As an investment advisor, clients often ask my opinion about a private deal they’ve been offered. You may be called upon to do the same. These deals vary from angel investments in start-up companies (pre-venture capital) to large rounds of capital for positive-cash-flow deals like a private real estate investment.
Here’s the general framework of how I assist the client in reviewing such investments. Understand that they come to me with the opportunity; I don’t recommend any private deals.
For starters, I advise the client that private markets are not as efficient as public markets (stocks). Private deals can be incredibly lucrative, but also turn out to be total losses. The first thing I tell the client is that I’ve seen far more poor to awful results from clients. The second thing I tell clients is that there is far more money in the private equity space and that drives up the market efficiency and drives down the return. In fact, I’ve had several general partners of private equity firms tell me that there is too much money chasing too few deals. Indeed, the coronavirus-induced market stress will be particularly challenging for private deals, especially those with high leverage.
While not remotely statistically meaningful, I’ve made two private investments over the years – one was close to a complete loss while the other had about a 12x return over a few years when the company was acquired. Before becoming an investment advisor, I assisted a few firms in writing private placement memorandums (PPMs) that accompanied the investment proposal sent to accredited investors with either joint annual net income of $300,000 or a net worth of over $1 million. There are some other qualifications as well, but I suspect most of our clients are accredited investors.
For the review process below, I’m referring to arm’s-length deals, rather than deals offered by friends and family. If I’m asked about the latter, I merely point out that if the deal goes sour, it could strain the relationship between the friend or family member. I recommend the client invest at most 20% of their net worth in these deals, as they are inherently risky and illiquid.
Review process
Step 1: Learn how the client was offered the deal
I want to understand the distribution channel of the deal. To be frank, roughly 80% of the time I don’t need to go past step one and even look at the PPM. The most common answers to this question are either they were presented the opportunity by an investment advisor or they saw or heard an advertisement for it. While there are exceptions, these deals are generally dogs.
One I reviewed came from a media advertisement of a large real estate deal raising several hundred million dollars. The advertisement was claiming a secured 18-21% annual return, implying it was virtually risk free. Before even reading the PPM, this failed my “smell test” badly. It wasn’t the “too good to be true” smell test, as some deals really can be great. It was the fact that that this firm chose the distribution channel of expensive advertising. If the deal was really this good, one or a few large pension plans or private equity groups would have quickly funded the deal. When I asked the firm why they didn’t go directly to large institutions to raise this money, they responded that they wanted to help smaller investors. I didn’t buy that answer. Still, I read the PPM, which was nothing like the radio ad.
It was full of risk.
The same goes for clients who have been presented deals by agents receiving commissions, typically about 10%. Again, there are exceptions but I’ve found these deals typically turn out poorly for the same reason – an expensive distribution channel. I’ve even seen these distributed via the, “free dinner seminar.” Good deals usually go quickly to large institutions and the general partner doesn’t need to spend much on getting funding.
But if the client learned of the deal from an association with one of the principals, that’s a different story. Many of my clients have cashed out from their own start-ups. The client may be an industry expert. In another case, the client helped out a billionaire who was letting her in on a small chunk of a deal as a token of appreciation. Those pass step one.
Step 2: Review the PPM and communications to the client
PPMs typically come with confidentiality agreements. In some cases, the agreement gives the client the right to share it with an advisor. But in some cases, I need to sign the agreement. Some clients ask me to review the financial projections and the terms of the deal. I tell them that’s the last thing I’ll look at because it’s really easy to prepare pro-forma financials that look rosy. It’s a heck of a lot harder to execute and achieve those projections.
Step 2A: Understand the principals
The client may tell me this is a brilliant start-up business idea, but I respond by saying, “principals first.” A so-so management team generally fails due to poor execution, while a great management team can often change the so-so business idea to stay ahead of the competition and succeed.
I need to understand the background of the management team. I’m not talking about what academic degrees they hold; rather, I’m referring to their track record in that specific industry. Have they built successful companies before – especially in the same industry? Have they made money for others? Are they also investing some of their own money in the deal under the same terms as the limited partner or common shareholder? Though it’s great for the management team or general partner to have upside, they have far more skin in the game if they also have downside.
Step 2B: Review the business idea and assumptions
I clearly admit I’m not an entrepreneur and I’m often wrong on my assessment of business ideas. Had I been offered to invest in the early stages of Starbucks, I would have turned it down. I probably would have said something like, “coffee is a commodity, not an experience.” And I have clients who have made tens of millions or more on business ideas I thought were downright stupid. Still, at least I try to assess the idea before looking at the assumptions.
The assumptions are critical in understanding the opportunity. Are they realistic and bottoms-up, meaning it addresses how they are going to sell the product or service and who will buy it? The opposite is something like, “all we need to do is capture a 2% share of this $10 billion market” with little specifics on how they will get there. If it is a real estate deal, are occupancy and expense assumptions reasonable and have they built in contingency expenses?
Then I follow those assumptions to the financial projections, which must include the balance sheet, income statement, and the most important statement of cash flows. If the financial statements look like a hockey stick (flat to no revenue historically followed by rapid projected growth), I need to understand why. And if the company has been around a couple years or more, I ask for their past projections to see if they have a history of overestimating their projected financial success.
Finally, the financials must produce an attractive IRR that should be at least 4-5 percentage points higher than expected public equity returns, since it is riskier and illiquid.
Step 2c: Understand the use of proceeds
It’s critical to understand what the company will be doing with the client’s money. If they are using it to pay down debt, that’s a deal killer as it’s typically bailing out existing investors of a financially stressed company. That’s true even if it’s a down round (lower valuation than the last round of financing) or bridge financing. The money should be used to grow the company and the cash flow.
Step 2d: Review the risks
This is the simplest element to review. Any good PPM should say everything can go wrong and have a long list included. If it doesn’t, this means they are taking short-cuts on thinking through the opportunity as well as not using appropriate legal counsel.
Step 2e: Review the terms
Though a business opportunity may look good, the terms may not. Granted, the investor will always be at the mercy of the principals, but terms should look reasonable. Do the terms provide some protection against further dilution from another round of needed capital? Does the class of investors have any right in the future to demand a liquidity event?
Step 3: Talk to the principals
Let’s say everything looks good on paper. But, like hiring an employee, you want to talk to the prospect or meet them in person. I ask some very tough questions intentionally to see how they will respond. Are they defensive or have they already thought through some of these issues?
Conclusion
An example of a deal that made my cut was a very experienced management team that was in a niche business that had a lot of small players. It was also a very “unsexy” business, which tends to attract less competition. The plan was to acquire some of the small players to roll up to become a national player with some realistically strong synergies. While full of risks, it seemed like a reasonable deal.
Even in that deal, which passed all of my three steps, I told the client to invest no more than a small part of their portfolio and that they should be prepared to lose some or all of their investment.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies, and consulted with many others while at McKinsey & Company.
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