Simple due diligence rules for investing in alternatives

Advisers should keep three common due diligence principles in mind when choosing alternative investment products such as nontraded real estate investment trusts and business development companies. Those are: how much “skin in the game” the fund's managers have; whether or not the fund is being “marked to market;” and whether the fund is paying a dividend or distribution above its cash flow or earnings, known in the industry as an “over-distribution.” That was the assessment of one industry panelist Tuesday in San Antonio, Texas, at the annual Financial Services Institute meeting, dubbed One Voice. “There are three critical factors when evaluating alternative investments,” said Lance Murphy, president of FS2 Capital Partners, a wholesaling broker-dealer, and executive vice president of Franklin Square, a sponsor of alternative investments, particularly nontraded BDCs. “Number one, does the sponsor over-distribute?” Mr. Murphy said in an interview after the due diligence panel. “What does that mean? Simply, is the sponsor paying out more than it is earning in the portfolio. If that's the case, later on, they will have a hole to dig themselves out of.” “The second issue is mark-to-market pricing,” he said. “Are they putting a mark, or value, on the investments in the portfolio and then rolling that up and providing a real value of the portfolio. If not, then clients are buying at more of an arbitrary number, and the (fund's value) could eventually be diluted.” “The third criteria advisers want to consider is sponsor co-investment, or whether the sponsor has skin in the game,” said Mr. Murphy. “This means the amount of money the people who work at the firm or are affiliated with the firm, such as board members, have themselves invested in the funds. This is always the first question institutional investors ask when evaluating a product or sponsor and making the determination to invest in a certain fund.” “Unfortunately, for some reason, on the retail side generally, in our business, that always hasn't been the first question,” he said. “It's something to definitely consider. We think sponsor co-investment is something advisers should pay attention to.”