A Comprehensive Guide to Due Diligence for Alternative Investments

Alternative investments offer enticing opportunities for diversification and potentially high returns. However, they come with risks that require thorough due diligence before committing capital. Whether you're considering investments in LLCs, corporations, real estate, precious metals, or other alternative assets, understanding the due diligence process is critical. This guide will walk you through the steps necessary to assess different types of alternative investments, helping you make informed decisions that align with your financial goals.

Understanding Due Diligence

Due diligence refers to the investigative process that a potential investor undertakes to verify the facts and details of an investment opportunity. The goal is to assess the viability, risks, and potential returns of the investment, ensuring it aligns with your financial strategy. Skipping this critical step can lead to unexpected losses or involvement in fraudulent schemes.

Due Diligence for LLCs & LP

Limited Liability Companies (LLCs) and Limited Partnerships (LPs) are popular structures for alternative investments, offering flexibility, tax advantages, and varying levels of liability protection. Conducting thorough due diligence on these entities is essential to ensure that your investment is sound and aligns with your financial goals. Here are the key documents and checks you should review when evaluating an investment in an LLC or LP:

Certificate of Good Standing (LLC): This document confirms that the LLC is authorized to do business in the state of formation. It verifies that the company has complied with all statutory requirements and is not at risk of involuntary dissolution.

Certificate of Limited Partnership (LP): Similar to the Certificate of Good Standing for LLCs, this document verifies the LP's authorization to conduct business and confirms that it is in good standing with the state.

SEC/CFTC Search: Perform a search with the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to ensure that the LLC or LP, and its principals, are not involved in any ongoing investigations or have a history of violations.

Articles of Organization (LLC): These documents outline the LLC's formation, including its purpose, duration, and management structure. Reviewing the Articles of Organization gives insight into the operational blueprint of the business.

Limited Partnership Agreement (LP): The Limited Partnership Agreement is a critical document that details the roles, responsibilities, and profit-sharing arrangements between general and limited partners. It also outlines the terms of governance and how decisions are made within the partnership.

Operating Agreement (LLC): This document details the governance of the LLC, including member roles, voting rights, profit distribution, and procedures for handling disputes. A well-drafted operating agreement can prevent future conflicts and protect your interests as an investor.

Investment Offering Memorandum (LLC/LP): If available, the investment offering memorandum provides an overview of the investment opportunity, including risks, objectives, and financial projections. Reviewing this document will give you a comprehensive understanding of what you are investing in.

Federal EIN: Ensure that the LLC or LP has a valid Employer Identification Number (EIN) issued by the IRS, which is necessary for tax reporting and compliance.

Onboarding Form (internal form Preferred Trust utilizes): This form provides detailed information about the LLC's ownership structure, including the names of individuals with ownership interest and any professional licenses they hold. Understanding the background of key stakeholders helps assess the credibility and expertise of the management team.

Due Diligence for S-Corps and C-Corps

S-Corporations and C-Corporations offer different tax treatments and shareholder structures, but both require a detailed review before investment. Here’s what to check:

Certification of Incorporation: This document verifies the legal creation of the corporation and provides details on the company’s name, address, and purpose.

Corporate Bylaws: The bylaws are the rules that govern the corporation’s operations. They include information on the board of directors, shareholder meetings, and the issuance of stock. Reviewing the bylaws can help you understand how decisions are made and the level of control you may have as a shareholder.

Licenses and Permits: Depending on the corporation’s industry, it may require specific licenses and permits to operate legally. Verify that the corporation holds all necessary authorizations, as operating without them can lead to legal troubles and financial losses.

Federal EIN: Like LLCs, corporations must have a valid EIN for tax purposes. This number is also used to open bank accounts and file tax returns.

Due Diligence for Real Estate (property) Investments

Real estate is a tangible asset class that can provide steady income and capital appreciation. However, it requires a thorough analysis of the property, market conditions, and legal considerations:

Title Search: A title search ensures that the property has a clear title, free from liens, disputes, or encumbrances. This is crucial to avoid legal complications after the purchase.

Property Appraisal: An independent appraisal provides an accurate market value of the property. It helps in determining whether the purchase price is fair and if the investment aligns with your financial goals.

Inspection Reports: Conducting a property inspection is vital to identify any structural issues, necessary repairs, or potential environmental hazards. This step can save you from unexpected expenses and ensure that the property is a sound investment.

Market Analysis: Research the local real estate market, including vacancy rates, rental yields, and economic factors that could impact property values. Understanding the market conditions can help you make a more informed investment decision.

Zoning and Land Use Regulations: Verify that the property complies with local zoning laws and land use regulations. This ensures that you can use the property as intended and avoid costly legal battles.

Due Diligence for Precious Metals

Investing in precious metals like gold, silver, and platinum offers a hedge against inflation and economic uncertainty. However, these investments require careful scrutiny:

Purity Verification: Ensure that the precious metals meet industry-standard purity levels. For example, investment-grade gold should have a purity of 99.5% or higher.

Storage and Insurance: Verify that the metals are stored in a secure, insured facility. You should also understand the costs associated with storage and whether you would like to have segregated or non-segregated storage.

Dealer Reputation: Research the reputation of the precious metals dealer. Look for reviews, industry affiliations, and any history of legal issues or customer complaints.

Spot Price and Markup: The spot price is the current market price of precious metals and serves as a benchmark for pricing. It fluctuates based on supply, demand, and other market conditions. When purchasing precious metals, check what the dealer is charging over the spot price. This markup can vary, but typically, the industry standard is between 5% to 8% over spot for common forms like bullion. Be wary of dealers who charge significantly higher markups, as this can erode your potential returns.

Due Diligence for Oil and Gas Investments

Oil and gas investments can offer substantial returns, but they are also highly speculative and come with significant risks. Due diligence in this sector is crucial:

Operator Track Record: Review the history and performance of the operator managing the oil and gas project. A strong track record of successful projects is a positive indicator.

Geological Reports: These reports assess the potential of the oil or gas reserves. Understanding the geological data helps in estimating the likelihood of a successful extraction and the potential returns.

Regulatory Compliance: The oil and gas industry is heavily regulated. Ensure that the operator complies with all federal, state, and local regulations, including environmental laws and drilling permits.

Revenue Distribution: Understand how the revenue from oil and gas production will be distributed among investors, the operator, and other stakeholders. The terms should be clearly outlined in the investment agreement.

Due Diligence for Syndications

Syndications pool resources from multiple investors to fund large projects, often in real estate or other capital-intensive industries. Due diligence is essential to ensure the syndication aligns with your risk tolerance and financial goals:

Syndicator’s Experience: Investigate the syndicator’s track record, including past projects, success rates, and any legal issues. An experienced syndicator with a history of profitable projects is a positive sign.

Investment Memorandum: This document provides detailed information about the syndication, including the project’s objectives, financial projections, risks, and the structure of the investment. Review it carefully to understand what you’re committing to.

Partnership Agreement: The partnership agreement outlines the rights and responsibilities of each investor, the syndicator, and other stakeholders. It should clearly define profit distribution, management fees, and exit strategies.

Project Viability: Assess the viability of the project by reviewing market studies, financial projections, and any relevant industry reports. The project should have a realistic chance of success based on current market conditions.

Final Thoughts

Due diligence is the cornerstone of successful alternative investing. Whether you’re investing in LLCs, corporations, real estate, precious metals, oil and gas, or syndications, taking the time to thoroughly vet the investment opportunity can help you avoid pitfalls and maximize your returns. By following the steps outlined in this guide, you can approach alternative investments with confidence, knowing that you’ve done everything possible to protect your capital and achieve your financial goals.

At Preferred Trust, we prioritize thorough due diligence as part of our investment process. While we conduct comprehensive checks on the companies we partner with, it is ultimately the client's responsibility to perform their own review of the investments they choose. Doing so ensures that the investment aligns with your personal financial goals and risk tolerance.

If you’re interested in a downloadable version of our alternative investment due diligence checklist, stay tuned for the release of our upcoming due diligence podcast, where we will discuss these topics in greater detail.