Note Supplement or Investment Memorandum to better understand the schedule of cash payments and the risks of each investment.

Steps to consider:

  • Understand that there are many ways to structure an offering in terms of timing and frequency of payments.
  • Assess payment structures and the timing of payments to clearly understand when and how you should expect to receive payment.
  • Understand other risks of each investment.

4. What is the liquidity of this investment?

Traditional investments like traded stocks and bonds, and cash have the advantage of strong liquidity. Because these investments trade in active markets with many buyers and sellers, it tends to be relatively easy to enter or exit traditional investments at prices close to fair value.

While some alternatives such as commodities and currencies also have strong liquidity, private debt investments tend to have reduced liquidity, meaning that the investment cannot be quickly sold or exchanged for cash without the potential for a substantial loss in value. In contrast, investors in illiquid assets often have the opportunity to earn higher returns than when investing in more liquid assets (what is known as a “liquidity premium”). However, investors should consider how their own need for cash might affect their investment decisions, while understanding that less liquidity may prevent them from accessing their capital until the final term of the investment. Investors in illiquid investors should be willing (if necessary) to hold their investments for an indefinite or long period of time.

Steps to consider:

  • Consider whether any reduced liquidity in an investment is justified by its target rate of return.
  • Compare the expected timing of payments and investment risks with any anticipated liquidity needs you may have as an investor.

5. Where does the investment’s underlying loan sit in the capital stack?

The capital stack (capital structure) is the ranking of different types of lenders in a loan according to their seniority in terms of payment and lien priority. Lenders at the top of the capital stack are more senior, and they can expect to be paid before lower-ranking investors. The lower a lender ranks in the capital stack, the greater the risk of loss. For example, if the underlying loan of an investment becomes impaired, lenders who are higher in the stack will have priority and a higher claim to be paid back before those lower in the stack, who are more likely to realize losses first. To compensate for the additional risk, lenders at the lower end of the capital stack tend to earn higher returns.

Steps to consider:

  • Assess the underlying loan’s level of payment and lien seniority by understanding how much capital has priority over the underlying loan’s lender and gauge how the capital stack affects your risk level.

6. What are the potential risks?

All investments carry risk, and understanding risk is a key step in any investment process. The definition of risk can vary for different types of assets. In private debt, investors typically consider risks in terms of defaults and permanent impairments. A default occurs when a borrower breaches some aspect of a loan agreement, for example by failing to make an interest payment on time. A default does not signify that the lenders will necessarily lose any interest owed or principal. A permanent impairment takes place when a loan incurs a loss that can’t be recovered.

Investors can use metrics like loan-to-value (LTV) ratio of the underlying loan to help them understand how serious the risks of default or impairment might be. Evaluating how concentrated or diversified an investment is can also help: Does the investment involve only one asset as collateral, or is there a substantial variety of underlying assets that helps spread around the risk?

While it’s fun to consider the potential rewards of an investment, especially one with an attractive yield, investors should carefully weigh what could happen in a downside scenario to reach a balanced and educated decision.

Steps to consider:

  • Carefully review any investment’s Private Placement Memorandum and Series Note Supplement or Investment Memorandum and other documents for details concerning an investment’s risk profile.
    Evaluate LTV as well as the originator’s and borrower’s circumstances and track record.
  • Get a clear sense for how similar assets/collateral have fared in the past and try to determine an expected value of the investment in an adverse situation.
  • Evaluate how diversified the investment is—exposure to a larger variety of assets may help reduce the investment’s concentration risk.

Investors in alternatives should carefully evaluate the risks related to each investment they’re considering, and have a strong understanding of the underlying assets, yield, timing of payments, liquidity, place in the capital stack, potential risks, among other factors.