Three questions to vet private alternatives before a downturn

Stacey McKinnon, chief operating officer and wealth advisor at Morton Wealth in Southern California, recommends that financial advisors ask three specific questions about private alternative investments before a market downturn.

McKinnon notes that private credit, private real estate, private equity and infrastructure often appear to diversify a portfolio, but can move with the same economic forces that affect public stocks and bonds. She points to current geopolitical and macroeconomic uncertainty as a reason to examine how those products behave under stress.

The first question concerns loan covenants. Loan covenants are contractual terms that give lenders early warning and the ability to intervene if a borrower’s performance worsens. Common features include minimum liquidity levels, earnings tests and asset-coverage ratios. The private credit market has expanded into a multitrillion-dollar sector, and that expansion has in some cases led managers to accept weaker covenants to close deals. McKinnon recommends confirming both the existence of covenants and whether they have been weakened relative to historical norms.

The second question focuses on liquidity and manager experience. Investments that look uncorrelated in calm markets can become highly correlated with public markets when liquidity dries up. Historical correlations can change during stress. McKinnon advises asking whether managers have faced real liquidity crises and whether they recovered value for investors. She emphasizes that recovery and workout experience matter in recessions.

The third question examines the source of cash flow. Returns that come from contractual payments, loan repayments or lease income carry different risks than returns that depend on market appreciation and future buyers. For example, a private loan secured by a company’s physical inventory produces cash flow tied to loan terms and provides an asset that can be sold if the borrower defaults. An investment that relies primarily on other buyers paying more later lacks that contractual cash flow.

McKinnon stresses that advisors should prioritize downside protection and reliable income when evaluating alternatives rather than focusing solely on headline return estimates.