We don’t feel like this post needs to go up but we have been asked about the topic numerous times and stated we would cover the topic as part of a series. Most people, including those with a relatively high net worth ($1-2 million), have no reason to dabble in such ventures. With that backdrop, we would not recommend any of the following ideas to your typical reader but below is an outline, by increasing risk tolerance.
Single Security: We assume you already have a large portfolio, it is growing (no matter what the doom prophets say – they have been wrong the last 3 years) and you have excess cash on the sidelines that you would like to use to invest into a single security.
“Diversification is protection against ignorance, it makes little sense for those who know what they’re doing.” – Warren Buffet
If you have niche knowledge perhaps you can obtain a medium sized position in a single security. Be prepared to watch that sucker go to zero.
Assuming you are prepared to watch the entire value go to zero then we would recommend the following bare minimum requirements.
1) You can build and understand a three statement financial model (should be easily understood). If you can’t… you don’t deserve to buy a single stock since it takes at maximum three months to understand a financial model.
2) You have read at least three equity research reports on the Company. Do not let equity research analysts determine your stock purchases but the reports give you a high level view of what is driving the stock. Get a negative analyst, a neutral analyst and a positive analyst if possible. If you can’t even obtain access to research… Again you don’t deserve to buy the stock
3) Understand the management team. You should know who is leading the Company what their strategy is and how they intend to grow the business. If they have a history of success… We know the general rule is that success begets success
Simply put, if you can’t do these three simple tasks, you don’t understand the stock at all and simply got lucky if it goes up. It is always better to be lucky than smart, but don’t bank on it.
We provided a rudimentary example of understanding a security with an overview of Facebook.
Leveraged Portfolio: Here we are getting into much more dangerous territory. Leverage cuts both ways, meaning you’ll see your value go to zero quickly if you are wrong. Leveraged portfolios include Margin Accounts, Real Estate and of course options (100x leverage).
What is the difference between leverage and single ownership? Timing.
In either case when you lever up to purchase an asset you are saying that the bottom is here. Unlike an unlevered purchase where you’re assuming you’re relatively close to the bottom you cannot take a large hit to your bottom line. If the asset drops 50% you’re down 100%. You’re at zero. Even worse? You could be under water if it had 3x+ leverage.
So why would you lever up? You are practically certain that there is near term upside. You need to be extremely confident. Confidence at the 50% level is simply not going to cut it.
1) Margin Account: This is the same as a single security with the added pressure of timing (and of course the rate on the margin).
2) Housing: Higher leverage. Usually 5:1 if you’re trying to keep your interest rate low and we have recommend a rough 3x Cap Rate/Interest Rate for safety
3) Options: Extremely high leverage and extremely precise timing. We don’t like using the work extreme in a back to back fashion but it is important here. Options are significantly more dangerous than a margin account due to timing and the leverage ratio. If you are certain? Well this is your best bet.
Silent Investor: Assuming you’re trying to tie up a larger amount of capital (6 figures plus) you can begin looking into equity or debt stakes in a wide variety of options: Real Estate, Companies, Rebuilding Projects, Commercial Projects (restaurants, malls, etc.) and others. Most importantly? You’re handing over the keys to an established professional.
Why would you do this? You are establishing trust with a new high level contact and you expect higher than average long-term returns that you won’t need access to for 5+ years. Anyone who is well off knows the best way to make good friends is by making money together. Money can be thicker than blood.
While we recommend having liquidity and managing your own money you eventually reach a certain level of net worth where most wealthy people begin locking up cash. They lock up a portion of their cash to prevent emotional sales and they expand their network by investing with a high end professional and at the same time they learn about a new business.
So how do you go about private investing?
1) Find the right driver. Repeat this over and over again. Find the right driver. When you go into a silent investment you have no say in the operations so you need to be certain that you trust the individual who will be running the project.
2) Only invest an amount you wont touch for 5+ years. Generally silent investments last anywhere from 3-5 years (some are large in scale and can last for a decade or longer). If you’re new to silent investments there is no reason to go big, shave off a percentage you’re willing to never see again and stick with a project with a 3-5 year turnaround.
3) Don’t be a nuisance. Most people will constantly email asking for updates 24/7/365. Let the other investors do this for you since you will be given access to a data room where updates are posted anyway. Literally become a silent investor. Why? When a new project comes up you’ll be first in line for investing since you have not annoyed the driver. If he is good… well you now have first dibs.
4) Make sure they have skin in the game. Depending on the investment type, you will be given a percentage of the initial profits (preferred) and there should be a water mark where the Company will obtain a profit if they outperform. In addition, you want the driver to be responsible for the sale of the asset where he/she will only be paid with excess returns.
Private Equity: Not to be confused with private investing as stated above. Here you’re looking to make a 20%+ returns… you are playing with serious debt. You are purchasing an entire asset with a large amount of debt. If you want to take a look at the most recent blockbuster deal look no further than the Leveraged Buyout of DELL.
Who is well positioned to invest in such transactions? As we stated in this post… money begets money… a person with experience in private equity or a person who has helped structure pitch and sell multiple LBO transactions. In addition, if you are extremely fortunate you may join a Private Equity group where you can participate in some of the transactions (don’t get your hopes up too high if you are an entry level hire).
This is likely old news for many that actually work on the Street but here are the basics for an LBO
1) The exit strategy is actually the most commonly failed part of a case study/interview. If you have no exit strategy the LBO is entirely worthless. When you flip the Company you’re looking to either take it public (for the first time or again) or sell it. If the Company is going to get an unattractive valuation during an IPO process and there are no logical buyers, you’ve simply made a bad decision
2) Rate of return, for the Wall Street folk we know there is no reason to ever take on an LBO with a 10% return because you may as well invest in the S&P 500. 20%+ is a napkin calculation, it can be lower but it is a good number to have in your head.
3) Synergy: If your firm cannot add revenue synergies or quickly adjust the cost side then you will be hard pressed to fix the Company. This is an obvious one.
4) Debt Structure: Ideally you will have a simple debt structure with minimal tranches all at low rates. This will never happen.
Venture Capital and Angel Investing: This is the last item on our list. The Mecca of high risk. If you have any interest in the field begin reading up on Marc Andreessen and Ben Horowitz.
Here you are assuming again that your investment is going to zero and your best bet is to create a team. You need to have a large rolodex of venture capitalists who can keep your pulse on the latest and greatest companies looking for funding. If you’re not plugged in we would recommend wiping venture capital off the list.
We are working under the assumption that you will be attempting such an investment from an individual basis which means you’re locked into extremely high risk angel investing. You are going to spend around $25-100K (minimum) and put it all into the hands of a single high risk start up.
We would outline basic steps to doing this successfully but unfortunately these projects take many years. While it is fun to have some skin in the game on maybe 1 or 2 companies in your life time, it is certainly not for the faint of heart. Again we recommend reading up on successful venture capital companies such as Accel Partners and Andreessen Horowitz.
Concluding Remarks: We repeat, we would not recommend any of these options for the average person or average reader. We wouldn’t even recommend these options to an intelligent reader. We are simply outlining various high risk investments. To sum up the level of risk you can think about it in terms of 1) timing, 2) leverage, 3) control and 4) liquidity.
Single security: Minimal timing, no leverage, some control and liquid
Margin: Needed timing, 2x+ leverage, some control and liquid
Housing: Some timing, 5x+ leverage, some control and illiquid
Options: Excellent timing, 100x leverage, no control and liquid
Silent Investor: Some timing, generally some leverage, no control and illiquid
Private equity: Timing, leveraged, next to no control and illiquid
Angel Funding: Timing, no leverage, no control and illiquid
