Part IV in my series on adding value through active management envisions a world where advisors are vetting a growing number of nontraditional investments for their clients.
If you were to look at 80% of Craig Martin’s client portfolios, they would be conventional and even a little boring. “Our core portfolios are invested in six passively-managed DFA funds, with an equity allocation of 60% foreign, 40% domestic,” says Martin, CEO and founder of The Family Wealth Consulting Group in San Jose, CA. “I should probably shift those allocations slightly,” he adds. “At the time we created it, the U.S. was 40% of the global market cap, but it has dropped somewhat recently.”
Wealth Consulting Group’s 140 clients have aggregate assets of $100 million, and this rather bland portfolio allocation accounts for about 89% of their investments. But 50 of Martin’s clients have invested a total of $11 million, in various percentages, in more interesting investments that include 12 managed futures and options trading funds; seven alternative income funds that include baskets of loans made to small business entities and collateralized debt; seven direct real estate investments including apartment buildings for workers in the new fracking oil fields in Williston, ND; plus 21 angel investments in non-publicly-traded startups.
What’s the point of adding all this complexity to client allocations? “Stock markets are increasingly efficient,” Martin explains. “Should I spend my time looking for somebody who can buy stocks and time the trades better than somebody else?” he asks rhetorically. “Or should I look for somebody in the alternative space who has a proven track record of outperforming their risk-adjusted benchmark by 2-3X? My answer to that,” Martin adds, “is, flat out, we are just going to buy the efficient market, allocate for risk and hold on, and meanwhile I’m going to go out there and search the alternative market like crazy.”
Diversification and capturing inefficiencies
The umbrella investing vehicle for all of these deeply-outside-the-box investments is a five-year-old invention called the Opportunity Fund: a 1940 Act 3©-1 fund structure which is typically used to create hub-and-spoke mutual funds with different share classes. “The fund allows me to put in 99 slots, so each client can customize their own portfolio,” Martin explains. “They get to choose which investments, how much and when. Everybody who is invested in the Opportunity Fund has a different portfolio.”
Beyond the opportunity to earn higher returns in inefficient corners of the investment opportunity set, Martin recommends that his clients consider some or all of these investments for diversification purposes. “During periods of high price volatility, marketable securities tend to go to a one-to-one correlation,” he says, “which eliminates their risk management potential right when you want it most.”
By adding a lot of small illiquid investments, Martin argues, an investor can attack the sequence-of-returns risk that drives a retiree’s safe withdrawal rate from the average return of the portfolio down to something less than half the average return.
“The S&P 500 can only sustain a 4% payout with any level of certainty, based on a lot of research, starting with [William] Bengen,” Martin says, adding that the most recent research might lead you to be even less optimistic. “A lower-volatility portfolio can pay out something much closer to 100% of the average return, because you aren’t getting the same losses in a bear market.”
Won’t liquid alternative funds accomplish the same thing with a lot less work? “Liquid alts are marketable securities on the public stock market,” Martin explains. “During periods of extreme market movement, either up or down, they’ll do what all publicly-traded securities do: approach that 1:1 correlation. If interest rates go up, and stocks go down and bonds lose value, my alternative income funds don’t change.” he adds. “That feels real good to clients.”
Of course, with such a broad array of potentially volatile investment programs, investors experience much more upside and downside than they would with mutual funds – leading to some interesting client communication issues.
“I met with the client last week, and we went over three pages of reports from my accountant,” says Martin. “He said, what’s the best one?
“I said, the best liquidations we’re getting are from a couple of real estate deals are averaging 25% to 35% IRRs.”
“Then he said, what is the worst one?” Martin continues. “I said, this one that just went bankrupt in November.”
Futures and income
Exactly what kind of investments are we talking about here? The four different categories are each handled somewhat differently, and are designed to not only provide asset-class diversification, but a great deal of manager diversification as well. “I would argue that as a diversified portfolio, the Opportunity Fund has less risk than bonds,” says Martin. “If we buy enough investments over a long enough period of time, the law of large numbers says we are going to approach the expected returns of those investments – which are all way above index returns.”
Start with the 12 managed futures and options funds, which come as a package – meaning that, unlike the other categories, Martin’s investors must participate in all of them or none. “I work with an introducing broker called Novus, located in East Bay [SF area], run by Don Davis,” says Martin. “Don is a Commodity Trade Advisor who runs his own precious metals fund, which happens to be the number one performer in the field over the past five years.”
Together, Martin and Davis look for managers who have good track records and also very little connection with the traditional investment markets. “I only select people who are trading precious metals, currencies, live animals and commodities,” Martin explains. “There is no stock or bond influence in my managed futures fund.” In aggregate, their composite track records would imply an expected return of 14% a year.
Next: the conservative income funds, which investors can invest in a la carte. This list includes Prime Meridian and Prime Meridian Small Business Loan and Direct Lending, which invest in packages of loans from peer-to-peer lenders on the Internet. “The big banks basically got out of the lending business around 2008,” says Martin, “but these companies have been doing it for decades and have it worked out to a very low default rate.”
Prime Meridian’s loans, he says, are generating roughly 8% a year with little volatility, while the small business operation can charge a bit more, in the 10% range. Another program in the fund, called Direct Lending, is a competitor in the small business loan market, lending to firms with a lower credit rating and, therefore, making loans at a higher rate. “They’re getting 12% instead of 10%,” says Martin, adding: “the small business loans are running half a percent volatility, so you might get 9.5% or 12.5% in any one program in any one year.”
Among the other programs in this category, Seattle-based Pyatt Loans specializes in short-term lending to real estate developers who need the money to complete their projects. “There is typically a 60/40 loan to value ratio in these completion loans,” Martin explains. “If the existing property is worth $1 million, Pyatt will loan up to $600,000. The contractor uses the money to improve the property, build it, add improvements, and sell it within six months.” Returns, he says, range from 6% to 8% every six months. “Most of the borrowers at Pyatt are repeat customers,” Martin adds.
Another program, LYNK Capital in Winter Garden, FL, is a direct competitor to Pyatt. “They’re apparently able to charge more on the East Coast than on the West Coast,” says Martin; “so they’re paying 15%.”
A completion fund called Broadmark Real Estate Loan; another firm that lends to auto dealerships; and a program called Lease to Own complete the mix. “Lease to Own is our newest choice in this category,” says Martin. The basic concept is to allow people who can’t yet afford to buy a home to set up a lease-to-own contract that gets them into a home until they can qualify for their own loan – at which point they buy the property back at a fixed appreciation rate.”
Martin recommends that his clients replace some or all of their bond allocations with a broad mix of these conservative income funds. “If investors choose all of these, and equal-allocate,” he says, “I would argue that the risk of any one of them devastating your portfolio is slim.”
Then there are the direct real estate investments, most of them private, small, quirky and – so far – profitable. “With the real estate that has liquidated so far, the lowest real rate of return we’ve gotten is 15%,” says Martin. “The highest was a 65% IRR. I would guesstimate the average IRR from our real estate that has been liquidated is mid-20s.”
The list includes interests in properties purchased and maintained by Pacific West Real Estate, headquartered on Bainbridge Island, WA; single family homes purchased by Praxis Residential in Santa Rosa, CA; and rehabbing apartments purchased and sold by Interstate Equities Corporation in Los Altos, CA.
As you might imagine, not all of these real estate investments work out as envisioned. One of the most interesting stories is the Dakota Ridge Apartments, an investment put together by Granite Peak Partners in Santa Barbara, CA. “The general partner and I have known each other for 12 years, and I’ve done three or four of their deals,” says Martin. “The latest one, we are building 300 apartment units in Williston, North Dakota, near the Bakken oil fields, the fracking capital of the world. Two years ago, when oil was selling for $110 a barrel, they said to me, the only risk we have is if the price of oil goes below $50 a barrel,” Martin adds. “And guess what?”
Altogether, Martin says that his investors have $105,000 at (as he calls it) ”increasing risk” in Williston. “No client has more than $10,000 in there,” he adds. “I’m hearing that the fracking oil producers are reducing their costs to lift oil closer to $45 a barrel, but the area is still under depression. The first set of apartments are about 85% occupied, and we’ve started construction on the second half. But rents have gone down, and we aren’t making any money yet.”
Angel opportunities
By far the biggest boom-and-bust potential comes from the angel investing, private equity and venture capital investments that Martin is assembling. This also happens to be where his heart is; he’s a member of the Keiretsu Forum of angel investors, an organization with 1,250 members in 30 chapters across three continents, and he wrote version one of the organization’s due diligence handbook (The current version is titled “The Due Diligence Handbook,” with Martin listed as a contributor.)
“I’m looking at 20-30 pitches a month,” Martin says, although, he adds, “I will only perform in-depth due diligence on 3-5 a year. If I can’t say ‘no’ in the first five minutes, I am probably going to spend an hour with that CEO. But I say ‘no’ in the first five minutes quite often.”
In all, the Opportunity Fund has 21 different angel investments in companies in various startup stages, and Martin recommends that his clients put no more than 1% of their total portfolio into any single deal. The list includes a company that is working on a breakthrough technology body scanner for airports and other high-traffic public places; Innovative Asset Group, which is developing software that will allow large companies to research and manage portfolios of thousands of patents; a pharmaceutical development company called Respira Therapeutics that is working on a dry powder inhaler as a targeted delivery vehicle for drugs to treat lung disease; and a company that is building a hand-held ultrasound breast cancer detection device.
But you get a sense that this is a boom-or-bust investment opportunity from Martin’s recent disclosure to clients. At a time when there were only 18 programs in this category, 11 had been crossed out as either busted or deemed unworthy of further investment until their fortunes had changed.
To see the ups and downs of angel investing, consider two stories. The first is Aspen Air, which has been developing sophisticated air filters for large buildings and closed environments. “We invested $250,000 at a $4 million capital valuation,” says Martin. “In December, they collected $2 million in additional funding and the company went up to an $11 million valuation. There was a likelihood of a contract with the Google complex and Intel was coming in, and we estimated that company would be worth in the $30 to $50 million range, pretty conservatively.”
Today, Aspen Air is shut down. “Prior to us investing in the project, five years ago, the inventor took the filter to a qualified test lab and the test lab came back with phenomenal results. 99.1% effective down to .1 micron, truly significant,” says Martin. “This year, a new CEO came in, and the first thing he did was take the filter back to the lab and said, hey, test this for us again. It totally failed. He took it to a second lab and it failed again.”
On the other end of the spectrum, Martin has added to the Opportunity Fund a company called SafeH20, which licenses technology from Sandia Labs. “They’ve invented a safe water pathogen testing machine, about the size of a briefcase,” he explains. “Under the current system, water utilities require one to five days to test their water, depending on which bug you’re looking for. SafeH2O can do it in less than four hours, on-site, and send the results up to the cloud.”
The current prognosis? “When we made the original investment a year and a half ago, the company was valued at $2 million, and we gave him $130,000,” says Martin. “He was able to get a proof of concept and build his first alpha-one machine with that money, and created two centrifuge disks, which would detect a bug apiece. It’s basically a disk the size of your hand with a hole in the center, and when you spin it at very high speeds, there are beads inside that attach to the bugs, which are then counted.”
The company has gotten calls from the water treatment contractor with the state of New York, regarding the recent discovery of a number of water facilities infected with Legionella bacteria. “They want our disks by the first quarter,” says Martin. “So the company is looking for $400,000 to build a commercial Legionella disk, and that round is going out at a $6 million valuation. Based on our original $2 million valuation,” Martin adds, “we are getting a 3X up-round” – meaning the new investors are assuming, based on the price they’re paying for the stock, that the company’s value has tripled.
And then there are the roads not taken – the investments that Martin passed on, which in retrospect generated terrific returns.
“When I put together a whole bunch of real estate investments in 2010 and 2011, a couple of people were buying hundreds of homes and leasing them back to the previous owners,” says Martin. “I looked at it, and said: it’s not manageable. It’s too big. Each address costs too much to manage. Your properties are going to depreciate, and you won’t be able to manage that depreciation. When the tenant or lessor leaves, you’re going to end up with a depreciated property, and your whole portfolio will suffer. So I didn’t invest in it.”
The company went public in July of 2014 with a $170 million raise. “At the time, I thought my due diligence was very smart,” Martin admits, adding: “I’ve been humbled a few times along the way.”
Operational challenges
Venturing deeply into these nontraditional waters can be challenging operationally. Martin acknowledges that it can be especially tricky to create performance statements for the Opportunity Fund, and he’s wrestled with the question of the most ethical way to present quarterly returns. All the nontraditional assets are custodied at Millennium Trust Company, located in Oak Brook, IL – a recommendation from Schwab Institutional, which refused to offer custody through its own system. The accounting and performance reports are handled by Oakpoint Fund Services in Avon Lake, OH, which Martin says is a huge piece of the puzzle, because in the hub-and-spoke system, every single investor has a different mix of the investment options. “The CPA that runs the firm is intimate with our fund and helping us manage it,” he says. “We couldn’t do it without his help.”
The reports show income from the alternative income funds and monthly returns from the managed futures and options funds. But the real estate, angel and venture investing investments are reported at net asset value each month until there’s an IPO, until a piece of real estate is liquidated, or until Martin crosses the startup off the list as a bust. “Suppose a real estate partnership buys two addresses, and puts 50% of its money into each,” he explains. “When it sells one of those addresses, they send us a K-1 that says, of the $100 you received, $10 was income, $80 was return of principal, and $10 was capital gains. After that,” he continues, “the $200 we put into that fund is now listed as being worth $100, because the K-1 reported that half of our initial investment had been returned.”
Martin has decided to list the angel or private equity deals at cost rather than follow the more traditional approach of revaluing them every time there is an up-round. “I’ve seen other angel or private equity deals where they count up-rounds as a revaluation of the business, saying that my dollar is now worth $2,” he says. “I don’t do that. One of our startup businesses two years ago was valued at $2 million when we wrote the check. Today, we are funding at a valuation of $6 million. That is a 3X return on the initial investment, but I have not changed the valuation, nor will I, based on that up-round.”
There are also some conflicts of interest. Martin invests his own money into the programs that he’s recommending to his clients. And he charges 1.5% a year on the valuations listed in his statements, plus 10% of the profits whenever there’s a liquidity event or distribution. When a program goes bust, he participates fully in the losses as an investor but doesn’t return his management fee as the portfolio manager.
Future shock?
Martin is an example of a manager who appears to be adding value to client portfolios above the indices, another proof of concept in this series on active management. But he also thinks that he’s in the vanguard of a service that many advisors will be providing their clients before long.
Why? Acting under the JOBS Act (otherwise known as the “Jumpstart Our Business Startups Act”), the SEC has greatly loosened the rules for angel investing and crowdfunding. Most notably, it has lifted the ban on general solicitations and public advertising for investments in new startup companies for accredited investors.
“Unlike a few years ago, all of our clients are vulnerable to being solicited for angel investments in start-up businesses,” Martin says. “The average guy has been given the go-ahead to start writing checks to startup companies. If we, as professionals, refuse to help them select investments that have government approval,” he continues, “then aren’t we abandoning our role as professionals?”
Martin says that, increasingly, advisors will start to encounter enthusiastic clients arriving in their offices looking for approval to take $100,000 out of the portfolio to invest in a new startup company they saw on a crowdfunding site. “She knows for sure that this company is going to be the next hi-tech manufacturing giant in the world,” says Martin, “and, besides, the CEO is a friend of her cousin in Philly, and her cousin says the CEO is a great guy!”
More broadly, it is not hard to envision a day when all corporate capital needs will be met over the Internet, rather than through the heavy toll roads that we call investment banking and venture capital firms. Your knee-jerk reaction to your clients, initially, will be to recommend against all of these investment “opportunities,” sight-unseen. “But,” Martin argues, “as a professional, we are stepping out of our expertise when we try to recommend actions for which we’re uneducated. That lack of fiduciary responsibility should not happen.” Eventually, sooner rather than later, professionals are going to have to vet these deals for unsophisticated investors.
Where can you learn more about startup and angel investing due diligence? “There are dozens of angel investment groups like Keiretsu Capital,” says Martin. “They have varying levels of efficiency and concentration in due-diligence processes. But,” he says, “there is no formal education, and I’m not sure you can learn how to become an angel investor by reading about it. I think you just have to go out there and put your own money at risk, and know what it feels like when you make a mistake on due diligence.”
Consolidation plans
Martin is already questioning whether his almost-five-year-old Opportunity Fund is the best way for him to offer nontraditional investments to his clients. “My biggest fear is the complexity of what I’m doing,” he says. “The Opportunity Fund hasn’t grown much, because I’m always so busy.
As you read this, he’s working on the creation of a closed-end blind pool, a single fund that will hold all the moving parts in a single portfolio. “I’d make all investment decisions myself,” says Martin. “I’d have discretion. And then, if I truly believe in diversification – and I do – I’d invest in 50-60 startup businesses every three to five years.”
What do you think? Is this the future of investing?
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Part IV in my series on adding value through active management envisions a world where advisors are vetting a growing number of nontraditional investments for their clients.
