The landscape of alternative investments, once a niche sector, has rapidly expanded, becoming an integral component of diversified portfolios managed by financial advisors. However, the accelerating pace of change within this asset class, coupled with a persistently volatile global economy, has introduced unprecedented challenges for wealth managers navigating the complexities of due diligence. Brad Updike, an attorney at Mick Law P.C. LLO, recently joined "The Alternative Investment Podcast" with host Andy Hagans to delve into the critical aspects of due diligence and alts investing for advisors operating in this turbulent economic environment.
Mick Law P.C. LLO, based in Omaha, Nebraska, stands as a prominent legal firm specializing in providing underwriting and due diligence support to a vast network of approximately 300 broker-dealers, investment advisors, and family offices. These entities collectively engage in raising capital for non-traded alternative investments, encompassing both debt and equity offerings. Their expertise is particularly crucial in the private placement arena, where regulatory oversight and readily available public information differ significantly from traditional, publicly traded securities.
The Dichotomy of Investment Worlds: Public vs. Private
Updike articulated a fundamental distinction in the securities product landscape, dividing it into two primary worlds. The first comprises public companies, characterized by high capitalization and debt and equity that trade on established public markets. Examples include large corporations whose securities are listed on exchanges like the New York Stock Exchange, a market boasting a staggering capitalization of $22.1 trillion.
The second world, where Mick Law primarily operates, is the non-traded sector, encompassing a broad spectrum of alternative investments. This universe includes offerings such as 1031 products distributed via private placement, such as Delaware Statutory Trusts (DSTs), real estate investment vehicles structured as LLCs and LPs, and Qualified Opportunity Funds. The energy sector, with its oil and gas programs, also falls under this umbrella, alongside other private placement offerings. Furthermore, the registered non-traded product universe includes non-traded Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and interval funds.
While the alternative investment sector might appear modest in volume compared to the public markets, its significance is far from negligible. Annually, approximately 20,000 Form D filings are submitted by various companies seeking to raise an estimated $1 trillion in debt and equity capital. Although not all sought capital is successfully raised, these figures underscore the substantial scale of the private capital markets. Notably, 15% to 20% of these filings involve FINRA member firms, including broker-dealers and investment advisors, indicating a significant portion of these offerings are syndicated to retail investors.
Growth and Resilience in Key Alternative Sectors
Despite economic headwinds, certain segments of the alternative investment market have demonstrated remarkable growth. Updike highlighted that DSTs alone raised $9.2 billion from 40 different sponsors in the past year, marking a substantial 30% year-over-year increase from 2021. The energy sector, perhaps surprisingly, also witnessed considerable expansion, with approximately $1.1 billion raised by a dozen companies that Mick Law covered, representing a remarkable 100% growth from 2021.
Qualified Opportunity Funds, despite the expiration of certain tax incentives, continue to present compelling investment opportunities. The deferral of capital gains until 2026 and the potential for a fair market value basis step-up after ten years remain significant tax advantages, making these structures attractive for investors seeking long-term tax efficiency.
The Indispensable Need for Professional Due Diligence
The contrasting regulatory frameworks and informational accessibility between public and private markets underscore the paramount importance of professional due diligence in alternatives. Unlike publicly traded securities, which benefit from periodic SEC filings and the rigorous scrutiny of investment banking underwriters, private placements lack these established checks and balances. This absence creates a critical need for specialized firms like Mick Law to bridge the gap.
"On the public side, it’s a little bit more maybe BD advisor-friendly," Updike explained. "You have the periodic SEC filings that have to be made, on a quarterly basis. You have an underwriter that’s actually in the process. That’s an investment banking firm that’s going out. They’re researching the company, they’re conducting interviews, they’re assessing the risk, they’re valuing the company, and they’re placing a price on that security. Whereas in the private placement side, you don’t have that. You don’t have periodic filings. You don’t have an underwriter. But what you do have is pretty stringent due diligence and suitability requirements, which is where we bring value."
Mick Law essentially performs an underwriting function for broker-dealers and advisors, empowering them to determine if an investment warrants their consideration and, more importantly, if it aligns with their clients’ best interests.
Navigating FINRA Rules and Fiduciary Duties
For financial advisors, particularly those operating as broker-dealers or Registered Investment Advisors (RIAs), understanding and adhering to due diligence requirements is not merely a best practice but a legal imperative. While broker-dealers are subject to FINRA rules, RIAs, though not directly governed by FINRA, operate under fiduciary duties that necessitate acting in their clients’ best interests.
Updike elaborated on the regulatory landscape: "On the broker-dealer side, there’s a lot of rules and guidance that cover due diligence and suitability. I think your main rules would include Rule 2111, which requires a broker-dealer to perform enough due diligence and research to make sure that this is an investment that’s suitable for at least one type of investor. But layer on that with Regulation BI, which was just passed a couple years ago, that requires broker-dealers, FINRA member firms, to actually do a couple different things. They have to understand the conflicts of interests that are involved with respect to all types of securities, public and private. It also requires a thorough understanding of the fees, the risks, and the costs that are involved in these products."
Even for RIAs, who are fiduciaries, the implication is clear: a thorough understanding of an investment’s risks, fees, and potential returns is essential to fulfill their obligation to act in their clients’ best interests. This necessitates a robust due diligence process, regardless of the advisor’s specific regulatory classification.
The Dual Pillars of Due Diligence: Sponsor and Product
Effective due diligence in alternative investments hinges on a dual-pronged approach, scrutinizing both the sponsor (the entity managing the investment) and the product (the specific offering). Relying solely on a sponsor’s established reputation or past track record, while a valuable starting point, is insufficient.
"Sponsor-level analysis, program-level analysis, both of them are very, very important processes, that need to be, I guess, prioritized and taken seriously," Updike emphasized. "You know, even with the highest-capitalized sponsors out there, you know, things turn on a dime. I mean, look at our economy. Look how many cycles that, you know, we’ve went through. And, you know, even highly-capitalized, experienced sponsors can face times of distress."
Sponsor review involves an in-depth investigation into the entity’s operational and financial capabilities to manage a program to a successful conclusion. Product review, conversely, focuses on the fairness of the offering to investors, considering the associated risks, the quality of the underlying assets, and the potential for returns.
The Shelf Life of Due Diligence
The ongoing nature of due diligence is critical, as market conditions and sponsor operations can evolve. While a sponsor-level review typically has a shelf life of two to four years, it is not a static assessment. Mick Law and similar firms will re-examine financial statements and performance data, updating their assessments as part of ongoing product reviews. However, substantial changes in a sponsor’s operations, financial health, or prospects may necessitate more frequent sponsor-level due diligence, potentially every 12 to 18 months.
A Framework for Assessing Risk and Reward Across Sectors
Despite the diverse nature of alternative investments, a common framework underpins the due diligence process at Mick Law. This framework systematically evaluates:
- Risk of Execution Failure: Assessing the likelihood of the sponsor failing to execute the investment strategy effectively, which can vary significantly between sponsors.
- Reward Potential: Analyzing the potential returns and the quality of the underlying assets under realistic and conservative assumptions.
- Alignment of Offering Terms with Risk: Ensuring that the terms of the offering are commensurate with the risks undertaken by investors.
- Disclosure of Material Risks: Verifying that all significant risks associated with the offering are clearly and accurately disclosed in offering documents like the Private Placement Memorandum (PPM) and prospectus.
- Fair Treatment of Investors: Evaluating investor access to financial information and the fairness of voting rights.
A crucial element of this framework is the "alignment of interest test," a formula designed to determine if the interests of investors are aligned with those of the sponsor and issuer. This involves examining who is contributing capital, who is receiving distributions, and whether the sponsor’s compensation is performance-based.
Financial and Investment Analysis: Beyond the Legalities
While legal considerations are paramount, due diligence in alternative investments extends into the realm of financial and investment analysis. Determining if an offering is "fair" to investors necessitates a deeper dive into asset quality and return potential. Mick Law employs independent appraisers and reservoir engineers to provide objective assessments of asset quality and potential returns. While the sponsor’s pro forma projections serve as a foundational document, they are not relied upon exclusively. Instead, independent underwriting and pro forma analyses are conducted, considering revenues, anticipated costs, sponsor compensation, and distribution structures.
Sector-Specific Due Diligence: Energy vs. Real Estate
The due diligence approach naturally adapts to the specific sector of the alternative investment. For instance, in the oil and gas sector, specialized consultants like reservoir engineers and geologists are engaged to analyze field dynamics, reservoir conditions, and probable production outcomes. In real estate, certified appraisers and professionals with designations like CCIM (Certified Commercial Investment Member) are utilized to evaluate market conditions and real estate assets.
These sector-specific analyses influence the timeline of the due diligence process. While DSTs and 1031 products might have a turnaround time of five to seven days, oil and gas offerings can extend to four to five weeks due to the more complex and specialized expertise required.
Navigating the Current Economic Headwinds
The current economic climate presents several significant headwinds for investors in alternative assets. Updike highlighted the dramatic increase in borrowing costs, with the prime lending rate climbing from 3.25% to 7.5% over a relatively short period. This, coupled with persistent inflation rates hovering around 6.5%, makes it increasingly challenging for businesses to drive Net Operating Income (NOI) and meet distribution obligations. This strain is evident in the declining year-one cash-on-cash returns for many 1031 products, which have compressed from historical averages of 5-6.5% to around 3.99% in late 2022.
In light of these pressures, advisors must perform a comprehensive comparative analysis, evaluating offerings not only against their own internal benchmarks but also against peer group performance and the broader investment landscape, as mandated by regulations like Regulation BI. The focus remains on ensuring that an offering can not only support its marketed yield but also return capital within the expected timeframe, typically seven to nine years for DSTs.
The Rewarding Aspects of Due Diligence
Despite the rigorous nature of the work, aspects of due diligence offer unique rewards. Site visits, often underappreciated, provide invaluable insights into a company’s operational pulse, staff morale, and management’s alignment with mission and goals. Interviews with bankers, contract vendors, and suppliers can yield candid perspectives on a sponsor’s reputation and operational effectiveness, even uncovering potential concerns that might not be apparent through formal documentation.
Common Pitfalls and Best Practices for Advisors
Mistakes in due diligence can have significant repercussions. Updike pointed to critical errors such as attempting to pay yield on non-yielding businesses, over-reliance on outsourced services in sectors like oil and gas where vertical integration is key, and a misunderstanding of the relevance of prior performance. Cherry-picking past successes without considering their applicability to current strategies or market conditions is a significant red flag. Lack of transparency, including limited access to audits, quarterly financials, appraisals, or reserve reports, also raises concerns.
Conversely, advisors who excel in due diligence exhibit several common threads:
- Regular and Ongoing Diligence: They conduct due diligence consistently and update their assessments of sponsors and products on a regular basis.
- Product Knowledge and Education: They invest time in understanding the intricacies of alternative investment products, utilizing resources like due diligence reports to deepen their knowledge.
- Comparative Analysis: They are adept at differentiating between competing products and understanding their respective strengths and weaknesses.
- Client Focus: They prioritize knowing their clients and ensuring that investments are appropriate for their individual circumstances and risk tolerance.
The Future of Alternative Investments and Due Diligence
The alternative investment industry has matured significantly, demanding a sophisticated approach to due diligence. Firms like Mick Law play a vital role in equipping financial advisors with the tools and expertise necessary to navigate this evolving landscape. As the industry continues to grow, the commitment to rigorous due diligence will remain the bedrock of investor protection and successful long-term wealth creation.
For advisors seeking to deepen their understanding of alternative investments and due diligence best practices, industry conferences, such as those hosted by ADISA and TNDTA, as well as specialized events organized by third-party providers like Mick Law, offer invaluable educational opportunities. These platforms facilitate knowledge sharing, networking, and a deeper immersion into the strategies and challenges of the alternatives sector.
