There’s a great scene from the 2002 movie, Catch Me If You Can, where Christopher Walken says to Leonardo DiCaprio:
“You know why the Yankees always win, Frank?”
“Because they have Mickey Mantle?”
“Nah. It’s cause the other teams can’t stop staring at those damn pinstripes.”
There’s a similar mystique that takes place in the world of alternative investments. The products that sometimes dominate the attention of financial services firms aren’t always at the top because of their sound investment strategies. In fact, some of the most devastating collapses in the space were big name offerings that had a lot of flash, distracting from the obvious red flags.
With the stock market’s negative returns in 2022, and the potential for a repeat performance this year, advisors and clients are increasingly prioritizing investments that are non-correlated. Cerulli Associates July 2022 white paper states that, “Reducing exposure to public markets is reported by advisors as a top reason (69% report this as a goal) for using alternative investment products in 2022.” Alts have the unique ability to fill this role, but only so far as the products themselves aren’t setup for failure. Clients of fiduciary-minded advisors should feel confident that their Alt recommendations were built on the foundation of a solid selection process.
In the simplest of terms, there are basically two issues at play: 1) Broker/dealers need a proven process that will allow them to approve the best alternative investments while avoiding potential disasters; AND 2) B/Ds need the resolve it takes to not deviate from their policy when the exciting new thing shows up, but it falls outside of the parameters.
Any firm looking to take a meaningful position in promoting alts has a crucial need to employ skilled analysts and researchers who understand the alt space and will dig deeply into PPMs (Private Placement Memorandums), prospectuses and subscription docs. Building on that foundation, clients and advisors should feel a measure of increased confidence if the firm’s due diligence also incorporates these 4 criteria from their sponsors:
- Independent Review and Analysis ought to be a requirement for any firm looking to approve an Alt product. Third party reports from firms like Mick & Associates, Snyder Kearney and others attempt to reveal strengths and weaknesses that might otherwise be overlooked. Additionally, audited financial statements allows for an independent peek behind the curtain which could reveal hidden red flags. These services can be costly for the Alt sponsor, but worth the price as part of a robust due diligence process.
- Expertise and Track Record of the Management Team is a measurement of industry experience that can help in the evaluation process. We all know that past performance does not guarantee future success, but if the management team has fooled the industry once, you can’t get fooled again as it’s been said. BDs should require Alt management teams to have a minimum number of years and a track record of successes to help validate their confidence in the current deal.
- Clear Separation Between Affiliated Entities can prevent one of the more common conflicts of interest that arise in the Alt space. Sponsors that operate multiple funds should have strict safeguards in place to keep those entities from putting customers at a disadvantage. For example when a new offering uses the capital it raises to fund the distributions of previous affiliated offerings, the system is functioning very much like a Ponzi scheme.
- Structures that Prioritize Clients so that the success of the sponsor is a derivative of the client’s success. This can be accomplished by approving products that pay the fund’s upfront expenses and fees out of the sponsor’s pockets. The sponsor and team should also have their own money invested in the outcome as part of the fund’s strategy. Sponsors that benefit more on the backend of a successful deal opposed to benefiting from simply raising money generally align the interests of all parties.
Avoiding bad product decisions is only partly solved by having a rigorous approval process. The harder part is recognizing the draw to make exceptions to your guidelines for emotional reasons. This is similar to the way that advisors need to help their clients stick to the fundamentals that guide long-term success in the face of short-term distractions.
Complementing the four things that will bolster a due diligence team’s effectiveness, here are four warnings that should be taken into account:
- Refuse Due Diligence by Proxy and rely instead on in-house resources and guidelines. Proxy due diligence occurs when a firm approves products for their advisors based on those products being green lighted at other BDs. This pitfall has snagged more than a few BDs who took comfort not in their own carefully selected criteria for Alts, but in the hope that some other BD had done the work. It wasn’t uncommon for our firm to hear a small BD say that they were willing to approve an Alt if Securities America had done so. This is one of those times that there isn’t safety in numbers as Securities America was hit hard by Alts that blew up. When a product fails, the argument that some other firm had also approved it will not be a good defense.
- Beware of Personal Affinity Towards the Leader of a product that can lead to approvals that fall outside of the normal Alt parameters. The financial service industry can be a relatively small and close-knit community. There are many long-term relationships that have been forged over the years and that is a great thing. However, prioritizing those relationships at the expense of sound due diligence is a dangerous trust exercise. BDs should make sure that they aren’t making exceptions to their protocols as a backscratching service to their allies in the industry. Bernie Madoff’s fraud was so successful in part because many people (including regulators) are willing to let affinity override good judgment.
- Don’t Believe the Hype when it comes to the sensationalized product or sponsor that seemingly everyone is buzzing about. The marketing budgets for many Alt products ensure that your glass will never be empty and your golf bag never lacking any swag. Creating the appearance of success with a well-oiled hype machine is not the same as having a sound product. Advisors and BDs alike can be drawn into a sense of FOMO (Fear Of Missing Out) when Alt sponsors unleash their best marketing efforts. GIMO (Glad I Missed Out) is what many of the BDs still around today feel about hyped-up products like GPB, Provident Royalties, Medical Capital and many others that they avoided.
- Separate the Recruiting Process from the Alt selection process. Too often BDs will sign a product because they believe that potential candidates won’t consider joining the firm unless a particular alternative investment is available. Along the same lines, some firms will let an onboarding advisor dictate what Alt products the BD will allow as a condition to join. Neither of these scenarios puts the BD in the best position to avoid problematic products. Recruiting is an essential function of the BD’s health and growth that should be a high priority at any firm. However, recruiting Alt-focused advisors can be detrimental long-term if due diligence lapses in order to land a deal.
Given the current market environment and the desire for dependable income, reduced volatility and portfolio diversification, it is not surprising that advisors plan to increase their exposure to alts. According to Cerulli’s 2022, alternative-focused investment survey, “advisors report allocating 14.5% of assets to alternative strategies, and plan to increase this portion to close to one-fifth of portfolios (17.5%) in two years.”
Alt products and sponsors need to have more going for them than the mystique of their pinstripes. As more advisors and their clients look to harness the advantages of Alts, the due diligence process of their firms has never been more important. Keep an eye on the ball by affiliating with a firm that has a proven approval process that prioritizes client success.
Vern Coates is Senior Vice President of Recruiting at Henschen & Associates. Prior to Henschen & Assoc., Vern was Regional Director of Business Development for 10 years at an Alts focused broker dealer giving him extensive insight into the pros and cons of this unique asset class.