Avoid Mismatching Clients with the Wrong Alternative Investment

Take these key steps to vet strategies and earn clients’ trust.

By Tim Smith

If this is indeed the year that private-market investments become a bigger part of more portfolios, are financial advisors equipped to handle these types of investments?

They better be.

After the poor performance of both stocks and bonds in 2022, the recurring theme among advisors, asset managers, and financial media has been that the traditional 60-40 portfolio needs a makeover, and that private-market assets and alternative investments should become a bigger part of many investors’ portfolios.

Indeed, the increase of allocations seems to be the mainstream point of view. According to a recent survey from alternative platform CAIS and Mercer, roughly 88% of financial advisors plan to increase their allocation to alternatives over the next two years. More than half estimate that their allocation to alternatives will make up more than 15% of their overall allocations.

Asset managers apparently see this demand. According to the same survey, 63% of asset managers say they are planning to roll out new alternative products in the coming years. About half said that they plan to roll out new structures, such as interval funds or 40 Act liquid alternative funds.

There is another factor at work. While most private-market assets are only available to accredited investors, there has been an increase in calls for regulators to ease some standards for other investors to allow them to have some private-market exposure.

In the face of all this, advisors need to be in a position to have more informed conversations with their clients. Clients look to advisors not just for advice, but also for knowledge and insight. With the prevalence of platforms like CAIS, iCapital, and specialty platforms like CrowdStreet Advisors for real estate, advisors have a full, transparent menu of options. Now, they just need to be better at fitting them into portfolios. Where to start?

First, remember the metrics available to vet private-market opportunities are different than the more fulsome disclosures for public markets. After all, public markets rely on public information. Private markets thrive on the scarcity of information, which is why these are largely only available to accredited, more sophisticated investors. That is an advantage for advisors. Advisors should have the ability to understand market dynamics and perform diligence for a range of strategies. That is how we earn our clients’ trust.

Understanding your client

As with all portfolio discussions, it begins with understanding clients’ needs, goals, and risk tolerance. Despite a view on alternative investments as being unduly risky or exotic, they aren’t necessarily hard to explain or understand. A private REIT, for example, is simply a real estate investment, as is an exchange-traded REIT. The difference between the two, however, is in liquidity. A client who needs liquidity isn’t served by a private option. Someone with a longer-term horizon and sufficient liquidity in the rest of the portfolio might be better served by the illiquidity.

Knowing which investment is best for each client and each portfolio is  the place to start and can make all the difference in the long run.

Eliminating the bad fits

One piece of feedback I’ve heard from other advisors about navigating the alts platforms is the sheer volume of product available makes selection daunting. Unfortunately, it’s only going to get worse. Private market fundraising has outpaced public market fundraising consistently and is projected to continue to do so.

Tackling the volume of these options takes a process of elimination. Think of it like looking at a restaurant menu. You may sit down and see three pages of entrees, but you’re really only searching the menu for pasta dishes. This allows you a sense of focus to really bear down on what types of pasta you want, and sauces or proteins.

Say you are looking for a multifamily apartment complex or a pooled real estate investment fund to satisfy the requirements for the tax benefits of a 1031 exchange. As you may know, a 1031 allows you to sell a real estate investment and defer capital gains taxes, provided that you swap that investment with a similar one, known as a “like-kind” swap. You may be selling a multifamily investment, and you start on a platform with 120 real estate options. But the need for an additional multifamily property to satisfy the “like-kind” requirement should allow you to whittle that down to, say, 30. That is a much smaller subset to tackle.

The importance of diligence

Here’s where the value of a strong advisor relationship stands out. In addition to our advice, they also expect us to never put an investment option in front of them that we have not vetted. As we have seen in the market in blowups like the FTX fiasco, there needs to be a heightened focus on due diligence when it comes to any investment, particularly with private equity.

So what do you eliminate? Again, it comes from understanding your client. If you have clients who are in need of more immediate liquidity, the longer time horizons for private equity funds won’t work. Investments in derivative funds can be great as a hedge for investors with a range of risk profiles, but those funds that use an inordinate amount of borrowing or leverage to fuel their strategies would likely not fit with a client with more conservative goals. Pore over the offering documents and compare and contrast factors to match what you think is in the best interests of your client.

Even after you’ve ruled out many options, double down on the diligence as you seek what is appropriate for your clients’ portfolios. It is true that the offering materials for many private-market opportunities do not have the same level of metrics and detail as public-market securities, but there is still enough information to ask the right questions.

Assess potential conflicts of interest. Evaluate the size and appropriateness of the management fees charged. Look to see the track record of the financial sponsors, and eliminate those with inadequate inexperience. And pick up the phone. Speak or meet directly with the managers and hear about their strategies first-hand. Just because you are using platforms to gain access to these strategies doesn’t mean you can’t add a layer of diligence. In the end, the diligence funnel will make your recommendations easier.

Private-market opportunities will undoubtedly be a bigger part of client portfolios in the coming years. Advisors can and should be ready to assess opportunities, think creatively, and have in-depth conversations with clients when these investments serve their best interests.

Tim Smith is CEO of Aurora Private Wealth, a wealth manager and independent broker-dealer based in Sarasota, Fla.

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