RISK MANAGEMENT SERVICES

Alternative investments programs involve many conflicts of interest, and offering documents often have an entire risk disclosure section dedicated to this issue. But not all conflicts are the same and vary by product and sponsor. Assessing conflicts really come down to two central questions:

By now, you may be generally familiar with the recent collapse of FTX, and some of the reasons for its failures are obvious. But by examining FTX side-by-side with perhaps the most infamous investment fraud ever perpetrated, we can discover some keys as to why lapses in due diligence may never be a thing of the past. These two epic failures bear little factual resemblance to one another at first glance, but this post will look more closely at the more transcendent lessons they hold.

It should come as no surprise that the old investment adage about getting what you pay for holds true for preferred stock, too. Despite often being pitched as a bond alternative, especially lately, there are multiple factors beyond dividend yield to consider. Among the features, an investor needs to understand are the liquidity provisions, dividend policy, and preferred shareholder rights. Sponsors tend to get irritable when FactRight stress tests their pro forma model or highlights weak investor protections, dismissing the concerns as implicating scenarios highly unlikely to ever occur. However, sometimes the unlikely or improbable does occur. This post will focus on a real scenario involving several preferred securities that underscores the need for due diligence in these areas.

In today’s low interest rate environment, the search for yield is driving an increasing number of investment decisions. However, higher yield options are somewhat limited in more liquid investments, such as rated bonds or stabilized stocks or mutual funds, causing investors to seek out other avenues to achieve their income goals. Alternative investments are increasingly filling this need in today’s portfolio construction. However, such products are often selected based on quoted yield without taking into account the underlying risk-return tradeoff. The alternative investment industry may have lost track of appropriate compensation for the risk investors are assuming since stated yield often sells itself.

During my tenure at FactRight, we have conducted operational due diligence on more than 150 alternative investment sponsors. Some have been very large, some very small, and many in between. I consider myself very fortunate because I enjoy the work. I enjoy getting to know the people, learning about their experience, about their investment process and how they envision growing their business. Some of the due diligence process is inevitably tedious, and to a certain degree repetitive, but ultimately no two companies are alike and that is what makes it always interesting.

If you are thinking about putting an investor in a private placement one of the first questions you should ask is:

Lynn Lawson, Esq. is the founder of Advertising Regulatory Consulting, LLC, which provides advertising and marketing guidance to broker-dealers, registered investment advisors, product sponsors, and financial services industry associations. Prior to starting Advertising Regulatory Consulting, Ms. Lawson served as a manager in FINRA’s Advertising Regulation Department for 22 years. Ms. Lawson has advised product sponsors that FactRight has covered, and given her experience at FINRA, we believe she can be a valuable regulatory resource for product sponsors and wealth managers who are distributing alternative investments.

Many sponsors of DST programs are including section 721 UPREIT options in their potential exit strategies. Several factors are likely contributing to this evolution.

FactRight is seeing a trend in non-traded real estate investment trusts (REITs) that are seeking to diversify their funding sources by offering 1031 exchange investment opportunities with the potential to be UPREITed into the sponsoring REIT at some later date. The UPREIT transaction would be done under section 721 of the Internal Revenue Code, which provides for continued tax deferral of the original capital gains. These investment opportunities provide a significant opportunity to the right investors, and long as they understand the ramifications of such investments. Let’s look at the main considerations for determining whether investing in a DST program with an UPREIT option is appropriate for your client.

As far as true confessions go, this is rather lightweight: I love spreadsheets and financial models. There’s something about the designing, linking and debugging that is satisfying, even after several decades. There are always new analytic approaches and different formulas, not to mention Excel updates that add even more features.