WHITEPAPER Family Offices and Alternative Investments By Paul A. Ehrhardt Managing Member Investment Business Advisors, LLC Washington DC October 2013 All Rights Reserved Family Office Association / WhitepAper Family Offices and Alternative Investments 2 Abstract In the midst of a prolonged low interest rate environment, many mid and large sized Family Offices are going beyond the traditional 60- 40 equity/fixed income asset allocation framework for their investment portfolios. In search of higher expected returns through portfolio diversification and lower volatility, and seeking to tap true alpha uncorrelated to traditional equity and fixed income markets, many Family Offices are making initial allocations or increased allocations to “alternative investments” including hedge funds, funds of hedge funds, private equity, real estate and commodities funds. How can Family Offices effectively and prudently pursue this trend? What are the specific lessons to be learned by Family Offices from the 2008-09 financial crisis regarding alternative investments? What additional lessons need to learned from the Madoff Ponzi scheme and other recent alternative investment frauds and failures? And what lessons can be learned from institutional investors (such as university endowments) whose portfolios have included significant allocations (>50%) to alternatives for many years? This White Paper posits that, as Family Offices pursue “alternative investments”, it is critical to their success that they undertake broader, deeper and more robust initial and ongoing due diligence assessment programs for these alternative investments. Traditional alternatives due diligence programs have had two major components: “Investment Due Diligence” and what has been termed “Operational Due Diligence” (“Ops DD”). This White Paper recommends expanding that framework to include 3 additional explicit categories of due diligence assessments regarding: “Alternatives Fund/Account/Investment Vehicle” due diligence, “Alternatives Manager Firm” due diligence and “Investment Business Process” due diligence. And to consider all 5 key areas under a new framework/heading called “Alternatives Investment Business Management Due Diligence”. Investment research shows that overall asset allocation decisions can be a very important driver of investment performance; explaining as much as 90% of the variability of portfolio returns. Research also shows clearly that “performance dispersion” among alternative investments (the difference between the highest and lowest performing funds/managers in a given alternatives strategy) varies much more widely than the performance dispersion in, e.g., long-only equity strategies. As a result, manager/fund selection is even more important in the alternatives arena than in the long-only world. This heightened importance of alternatives manager/fund selection further reinforces the importance of Family Offices adopting the broader, deeper and more robust due diligence programs as recommended in this White Paper. The author also suggests that use of formally adopted alternatives industry “Best Practices” can guide and give confidence to Family Offices as they pursue alternative investments more extensively. Several sources of formal alternative industry “Best Practices” are highlighted and the author also describes how these “best practices” should be customized to Family Offices based on each Family Office’s distinctive overall investment program characteristics and operating model (mix of internal and outsourced assistance). Attention is also drawn to a potential distinctive “sweet spot” for Family Offices investing in alternatives; i.e., by seeking to align the typical size of individual alternatives investments made by many Family Offices with the smaller and “younger” alternatives funds/ managers who have outperformed their larger peers. Following a summary of recommendations, there are 3 Appendices: Appendix A: Bibliography with relevant website addresses; Appendix B Sample Model Due Diligence Questionnaires (DDQs) – one for assessing Hedge Funds and the other for assessing Private Equity investments, and finally, Appendix C: Table of Contents (for 16 different) Alternatives Industry “Best Practices” documents”. © 2013 Family Office Association and Angelo J. Robles Family Office Association / WhitepAper Family Offices and Alternative Investments 3 Table of Contents I. Trends: Family Offices and Alternatives…………………………………………………………......................................................4 a. Moving away from “60-40 Asset Allocation Model” b. Importance of Asset Allocation as “Return Driver” c. Rationale for Allocations to “Alternatives” II. Types and Characteristics of Alternative Investments…………………………………………………………...............................7 a. Hedge Funds, Funds of Hedge Funds, Private Equity, Real Estate, Commodities b. Varied Strategies, Holding Periods, Liquidity & Other Terms c. Importance of Performance Dispersion and Manager Selection III. Family Offices Take Note of Lessons Learned From…………………………………………………………..............................12 a. 2008-09 Financial Crisis: • Liquidity/Illiquidity • Enhancement of Risk Management Capabilities • Transparency • Alignment of Interests • PPM Terms • Credit Facility Issues • Portfolio Diversification Low/No Correlation • Downside Protection • Leverage • Firm Leadership, Management & Governance • Valuation of Assets • Increased Regulation b. Madoff Ponzi Scheme c. Other Alternatives Frauds and Failures d. Institutional Investors with Extensive Alternatives Experience IV. Past/Present: Traditional Due Diligence…………………………………………………………....................................................30 a. 2 Types: “Investment Due Diligence” &“Operational Due Diligence” b. Continuing Evolution of Due Diligence Programs V. Future: Broader & Deeper “Alternatives Investment Business Management” Due Diligence…………………………………………………………..........38 a. 5 Part Due Diligence Framework b. Add “Fund”, “Firm” and “Business Process” Due Diligence VI. Alternatives Industry “Best Practices”…………………………………………………………......................................................45 a. Government, Industry and Other Sponsors of Formal “Best Practices” b. Examples of “Alternatives Industry Best Practices” VII. Customizing “Best Practices” to Family Offices…………………………………………………………......................................50 a. Meeting Family Office Specific Needs for Best Practices VIII. Family Office Investment Management Models…………………………………………………………........................................51 a. “Insourced” And “Outsourced” b. Combination IX. Family Offices & Alternatives Investment “Sweet Spot”…………………………………………………………........................52 a. Performance Advantage of “Smaller” and “Younger” Alternatives Funds/Firms b. Alignment with Family Office Alternatives Investments X. Conclusions & Recommendations…………………………………………………………............................................................62 Appendix A: Bibliography…………………………………………………………..........................................................................64 Appendix B: Sample Due Diligence Documents…………………………………………………………......................................73 Appendix C: Alternative Industry “Best Practices” Documents………………………………………......................................74 © 2013 Family Office Association and Angelo J. Robles Family Office Association / WhitepAper Family Offices and Alternative Investments 4 I. Trends: Family Offices and Alternative Investments Family Offices (along with other institutional and ultra- Kaplan demonstrated that “asset allocation explains high net worth individual investors) are increasingly approximately 90% of the variability of portfolio returns moving away from the traditional “60-40 Asset Allocation over time.”1 So it is clear that Family Offices and investors Model”; meaning 60% allocation to equities and 40% to of all types need to focus on the need for an asset fixed income assets. Even within the “60-40” model in allocation policy and strategy that reflects the investors’ recent years there has been a trend for many investors appropriate asset–liability matching needs, cash flow to diversify the types of equities (growth, value, core) requirements, risk tolerance and other factors. the target capitalization category/size (i.e., small, mid and large cap) and the geographic focus of equity This trend among virtually all investors in recent investments, (i.e., US, international, regional, emerging years toward making initial or increased allocations to markets, and global). Similarly, many investors have “Alternative Investments” has been documented in a diversified the type and maturity of fixed income securities variety of studies and research reports. For instance, held in their portfolios (i.e., US government and corporate a Rothstein Kass study in June 2011 found that more bonds, high yield bonds, target date maturity bonds, than 85% of Family Offices investing in hedge funds foreign sovereign bonds, emerging market bonds, etc.). at that point were highly likely to increase hedge fund allocations.2 In July 2012 McKinsey & Company predicted These changes in asset allocation have been a factor that allocations to alternatives will increase to 28% of total of the general level of knowledge, sophistication and portfolio assets by the end of 2013.3 The main purpose in experience of each investor and related advisors, and a adding such allocations is in order to achieve increased factor of the prolonged low interest rate environment that diversification and to increase