How to Participate in the Private Markets | AWM Insights #107

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Episode Summary

Last week, Brandon and Justin answered the question “Should I Own Private Investments?” In that episode, they gave a framework to consider before an investor jumps into the private markets. This week we continue our private markets series by answering the question of How to participate in the private markets.

Private equity consists of all the companies that are not publicly traded. These companies are too new or too small to trade in the stock market. Private debt is just the bond equivalent in the private world. It is a very broad world of investing and carries different sources of risk but the potential for higher returns.

Venture capital is one subsection of private equity and focuses on early-stage companies that are looking to change the world with new technology, ideas, or business models.

Private equity can be mature companies that are bought to improve efficiency, operations, and financial structure. These companies can even be publicly traded, then bought out, and taken private. We’re seeing this in the news now as Twitter has apparently accepted Elon Musk’s bid to buy it.

Private real estate is another massive area of private investing. These private real estate deals can be used to produce income, capital appreciation, or a mixture of both. The key is to know the tax implications and do the tax planning ahead of time. 

Private investments are an area a capable team can add significant value by providing the resources and the analysis necessary to do it well, but what are the areas you should be aware of before you jump in? Join Brandon and Justin in this week’s episode as they discuss.

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Episode Highlights

  • (1:20) Venture Capital is one subsection of private equity that has been rewarding for investors in the past. The highest historical returns have existed in early-stage venture capital.

  • (2:30) Venture investing is simplified as becoming an owner in startup companies. These companies are disruptors and you’re backing new ideas or business models.

  • (2:55) Different Stages of raising money: angel, pre-seed, bridge, series a, b, c, d. These rounds line up with the maturity of the company.

  • (3:50) These companies need fresh capital because in the early stages they are not usually profitable. Once the business matures, they normally look to exit in a liquidity event. Possibly an IPO or an acquirer.

  • (4:00) Private debt is another area of private investing. Rather than sell equity in their company, the company can take on debt to finance their operations.

  • (5:20) Twitter is a good example of a company that is publicly traded but could be purchased by Elon Musk and taken private.

  • (7:18) Private equity usually buys mature companies, takes on debt, and tries to improve operations and financial structure of the company.

  • (8:40) 40% of publicly traded companies have been venture backed since 1980, and over 50% since 2000.

  • (9:40) Private real estate is massive and is more than just the shows on TV that usually involve flipping residential housing.

  • (10:10) Residential real estate investing returns are not very good because of the amount of competition. The juice isn’t worth the squeeze here.

  • (10:26) Better areas of real estate investing can be found in multi-family, commercial, and industrial. These areas better compensate investors in the long-term.

  • (11:15) Various stages of these markets exist. Value-add, income producing, farmland, and developmental land all have different intricacies.

  • (12:25) Understanding tax impacts of different real estate investments is crucial. Income producing properties will be taxable at ordinary income rates so normally won’t make sense for those in the top tax brackets.

  • (14:05) In private markets, you must do all the due diligence yourself. It’s an uphill battle and takes time and experience to become proficient.

  • (14:45) If you don’t have an advisory team that can do the analysis of these private deals be very cautious. You will have to do the due diligence of reading through the reports, requesting data room access, and making the call on whether the potential reward is worth the risk.

  • (15:20) For those that have built a strong financial structure, private investments can be a good place to take compensated risks for the potentially higher expected returns.

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Justin Dyer: LinkedIn
Brandon Averill: LinkedIn

+ Read the Transcript

Brandon Averill (00:03): Well, Justin, welcome back. We're splitting up in offices again. We got a little teaser when we come to you next week. Hopefully we can figure out, a bunch of finance guys figuring out a sound board and some lighting, but not to digress, last week we jumped in, we talked about the private markets a little bit. Really hit on when private markets become available or should become available to you, as the investor and why you should actually be interested and why you would want to participate. So, kind of laying that foundation, we wanted to get in and start talking a little bit more tangibly about, okay, we talked about the private markets extremely broadly. Let's start to define a little bit, some different ways that you could actually participate in the private markets and we'll start high level here today and then in the coming weeks, I think, we're going to try to take some deep dives into these different sections, but for today Justin, why don't we just start to define, if you don't mind, what are the different areas that we can participate in the private markets?

Justin Dyer (01:10): Yeah, I'll jump right into it and like you said, we'll build on this in the coming weeks and try not to nerd out too much, but let's start with venture. I think we focused a lot on that in the first conversation we had and that is a favorable part of the private markets that we have. Just as a refresher, the reason being there that the highest expected returns or the highest proven returns have been there and the highest expected returns going forward still largely exist in the venture capital space. So, let's define it. Venture capital, really quite simply, it's a subset of private equity. Private markets, let's start high, high, high level, private markets we've defined that. These are non-publicly traded entities, securities, companies, et cetera, et cetera. Private equity is the equity side of the balance sheet.

Justin Dyer (02:03): Meaning you actually have an ownership stake in a company. Private debt, on the other hand is exactly what it says that you own debt on a privately backed company or privately held company. Venture is a further subset, like I said, where really what's going on there, you could think about it, you're taking an adventure in a sense and really, really backing new ideas, backing unproven ideas, new business models where they're trying to disrupt potentially an existing market or an existing industry or create a new one essentially from scratch based on some new technology, some new idea, et cetera, et cetera. Within venture you'll hear all sorts of or you've heard, you may be familiar with the different stages of raising capital. So there's angel investing, there's pre-seed, there's bridge round, seed round, Series A, B, C, D E, et cetera, et cetera.

Justin Dyer (03:06): The simplest way to think about that is those line up with the maturation of a company. Not all companies have every single one of those funding rounds, but essentially they line up with the maturation of the company and when a company's starting, they're going to be on the earlier stage so pre-seed, maybe they have some angel investors to help them get started or they just went directly to a seed round. The later, more mature companies maybe they have a proven business model, slightly profitable or a very realistic close time frame to get profitable. They're going to be raising something like a Series D, Series C, D, E et cetera type round of financing to hopefully bridge that gap, to get them to some sort of liquidity event, an IPO, maybe it's an acquisition from an existing player, et cetera, et cetera. So, that's private equity. Brandon, you want to go into the debt side of things a little bit.

Brandon Averill (04:02): Yeah, I think. So the debt side, probably a little less common. You see a lot of later stage private debt. You think about this like we have a lot of athletes and unfortunately that predatory, kind of hard money lending is a good way to think about it. You'll have private debt where you have a private company and maybe they can't access the big bank market and so there'll be opportunities to actually lend money on this side. It could show up on in real estate, it could show up for a company, but it also shows up in venture.

Brandon Averill (04:37): So what you just talked about, Justin, you have a company that's just starting up. A lot of times or sometimes you will actually have a venture debt firm partner up with a venture capital firm. The venture capital firm's buying equity so ownership in that company, whereas the venture debt firm is typically coming in and lending money to that company and there's something typically attached to that, including, called warrants. We'll get into that in the future, but at a very high level it's going into those private companies and lending money to them.

Justin Dyer (05:10): And maybe it's a good time to put some actual tangible examples here. There's a big topic in the news right now with Twitter and Elon Musk trying to take Twitter private and that private term that you're seeing in the news is exactly what we're talking about here. Essentially, Twitter, let's go through the life cycle, Twitter was a venture backed company early on. It grew, it matured. The owners of Twitter decided to take it public, to take some chips off the table. There's benefit, pros and cons to going public which we can potentially talk about maybe at the end of this whole series. But essentially, Twitter started as a venture company, went public. Now Elon Musk is making a bid to take it private. It's not the traditional private equity side of it.

Justin Dyer (05:59): So again, private venture being a subset of private equity. Private equity just being a private party or a set of private parties owning a company as opposed to it being listed on the public stock exchanges. So this Elon Musk bid is not necessarily the traditional. It's not a big private equity group that's coming in to try and take Twitter public. It's essentially a single guy. Now, in all reality, he's got a lot of financial backing. It seems like he's still trying to put together his whole financing package, but he's got some big banks that are coming to the table to give him some loans and he needs to come up with the equity side. So a big difference between venture and private equity, in the traditional sense, is I'd go back to this stage definition, the stage analogy, the life cycle, the maturity of the company. Twitter is a mature, publicly traded company.

Justin Dyer (06:51): It has profitability and what Elon Musk is trying to do is trying to improve the overall makeup, the overall financial situation of Twitter, through a combination of things. His pure raw brains and brawn, if you will, but also traditionally and this will be yet to be seen of Twitter is a perfect example of this, what private equity traditionally does as well is put debt on the books of the company and try and through some sort of financial engineering or financial leverage improve their potential returns from that transaction.

Justin Dyer (07:33): I know that's a little into the weeds there, but it's a big difference between venture and private equity venture. Again, new idea, new market, new company, new business model, trying to disrupt things whereas private equity is probably generally taking a more mature business model, in an existing industry that can be improved, efficiencies can be brought to the table, whether that just be through financial structure, bringing debt on or through rebuilding the operations from scratch, essentially. So hopefully that's the private equity side. Maybe we get into the real estate side now or if you have anything else to say private equity.

Brandon Averill (08:11): Yeah. One quick thing is just, I think it's really great to think about the different, the maturation of the company, but just to be clear that doesn't always mean size. So, venture backed companies typically, you are investing in an idea, you're investing in something that is going to grow big. That's the idea. In fact, I looked it up before the podcast, but there's a paper that Jay Ritter at the University of Florida wrote and it's 40% of publicly traded companies, since 1980 have actually been venture backed and since 2000 more than 50%. So you're investing early and you're hoping for a big outsize return, whereas on the private equity side, that could be the case.

Brandon Averill (08:56): They could be multi-billion dollar companies, but it also could be the regional hardware store that's been in business for 75 years, maybe family run and a private equity group may come in and see those efficiencies Justin, you talked about. Maybe they can improve operations, logistics, supply chain, et cetera. Maybe they're looking at it and maybe it's a $20 million revenue company and they're going to invest five, 10 million dollars and operationalize it. So, just to be clear, it's not always the size of the company, but that is a more mature business model as you were pointing out there Justin.

Justin Dyer (09:35): Yeah.

Brandon Averill (09:37): Yeah. So, and then moving on to real estate. I think a lot of people think about real estate in the private sense. There is a public side of real estate as well that I think often gets ignored, but real estate, the world is massive on the private side. You've got what a lot of people, again, I think, think of when they think of private real estate, those single family homes, a fix and flip, we're going to buy 20 homes and rent them out. When we talk to our clients, unfortunately the evidence shows that's just not typically the most successful way to go about private real estate investing is juice just really isn't worth the squeeze and you're competing against a lot of people, but then as you start to move on from there it's multifamily.

Brandon Averill (10:24): So apartment, complexes and these could be any size. It could be a five unit building up to several hundred units just depending on where you're at and price standpoint. Then you've got commercial. So think about your strip malls, your big Kmart. Is Kmart even still around? I'm dating myself, but Kmart Shopping Center. I don't know why I think about that-

Justin Dyer (10:49): That was Walmart.

Brandon Averill (10:49): Yeah, Walmart. Then you've got your more industrial so things like Amazon warehouses, et cetera. All ways to participate in the private markets and I'm only touching the surface there, but I'm sure Justin, you could probably take us a little further.

Justin Dyer (11:06): Yeah. The real estate market truly is vast, vast, vast and there's also different stages within that, this part of the market as well. So, we're touching the surface on various types, whether it's commercial, residential, industrial, et cetera, et cetera, but you can also think about it as similar to venture in a sense, the stage of that asset. Maybe it's just a hole in the ground or maybe it's just a piece of raw land and it needs to be developed. Maybe it's also, it can potentially be farmland. We didn't even touch on that as a part of a sub, even further subset within real estate, which is an interesting one as well, but just briefly on the stages and there's different things to think about with respect to the stage. So, raw land or developable land.

Justin Dyer (11:58): That's attractive from a purely capital, pure capital appreciation standpoint. It's, you're likely going to buy the land, develop, build a building, build a multifamily, whatever it is, maybe it's a commercial building and then likely sell it to somebody who is looking for a more income oriented real estate asset. So the development is more of a capital appreciation. You put money into it and then hopefully sell it for more than you put into it. And that's a capital gain type situation versus a more stabilized asset that is, maybe it's an office tower, an office building that is whatever, 90% occupied, something like that, just kicking off nice recurring income from the tenants. That could be what all an investor wants. They don't care so much about the capital appreciation side. They're making an investment for income.

Justin Dyer (12:50): Just quick teaser. One reason why we generally don't go after pure income plays with real estate is that, that income is also taxed at your ordinary income rates and so if you're in the highest tax bracket, which most of our clients are, you're giving up a decent amount of your return if a lot of it's coming from the income side of the appreciation equation. So a little teaser there, we'll get into that more and more, but then there's also, hey, you can buy a building that needs some improvements. It's already been built, but it's been run down, poorly managed or it's in a up and coming part of a city or town or whatever the case may be and then there's somewhat of a combination play there where you're buying it and you're going to add through improvements, but you also have some sort of income, current income to offset it. So real high level, those are just ways to think about real estate in terms of stages and whether may or may not be good fit given certain client profiles and goals.

Brandon Averill (13:50): Oh, I think that's great, Justin. I think one last thing to mention before we close out today is, and we're going to take a deep dive here, but the big difference here too, in the private markets is the onus on you to do the due diligence. I think that's a key point. The public markets information's efficient, it's available to everybody. There's tons of regulation and so it's a little bit easier. You can offload a lot of that to other people in the private markets. I think it's good to note, a lot of the work is on you and your advisors. If your advisor's not willing to dig in with you, that potentially you're up against a uphill battle in the private markets and so you have to really dig in and understand this stuff.

Brandon Averill (14:42): If you're being approached with a private real estate deal or a private equity or a venture deal and you don't have an advisory team that's digging into it and you're not willing to read through the reports, request the data room, really try to understand it all, none of this stuff is very simple. So we just throw out a word of caution and hopefully over the next few weeks we're giving you some tools to be able to do the due diligence on these projects and participate if your financial structure allows for it because as we said, is the place that you have the highest expected returns and so if you've done a good job putting your financial structure in place, this is a place that you should want to participate potentially, but it's ripe with risk as well. We look forward to hopefully guiding you through the next few weeks.

Brandon Averill (15:38): We're going to dig into venture capital first. Really frame that for you. How are the different ways you could participate? What are the things you need to ask? All that good stuff and it's something we're passionate about so we hope you enjoy taking this journey with us. If you have any upfront questions, by all means, shoot me a text. As you guys know that text comes directly to me. The phone number is (602) 704-5574. You could throw insights in that initial message or the little light bulb emoji. Throw me your question. We'll get to it on the podcast. We would love to answer your questions directly. Again, that number is (602) 704-5574 and until next time, own your wealth, make an impact and always be a pro.