Case Study: Due Diligence Concerns Foreshadow Poor Outcomes
By: Sloan Smith | Principal, Director
Innovest meets with hundreds of investment managers every year to see if they might be an adequate fit for client portfolios. During this process, we learn about their organization, culture, philosophy/process, style, performance, assets under management, and fees. We seek to understand whether an investment manager’s strategy has an “edge” and the infrastructure necessary to generate robust long-term returns while mitigating risk. Sometimes, we review unique strategies that our clients might find appealing. Our goal is to share our insights and relay any potential concerns.
Over six years ago, we went through this process for a real estate manager where one of our clients was considering an allocation. Performance was strong, historically, but there were qualitative concerns such as key man risk, above-average team turnover, questionable transparency, and lack of firm focus. We highlighted these issues and recommended that our client not make an allocation. Interestingly, in 2024, this real estate firm had a product that had to declare bankruptcy due to unnecessary cash flow needed to meet the demands of an underlying lender. This issue was unfortunate, especially for all investors involved. However, our initial due diligence foreshadowed these potential problems,, demonstrating the importance of a thorough research process before an allocation.
Risk/Considerations found during our due diligence:
Above Average Team Turnover and Key Man Risk: We identified a reasonable amount of team turnover since the firm’s inception. Also, the founder’s Visa/Income Tax issue(s) prevented him from entering the United States, which could cause added risk during a critical time when his on-the-ground leadership might be important.
Questionable Transparency: During our on-site visit, we met with the Chief Operating Officer (COO), and he seemed to gloss over some key turnover-related facts. Also, the COO was not transparent about the founder’s relocation to Bermuda and inability to live in the United States. Lastly, he brushed over several aspects of products, investors, and investment results.
Firm Focus: The firm had built numerous unrelated investment strategies requiring differing types of investment expertise. They built a multi-strategy hedge fund and a life settlements product, were invested in one-off private equity deals, planned to launch a bond strategy, were allegedly approached to run a public real estate investment trust (REIT), and wanted to broaden their real estate investments from the Rocky Mountain region to potentially as far as Europe. All of this, combined with a growing office in Bermuda, made this small firm with only 13 full-time employees exceptionally fragmented.
Non-Institutional Quality Firm: The firm could not complete several of our simple requests in a timely manner. They rescheduled our meetings/calls more than once. They did not promptly provide the requested information or make certain institutional quality information available.
Performance: While the performance of the real estate investments was good, the vast majority remained unrealized and based on third-party appraisals.
Investor Base: There was a lack of diversity and uncertainties about their investor base. The COO mentioned that approximately 10% of the investors in the funds were foreign, and 90% were from the United States. The COO stated that the founder had “wealthy friends” and knew “institutional foreign investors,” but offered no documentation of the specific make-up of their investor base.
Regulatory Oversight: The firm did not appear to be registered with the United States Securities and Exchange Commission (SEC) nor the state of Colorado. They mentioned trying to get their United States Broker Dealer and Registered Investment Advisor (RIA) set up so they can start marketing their products to a larger subset of investors. The founder further mentioned plans to be registered in the Bahamas and with the Toronto Securities Commission. While we understand that real estate investments do not always require registration, we would prefer some regulatory oversight for this multi-jurisdictional, multi-product firm.
Through this due diligence process, Innovest was concerned about the underlying firm and its founder. In our view, the firm was non-institutional, multi-product, and multi-jurisdictional, and it lacked a clear focus going forward. The founder’s visa issue remained a challenging item for us to overcome as well. In addition, through their sales-oriented culture, they appeared determined to gather as many assets as possible through their numerous investment vehicles. Though the firm’s real estate returns seemed strong, relative to other funds in this asset class, the uncertainties surrounding their transparency, team, and leadership were risks we could not ask an investor to accept. We did not recommend additional investments in any of the firm’s underlying strategies going forward unless the firm undertook substantial organizational institutionalization. Ultimately, they didn’t, which we believe led to their eventual demise.