The alternative investment landscape, once a niche segment for sophisticated investors, has rapidly evolved, presenting both opportunities and significant challenges for financial advisors. In an era marked by economic volatility and a dynamic market, the critical step of due diligence for advisors allocating client funds to alternatives has become more complex than ever. This article delves into the intricacies of due diligence in the current economic climate, drawing insights from a discussion with Brad Updike, an attorney at Mick Law P.C. LLO, a firm specializing in providing underwriting and due diligence support to the alternative investment sector.
The Evolving Due Diligence Imperative
For financial advisors, particularly Registered Investment Advisors (RIAs) and broker-dealers, ensuring the suitability and integrity of alternative investments is paramount. Unlike traditional securities like stocks and bonds, which benefit from extensive public filings and established market oversight, alternative investments often operate in less transparent environments. This disparity necessitates a robust and professional due diligence process.
"We live in two worlds from a securities product perspective," explained Updike. "You have the public companies, which are highly capitalized and whose debt and equity trade on public markets. Then you have the non-traded sector, the alternative investments, where our firm is involved. This includes private placements like DSTs (Delaware Statutory Trusts), real estate LLCs and LPs, Qualified Opportunity Funds, oil and gas programs, as well as registered non-traded products like REITs (Real Estate Investment Trusts), BDCs (Business Development Companies), and interval funds."
The sheer volume of activity in the alternative space underscores the need for rigorous scrutiny. Annually, approximately 20,000 Form D filings are made, seeking an estimated $1 trillion in debt and equity capital. While not all filings result in successfully raised capital, a significant portion, particularly those syndicated by broker-dealers and investment advisors, do reach the market. Updike noted that roughly 15% to 20% of these filings involve FINRA-registered firms.
Key Sectors and Their Due Diligence Nuances
Mick Law’s expertise spans several core alternative investment sectors, primarily focusing on real estate, energy, and private debt and equity. While a general framework for due diligence exists, sector-specific considerations are crucial.
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Real Estate: This sector, encompassing products like DSTs, has seen substantial growth. In 2022, DSTs alone raised $9.2 billion from 40 different sponsors, marking a 30% year-over-year increase. Due diligence in real estate often involves engaging independent appraisers and professionals with designations like CCIM (Certified Commercial Investment Member) to assess market conditions and asset quality. The process for DSTs and 1031 products typically has a turnaround time of five to seven days.
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Energy: The oil and gas sector, surprisingly, also experienced significant growth, with $1.1 billion raised by approximately a dozen companies covered by Mick Law in 2022, representing a 100% increase from 2021. Due diligence in this area requires the expertise of reservoir engineers and geologists to evaluate fields, reservoirs, and probable production outcomes. The underwriting process for oil and gas deals tends to be more extended, often taking four to five weeks.
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Private Debt and Equity: These segments, along with real estate and energy, form the bedrock of Mick Law’s due diligence practice. While attorneys are well-versed in registered non-traded products, their underwriting services are more heavily utilized in the private placement arena.
Regulatory Framework and Fiduciary Duties
Both broker-dealers and Registered Investment Advisors (RIAs) are bound by regulations that mandate thorough due diligence, albeit through different lenses. Broker-dealers operate under FINRA rules, including Rule 2111 (Suitability) and Regulation Best Interest (Reg BI). Reg BI, implemented a few years ago, requires firms to understand conflicts of interest, fees, risks, and costs associated with securities, and to undertake comparative analyses of different investment opportunities.
RIAs, while not subject to FINRA rules, are bound by fiduciary duties to act in their clients’ best interests. This fiduciary obligation inherently requires a comprehensive understanding of any investment recommendation, mirroring many of the due diligence steps undertaken by broker-dealers. "On paper, if you compare the due diligence obligation of a registered investment advisor to a BD, it looks like there are compelling differences, but not really," Updike observed. "The RIA, while they’re not subject to the FINRA rules, they do have fiduciary duties to act within their client’s best interests."
The Core of Due Diligence: Sponsor and Program Analysis
A fundamental aspect of due diligence in alternatives involves a dual analysis: evaluating the sponsor or manager and the specific investment program or offering. This is not a perfunctory exercise, even for well-established sponsors with a long track record.
"Sponsor-level analysis, program-level analysis, both of them are very, very important processes," Updike stressed. "Even with the highest-capitalized sponsors out there, things turn on a dime. Look at our economy. Look how many cycles we’ve gone through. And even highly-capitalized, experienced sponsors can face times of distress."
Sponsor review aims to ascertain operational and financial capability, while program review focuses on the fairness of the offering in relation to its risks, asset quality, and return potential. The shelf life of a sponsor-level review is typically two to four years, but this can be shortened if significant changes occur in the sponsor’s operations or market position.
The "Alignment of Interest" Test
A key methodology employed by Mick Law is the "Alignment of Interest Test," a concept developed by the firm’s founder, Brian Mick. This test, applicable to any due diligence engagement, poses three critical questions:
- Who is putting money into the investment?
- Who is taking money out of the investment?
- Is the sponsor compensation performance-based?
By analyzing these factors, advisors can gain a clear understanding of whether the interests of investors are aligned with those of the sponsor and issuer.
Financial Analysis Beyond Legal Scrutiny
While legal frameworks provide a foundation, a thorough due diligence process extends into financial and investment analysis. Mick Law utilizes independent appraisers and reservoir engineers to assess asset quality and return potential. They critically review sponsor-provided pro formas, developing their own independent projections that 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. 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," Updike explained, highlighting the importance of analyzing gross versus net performance.
The deviation between a sponsor’s pro forma and an independent analysis can vary. For 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 optimistic outcomes, the disparity can be substantial, with Mick Law projecting significantly lower returns or even identifying assets as non-performing.
Navigating Economic Headwinds: Increased Borrowing Costs and Inflation
The current economic climate presents significant headwinds, particularly for real estate investments. Borrowing costs have surged dramatically, with the prime lending rate climbing from 3.25% to 7.5% in a relatively short period. Coupled with persistent inflation, which has hovered around 6.5% to 7%, 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 products. For instance, average year-one cash-on-cash returns across all 1031 products were reported at 3.99% in Q4 2022, a notable decrease from the 5% to 6.5% seen in prior years. While some sectors, like senior housing and hospitality, still offer attractive yields, the overall trend necessitates a more conservative approach to yield projections.
Best Practices for Advisors: Continuous Learning and Collaboration
The complexity of alternative investments and the current economic environment underscore the importance of best practices for financial advisors. Mistakes often stem from a lack of understanding or insufficient diligence.
Common pitfalls include:
- Paying Yield on Non-Yielding Businesses: Recommending investments based solely on advertised yields without a clear understanding of the underlying business’s ability to generate that income.
- Over-reliance on Outsourced Services in Energy: In the oil and gas sector, sponsors that are vertically integrated and directly supervise field operations tend to outperform those heavily reliant on external geological and drilling services.
- Misunderstanding Prior Performance: Prior successful outcomes are only relevant if they align with current strategies, fields, or real estate sectors being deployed.
- Lack of Transparency and Accountability: Investors should have access to audits, quarterly financials, appraisals, and reserve reports.
- Inadequate Voting Rights: Ensuring investors have appropriate voting rights is crucial for governance.
Conversely, advisors who excel in this space exhibit several common traits:
- Product Knowledge: A deep understanding of the alternative products they offer, often facilitated by utilizing due diligence reports from specialized firms.
- Ongoing Due Diligence: Regularly updating sponsor-level due diligence and staying informed about market developments.
- Comparative Analysis: Understanding the differences between competing products and their suitability for different client needs.
- Client-Centric Approach: Prioritizing client well-being and ensuring recommendations are appropriate for their individual circumstances.
The Value of Third-Party Due Diligence
Firms like Mick Law play a vital role in bridging the knowledge and resource gap for financial advisors. While advisors cannot be expected to possess the in-depth expertise of specialized legal and financial analysts for every alternative investment, they can leverage these third-party services to supplement their own knowledge and fulfill their regulatory and fiduciary obligations.
"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 is very, very important," Updike emphasized.
Looking Ahead: Continued Growth and Vigilance
The alternative investment industry continues to mature, with increased institutional interest and product innovation. As the sector grows, the importance of rigorous due diligence will only intensify. Financial advisors who embrace a proactive, informed, and collaborative approach to evaluating alternative investments will be best positioned to serve their clients effectively in this dynamic and evolving market.
For those seeking to deepen their understanding of due diligence best practices in alternative investments, industry conferences like those hosted by ADISA (Alternative & Direct Investment Securities Association), TNDTA (The Non-Traded Direct Investment Association), and specialized events by firms like Mick Law, Buttonwood, and FactRight offer valuable educational opportunities. These forums provide insights into emerging strategies, regulatory updates, and practical guidance for screening and evaluating a wide array of alternative investment products.
