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Alternatives in portfolio context — due diligence + sizing

In this chapter: Investment due diligence (IDD) · Operational due diligence (ODD) · Pacing model for PE/VC · Liquidity tiering

~3 min readLayer 4 · Professional CertificationsFree

Adding alternatives to portfolio improves risk-adjusted returns but creates manager-selection risk + liquidity constraints. CFA L3 tests both.

Foundation

**Due diligence levels**: **Investment DD (IDD)**: - Strategy: edge, capacity, scalability. - Track record: returns, drawdowns, attribution. - People: pedigree, retention, succession. - Process: discipline, repeatability. - Performance metrics: Sharpe, IR, alpha, factor exposures. **Operational DD (ODD)**: - Trade execution. - Counterparty management. - Custody. - Valuation policies (especially for illiquid). - Compliance + legal. - Audit, financial controls. - Key-person risk. - Cybersecurity. Most hedge fund failures are operational, not investment-related. Madoff was 100% operational red flag.

Deep Dive

Pacing model for PE: - Target ultimate allocation: e.g., 15% to PE. - Vintages mature over 8-12 years (J-curve). - Need to commit ~4-5x annual deployment to reach steady state. - Build commitment schedule across vintages to maintain target. Liquidity tiering: - Tier 1 (daily): listed equities, bonds, ETFs. - Tier 2 (monthly-quarterly): hedge funds with redemption. - Tier 3 (annual+): PE, VC, real estate, infra. Lock-up + secondary market for liquidity. Portfolio constraint: liquidity demands of investor / liability profile. For pension: long-horizon → larger Tier 3 OK. For endowment with 5% spending: ~80% liquid, ~20% illiquid OK. For foundation with redemptions: more liquid.

Advanced

L3 essay: "Allocate $500m for university endowment to alternatives. Recommend due diligence framework + portfolio targets." Framework: 1. Define role of alternatives (return enhancement, diversification, inflation hedge). 2. Set target allocation: 30% (Yale-like) or 15-20% (more conservative). 3. Manager selection process: - Screen for IRR, MoM, IR over multiple cycles. - IDD + ODD before commitment. - Diligence sources: GP communications, LPs, references. 4. Pacing: 4x annual commitment to reach 30% target. 5. Concentration limits: max 5% to single fund. 6. Reporting: NAV-based for PE, marked daily for hedge funds.

Regulatory references
  • SEBI AIF Regulations 2012
  • CFA Institute Alts curriculum
Common mistakes & pitfalls
  • Underweight ODD — operational failures cause big losses.
  • Over-committing to alternatives without liquidity buffer.
  • Concentration in single fund or vintage.

Frequently asked

Why is ODD as important as IDD?
Most fund failures (LTCM, Madoff, etc.) had operational red flags. ODD catches what IDD misses.
How much liquidity buffer to keep?
Match to spending/redemption needs. Typically 1-3 years of cash flow in liquid (Tier 1).

Practice questions

Click each question to reveal the answer and explanation.

Q 1
ODD focuses on:
  1. (a)Investment strategy
  2. (b)Operations, controls, custody
  3. (c)Track record
  4. (d)Manager pedigree
Correct: (b) Operations, controls, custody
ODD: operations, valuation, controls, compliance. Distinct from investment due diligence.
Q 2
PE pacing model:
  1. (a)Annual commitment to maintain target
  2. (b)Single lump sum
  3. (c)Quarterly rebalance
  4. (d)No commitment plan
Correct: (a) Annual commitment to maintain target
Pacing: spread commitments across vintages to maintain target through J-curve.
Q 3
Tier 3 liquidity =
  1. (a)Daily
  2. (b)Monthly
  3. (c)Annual or longer
  4. (d)Hourly
Correct: (c) Annual or longer
Tier 3 = illiquid (PE, RE, infra). Annual+ liquidity, often via lock-up.
Q 4
Endowment alternatives target typically:
  1. (a)<5%
  2. (b)15-30%
  3. (c)60%
  4. (d)95%
Correct: (b) 15-30%
University endowments often 15-30% in alternatives. Yale model 50%+.
Q 5
IDD includes:
  1. (a)Counterparty
  2. (b)Custody
  3. (c)Strategy + track record + people + process
  4. (d)Cyber
Correct: (c) Strategy + track record + people + process
IDD: investment-side analysis (strategy, returns, team, process).
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.