Private Investments: Are They Really Worth It? | Travis Chick
Ironically, I could trace my desire to become a wealth advisor back to my early introduction into private investments. I very vividly remember sitting in a clubhouse in the middle of nowhere America listening to a teammate tell me about his dad’s buddy’s new oil and gas investment. What shocked me then (and still does now) is how many of my teammates were captivated by the allure of huge returns, without digging into the nuts and bolts of how the return would actually be generated.
Over the last 6 months, I have had the opportunity to sit down and be “pitched” several private investments. Some have been extremely intriguing, some have been an automatic no, and others we are still kicking down the road for our clients.
Over the next few blogs, I will begin to unpack some of the due diligence we put into the recommendations we make when it comes to the exciting world of private investments.
First, I want to stress how we view the investment world as a whole. On the public side (which everyone has access to), you and everyone else have access to the same information at the same time, which makes the market very efficient, and also very difficult to consistently outperform. Often investors rationalize their simplistic approach to the public investments with purchasing an S&P 500 ETF or Mutual Fund as their sole investment because “you can’t beat the market.” But this clearly is the Warren Buffet model - BUY and HOLD - and its never the exciting investment. And to circle back, having a globally diversified portfolio is generally the best way to invest your money with a predictable return over long periods of time.
The opposite investments come on the private side. This is the “exciting” side of investments as the allure of experiencing outsized returns is always there. It is very common to hear about investors doubling their money in very short periods, or even more. So why shouldn’t people invest more on the private side?
First, not all private investments are the same. One of the first things you will experience when being introduced to a new private investment is “the potential.” The potential yield, the potential return, the potential opportunity to roll into future investment. All of this sounds great, especially because often you will hear those potential opportunities being proposed as larger than if you “just invested” in the average S&P 500 index fund or stock. What is often overlooked here though, and I can’t emphasize enough, is the word POTENTIAL. We are conditioned to try to overcome and outperform. When I sat in clubhouses with my teammates, we didn’t talk about the bad/boring investments we had made, we only “bragged” about the best ones. And considering the time we had together, the best ones never had the time to take advantage of compounding returns over long periods. This inevitably left us talking about how the oil and gas deal had done recently, or the investment in rodeo bulls, or … or… or…
What was notably left out of the conversation was the fees associated with the investment, or how the investment would be taxed, or the lockup period and how it impacted liquidity, or the risk associated with the potential return that was emphasized or how the investment tied into our long-term financial plan. This is where I will begin unpacking private investments.
FEES
Studies show that the biggest impact to the return in private investments is fees. There are often multiple layers of fees that go into each investment that you should ask about prior to entering the investment. Often, one of the biggest internal costs associated with private investments is what is called the “promote.” This word is just industry jargon to explain the disproportionate share of profits in the deal above a predetermined return threshold that should be highlighted in the original pro forma or business plan. It can easily be justified due to the heavy lifting they do to generate the return for all investors. Often, this upfront fee is as high as 10% - 15%. One of the back-end costs of these private investments is what is called a “distribution waterfall.” This could be explained as the following:
The first 100% of the return would go to all members pro-rata until each investor has received a pre-determined preferred return and its unrecovered capital contribution.
The next 75% of the return would go to each member until reaching a second pre-determined IRR (internal rate of return), with the remaining 25% to be distributed to the General Partners
Finally, it is typical for any remaining net cash to be distributed 60% to the members and 40% to the General Partner.
You may be seeing a trend that the GP is highly incentivized to maximize the potential return, which is what you want when you hire someone. However, when you make an investment, you have to go into it with an expected return. Under the above payout, if looking at it from a pure investor vs. sponsor split, the investor receives only 54% of the profits above a 20% IRR (not considering the upfront promote).
There are often management/internal costs that are passed along to the investor for accounting and management. I have seen these as high as 3% - 4% annually of your initial investment.
Lastly, the “cost” that is most overlooked is the taxation of this investment. Typically, it is very difficult to source these deals in tax-free or tax-deferred accounts. Because of this, after the initial return of capital, the taxation of these investments often erodes what is left from the investment after the other costs dramatically. Often, these investments (especially real estate) are viewed as a “mail-box money” type of investment that is intended to generate current/future income. The issue with this is simple; to gain access to these types of investments, you typically are what is considered a qualified investor and find yourself in the upper part of the tax bracket.
Questions to ask when considering cost.
What is the promote?
What are the back-end costs?
What is the expected return?
Is this a yield play or capital appreciation play? Or both?
Will I be required to file an extension due to the tax reporting?
LIQUIDITY
When we talk to our clients about investments, one of the very first planning topics we focus on is centered around current liquidity. We want to make sure that if COVID happens again and the world shuts down, then lifestyle is not impacted in a dramatic way for at least two years. If our clients have this safety net covered, we then can move on to long term investments. With private investments, they are often considered very illiquid. And they have to be in order to generate the type of return they promote. Where this becomes a problem is if you don’t fully understand the liquidity of the investment. Often, there are periods called hard lock-ups that can last several years, which means you literally have no access to the money you contributed. After that, there may be quarterly, semi-annual or annual liquidity options for which you might get access to your money (if you needed it), but often there are costs to pull your money out. The investment period can be as little as 5-7 years and as many as 10-12 years. When entering the investment, you need to fully understand the investment period, as well as the liquidity of the investment, just in case you would want or need access to your money.
RISK
Risk is both one of the easiest and hardest things to break down when considering private investments. This is primarily due to the lack of transparency required to be disclosed. Often, the secret sauce in generating returns is the access to information that nobody else has. If you are investing in a specific publicly traded stock, you and I and everyone else have all the same access to the same information at the exact same time. This allows us all to take real reported numbers and have an expected return and calculate the standard deviation (risk) and how it correlates to the rest of my investments. This is nearly impossible on the private side because the majority of what would be on the pro-forma is forward looking rather than reported numbers.
This leaves the investor two options: 1) Rely on the sponsor to produce reports with enough transparency to give you (the investor) full confidence that the investment fits your desired investment; or 2) do your own due diligence on the investment to give you the confidence that the exciting return that has been promoted might actually come to fruition.
This is where I strongly urge you to seek outside qualified experts to offer guidance on the investment and how it can impact your personal situation.
LONG-TERM PLANNING
At AWM, we are strong believers in taking advantage of the higher returns that private investments can generate. But only if it completely fits into the long-term financial plan of our clients. As I stated earlier, we first want to ensure plenty of liquidity. Once we are comfortable that the desired outcomes of our clients have been satisfied with the least amount of risk, we can then move on to allocating money to private investments. Academic research shows that the highest and most persistent return comes from Venture Capital. There are a few reasons for this, but primarily it’s because of the costs associated with the other types of unregulated investments. Unfortunately, gaining access to the best VC funds is extremely difficult. And frankly, you don’t want to invest in anything less than the best of the best VC Funds. Luckily, because of our relationships, we have that access.
The fun part of that access is that we get to invite our clients to Silicon Valley to meet the people making these investments in some of the most famous start-ups you have all heard of. They have even taken our clients and toured them through CES in Vegas. This is all part of the planning process. Often, we find that the greatest driver of wealth is our clients own Human Capital, or their ability to earn income. This can come from a baseball field, an operating room, a board room or, in a COVID world, a converted office that was once a bedroom or closet.
These types of tours have excited our clients’ internal quest to learn, grow and take ownership of their financial experience. And for us, it has allowed for deeper and more profound conversations to create truly comprehensive financial plans.
We all want access to the best investments. Sometimes we even believe we have access to the best because our friends or family told us about it “first.” But do you really have access to the best? Do you really want access to the best? If so, we should talk.
