Third party due diligence has evolved into a critical component in the distribution of alternative investments over the past decade. Prior to the Great Recession, third party reports were helpful in the review of products, but the regulatory examiners had yet to require these reports in the every selling firms’ file. The diligence done internally by many of the firms in those days was sufficient to satisfy its obligations to the extent the regulators were enforcing them. Today, good luck finding any regulatory examiner who doesn’t first ask for a third party report when reviewing diligence files. Third party reports are all but mandatory today in any regulatory audit.
The one constant in the financial services industry is change. As the industry continues to adapt to once-in-a-generation regulatory changes by way of the Fiduciary Rule, firms are reexamining its business processes, operations and resources to identify the potential for efficiency and improvement. The areas of product management and diligence are not immune to these reviews. Most firms, however, began seeing increased costs of compliance in these areas long before the Fiduciary Rule was enacted. Since FINRA issued its Regulatory Notice 10-22, firms have experienced increasing expenses for internal product diligence, ongoing review, advisor training, and process development. Whether it’s the Fiduciary Rule or another impetus, many firms are wondering how they can continue offering alternative investments given the increasing cost to comply.
FactRight’s third party diligence reports go a long way to reducing costs for our clients. Imagine having to do a full corporate and offering diligence review internally as a financial services firm. The expense wouldn’t justify adding alternative investments to almost any platform. The prevalence of third party diligence reports, however, are not stemming recent cost increases. There’s a simple reason for this: third party reports are purely informational, whereas expense increases experienced by our clients today are related mostly to process and procedure. These firms largely don’t need more third party help. Today, firms need more help running their own party.
Based on our work and discussions with hundreds of financial advisory firms, we’ve identified three major areas where firms struggle internally, even after receiving the third party reports.
Due diligence costs are mostly related to people
There isn’t a deep pool of analytical talent that are experienced with alternative investments. To fill internal positions, most firms find capable, but inexperienced diligence analysts who need training on product reviews, a function that most firms find difficult to perform. Quality talent is also expensive, and often, the firm has critical needs in other areas that gain more attention from executives who write the checks. Alternatives are some of the riskier products offered by our financial services clients, but their businesses struggle to hire and retain the right internal analysts to properly review them.
Then there’s the case when analytical talent gets hired and succeeds at reviewing alternative products. Over time, these talented individuals tend to get more projects and assignments from management beyond product reviews. So, while their available time to run product reviews declines, the overall burdens of doing the work is increasing in proportion to the size of the firm’s platform. And when that individual’s time gets syphoned off with other projects and assignments, the firm is increasingly finds itself back at the beginning: looking for help to do the alternative investment work that’s very time consuming and won’t go away.
Ongoing diligence is exponentially harder
An analyst usually has ample time to perform initial diligence on a new product. The allotted time is even greater if the product sponsor is under initial review by the firm as well. In addition, analysts are often constrained by the amount of information available when conducting initial reviews in that most funds under initial review only recently began raising capital, and may have limited operational history to assess. Performing initial diligence isn’t easy by any means. Firms have to make significant bets on products and the sponsors issuing them. Those are big decisions. Fortunately, firms have the luxury of time to draw those critical initial conclusions.
Once a product is approved for the firm’s platform, the dynamics of time and information start changing immediately. With every quarterly SEC filing, the firm is on the clock to conduct the review in time to make an assessment before the product’s next filing. Coupled with new time constraints, the flow of critical operational information goes from a stream to a flood as fund operations become more complex. To make things even more difficult, modern SEC quarterly filings dwarf the size of similar filings several years ago. And we’re only still talking about just one product. Add just a few more products, and the workload grows rapidly.
What to do with all that Information?
Here’s where the functionality of the third party diligence reports ends. Having played football in my younger years, I use the analogy that third party reports take a firm from kickoff to the opponent’s 25 yard line. The problem: firm’s need to get the ball past the goal line…they need to make a decision on the product. Reports can’t make a decision for a firm. Someone needs to synthesize all the information, cover off on red flags that most concern the firm, and guide an investment committee to a thoughtful decision.
The job we’re describing is hard to fill under any circumstances. It requires analytical acumen as well as some executive presence to confidently recommend complex products. New fiduciary requirements will surely make it an even more challenging position. The review and recommendation isn’t just about a particular product anymore. Now, analysts have to be concerned with both a particular product and how it compares against all similar products.
And all of this must be orchestrated using a clear process that’s consistently followed.
Like all the other challenges presented in this piece, a firm’s ability to understand and structure the information so that it can make decisions is yet another issue that’s related to the scarcity of resources available to most financial advisory firms.
From third party to your party
At FactRight’s 4th Annual Conference held in early September, we launched a new services platform that we’re calling True Diligence. Building off of the service work we’ve performed for dozens of firm in the past five years, the new platform combines all the product information we gather with a comprehensive process that’s customized for each client. It’s our solution to the resource problems many of our clients continue to face in today’s environment. To learn more about it, please visit our website and reach out to us using the contact form at the bottom of the page.
Third party reports are an indispensable component for financial advisory firms doing business with complex alternative products. We like to think we’re really good at producing those reports, and are humble enough to know we can always get better. Despite the success we’ve enjoyed as a third party firm over the past 11 years, we believe there’s much more we can do for our clients. Through our True Diligence platform, there’s much more we will do to place our relationships with our clients first.