In recent years, retail alternative investment products, along with the companies that package them, have come under siege from regulators, investors, the press and even some advisers. None of this is a secret, and, quite frankly, some of the criticism has been well-deserved, as we've seen offerings that were poorly designed, not well-vetted or improperly managed — or, in some cases, a combination of all three.
The entire alternative product universe has been tarred with an unreasonably broad brush as a result of the misdeeds of a few bad actors. But the hard reality is that a poor reputation is hard to shed, even when it's not entirely earned.
That, in part, explains why some in the retail alternative space at first welcomed the arrival of larger product sponsors that typically target the institutional market, including pension funds, family offices and private equity firms. These more esteemed brand names, the thinking went, would provide a much-needed veneer of respectability to retail alternatives.
It hasn't quite worked out that way. A significant percentage of the new entrants of all sizes have been forced to withdraw interval funds, as well as some nontraded REIT and Reg D offerings prematurely because of a lack of demand — which sometimes suggests their products were not able to stand up to rigorous due diligence processes, meaning few firms were willing to put them on their platforms.
When this happens, investors, in the best-case scenario, get most of their principal back. In the worst, they lose everything, which has financial implications for them but also could trigger a series of regulatory and reputational risks for firms and advisers. All firms will say they are serious and long-term players, so before succumbing to the halo effect created by well-known, institutional-focused product companies with very little experience serving mass-affluent investors, here are some red flags to look for:
Principals are not willing to meet with you face to face. Any time a sponsor that has experienced success in one market suddenly makes a jump to another market that's decidedly different, it's the firm's obligation to understand what's driving that decision. Request a face-to-face meeting with the company's principal or principals. Having the ability to look people in the eye is a way to gauge whether they understand the retail market and are committed to it long term — or whether they view it as an easy money grab, like so many others have in the past. If the principals are unwilling to meet with you, it's a huge cautionary sign, suggesting that they are not reliable.
The program cannot stand on its own. Sponsors often feel pressure to pay distributions from capital, since some alternative programs take time to produce earnings. But that's the nature of the beast, thanks to sometimes lengthy development time lines and high operational costs — and investors who are qualified to buy into such programs should be sophisticated enough to understand that. If a sponsor nonetheless wants to make a distribution during the ramp-up phase, it should be prepared to subsidize future earnings to allow that to occur. An unwillingness to make that sort of commitment is reason enough not to make distributions until the investment has time to mature.
Taking shortcuts on the legal front. New sponsors will frequently enter this arena with the same attorneys who have served them well in the past. Ordinarily, there's nothing wrong with leaning on the counsel of trusted advisers. The problem, though, is that while many of these attorneys have a wide range of experience dealing with corporate matters or may even have a mastery over securities law in general, they frequently have no Reg D expertise. If a sponsor is unwilling or unable to secure the right kind of legal counsel, it hardly bodes well for the future of the program.
Not willing to specifically outline how they will deploy capital. Even though a sponsor may have a 30-year track record producing consistent returns for institutional investors, it needs to realize that the mass-affluent market is different. There are far more stakeholders who, on a relative basis, have far more to lose were something to go awry. Firm vetting and due diligence processes need to reflect this, requiring sponsors to be more transparent and focused.
Whatever troubles alternative investments may have experienced in the past, they did not, for the most part, stem from existing players lacking sophistication. Consequently, the notion that better-known institutional players could play savior was flawed from the start.
The bottom line is that neither size nor experience alone will determine whether a product is successful. It is the capability, experience and seriousness of the commitment.