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Understanding the Alternative Needs of High Net Worth Investors

By: John P. Napolitano, CFP®, CPA, PFS, MST

The high net worth investor is sometimes different. Many HNW investors earned their HNW status through a business or a C Level job that created wealth beyond retirement security and a great lifestyle. These investors took risks on many levels. They faced liquidity risk, they faced market risk, they faced economic risk and they faced concentration risk. After all, many built that wealth in one or two positions such as the company itself and perhaps the real estate in which their business lived. A characteristic in building wealth that way is a different perspective on liquidity, risk and return. These inherent features leave many HNW investors underwhelmed with the offerings by the average financial planning firm.

Even though the values of the businesses and real estate that created their wealth may go up and down like any other investment, these investors often don’t see that or don’t care about that. Compared to publicly traded shares of XYZ Company where they can see the value change every minute of every day, they don’t see their closely held businesses in the same light. A primary characteristic that I’ve observed amongst this crowd is that of control. They inherently believe that their day to day participation in the operation of the business insulates them somewhat and they feel that their impact can be felt as opposed to owning shares of a publicly traded investment. These are true entrepreneurs believing that good ideas executed by smart, hardworking people will pay off. It’s easy for them to get behind an idea they like backed by good people with experience at creating value.

These are just some of the reasons why these investors may be drawn to alternative investments. The term alternative investments is a loose one, which includes many asset classes. The only thing that isn’t considered an alternative may be your traditional investments such as equities, cash, bonds, and things that are generally traded and marked to market each day. Examples of alternative asset classes would be real estate, private equity, private loans, collectables, wine, antique cars and so forth.

As with any investor, each HNW investor has their own appetite for risk. Rarely would (or should) a HNW investor park all of their assets in alternatives even though that may be how they created their wealth in the first place. How much is appropriate for any particular investor needs to be determined client by client. For me, Alternatives may have a place when we are talking about someone’s risk capital, or their investments that may be above and beyond their needs for retirement and lifestyle security.

For the average financial advisor, the alternative investments available through your typical broker dealer platform may not be exactly what your client is looking for. I have had personal experience with some BD offered Alts, such as non-traded REITS and Business Development Companies (BDC’s) and have never had a positive experience. In my opinion, most of these products are built as financial tools that are good for the sponsor firms, the BD’s and the advisors. In fact, a friend of mine who is widely known as one of the country’s top real estate professionals has only one good thing to say about these types of BD offered non-traded products- “YTB” or, Yield To Broker! Some have lucrative commissions attached to them. Even when seeking out no commission or low commission products my searches have left me feeling empty and vulnerable.

Now that we know what types of alternative investments to avoid, how can you add value to a client relationship who invests in alternatives or needs help to find and evaluate opportunities? Starting with clients who already own “alts”, you can help by evaluating how well the alts are working as a portfolio. Like a traditional portfolio, an alternative portfolio should also be well balanced and diversified. When evaluating the alt portfolio for diversity and balance, you would use the same theory that you would use with traditional investments. Break them down by asset class to see that all of the Alt Eggs are truly in different baskets as opposed to different sections of the same basket. For example, if your client owns several different office properties, are they really diversified?

You can begin to create a scorecard or some performance measurement for your client. It may not be feasible to evaluate an Alternative Investment based on its current value because you may not know the current value. If the General Partner or sponsor of the deal is willing to estimate the current value, then go with it. But beyond the value of the deal, you can evaluate it for its current cash flow or yield compared to what was forecast when they first looked at the opportunity. Are they on track or did it stray, and if it strayed was it for a good reason and is it expected to turn around in the future? Office properties may well be in this category due to the Pandemic. The short term vacancy or loss of cash flow may be causing some deviation from what was forecast.

You can help evaluate the structure of the deal. Alternative investments are frequently held in some form of limited partnership or LLC structure. In these structures the General Partner or sponsor is usually paid a few ways. Some are paid up-front fees simply for getting the deal going. Others take a piece of the cash flow with or without a preferred return to the investors first and most take a carried interest in the ultimate profits from the deal. The range of what you’ll find will be all over the place. But if your client has a few alternative investments, you may be surprised to discover that they may not recall the terms and structure of the alternative investments that they own. You can create a useful summary as a resource to save time for the client. This understanding of the structures will also be a helpful guide for your client when it comes to evaluating future alternative investments.

Record keeping for these investments may also be valuable for your clients. In my past life as a CPA, I recall having wealthy clients with so many Alt deals that they didn’t know when capital calls were due and how much they actually had committed to deals. In some cases, investors with tens of millions in investable assets would bounce checks when making capital calls because they simply didn’t pay attention. Tracking their Internal Rate of Return is also something that may be helpful. With all the capital calls and cash flow from a deal, it could materially impact the final IRR beyond the simple original investment and proceeds from liquidation.

Helping your client source and evaluate alternative investments may also be valuable to your clients.  I’ve discovered that many clients find their alternative investments through friends or family, and have a limited selection from which to choose. The resulting portfolios frequently lack diversity from either an asset class perspective or a sponsor or GP perspective. Just because you love a sponsor doesn’t mean that you cannot invest more with them, but it doesn’t mean that you shouldn’t seek diversity either. 

Diversity can happen in many ways. It can happen by asset class and within asset classes, by sponsor, by geography, duration, risk and any other metric that is used for any type of investing.

For real estate you may own different asset classes such as apartments, office, warehouse, retail etc.  Even within each sub-category of real estate you can further diversify based on the intention for the property. Is it a development deal, a cash flow deal or a fix up and sell type of deal? Will it be low leverage or highly leveraged? While diversifying amongst and within asset classes doesn’t guarantee better results or prevent losses, it still makes a lot of sense.

A similar approach is wise when evaluating private equity offerings. Your clients may want to invest in private equity in an industry they are familiar with or invest in areas where they haven’t been before.  Even with private equity, beyond industry diversity, you have opportunities to invest in start-ups, early stage or venture capital, mature companies or roll up companies. Investing in private landing also has a place. In the yield starved environment we live in today, investors have few choices to generate pure yield. It may be mezzanine financing for developers or lending to distressed companies, but private lending also needs the same or more care and evaluative skills as any other private investment. Private loans may be ideal for qualified accounts through a self-directed custodian.

And my last financial planning point, make sure that these private investments fit into the clients estate plan. Make sure that they are owned properly, such as in their trusts or family partnerships. Also make sure that there is a plan for estate liquidity in the event of a premature death. Getting out of private investments early may not be possible, and if it is possible, may come at a steep price.

There are several reasons why should you care about alternative investments. First off, your wealthy clients do. If you don’t care or have the bandwidth to help, someone else will. They need help and will seek out what they need.

Second is the trend. In a recent survey by a prominent HNW firm, it was pointed out that amongst the services that HNW investors want most from their family offices and financial advisors is assistance with private investments.

John P. Napolitano CFP®, CPA is CEO of US  Wealth Management in Braintree, MA. Visit JohnPNapolitano on LinkedIn or uswealthnapolitano.com. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. US Wealth Management, US Financial Advisors and LPL Financial do not offer tax advice. John Napolitano is a registered principal with and securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through US Financial Advisors, a Registered Investment Advisor. US Financial Advisors and US Wealth Management are separate entities from LPL Financial. He can be reached at 781-849-9200.

Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

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Making Cents: How to Pick a Trustee

By: John P. Napolitano, CFP®, CPA, PFS, MST

A trustee is generally a person or a company who oversees the governance and maintenance of a trust.