Checking out “just the numbers,” isn’t an option for financial advisors recommending alternative investments to clients. If advisors don’t go beyond the numbers in due diligence investigations, they could be doing a catastrophic disservice to their clients and themselves.
Of course, a thorough due diligence investigation must include qualitative data as well—information that is not necessarily part of a chart, a financial report or a bank statement. Here are some key ways for advisors to go beyond the numbers—focusing on transparency, fee structures, and liquidity—when conducting due diligence on alternative investment programs.
Consider Transparency
Advisors should understand how they and their clients will obtain information on the investment program initially, and how they will stay informed of the program’s performance and other material happenings on an ongoing basis.
For publicly registered direct participation programs (like non-traded REITs) or other reporting companies (like Reg. A+ issuers), federal securities law and SEC rules dictate the path to transparency. Prospectuses and key supporting documentation are available on the SEC’s EDGAR system. Once the program is launched, advisors can expect regular updates on financial performance, operational results, and portfolio holdings. Keep in mind, though, that for funds of funds and other programs, information on the underlying assets may be scant. Pay particular attention to the levels at which such assets are marked under fair value measurements (Level 1, 2, or 3), which may tell you the degree of pricing transparency and ultimately, the level of confidence that investors should place in values reflected in the financial statements.
Given the relative lack of regulations for privately offered securities, transparency is often hard to come by, but practices do vary. Often, the program’s operating or partnership agreement will prescribe the content and frequency of reporting to investors. Key considerations include whether the company must annually provide audited financial statements to investors, and the specific rights investors may have to inspect books and records. Beyond what the governance documents require, does management do a good job of communicating key information with advisors and investors through online portals, newsletters and conference calls? Companies whose policies promote transparency are often more credible recommendations.
Advisors should also review third party due diligence reports to gain access to information that is not readily discoverable. Third party research firms have analytical tools that can also place raw information into a more helpful context, which generally enhances transparency and understanding around these complex products.
Consider Fees
Ever-evolving features and fee structures of the alternative investment products represent another challenge to financial advisors. These structures have changed significantly over the last few years and will continue to do so as alternative investments enter the mainstream and regulatory scrutiny increases.
Financial advisors should be concerned with not just the numbers behind fees, but the fee structures involved. As investment options proliferate, fees do not lend themselves to apples-to-apples comparisons between programs. And even when they may be relatively standardized, such as for 1940 Act funds, be aware that the underlying assets may be subject to their own layer of fees (which may not be very transparent). Make sure that you obtain clear documentation, that you fully understand how fees are structured, and that you clearly communicate this information to clients when recommending alternative investments.
Consider Liquidity
Liquidity is another significant consideration for advisors recommending alternative investments to their clients. While by their nature, most alternative investments should be considered illiquid, enterprising product sponsors continually innovate new ways of adding some dimension of liquidity to their programs. This is a net positive for investors, but should not be oversold. Pay attention to how easily management can change or suspend liquidity features.
For interval funds, the mandated level of liquidity can hamper investment strategy, given that the program usually maintains a certain allocation to liquid assets in order to make regular tender offers. Interval funds also may have to sell off productive assets at inopportune times if a mass of investors want to exit, which could disadvantage remaining shareholders. And just because a liquidity option may be available in theory, understand the caps that may limit its applicability in practice. Secondary market liquidity may be an option, but often at a steep discount.
In Conclusion
Due diligence is about preventing future problems. Failing to look beyond the numbers can lead to serious liability, financial losses, regulatory investigations and damage to a client’s reputation. But advisors who put the foregoing advice into practice will be well on their way to performing thorough due diligence for the benefit of their clients.