The landscape of alternative investments, a crucial component for financial advisors managing client portfolios, has become increasingly complex and challenging in recent years. A volatile global economy, coupled with the rapid evolution of the alts sector, has amplified the importance of rigorous due diligence for wealth managers. 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, offering valuable insights into the intricacies of due diligence for advisors navigating these turbulent times.
The Evolving Role of Due Diligence in Alternative Investments
Due diligence in the realm of alternative investments serves as a cornerstone for financial advisors, particularly those allocating client funds to less traditional assets. Unlike publicly traded securities, which benefit from extensive regulatory oversight and readily available market data, alternative investments, such as private equity, venture capital, real estate syndications, and private debt, often operate with less transparency. This inherent opacity necessitates a deeper, more proactive approach to vetting potential investments.
Mick Law P.C. LLO, based in Omaha, Nebraska, positions itself as a vital support system for this due diligence process. The firm comprises nine attorneys dedicated to providing underwriting and due diligence support to a network of approximately 300 broker-dealers, investment advisors, and family offices. Their specialization lies in non-traded alternative investments, encompassing both debt and equity offerings.
The Two Worlds of Securities: Public vs. Private
Brad Updike highlighted a fundamental distinction in the securities market: the public domain versus the non-traded or private sector. Public companies, characterized by their substantial market capitalization and publicly traded debt and equity, are subject to stringent reporting requirements by entities like the New York Stock Exchange. In contrast, the alternative investment space, where Mick Law primarily operates, includes a diverse array of products.
These alternative investments encompass offerings structured through private placements, such as 1031 exchange programs (including Delaware Statutory Trusts – DSTs), real estate investment vehicles (LLCs and LPs), and Qualified Opportunity Funds. The universe also extends to publicly registered but 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 sheer volume compared to the public markets, its significance is undeniable. Updike noted that approximately 20,000 Form D filings are made annually, seeking an estimated $1 trillion in debt and equity capital. While not all of this capital is successfully raised, it underscores the substantial scale of the private capital markets. A significant portion of these filings, approximately 15% to 20%, involve FINRA-regulated firms such as broker-dealers and investment advisors, indicating the direct impact on retail investors.
Growth and Resilience in Key Alternative Sectors
Despite economic headwinds, certain sectors within alternative investments have demonstrated remarkable growth and resilience. Delaware Statutory Trusts (DSTs), a popular vehicle for 1031 exchanges, saw $9.2 billion raised from 40 different sponsors in the past year, representing a substantial 30% year-over-year increase from 2021.
Surprisingly, the energy sector, particularly oil and gas programs, also experienced significant growth. Mick Law covered offerings that raised $1.1 billion from approximately a dozen companies, doubling the capital raised in 2021.
Furthermore, Qualified Opportunity Funds continue to be a compelling investment avenue, even after the expiration of certain tax benefits. The ability to defer capital gains until 2026 and the potential for a fair market value basis step-up after ten years offer attractive incentives for investors seeking long-term tax advantages.
The Due Diligence Imperative for Advisors
The necessity for professional due diligence in the alternative investment space stems from the lack of a public market underwriter, a role that typically performs extensive research, interviews, and risk assessments for publicly traded securities. In the private placement arena, financial advisors and broker-dealers bear a significant responsibility to ensure the suitability and appropriateness of these investments for their clients.
Brad Updike emphasized that while Registered Investment Advisors (RIAs) operate under a fiduciary duty to act in their clients’ best interests, and broker-dealers adhere to suitability standards, the underlying requirement for thorough due diligence remains consistent. Regulation Best Interest (Reg BI), implemented in recent years, further mandates that broker-dealers understand and mitigate conflicts of interest, thoroughly assess fees, risks, and costs, and conduct comparative analyses of investment products. This regulatory evolution reinforces the critical nature of a robust due diligence framework.
Differentiating Due Diligence: Sponsor vs. Offering
A key aspect of due diligence involves evaluating both the sponsor or manager of an investment and the specific offering itself. While a sponsor with a long track record and consistent positive outcomes might seem like a safe bet, Updike stressed that rigorous analysis is required for every offering, regardless of the sponsor’s reputation.
Sponsor-level analysis aims to determine if the entity is operationally and financially capable of managing a program to a successful conclusion. This involves investigating their operational infrastructure, financial stability, and management team’s expertise.
Concurrently, product-level analysis focuses on the fairness of the offering to investors, considering the risks, asset quality, and potential returns. Updike noted that even highly capitalized and experienced sponsors can face unforeseen challenges, as evidenced during the COVID-19 pandemic, which saw varied performance across different real estate sectors.
The shelf life of a sponsor-level review typically spans two to four years. However, ongoing monitoring of financial statements, performance, and any substantial changes in the sponsor’s operations or market outlook is crucial. This ensures that due diligence remains a dynamic and continuous process, not a static one-time assessment.
A Framework for Due Diligence Across Sectors
Mick Law employs a consistent framework for due diligence across various alternative investment sectors, including real estate, energy, and private debt and equity. This abstract framework focuses on five core areas:
- Risk of Execution Failure: Assessing the likelihood of the investment failing to meet its objectives due to operational or management issues.
- Reward Potential: Evaluating the projected returns under realistic and conservative economic assumptions.
- Quality of Assets: Analyzing the underlying assets to determine their intrinsic value and potential for appreciation or income generation.
- Material Risk Disclosure: Ensuring that all significant risks associated with the offering are clearly and accurately disclosed in the offering documents (Private Placement Memorandum – PPM, prospectus).
- Fairness to Investors: Verifying that investors have appropriate access to financial information and reasonable voting rights.
Beyond these core areas, Mick Law applies the "Alignment of Interest Test," a formula designed to assess whether the interests of investors are aligned with those of the sponsor and issuer. This involves examining who is contributing capital, who is receiving compensation, and whether the sponsor’s compensation is performance-based.
Financial and Legal Interplay in Due Diligence
The due diligence process inherently involves both legal and financial analysis. While legal aspects like voting rights and offering structure are critical, determining the fairness of risk-reward profiles necessitates a deep dive into financial projections and asset valuations.
To address this, Mick Law utilizes independent appraisers and reservoir engineers to assess asset quality and return potential. While sponsor-provided pro forma statements serve as a foundational piece of information, the firm conducts its own independent underwriting and develops its own pro forma projections. This independent analysis considers revenues, anticipated costs, sponsor compensation, and sales loads, providing a more objective view of the investment’s viability.
The deviation between a sponsor’s pro forma and Mick Law’s independent analysis can vary. For well-established sponsors with a deep understanding of their operational focus, deviations might be as small as 5% to 10%. However, in instances where sponsors may be "cherry-picking" best-case scenarios or where the underlying assets are fundamentally weaker, the divergence can be substantial, with Mick Law identifying potentially losing assets where a sponsor projects significant returns.
Sector-Specific Nuances in Due Diligence
While a general framework exists, the due diligence approach is tailored to the specific sector of the alternative investment. For instance:
- Energy: This sector requires specialized expertise from reservoir engineers and geologists to evaluate field characteristics, operating conditions, and probable production outcomes. The firm prioritizes vertically integrated sponsors who directly supervise field operations over those acting primarily as promoters.
- Real Estate: Due diligence in real estate involves appraisers and professionals with designations like CCIM to analyze markets and real estate assets. The turnaround time for real estate offerings, such as DSTs, is generally quicker, often within five to seven days, compared to oil and gas deals which can take four to five weeks.
Navigating Current Economic Headwinds
The current economic climate presents significant headwinds for alternative investments. Notably:
- Rising Borrowing Costs: Prime lending rates have surged from approximately 3.25% to 7.5% in a relatively short period, dramatically increasing the cost of capital for real estate and other debt-financed ventures.
- Inflationary Pressures: Elevated inflation rates (around 6.5%) further squeeze net operating income (NOI) and challenge the ability of investments to meet distribution expectations.
These factors have led to a compression of yields in some sectors. For example, average year-one cash-on-cash returns for 1031 products have declined to around 3.99%, a notable decrease from historical averages of 5% to 6.5%. However, certain sectors like senior housing and hospitality continue to offer yields above 5%.
When evaluating investments in this environment, a comprehensive approach is essential. Advisors must consider the entire investment landscape and peer group performance, as mandated by regulations like Reg BI, while also conducting a thorough underwriting analysis that assesses not only the marketed yield but also the potential for capital return at the investment’s exit.
Common Pitfalls and Best Practices for Advisors
Learning from mistakes is a continuous process in the financial advisory world. Brad Updike identified several common errors advisors make when evaluating alternative investments:
- "Paying Yield on a Non-Yielding Business": Investing in ventures that lack a clear path to generating income to support distributions.
- Over-reliance on Outsourced Services (Energy Sector): In oil and gas, sponsors heavily reliant on external geology and drilling expertise may underperform those with in-house capabilities.
- Misunderstanding Prior Performance: Relying on past successes without verifying their relevance to current strategies, fields, or market conditions.
- Lack of Transparency and Accountability: Failing to ensure investors have access to audits, quarterly financials, appraisals, and reserve reports.
- Ignoring Voting Rights: Neglecting the importance of investor participation and control mechanisms.
Conversely, successful advisors and RIAs demonstrate several best practices:
- Performing Regular and Ongoing Due Diligence: Continuously updating sponsor-level assessments and staying informed about market dynamics.
- Deep Product Knowledge: Thoroughly understanding the intricacies of alternative investment products and their differences from competing offerings.
- Client Suitability: Prioritizing a deep understanding of their clients’ financial situations, risk tolerance, and investment objectives to ensure appropriate product placement.
- Leveraging Expert Resources: Partnering with specialized firms like Mick Law to supplement internal expertise and access comprehensive due diligence reports.
The Future of Alternative Investments and Due Diligence
The alternative investment industry has matured significantly, growing from a niche market to a substantial force in wealth management. As this sector continues to expand and evolve, the imperative for robust due diligence will only intensify. Financial advisors and wealth managers who prioritize comprehensive, ongoing, and sector-specific due diligence will be best positioned to navigate the complexities of the market, protect their clients’ interests, and capitalize on the opportunities within the dynamic world of alternative investments. For those seeking further education and resources, industry conferences and specialized due diligence providers like Mick Law offer invaluable support.
