The realm of alternative investments, a crucial component for financial advisors seeking to diversify client portfolios, is currently navigating a period of significant transformation. A rapidly shifting market and persistent economic volatility have introduced unprecedented complexities for wealth managers, making robust due diligence more critical than ever. Brad Updike, an attorney at Mick Law P.C. LLO, recently shared his expert insights on the intricate processes and evolving challenges of due diligence in alternative investments during a discussion on "The Alternative Investment Podcast."
The Imperative of Due Diligence in Alternatives
The core of alternative investment allocation hinges on thorough due diligence. Unlike publicly traded securities, which benefit from extensive regulatory oversight and readily available market data, private placements and non-traded alternative products require a deeper, more specialized investigative approach. Mick Law P.C. LLO has established itself as a leader in providing this vital support, serving approximately 300 broker-dealers, investment advisors, and family offices that engage in raising capital for non-traded debt and equity alternatives.
Brad Updike explained the fundamental difference between the two primary investment worlds: the public markets and the non-traded alternative sector. Publicly traded companies, such as those listed on the New York Stock Exchange with a market capitalization of $22.1 trillion, operate within a highly regulated and transparent framework. In contrast, the alternative investment space encompasses a diverse array of products offered through private placements. These include 1031 exchange products like Delaware Statutory Trusts (DSTs), real estate investment partnerships (LLCs and LPs), and Qualified Opportunity Funds. Additionally, the universe includes registered non-traded products such as non-traded Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and interval funds.
While the alternative sector may be smaller in volume compared to the public markets, its significance is far from negligible. Annually, there are approximately 20,000 Form D filings made by companies seeking to raise capital, often totaling around $1 trillion in debt and equity. A substantial portion of these filings, estimated between 15% to 20%, involve FINRA-registered broker-dealers and investment advisors, indicating the significant reach of the alternative investment market to retail investors.
Key Sectors and Growth Trends in Alternatives
Within this dynamic landscape, certain sectors have demonstrated notable growth. Delaware Statutory Trusts (DSTs), a popular vehicle for 1031 exchanges, saw $9.2 billion raised from 40 different sponsors in the past year, representing a 30% year-over-year increase from 2021. The energy sector, particularly oil and gas programs, also experienced a remarkable resurgence, with approximately $1.1 billion raised by a dozen companies covered by Mick Law, doubling the amount raised in 2021.
Qualified Opportunity Funds, despite the phasing out of certain tax basis step-ups, continue to offer compelling tax advantages, including the deferral of capital gains through 2026 and a fair market value basis step-up after ten years of holding the investment. This sustained appeal underscores the ongoing relevance of these alternative structures.
The Legal Framework for Due Diligence
For financial advisors, particularly those operating as FINRA member firms, due diligence is not merely a best practice but a regulatory imperative. Rule 2111 of the Financial Industry Regulatory Authority (FINRA) mandates that broker-dealers conduct sufficient due diligence and research to ensure an investment is suitable for at least one type of investor. This is further reinforced by Regulation Best Interest (Reg BI), which requires broker-dealers to understand conflicts of interest, fees, risks, and costs associated with all securities, and to perform comparative analyses of different investment products.
While Registered Investment Advisors (RIAs) are not directly subject to FINRA rules, they operate under a fiduciary duty to act in their clients’ best interests. This fiduciary obligation implicitly requires a comparable level of due diligence to ensure that investments are appropriate and aligned with client objectives. Updike emphasized that while the legal obligations may appear different on paper, the practical execution of due diligence for both broker-dealers and RIAs should be robust and comprehensive.
The Duality of Due Diligence: Sponsor and Product
Mick Law’s due diligence process is bifurcated into two critical areas: sponsor-level analysis and program-level analysis. Both are considered paramount, as even highly capitalized and experienced sponsors can face unforeseen challenges. The economic cycles and market volatility experienced in recent years, including the impacts of the COVID-19 pandemic, have demonstrated that no entity is immune to distress.
Sponsor review focuses on assessing the operational and financial capabilities of the entity to manage a program to a successful conclusion. This involves a deep dive into their track record, management team, operational infrastructure, and financial health. Program review, conversely, concentrates on the fairness of the offering itself. This includes evaluating the quality of the underlying assets, the alignment of risks with potential returns, the clarity of risk disclosures in offering documents, and the fairness of terms and investor rights.
The "alignment of interest test," developed by Brian Mick, founder of the firm, serves as a foundational element in this process. It systematically evaluates who is investing capital, who is receiving distributions, and whether sponsor compensation is performance-based, providing a clear indicator of alignment between investor and issuer interests.
Sector-Specific Due Diligence Approaches
While a general framework for due diligence exists, the specific application varies across different alternative investment sectors. Mick Law focuses primarily on three key areas: real estate, energy, and private debt and equity.
In the energy sector, particularly oil and gas investments, due diligence involves engaging specialized experts such as reservoir engineers and geologists. These professionals assess the geological formations, reservoir conditions, and probable production outcomes. The firm prioritizes vertically integrated sponsors who directly supervise field operations over those acting solely as promoters, as empirical data suggests a stronger performance record from the former. The process for oil and gas offerings typically takes around four to five weeks from start to finish.
For real estate investments, including DSTs and 1031 products, the firm utilizes independent appraisers and individuals with certified appraisal credentials or CCIM designations. These experts analyze market conditions and evaluate the quality of the real estate assets. The due diligence process for real estate offerings is generally more expedited, often completed within five to seven days, reflecting the rapid pace at which these products are brought to market.
In the realm of private debt and equity, the due diligence process involves a more intricate analysis of financial statements, business models, management teams, and the competitive landscape. The firm scrutinizes the potential for risk mitigation and the viability of projected returns.
Navigating Current Economic Headwinds
The current economic climate presents significant headwinds for alternative investments. In the real estate sector, a substantial increase in borrowing costs, with prime lending rates reaching 7.5%—a 450-basis-point increase from two years prior—coupled with persistent inflation, makes it challenging to drive Net Operating Income (NOI) and meet distribution expectations. This has led to a noticeable compression in yields. For instance, average year-one cash-on-cash returns across all 1031 products in Q4 2022 were around 3.99%, a decrease from the 5% to 6.5% observed in previous years.
Updike stressed the importance of a holistic approach to due diligence in this environment, considering both absolute yields and peer group comparisons, as mandated by Regulation BI’s requirement for comparative analysis. The focus extends beyond simply meeting advertised yields to ensuring the underlying assets can sustain distributions and provide capital return within the typical seven-to-nine-year exit horizon for DSTs.
Common Pitfalls and Best Practices for Advisors
Learning from past mistakes is crucial in the investment advisory field. Updike highlighted several common errors advisors make when evaluating alternative investments. These include:
- Attempting to generate yield from non-yielding businesses: Advisors must scrutinize the underlying assets to ensure they can realistically support distribution payments, rather than relying solely on attractive business plans.
- Over-reliance on outsourced services in specialized sectors: In oil and gas, for example, sponsors heavily dependent on external geological or drilling services may underperform those with integrated operations.
- Misunderstanding the relevance of prior performance: Past successes are only valuable if they are directly applicable to current strategies, fields, or asset classes. Advisors must assess the relevance and comparability of a sponsor’s historical track record.
- Lack of transparency and accountability: Investors should have access to audits, quarterly financials, appraisals, and reserve reports that clearly explain asset quality and upside potential.
- Ignoring investor rights and voting power: These are critical components of investor protection and should be thoroughly reviewed.
Conversely, advisors who excel in due diligence exhibit several best practices:
- Consistent and ongoing due diligence: Regular updates on sponsor-level information and market conditions are essential.
- Product knowledge and education: Advisors must deeply understand the alternative investment products they offer and how they differ from competing options.
- Client-centric approach: Prioritizing fair treatment and understanding the client’s specific needs and risk tolerance is paramount.
- Leveraging expert resources: Partnering with firms like Mick Law provides advisors with specialized knowledge and capacity to conduct thorough due diligence, supplementing their internal expertise.
The Rewarding Aspects of Due Diligence
Despite the demanding nature of the work, Updike noted rewarding aspects, particularly the site visit component of due diligence. These visits offer invaluable insights into a company’s operational pulse, staff morale, and management alignment with the firm’s mission and goals. Additionally, conducting interviews with bankers, contract vendors, and suppliers can uncover crucial information and potential concerns that might not be apparent from official documentation alone. These interactions provide a qualitative layer to the quantitative data, offering a more comprehensive understanding of a sponsor’s operational dynamics and relationships.
The Future of Alternative Investment Due Diligence
As the alternative investment industry continues to mature and grow, the importance of rigorous due diligence will only intensify. The complexity of products, coupled with economic uncertainty, necessitates a proactive and informed approach from financial advisors. Firms like Mick Law play a vital role in equipping advisors with the necessary tools and insights to navigate this evolving landscape, ensuring that client capital is allocated responsibly and strategically. The ongoing development of industry conferences and educational resources, such as those hosted by ADISA and TNDTA, further supports this mission, fostering a more knowledgeable and resilient investment community.
