The landscape of alternative investments, while offering significant growth potential for wealth creation, presents a complex terrain for financial advisors and wealth managers tasked with allocating client funds. In recent years, this complexity has been amplified by a rapidly evolving alts sector and a volatile global economy, creating new and persistent challenges for due diligence processes. Brad Updike, an attorney at Mick Law P.C. LLO, recently joined "The Alternative Investment Podcast" to discuss the critical importance of robust due diligence in the current economic climate and its implications for advisors.
The bedrock of responsible investment in alternative assets lies in thorough due diligence. This process is not merely a procedural step but a fundamental requirement for financial professionals who manage client portfolios that include private equity, venture capital, real estate, and other non-traditional assets. Unlike publicly traded securities, which are subject to extensive regulatory oversight and frequent public disclosures, alternative investments often operate in less transparent environments, necessitating a deeper dive into their structure, management, and underlying assets.
Mick Law P.C. LLO, based in Omaha, Nebraska, is a prominent legal firm specializing in providing underwriting and due diligence support. Their expertise serves a network of approximately 300 broker-dealers, investment advisors, and family offices that engage in raising capital for non-traded alternative investments. This focus positions them as a critical resource in an industry where meticulous examination is paramount.
The Two Worlds of Securities: Public vs. Private
Brad Updike articulated a clear distinction between the public and private securities markets, highlighting why due diligence is exponentially more critical in the latter. The public market comprises highly capitalized companies whose debt and equity are traded on exchanges like the New York Stock Exchange, a market with a reported capitalization exceeding $22 trillion. These entities are subject to rigorous quarterly and annual reporting requirements mandated by the Securities and Exchange Commission (SEC), providing a continuous stream of financial information and risk disclosures.
In contrast, the non-traded sector, where Mick Law primarily operates, encompasses a diverse array of alternative investments. These include private placement offerings such as 1031 products (e.g., Delaware Statutory Trusts – DSTs, real estate LLCs and LPs, Qualified Opportunity Funds), oil and gas programs, and registered non-traded products like non-traded REITs, Business Development Companies (BDCs), and interval funds. While this sector is significantly smaller in volume compared to the public markets, its sheer scale and the capital it seeks are far from insignificant. Annually, there are around 20,000 Form D filings made by companies seeking capital, often totaling approximately $1 trillion in debt and equity.
Due Diligence: A Non-Negotiable Requirement
The emphasis on professional due diligence in alternatives stems from the inherent differences in regulatory frameworks and information availability. "On the public side, it’s a little bit more maybe BD advisor-friendly," Updike explained. "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."
However, the private placement side lacks this established infrastructure. "You don’t have that. You don’t have periodic filings. You don’t have an underwriter," Updike continued. "But what you do have is pretty stringent due diligence and suitability requirements, which is where we bring value." This is where firms like Mick Law step in, performing a quasi-underwriting function to help broker-dealers and advisors determine if an investment warrants their consideration and, more importantly, their clients’ capital.
Regulatory Mandates and Fiduciary Duties
For broker-dealers, due diligence is intrinsically linked to FINRA rules, particularly Rule 2111, which mandates that firms perform sufficient due diligence and research to ensure an investment is suitable for a particular type of investor. This is further amplified by Regulation Best Interest (Reg BI), a more recent rule requiring broker-dealers to understand conflicts of interest, fees, risks, and costs associated with all securities, and to conduct a comparative analysis of similar products to ensure clients are placed in the most advantageous opportunities.
Registered Investment Advisors (RIAs), while not directly subject to FINRA rules, are bound by fiduciary duties. This means they are legally obligated to act in their clients’ best interests. Consequently, the spirit of due diligence required of broker-dealers often translates into the practical obligations of RIAs. "On paper, you know, if you compare the due diligence, maybe obligation of a registered investment advisor to a BD, you know, on paper, it looks like there’s compelling differences, but not really," Updike stated. "Because if you think about it, you know, 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."
The Nuances of Sponsor and Offering Due Diligence
A critical aspect of alternative investment due diligence involves evaluating both the sponsor (the entity managing the investment) and the offering itself. Advisors often grapple with how much weight to give to a sponsor’s established track record versus the specific details of a current offering. Updike emphasized that both are crucial and distinct processes.
"Sponsor-level analysis, program-level analysis, both of them are very, very important processes, that need to be, I guess, prioritized and taken seriously," he noted. Even highly capitalized sponsors can face unforeseen challenges, as evidenced during the COVID-19 pandemic, where certain real estate sectors experienced significant downturns. Sponsor review aims to ascertain operational and financial capability, while product review focuses on the fairness of the offering concerning risks, asset quality, and return potential.
The shelf life of a sponsor-level review typically ranges from two to four years, although significant changes in a sponsor’s operations or market outlook may necessitate more frequent re-evaluation. This ongoing monitoring is essential, as management teams can change, and market conditions are perpetually dynamic.
Sector-Specific Due Diligence: Real Estate, Energy, and Private Markets
Mick Law’s expertise spans several key sectors: real estate, energy, and private debt and equity. While a common framework underpins their due diligence, sector-specific nuances dictate the approach. The general framework involves assessing risk of execution failure, evaluating the potential reward, examining asset quality under conservative assumptions, ensuring material risks are adequately disclosed, and verifying fair treatment of investors through access to information and voting rights.
A key analytical tool is the "alignment of interest test," a formula developed by Brian Mick, the firm’s founder. This test scrutinizes who is putting money in, who is taking money out, and whether sponsor compensation is performance-based, providing a clear indication of whether investor and sponsor interests are aligned.
The due diligence process also incorporates financial and investment analysis beyond purely legal considerations. For instance, in real estate, independent appraisers and certified real estate professionals (e.g., those with CCIM designations) are engaged to analyze markets and assets. In the energy sector, reservoir engineers and geologists are crucial for assessing field viability and production potential.
The timeline for these analyses can vary significantly. Real estate-related products, such as DSTs, can often be underwritten within five to seven days, reflecting the relatively standardized nature of appraisals and market data. Energy offerings, however, tend to require a longer turnaround, typically four to five weeks, due to the complexity of geological and engineering assessments.
Navigating the Turbulent Economic Landscape
The current economic climate presents several headwinds that directly impact alternative investments and, consequently, due diligence efforts. In real estate, a dramatic increase in borrowing costs is a primary concern. The prime lending rate has surged from approximately 3.25% to 7.5% in just a couple of years, a 450-basis-point increase. Coupled with persistent inflation, currently around 6.5%, this makes it increasingly challenging for investments to generate sufficient Net Operating Income (NOI) to cover distributions.
This pressure is reflected in declining cash-on-cash returns for some alternative products. For example, average year-one cash-on-cash returns for 1031 products in Q4 2022 were around 3.99%, a notable decrease from the 5% to 6.5% observed a few years prior. While some sectors, like senior housing and hospitality, continue to offer competitive yields, the overall trend highlights the need for more conservative underwriting and a critical evaluation of marketed yields against the backdrop of rising costs.
When assessing these trends, a comparative analysis is essential. Updike stressed the importance of looking at the entire investment landscape and peer group performance, especially in light of Regulation Best Interest’s requirement for comparative analysis. Due diligence must not only ascertain whether an asset can support a marketed yield but also its potential to return capital within the expected timeframe, typically seven to nine years for DSTs.
Rewarding Aspects and Common Pitfalls
Despite the demanding nature of due diligence, Updike identified aspects of the work that he finds particularly rewarding. Site visits, though often underappreciated, offer invaluable insights into a company’s operational pulse, staff morale, and management’s alignment with mission and goals. Interviews with bankers, contract vendors, and suppliers can also yield critical, candid information about a sponsor’s reputation and financial stability. "You’d be surprised, though," Updike commented. "Once in a while, you’ll get a vendor or a banker that will open up a little bit, and they’ll voice some concerns."
Conversely, advisors can fall into several common due diligence traps. One significant mistake is the attempt to "pay yield on a non-yielding business." This involves relying too heavily on a speculative business plan without adequately assessing the underlying assets’ capacity to generate consistent income. In the oil and gas sector, an over-reliance on outsourced services, particularly in geology and drilling, can be problematic. Vertically integrated sponsors who directly supervise field operations tend to outperform those who act primarily as promoters.
A misunderstanding of prior performance relevance is another pitfall. Past success is only valuable if it is relevant to current strategies, fields of exploration, or real estate sectors. Transparency is also key; advisors should look for sponsors who provide access to audits, quarterly financials, appraisals, and reserve reports, demonstrating a culture of accountability. Finally, overlooking investor rights, such as voting rights, can lead to future complications.
Best Practices for Advisors
Advisors who excel in due diligence share common threads. They prioritize product knowledge and regularly update their understanding of sponsors and offerings. This often involves leveraging the expertise of firms like Mick Law to supplement their own research and gain a deeper understanding of alternative investment strategies and the distinctions between competing products.
Crucially, successful advisors know their clients intimately and treat them fairly. This involves not only understanding a client’s financial situation and risk tolerance but also ensuring that the chosen investments are genuinely appropriate. As Updike noted, "The advisors that don’t get into trouble and that do it right, they know the product. And they use our due diligence reports to get to know the product, because product education, very, very important."
The alternative investment industry, while smaller than traditional markets, has matured significantly, particularly in recent years. The increasing complexity and economic volatility underscore the indispensable role of rigorous due diligence. Firms like Mick Law P.C. LLO are at the forefront of this critical function, providing the expertise and insights necessary for financial advisors to navigate this evolving landscape responsibly and effectively, ultimately safeguarding client interests in the pursuit of generational wealth.
For advisors seeking to deepen their understanding of alternative investments and due diligence best practices, industry conferences such as those organized by ADISA and TNDTA, as well as specialized events hosted by third-party providers like Mick Law, offer valuable educational opportunities. These forums provide platforms for learning about diverse alt strategies, evaluating investment opportunities, and honing the skills needed to thrive in this dynamic sector.
