I am not much for sizzle, glamour, or sensational TV. However, now and again my teenage daughter will put something in front of me that grabs my attention. Have you seen the Nightbirde ditty from America’s Got Talent on YouTube? You should take a moment; it is touching. When competing as a singer on AGT, artist Jane is asked about her life. Her answers are jarring and painful. What follows is amazing.
This grabbed my attention because, without the panelists’ questions of the artist, the performance would have been sensational. But within the context of Jane’s life circumstances, her performance was beautifully profound. My point? The right questions allowed the audience to experience the strength of an undaunted human spirit mired in the most challenging tragedies of human life.
Asking the Right Questions
Hitting closer to home, you too must ask the right questions related to your private investments (think self-storage, multifamily, and industrial). The art of finding the right question is critical as you determine value and find facts and truth.
As you approach investment opportunities, you face a significant risk because your assumptions about how the investment will function might not be accurate. Oftentimes in life, the subject matter is awfully complex. How are we to know the right answer when we see it if our assumptions are flawed?
I will return to this point at the end of this article, but let me stress this again: If the assumptions we make about how the asset will function are invalid, we face a meaningful risk in the world of private investments.
Unpacking the World of Private Investments
My dear wife Melissa works at a biotech company. When she talks to her colleagues, I do not have a clue what they are talking about other than they are trying to make drugs that cure cancer. Recently at a post-COVID gathering with friends, I started talking about prohibited transactions in IRAs. Melissa gently pulled me out of the weeds, reminding me that a subject matter that is common ground is a better place to spend time socially.
Thank goodness I married up and can rely on her to be my guardrail in life. She was spot on and is better at reading social cues than I am. I was off in the weeds on a topic nuanced with smart-sounding 20-dollar words, enjoying myself as I put on a clinic of technical precision and accuracy. Everybody else was thinking, “What a dork.”
I mention this because many areas of life are specialized. And not just a little. The world of private investments can be one of these areas. Let’s focus on a topic that is often confusing to investors and packed with 20-dollar words. Just as Melissa’s world of oncology is a maze of SOPs, tangled multinational partnerships, and real people who are dealing with cancer, the world of private investments also needs to be understood, evaluated, and unpacked.
The “Safe” Investments That Led to the Great Recession
Back in the ’80s and ’90s at banks and brokerage firms, investors frequently purchase mortgage-backed bonds. These bonds were called Ginnie Mae, Freddie Mac, and Fannie Mae bonds. These bonds are still around today, but the shine partially faded due to the Great Recession.
Remember 13 years ago (2008–2010) when we first heard about TARP (Troubled Asset Relief Program) from Hank Paulson? He was our Secretary of the Treasury at the time, as well as the former Goldman Sachs Chairman and CEO.
Back then the mortgages were packaged and sold as presumably safe investments. What we discovered in the great recession was that these packaged, mortgage-backed securities were not actually the high-quality collection of mortgages they were presumed to be. Frankly, they contained poisonous high-risk mortgages that subsequently defaulted. Think Countrywide Financial, civil fraud, and Angelo Mozilo. Creepy stuff.
Remember that home mortgages are assets that are bought and sold by various banks, institutions, and entities as their marketability provides the liquidity needed by the underwriter. The underwriting entity can package a tranche of home loans and sell them into the market and go back to new borrowers to underwrite additional loans, then rinse and repeat.
Chasing Cash Flow
Investors viewed these packaged loan portfolios as reasonable and safe assets for investment. Investors would frequently purchase GNMA bonds (often referred to as Ginnie Mae) with the anticipation of using the cash flow provided by the asset to service lifestyle needs.
Where it gets tricky for investors is when a mortgage in the tranche is refinanced. Think about it — when a mortgage is refinanced, the lender is repaid their principal as a new lender now carries the note. In the context of a GNMA bond, the investor receives a portion of their original principal back as the borrower is no longer paying interest since the debt has been paid.
To the investor, the sum of the monthly cash flow is higher than the bond’s anticipated yield due to mortgages in the tranche being refinanced. But because the principal was mixed in with the interest payment on the bond, the investor did not care. They just knew they liked the cash flow, and the cash flow was relatively high. Until that is, they realized the remaining principal was less than what was originally invested.
That was when it got tricky. If you expected to receive a payoff of $50,000 at the maturity of the bond, which equaled what you invested, you would be disappointed when you received something less.
Your Capital Account
Some private investment syndicators apply a similar approach when accounting for the invested principal. Here is some terminology to be watchful of. Not that the following is wrong, it is just a distinct way of handling things:
“Any capital that is returned on the aggregate is considered a return of capital.”
What this means is that your capital account will be diminished during the life of the investment. That is not to say that your ownership is diminished — just your capital account. So, if you invest $50,000 in a deal with the assumption that you will participate pro rata in the gains at the end of the deal, plus receive your original principal back, you will be disappointed.
In the above scenario, you will most definitely participate in the gains on the investment as your ownership does not change based on the balance of your capital account. It is just that, because your principal is being returned to you during the life of the investment, you will not have a singular event where you receive the original amount invested being returned to you.
Additionally, your preferred return, if contingent on the balance of your capital account, will cash flow less to you each month/quarter based on the decreasing balance of your capital account. This may be significant. Admittedly, cash will build more quickly in an investment where the burden of preferred payments declines. Your ownership remains the same, so you eventually get the bucks. Only you can determine which you prefer.
Thinking Beyond the IRR
Remember that the Internal Rate of Return (IRR) calculation of your investment is only one method for measuring performance. Strong IRR numbers can be impacted by providing a return of principal early on. I feel the truest measure of performance of an investment is the equity multiple within the context of the number of years for the life of the investment. In other words, an equity multiple of 2 within 5 years tells me almost everything I want to know. An IRR of 18 only tells me part of what I want to know.
Now, please re-read the second paragraph of this article. My advice? Before you talk with an investor relations representative about a private investment, compile a list of your assumptions, and during your conversation, ask the representative to validate or contradict those assumptions.
Investors make their best decisions when they are well informed. Talk to your friends and ask for their advice. Spread your investments out in position sizes of 2% to at most 10% of your net worth, and diversify by year of maturity, type of asset, and geographic location of the investment.
All my best as you manage the tension between risk and return!
About the Author:
Ted Greene is part of the Investor Relations team at Spartan Investment Group. Spartan syndicates self-storage assets for investment. Ted has 24 years of experience in the financial services industry as an investment advisor and Chief Compliance Officer. Ted can be found on LinkedIn at www.linkedin.com/in/ted-greene-dontbeafraid or firstname.lastname@example.org.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.