“Disclosure is a great defense. It turns out you can do some pretty egregious things to your clients if you tell them you’ll do so in a document.”
My friend Simon Lack, author of the incendiary The Hedge Fund Mirage, is back with his new book, Wall Street Potholes. In it, Lack explains why there are so many horrible products being made available to investors and how to spot them.
In my first book, Backstage Wall Street, I have a chapter on these types of broker-sold products in which I refer to them as “Murder Holes”, but Simon is British and the term potholes is much more genteel 🙂
Anyway, here’s Simon explaining why non-traded real estate investment trusts (non-traded REITs) even exist in the first place (emphasis mine):
So now we return to non-traded REITs, and consider why a company that is qualified to seek a public listing because its securities are registered nonetheless chooses not to. Generally, you want to raise money at the cheapest possible cost, so why do these companies deliberately operate in a way that raises their cost of financing?
I think the answer is, they don’t wish to attract any Wall Street research. Brokerage firms routinely publish research on stocks and bonds, and they look to get paid for their research through commissions. Good research gets investors to act on it, and the commissions generated by this activity are what pay for the analysts. Companies want positive research because it will push up their stock price, making the owners richer as well as making it easier to raise more money later on.
But suppose you run a company that us designed primarily to enrich the sponsors at the expense of the buyers? What if you knew that drawing the interest of research analysts is likely to result in reports that are critical of fees charged to investors, and the conflicts of interest in your business model? Then you would conclude that the higher cost of financing caused by the absence of a public listing is a reasonable price to pay for the higher fees you can charge away from the glare of investment research. because if there’s no public listing, there are no commissions to be earned from trading in the stock, and no commissions means there is little incentive to produce research coverage.
It is into this regulatory gap that the sponsors and underwriters of non-traded REITs have built their business. Illiquid securities are normally only sold to sophisticated investors, but since the securities are registered, they can be sold to anybody. This means millions of unsophisticated investors can be induced to make investments that they’d be better off avoiding.
I’ll add a few other points:
- This gets to the heart of the Fiduciary debate now raging between the securities industry (entrenched broker-dealers) and the Department of Labor. These products are almost never sold to an investor by an investment advisor operating as a client’s fiduciary – they are almost always sold by a transactional broker who is being paid an enormous commission and operating under the much weaker “suitability standard”. DOL wants brokers handling people’s retirement investments to be held to this higher standards. The brokerages argue that there won’t be enough profit in doing so, which will reduce service. In other words, if we can’t take advantage of people then they’re not worth our time to work with.
- The biggest bomb to go off within the industry this year involved the collapse of a brokerage empire built from non-traded REIT sales. The fallout continues to rain down from the sky on this one.
- Any product that pays the salesman a commission or concession exceeding 7% cannot possibly be good for the investor who buys it. The worse the investment, the more a salesperson / broker has to be compensated to inflict it on someone. Lack reveals that one of the largest non-traded REITs pays its seller a 10.5% commission for placing it in client accounts and its disclosure docs actually allow for that fee to rise to 15% if need be. How the hell can any investment be good enough to start 10 to 15% in the hole?
- My favorite argument in favor of non-traded REITs is that they reduce the volatility of a portfolio because they don’t reprice and trade every day, therefore, they create the appearance of stability while publicly-traded REITs fluctuate. This is a Schrodinger’s Cat argument, wherein the cat isn’t dead until you open the box to confirm that it’s dead. Before you open the box, the possibility exists that the cat is still alive. Eventually, when non-traded REITs do get updated on a brokerage statement, they will absolutely have had volatility in their price.
Anyway, Simon is a super-smart guy and knows how to write. He’s consulted with several insiders who served as co-authors on the new book, there’s tons of valuable knowledge to be gotten here. Buy it today!