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Independent financial advisors have warmed up to retail alternative investments in recent years, and it’s no secret why. Having experienced more frequent bouts of volatility in the equity and fixed income markets, highlighted by the recent trade-related rumblings, retail investors gradually have come to demand options that offer some potential for capital appreciation alongside inverse correlation to the broader markets.

As a result, advisors have developed respect for the role alternatives can play in a balanced, diversified portfolio. Even as these vehicles gain greater acceptance, though, advisors should tread carefully when recommending them for clients — and make sure to perform careful due diligence to gauge whether they are appropriate for an investor.

Advisors often rely on their firm’s home office to do most of the detailed work in due diligence, which can create problems. Ordinarily broker-dealers have only a few general-purpose due diligence professionals who are faced with vetting and offering expertise on a wide range of products, not just retail alts. That’s a tall task for anyone, no matter how much experience they may have in the area.

There is hope for advisors interested in offering retail alts. Here are four key traits to look for when evaluating a broker-dealer’s due diligence capabilities:

  • Dedicated product strategy expertise. Due diligence teams should have product strategists as a dedicated resource, versus someone who is a jack of all trades attempting to perform due diligence services on a collection of diverse investments.

Additionally, they should have expertise in retail alts, especially when it comes to diving into the fundamental questions that can help identify not just the risks and benefits, but also how to use these investment vehicles. These questions relate to the product’s time horizon, risk profile and whether it makes more sense as an income generator or as an inverse-correlation play.

  • Rigorous process for evaluating sponsors’ commitment to retail. It’s not uncommon today to see sponsors who previously focused on institutional investors branch out into retail-alt products. But the problem often isn’t in the offering, rather, it’s whether the sponsor will stick around following the offering stage. If a retail-alt sponsor launches a new product but then bails mid-cycle, that creates problems for the firm, the advisor and the end client.

The due diligence process should screen for the sponsor’s ability — and, frankly, its stomach — for staying in the retail space long term. The process also should establish whether there is a contingency plan for running the investment if the sponsor backs out.

  • Ability to ferret out unfavorable distribution rules. Firms should know the contractual requirements regarding income distributions. Are they made from capital or purely from investment returns? When will they be made and how much will they be? The more latitude the sponsor has on these points, the greater the risk for the investor, and it’s incumbent upon due diligence personnel to find any potential red flags.
  • Ability to determine that final waterfalls are distributed fairly. Most illiquid private retail-alts have the proverbial “kiss at the end” of the life cycle, amounting to some capital appreciation as they exit the investment. A proper due diligence process must be able to determine whether the final payouts will be shared between investors and the product sponsor equitably. It should also yield a firm understanding of where investors stand in the payout order. Why? So the sponsor doesn’t hoard an unduly large portion of the capital appreciation for themselves, leaving investors high and dry.

There’s little doubt that alternatives bring important opportunities to the table and, when deployed wisely, can fit well within a sophisticated, diversified portfolio. Investors need advisors, however, to help them to make informed decisions on such products — many which do not offer much publicly available information.

In this light, it’s incumbent on advisors to make sure their broker-dealer has a robust due diligence process and a team of expert professionals to execute it. Having a strong infrastructure behind them empowers advisors to wade into retail alts confidently.

In the current environment of rising demand among pre-retirees and retirees for alternatives to vanilla investments, this can give advisors the ability to drive further growth for their businesses.


Jean Merriman is vice president of Due Diligence & Product at SFA (www.thesfa.net), an independent broker-dealer, and a board member of the Alternative & Direct Investment Securities Association, a trade association serving the alternative investment and securities industry.