The Importance of Ongoing Due Diligence for RIAs

It is more important than ever that advisors engage in ongoing due diligence on the alternative investments they recommend to clients. Changes happen quickly and factors that may not affect the equity markets can greatly affect some alternatives. 

Before and after recommending a publicly registered alternative to your client, become intimately familiar with the SEC filings on the product. Keep in mind these three important things: doing due diligence on old information is useless and relying on it is risky; you need to analyze findings thoroughly to make educated decisions; and, you need to know where to look for relevant information in ongoing filings, especially 10-K and 10-Q reports. 

The information you review must be current 

Often, RIAs rely on prospectuses in due diligence investigations. However, doing so is not sufficient if there is quarterly financial and performance data on the program that has been filed subsequent to the prospectus. 

Quarterly filings are often as dense and packed with as much legalese as available offering material. However, by comparing changes from one quarterly filing to the next, you’ll pick up subtle clues about what is happening with the program—even if the managers don’t want you to. If you simply take what management is saying at face value, or rely on marketing-type materials, you will miss important information that could cost your client part of his or her future. 

Understand the direction the investment is heading  

Maintaining an ongoing due diligence process for each publicly registered investment program means actively reviewing, comparing and contrasting the information in quarterly SEC filings yourself.  

By doing meaningful comparisons of quarterly reports over a period of time, you can understand how the program’s performance is trending. Below, we’ve listed some of the most important points to dig into, and what sort of red flags you should be noticing. 

Alternative investment programs evolve over time. Since investors are able to jump into an alternative with an open offering at various points, investors can face different investment scenarios and risk profiles from quarter to quarter.  

It’s your job as the advisor to monitor investment program changes for the client who has already invested, and advise the client who is considering the alternative product. Regular and timely quarterly reviews are absolutely necessary to see what the fund’s management is doing, and whether that matches up with what they said they would do. 

And, by documenting the due diligence you conduct—your methodology and your findings—you will be protecting yourself and the clients to whom you recommend an investment.  

What to look for and how to find it 

You need to make sure that, on a quarterly basis, an alternative is still performing as expected, fees remain reasonable, and management is stable. You also must assess whether market conditions have materially changed, and how that impacts the risk-reward profile of the deal. Ask the following questions: 

• What trends could affect the program’s performance? 
• How is the company making or losing money? 
• How are the advisors being paid? 
• Is management adhering to its investment thesis, changing focuses within that thesis, or succumbing to style drift? 
• Out of what sources is the program making distributions? Is the program distributing more that it should to investors? 
• Does it appear that there may be a legal or insolvency issue in the future?  

Admittedly, the amount of information RIAs must review and consider for each and every alternative investment is overwhelming, and complaints about information overload are well-taken. And, the average length of quarterly filings is growing. However, ongoing due diligence reviews are now more necessary than ever. RIAs have no choice but to step up their game. You can do this by using the right technological tools to focus on the most important information. 

There is software available that helps you track changes in quarterly SEC filings so that you understand the “why” behind the numbers. Use redlining, or word processing or tracking software, like Contexxia or BamSEC, to discover changes from quarter to quarter.  Pay attention to the "Business" section in 10-Ks. This section contains management’s business strategy, a listing of regulations with which they need to comply, the investment process and what outside market factors affect operations and compliance. 

Equally important are the "footnotes" to the financial statements (in addition to the statements themselves) and other required disclosure items. To  A review and redline of changes from quarter to quarter can help you and your clients avoid nasty surprises. Pay attention to these items: 

• Management’s discussion and analysis (MD&A). RIAs should review this very important section first. It is made up of the fund’s management’s discussion of the company and its goals. It explains the changes in numbers over time, business trends and uncertainties, changes in accounting methods and off-balance sheet arrangements. Reading this note is absolutely necessary to understanding any significant change in financial condition and operations. Management is under strict legal requirements when making disclosures here, so advisors can be assured that the discussion does not comprise a “sales pitch.” 
• 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 fun 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. 
• Distribution sources and coverage. What are the sources of distributions—investment income, financings, or net proceeds of the offering? Check the sources against the cash flow statements and compare to additional details in the MD&A. 
• Investment portfolios for BDCs. This footnote discloses how much management has invested in different kinds of assets and the percentage in each, as well as the acquisition activity. 
• Required disclosure item. In this footnote, fund managers tend to and can bury problems here, common examples would include litigation settlements and other sources of debt. Check this section on the 10-K and 10-Q carefully. 
• Risk factors. Always run comparison software between quarters to see if management adds something here. Generally, 90 percent of the language in this section is boilerplate. But, the other 10 percent often covers imminent risks.   

Keep your client’s best interest in mind 

By keeping on top of changes in the most current SEC filings using readily-available software, you’ll be able to confidently advise clients on appropriate alternative investments. You’ll make more accurate and strategic recommendations by becoming better informed about the most up-to-date information affecting the viability and success of an alternative investment program.