In an era marked by economic volatility and a rapidly evolving financial markets, financial advisors face increasing scrutiny and complexity when allocating client funds to alternative investments. Due diligence, a cornerstone of responsible wealth management, has become more challenging, demanding a deeper understanding of market dynamics and rigorous evaluation processes. Brad Updike, an attorney at Mick Law P.C. LLO, recently joined "The Alternative Investment Podcast" to discuss these challenges, emphasizing the critical role of thorough due diligence in navigating the current economic climate.
Mick Law, a firm based in Omaha, Nebraska, comprises nine attorneys dedicated to providing underwriting and due diligence support for a network of approximately 300 broker-dealers, investment advisors, and family offices engaged in raising capital for non-traded alternative investments, including debt and equity. Their expertise lies in a crucial segment of the financial market often overlooked by traditional analysis.
The Duality of Investment Worlds: Public vs. Non-Traded Alternatives
Updike highlighted the fundamental distinction between two primary investment worlds: the public markets and the non-traded alternative investment sector. Public companies, with their highly capitalized debt and equity trading on exchanges like the New York Stock Exchange, benefit from a transparent and regulated environment. The NYSE, for instance, boasts a market capitalization of $22.1 trillion, providing a vast pool of readily available information and investor protection mechanisms.
In contrast, the alternative investment space, where Mick Law focuses, encompasses a diverse range of products often sold through private placements. This includes 1031 exchange products like Delaware Statutory Trusts (DSTs), real estate investment vehicles (LLCs and LPs), Qualified Opportunity Funds, oil and gas programs, and registered non-traded products such as non-traded REITs, Business Development Companies (BDCs), and interval funds. While this sector may appear smaller in volume compared to the public markets, its significance is substantial. Annually, around 20,000 Form D filings are made, collectively seeking approximately $1 trillion in debt and equity capital, underscoring the scale of this market.
The Imperative of Professional Due Diligence in Alternatives
The inherent nature of private placements and non-traded securities necessitates a more intensive due diligence process compared to publicly traded assets. "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… 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."
This means that financial advisors and wealth managers, often lacking the specialized expertise or the extensive time required to meticulously vet each offering, rely heavily on firms like Mick Law. This professional due diligence acts as an underwriting function, helping advisors determine if an investment is suitable and merits their clients’ capital.
Market Trends and Growth in Alternative Investments
Despite economic headwinds, certain sectors within alternative investments have demonstrated resilience and even growth. Updike pointed to the continued strength in the DST market, with $9.2 billion raised from 40 different sponsors in the past year, representing a 30% year-over-year increase from 2021. The oil and gas sector also experienced significant growth, raising $1.1 billion from a dozen companies covered by Mick Law, a remarkable 100% increase from 2021.
Qualified Opportunity Funds, despite the phasing out of certain tax basis step-ups, remain a compelling option due to their ability to defer capital gains through 2026 and offer a fair market value basis step-up after ten years of holding the investment. This highlights the enduring tax advantages that continue to attract investors to these structures.
Regulatory Frameworks and Fiduciary Duties
The due diligence obligations for financial advisors are shaped by regulatory requirements. For broker-dealers, FINRA Rule 2111 mandates sufficient due diligence to ensure an investment is suitable for at least one type of investor. This is further amplified by Regulation Best Interest (Reg BI), which requires broker-dealers to understand conflicts of interest, fees, risks, and costs associated with all securities, including private placements. Reg BI also encourages a comparative analysis of investment products to ensure clients are placed in optimal opportunities.
Registered Investment Advisors (RIAs), while not directly subject to FINRA rules, operate under a fiduciary duty to act in their clients’ best interests. This fiduciary standard, Updike argued, necessitates a level of due diligence comparable to, if not exceeding, that of broker-dealers. "On paper, you know, 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. 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."
The Due Diligence Process: Sponsor vs. Offering
A critical aspect of alternative investment due diligence involves evaluating both the sponsor (the entity managing the investment) and the offering itself (the specific investment product). Updike stressed that both are paramount and require distinct yet equally rigorous analysis. Even highly capitalized sponsors can face financial distress, as evidenced by market fluctuations and unforeseen economic events like the COVID-19 pandemic, which impacted various real estate sectors differently.
Sponsor review focuses on their operational and financial capability to manage a program to successful completion. Offering review, conversely, centers on the fairness of the investment to investors, considering the associated risks, asset quality, and return potential.
The "Alignment of Interest Test," developed by Brian Mick, founder of Mick Law, is a foundational tool in this process. It involves assessing who is putting money in, who is taking money out, and whether sponsor compensation is performance-based, providing a clear indicator of whether investor and sponsor interests are aligned.
Sector-Specific Due Diligence Approaches
Mick Law’s due diligence efforts span three primary economic sectors: real estate, energy, and private debt and equity. While a general framework applies across all sectors, specific methodologies and expertise are employed based on the asset class.
For energy investments, Updike noted the utilization of reservoir engineers and geologists to analyze fields, reservoirs, operating conditions, and probable production outcomes. This contrasts with real estate due diligence, which relies on appraisers and individuals with certified appraisal credentials or CCIM designations to assess markets and analyze real estate assets.
The turnaround time for due diligence also varies by sector. While DST and 1031 products can typically be reviewed within five to seven days, oil and gas projects require a more extensive four to five-week process, reflecting the complexities of geological and operational assessments.
Navigating Current Economic Headwinds
The current economic landscape presents significant headwinds for investors in alternative assets. Rising borrowing costs, with the prime lending rate reaching 7.5% from a previous low of 3.25%, coupled with persistent inflation at 6.5%, make it increasingly difficult for businesses to drive Net Operating Income (NOI) and meet distribution payments. This is reflected in declining cash-on-cash returns for some DST products, which have shrunk from 5-6.5% in previous years to around 3.99% in Q4 2022.
However, Updike emphasized that due diligence must consider the entire investment landscape and peer group performance, particularly in light of Regulation BI’s requirement for comparative analysis. The goal is not only to assess if a product can meet its marketed yield but also to ensure capital can be returned within the expected timeframe.
Rewarding Aspects of Due Diligence
Despite the rigorous nature of the work, Updike identified rewarding aspects of due diligence, particularly the site visit component. These visits offer invaluable insights into a company’s operational pulse, staff morale, and management alignment with the mission and goals. Interviews with bankers, contract vendors, and suppliers also provide crucial, often candid, information about a sponsor’s financial health and operational relationships.
Common Pitfalls and Best Practices for Advisors
Drawing from past experiences, including significant "blow-ups" like Provident and Med Cap, Updike highlighted common mistakes advisors make. These include attempting to pay yield on non-yielding businesses, an over-reliance on outsourced services in sectors like oil and gas (favoring vertically integrated sponsors), and a misunderstanding of prior performance relevance. Sponsors may present past successes that are not applicable to current strategies or market conditions. Lack of transparency, limited access to audits and financial statements, and insufficient investor voting rights are also red flags.
Conversely, successful advisors and RIAs demonstrate a commitment to ongoing due diligence. They prioritize product education, understand the differences between competing products, and, crucially, know their clients intimately, ensuring investments are appropriate for their individual needs and risk profiles. Many advisors leverage the expertise of firms like Mick Law to supplement their internal knowledge and ensure continuous oversight.
The Future of Alternative Investment Due Diligence
As the alternative investment industry matures and grows, the importance of robust due diligence will only intensify. Industry conferences, such as those organized by ADISA and TNDTA, along with specialized events hosted by third-party providers like Mick Law, offer valuable platforms for advisors to enhance their knowledge and network with industry experts. Mick Law’s own conferences, focusing on energy in May and real estate in October, aim to equip advisors with best practices for screening and evaluating alternative investment products.
In conclusion, navigating the complex and dynamic world of alternative investments demands a proactive and thorough approach to due diligence. As Brad Updike of Mick Law articulates, a deep understanding of market dynamics, regulatory requirements, and rigorous analytical processes are not merely best practices but essential components for financial advisors seeking to protect client interests and achieve long-term wealth-building objectives in today’s turbulent economic environment.
