Ethical and Professional Conduct in Alternatives

Introduction

Ethics in alternative investments can be a bit tricky—trust me, I’ve been there. When you start dealing with less regulated markets, opaque valuation methods, and complex fund structures, everyone involved has to be extra vigilant. Of course, the CFA Institute Code of Ethics and Standards of Professional Conduct (the “Code and Standards”) remains pivotal in guiding how we uphold professionalism and integrity. In the context of alternatives—whether private equity, real estate, hedge funds, or digital assets—professionals encounter forms of information asymmetry, valuation intricacies, and potential conflicts of interest that require deeper ethical scrutiny.

In my early days of working in a hedge fund, I remember feeling a sense of excitement about how creative you could be with investment strategies. At the same time, I learned that this creativity opens the door to potential ethical lapses if you’re not careful. So let’s walk through the fundamentals, highlight common pitfalls, and reinforce best practices for ethical conduct in the alternatives space.

Relevance of the CFA Institute Code of Ethics in Alternatives

The Code and Standards is the bedrock of professional conduct for investment practitioners. Specifically in alternatives, the stakes are often higher because of the relatively opaque nature of underlying assets and the presence of non-traditional structures. Practitioners might be tempted to push boundaries—but a robust ethical framework ensures that decisions reflect the highest standard of integrity.

• Client First: Even in a private equity fund, where a General Partner (GP) has wide discretion, maintaining a client-first mentality is crucial.
• Independence and Objectivity: The fluid, sometimes illiquid, nature of alternative assets can translate into a greater reliance on subjective judgment. Independence of thought and a steadfast commitment to objectivity are essential to keep biases at bay.
• Integrity of Capital Markets: Alternatives often operate with limited disclosure requirements, which can lead to insider trading or misrepresentation if parties aren’t vigilant.

Common Ethical Dilemmas in Alternatives

Several ethical minefields present themselves in alternative investments, and it’s not unusual for professionals to face tough calls. Here are the big ones:

Conflicts of Interest

Conflicts of interest might occur when a GP has personal incentives not aligned with Limited Partners (LPs), or in real estate deals where the sponsor stands to gain more by choosing a certain property manager. Some situations:

• Side Letters: Certain investors negotiate preferential terms (e.g., lower fees) that are undisclosed to others.
• Self-Dealing: A GP may steer a prime investment toward a side vehicle in which they have a greater stake.

Valuation Manipulation

Investors in private capital and hedge funds rely on reported valuations to gauge performance. There’s often limited market pricing available for illiquid assets. If managers systematically inflate valuations, they’re effectively providing inaccurate performance pictures:

• Overstating Valuations: This can attract new investors or inflate performance fees.
• Understating Valuations: In certain scenarios, managers might downplay valuations to manage expectations or manipulate capital call timing.

Insider Trading

Alternative investment managers frequently interact with companies, real estate developers, or data from private deals. Doing a quick we-shouldn’t-do-this scenario check is critical:

• Access to Non-Public Information: Hedge fund analysts who talk to mid-level executives at target companies must ensure they’re not gleaning material non-public info.
• Industry Conferences: Managers might inadvertently share or overhear sensitive information relevant to a pending merger.

Limited Transparency

The complexity of alternative fund structures can lead to insufficient or unclear disclosures:

• Complex Fee Arrangements: Performance-based fees, carve-outs, and multi-layer structures can hide real costs from investors.
• Opaque Investment Process: Some funds disclose minimal details about trading strategies and risk exposures, leaving LPs in the dark about how decisions are actually made.

Best Practices in Disclosure

Disclosure is a cornerstone of ethical conduct. Investors deserve an accurate and full picture of what they’re buying into. A robust disclosure policy often involves:

• Clear Explanation of Fees: Spell out management fees, performance fees, and any pass-through expenses.
• Portfolio Holdings and Valuations: Provide at least periodic transparency into top positions, sector exposures, or aggregated value.
• Potential Conflicts: Declare them openly. Maintaining a conflict-of-interest policy to guide employees and managers is a must.

Consider a short anecdote: My team once prepared an investor pitch for a private debt fund, and during the diligence process, a prospective investor asked, “What if the deal sponsor is also a part-owner of the brokerage we intend to use?” We realized we had to state that conflict plainly in the offering materials, ensuring clarity on how we’d handle broker selection.

Protecting Confidential Information

Alternative investments often revolve around proprietary strategies, private company insights, or sensitive negotiation details. A manager’s duty to preserve confidentiality is both ethical and strategic:

• Use of Non-Disclosure Agreements (NDAs): Standard practice before delving into due diligence of a target company.
• Encryption and Data Security: Hedge funds, especially those with algorithmic strategies, must invest in robust cybersecurity protocols to prevent data leaks.
• Internal Walls: For multi-strategy platforms, establishing “information barriers” ensures that material non-public data does not flow to teams that could misuse it.

Role of Third Parties and the Necessity for Unbiased Advice

Third-party relationships—placement agents, consultants, prime brokers—are integral to alternative investing. Yet these relationships sometimes carry the risk of persuasion or undisclosed compensation:

• Placement Agents: They help raise capital but might pressure GPs to offer sweeteners or special deals to large investors.
• Consultants: Ideally, they provide objective advice, but conflicts can arise if they receive “consulting fees” from both managers and investors.

It might help to visualize how these parties interact:

    flowchart LR
	    A["Alternative Investment <br/> Manager (GP)"] --> B["Limited Partners <br/> (LPs)"];
	    A --> C["Placement Agent"];
	    A --> D["Consultants <br/> / Advisors"];
	    D --> B;

As you see, these intermediaries (C and D) bridge the gap between Managers (A) and Investors (B). Maintaining transparency about referral fees and potential conflicts keeps the chain of trust intact.

Governance Structures andFair Treatment of Investors

High-quality governance can help mitigate conflicts of interest and ensure accountability. Governance frameworks typically include:

• Independent Boards or Committees: They provide oversight on valuations, strategic decisions, and conflict resolutions.
• Audit and Valuation Committees: Especially critical in real estate or private equity funds that invest in difficult-to-price assets.
• Rotation of Service Providers: Periodic changes of auditors or third-party valuation agents can bolster objectivity.

Fiduciary Duties: Loyalty, Care, and Full Disclosure

General Partners are frequently bound by fiduciary duties—legal or ethical obligations to act in the best interests of Limited Partners:

• Duty of Loyalty: Refrain from self-dealing or conflicts that put personal interests ahead of the fund’s interests.
• Duty of Care: Carry out a prudent due diligence process and maintain high professional standards.
• Duty of Full Disclosure: Provide sufficient, accurate, and timely information so that investors can make informed decisions.

At many private funds, the partnership agreement formalizes these duties, referencing the Code and Standards for additional guidance. Violations can lead to lawsuits, regulatory action, and an exodus of unhappy investors.

Reputational and Regulatory Consequences

Ethical lapses can quickly spiral into major reputational damage. One well-known example is the fallout from insider trading cases where alternative managers faced heavy fines and lost investor confidence—practically overnight. Regulatory bodies worldwide keep increasing their focus on hedge funds, private equity, and other alternative entities.

• Negative Press: Media coverage of ethical violations (like hidden fees or inflated valuations) can lead to investor redemptions.
• Enforcement Actions: Regulators can impose bans from the industry, or even criminal penalties in severe cases.

Practical Steps to Uphold Ethical Standards

Formal codes and frameworks are only as strong as the actions they inspire. To mitigate risks:

• Conduct In-Person or Virtual Training: Regular staff sessions on confidentiality, insider trading, conflict management, and compliance.
• Maintain Up-to-Date Policies: Address new trends, such as digital token valuation or ESG disclosure.
• Encourage Whistleblower Protections: Ensure employees feel safe reporting issues without fear of retribution.
• Document Everything: From compliance checks to conflict resolution, a culture of thorough record-keeping is a robust deterrent to wrongdoing.

A Personal Reflection

Maybe you’re thinking, “This is all obvious, right?” But in real practice, it’s quite easy to rationalize small slips. For me, a tricky moment happened when I was analyzing a Series B funding round for a private tech company. I received a call from a friend who worked at the startup, offhandedly mentioning a potential acquisition deal. Now, of course, I was excited. But that was precisely the moment I knew I couldn’t let my emotions overshadow the code—I politely ended the call, reminded my friend not to reveal information that wasn’t public, and immediately informed our compliance officer. It felt a little awkward, but that’s what the Code is there for.

Conclusion

Ethical and professional conduct in alternative investments is not an optional ideal; it’s downright essential. Alternative assets—by nature—present unique challenges, including illiquidity, limited oversight, and often complex fee and return structures. By adhering to the CFA Institute Code and Standards, implementing strong governance, and nurturing a culture of disclosure and confidentiality, market participants reinforce the integrity and credibility of the entire ecosystem.

Professionalism is a marathon, not a sprint. Perhaps we might slip occasionally, but by fortifying ourselves with solid ethical principles, we’re better positioned to serve clients, uphold market integrity, and preserve our reputations for the long haul.

References

• CFA Institute. “Code of Ethics and Standards of Professional Conduct.”
• CAIA Association Journal. “Revisiting Ethics in Alternative Investments.”

Test Your Knowledge: Ethical and Professional Conduct in Alternatives