A friend from the neighborhood approached me about six months ago about a private investment deal. He's a very smart guy, a family man, and I have good reason to believe he is a man of integrity.
He had successfully run a Japanese convertible arbitrage fund specializing in Asian securities for many years, but by 2007 spreads narrowed for a variety of reasons, including the fact that too many other professional investors started using the strategy. He shut down his hedge fund in late 2007, just months before the markets and economy got really ugly.
Around October 2009, he approached me about a private deal. He was now working with a friend he had known since college providing debt to venture-capital-backed companies that needed additional funding. The group was able to get a commitment from the U.S. Small Business Administration to provide financing to small companies it sought to fund. The group had done several of these deals over the previous decade, and the VC-backed companies it would fund were in a pinch last fall to raise cash because bank financing had become so difficult to obtain.
As a columnist for Financial Advisor with a lot of contacts in the industry, I should have been in a good position to help my friend. So I called financial advisor Tom Connelly, president of Versant Capital Management of Phoenix. I figured that if Tom would vet the deal, I would feel comfortable about introducing other advisors to my friend.
But what happened next really surprised me. Tom is one of the nicest guys in the world and would give you his right arm if you asked for it. But he told me that he wasn't interested in my friend's deal.
Tom runs his own firm that manages assets for ultra-high-net-worth investors and serves as chairman of the investment committee of the Arizona state-employee pension fund. He told me that the amount of due diligence he would have to do before investing in a private deal with strangers made the opportunity impractical. While the deal may turn out to be very good, researching it properly would be too expensive an undertaking.
"At the pension fund, before we invest in a private deal, we'll spend tens of thousands of dollars researching it," Tom said.
In the months since that conversation with Tom, the question about whether advisors can perform adequate due diligence on private deals has stayed on my mind. For many years I have written about the need for advisors to explore investments not correlated with the stock market, but events in the last couple of years now make me think that advisors should pass on almost all private deals unless they've previously worked for several years with a principal in the deal.
There has been no shortage of stories in the trade press focusing on a few independent advisory firms that have successfully led clients into private deals in alternative investments. I myself have written stories like that. But it may have been naïve to think that most advisors can do the research needed to pick the right deals.
In addition, because advisors cannot invest with anything approaching the scale of a pension fund, the risk of a fraudulent conspiracy can have a devastating impact on an advisor and his clients. Getting duped on a single crooked deal can set an advisor's career back for years, blemishing a reputation that might have taken many years to build. While the risk of fraud is low, its consequences are so severe that the risk/reward tradeoff on private deals may not make sense for the vast majority of advisors.