In an era marked by rapid shifts in the alternative investment landscape and a persistently volatile global economy, financial advisors face mounting challenges in conducting thorough due diligence before allocating client funds. Brad Updike, an attorney at Mick Law P.C. LLO, recently shared his expert insights on this critical aspect of wealth management during an episode of The Alternative Investment Podcast. His discussion with host Andy Hagans highlighted the intricate processes and evolving demands of evaluating alternative investment opportunities, underscoring the vital role of rigorous due diligence for advisors and their clients.
The alternative investment sector, encompassing private equity, venture capital, real estate, and other non-traditional assets, operates with a distinct set of complexities compared to publicly traded securities. Unlike stocks and bonds, which are subject to regular SEC filings and extensive public market scrutiny, alternative investments often rely on private placements and structures that necessitate a deeper dive into their underlying fundamentals. This is where firms like Mick Law P.C. LLO play a crucial role, providing specialized underwriting and due diligence support to a broad network of broker-dealers, investment advisors, and family offices.
The Dual Worlds of Securities and the Need for Due Diligence
Updike elaborated on the dichotomy of the securities market, dividing it into two primary spheres: the public markets and the non-traded, alternative investment sector. The public markets are characterized by highly capitalized companies whose debt and equity are traded on exchanges like the New York Stock Exchange, which boasts a market capitalization in the trillions. This environment offers a degree of transparency through mandated periodic filings.
Conversely, the alternative investment space, where Mick Law focuses its expertise, includes products such as 1031 exchange properties (DSTs, real estate LLCs, LPs), Qualified Opportunity Funds, oil and gas programs, non-traded REITs, Business Development Companies (BDCs), and interval funds. While the alternative sector may be smaller in volume compared to public markets, it is far from insignificant. Annually, approximately 20,000 Form D filings are made, signaling a collective capital raise of around $1 trillion in debt and equity. Of these filings, 15% to 20% involve FINRA-registered firms, indicating a substantial portion of these offerings are syndicated through broker-dealers and investment advisors.
The inherent lack of continuous public disclosure in the alternative space amplifies the importance of professional due diligence. While public companies are subject to quarterly and annual reporting requirements, private placements do not have the same oversight. This absence of readily available, standardized information places a significant onus on advisors to conduct their own in-depth investigations to ensure suitability and compliance with regulatory standards.
Navigating the Alternative Investment Landscape: Key Sectors and Trends
Mick Law P.C. LLO specializes in due diligence across several key sectors within alternative investments: real estate, energy, and private debt and equity. Within these broad categories, specific product types have shown notable activity. For instance, in 2022, DSTs alone saw $9.2 billion raised from 40 sponsors, representing a 30% year-over-year growth. The energy sector, often perceived as volatile, also experienced significant growth, with approximately $1.1 billion raised by a dozen companies covered by Mick Law, marking a 100% increase from 2021.
Qualified Opportunity Funds, despite the expiration of certain tax benefits, continue to offer compelling advantages. The ability to defer capital gains until 2026 and the potential for a fair market value basis step-up after 10 years remain attractive features for investors seeking tax-efficient investment strategies.
Regulatory Frameworks: Suitability and Fiduciary Duties
For financial advisors, particularly those registered with FINRA as broker-dealers, due diligence is not merely a best practice but a regulatory mandate. Rule 2111 of FINRA’s Conduct Rules requires broker-dealers to perform adequate due diligence and research to ensure that any investment recommendation is suitable for at least one type of investor. This standard is further bolstered by Regulation Best Interest (Reg BI), which mandates that broker-dealers act in the best interest of their retail customers when making recommendations. Reg BI requires a thorough understanding of conflicts of interest, fees, risks, and costs associated with all securities, including alternatives, and encourages a comparative analysis of different investment opportunities.
Registered Investment Advisors (RIAs), while not directly subject to FINRA rules, operate under a fiduciary duty. This legal obligation requires them to act in their clients’ best interests at all times. Consequently, the principles of due diligence and suitability are implicitly embedded in their fiduciary responsibilities. Effectively, both broker-dealers and RIAs must conduct comprehensive investigations to ensure that alternative investments align with their clients’ financial goals, risk tolerance, and investment objectives.
Sponsor vs. Offering: A Dual Focus in Due Diligence
A critical aspect of due diligence involves evaluating both the sponsor (the entity managing the investment) and the offering itself (the specific investment product). Updike emphasized that both are paramount and require distinct, yet interconnected, analyses. Sponsor-level analysis aims to determine if the entity is operationally and financially capable of managing a program to a successful conclusion. This involves assessing their track record, management team, operational infrastructure, and financial stability.
Offering-level analysis, conversely, focuses on the fairness of the investment product to investors. This includes scrutinizing the quality of assets, the alignment of offering terms with the inherent risks, the clarity of risk disclosures, and the fairness of investor rights, such as voting power and access to financial information. Relying solely on a sponsor’s established reputation, even one with a long history of successful offerings, is insufficient. Economic conditions can shift rapidly, impacting even well-capitalized and experienced sponsors. Therefore, a rigorous, case-by-case evaluation of each offering and its sponsor is indispensable.
The Evolving Due Diligence Process
The shelf life of a sponsor-level review typically ranges from two to four years. However, ongoing monitoring is crucial, especially if substantial changes occur within the sponsor’s operations, financial standing, or market prospects. Mick Law’s process involves a comprehensive underwriting function that includes evaluating financial statements, performance metrics, and operational data. When assessing the quality of assets, the firm often employs independent appraisers and, in the case of energy investments, reservoir engineers and geologists to provide objective valuations and projections.
While sponsors provide pro forma financial projections, Mick Law conducts its own independent underwriting. This involves analyzing revenues, projected costs, and sponsor compensation, with a particular focus on ensuring that projections are presented on a load-adjusted basis, reflecting gross performance and accounting for all fees and expenses. The deviation between a sponsor’s pro forma and Mick Law’s independent analysis can vary significantly. For established sponsors with deep operational expertise, differences might be as small as 5% to 10%. However, in cases where sponsors may be overly optimistic or cherry-picking favorable data, the divergence can be substantial, sometimes leading to diametrically opposed conclusions regarding an offering’s viability.
Sector-Specific Due Diligence Approaches
The due diligence process, while sharing common themes across sectors, also incorporates sector-specific expertise. In real estate, for instance, the firm utilizes independent appraisers and professionals with designations like CCIM to analyze market conditions and asset quality. For oil and gas investments, specialized consultants such as reservoir engineers and geologists are engaged to assess field conditions, reservoir potential, and probable production outcomes.
The timeline for diligence also varies by sector. Real estate offerings, particularly DSTs and 1031 products, can often be reviewed and turned around within five to seven days due to established processes and readily available data. Energy-related diligence, however, tends to be more involved, often requiring four to five weeks from start to finish, reflecting the complexity of geological and engineering assessments.
Headwinds in the Current Economic Climate
The current economic environment presents significant headwinds for alternative investments, particularly in the real estate sector. The dramatic increase in borrowing costs, with the prime lending rate climbing from 3.25% to 7.5% in recent years, coupled with persistent inflation (currently around 6.5%), makes it increasingly challenging for properties to generate sufficient net operating income (NOI) to support distributions. This has led to a noticeable compression in yields for many DST products. For example, average year-one cash-on-cash returns for 1031 products have fallen to around 3.99%, a decrease from the 5% to 6.5% observed in prior years.
When evaluating these compressed yields, a dual approach is essential. Advisors must consider the peer group to meet regulatory requirements for comparative analysis (as per Reg BI) and simultaneously conduct a comprehensive underwriting that assesses not only the marketed yield but also the ability to return capital within the typical seven-to-nine-year holding period for DSTs.
Rewarding Aspects of Due Diligence
Despite the rigorous nature of due diligence, there are rewarding aspects to the work. Updike highlighted the value of site visits, which offer a tangible sense of a company’s operational pulse, staff morale, and management alignment. Interviews with bankers, contract vendors, and suppliers also provide invaluable, often candid, insights into a sponsor’s reputation and operational effectiveness. These interactions, while sometimes challenging to elicit candid feedback, can uncover crucial information that might not be apparent in formal documentation.
Common Pitfalls and Best Practices for Advisors
Advisors can learn from historical mistakes in due diligence. A significant pitfall is attempting to derive yield from non-yielding businesses, often driven by an overemphasis on a "sexy" business plan rather than the underlying asset’s ability to generate income. In the oil and gas sector, over-reliance on outsourced services, particularly for geological and drilling expertise, can be a red flag. Vertically integrated sponsors who directly supervise field operations often demonstrate superior performance compared to those acting primarily as promoters.
Misunderstanding the relevance of a sponsor’s prior performance is another common error. Successful outcomes in past ventures are only valuable if they are directly applicable to the current strategies, fields, or real estate sectors being explored. Transparency is also key; advisors should look for sponsors who provide access to audits, quarterly financials, appraisals, and reserve reports, and who offer clear voting rights to investors.
The advisors who excel in due diligence exhibit several common traits. They prioritize product knowledge and utilize due diligence reports to gain a deep understanding of alternative investment strategies and their differences compared to competing products. They consistently perform due diligence on an ongoing basis, maintaining an active awareness of sponsor operations. Crucially, they understand their clients intimately, ensuring that any recommended investment is not only a sound opportunity but also a suitable fit for the individual investor’s financial situation and risk profile. This client-centric approach, combined with robust due diligence, is fundamental to avoiding costly mistakes and fostering long-term client trust.
The Growing Importance of Alternative Investments
The alternative investment industry has matured significantly in recent years, transitioning from a niche market to a substantial component of diversified investment portfolios. As this sector continues to grow and evolve, the role of expert due diligence providers like Mick Law P.C. LLO becomes increasingly critical. Their commitment to providing thorough, objective analysis empowers financial advisors to navigate the complexities of alternative investments with greater confidence, ultimately benefiting the investors they serve.
