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Financial Advisor Due Diligence – What Are the Right Tools?

One bad investment can blow up a good client relationship. Stephen J. Martin, CEO & Wealth Advisor for SRQ Wealth Management in Sarasota, Florida and Elias Rauch, Chief Investment Officer & Financial Planner for Gitterman and Associates Wealth Management in Iselin, NJ keep this in mind when reviewing alternative investment options for their clients.

Alternatives, which include, but are not limited to hedge funds, private equity, commodities, liquid alt funds, and direct investments (DI), typically account for 10 to 20% of asset allocations for advisors’ high net-worth clients. DI alone may be a smaller percentage.

Due diligence of direct investment products and sponsors occupies considerable time for financial advisors. Some may rule out the asset class all together because they don’t have the time or resources to properly vet each product.

Advisors or registered representatives, licensed through independent broker dealers (BD), have comfort in knowing that before a product makes it to the shelf, their BD has conducted a thorough due diligence of both the sponsor and product.

Despite this first level of evaluation, it’s the advisors responsibility to conduct their own due diligence to ensure the product and sponsor appropriately match clients’ investment objectives.

Just recently, the SEC issued a warning to investment advisors that they should carefully conduct diligence when suggesting alternative investments to clients. The warning, based on reviews of advisors’ processes when examining alternatives notes shortfalls, but does not offer any specific guidance.

In order to assist advisors, The DI Wire spoke with the two wealth managers, Martin and Rauch who have thorough due diligence procedures when it comes to alternative investments.
Some of the key steps in either’s process are:

  • Know and understand your broker dealer’s due diligence process
  • Meet with your broker dealer’s due diligence analysts
  • Stay consistent each time, no matter the product or sponsor
  • Meet face to face with a senior executive of the sponsor, not just the wholesaler
  • Ask the tough questions such as what is the financial commitment of the sponsor
  • Gather and review all available documents from your broker dealer
  • Use third party data reports that are available, even if there is a fee
  • Utilize your broker dealer’s due diligence analysts for initial and on-going due diligence
  • Talk to other financial advisors who have worked with that sponsor or product in the past
  • Due diligence does not stop with a sale, its on-going

Straight from the advisors’ mouths
Stephen J. Martin, CEO of SRQ Wealth Management, has recently reviewed several non-traded REITs, a hedge fund offering, and a private equity offering, while relying on his broker dealer, LPL, and their team of analysts for support.

Martin says LPL has the size and scope to have a deep research team. He prefers to get to know the analysts and understand why they choose some products over others. This helps him determine how best to position the investment.

Of the 50 to 60 alternative investments on LPL’s platform, Martin and his team only use four to five.
The product has to fit the clients’ goals.

It takes Martin about six months of review before first offering an alternative to a client. He’s not in a rush to jump into something new.
“Our clients tend to be rich so it’s our job to keep them from being poor,” commented Martin.

As part of his analysis, Martin takes time to understand each product’s cost structure, liquidity features, and the risks, among other factors. He also makes it a priority to get to know the management team preferably during a face to face meeting. Martin believes it’s prudent to interact in person rather than over the phone because you are able to gain more insight from body language than simply words.

Lastly, he wants to know the sponsor has skin in the game. If there isn’t, he’s not interested.

“I want [a manager] that believes so much in their product they’ve got every dollar they could possibly [invest], in it,” he declared. Martin acknowledges this approach may not be right from a planning perspective, but it’s telling of how much focus the manager will give the product.

Elias Rauch, a founding partner and Chief Investment Officer for Gitterman and Associates Wealth Management, has a formal written due diligence process. Recently, he’s reviewed several non-traded REITs including Steadfast Apartment REIT and other direct investment offerings.

Rauch reviews and approves only one of five offerings made available through his broker dealer Triad Advisors. His process includes reviewing all 1st, 2nd, and 3rd party disclosures.

Anything available that is willingly shared, Rauch wants to review it. If he has to sign a non-disclosure agreement (NDA), to assess documents, he will.

Rauch also pays for research and data from third party firms such as Robert A. Stanger & Co.

He relies on the comments and insights of other advisors who have used sponsors’ products in the past. Rauch says that he uses very little of the marketing materials sponsors make available during his due diligence process. He prefers to do a completely “independent dive.”

Rauch typically begins the due diligence process in September with 30 products to review and a goal of creating a short list of 5 to 6 approved for the following year. He estimates spending 7 to 10 hours a week on initial and on-going due diligence efforts. Rauch constantly monitors the products and sponsors on his short list for updates, changes, or anything material that may affect his clients’ investments.
Many broker dealers impose allocation limits on alternatives. Rauch’s firm has a self imposed limit of 15% of a client’s portfolio. Despite the endowment model allocating as much as 40% to alternatives, he believes illiquidity at that level is not appropriate for his firm’s clients.

That 15% includes alternatives such as hedge funds, private equity, commodities, and traded REITs, in addition to Direct Investments. It’s worth repeating; Rauch spends 7 to 10 hours a week conducting due diligence on investments that only make up about 15% of his clients’ portfolios.

His thorough, ongoing process should provide some confidence, however, he’d like to know what compliance counsels and/or regulatory agencies would like to see for advisor due diligence. “In some senses, what I’d like to ultimately get to is that we as practitioners all have a similar process,” says Rauch.

He says that if his firm were subject to a compliance audit, it would be helpful to have clear guidance on what regulators expect of advisors. “It doesn’t seem like there is any kind of consistent rubric for practitioners doing a due diligence process.”

Tomorrow, visit The DI Wire for an article discussing how one Broker Dealer assists its advisors with alternative investment due diligence.