3 ways to stress-test alternative investments before a market downturn

Whether it's private credit, private real estate, private equity or infrastructure, not all alternative investments provide meaningful diversification in a client's portfolio. Indeed, in a market downturn many such products can behave similarly to stocks and bonds. 

That matters in today's genuinely uncertain geopolitical and macroeconomic environment. Some alternatives are still heavily tied to the same economic forces that affect public markets. If alternatives act like traditional products in the same market conditions, that doesn't make a portfolio more resilient, just more complicated.

The goal isn't to add alternatives to a portfolio just for the sake of it. Here are three questions financial advisors should ask fund managers to determine whether an investment truly diversifies and protects a client's portfolio.

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1. Have private loan covenants been weakened?

Every marketing deck makes an investment look great. The important question is: What happens when things don't go as planned? 

For instance, well-structured private loans include covenants — contractual controls that give lenders the ability to step in if a borrower's performance starts to deteriorate before things go too far. Minimum liquidity requirements, earnings thresholds and asset coverage ratios are the mechanisms that separate a private loan with a real recovery path from one where investors are left hoping.

This is where advisors need to be especially vigilant right now. As private credit has grown into a multitrillion-dollar market, the pressure to deploy capital has caused some managers to loosen those controls, accepting weaker covenants just to get deals done. Advisors should be asking not just whether covenants exist, but whether they've been watered down.

READ MORE: Private credit is deliberately illiquid — did advisors explain that?

2. Have managers weathered the liquidity storm before?

Many alternatives look uncorrelated in normal environments but behave very differently when liquidity dries up. Historical correlations often change during periods of stress. The true test isn't how an investment performs when markets are calm; it's whether it can continue to generate income and protect capital when conditions deteriorate.

This is also where manager experience matters. The private credit market has been operating in a relatively benign environment for years. The question advisors should be asking is whether those managers have ever navigated a real downturn and recovered value for investors. 

When a recession hits, origination skill isn't what protects a portfolio. Recovery capability is.

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3. What is the real source of cash flow?

The starting point in evaluating a private investment shouldn't be the projected return, but the source of the return. In other words, is income generated by contractual payments, lending arrangements or leases — or does it depend primarily on market appreciation and investor sentiment?

For instance, a private loan to a medical device company backed by the physical inventory itself generates income based on the terms of the loan. In a well-structured deal, if the borrower defaults, the underlying assets exist to sell and recover value. 

That's a fundamentally different risk profile than an investment whose returns depend on what someone else is willing to pay for it tomorrow. Understanding the cash flow source is usually the first clue to how an investment will behave when conditions deteriorate.

The ultimate goal is to build a portfolio designed to generate income and protect against downside no matter what the headlines bring. That's what alternatives are supposed to do. Used with discipline, they can. Used carelessly, they won't.