Alternative investments have been used for years by institutions seeking higher average returns while reducing the correlation of their portfolios to the market. During the late 90’s, the use of alternatives such as Real Estate Investment Trusts (REITs) started to hit the main stream. Firms such as CNL and Inland made it possible for non-accredited retail investors to access solutions that had long been available only to ultra high net worth individuals and institutions. The concept of providing a stable valuation combined with a respectable yield made this type of investment attractive to investors and the representatives who sold them. Clients were able to access low correlated investments and representatives received a substantial commission. The concept behind this type of investment wasn’t bad, but the need for ideal markets and the presence of greed quickly placed it in the crosshairs of the regulators.
Design Flaw
Many of the alternative investments available to registered representatives carry high upfront costs. REITs average a 15% (approximate) internal load. This means that for every dollar invested, 85 cents will be used for acquisitions. The oil and gas programs may have internal costs as high as 24%. The sponsor (firm bringing the investment to the market) incurs significant capital costs to get the investment off the ground. New REIT sponsors may spend as much as $25M to enter the market. The average new REIT sponsor spends about $16M. These costs involve overhead, paying commissions to representatives, and marketing/due diligence fees to broker dealers. The challenge with the industry is that in many cases, if given the choice, a representative will select a higher commission offering over a perceived equal program that pays less. Certainly, quality representatives will use the offering that is most appropriate for the client. In short, it may take a REIT six or more years to recover the load and in many cases, the load may never be recovered.
Marketing tactics tend to be a major challenge as well. Some REITs opt to start by paying a yield of 7.25% while others may only pay 6.5%. As a client, which one would you pick? Investors and their representatives tend to gravitate towards the highest yielding offering. Most investors recognize but don’t always internalize the fact that a higher yield typically equates to higher risk. In order for a REIT to cover a 7.25% yield, everything must go flawlessly. The amount of pressure that this level of yield places on the performance of the REIT is tremendous; however, sponsors realize that the lower their yield, the less likely they are to raise assets.
When evaluating REITs, I put them into one of two categories – Marketing Firm or Acquisition Firm. Marketing firms, based on my definition, are those firms that game the system to position their product to raise assets, i.e., a 7.25% yield, but lack the qualities found in true real estate firms. Acquisition firms are those who specialize in their field, have proven track records, and have made a business decision to raise capital through the broker dealer network – in other words, the broker dealer channel doesn’t represent their saving grace because they were failing in the outside world.
3rd Party Firms
There are a number of 3rd party firms that provide sponsor reports to broker dealers. These reports are not for investor distribution and in some cases, can only be shared with due diligence officers. These reports are more about the legalese of the sponsor than a review of the quality of the offering. 3rd party reports often lack the analytical review to truly evaluate the merits of the investment and its probability of success. Many of these firms are law firms and as such, their communications are loaded with disclosure in order to mitigate any potential level of accountability. Having worked with some of these firms for a number of years, some provide a great service. The challenge is the reports lack the necessary facts to make a decision to approve the use of an offering. An inherent conflict of interest exists as the 3rd party firms charge the sponsor to complete the review. In some cases, the cost of completing a 3rd party review is $30,000.
Firm Due Diligence
Firm due diligence is likely the most glaring issue in the investment industry. There are a number of factors that contributed to the failure of firms to identify potentially bad alternative investments.
- Qualifications – In many instances, the individual in a firm making approval decisions has limited retail experience and lacks the relevant academic qualifications. The last point is not to say that these individuals are not educated, many simply don’t have finance or accounting degrees or designations such as a CIMA or CFA.
- Conflict of Interest – In some firms, the head of marketing conducts the reviews. Among their duties is to raise funding to cover the cost associated with annual and top producer conferences. While some discussion surely occurs as to the fundamentals of the investment, one qualifying feature to be added to the approved list is whether or not the sponsor would contribute to the conference. At some level, we’re allowing the fox to reside in the hen house.
- Marketing Fees – Above the initial entry fee of paying for a conference, alternative investments such as REITs, Oil and Gas, Royalties, Business Development Companies, and etc, pay marketing reallowance fees (aka Due Diligence Fees). These fees can range from 50 bps to 150 bps. Depending on the size and demand of a broker dealer, many will demand a minimum of 100 bps with many garnishing 150 bps. To translate this into real dollars, if a firm’s clients invest $300M, the firm is earning $4.5M just in additional fees. For large firms, it is not uncommon for the total amount of marketing fees and conference funding to equal $20M.
Top Representative Conundrum
A glaring problem for broker dealers in the past has been the demands placed on them by top producing representatives. This likely has happened more often than any firm would like to admit. A representative is approached by a wholesaler who sells him or her on the greatest story since the US Men’s Hockey Team beat the Russians in the 1980 Olympics. The representative becomes convinced that this one investment will make a difference in their ability to be successful and provide their clients with a solution that they cannot access anywhere else. In many cases, if the firm was hesitant about making an approval, the representative would threaten to change firms to one that will allow them to sell the investment. In this industry, retention is very important and occasionally a firm will feel compelled to make a business decision that they might not normally want to make to prevent the loss of a top producer. While some representatives are outraged by the lack of due diligence conducted by firms, there is equal accountability of the representatives to have better understood the investment and to not apply such pressure and demands on a firm to make an approval.
Regulatory Role
The regulatory bodies have demonstrated a lack of knowledge and understanding as it pertains to alternative investments. Like the challenge experienced by broker dealers, regulators themselves (in many cases) lack the retail and academic knowledge necessary to make prudent decisions regarding these investments. Limited regulatory guidance is the result of two issues: Lack of knowledge and the need for ambiguity. Not unlike many legal documents, interpretation of various rules varies greatly. Often interpretations of rules differ from examiner to examiner. The other, the need for ambiguity, is driven by the regulators need to limit their own level of accountability. A failure by a firm that followed all of the requirements would mean the regulatory body also failed.
A glaring example of this lack of clarity can be found in FINRA Regulatory Notice 09-09. This rule requires publicly traded REITs to publish a per-share value 18 months after they end the capital raise period. In reviewing the rule, there is absolutely no guidance on how the valuation is to be created. FINRA Regulatory Notice 09-09 has merit but the execution is flawed and the valuations being provided by REIT sponsors are suspect at best. The need to avoid accountability appears clear.
Final Thought
In general, broker dealers and representatives work diligently to provide their clients with the best possible investment solutions. Many of the failures the industry has experienced are due to a lack of guidance, greed by some sponsor firms, and inadequate resources. Future success of firms will be heavily dependent on the offerings they approve and decline. In order to effectively minimize the risk to clients, representatives and broker dealers, the industry must move towards a more collaborative working relationship and utilize expert guidance, whether in-house or external. The continued flood of new sponsors into the alternative space will only make the review process more difficult and increases the likelihood of more failures. Sponsors need to provide greater transparency regarding their assets, financials and general health of the offering. In the end, only a small percentage should be approved. It is a real possibility that 80% of these investments will not provide the intended results that it expects. The industry has an opportunity to make a difference in the lives of investors and must learn from its failures.