Every day see people engage in what I consider insanely risky activities. For starters millions of us jump into a 5000 LB hunk of metal that kills and disables millions of people every year. And yet most of us also would not consider driving a car a recklessly risky decision. Why is that? Is it because the odds of a fatal accident are low, that may be part of it but we humans are not rational calculation machines. The reason is that we have acquired the knowledge to control our destiny and drive safely. We know how to drive, we’ve learned the rules of the road and how to keep a safe distance. We all know though that there is real risk, things we can’t control no matter how much we learn. Accidents happen we can’t control, so we put on a seat belt, buy a car with airbags, keep our distance from the car in front.

I have noticed that its exactly the same with alternative investing. Investors often have a knee jerk response to an alternative strategy that it must be much more risky than investments they know and are familiar with. If the last couple of years with the stock market doesn’t illustrate the extreme real risk in equities I am not sure what will. But sometimes people start to confuse familiarity with knowledge. Like the driver who, starts drifting to close to the truck in front on his daily commute. Just because equities and bonds are what every body does and talks about does not mean they are less risky than other alternatives.

Of course, I am not suggesting alternatives may not be risky but just because investment strategies are less widely known has nothing to do with the real risk involved. The only way you can know the real risk is to do some homework and gain some knowledge about the investment strategy. Also in regard to your portfolio you must consider what drives the real risk in the asset class or strategy. Because even if you have two different asset classes, if they are impacted by the same risk factors your portfolio is exposed to more risk. For example, corporate earnings drive stocks and corporate bonds. Know the risks in your portfolio, not to eliminate them because you cant, but when you have the knowledge of what the risks are you can manage them.

Some alternative strategies are very risky and you should only consider with the help of an expert. To torture my transport analogy a little further, I like a professional pilot to fly my planes rather than being thrown the keys to a jet liner. The fact is this is how fortunes are made on what finance professionals call asymmetric information. When you have information or knowledge about an asset you can profit where others fear to tread. Professional asset managers know this and bank on it all the time. I am not referring to anything nefarious or immoral. Simply the advantage that knowledge of how something works allows you to see opportunity where others see risk.

In working with investors we are regularly asked to review portfolios. Buying life settlements requires extensive due diligence but often when you are first presented with a portfolio you can spot some red flags. Now these red flags don’t mean that you have a bad portfolio or that you should go running for the hills. Quite the contrary in my opinion if you are expert enough in your ability to do the due diligence required this might be exactly where you will find the best deals. But this is definitely an area of life settlement investing to keep your wits about you.

We were asked to help a client recently and as normal the first look at this $500M portfolio was a spreadsheet.

Red Flag 1: Who owns the portfolio? And more importantly are you talking to them directly? The fact is that spreadsheets are passed around this industry like dinner rolls. Long broker chains will kill any chance of a deal.

Red Flag 2: All policies are 2-3 years old. That means this is likely a BI portfolio or financed, so buyer beware of STOLI.

Red Flag 3: These recently issued at Preferred rates and new LE’s are now all short. Sure declines in health happen but if you are looking at a few dozen policies with that fact pattern in the same portfolio statistics would say something is awry.

Red Flag 4: Lots of insurance on single lives. It goes without saying that concentrating in relatively few lives is a risky proposition. But also when one portfolio has been assembled this way it should call into question the sellers motives and caliber of origination.

Red Flag 5: The Brooklyn specials. The simple fact is that there has been a good deal of questionable inventory originated in the NE area and a concentration from there is cause to increase scrutiny.

There are plenty of life settlement portfolios that have one or all of these flags. If you have the ability to do the due diligence necessary it could be a great opportunity to pick up some very discounted life settlement inventory.

Red Flag 4:

PIPE (Private Investment In Public Equity) deals remind me of the NBA draft. Of course there is no David Stern, but there are plenty of tacky suits and talks of upside.

Optimism reigns and potential dominates substance. This isn’t necessarily bad. Take John Wall for example. He showed enough promise in one year at Kentucky to become the #1 pick of the 2010 NBA draft. Wall’s collegiate numbers were compelling but not off the charts. It’s what Wall will do in three years that causes scouts to drool. Similar to John Wall, many young companies want to cash in when expectations exceed past performance. Why not? Expectations play a huge role in determining the present value of companies.

From an investor standpoint, the big rewards don’t come from drafting the All-American in the lottery; the true spoils come from finding the player overlooked by all the experts who becomes an All-Star. Investment bankers and companies know this. They position companies as “diamonds in the rough.” Proud CEOs tout tantalizing projections and heroic expectations of market share. We investors get caught up too, but we have the balance the hopes of a 500X ROI against the possibility of losing our shirt. Similar to the NBA draft, there are some Hall of Famers who get picked in the second round but the majority don’t last more than a year in the league.

We investors should keep our eyes out for the 6’10” freshman with crazy hops who has yet to average more than 15 points a game, but we can’t lose sight of the role players, those yeomen who do the little things to bring a team over a top. Therefore, PIPE investors should allocate funds to a spectrum of companies with a wide range of return opportunities. Maybe that stable consumer products deal may not get you staggering returns, but it helps form the core of the portfolio that allows the more high flying investments to shine. The Lakers drafted Derrick Fisher the same year they signed Kobe Bryant.

Whether we’re drafting players or companies, we’re all geniuses in hindsight.