In the dynamic world of alternative investments, rigorous due diligence is not merely a procedural step but a fundamental safeguard for financial advisors entrusted with client capital. However, recent years have presented an increasingly complex landscape for wealth managers, characterized by rapid evolution within the alts sector and a volatile global economy. These intertwined factors have amplified the challenges associated with discerning viable investment opportunities. To shed light on these critical issues, Brad Updike, an attorney at Mick Law P.C. LLO, joined "The Alternative Investment Podcast" for an in-depth discussion on due diligence and alts investing strategies in the current economic climate.
The Dual Worlds of Securities and the Imperative of Due Diligence
Updike began by outlining the two distinct universes within which investment products operate: the public markets and the non-traded, or alternative, sector. The public markets, exemplified by major corporations whose debt and equity are listed on exchanges like the New York Stock Exchange (valued at $22.1 trillion), are characterized by extensive regulation and readily available information. In contrast, the alternative investment space, where Mick Law focuses its expertise, encompasses a diverse array of products often structured as private placements or registered non-traded vehicles.
This category includes 1031 exchange products such as Delaware Statutory Trusts (DSTs), real estate limited liability companies (LLCs) and limited partnerships (LPs), and Qualified Opportunity Funds. It also extends to oil and gas programs and registered non-traded products like non-traded Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and interval funds. While the alternative investment sector may be smaller in volume compared to public markets, its significance is far from negligible. Annually, approximately 20,000 Form D filings are submitted by companies seeking to raise an estimated $1 trillion in debt and equity capital, highlighting the substantial capital flows within this segment.
The inherent opacity and less standardized reporting mechanisms in private placements necessitate a more intensive due diligence process compared to publicly traded securities. Unlike public companies, which are subject to periodic SEC filings and benefit from the research and valuation conducted by investment banking underwriters, private offerings often lack these built-in layers of scrutiny. This is where firms like Mick Law play a crucial role, providing underwriting and due diligence support to a network of broker-dealers, investment advisors, and family offices.
Navigating the Growth and Nuances of Alternative Investments
Updike elaborated on the significant activity within specific alternative investment sectors. In 2022, the DST market alone saw $9.2 billion raised from 40 sponsors, representing a substantial 30% year-over-year growth from 2021. The oil and gas sector also experienced a remarkable surge, with approximately $1.1 billion raised by a dozen companies covered by Mick Law, a 100% increase from the previous year.
Qualified Opportunity Funds, despite the expiration of certain tax basis step-ups, continue to offer compelling tax advantages, including capital gains deferral through 2026 and a fair market value basis step-up after ten years. This persistent appeal underscores the ongoing investor interest in these structures.
Legal Frameworks: Due Diligence and Suitability for Advisors
For financial advisors, particularly those operating under FINRA regulations, due diligence and suitability requirements are paramount. While registered investment advisors (RIAs) are not directly subject to FINRA rules, they are bound by fiduciary duties to act in their clients’ best interests. This fiduciary obligation effectively mirrors many of the due diligence and suitability standards expected of broker-dealers.
FINRA Rule 2111 mandates that broker-dealers conduct sufficient due diligence and research to ensure an investment is suitable for at least one type of investor. Furthermore, Regulation Best Interest (Reg BI), implemented in recent years, requires FINRA member firms to understand and disclose conflicts of interest, fees, risks, and costs associated with all securities, including private placements. Reg BI also encourages a comparative analysis of investment products to ensure clients are presented with optimal opportunities.
The Dual Pillars of Due Diligence: Sponsor and Product Analysis
Mick Law’s due diligence process bifurcates into two critical areas: sponsor-level analysis and program-level analysis. Sponsor review focuses on the operational and financial capability of the entity managing the investment to guide it to a successful conclusion. This involves assessing the sponsor’s track record, management team’s expertise, financial stability, and overall operational infrastructure. Program review, conversely, scrutinizes the fairness of the offering itself, evaluating the quality of the underlying assets, the reasonableness of projected returns against associated risks, and the alignment of investor interests with those of the sponsor.
Sponsor-level reviews typically have a shelf life of two to four years, though this can be shorter in instances of significant changes to a sponsor’s operations or market position. Product reviews are conducted for each offering, ensuring ongoing assessment of asset quality, projected returns, and the adequacy of risk disclosures within offering documents like the Private Placement Memorandum (PPM) and prospectus.
A Common Framework with Sector-Specific Expertise
Despite variations across different asset classes, Mick Law employs a consistent framework for due diligence. This framework prioritizes the assessment of execution risk, potential rewards, asset quality under conservative assumptions, alignment of offering terms with investor risk, and the thorough disclosure of material risks. A key component of this process is the "alignment of interest test," a proprietary formula developed by Brian Mick, the firm’s founder. This test evaluates who is investing, who is benefiting, and whether sponsor compensation is performance-based, providing a crucial insight into the alignment of interests between investors, issuers, and sponsors.
To determine asset quality and return potential, Mick Law engages independent appraisers and, in the case of energy investments, reservoir engineers and geologists. While the sponsor’s pro forma projections serve as a foundational document, the firm conducts its own independent underwriting and develops its own pro forma, considering revenues, projected costs, and sponsor compensation and fees. The deviation between the sponsor’s pro forma and Mick Law’s independently derived projections can range from a mere 5-10% for highly experienced and operationally sound sponsors to significant discrepancies where projections are deemed overly optimistic or based on cherry-picked outcomes.
Sector-Specific Nuances in Due Diligence
The due diligence approach is tailored to the specific sector. For oil and gas investments, specialized expertise from reservoir engineers and geologists is essential to assess field characteristics, reservoir conditions, and probable production outcomes. Real estate due diligence relies on the expertise of certified appraisers and individuals with designations like CCIM to analyze market dynamics and real estate assets.
The turnaround time for due diligence also varies. Real estate offerings, particularly DSTs and 1031 products, can typically be completed within five to seven days. Energy sector due diligence, however, is a more protracted process, often requiring four to five weeks due to the complexity of geological and engineering assessments.
Headwinds in the Current Economic Landscape
The current economic environment presents significant headwinds for investors. In real estate, borrowing costs have surged dramatically. The prime lending rate has risen from approximately 3.25% two years ago to 7.5%, a 450-basis-point increase. Coupled with inflation rates hovering around 6.5%, this makes it increasingly challenging for Net Operating Income (NOI) to support distributions. This pressure is evident in the declining cash-on-cash returns for DST products, which have fallen to approximately 3.99% in Q4 2022, a notable decrease from the 5-6.5% observed in prior years.
When assessing these shrinking yields, a comprehensive approach is crucial. Advisors must consider the entire investment landscape and peer group performance, as mandated by regulations like Reg BI, which requires comparative analysis. The due diligence must not only ascertain if a product can meet its marketed yield but also its capacity to return capital within the expected timeframe.
Common Mistakes and Best Practices in Due Diligence
Mick Law’s experience, including navigating the aftermath of significant investment blow-ups like Provident and Med Cap, has informed its understanding of common advisor mistakes. These include attempting to generate yield from non-yielding businesses, over-reliance on outsourced services in sectors like oil and gas (favoring vertically integrated sponsors who directly supervise operations), and a misunderstanding or irrelevance of prior performance metrics. Sponsors may tout past successes that are not applicable to current market conditions or strategies.
A lack of transparency, including insufficient access to audits, quarterly financials, appraisals, and reserve reports, is another red flag. Additionally, inadequate attention to investor rights and voting power can lead to issues.
Conversely, advisors who excel in due diligence exhibit several key characteristics. They possess a deep understanding of the products they offer, utilizing due diligence reports for product education and to differentiate between competing offerings. Crucially, they maintain an ongoing commitment to due diligence, regularly updating their assessments of sponsors and products. They prioritize knowing their clients and ensuring fair treatment, a cornerstone of ethical advisory practice.
The Rewarding Aspects of Due Diligence
Despite the demanding nature of due diligence, there are rewarding elements. Site visits offer invaluable insights into a company’s operational pulse, staff morale, and management’s alignment with the mission. Interviews with bankers, contract vendors, and suppliers can uncover critical information and perspectives not found in official documentation. As Brad Updike noted, "You’d be surprised. 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." These interactions, when skillfully managed, can reveal the true health and operational realities of a business.
The Evolving Landscape and Future of Due Diligence
The alternative investment industry has matured significantly, with a growing emphasis on robust due diligence processes. Mick Law, through its comprehensive approach, aims to provide advisors with the necessary tools and insights to navigate this complex environment. The firm’s conferences, focusing on energy and real estate, offer platforms for education on due diligence best practices and product evaluation.
As the market continues to evolve, the role of thorough, ongoing due diligence will remain indispensable for financial advisors seeking to protect client capital and achieve favorable investment outcomes in the alternative investment space.
