"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.