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.  

"A brilliant fraudster bent on deceiving an advisor and the world around him is a trap that sadly awaits the well intentioned," says Rick Lake, co-founder of Lake Partners in Greenwich, Conn., which analyzes hedge funds and alternative strategies and helps professional investors run portfolios of alternatives. "So the advisor always has to ask himself what calamitous risk would await him if something goes very wrong. If that risk is too high, an advisor should pass on the opportunity."

Many advisors in recent years moved into private deals based on success stories from the institutional investment world. The most well-known success story is The Yale Model developed by David Swensen and Dean Takahashi. Swensen since 1985 has served as the chief investment officer of Yale University, which has assets totaling more than $22 billion, according to Wikipedia.

Swensen described his investment ideas in Pioneering Portfolio Management (Free Press, May 2000). Swensen spread Yale's portfolio across roughly equal investments in five or six asset classes. Swensen avoided asset classes with low expected returns such as fixed income and commodities.
"Particularly revolutionary at the time was his recognition that liquidity is a bad thing to be avoided rather than a good thing to be sought out, since it comes at a heavy price in the shape of lower returns," says Wikipedia. "The Yale Model is thus characterized by relatively heavy exposure to asset classes such as private equity compared to more traditional portfolios."

For years, advisors have been following the trail blazed by institutional investors. After institutions embraced Modern Portfolio Theory in the 1970s, advisors followed suit in the 1980s. More recently, the movement to make advisors to individual investors adhere to many of the same standards imposed on fiduciaries is based on the standard of care that has been imposed by law on institutional managers advising public pension funds. Similarly, many independent advisors have embraced the institutional investment world's penchant for private investments.

However, the difference in scale between investors of institutional money and advisors investing on behalf of individuals may make following the leader a poor path for advisors. The sheer heft of institutions buys them due diligence on private deals that advisors simply cannot provide.

Allan Martin, a managing partner and senior consultant at NEPC LLC, which performs due diligence for some of the nation's largest pension funds and other institutional investors, says consultants such as his firm conduct extensive background checks on managers of private deals on behalf of its institutional clientele. Founded in 1986, NEPC has regional offices in Detroit, Las Vegas and San Francisco in addition to its Cambridge, Mass., headquarters. NEPC's Web site says more than 283 clients that in aggregate manage more than $342 billion pay its annual retainer fees. The process of due diligence he describes is extensive and expensive.

"You hire specialized firms that search through databases like Lexis/Nexis," says Martin. Divorce filings and other public documents are sought out by researchers, Martin says, and the firm offering the investment typically has 15 or 20 employees whose credentials and public filings must be checked at a cost of about $1,000 each.

In addition to background checks, institutional due-diligence consultants typically review the books to advise a client on private investments. Accountants pore over audits of returns and verify that securities exist. Investment experts interview managers and visit them personally before rendering an opinion.  

Typically, according to Martin, a $1 billion to $5 billion institution might pay a fee equal to one or two basis points annually or a retainer about equivalent to that amount to a due diligence consultant that is a generalist. Thus a $5 billion pension fund might pay $500,000 annually to retain a generalist due-diligence firm. Due-diligence generalists help pension funds and other large institutions write their investment policy statements, conduct searches for managers of traditional securities portfolios, and help large funds meet their obligations as a fiduciary.

In addition to generalists, a growing number of due-diligence consultants specialize in one particular asset class. For instance, NEPC (formerly known as New England Pension Consultants), offers specialized services focused on private equity deals. According to Martin, specialists typically charge institutions fees of 10 to 20 basis points based on the amount of assets committed to a style or asset class.

At the end of 2009, Martin says NEPC data show the average large institutional fund, defined as those with more than $1 billion in assets, had committed 5% of its assets to private equity deals, 6.7% to hedge funds, and 8% to direct real estate investments. Martin says the commitments are actually a floor because deals are continuously cycling.

For instance, a pension fund seeking to make a $50 million commitment to private equity might actually invest $75 million because by the time its money is fully invested, earlier deals typically have returned all of the money invested. It might take the fund three years to get fully invested in private, hence the larger investment than the amount originally committed. Thus a specialist due diligence firm could get paid $150,000 a year (20 bps) on $75 million of assets invested in private equity deals and the typical deal is a $25 million to $30 million investment.  

Stephen McCourt, a managing principal at Meketa Investments Group of Westwood, Mass., concedes he knows little about the independent advisor business. But he has spent almost his entire career advising large institutions, and he says alternative investments require diversification.

"You really have to diversify the individual risk of any particular strategy by spreading your investments across multiple strategies," says McCourt. "If you diversify across 10 strategies, then having one strategy that's a flop is a lot less impactful. Most institutions have investments in much more than 10 strategies and it would not be atypical to have investments in 30 or 40 different strategies."

McCourt says vetting an investment is usually a three- or four-month process that takes his firm 50 to 100 man-hours at a rate of about $400 per hour. That does not include the additional time that the institutional investor's staff puts in to research the deals on their own and choose the right due-diligence firms.

As if the daunting due-diligence responsibility is not enough to make independent advisors skeptical, lower-than-expected returns being earned by institutions on private equity investment is sure to bolster negative sentiment. According to a recent story by Jenny Anderson in The New York Times, the nation's 10 largest public pension funds have paid private equity firms more than $17 billion in fees since 2000.

"But few big public funds ended up collecting the 20% to 30% returns that private equity managers often held out to attract pension money, a review of the funds' performance shows," according to the report. "Two professors, Steven Kaplan of the University of Chicago and Per Strömberg of the Stockholm School of Economics, contend that, after fees, many private equity investments just about match or even trail the returns of the broad stock market between 1980 and 2001."

Although private equity returns over the last decade have beaten the abysmal gains on stocks, cushioning some funds, the heady economic expansion leading up to the financial crisis is thought to have enticed even institutional investors to chase returns on an abundance of private equity deals brought to market during the three years preceding the 2007 credit crisis. That crop of private equity deals is not expected to deliver anything approaching the outsized returns advertised at the time they were bought by institutions. Deals were in demand, which allowed weaker ventures to raise money.

My guess is that between the heightened fear of leverage, fraud and due-diligence risk posed by private placements, the days of advisors putting together their own partnerships are probably over. At the very least, they won't be as popular with advisors over the next few years.

In the meantime, advisors seeking alternative investments are likely to find solutions in the growing list of mutual funds employing hedge fund strategies. Consultant Lake of Connecticut, for example, in April 2009 partnered Aston Funds to launch a mutual fund for investors seeking a diversified portfolio of mutual funds employing hedge fund strategies.

While the track record of the Aston/Lake Partners LASSO Alternatives Fund (ALSOX) only stretches back to its inception date of April 1, 2009, the LASSO (Long And Short Strategic Opportunities) strategy was employed successfully by Lake in a separate account portfolio with a GIPS-compliant track record dating back to inception on December 31, 1998. From inception, the LASSO composite produced a cumulative return of 79% versus 16% on the Standard & Poor's 500-with LASSO having one-third the daily volatility. In 2008, when the Standard Poor's 500 stock index collapsed 37% in value, ALSOX lost a relatively modest 16%.

"It's a kinder, gentler hedge fund," says Lake. By law, registered investment companies are limited in the amount of leverage and illiquid securities they are permitted to hold. This blunts the effects on returns in a downturn, but limits upside potential in good times, making it attractive to those skeptical about the economic recovery and rise in stock prices in 2009 and so far in 2010.

Investors in mutual funds mimicking long/short hedge funds can also take comfort in the fact that registered investment companies require independent custody of their securities positions, so you avoid the risk of fraud seen in private placements. Even some of the biggest due-diligence firms did not detect the Bernie Madoff fraud.

On the other hand, you also are buying securities and don't get the same covariance afforded by investing in hard assets like real estate or interests privately held companies.

What it comes down to is that hedge funds, real estate, private equity and other direct alternative investments impose a heavy burden of due-diligence responsibility and a layer of expenses that seem hard to justify for independent advisors. When the cost of a mistake can be so great, that outlier risk of a fraudulent deal appears to be unacceptable.

However, when the combination of excess returns and complacency again take hold, the pendulum will swing back. Then, my friend from the neighborhood will probably be laughing at me.

And, in the meantime, he makes a strong argument: "If advisors are not putting investors into deals that are hard to research, then what's their value add?" he asks. "This is precisely what they should be doing on behalf of their clients."

Editor-at-large Andrew Gluck, a veteran financial writer, owns Advisor Products Inc., a marketing technology company serving 1,800 advisory firms.