OnNe Consulting Family Office and Business Advisors Back to Basics Private Direct Investments-­‐ A Rediscovered Asset Class By Carlos Nieto The markets: where they were and where they are as a path to private direct investment. Real estate: the private direct investment by intuition. In the last five years, we have witnessed equity and fixed-­‐income markets move sideways, with limited growth and increased volatility as measured over the previous 10 years that has moved from the high teens in May of 2003 to over 80 in November of 2008 back to under 15 in the first quarter of 2013. As a result, investors were challenged to obtain returns that rewarded the risk they were taking. Many investors may now be so concerned about safety and the return of their principal that they have become disappointed with paltry yields due to the current yield on many asset classes. In addition, investors may be searching for a way to have greater control over their investments after concepts like volatility, market risk, government policy and others rendered institutional investments and investment vehicles at risk with little input from individual investors in the last few years. For these reason, investors have been turning to investment solutions where they have greater control and can influence how their capital is being employed—be it positive or negative—and at least have a say in the outcome. Plus, they are searching for opportunities for growth as well as safety. On this quest, we have seen investors examine real estate as a first approach to private direct investment. But depending on the level of involvement investors are willing to undertake, they can look beyond real estate by investing in operating companies as a private direct investment. Real Estate as a Private Direct Investment As my grandfather used to say, “Own land and you will always have something to rely on.” He meant real estate in general—land, buildings and houses. In short, “Back to Basics.” Investing in real estate demands considerable specific knowledge of the asset class you select, just as any other investment. But as an investor, the first question you should ask yourself is: “What do I want this investment for?” Real estate investments can be placed into many categories, but there are three main ones I would mention: value, growth and income. Each one behaves differently and serves a different purpose in an investment portfolio, and therefore, should be managed accordingly. Remember that the goal of every investor is to generate a profit or income stream. As an example, let’s look at Miami after the real estate bubble burst in 2007, when properties were being sold at deep discounts. Most of these properties OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283 Private capital markets as a solution to transparency. were value investments that would yield attractive returns in a short period of time. In this case, knowledge lies in being able to assess the real value of the property, the amount of capital necessary to invest to bring it to market, and the ability to sell it and make a profit. These are skills that are not to be taken lightly. For an example of a growth investment, you just need to turn back to the days of Miami’s real estate boom. Investors were purchasing options in pre-­‐construction that could be flipped before the property even broke ground. An even better example would be a high-­‐rise building in Manhattan, where you can invest in pre-­‐
construction and due to the nature of the location, Manhattan being Manhattan, it’s just a matter of time until the property yields a return (include property value growth in Manhattan in the past decade). The skill set is different for this type of investment, along with the risks and returns. Additionally, most of the analysis and risk management has been completed by the developer and not the investor. The investor would need to focus on aspects such as the developer’s track record and macro aspects of the property’s location to make a sound assessment of its expected returns. Lastly I would like to point out that income is one of the main reasons to invest in real estate. Historically, real estate investment properties have been a substitute for fixed income. Most sophisticated investors keep a percentage of their portfolios in income-­‐producing residential, commercial or industrial properties. Investors have historically perceived real estate as a safe investment because of the assets backing it. Having said this, this is one of the most demanding ways of investing in real estate because it involves property management, and that, by itself, requires a level of expertise that will impact the return on the investment. Private Direct Investment in Operating Companies That said, I would like to point out that since 2008, many investors have switched from investing in real estate for the reasons mentioned above to investing in operating companies for similar reasons. This has led to great opportunities for companies and investors to create the private capital markets, where private money accesses private operating companies and opportunities. As I explained above about real estate, investments in operating companies or private businesses can be viewed as any other asset in your investment portfolio, i.e., you need a specific skill set to be able to analyze and make informed decisions regarding such investments. Investing in operating companies is not new, but it has typically been achieved through investment vehicles such as hedge funds, private equity funds or co-­‐
investment funds. Due to their collective nature, these vehicles lack the transparency or control over liquidity that investors expect these days from their investments. That is precisely what makes private direct investments attractive. Experienced investors like to maintain control over their investments, or if not control, a finger on the pulse of the operation. Unfortunately, even though OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283 Return of investment vs. return on investment The private capital markets: a gateway to capital investors might have the desire for control, they often lack the skill set or the team of professionals needed to evaluate the opportunities. The challenge in this case is not only the initial investment and evaluation of the company, but the ongoing due diligence to assure the return of your principal. In my day-­‐to-­‐day interactions, I consult many individual investors, family offices, accountants, attorneys and bankers and their main concern is not usually return on investment (ROI), but return of investment, which I abbreviate as (ROFI). For example, during a conversation with a managing director of a private direct investment holding (it is controlled by a wealthy individual with a controlling interest in more than 30 companies), he explained that he examines 100 opportunities to find two or three that are worth purchasing. The other main point we touched was that to make this investment opportunity successful and profitable, the investor has to be involved and must add value to the operation, either directly or through an advisor or group of advisors. Private direct investments have different asset classes and all investors should understand them in order to understand the purpose of the investment and how it fits in one’s overall portfolio or asset base. You can invest in private companies or businesses through debt or equity, just like you would in the public markets (i.e., stock market, bond market, etc.). In the last few years, we have been experiencing an interesting phenomenon that has led to the rise of the private capital markets. This era has been characterized by a lack of transparency and volatility in public markets paired with a restrained credit environment and a lack of risk capital for middle-­‐market enterprises. These forces have led companies and organizations to access alternative sources of capital, and that has led to large pools of funds from private investors who were sitting in cash for various reasons. The reasons include a low interest-­‐rate environment, uncertainty, lack of trust in the system, and low and volatile equity returns. Investors wanted more control and the ability to see where their money was going. As mentioned before, this comes with responsibility. Also, the structures used to invest in private capital markets are the same as those used in corporate finance. When making a direct investment in an operating company, you can chose to invest anywhere in the company’s capital structure, ranging from pure debt as a senior loan collateralized by the company, to taking a different place in the capital stack by taking subordinate debt or mezzanine structure. That last selection would increase your risk, but it could be rewarded through options or equity incentives on the company’s performance. In this case, you can view your investment as a fixed income investment and it should be managed accordingly. The risk assessment process to make a fixed-­‐income investment in a middle-­‐market private company is quite complex, but at the same time it will allow you, as an investor, to secure your loan the best way possible and according to your own risk profile. The perceived risk in an investment depends on many aspects that are OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283 Dipping your toes in a private company intimately related to the investor. This brings us to risk perception: the perceived risk is different for each investor. Therefore, it is very difficult to predetermine the risk profile of an investment without taking into consideration the investor’s knowledge in this matter, the level of involvement the investor is willing to commit to the investment and the investor’s risk profile. Once all these variables are taken into account, we can understand the risk an investor is undertaking, and that, in turn, increases the level of transparency and alignment of interests. Most investments in private equity we view through private equity funds, but more and more investors are choosing to invest directly in private companies and businesses. Families and wealthy individuals are collaborating with their peers, levering their areas of expertise per sectors and industries to make educated decisions on their private investments, according to “Framework for Understanding Family Office Trends,” by Stephen Martiros and Todd Millay, found in the CCC Alliance (http://www.cccalliance.com ). The article also points out, as I stated earlier, that the trend is becoming prevalent among affluent individuals or investors in general. The direct investment does entail an increased level of risk to the investor. In order to minimize that risk, I want to provide a few recommendations for investors who are evaluating an investment. Typically when you conduct due diligence on a middle-­‐market company with $5 million–$100 million in annual revenues, the top manager is either an entrepreneur, a family or a group of entrepreneurs. In most cases, these companies have grown intuitively based on a great idea and the work ethic of a leader, his team or both, but often they lack a method to their success. Most of the time, entrepreneurs focus on the product or the service and leave aside the most important part of a business model, which is “The Value Proposition.” As Warren Buffett would say, “People buy value not products or services.” Once the entrepreneur understands that they are delivering value, this will lead them to a process and then to a method and so on. So as an investor, the first thing you should understand is the value proposition of a potential investment, i.e., a company or business in which you are being invited to invest. Before undertaking a private investment, here are some questions you should answer yourself: 1. What is your Value Proposition? 2. Is this a business, industry or sector that you or your team understands? 3. Will you or your team be able to conduct ongoing due diligence on the opportunity that would minimize the risk of failure and loss of investment? 4. What is the motivation behind the leadership of the company and how long have they worked together? 5. What is your motivation to invest in this opportunity? OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283 6. Can you or your team add value to this business or company? Once you have answered all of these questions and you are comfortable with the risk you are undertaking in making this investment, I would suggest going to the second step. The next step is a traditional due diligence process that is typically conducted before a merger and acquisition transaction with a special focus on six main points that pertain to the private enterprise: 1. Value Proposition: We need to understand the definition of the value proposition to identify it in a company or potential opportunity. To wit, “Value is the sum of all benefits a customer will receive in exchange for their money or valuable consideration.” Once you understand this, it will be easy to understand how the enterprise will generate a profit. 2. Management Team and Leadership: It’s very important to understand the corporate team and company’s leadership. The questions one must answer include what moves them, how they work together, what is the role of each team member in the value chain and, most importantly, how they work together and how it impacts the value creation process. 3. Strategy and Methodology: This is one of the most important aspects of your analysis because it will help you understand how the company’s leaders will use your investment. Is there a strategy in place and a methodology to deploy this strategy? 4. Processes and Scalability: Every value proposition, product or service has a process and you should be able to understand it. Understanding it will give you the ability to track and follow a company’s success or failure. As a result, it will enable you to foresee distress situations for your investment and act proactively as shareholder. 5. Performance: In order to understand if the company is performing well, you need to understand how to measure its performance in terms of the aspects that matter most in its value creation process. The ability to identify nonperforming areas quickly will lead to better performance and reduced risk in your investment. 6. Legal and Corporate Governance: Most entrepreneurial endeavors lack a sound legal framework and corporate governance, which leads to increased risk and lack of protection for any investor. These are important details that most investors miss when examining a private opportunity, and are the ones that in most cases destroy value. Investors seldom try to understand or ask about OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283 ownership structure or governance of the company, but failure to do so can have devastating implications in the performance of your investment and the influence you may have in what is done with your capital. Investors usually focus on what being offered to them and if it seems fair to them! And they often fail to understand how the founding partners have established conflict resolution processes amongst partners or similar governance frameworks. These are aspects in which you should become expert. 7. Return on Investment and Return of Investment: Last but not least, you should always be cautious and closely monitor the ROFI, a term people take lightly. Most investors are blinded by the illusion of the return on investment, but this illusion is sometimes trumped by ROFI, or return of investment. Make sure you know how your principal will be returned. The ROI will come if you have diligently completed your homework on the company. Make sure you know the exit strategy, when will it happen, and even if you want to exit or just collect the profits indefinitely. Know your own strategy and motivation for investing in the opportunity. Private companies may not have some of these aspects in place or, if they do, they might not be incorporated in a way that protects the investor and the return of his or her investment. Make sure that you maintain a close relationship with management so that they perceive you as a resource to add value to their enterprise, and invest sufficiently in the opportunity that you can always have a say in what’s going on, but not too much that you have a stronger position than the management team, which may make them lose their motivation towards the company. To sum up, let’s go Back to Basics! Take the first step: Start looking at private direct investment opportunities. Carlos Nieto is a managing director of OnNe Consulting in Miami, FL. He can be reached at the following email: [email protected] OnNe Consulting specializes in supporting entrepreneurs and high-­‐net-­‐worth individuals manage their businesses, wealth and Family Offices. We contribute value by bringing to our clients a unique combination of financial strategies, management practices and organizational development techniques that focus on effectiveness in the wealth creation process. OnNe Consulting 1001 Brickell Bay Dr. Suite 2700| Miami | FL 33131 Ph.: +1 786 246 6283