The recent increase in demand for alternative products has propelled investment professionals to open client portfolio doors previously considered locked. Changes in the alternative landscape have invited new sponsors and encouraged seasoned companies to provide more appealing products. The economy, meanwhile, continues its run on the longest expansion in history, helping to create a Golden Age of Investing.
Clients and investment professionals are both concerned about low interest rates and want to diversify away from the volatility of the stock market. In spite of strong returns in 2019, more and more investment advisers are considering ways to shelter their client returns from global economic and political fluctuations. Clients are listening too, knowing full well that a bullish market will not last forever.
Product sponsors have reacted to the changing landscape by lowering fees and improving investor communication. New sponsors have also entered the field. New sponsors are raising the bar for all by absorbing many of the charges previously laid upon investors, offering more sophistication in their analysis, and in choosing target markets. This has been a function of the regulatory community (SEC and FINRA) raising the bar for both publicly registered and private placements.
Further, the U.S. economy has grown for 126 consecutive months following the global financial crisis, marking the longest economic expansion in American history. The economy has been on a growth spurt since June 2009 and now surpasses the previous record expansion set between March 1991 and March 2001 before the dot-com bubble burst. Coupled with concerns over future growth, the environment in which we find ourselves has opened the floodgates for a revolution in alternative product development.
CHANGES TO PUBLICLY REGISTERED PROGRAMS
Perhaps the best way to see where we are and where we may be going is to examine the evolution of alternative products. Examining changes in the regulatory environment tells much of the story, going back to 2009, when FINRA’s Regulatory Notice (RN) 09-09 required sponsors of public offerings involving real estate to provide valuations within 18 months following the conclusion of the offering. This arose from concerns that sponsors were valuing their assets at the original offering price, often with programs that were five or more years old. While there was wisdom in the intent, clarification as to how and which assets were to be valued, left many investors with confusion, inconsistent information and often flawed pricing.
Two years later, FINRA responded with its proposal to change customer account statements (NASD Rule 2340) with their RN 11-44. Recognizing the need to further clarify how firms should report the per-share estimated value of unlisted direct participation programs (DPPs) and real estate investment trusts (REITs), FINRA directly attacked how customer account statements were prepared, proposing that statements include: issuer expenses, underwriting compensation, due diligence expenses, and that statements be prepared within three years of the initial date of the registration statement.
But the industry really changed with FINRA’s release of RN 15-02, again addressing customer account statements. FINRA acknowledged that many offerings could last as long as seven-and-a-half years, resulting in a greatly distorted share price. The rule was to take effect on April 11, 2016, and required publicly registered sponsors to report their NAV using one of two methods:
- Net investment methodology: to deduct the sales commission, dealer manager fees, and offering and organization expenses immediately and until 150 days following the second anniversary of breaking escrow; or
- The appraised value: to be implemented at any time (required following the expiration of the net investment methodology). This clarified that the valuation of all assets should be performed at least annually, derived from a method that conforms to industry practice.
The notice further required the disclosure that past distributions represent a return of capital.
Sponsors offering publicly registered programs responded with new valuations that lowered the NAV by 10 percent to 15 percent reported with the first customer statement. This shock rippled through the industry, resulting in a dramatic shift away from public programs to private placements, where the restrictions from RN 15-02 did not apply. That said, sponsors accepted that upfront fees would need to drop, which has occurred with many that are still in the playing field. Many new and old entrants have recognized the appeal of private placements and have actively pursued that market.
Considered a hybrid product, interval funds are penetrating the market with a vengeance. As a 40 Act closed-end fund, disclosure is significantly more than for private placements. Offering a liquidity option (typically 5 percent per quarter), their goal is to take advantage of the illiquidity premium inherent in certain types of investments. With more than 90 funds, the old saying that “the first to enter the market wins” applies here as the top five sponsors controlled more than 67 percent of the total net sales for 2019.
CHANGES TO PRIVATE PLACEMENTS
Real estate companies seeking $5 million to $500 million for individual projects and for funds have entered the private placement market with some companies trying to circumvent strict SEC and FINRA reporting requirements for public programs. Although the regulatory notices applicable to public programs do not directly apply to private placements, the notices by implication set a higher standard for all offerings. Broker/dealers and financial advisers acknowledge that this calls for heightened due diligence, which ultimately protects them and the investing public.
One of the fastest areas of growth within private placements is the resurgence of 1031 exchanges, notably Delaware Statutory Trusts (DSTs). The appeal of these programs is greatly tied to the economy as sales hit record levels in 2006 only to collapse following the Great Recession of 2008 and 2009. Since then, sales have grown steadily with total sales reaching roughly $3.5 billion in 2019. Many sponsors have lowered their fees in response to investor demand although there still exists the temptation for investors to minimize their taxes at any cost. With 15 active sponsors, the top five established players occupy more than 80 percent of the market. Some may question if so few players provide sufficient competition to provide the best product at the lowest price.
Another area of growth are qualified opportunity zones. With more than 130 sponsors presently, the dollars coming into their coffers are not flowing as quickly as anticipated, and Congress continues to make gestures that they will examine or even revoke the opportunity zone tax benefits. Nevertheless, many programs with seasoned sponsors suggest that investors can have confidence in their ability to provide the long-term hold (and benefits), needed for a successful program. Popular criticisms of these programs include questioning whether and how cash flows will be available after 2026 to pay taxes for the initial investment, whether the property (or business) can successfully be established within the pre-set guidelines of 30 months, and if an investment should include just one property (or business) or provide a diversified pool. All investors considering an investment of this type should disclose their awareness that an investment must be held for 10 or more years and that this may lower the internal rate of return (IRR) below the standard needed for a development project.
Private equity (PE) or companies investing in shares outside a stock exchange, have also seen an increase in popularity. Capital has flowed at an increasing pace to PE funds’ coffers so steadily that U.S. private equity dry powder alone is now near $700 billion, according to PitchBook estimates. Given the broader macroeconomic environment, lack of sufficient uncorrelated returns in traditional equity and fixed-income investments, as well as the popularity and performance of passive indexes since the financial crisis, private equity’s allure is clear. However, competition across the PE landscape is at near-record highs, especially in the United States.
DEFINITION OF ACCREDITED INVESTOR
Regulation D of the Securities Act of 1933 first defines the term “accredited investor.” However, it wasn’t until 1982 that the SEC established guidelines in the definition to include annual income of $200,000 or a net worth of $1 million or more. This changed with the Dodd Frank Act, which required the definition be updated every four years. It should be noted that in 1982 less than 2 percent of the investing public was considered accredited versus 2013 when 9.9 percent were considered accredited. This suggests an even larger percentage would be accredited today. Even as more investors are eligible for private placements, in December 2019 the SEC proposed amendments to the definition to include those with certain professional certifications and designations, knowledgeable employees of a private fund, certain limited liability companies, registered investment advisers and others.
REGULATION BEST INTEREST
On June 5, 2019, the SEC adopted Reg BI which established a “best interest” standard of conduct for broker/dealers and associated persons when they make a recommendation to a retail customer. This applies to any securities transaction or investment strategy involving securities, including recommendations of types of accounts. As part of the rulemaking package, the SEC also adopted new rules and forms to require broker/dealers to provide a brief relationship summary (Form CRS) to retail investors. Firms must comply with Reg BI and Form CRS by June 30, 2020. Certain states have responded proactively, stating that all accounts should be treated with a fiduciary standard, rather than Reg BI.
WHAT THE FUTURE HOLDS
The uncertainty provided by economic and political factors — Congress, regulators and individual U.S. states — makes for an interesting match-up when considering the future of alternatives. One thing, however, is certain: The table has been set for financial professionals and their clients to reap the rewards of quality alternative investments and a Golden Age of Investing.
Dana Woodbury is founder and chairman of Buttonwood Investment Services.