While you are considering investing in the ever-popular alternative investment space, there are several traps to be aware of before signing up for any investment. Risks exist in every investment opportunity — which is why you get a return greater than 0 per cent — but this doesn’t mean it’s fine to take a cavalier approach. Due diligence and thorough risk assessment can highlight which investments are worth the risk they come with, and which most definitely are not. Let’s take a look at some potential traps to watch out for.
1. Refinance risk
Refinance risk is a genuine risk in private credit. If the capital raiser can’t find another funder, you may end up holding an investment for longer than expected. This is something you need to consider. In the investment scenario, your refinance risk of loss as a lender is considerably reduced if you’re senior in the capital structure because you’ve got the asset as your security. Although, if you need to exercise on the security, where you rank in the capital structure does not save you the time, legal costs, price impact and administration burden of having to take over the asset and force the sale to get your money back.
2. Counterparty risk
The counterparty is the company you are doing the trade with. You want to be sure the counterparty has a ringfenced legal structure that avoids being polluted by losses on other assets; for example, a unit trust set up with a segregated trustee bank account that your investment will go into. This ensures your investment never gets mixed up with the operations of the capital-raising company, which would expose you to substantially more risk. If the company folded, your money would become part of the assets in liquidation. However, if it is segregated in a special purpose company or trust, you have more exposure to the underlying investment because the special purpose entity has one job: to hold the underlying investment for your beneficial interest.
Also read: Financial Markets Remain Challenged By Multiple Threats
3. Operational risk
Operational risk is the risk that a good investment will go bad due to operational aspects (sloppy administration). You could invest with a great team who finds you the best investment opportunity on paper, but if the counterparty is a small business with no operations staff or a medium-sized business lacking operational experience and expertise, things can go bad. Operational aspects include things such as making sure bank accounts are set up correctly, payments are being made to the right bank accounts, the right payments are being made, payments are being chased up and the company is being run well operationally.
4. Market risk
Market risk is part of investing. Without it you would not get any return on your capital. These risks exist everywhere in investing and include credit, interest rate, currency, commodity and inflation. They can be tolerated as part of investing with the understanding that with the risk comes the return, or you can attempt to isolate and hedge a particular risk. A simple example could be hedging an interest rate risk; for example, you could buy a floating rate corporate bond (you receive a floating interest rate) and be happy with the credit and liquidity risk of the underlying bond but be concerned interest rates may fall. You could hedge this risk through receiving a fixed interest rate swap from a bank and paying a floating interest to the bank, effectively removing the falling interest rate risk.
5. Business risk
This is like market risk but relates to the day-to-day risks of investing at the operating business level. General market conditions can impact the performance of a business. This risk is more idiosyncratic in that management can underperform, struggle to hire staff, find finance or back the wrong widget. Be aware that exposure to a single company is a very concentrated investment: if the business performs well you win, if not, you lose. You could invest through a pooled, diversified type of structure. There is a place for single business investing such as providing growth capital to an emerging business, although because it is higher risk–higher return, you need to be aware that you could lose your entire capital.
A good investor document will disclose major relevant risks. However, the list could theoretically be endless. If none of them are disclosed, consider it a red flag, as many of these are relevant in the alternative asset space.
