The landscape of alternative investments, encompassing areas like private equity, venture capital, and real estate, presents a complex yet rewarding frontier for financial advisors and wealth managers. However, the inherent complexities of these markets, coupled with a volatile global economy, have amplified the challenges associated with conducting thorough due diligence. Brad Updike, an attorney at Mick Law P.C. LLO, recently shared his expertise on this critical topic during an episode of "The Alternative Investment Podcast," hosted by Andy Hagans. His insights shed light on the evolving demands placed upon advisors navigating the intricate world of alts investing.
The Growing Imperative of Due Diligence in Alternatives
In the realm of finance, due diligence serves as a foundational pillar, particularly for advisors tasked with allocating client capital to alternative investments. Unlike traditional securities such as stocks and bonds, which benefit from extensive public disclosures and established regulatory oversight, alternative investments often operate within a more opaque framework. This disparity necessitates a more rigorous and specialized approach to due diligence.
"We live in two worlds from a securities product perspective," explained Updike, drawing a distinction between publicly traded companies and the non-traded alternative investment sector. Publicly traded entities, backed by substantial market capitalization, are subject to regular reporting requirements from entities like the New York Stock Exchange. In contrast, the alternative investment space, where Mick Law primarily operates, involves products offered through private placements. These include 1031 exchange programs, Delaware Statutory Trusts (DSTs), real estate investment limited partnerships and limited liability companies, Qualified Opportunity Funds, oil and gas programs, and registered non-traded products such as non-traded REITs and Business Development Companies (BDCs).
The sheer volume of activity in the private placement market underscores the need for expert oversight. Updike noted that approximately 20,000 Form D filings are made annually, with companies seeking to raise an estimated $1 trillion in debt and equity capital. While not all seeking capital ultimately raise it, a significant portion, around 15% to 20%, involves broker-dealers and investment advisors registered with FINRA. This substantial market activity necessitates robust due diligence to ensure investor protection and suitability.
Mick Law: A Leader in Alternative Investment Due Diligence
Mick Law P.C. LLO, based in Omaha, Nebraska, has established itself as a key player in providing underwriting and due diligence support to a network of approximately 300 broker-dealers, investment advisors, and family offices. The firm’s team of nine lawyers specializes in supporting the complex process of raising capital within the non-traded alternative investment sector.
Updike elaborated on the firm’s role, likening it to an underwriting function for broker-dealers and advisors. "What we do is we provide underwriting and due diligence support," he stated. "Our staff consists of nine lawyers, most of whom work out of our Omaha office." This support is crucial because, unlike public securities, private placements lack the ongoing SEC filings and the involvement of investment banking underwriters who typically conduct initial research, risk assessment, and valuation.
Navigating Regulatory Requirements for Advisors
The due diligence obligations for financial advisors engaging with alternative investments are shaped by regulatory frameworks. While the specific rules may differ between Registered Investment Advisors (RIAs) and broker-dealers, the underlying principle of acting in the client’s best interest remains paramount.
For broker-dealers, FINRA Rule 2111 mandates a suitability standard, requiring sufficient due diligence and research to confirm an investment’s appropriateness for a specific investor profile. Furthermore, Regulation Best Interest (Reg BI), implemented a few years ago, imposes additional obligations on broker-dealers. These include a thorough understanding of conflicts of interest, fees, risks, and costs associated with all securities, both public and private. Reg BI also encourages a comparative analysis of investment products to ensure clients are presented with the most advantageous opportunities.
RIAs, while not directly subject to FINRA rules, are bound by fiduciary duties to act in their clients’ best interests. This fiduciary standard inherently requires a deep understanding of any investment recommended, including comprehensive due diligence on alternative offerings. "On paper, 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 observed. "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."
Sector-Specific Due Diligence: Real Estate, Energy, and Private Capital
Mick Law’s due diligence efforts span several key sectors, including real estate, energy, and private debt and equity. While a general framework guides their work, sector-specific nuances require tailored approaches.
In real estate, the firm often focuses on products like DSTs, which have seen significant growth. In 2022, DSTs alone raised $9.2 billion from 40 sponsors, representing a 30% year-over-year increase. Energy, particularly oil and gas programs, also experienced substantial growth, with $1.1 billion raised by a dozen companies covered by Mick Law, a 100% increase from 2021. Qualified Opportunity Funds, despite the phasing out of certain tax benefits, continue to be a relevant investment vehicle due to their capital gains deferral and potential basis step-up features.
The due diligence process, regardless of sector, generally involves evaluating five core areas:
- Risk of Execution Failure: Assessing the likelihood of the sponsor failing to execute the business plan.
- Reward and Asset Quality: Analyzing the potential returns and the quality of the underlying assets under conservative assumptions.
- Fairness of Offering Terms: Determining if the terms adequately reflect the risks investors are undertaking.
- Disclosure of Material Risks: Ensuring that all significant risks are clearly communicated in offering documents.
- Investor Treatment: Examining investor access to financial information and voting rights.
A critical component of this process is the "alignment of interest test," a framework developed by Brian Mick, the firm’s founder. This test scrutinizes who is investing, who is profiting, and whether sponsor compensation is performance-based, offering a clear indication of how aligned the interests of investors are with those of the sponsor and issuer.
Financial Analysis Alongside Legal Scrutiny
While legal frameworks and disclosures are paramount, the due diligence process also requires significant financial and investment analysis. Mick Law engages independent appraisers and reservoir engineers to assess asset quality and return potential. They meticulously review sponsor-provided pro forma financial projections, developing their own independent underwriting to account for revenues, costs, sponsor compensation, and loads.
"We do consider the revenues, the costs that are likely to be incurred during the operational period," Updike explained. "We’ll take a look at the sponsor compensation and the load. You gotta factor that as well, because there have been a lot of times where the sponsor will give us its pro forma, but it won’t be on a load-adjusted basis."
The deviation between a sponsor’s pro forma and Mick Law’s independent analysis can vary. For highly experienced sponsors with deep operational knowledge, the difference might be as low as 5% to 10%. However, in cases where sponsors may be "cherry-picking" the best outcomes or where Mick Law identifies significant discrepancies in economic assumptions, the divergence can be substantial, sometimes indicating a potential for loss rather than the projected returns.
Sector-Specific Expertise and Timelines
The approach to due diligence differs across sectors. For oil and gas offerings, the firm relies on reservoir engineers and geologists to evaluate fields, reservoirs, operating conditions, and production forecasts. In real estate, certified appraisers and professionals with designations like CCIM (Certified Commercial Investment Member) are employed to analyze markets and assets.
These sector-specific requirements influence the timeline for due diligence. While real estate offerings, particularly DSTs and 1031 products, can often be reviewed and completed within five to seven days, oil and gas projects typically require a longer process, around four to five weeks, due to the complexity of geological and engineering assessments.
Headwinds in the Current Economic Climate
The current economic environment presents significant headwinds for alternative investments. "Stating the obvious, it costs more to conduct business today," Updike noted, highlighting the dramatic increase in borrowing costs. The prime lending rate has risen significantly, from approximately 3.25% a couple of years ago to 7.5% currently, a 450-basis-point increase in the cost of capital. Coupled with persistent inflation, which remains around 6.5%, driving Net Operating Income (NOI) and supporting distributions has become increasingly challenging.
This economic pressure is reflected in declining cash-on-cash returns for certain products. For instance, average year-one cash-on-cash returns across all 1031 products in Q4 2022 were around 3.99%, a notable decrease from the 5% to 6.5% observed in previous years. While some sectors, like senior housing and hospitality, maintain relatively higher yields, the overall trend indicates tighter margins and increased pressure on investment performance.
Advisors must consider these broader market trends when evaluating individual offerings. "We have to look at it from I think the entire investment landscape," Updike stressed. "We need to look at the peer group, because that’s important from a Reg BI perspective, you know, comparative analysis." This comparative analysis, alongside a comprehensive underwriting that assesses not only the marketed yield but also the potential for capital return at the investment’s exit, is crucial.
Common Pitfalls and Best Practices in Due Diligence
Drawing on years of experience, Updike identified several common mistakes advisors make when evaluating alternative investments. These include:
- Promising Yield on Non-Yielding Businesses: Investors should be wary of offerings that promise high yields from businesses not inherently structured to generate such income. A thorough review of the underlying assets’ ability to support distributions is critical.
- Over-reliance on Outsourced Services in Energy: In oil and gas investments, sponsors that are vertically integrated and directly supervise field operations tend to perform better than those heavily reliant on third-party geology and drilling services.
- Misunderstanding Prior Performance: Past success is not always indicative of future results. Advisors must ensure that a sponsor’s prior performance is relevant to the current strategy, market conditions, and asset class being considered.
- Lack of Transparency and Accountability: A culture of accountability, including investor access to audits, quarterly financials, appraisals, and reserve reports, is vital.
- Insufficient Scrutiny of Voting Rights: Ensuring investors have adequate voting rights is an important aspect of due diligence.
Conversely, advisors and RIAs who excel in due diligence often exhibit several best practices:
- Regular and Ongoing Due Diligence: Maintaining a consistent review process for sponsors and their offerings is key, especially given the dynamic nature of the market.
- Product Knowledge and Education: Advisors must thoroughly understand the alternative investment products they offer, utilizing resources like due diligence reports to gain comprehensive product education.
- Understanding Product Differentiation: Recognizing the differences between competing alternative investment products allows advisors to recommend the most suitable options for their clients.
- Client-Centric Approach: Prioritizing client needs and ensuring fair treatment remains fundamental to successful and compliant advisory practices.
The Rewarding Aspects of Due Diligence
Despite the inherent challenges, the work of due diligence offers rewarding aspects. Updike finds particular satisfaction in site visits and interviews with bankers, contract vendors, and suppliers. These interactions provide invaluable insights into a company’s operational pulse, staff morale, and management alignment, often revealing information not present in official documents. "You’d be surprised," he remarked, "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 conversations can uncover critical details about a sponsor’s relationship with its stakeholders and its operational realities.
Looking Ahead: Industry Growth and Continued Vigilance
The alternative investment industry has matured significantly, with growing recognition of its importance in diversified portfolios. As this sector continues to expand, the role of rigorous due diligence becomes even more pronounced. Mick Law remains committed to providing the expertise and support necessary for advisors to navigate this evolving landscape.
For advisors seeking to deepen their understanding of alternative investments and due diligence best practices, industry conferences offer valuable educational opportunities. Organizations like ADISA (Alternative & Direct Investment Securities Association) and TNDTA (The Non-Traded Direct Investment Association) host events, and many third-party providers, including Mick Law, conduct their own conferences focused on specific sectors and due diligence methodologies.
In conclusion, the current economic climate demands heightened vigilance and a sophisticated approach to due diligence in the alternative investment space. By understanding the regulatory landscape, embracing sector-specific expertise, and adhering to best practices, financial advisors can effectively navigate these complexities, ultimately safeguarding their clients’ interests and pursuing opportunities for long-term wealth creation.
