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So I'd left the huge company where I'd spent almost my entire adult life to run something far smaller but also completely devoid of bureaucracy. My firm would reflect the values of the best people I'd worked with over the years as it sought attractive long-term investments in a format that treated clients' money as if it was mine. Many firms, and many people, do the same thing. But as I've found out since 2009, they don't all do the right thing. There's plenty of room for improvement in the quality of financial advice that is given to investors.
We all have to trust professionals when we need help with something that is not what we do for a living, whether it's medical treatment, legal advice, or auto repair. We generally buy products and services with the knowledge of an amateur, and we are often vulnerable to an unscrupulous provider. We look for honesty; when we don't find it, sometimes we discover in time to protect ourselves and sometimes we don't.
The world of investment advice can be dauntingly confusing. Saving for retirement is increasingly the responsibility of the individual, as defined benefit pension plans are phased out in favor of defined contribution plans, 401(k)s, and IRAs. Unless you're a public-sector employee where pensions are still based on your salary just prior to retirement, the money you have when you stop working will largely be the result of decisions you made (or failed to make) during your decades in the work force.
My client, whom we'll call Penelope (not her real name), sat across from me waiting for an explanation as to precisely what poor advice she had received. She was here with her husband, and we had met through a mutual friend. Like many investors, Penelope and her husband are smart people who have enjoyed professional success without having to understand the intricacies of investment products. Penelope is in the pharmaceutical industry (not uncommon in New Jersey) and her husband works for an information technology company.
Penelope had bought into a very common investment called a Real Estate Investment Trust (REIT). REITs typically own income-generating commercial property, including office buildings, warehouses, shopping centers, rental apartments, and so on. They can be a great way for individuals to own real estate managed by a professional company. Many REITs are publicly traded, allowing investors to sell their holding at the market price, and there are mutual funds and exchange traded funds (ETFs) that provide exposure to REITs. Used properly, they can be a legitimate component of an investor's portfolio providing income and some protection against inflation.
However, not all REITs are good, and a particular class of them called “non-traded REITs” is generally to be avoided. Penelope had unwittingly invested some of her savings in the wrong kind of REIT, one that provides substantial guaranteed fees to the broker selling it while often generating disappointing returns for the investor.
Public securities are registered with the SEC under the 1940 Investment Company Act. Registering a security requires the company to meet various tests for accounting standards, transparency, and so on. The advantage of registering is that the security can be sold to the general public. Unregistered securities have a far more restricted set of potential buyers. The investors have to be “sophisticated” (meaning wealthy, in this case), and the seller of such securities has to adopt a targeted marketing approach, going directly to people he thinks may be interested. You won't often see an unregistered security advertised, because the laws are designed to prevent that.
Hedge funds are another example of an unregistered security. Their sale is restricted to “sophisticated” investors deemed able to carry out their own research. It's a sensible way to divide up the world of available investments. Retail investors are offered securities that are registered and usually those securities are publicly traded, enabling the investor to sell if they wish. Sophisticated investors including high-net-worth individuals and institutions don't need the same type of investor protection, which allows them to consider unregistered investments that have higher return potential and also higher risk.
Non-traded (also known as unlisted) registered REITs fall in between these two classes of investment. By being registered, they are available to be sold to the general public. Having gone to the effort of registering, it's a reasonable question to ask why they don't also seek a public listing. It would clearly seem to be in the interests of the investors to have the liquidity of a public market listing so that they can choose to sell in the future. In fact, non-traded REITs have highly limited liquidity and often none at all. They can only be sold back to the issuing REIT itself, and the REIT is under no obligation to make any offer to repurchase its shares. They are a hybrid security – no public market liquidity and yet available to be sold to the public.
Generally, companies that need to raise capital, whether equity or debt, desire liquid markets in which to issue their securities. Liquid markets are widely believed to reduce a company's cost of finance. This is because investors require an illiquidity premium, or higher return, if they have limited opportunities to sell. Private equity investors expect to earn a higher return than if they had invested their capital in public equity markets. Small-cap stocks similarly need to generate higher returns than large-cap stocks to compensate for their more limited liquidity.
Although monthly income is the main selling point, the illiquidity can mean that your holding period exceeds the lease term on the properties. For example, if the non-traded REIT in which you're invested has five-year leases on its properties but you hold the investment for ten years, you have much more at risk than just your exposure to the monthly income.
Bond issuers care a great deal about the liquidity in the bonds they issue, and the selection of bond underwriter is based in part on the firm's commitment and ability to subsequently act as market maker after the bonds are issued. The ability to sell bonds at a later date induces buyers to accept a lower yield than they would otherwise, thereby reducing the bond issuer's interest cost.
To cite a third example, the justification for high-frequency traders (HFTs) with their lightning-fast algorithms in the equity markets is that their activities improve liquidity. Michael Lewis in Flash Boys provided a fascinating perspective on how HFT firms have been able to extract substantial profits from investors through using their speed to front run orders. I'm not going to examine HFT firms here, but suffice it to say that their existence reflects the overwhelming public interest in the most liquid capital markets possible.
Why Not Get a Listing?
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 is designed primarily to enrich the sponsors at the expense of the buyers? What if you know 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.
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