The imperative for thorough due diligence in the alternative investment sector has never been more pronounced. Financial advisors tasked with allocating client capital to these non-traditional assets face an increasingly complex environment, shaped by rapid market evolution and persistent economic volatility. Brad Updike, an attorney at Mick Law P.C. LLO, recently joined "The Alternative Investment Podcast" hosted by Andy Hagans to dissect these challenges, offering critical insights into due diligence best practices for advisors navigating today’s turbulent economy.
Mick Law, based in Omaha, Nebraska, operates as a specialized law firm supporting a network of approximately 300 broker-dealers, investment advisors, and family offices. Their core service lies in providing underwriting and due diligence support for entities raising capital through non-traded alternative investments, encompassing both debt and equity offerings. This niche focus positions them as a crucial partner for wealth managers seeking to navigate the intricate world of private placements, real estate investment trusts (REITs), business development companies (BDCs), and other alternative structures.
The Dichotomy of Public and Private Markets
Updike underscored the fundamental distinction between the public securities market and the alternative investment space. While public markets, characterized by highly capitalized companies and liquid trading on exchanges like the New York Stock Exchange (valued at approximately $22.1 trillion), offer a degree of transparency and regulatory oversight, the alternative sector operates under a different paradigm. This "second world" includes private placement offerings such as 1031 exchanges (DSTs, real estate LLCs and LPs), Qualified Opportunity Funds, oil and gas programs, and registered non-traded products like non-traded REITs and BDCs.
The sheer volume of activity in the private placement arena, though smaller than the public markets, is significant. Updike noted that approximately 20,000 Form D filings are made annually, seeking an aggregate of about $1 trillion in debt and equity capital. While not all filings result in successful capital raises, a substantial portion, particularly those syndicated by broker-dealers and investment advisors, do reach the market. Roughly 15% to 20% of these filings involve FINRA-regulated firms, highlighting the reach and importance of these offerings.
Sector-Specific Growth and Enduring Appeal
Certain sectors within alternatives have demonstrated notable growth. In 2022, the DST market alone saw $9.2 billion raised from 40 sponsors, representing a 30% year-over-year increase. The oil and gas sector also experienced a resurgence, with approximately $1.1 billion raised by a dozen companies covered by Mick Law, marking a 100% growth from 2021.
Furthermore, Qualified Opportunity Funds, despite the phasing out of certain tax basis step-ups, continue to offer compelling tax advantages. Investors can defer capital gains until 2026 and benefit from a fair market value basis step-up after a decade of holding the investment, making the structure attractive for long-term wealth preservation.
The Due Diligence Imperative: A Legal and Fiduciary Duty
The need for professional due diligence in alternatives stems from the inherent differences compared to traditional investments. Unlike publicly traded securities, which benefit from periodic SEC filings and underwriter scrutiny, private placements lack these immediate oversight mechanisms. This absence places a heightened responsibility on financial advisors to conduct thorough investigations to meet stringent due diligence and suitability requirements.
For broker-dealers, FINRA Rule 2111 mandates sufficient due diligence to ensure an investment is suitable for a particular type of investor. The advent of Regulation Best Interest (Reg BI) has further amplified these obligations, requiring broker-dealers to understand conflicts of interest, fees, risks, and costs associated with all securities, and to engage in comparative analysis of alternative products.
Registered Investment Advisors (RIAs), while not directly subject to FINRA rules, are bound by fiduciary duties to act in their clients’ best interests. This fiduciary standard implicitly necessitates a level of due diligence comparable to, if not exceeding, that of broker-dealers. Therefore, regardless of the advisor’s regulatory classification, rigorous due diligence is not merely best practice but a fundamental legal and ethical requirement when placing client funds into alternative investments.
The Duality of Sponsor and Product Diligence
Effective due diligence in the alternative investment space operates on two critical fronts: the sponsor and the product itself.
Sponsor-Level Analysis: This involves a deep investigation into the operational and financial capabilities of the entity managing the investment. The goal is to ascertain whether the sponsor is equipped to guide the program to a successful conclusion. This assessment considers factors such as the sponsor’s track record, management team expertise, operational infrastructure, and financial stability.
Product-Level Analysis: This focuses on the fairness and viability of the specific offering. Key considerations include the quality of the underlying assets, the reasonableness of projected returns in relation to associated risks, and the alignment of offering terms with investor interests. This analysis delves into the structure of the investment, the disclosure of material risks, and the fairness of investor rights and compensation structures.
Updike emphasized that neither sponsor nor product diligence can be performed in isolation. Even highly capitalized and experienced sponsors can face distress, as evidenced during the COVID-19 pandemic, where market dynamics significantly impacted different real estate sectors. Therefore, a comprehensive approach that scrutinizes both the entity and the offering is paramount.
The Evolving Sponsor Review Cycle
The shelf life of a sponsor-level due diligence review typically ranges from two to four years. However, this is not a static assessment. Mick Law, for instance, re-examines financial statements and performance data as part of their ongoing product reviews, which can necessitate updates to sponsor evaluations. Substantial changes in a sponsor’s operations, financial health, or future prospects may trigger more frequent sponsor-level due diligence, potentially every 12 to 18 months.
A Universal Framework with Sector-Specific Nuances
Despite variations across sectors like real estate, energy, private debt, and private equity, Mick Law applies a consistent framework for due diligence. This framework centers on five key areas:
- Risk of Execution Failure: Assessing the likelihood of the sponsor failing to successfully implement the investment strategy.
- Reward Potential: Evaluating the projected returns and their alignment with the risks undertaken.
- Quality of the Asset: Independently verifying the value and potential of the underlying assets, often utilizing external appraisers and engineers.
- Disclosure of Material Risks: Ensuring that all significant risks are adequately and transparently disclosed in offering documents.
- Fairness to Investors: Examining investor access to financial information, voting rights, and overall treatment within the offering structure.
A crucial element of this process is the "alignment of interest test," a formula developed by Brian Mick, the firm’s founder. This test evaluates who is investing, who is profiting, and whether sponsor compensation is performance-based, providing a clear indication of how well investor and sponsor interests are aligned.
Financial Analysis Beyond Legal Scrutiny
While legal frameworks underpin much of due diligence, a robust assessment requires financial and investment analysis. Mick Law employs independent appraisers and reservoir engineers to determine asset quality and return potential. They treat sponsor-provided pro formas as a starting point, conducting their own independent underwriting. This includes a detailed review of projected revenues, operational costs, sponsor compensation, and fees, often on a load-adjusted basis to present a realistic picture of gross performance.
The deviation between a sponsor’s pro forma and Mick Law’s independently derived projections can vary. For established sponsors with deep operational knowledge, differences might be as small as 5% to 10%. However, in instances where sponsors may be "cherry-picking" optimal outcomes, discrepancies can be substantial, with Mick Law identifying potentially underperforming assets. This highlights the importance of sponsors employing conservative, middle-of-the-road assumptions rather than overly optimistic projections.
Sector-Specific Due Diligence Approaches
The due diligence process adapts to the unique characteristics of each sector:
- Energy: This sector necessitates the engagement of reservoir engineers and geologists to assess field potential, reservoir conditions, and probable production outcomes.
- Real Estate: Appraisers and individuals with designations like CCIM are employed to analyze market conditions and evaluate real estate assets.
The turnaround time for due diligence also varies. Real estate offerings, such as DSTs and 1031 products, can often be completed within five to seven days. Energy offerings, due to the complexity of expert analysis, typically require a longer timeframe, around four to five weeks.
Navigating Current Economic Headwinds
The current economic climate presents significant headwinds for alternative investments. In real estate, sharply increased borrowing costs—with the prime lending rate rising to 7.5% from a historical low of 3.25%—coupled with persistent inflation (currently around 6.5%), make it challenging to drive net operating income (NOI) and sustain distributions. This has led to a compression of yields, with average year-one cash-on-cash returns for 1031 products falling to around 3.99% in Q4 2022, a noticeable decrease from the 5% to 6.5% seen in previous years.
Comparative Analysis and Long-Term Outlook
In light of these market conditions, a comprehensive approach to due diligence is essential. This includes not only assessing a product’s ability to meet its marketed yield but also its capacity to return capital within the expected seven-to-nine-year timeframe for DSTs. Comparative analysis against peer groups and the broader investment landscape is crucial, particularly to satisfy regulatory requirements like Reg BI.
Rewarding Aspects of Due Diligence
Despite the rigorous nature of the work, aspects of due diligence can be particularly rewarding. Site visits offer invaluable insights into a company’s operational pulse, staff morale, and management alignment. Interviews with bankers, contract vendors, and suppliers can also yield critical, often candid, information that may not be present in formal documentation. These "underappreciated" elements of the process provide a more holistic understanding of a sponsor’s true operational capabilities and relationships.
Common Pitfalls and Best Practices for Advisors
Historically, advisors have made several mistakes in due diligence, including:
- Paying Yield on Non-Yielding Businesses: Failing to adequately assess whether a business plan can support distribution payments from actual operational income.
- Over-reliance on Outsourced Services (Energy): In the oil and gas sector, sponsors heavily reliant on external geological and drilling services often underperform those with vertically integrated operations.
- Misunderstanding Prior Performance: Relying on past successes without verifying their relevance to current strategies, fields, or real estate sectors.
- Lack of Transparency: Insufficient investor access to audits, quarterly financials, appraisals, or reserve reports.
- Ignoring Voting Rights: Neglecting the importance of investor governance and participation.
Conversely, advisors who excel in due diligence exhibit several common threads:
- Regular and Ongoing Due Diligence: Committing to continuous review of sponsors and offerings.
- Product Knowledge and Education: Thoroughly understanding the investment products being offered, often by utilizing third-party due diligence reports.
- Understanding Competitive Products: Differentiating between competing offerings to identify the most suitable options.
- Client Focus: Prioritizing client needs and ensuring investments are appropriate for individual circumstances.
The Future of Alternative Investment Due Diligence
The alternative investment industry has matured significantly, with a growing demand for sophisticated due diligence. Mick Law’s commitment to providing comprehensive analysis across various sectors positions them as a vital resource for financial advisors. As the economic landscape continues to evolve, the rigorous application of due diligence principles will remain a cornerstone of responsible wealth management, safeguarding client interests and fostering long-term investment success. Advisors seeking to deepen their understanding of due diligence and alternative investment strategies are encouraged to explore industry conferences and resources, ensuring they are equipped to navigate the complexities of this dynamic market.
