Should I Own Private Investments? | AWM Insights #106
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Episode Summary
Just because you qualify on paper for private investments doesn’t mean you should have them in your portfolio. Ignoring current spending and future income can lead to poor results that can and should be avoided. Just as Maslow created the “hierarchy of needs,” portfolio construction can follow a similar pyramid. Liquid assets reside at the bottom and illiquid (private investments) at the top. Investing for your priorities in alignment with a strong financial structure will increase the chance of achieving the outcomes you desire.
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Episode Highlights
(1:21) What is private investing vs public markets? Should I be investing in private companies?
(1:44) Many private investments are sold to people without a full understanding of the risks.
(2:23) Why invest in the private side? Data shows higher expected returns!
(3:27) The range of returns is very very wide. This variance of returns is the norm in private deals.
(4:01) Public market managers do not have this same dispersion of returns.
(4:50) “Every single company is a technology company whether they like it or not” is a common saying in private markets.
(6:11) Why invest in private companies if the downside could be so bad?
(6:35) With more risk, comes a higher expected return.
(7:05) Buying ownership in companies that are just starting out. This is especially true in venture capital which has a high failure rate.
(7:55) LIquidity is the ability to sell your investment with little time and cost to get the money. Publicly traded stocks are very liquid.
(8:39) Everyone has the same information in public markets. If not, that is insider trading and people go to jail for that. This isn’t the case in Private Markets. Smart investors want an information advantage.
(9:10) Information is king and access to the best information leads to the ability of the best to continue to outperform. There is no requirement to equally distribute public information.
(10:20) Who can and should invest in private markets?
(10:40) The SEC also regulates private securities and you must be an Accredited Investor or Qualified Purchaser to even be legally allowed to participate.
(12:06) Illiquidity or locking your money up for 5-10 years is a trade-off of private investments.
(13:10) Important priorities including your essential spending need to be sufficient before you can commit to these illiquid investments.
(14:08) The investment “hierarchy of needs” in portfolio construction is a good analogy to think of when working your way up to private investing. Venture capital lives at the top of the pyramid.
(15:09) According to the SEC, two people with identical situations could technically qualify to invest in private investments. But that ignores the priorities and spending of the family. They may spend so much per year that they cannot afford to have their capital locked up for 5 or 10 years in the private deals.
(16:56) Your financial structure has to be set up to invest in these opportunities that can take up to 15 years to reap the rewards.
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+ Read the Transcript
Brandon Averill (00:03): Well, Justin, we're back for another good week here. Last week, we took a little deviation, did a little quarter market review for those that you haven't listened, encourage you to go back. We just talked a little bit about what's happened over the past quarter, but this week we're going to jump into, at least in our opinion, a more exciting topic, something that I know both Justin and I really enjoy chatting about, spending a lot of time in. We're going to go from the public equity markets, public kind of investing markets, to the private side.
Brandon Averill (00:39): There was a quote recently, I'll paraphrase, but in the financial times we've been talking about, this is actually the hottest thing in finance. It's not passive funds. It's not crypto, it's not commodities, but it's private capital. Things like venture capital, infrastructure, private equity, et cetera. All these things kind of get lumped into together, there's private real estate as well.
Brandon Averill (01:05): I think it'd be fun to start, Justin, with a topic that we spend a lot of time in and that's private investing in the venture capital markets. And just start to unpack this a little bit for everybody. What is private investing? Why is it different? How's it different from public market investing? What are the considerations? Why should we even do this in the first place? Even get into a little bit about when we should consider doing this, because that's something we see all the time, is people that shouldn't be messing around in the private markets get really excited about them. It's probably the easiest thing for our industry to sell to people. So anyways, lot of topics, a lot of juice to jump into here. So maybe just start out for us, Justin, why even do this? Why go through the hassle of trying to figure out the private markets?
Justin Dyer (02:00): Sure. Yeah. That's a great place to start and there's, there's a lot of hype that we can hopefully at least start to dispel a little bit and a lot of excitement and a lot of good reason to talk about the subject and to invest in it if a lot of the things that you were kind of teasing out there makes sense. But going into the why, quite simply is if you look at the data and we will say, hey, the private market data in general, isn't as robust as it is on the public market side. Maybe we'll define that a little bit more, but the data does show us that private investing has a higher expected return or at least it has a higher expected return over the history of investing.
Justin Dyer (02:51): Now more specifically to your point, Brandon, venture capital is at the upper end of that range. Now the thing to really keep in mind here, and I want to lead with this as we're talking about, hey, it's wonderful, there's higher expected returns. The range of returns within the private markets and venture specifically, we will probably be turning this conversation more and more to venture, but touch on other related aspects of private market investing in general. But the range of returns, from those who return the best at the top to those who return the least at the bottom, is incredibly wide. So it's at the dispersion of returns, at the variance of returns. It's really, really, really, really wide, whereas to compare and contrast that with the public markets, the number of investors or funds that outperform or underperform and the magnitude at which they outperform or underperform the market, let's just say the S&P 500, is really, really, really tight.
Justin Dyer (03:55): Maybe there's an outlier here or there, but in general, managers or funds or within a couple percentage points if not even less than that, relative to say the S&P 500. Again, using that as a standard benchmark. Whereas the managers within venture capital, as an example, some managers hit it out of the park. Other managers fail miserably, and that bring with it some challenges, some trade offs, which we'll talk about, and some things to be really, really cognizant of when we're talking about this space. But also let's take a step back from the pure data side of it. Why? Well, we hit on the data side, the high expected return, but just think about where we are in the world right now.
Justin Dyer (04:41): Technology is becoming such a critical part of everything we do and there's a common quote or statement that every single company is a technology company, whether they like it or not. And venture and technology, they kind of go hand in hand, not exclusively, but most venture capital companies have a pretty strong element of technology and that has already become such an integral part of our day-to-day lives. That will just continue to happen as old industries get refreshed and challenged and new technologies invented to come in and disrupt it really, using that catchphrase.
Justin Dyer (05:28): I would say that's the real high level of why we think about public or private market investing, specifically to venture capital as well. There are some attractive things within private equity, which I think that will be something we potentially get in, in future episodes, in real estate as well. But venture capital really, in our opinion, sits kind of at the top of the private market ledger, if you will, because of that expected return component and how it also sits within the overall economy.
Brandon Averill (06:03): I think that's a great framework, obviously, Justin, for why. It comes down to the expected higher returns. That's it, right? We're expecting higher returns to participate in the private markets and reason being is a few factors, but I think that, even going back to the basics here to maybe even explain for people what you're actually choosing to do when you invest in the private markets. But again, going back to venture capital, this would apply to private equity as well, but you're choosing to take your hard earned money, and you're choosing to give it to a company in exchange for ownership in that company. And when you do that, what you're doing is, you're kind of putting yourself in a position where you're going to benefit if that company does well, but you're also going to lose money if the company doesn't do well.
Brandon Averill (06:56): When you're moving to the private market side, especially the venture capital side, you're often doing this in companies that are just starting out. So that quote, unquote startup world, where risk of survival for that company is probably the highest. In turn, you would expect to have the highest expected returns from that risk profile. So it doesn't come without the risk.
Brandon Averill (07:22): The other part of this is, we talk a lot about the public market. That's a place where you can go and buy and sell companies, and you can do this on a daily basis. There's a lot of something that we call liquidity, meaning, hey, if I want to sell out of this position today, I can sell and I have my money in a reasonable period of time. When we move to the private market side, you're choosing to give that money to a company and if that company doesn't do well, for instance, now you have to go find somebody that buys. If you want to sell your ownership, you have to go find somebody that's going to buy it from you. Even if the company does well, you still have to go do that. That's going to take a longer period of time, theoretically.
Justin Dyer (08:07): And have higher costs.
Brandon Averill (08:10): Yeah, and have higher costs. So a lot of times that's when we refer to liquidity risks. So when we're starting to invest in the private markets, that's just hopefully a good base level of what you're doing. And then information becomes king in this environment, right? And it's no longer illegal. We've talked about this on the public market side. Everybody has access to same information. If you don't, that's illegal, insider trading. People go to jail, bad things happen. On the private market side, that's totally different. What we're doing is, we're hoping that we have an information advantage. I frame this for clients a lot of times.
Brandon Averill (08:53): If we are going to sell AWM capital and I was going to sell it to the guy down the hall, I might like him. I might give him a little bit more visibility into the business. If I just put it on the market, some other business person comes in. I may not trust them quite as much. I might not want to give them as my to information. So the guy down the hall that I like probably has a better idea of what we're really worth and that's all okay. We don't have to abide by any other rules. We can distribute information differently to different people.
Brandon Averill (09:30): It really does come down to having a really good system. We'll get into all of this. That's a big reason why the winners keep winning. Kind of framing that, Justin, a little bit of what's happening. We got the why, we got the what's happening. I think the biggest question then becomes the when, or who should actually be tapping into these markets? So maybe hit on that kind of high level. And certainly it'll frame us for future conversations as well.
Justin Dyer (10:00): Yeah. As you mentioned, there's a lot of interest and I would even say hype around the private markets in general right now. And the question you pose is an incredibly important one when there is so much hype and everyone thinks they need private market investing. And really the way we think about this is, well, first of all, let's start with the pure regulatory environment. The SCC Securities and Exchange Commission regulates the private markets, just like they regulate the public markets. They oversee everything within the securities world, which private markets fall into as well. A lot of people disagree with these regulations and they have changed over time, but as such, there are some minimum standards that you need to have in order to actually participate in private market investing.
Justin Dyer (10:54): And the common terms out there are accredited investor or qualified purchaser. And I won't get into the nitty gritty, but essentially what those two terms mean are some sort of minimum income level, sophistication, net worth, or a combination of those three items to qualify you as one of those definitions. And if you fall into one of those definitions, you can then participate in the private market world or realm of things.
Justin Dyer (11:29): Taking it a step further with how we think about it, we talk a ton about, hey, priority driven investing. Everything should come back to your unique priorities. This conversation is no different when it comes to private market investing. In fact, it's even more important you could argue, because of some of the trade offs that exist with private investing. We're talking about some amazing things here, like private investing venture capital sounds phenomenal, higher expected returns, interesting access to cool companies that you hear about in the news, et cetera, et cetera, et cetera.
Justin Dyer (12:05): But there are trade offs. These are very long term investments. Brandon, you mentioned liquidity. The flip upside of that is illiquidity which, like you were alluding to, means it's difficult to get your money out of some of these investments. And if you're investing in a fund, which is a great way to do that because you get some diversification benefits and you're spreading your bets across a number of different startup companies, because you look at the statistics, most startups fail a significant amount of startups fail, so doing it through a fund makes sense. But guess what? You're locking your money up for minimum five years, if not 10 years, in some cases. Hopefully it's somewhere in that range, but you need to go into it with this expectation that you're not going to realize any sort of return on your money for quite some time. Maybe there's going to be markups along the way, but you're not going to actually get your cash back for quite some time.
Justin Dyer (13:06): As a result of that, you need to make sure your important priorities, your essential spending, is really, really, really buttoned down in order to start to allocate to the private markets. Liquidity is incredibly important. And so many people talk about that as a risk factor when they participate in the private markets. And in my opinion, it's thinking about it the wrong way, or they're going about portfolio construction, the wrong way. If you are thoughtfully constructing a portfolio, looking at someone's priorities, making sure that they are really, really, really allocated to solve for quite well, then you start to allocate to risk assets. The first bucket of risk assets, if you will, or risky assets, is public equity because there's liquidity. There still is a very nice, expected, positive rate of return over there.
Justin Dyer (14:01): And then we can start to spill over into the private markets as you meet this kind of portfolio hierarchy of needs. I use the term somewhat internally, not sure if I've used it on the podcast, but there's, Maslow's hierarchy of needs with just humans, if you're familiar with that term. The same thing should be thought about when you're thinking about investing. At the very top of that hierarchy or that pyramid of portfolio construction lives the private market space and venture capital specifically. And so not until your portfolio meets these priorities of needs do you start to invest in the private markets. I think that's really, really important to keep in mind.
Brandon Averill (14:43): Yeah, I think that's a great way to frame it, Justin, because I think at the end of the day, what we see so often, and we've seen this with clients, we've seen this with prospects that we've talked to, is if you focus on the priorities, everybody is so different, and that's okay. That customizes it to you and it also sets things up. If your priorities state that... You could have two exact same clients for instance, or two exact same people that let's say you've got $15 million of net worth. On paper, you pass the accreditor, you pass the qualified purchaser test. On paper, you should be a private market investor, theoretically, other factors kind of simplified.
Brandon Averill (15:26): But if we take a look and you've got one of these people or one of these families, that $15 million might not be coming for a few years, they signed a longer term contract, the money's not come in yet. Maybe they only have $3 or $4 million to actually be investing, but the kicker is they spend $1 million dollars a year. These people shouldn't be anywhere near private equity or private assets. Yet, they probably get pitched all the time. You've got the big groups that are coming in and they might say, oh, $15 million, you're on a long term contract. You should have private investments in your portfolio. They know nothing about your situation. It's a completely irresponsible comment to actually make, because they might not realize that you spend $1 million dollars a year. Now, if you had different priorities, you lived a more humble means, you have that $15 million and you spend $200,000 a year, now we start to see the priorities line up. And absolutely do private assets fit in your portfolio.
Brandon Averill (16:38): We just encourage everybody to really work with their advisors and be honest with themselves on what those priorities are because it's an exciting space. It gets pitched a lot, It can get sold pretty easily on paper. You can meet all the qualifications, but if your financial structure's not set up, this stuff also doesn't manifest itself for 10, 15 years. So you need to be focused on it and if you're not, you're you're kidding yourself.
Brandon Averill (17:08): This is a lot of fun, Justin. I think it's a great place to start. We're going to dig deeper into all this stuff over the next few weeks, get a little more granular on the private markets what the opportunities exist, how to start thinking about it and just expose to everybody a little bit more to what's going on in the private markets as well.
Brandon Averill (17:32): We're going to close out for today. So reminder, shoot me a text. We'd love to hear from you. That text comes directly to me. I'll respond back to you. We'll get you on a list, potential swag, all that good stuff. To get the text over to me. Shoot, shoot it to 602-704-5574. Throw insights in the text, little light bulb emoji. Would love to hear from you. Again, 602-704-5574. And thank you. Thanks for your attention. Until next time. Own your wealth, make an impact, and always be a pro.