Practice Tips on Reviewing Quarterly Filings

by Jacob Mohs

It’s 10-Q review season again, and at FactRight and FR Risk Management, we’re assessing the filings for many public, non-listed investment programs and updating our ongoing reviews for our clients. It’s a good time to share pointers on how to perform efficient and effective due diligence on platform programs through reviews of quarterly filings.

Best practices for an ongoing due diligence program

Before we dive into how to review a 10-Q or 10-K, a word about monitoring processes globally. Ongoing due diligence is a process of continually reducing or mitigating investment risk. This task is easier with a defined review structure in place. The due diligence process does not need to be complicated, just thorough. Here are four steps to developing a quality ongoing monitoring program:

Step 1: Review each platform offering on at least a quarterly basis. In particular, look for changes in the following factors:

  • Fund performance
  • Compensation structure
  • Management structure
  • Risk related to market conditions or investment strategy

Step 2: Evaluate how each of these factors affects risk to your clients.

Step 3: Document your conclusions, describing specifically how they are based on your analysis.

Step 4: Archive your conclusions regularly to maintain proof of compliance 

Following this process demonstrates not only product expertise but also ensures a continuing quality platform of offerings. Most importantly, it demonstrates why your recommendations are in the client’s best interest.

How to find risk in the filing haystack

The length of public fund filings can make it challenging to find changes in investor risk in an efficient and timely manner. In fact, Deloitte reports that the length of quarterly and annual filings has more than tripled since the 1990s. Fortunately, the consistent structure of these filings simplifies the process for evaluating risk. For example, web applications such as BamSEC or Contexxia allow you to compare the filings’ text over time and highlight where changes have occurred. Any redrafted language may signify changes in risk that might otherwise have been obscured.

The following descriptions explain where to look for red flags in 10-Qs and 10-Ks for non-traded REITs and BDCs that may suggest a fund is no longer a prudent investment. The legal reporting requirements for these forms are very strict, so the quality of their information is high. (Unfortunately, other types of investment programs have different reporting requirements and therefore different filing structures from non-traded REITs and BDCs. However, the basic strategy for ongoing due diligence remains the same.)

Access distribution sustainability through the financial statements

Distributions are a key reason people seek out alternative investments. Review the fund’s distribution coverage, and analyze the trends for increased investor risk related to fund performance, including whether fees are impacting financial performance and the sustainability of distributions. Fund performance should be evaluated in the context of current market conditions to understand what is driving fund changes.

Yes, read the footnotes!

Footnotes (found in the Financial Statements section) are where issuers often disclose valuable portfolio information, especially in BDCs. With REITs, footnotes are also where issuers often disclose recent or pending acquisitions that can alert you to drifts in the offering’s investment strategy.

  • The offering’s fee structure is often discussed in a footnote usually labeled “Related-Party Transactions” (this assumes the fund uses an affiliated external manager, which is almost always true).
  • Other important footnote material to review includes the discussion in “Subsequent Events.” This material will discuss information that came out after the end of the most recent quarter but before the filing was posted. Subsequent events are particularly important to review when a fund is in acquisition mode, when either acquisition spending or raised capital can be proportionally large.

Tip: Footnote numbers rarely change between quarterly reports, so changes in wording are often easy to review.

Other critical sections to review

These include:

  • Management Discussion & Analysis: This section is a good place to start when reviewing a new 10-Q or 10-K. REITs often disclose FFO in this section and explain how they calculated those figures. A key subsection when reviewing a BDC is “Portfolio Asset Quality,” where management often discloses problem loans or where it notes improved conditions compared with previous filings.
  • Other Information: This section usually only contains generic boilerplate, but it sometimes contains information that otherwise would be given in a Form 8-K. However, fund managers may sometimes report problems in this non-specific section because it allows them to remain in compliance with regulations without drawing unwanted attention.
  • Quantitative and Qualitative Disclosures About Market Risk: This section looks at how a fund expects to react to changing interest rates or capital market volatility. Issuers are required to disclose how they think a fund will be affected by changing conditions. These comments can be enlightening.

Red flags can crop up in other sections, too

Other quarterly filing sections may contain red flags, including:

  • Material legal proceedings
  • Major changes to agreements with external management
  • Qualified audit opinion/internal control concerns
  • Negative news under Other Information
  • Exhibits amending external management agreements
  • Changes to the Risk Factors section, such as changes in market conditions, management, or investment strategies or the addition of new risks
  • The presence of potentially troublesome key terms, such as “going concern” or “default” (the search function is helpful here)

An efficient ongoing due diligence process, performed quarterly and documented and stored appropriately, will both lower your risk regarding fiduciary compliance as well as demonstrate your firm’s commitment to your client’s best interest.

For more practice tips on ongoing due diligence and how to review quarterly filings, see the webinar I presented entitled “Mitigating Risks with Ongoing Reviews.” 


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Filed Under: Due Diligence, REITs, BDC's