At one point or another, almost all the Small Balance Real Estate (“SBRE”) entrepreneurs I meet, coach, advise, and/or invest in ask me what I think about raising capital from financial planners, wealth managers, or Registered Investment Advisors (“RIAs”). They are seemingly a logical, viable and gargantuan source of potential capital for any SBRE entrepreneur running a 506 Regulation D pooled investment fund or even just doing syndications or one-off real estate deals. There are literally thousands and thousands of these RIAs all over the United States with varying numbers of high net worth clients and total books of between say $50,000,000 (which would be a rather small RIA) to upwards of several billion dollars.

To add to the allure of this potential capital source, there is clearly a trend in the investment community towards considering alternative investments (“Alts”), which is truly what an SBRE fund is, as a significant portion of their client’s overall investment allocation. Just google “percentage of portfolio in alternatives” and over 40,000,000 items will show up. Depending on what source you research, the recommended range varies from 5-10% to upwards of 50% of a person’s net worth that should be invested in Alts. We met a very sizable investment advisor ($8B plus) the other day whose belief is that 70% of his client’s money should be in private equity, real estate, and other Alts. Granted, that level of allocation is a rare belief amongst most RIAs I have ever met, but the point is that almost all of them seem to believe that Alts belong as a component, often a significant component, of their client’s portfolio.

The reality is, however, that far fewer RIAs follow through on this belief and allocate these type of percentages into actual Alts on their client’s behalf. While larger institutional investors (pension funds, endowments, and the like) seem to have been able to allocate significant percentages of their portfolios to Alts, these are typically allocated towards very large hedge funds, private equity funds, and venture capital via large institutional fund managers. This does not do our SBRE entrepreneurs and fund managers much good as the amounts allocated by these types of investors are far beyond what they can possibly accept even if they could get their attention in the first place (which they cannot). The RIAs I am talking about, those with say, $100M to $500M of AUM, simply do not systematically allocate anywhere near the type of percentages most seem to think is desirable to Alts on behalf of their high net worth (“HNW”) clients which, as any regular reader of this blog knows, is who I believe is by far the most appropriate investor for SBRE funds. Why the difference between belief and actuality?

This is a question I have asked, consciously or subconsciously, for many years. If RIAs believe that it is a good idea, if their clients are seeking better risk-adjusted returns and/or an investments that can actually produce a consistent dividend or distribution, and if there are good, solid, well-managed and strong return producing Alts (such as SBRE funds) out there that would fulfill these goals, why don’t RIAs actively participate with these SBRE (and other Alt) managers to underwrite and recommend these investments? I do not pretend to understand every layered and nuanced consideration and implication to RIAs of becoming more active in Alts, nor do I pretend to have all of the answers to this question. I do know, however, that human beings will always make decisions based on a combination of factors that may not be easily understood by others who are not facing the same dynamics, limitations, constraints, biases, opportunities, and realities. Not being in that business, I’m certain that I cannot fully appreciate all of these factors. But I do believe I have come to grasp at least some of the reasons why penetrating this very fragmented but huge potential source of capital as an SBRE fund manager is so difficult and challenging and how it might be able to be accomplished more successfully.

Here are what I think are the most important issues and/or constraints facing many RIAs, at least some of which must be successfully addressed or overcome in order for them to advocate for a greater allocation towards Alts and become more actively involved in that process, not necessarily in the order of their importance:

  1. Upfront underwriting and due diligence requirements (resources)
  2. No centralized reporting of Alt investments (similar to their mutual funds, ETFs and equities) to major custodial platforms
  3. Lack of adequate and timely reporting from the alternative manager
  4. Administrative burdens and restrictions (a very big one)
  5. Reputation risk
  6. Inertia
  7. Inadequate compensation for the additional burden and risk (real or perceived)
  8. Ability (or inability) to monitor the investment closely
  9. Lack of liquidity
  10. Regulatory and compliance factors

Even if a super high quality, established, and successful SBRE fund manager who by any measure could stand up to the extensive due diligence a good RIA will (rightly and smartly) perform, it is still very difficult to get their attention to even have a meaningful discussion, let alone receive an allocation of their client’s money, due to some combination of the above factors. Not the least of these is the extra work and inefficiencies most of these SBRE funds or Alts are going to require of them, probably for no additional compensation but only for the (hopefully) improved returns to their clients. While potential return is certainly a motivator, they have to weigh the risks of this significant additional work (for no additional money) to their reputation, their business and their ability to retain existing (and attract additional) AUM. If an Alt manager does not have a super compelling way for them to do this, which most don’t, attempts to get engagement from them are highly likely to fall on deaf ears.

Think about it. Let’s say they sincerely believe that each of their very high net worth (HNW) clients should have 20% of their portfolio in Alts. Most will take the approach that this 20% should be spread amongst at least 3-4 (let’s say 4) different Alts to achieve reasonable diversity. This means that if they have 100 clients at $1,000,000 in AUM each, then the RIA has a total of $20,000,000 to allocate to Alts (100 x $1M x 20%), or $5,000,000 to each of 4 different investments. This requires the RIA to underwrite and perform due diligence on probably 8 or 10 or 12 different investment opportunities to find 4 they can approve, which is a significant expenditure of their resources just to get started. If they are willing to make this upfront sacrifice and actually allocate, they then have 100 clients (or some portion thereof) placed in each of 4 different Alts (or some portion thereof as each client prefers), each of which reports performance results to them in different formats at different speeds. They then have to assemble that information, incorporate it into their own reporting and statements being delivered, and communicate that information back to clients along with all of the traditional investments in their portfolios. They also know that there is probably little to no liquidity in these 4 Alts so they have to hope that the predicted outsized returns materialize to justify their decision to take on all this extra work and tie up the client’s money in something that cannot be easily liquidated for a significant period of time. And oh yeah, they aren’t likely to be making any more money than before for doing all of this.

If the RIA or their client loses confidence in the alternative manager, they now have to attempt to liquidate (if that is even possible) positions in 20 or 40 or 50 of their client’s portfolios. This is neither quick nor easy and they have to explain (or re-explain) to clients what is happening, why it is happening, and remind them why they chose to do this (on the RIA’s recommendation) in the first place. The upside is that if these investments outperform the broader market to which they are presumably non-correlated, they produce a better return to their clients than they would have otherwise (and better than other RIAs might have who are not bold enough to include Alts), thus perhaps attracting more clients and greater AUM. If they don’t go so well, it is a scarier proposition because exiting their position will be very difficult. Even if the RIA loses money in a publicly traded stock or mutual fund they recommended, at least they can push a button to liquidate the client’s position on a moment’s notice, take solace in the fact that the market moved down for all of their brethren as well (so relative performance was likely no worse than most of theirs), and simply move on to other equally liquid, if unexciting and non-differentiated, opportunities that do not contain the same level of additional work, bandwidth, and risk that Alt recommendations do (and all for the same amount of money). In many, many ways, it is simply far easier to do what everyone else is doing and not stick their neck out for something that may chop it off, especially when they consider all of the additional work and administrative burden that goes along with it.

When I look at it from their perspective as best I can, given that I am not in their shoes, I can understand the hesitancy to pursue something that might on the surface appear to be (and in fact may very well be) an attractive alternative investment that would be perfectly appropriate for many of their clients. The fact is that it is hard for an SBRE fund manager to swim upstream against these dynamics no matter how great a strategy they have and how well they manage that strategy and that fund. Unless SBRE and other Alt managers can address these dynamics and remove some of the constraints faced by RIAs trying to pursue what seems to be a widely held belief that Alts should be a larger percentage of their client’s portfolio, my opinion is that they will likely continue to meet with resistance and mostly failure in raising capital from this source. The fact that RIAs believe in higher allocations so far is not enough to overcome the practical and operational hurdles of implementing that belief. The real opportunity in that space is to figure out how to solve those problems if this gigantic pool of capital is to remotely be tapped.

The good news is that there are several emerging solutions for these barriers facing RIAs which we are attempting to help bring to the forefront. For example, we have located a viable centralized reporting conduit for Alts that help reduce administrative burdens for RIAs and make reporting far more seamless. If an SBRE or other Alt manager chooses, they can apply for and become reporting members to an Alternative Investment Platform offered by one of the largest clearing houses in the country. This platform brings together the reporting of purchase price, net asset value (“NAV”), share pricing, and distributions along with a litany of other reporting options and data transmission ability to help an Alt get on the same playing field (and in fact be able to be viewed in the same manner) as traditional investments. This enables the RIA to include the Alt on their client’s statements and the CRM of the custodian, advisor and client, thus removing the very burdensome “off balance sheet” transactions (which Alts not on this platform are) that have to be “added back” to the client statements.

Another trend we are seeing and facilitating for RIAs is to establish their own Alt in the form of a proprietary pooled investment fund that they themselves manage directly. Rather than placing individual clients into multiple Alts to achieve diversity, creating an Alt investment strategy and putting a pooled investment fund around that strategy enables the RIA to far more effectively manage the dynamics associated with Alts. Being able to market a single investment vehicle designed specifically to suit them and their client base and which they manage directly – a vehicle which can, by the way, also report through the Alternative Investment Platform – rather than picking and choosing multiple Alts in varying combinations for many different clients, creates greater control, less administrative burden, and more consistency for both the RIA and their clients. Because it addresses many of the issues I outlined above, we have seen this approach embraced by several RIAs we know and be implemented quite effectively. The challenge for the RIA has always been how to set it up, structure it, create it, and administer it, but these are the core competencies that we have successfully brought to the SBRE fund world over the past several years that we believe are highly applicable and translatable to the RIA world. We are seeing significant interest from more and more RIAs to explore this approach and are highly encouraged with the early feedback from those we have worked with to try to develop a far more effective approach for them to get more involved with Alts.

In these and other ways, we are working with RIAs to attempt to shrink the distance between the belief about an appropriate allocation towards Alts and the far different reality that exists. By working on the core issues that face this constituency, rather than just knocking on their door asking for investment dollars while failing to acknowledge the things that have always prevented them from doing it, we are attempting to strike at the root of the problem. The evidence is overwhelming that RIAs already believe clients should have more exposure to Alts.  The fact that they do not allocate that direction is therefore based on something besides belief which must be effectively addressed before it is ever going to happen in any meaningful way. There is a long ways to go, but as more and more RIAs see that there is a viable path towards this end that doesn’t just add to their already burdensome regulatory and administrative requirements without any additional compensation, we believe that greater allocations for competent, capable and high performing SBRE (and other Alt) fund managers are not only possible but increasingly likely.

Matt Burk
JANUARY 27, 2016