How to invest: What to look for before you invest

In the Financial Post exclusive web series on alternative investing, David Kaufman, president of Westcourt Capital Corp., takes investors beyond traditional stocks and bonds to explore how to add value to your portfolio with hedge funds, debt instruments, real estate investment trusts, mortgage funds, private equity and even collections of art and wine. The series will run Wednesdays and Fridays.

If you are considering an investment in any private alternative investment fund (such as a REIT, a mortgage fund, a hedge fund or a private equity fund), the onus is on you to undertake due diligence to ensure that you have a complete understanding of the nature of the offering so that your ultimate decision of whether to invest will be fully informed. Typically, investment funds are sold through an "offering memorandum" (OM), a legal document that establishes the rules that the fund and its managers must follow. You must read this document! To facilitate this process, the following will highlight what you ought to look for in the OM and what other key pieces of information you should elicit in the due diligence process.

A good OM provides a narrative regarding the identity and experience of the fund managers, and provides a clear explanation of the methodology employed by them to provide the returns to investors promised in the marketing documents. If the fund is "open", meaning that it is already in existence and taking on new investors, the OM should provide details about how the fund has performed so far. If the fund is new, the OM should provide detailed information about similar funds operated by the managers in the past, including specific performance metrics. Careful study of the OM, complemented by interviews with the management team, should also alleviate any concerns that the fund might rely on raising capital from new investors to provide returns to the existing investors.

Once you understand the nature of the investment, you should carefully consider two critical factors: management fees and redemption policies. The managers are the group investing your money on your behalf and obviously must be compensated for this service. Annual management fees below 3% are generally considered reasonable, and performance fees (or "carried interest"), where the managers receive a bonus for enhanced returns, are usually capped between 10-20% of the gains. What you must consider regarding fees is the extent to which they diminish your returns, potentially negating (from a returns perspective) much of the management expertise which supported the investment in the first place. You should also be wary of performance fees in funds specializing in providing conservative income, since managers should never be incentivized to take on undue risk to their benefit.

Opponents of investment funds that are not publicly traded usually point to the lack of liquidity as their major drawback. Most of these funds have "lockup" periods of a year or more during which investors have no opportunity to withdraw their money, with redemption fees ranging from 1-5% in the 3-5 years following the lockup. Other funds lockup investors' cash for five years or more, and provide no opportunities for early redemptions. In either scenario, you must fully comprehend the redemption policies of the fund you are considering and how they have been applied in the past.

In many cases, investors in private funds have enjoyed excellent risk-adjusted returns over the life of their investments. If you have the financial wherewithal to participate in a private investment fund, and have engaged in adequate due diligence to satisfy yourself that both the fund and the fund manager are sound, you could well reap these same rewards.

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