Episode 386: Is anyone doing dd? with Aravind Sithamparapillai

Episode Summary

Executive Summary: In this episode of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore are joined by financial planner Ervind Sithaparapillai to discuss alternative investments. Ervind shares his deep dive into the due diligence of private funds, revealing common marketing tactics, hidden fees, and risks like stale pricing and gating. He argues that for most advisors, the complexity and idiosyncratic risk of alts outweigh potential benefits, advocating instead for a focus on high-quality financial planning and low-cost indexing.

Main Topics: The Rise of Alternative Investments in Advisor Practices (Priority: 5/5): Discussion on how alternative investments (private equity, private debt, private real estate) have become a common value proposition for advisors, especially in markets like Toronto, often driven by client demand and the narrative that '60/40 is broken'. Due Diligence Challenges and Marketing Tactics (Priority: 5/5): Ervind details the difficulty of conducting proper due diligence on alts, including misleading benchmarks, cherry-picked start dates, and the use of IRRs that can obscure poor later performance. He shares a real-world example of a mortgage fund that used 'extend and pretend' to maintain a stable NAV. Fees, Performance Fees, and Net Returns (Priority: 4/5): Analysis of the complex fee structures in alts, including management fees, performance fees, and the asymmetric impact of performance fees on winners without rebates on losers, which can leave investors with negative net returns despite gross gains. The Low Correlation Argument and Its Pitfalls (Priority: 4/5): Examination of the claim that alts provide diversification benefits. Ervind argues that stale pricing smooths returns, and the practical challenges of rebalancing illiquid assets during market stress (e.g., COVID) undermine the supposed benefit. Expected Returns and Financial Planning Integration (Priority: 4/5): The importance of deriving a net-of-fee expected return for alts to integrate into financial plans. Ervind presents a framework starting from gross asset class returns, adjusting for leverage, interest, and fees, often finding expected returns similar to public equities but with added risks. Operational and Legal Risks Beyond Financials (Priority: 3/5): Beyond financial statements, due diligence must include operational controls, AML processes, background checks on fund managers, and understanding the legal structure. Ervind notes that even large firms have missed fraud (e.g., FTX) and that Canadian OM documents are often less detailed than US counterparts. Focus on Planning Over Alts (Priority: 5/5): The hosts and guest conclude that for most advisors, the reliable value-add comes from deep financial planning (tax, corporate compensation, asset location) rather than chasing the marginal, uncertain outperformance of alts, which requires significant resources and expertise.

Key Arguments: Alternative investments are often marketed with misleading benchmarks and cherry-picked start dates, making them appear more attractive than they are. The low correlation benefit of alts is often overstated due to stale pricing and the practical difficulty of rebalancing illiquid assets during market downturns. Performance fees on alts can be asymmetric: managers take fees on winners but do not rebate on losers, potentially leaving investors with negative net returns even if gross returns are positive. Deriving a net-of-fee expected return for alts is essential for financial planning, but when done properly, expected returns often align with public equities, without compensating for the added illiquidity and operational risks. Proper due diligence on alts requires not just financial analysis but also operational checks (AML, background checks, legal structure), which is beyond the capacity of most individual advisors. The industry is bifurcating: firms that focus on planning and low-cost indexing can add more reliable value than those chasing alts, which require significant resources and expertise. Advisors who do not fully understand alts but allocate to them risk blowing up their clients' financial plans, as seen in cases of fund gating and hidden risks.

Data Points: Private credit fund fee structure example: 1.5% management fee + 15% performance fee above a 5% hurdle - Ervind cites this as a typical fee structure for a private credit fund, noting that with T-bills at 5%, the performance fee is essentially a fee on additional risk taken. Expected return comparison: private real estate vs. public equities: ~8% for private real estate vs. ~6.5-7% for public equities - After accounting for leverage, interest, and fees, a private real estate fund's expected return was roughly 8%, only marginally higher than public equities, but with added illiquidity and operational risks. Impact of performance fees on venture capital returns: Investors can end up net negative despite gross gains - Ervind explains that with high variance in returns (e.g., one unicorn, many zeros), performance fees on winners can consume all gains, leaving investors with losses. Weight of a single private REIT in a diversified portfolio: 0.15% to 0.29% - Ervind notes that a Midwestern residential REIT, if held at market weight, would be a tiny fraction of a portfolio, making the due diligence effort disproportionate to the potential benefit. Duration of mortgage fund loans: Under 2 years - A fund claimed ultra-short duration, but when pressed, it was revealed they were extending loans at the same terms to avoid marking down NAV, a practice known as 'extend and pretend'.

Pivotal Quotes: "I tell my clients, like some of my best, biggest clients, someone's going to show up on your doorstep one day, and they're going to tell you, Ervind's lazy, or the way Ervind's doing things, there's a better way to do things. ... If that's not the value proposition, then doing this work at least gives me an edge because my clients know that I've done enough homework to tell them why not." — Ervind Sithaparapillai: Ervind explains how his deep due diligence on alts helps him defend his investment philosophy to clients and build trust, even when competitors offer 'spicy' products. "You could be right and then still have everyone think that you're crazy for a very long time before the fund gates or the crows come home to roost." — Ervind Sithaparapillai: Reflecting on a mortgage fund that eventually gated, Ervind highlights the challenge of being correct about risks in alts while the fund continues to show stable returns for an extended period. "The juice isn't necessarily worth the squeeze." — Ervind Sithaparapillai: Summarizing his view that the potential outperformance from alts, after accounting for fees, illiquidity, and the tiny portfolio weight, does not justify the extensive due diligence required.

Implications: For financial advisors and investors, this episode underscores the importance of rigorous due diligence on alternative investments and cautions against relying on marketing narratives. The reliable path to adding value lies in deep financial planning and low-cost indexing, not chasing complex, high-fee alts that may not deliver net benefits.