Risk & Drawdown Analysis for Alternative Investments
In private markets, manager risk exceeds market risk. Illiquidity prevents exit, opacity enables fraud, and alignment failures compound losses. This framework identifies red flags, walk-away signals, and structural risks before capital commitment.
The Centrality of Non-Market Risk
Alternative investments introduce risks absent from public markets: operational failures, valuation manipulation, misaligned incentives, and legal structure exploitation. Unlike market volatility (which is cyclical), these risks are often permanent and unrecoverable.
The AltStreet Standard: Assume all red flags are fatal until proven otherwise. Due diligence is primarily a defense against fraud, incompetence, and structural misalignment—not a prediction of returns.
If You Only Read One Thing
- 1.Manager risk exceeds market risk. In private markets, illiquidity prevents exit—fraud and operational failures generate permanent losses.
- 2.Walk-Away Signals (W.A.S.) are non-negotiable. Self-custody, unverified track records, GP investment below 1% of AUM, and liquidity mismatches warrant immediate rejection.
- 3.Three pillars cover all alternatives: Manager & Personnel Risk, Operational & Infrastructure Risk, Legal & Financial Structure Risk. Every investment must pass all three.
- 4.Document every red flag immediately. Seek written clarification, consult third-party experts, and assume flags are fatal until proven otherwise.
- 5.Position sizing limits catastrophic loss. Maximum 5-10% per manager, 15-25% per asset class, 20-40% total alternatives. Use staged deployment for new managers.
The Three-Pillar Risk Assessment Framework
Manager & Personnel
- Unverified track record
- Minimal GP investment
- Personnel turnover
- Regulatory violations
Operational & Infrastructure
- Self-custody / related parties
- Opaque valuations
- Inadequate insurance
- Late/non-standard reporting
Legal & Financial Structure
- No hurdle rate / high-water mark
- Excessive catch-up provision
- Liquidity mismatch
- GP-favoring jurisdiction
Walk-Away Signal (W.A.S.)
A red flag so severe it warrants immediate rejection without further diligence. These indicate structural problems that cannot be mitigated through monitoring or side letters. Examples: self-custody, unverified performance, manager investment below 1% of AUM.
Yellow Flag
A concerning issue that requires investigation and written clarification from the manager. May be explainable, remediable, or mitigatable through structural changes or side letters. Examples: late reporting (first occurrence), personnel turnover, covenant-lite structures.
How AltStreet Uses This Framework
This risk assessment methodology is foundational to everything we publish. It's not standalone content—it's the doctrine that drives our platform reviews, scorecards, and investment analysis.
Platform Reviews
Every AltStreet platform review applies this three-pillar framework. If a platform fails operational risk assessment, we don't publish coverage.
Scorecards & Ratings
Our ratings and comparisons are downstream of this logic. Walk-away signals result in automatic disqualification from ranking tables.
Return Modeling
If a deal fails here, we don't model returns. Risk assessment precedes financial analysis—always.
Our Commitment: No manager relationships, no affiliate incentives, no conflicts. This framework protects capital, not commissions.
The Three Pillars of Alternative Investment Risk
Every alternative investment carries risk across three universal dimensions. This framework applies to all asset classes: private credit, real estate syndications, litigation finance, farmland funds, tokenized assets, and beyond.
Pillar I: Manager & Personnel Risk
Manager integrity, experience, and alignment determine whether capital is safeguarded or exploited. This pillar evaluates the people controlling your investment.
Walk-Away Signals (W.A.S.)
Unverified Track Record
Red Flag: Performance data not audited by a Big Four firm (Deloitte, PwC, EY, KPMG) or recognized regional auditor.
Why It Matters: Self-reported returns can be fabricated, cherry-picked, or calculated using non-standard methodologies. Without third-party verification, you're trusting marketing materials.
→ W.A.S.: Do not invest without audited performance history.
Misaligned Skin in the Game
Red Flag: GP/sponsor investment represents less than 1% of fund AUM, or their capital contribution is borrowed rather than from personal wealth.
Why It Matters: Managers with minimal personal capital at risk can pursue strategies that maximize fees over returns. Borrowed GP commitment signals lack of confidence or insufficient personal wealth.
→ W.A.S.: Require 1-3% GP investment minimum (5-10% for funds under $50M), funded from personal capital.
High Personnel Turnover
Red Flag: Key investment professionals (portfolio managers, analysts) leave the firm within 12 months of fund launch or capital raise.
Why It Matters: Departures signal internal dysfunction, strategic disagreements, or compensation disputes. The team that marketed the fund may not be managing it.
→ Requires immediate investigation and potential redemption consideration.
Undisclosed Regulatory History
Red Flag: Any SEC, FINRA, or state securities regulator disciplinary action within the past 5 years that was not proactively disclosed in offering documents.
Why It Matters: Regulatory violations indicate past misconduct. Failure to disclose suggests ongoing integrity issues and disregard for compliance obligations.
→ W.A.S.: Check Form ADV Part 2, BrokerCheck, and state securities databases before any commitment.
What Good Looks Like
- •Audited track record spanning multiple market cycles (minimum 5 years, ideally 10+)
- •GP investment of 3-5% of AUM on same terms as LPs, from personal capital
- •Stable investment team with average tenure exceeding 7 years
- •Clean regulatory record with proactive disclosure of any past issues (even if minor)
Pillar II: Operational & Infrastructure Risk
Operational risk encompasses custody failures, valuation manipulation, reporting opacity, and inadequate controls. These risks often enable fraud or conceal underperformance.
Walk-Away Signals (W.A.S.)
Self-Custody or Related-Party Services
Red Flag: The manager also serves as custodian, administrator, transfer agent, or valuation provider—or these services are provided by affiliated entities.
Why It Matters: Self-custody is the primary enabler of Ponzi schemes and asset misappropriation. Independent third-party custody creates separation of duties and prevents commingling.
→ W.A.S.: Require institutional-grade third-party custodian (e.g., BNY Mellon, State Street, Northern Trust for liquid assets; qualified intermediaries for real assets).
Lack of Valuation Transparency
Red Flag: Valuation reports are generated internally without oversight from a recognized third-party valuation firm (Duff & Phelps, Houlihan Lokey, Lincoln International, etc.).
Why It Matters: Illiquid assets require subjective valuation methodologies. Internal valuations can inflate NAV to hide losses, justify performance fees, or delay write-downs.
→ Require quarterly third-party valuations or annual independent appraisals for real assets.
Inadequate Insurance Coverage
Red Flag: Fund or manager cannot provide proof of Errors & Omissions (E&O) insurance and Directors & Officers (D&O) liability coverage.
Why It Matters: Without insurance, investor recourse in cases of operational failures, breaches of fiduciary duty, or negligence is limited to manager assets (often minimal).
→ Require minimum $5M E&O and $10M D&O coverage for funds over $50M AUM.
Late or Non-Standard Reporting
Red Flag: Quarterly investor reports are delayed by more than 60 days after quarter-end, or use non-GAAP/non-standardized performance metrics without reconciliation.
Why It Matters: Reporting delays often precede liquidity crises, hidden losses, or operational breakdowns. Non-standard metrics obscure true performance.
→ W.A.S. unless delay is transparently explained and one-time (e.g., auditor change).
What Good Looks Like
- •Institutional third-party custodian for all liquid assets; qualified intermediary for real assets
- •Quarterly third-party valuations with methodology disclosure and variance analysis
- •Comprehensive E&O and D&O insurance with coverage minimums tied to AUM
- •Quarterly reports delivered within 45 days, annual audited financials within 90 days
Pillar III: Legal & Financial Structure Risk
Fee structures, governance rights, and liquidity terms determine whether a fund is designed to benefit investors or extract value for managers. Poor structures can turn otherwise sound strategies into investor-hostile vehicles.
Walk-Away Signals (W.A.S.)
No Hurdle Rate for Performance Fees
Red Flag: Performance fees (carried interest) are charged from the first dollar of profit without a hurdle rate or high-water mark.
Why It Matters: Managers earn incentive compensation even when returns fail to exceed cash equivalents or justify illiquidity risk. This structure rewards mediocrity.
→ W.A.S. for most strategies. Require minimum 5-8% preferred return (hurdle) before carry is earned.
Uncapped or Exploitative Catch-Up Provision
Red Flag: Catch-up provision allows GP to take 100% of profits immediately after the hurdle is met until they've received their full carried interest allocation.
Why It Matters: While standard in private equity, excessive catch-up (above 100% GP take) disproportionately benefits managers during modest return scenarios.
→ Review carefully. Standard is 100% catch-up; anything higher warrants scrutiny.
Liquidity Mismatch: Short-Term Redemptions, Long-Term Assets
Red Flag: Fund offers monthly, quarterly, or annual redemptions while investing in illiquid assets (private equity, real estate, litigation finance, farmland).
Why It Matters: Creates run-on-the-bank risk. During market stress, redemptions force fire-sale liquidations or redemption gates, leaving remaining investors trapped with devalued assets.
→ W.A.S.: Liquidity terms must match underlying asset liquidity. Illiquid assets require closed-end structures or 3-5 year lock-ups.
GP-Favoring Jurisdiction
Red Flag: Fund is domiciled in an unfamiliar or historically non-investor-friendly jurisdiction (e.g., certain offshore centers) without clear tax advantages or regulatory oversight.
Why It Matters: Some jurisdictions provide minimal investor protections, opaque legal frameworks, or expensive dispute resolution processes.
→ Require jurisdictional justification (tax efficiency, regulatory certainty) and legal counsel review.
What Good Looks Like
- •5-8% preferred return (hurdle rate) before performance fees; high-water mark provision
- •Standard 100% catch-up (GP takes 100% of returns after hurdle until reaching 20% allocation)
- •Liquidity terms match asset duration: 7-10 year closed-end for PE; 3-5 year lock-up for real estate
- •Domicile in established jurisdiction (Delaware, Luxembourg, Cayman with CIMA oversight) with transparent rationale
Asset-Specific Red Flags
Beyond the universal three-pillar framework, each alternative asset class carries unique structural and operational risks. These mini-checklists highlight critical warning signs by strategy.
Private Credit & Direct Lending
- No Covenant Structure: Loans lack minimum debt/equity ratios, interest coverage requirements, or material adverse change clauses
- High Unsecured Percentage: More than 30% of portfolio in unsecured or subordinated debt
- Opaque Borrower Quality: No disclosure of weighted average EBITDA, revenue, or leverage ratios for portfolio companies
- Payment-in-Kind (PIK) Toggle: Over 20% of interest accrued rather than paid in cash (inflates returns artificially)
Real Estate Syndications
- Guaranteed Returns: Promoter promises fixed returns (e.g., "guaranteed 10% annually") regardless of property performance
- No Recent Appraisal: Property valuation over 12 months old or not conducted by MAI-certified appraiser
- Missing Environmental Report: No Phase I Environmental Site Assessment for properties with industrial history
- Excessive Leverage: Loan-to-value ratio exceeds 75% without recourse or additional collateral
Tokenized Real-World Assets
- Unaudited Smart Contract: Token contract not audited by recognized blockchain security firm (Trail of Bits, OpenZeppelin, CertiK)
- No Legal Entity Holding Title: Token represents on-chain claim without off-chain SPV or legal entity holding actual asset
- Non-KYC Exchange Reliance: Token only tradeable on non-KYC/AML-compliant exchanges (regulatory risk)
- Unclear Redemption Rights: No defined process to convert token back to fiat or underlying asset
Litigation Finance
- Single-Case Concentration: Fund invests over 50% of capital in a single legal claim (binary outcome risk)
- No Independent Legal Review: Case selection not vetted by external law firm or legal advisory committee
- Defendant Insolvency Risk: No disclosure of defendant financial condition or ability to pay judgment
- Opaque Fee Waterfalls: Returns calculated after deducting legal fees, but fee structure not disclosed
Red Flag Quick Reference: Issue → Action
Structured decision matrix for rapid red flag triage during due diligence. Use this table to determine immediate next steps when warning signals emerge.
| Red Flag | Category | Severity | Action Required |
|---|---|---|---|
| Self-custody or related-party administrator | Operational | W.A.S. | Walk away immediately |
| Unverified / unaudited track record | Manager | W.A.S. | Walk away immediately |
| GP investment below 1% of AUM | Manager | W.A.S. | Walk away immediately |
| Liquidity mismatch (daily/monthly redemptions + illiquid assets) | Structure | W.A.S. | Walk away immediately |
| No hurdle rate or high-water mark | Structure | W.A.S. | Walk away (most strategies) |
| Undisclosed regulatory violations | Manager | W.A.S. | Walk away immediately |
| Late reporting (60+ days past deadline) | Operational | Yellow | Request written explanation; walk if recurring |
| Key personnel turnover (within 12 months) | Manager | Yellow | Investigate reasons; consider redemption |
| Internal-only valuations (no third-party) | Operational | Yellow | Require independent valuation; walk if refused |
| Excessive leverage (75%+ LTV, no recourse) | Structure | Yellow | Stress test; negotiate lower allocation |
| Offshore domicile (unclear rationale) | Structure | Yellow | Request jurisdictional justification; legal review |
How to Use This Table
W.A.S. (Walk-Away Signal): Non-negotiable rejection criteria. Do not proceed to financial analysis or return modeling.
Yellow Flag: Requires investigation. Document, request written clarification, consult third-party experts. Proceed only if satisfactorily resolved.
How a Liquidity Mismatch Destroyed $180M in Investor Capital
Anonymized composite of actual alternative investment failures. Names and details changed, but the structural failures and warning signs are accurate.
The Fund: "Premium Real Estate Income Fund"
Marketed as "institutional-grade real estate with daily liquidity"—a structural impossibility that should have been immediately disqualifying.
1The Pitch (2019)
$180M fund investing in Class A multifamily properties across Sun Belt markets. Offered daily redemptions with 30-day notice. Projected 8-10% annual returns. Marketing emphasized "institutional managers" and "diversified portfolio."
2The Red Flag (Ignored)
Liquidity Mismatch W.A.S.: Fund offered daily redemptions while holding properties with 6-12 month expected sale timelines. Cash reserve policy: 5% of NAV (insufficient for meaningful redemption pressure).
What Should Have Happened: Immediate rejection. This structure creates inevitable run-on-the-bank risk during any market stress.
3The Crisis (March 2020)
COVID-19 triggers market panic. Investors rush to redeem: $45M in redemption requests (25% of AUM) within 2 weeks. Fund has only $9M cash (5% reserve). Properties cannot be sold quickly without accepting 20-30% discounts.
4The Collapse
Week 1: Fund announces "temporary redemption suspension" to prevent fire sales.
Month 2: NAV marked down 18% as manager conducts emergency property sales at distressed prices.
Month 6: Fund liquidates. Remaining investors (those who couldn't redeem) receive $0.65 per $1.00 invested.
Final Loss: $63M in investor capital destroyed. Properties themselves were not impaired—the loss was entirely structural.
The Lesson
This was not a management failure, market crash, or fraud. It was a structural design flaw that should have been identified in initial due diligence.
Key Takeaway: Walk-away signals exist because certain structures are inherently unfixable. No amount of manager skill, market performance, or operational excellence can overcome a liquidity mismatch. The red flag was present from day one—before any capital was lost.
Source: Composite of multiple documented alternative investment failures 2019-2021. Specific details anonymized. Structural failures are accurate.
Quantifying Risk vs. Return Trade-offs
Not all alternative investment risk is compensated with higher expected returns. Understanding when risk premiums justify illiquidity and complexity is critical to portfolio construction.
Expected Return Ranges by Risk Profile
When Higher Risk is NOT Compensated
Certain risks add volatility or loss potential without corresponding return premiums:
- •Manager Risk: Fraud and operational failures generate losses without return compensation (pure downside)
- •Concentration Risk: Single-asset or single-manager exposure without diversification benefit
- •Liquidity Mismatch Risk: Redemption gates or forced sales during stress (structural flaw, not market cycle)
- •Regulatory Risk: Unclear legal status or compliance exposure (especially in tokenized assets)
Risk-Adjusted Return Metrics for Alternatives
Traditional Sharpe ratio is less useful for illiquid alternatives due to smoothed valuations and infrequent pricing. More appropriate metrics include:
- •Public Market Equivalent (PME): Compares private fund returns to what would have been earned investing in public markets over the same time period
- •Illiquidity Premium: Return spread above comparable liquid assets (e.g., private credit yield minus high-yield bond ETF yield)
- •Loss Ratio: Percentage of investments resulting in partial or total loss (more relevant than volatility for binary outcome strategies)
- •Maximum Drawdown: Largest peak-to-trough decline; particularly important for real estate and leveraged strategies
Common Investor Mistakes in Risk Assessment
Even sophisticated investors fall into predictable behavioral traps when evaluating alternative investments. Awareness of these mistakes improves decision quality.
Action Plan: What to Do When You Find a Red Flag
Red flags are decision triggers, not automatic disqualifications (except W.A.S.). This framework guides response to warning signals during due diligence.
Step 1: Document the Flag
Create written record of the concern immediately. Include:
- Exact nature of the red flag (quote from documents if applicable)
- Source document and page number where flag was identified
- Date flag was discovered during due diligence timeline
- Classification: W.A.S. (walk-away signal) vs. yellow flag requiring investigation
Step 2: Seek Immediate Clarification
For non-W.A.S. flags, request formal written explanation from the manager. Do NOT accept verbal explanations or phone calls alone.
Sample Clarification Request
"During our review of the [Fund Name] Limited Partnership Agreement, we noted that quarterly investor reports are contractually due within 60 days of quarter-end. However, historical reports for Q2 2023 and Q4 2023 were delivered 78 and 82 days after quarter-end respectively. Please provide a written explanation for these delays and confirm current reporting timeline compliance."
Step 3: Apply the AltStreet Decision Standard
The AltStreet Standard
Assume all red flags are fatal until proven otherwise. Burden of proof rests entirely on the manager to demonstrate the flag is either (a) explainable with transparent evidence, (b) being remediated with concrete timeline, or (c) mitigatable through structural changes.
Download the AltStreet Risk Assessment Scorecard
Point-based evaluation framework covering all three risk pillars. Score investments on a 100-point scale to identify walk-away signals before capital commitment.
Manager Risk
35-point evaluation
Operational Risk
35-point evaluation
Structure Risk
30-point evaluation
Scoring Guide: 85-100 (Proceed), 70-84 (Yellow Flags), 50-69 (High Risk), Below 50 (Walk Away)
Download Scorecard (PDF)Frequently Asked Questions
What is the difference between market risk and manager risk in alternative investments?
Market risk refers to losses from asset price movements or economic conditions. Manager risk encompasses fraud, operational failures, misalignment, and incompetence. In private markets, manager risk typically exceeds market risk because illiquidity prevents exit and opacity enables misconduct. Proper due diligence focuses primarily on identifying and avoiding manager risk.
What are walk-away signals in alternative investment due diligence?
Walk-away signals are red flags so severe they warrant immediate rejection of an investment opportunity. These include: unverified track records not audited by recognized firms, manager investment below 1% of AUM, self-custody arrangements, funds offering daily liquidity while holding illiquid assets, and undisclosed regulatory violations. These signals indicate structural problems that cannot be mitigated through monitoring.
How much skin in the game should a general partner have?
GP investment should represent at least 1-3% of total fund AUM, funded from personal capital rather than borrowed funds. For smaller funds under $50M, higher percentages (5-10%) are common. The investment should be on the same terms as LPs without preferential fee structures. Meaningful GP commitment aligns incentives and signals confidence in the strategy.
What is a liquidity mismatch and why is it dangerous?
Liquidity mismatch occurs when a fund offers short-term redemption rights (daily, weekly, or monthly) while investing in long-term illiquid assets like private equity or real estate. This creates run-on-the-bank risk: if many investors redeem simultaneously, the fund must sell illiquid holdings at distressed prices or gate redemptions. This structure is a walk-away signal for most alternative strategies.
Should I trust manager-provided references?
Manager-provided references are curated and should be treated as floor, not ceiling, for performance and operational quality. Always request permission to contact additional LPs not on the reference list. Ask references specific questions: "What operational issues have you encountered?" and "What would you change about the fund structure?" rather than "Would you recommend this manager?" More valuable: Find investors who redeemed from the fund and ask why.
Are offshore fund domiciles always red flags?
No. Many institutional-grade funds domicile in Cayman Islands, Luxembourg, or Ireland for legitimate tax efficiency and regulatory clarity. Red flags emerge when: (1) domicile has weak investor protections or opaque legal frameworks, (2) manager cannot articulate clear rationale for jurisdiction choice, (3) fund targets primarily U.S. taxable investors (offshore domicile provides no benefit), or (4) alternative onshore structure is not offered. Require legal counsel review of any non-U.S. fund structure.
Related Due Diligence Resources
Due Diligence Framework
Comprehensive guide to evaluating alternative investment managers, reviewing offering documents, and conducting operational due diligence.
View FrameworkRegulation & Compliance
Understanding SEC rules, accredited investor requirements, Reg D offerings, and regulatory protections in alternative investments.
Learn MoreTax Treatment Guide
K-1 partnerships, UBTI, capital gains treatment, and tax-efficient structures for alternative asset allocations.
Explore Tax StrategiesPortfolio Strategies
Allocation frameworks, diversification principles, and risk management for alternative investment portfolios.
View StrategiesDue Diligence is Defense, Not Prediction
Rigorous risk assessment cannot predict returns, but it can prevent catastrophic losses. Every hour spent identifying red flags before investment saves hundreds of hours recovering from manager failures, operational breakdowns, or structural exploitation.