The allocation of client funds into alternative investments, a critical function for financial advisors, has become increasingly complex in recent years. A rapidly evolving alternative investment market, coupled with significant economic volatility, has presented new and substantial challenges for wealth managers navigating this sector. To address these pressing issues, Brad Updike, an attorney at Mick Law P.C. LLO, recently joined "The Alternative Investment Podcast" hosted by Andy Hagans to discuss the intricacies of due diligence and alternative investment strategies within the current turbulent economic climate.
The Dual Worlds of Securities and the Imperative of Due Diligence
The financial securities landscape can be broadly categorized into two distinct realms: the public markets and the non-traded, or alternative, investment sector. Publicly traded companies, characterized by substantial market capitalization and securities that actively trade on exchanges like the New York Stock Exchange, offer a degree of transparency through regular SEC filings. In contrast, the alternative investment space, where Mick Law P.C. LLO focuses its expertise, encompasses a diverse array of products often sold through private placements. This includes 1031 exchange-like offerings such as Delaware Statutory Trusts (DSTs), real estate investment limited liability companies (LLCs) and limited partnerships (LPs), Qualified Opportunity Funds, oil and gas programs, and registered non-traded products like non-traded Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs), as well as interval funds.
While the alternative investment sector may appear smaller in volume compared to the public markets, its significance is far from negligible. Annually, approximately 20,000 Form D filings are submitted by various companies seeking to raise an estimated $1 trillion in debt and equity capital. A substantial portion of these filings, typically 15% to 20%, involve FINRA-regulated firms such as broker-dealers and investment advisors. This highlights the sheer volume of private capital activity and underscores the critical need for rigorous due diligence.
Mick Law P.C. LLO: A Pillar in Alternative Investment Due Diligence
Mick Law P.C. LLO, based in Omaha, Nebraska, is a law firm that has established itself as a leader in providing underwriting and due diligence support. The firm’s nine attorneys cater to a network of approximately 300 broker-dealers, investment advisors, and family offices that engage in raising capital for non-traded alternative investments across debt and equity. Their specialized focus on this complex niche allows them to offer a deep level of expertise that is crucial for navigating the unique risks and regulatory requirements of the alternative investment space.
"We provide underwriting and due diligence support to a network of about 300 broker-dealers, investment advisors, and family offices that raise money in non-traded alternative investments, debt, and equity," Brad Updike explained during the podcast. This comprehensive support system is vital for financial professionals who may not possess the internal resources or specialized knowledge to conduct such in-depth evaluations themselves.
The Due Diligence Mandate for Financial Advisors
The fundamental difference between traditional investments and alternatives, particularly in terms of regulatory oversight and transparency, necessitates a more robust due diligence process for the latter. While publicly traded securities benefit from continuous disclosure requirements and the presence of investment banking underwriters who conduct extensive research, private placements in the alternative space lack these immediate safeguards.
"On the public side, it’s a little bit more maybe BD advisor-friendly. You know, you have the periodic SEC filings that have to be made, on a quarterly basis. You have an underwriter that’s actually in the process. That’s an investment banking firm that’s going out. They’re researching the company, they’re conducting interviews, they’re assessing the risk, they’re valuing the company, and they’re placing a price on that security," Updike elaborated. "Whereas in the private placement side, you don’t have that. You don’t have that periodic filings. You don’t have an underwriter. But what you do have is pretty stringent due diligence and suitability requirements, which is where we bring value."
Regulatory Frameworks: Suitability and Fiduciary Duty
Both broker-dealers and Registered Investment Advisors (RIAs) are bound by regulations that mandate due diligence, albeit through different frameworks. Broker-dealers are subject to FINRA rules, including Rule 2111, which requires them to perform sufficient due diligence to ensure an investment is suitable for at least one type of investor. More recently, Regulation Best Interest (Reg BI) has imposed additional obligations on broker-dealers, requiring them to understand conflicts of interest, fees, risks, and costs associated with securities, and to undertake comparative analyses of different investment opportunities.
RIAs, while not directly bound by FINRA rules, operate under a fiduciary duty to act in their clients’ best interests. This fiduciary standard inherently necessitates a thorough understanding of any investment product before recommending it. "The RIA, while they’re not subject to the FINRA rules, you know, they do have fiduciary duties to act within their client’s best interests, so I would say that a lot of the guidelines and things that you’re supposed to do as a broker-dealer, you should be doing as an RIA," Updike noted. This convergence of responsibilities emphasizes that comprehensive due diligence is not merely a regulatory checkbox but a fundamental ethical obligation for all financial professionals managing client assets.
Sponsor and Program-Level Due Diligence: A Two-Pronged Approach
Effective due diligence in the alternative investment sector requires a bifurcated approach, focusing on both the sponsor (the entity managing the investment) and the program (the specific investment offering).
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Sponsor Analysis: This involves a deep dive into the sponsor’s operational and financial capabilities. It seeks to determine if the sponsor possesses the experience, infrastructure, and integrity to manage a program effectively through its lifecycle. Key areas of inquiry include the sponsor’s track record, management team’s expertise, financial stability, and adherence to ethical business practices. "With the sponsor review, you’re going in and you’re doing an investigation to determine whether this is a sponsor that’s operationally and financially capable of managing a program to a successful conclusion."
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Program Analysis: This focuses on the specific offering’s terms, structure, and underlying assets. It aims to assess the fairness of the offering to investors, considering the associated risks, the quality of the assets, and the potential for realistic returns. This includes evaluating the offering documents for accurate and complete disclosure of all material risks. "On the other side, with the product review, it’s more about product fairness. Is this offering fair to the investors, given, you know, the risks and given the quality of the assets and the return potential?"
Both sponsor and program-level due diligence are considered equally critical. Even highly capitalized and experienced sponsors can face unforeseen challenges due to economic downturns or shifts in market dynamics, as evidenced during the COVID-19 pandemic, which saw significant divergence in performance across various real estate sectors.
The "Alignment of Interest Test"
A core component of Mick Law’s due diligence methodology is the "Alignment of Interest Test," a framework developed by Brian Mick, the firm’s founder. This test, applicable across various due diligence engagements, seeks to answer three fundamental questions:
- Who is putting money into the investment?
- Who is taking money out of the investment?
- Is the sponsor’s compensation performance-based?
By analyzing these three elements, the test provides crucial insights into whether the interests of investors are genuinely aligned with those of the sponsor and the issuer. This is particularly important in structures where compensation models might incentivize short-term gains over long-term investor success.
Sector-Specific Due Diligence: Real Estate, Energy, and Private Debt/Equity
While a general framework for due diligence exists, the specific application varies across different sectors. Mick Law primarily focuses on three key areas: real estate, energy, and private debt and equity.
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Real Estate: Due diligence in real estate often involves engaging independent appraisers and real estate professionals with designations like Certified Commercial Investment Member (CCIM) to analyze market fundamentals and asset quality. The process for certain real estate products like DSTs can be relatively swift, with turnaround times for due diligence reports often ranging from five to seven days, reflecting the fast-paced nature of these offerings.
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Energy: The energy sector requires specialized expertise, involving the engagement of independent reservoir engineers and geologists. These experts assess the quality of reservoirs, operating conditions, and the probability of oil and gas production. The due diligence process for energy investments tends to be more time-consuming, typically spanning four to five weeks from start to finish, due to the complexity of geological and engineering assessments.
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Private Debt and Equity: Due diligence in these areas involves a comprehensive review of financial statements, operational capacities, and the historical performance of the sponsor and its prior funds. The emphasis is on understanding the underlying creditworthiness of debt instruments or the growth potential and management quality of equity investments.
Navigating Current Economic Headwinds
The current economic environment presents significant headwinds for alternative investments, particularly in the real estate sector. Rising borrowing costs, with prime lending rates increasing by approximately 450 basis points over the past couple of years, coupled with persistent inflation, make it increasingly challenging for sponsors to generate net operating income (NOI) and meet distribution obligations. This has led to a noticeable compression in yields. For instance, the average year-one cash-on-cash return for 1031 products has reportedly fallen to around 3.99%, a decrease from previous years when yields of 5% to 6.5% were more common.
"Stating the obvious, it costs more to conduct business today. Most notably, borrowing costs have gone way, way up," Updike stated. "You gotta couple that with inflation… It becomes very difficult to drive NOI and to pay the distributions. And we’re seeing evidence of that, like, in a lot of these DST products that we’re looking at."
In light of these challenges, Updike emphasized the importance of considering the broader investment landscape and peer group performance when evaluating offerings. Regulatory requirements like Reg BI mandate comparative analysis, meaning advisors must not only assess an individual product’s viability but also how it stacks up against similar investments in the market. Furthermore, a comprehensive underwriting analysis must consider not only the ability to meet marketed yields but also the potential to return capital within the typical investment horizon of these products, often seven to nine years for DSTs.
Common Pitfalls and Best Practices in Due Diligence
Drawing from past experiences and market observations, Updike highlighted common mistakes advisors make when evaluating alternative investments:
- Paying Yield on Non-Yielding Businesses: Recommending investments that promise high yields without a sound business plan or underlying assets capable of generating that income.
- Over-reliance on Outsourced Services in Energy: In the oil and gas sector, sponsors heavily reliant on external geological and drilling services may underperform compared to vertically integrated firms that manage their own field operations.
- Misunderstanding Prior Performance: Relying on past successes without verifying their relevance to current strategies, markets, or economic conditions. "Prior performance. Is it relevant?" Updike questioned.
- Lack of Transparency: Insufficient access to audits, quarterly financials, appraisals, or reserve reports hinders an investor’s ability to assess asset quality and potential.
- Inadequate Voting Rights: Not ensuring investors have appropriate governance rights and access to information.
Conversely, advisors who excel in due diligence exhibit several key characteristics:
- Regular and Ongoing Due Diligence: They understand that due diligence is not a one-time event but an ongoing process, particularly concerning sponsor-level reviews, which typically have a shelf life of two to four years.
- Product Knowledge and Education: They invest time in understanding the intricacies of alternative investment products, utilizing resources like due diligence reports to enhance their knowledge.
- Understanding Competitive Products: They can effectively differentiate between competing offerings, identifying the unique strengths and weaknesses of each.
- Client Focus: They prioritize knowing their clients and ensuring that any recommended investment is genuinely appropriate for their individual financial situation and risk tolerance.
The Rewarding Aspects of Due Diligence
Despite the demanding nature of due diligence, there are aspects of the work that Brad Updike finds particularly rewarding. Site visits offer invaluable insights into the operational pulse and morale of a company. Interviews with bankers, vendors, and suppliers can uncover critical information that may not be readily available in official documentation. "You can get a lot of information by just picking up the phone and talking to, you know, key suppliers, key vendors, and even, you know, bank officers. How they feel about the sponsor. Whether they, you know, are comfortable with the relationship," Updike shared. These direct interactions provide a more nuanced understanding of a sponsor’s capabilities and potential risks.
Looking Ahead: Industry Conferences and Resources
As the alternative investment industry continues to mature and grow, education and information sharing become paramount. Updike highlighted several industry conferences, such as those hosted by ADISA (Alternative & Direct Investment Securities Association) and TNDTA (The Non-Traded Direct Investment Association), as valuable resources for advisors seeking to deepen their understanding of alternative investment strategies. Mick Law P.C. LLO also hosts its own conferences, with a focus on energy in May and real estate in October, providing platforms for educational sessions on due diligence best practices and product evaluation.
The landscape of alternative investments is dynamic and increasingly critical for diversified portfolios. As economic conditions shift, the role of rigorous and informed due diligence, expertly guided by firms like Mick Law P.C. LLO, remains indispensable for financial advisors aiming to protect client interests and achieve long-term wealth-building objectives.
