For families seeking to build generational wealth, private markets offer investors a familiar siren song – the potential for better risk-adjusted returns (called “Alpha”).
According to Hamilton Lanes 2023 Market Overview, private market strategies have consistently outperformed public markets over the last 15 years (with one exception, REITS).
As usual, the devil is hidden deep in the details, most notably, how returns are calculated based on something called the internal rate of return (IRR) – a metric used in financial analysis to estimate the profitability of potential investments, but doesn’t describe the actual “cash-on-cash” returns delivered to investors.
Why does this matter?
Because in the Game of Private Capital, the Banker’s strategy is all about generating the best possible returns, as safely as possible.
How do Bankers do this? By shifting risk and volatility (called “Beta”) onto other participants.
Never forget that you – the retail investor – are often someone else’s exit strategy.
The game is rigged in favor of Insiders who often benefit from YEARS of guaranteed returns (and other means of value extraction) while the company is private…
And leave little upside remaining for buyers in the public markets.
So what options do regular investors have when searching for Alpha in a world full of Beta?
That’s what we’re talking about today.
-Jake Hoffberg
Nevada Canyon Gold (OTC: NGLD) is a publicly traded gold royalty and streaming company. Their business model is providing non-dilutive financing to junior mining companies in exchange for something we call Golden Cash Flow Contracts.
Management is leveraging a similar playbook used by Ely Gold that provides an interesting combination of downside protection, cash flow, and upside potential (although should still be considered high risk and speculative in nature).
FG Communities is a private real estate company focused on protecting and preserving affordable housing in America. On the surface, their business model is simple – buy small-format manufactured housing communities and hold them for long periods.
But what makes this strategy interesting is similar to what happens when you convert a real estate operations company into a real estate investment trust (REIT).
According to data from NYU Stern, the EBITDA multiple may jump from ~8x to 19x.
As a reminder, securities sold under Reg CF, Reg A, and Reg D are often considered high risk, and speculative in nature. Please do not invest funds you cannot afford to lose, or otherwise need immediate access to.
The Easiest Money on Wall Street
In my opinion, the perfect investment opportunity offers four things:
- Downside Protection: I would have little to no chance of losing money
- Cash Flow: I would receive regular income from the asset
- Growth: My investment would grow in value at above-market rates
- Liquidity: At any point in time, I could exit my position at fair market value
Generally speaking, all investment opportunities require some sort of tradeoff between these four things – in private markets, potential outperformance often comes at the expense of liquidity and downside protection.
But with that said, there’s one type of business that has an overwhelming advantage when it comes to maxing out these four traits.
The Money Business.
To understand why, let’s take a look at one of the most “rigged” games on Wall Street: IPOs.
“Of more than 400 listings where companies raised at least $100mn between 2019 and 2021, 76 percent are below the price at their initial public offering… The group’s median return since their respective IPO dates is negative 44 percent.”
Since then, the losses have only gotten worse as rising interest rates continue to put pressure on bloated VC-backed companies struggling to reach profitability, with many either going out of business or taking “cram down” rounds in order to survive.
Now, check out this headline from MarketWatch on Jan 1, 2022: Wall Street banks post record $10 billion in IPO revenues even as average investors in 2021 face worst return in years.
This is the definition of “Insiders” taking all the Alpha while “Outsiders” are taking all the Beta.
And the more we understand how the Bankers engineer this rather one-sized return stream is key.
It all has to do with the wildly lucrative business model that is private equity and venture capital.
The Problem With Investing in Private Equity and Venture Capital Funds
I know you’ve been taught to believe that you can’t beat “the market.”
Even Warren Buffet says that for most small investors who don’t have time to research individual companies, cheap index funds are the best way to invest in the stock market.
But here’s what the Oracle of Omaha wrote in a 1988 letter to Berkshire Hathaway shareholders:
[Efficient Market Theory], moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.
Naturally, the disservice done to students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us.
In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.
From a selfish point of view, [we] should probably endow chairs to ensure the perpetual teaching of EMT.
When it comes to investing in public markets, I certainly agree that retail investors may have essentially little ability to outperform over the long term.
But that doesn’t mean it’s impossible for small-balance investors to generate better risk-adjusted returns by doing something else.
Why? Because not all risks are created equal.
And if you have a way to reduce, manage, or otherwise mitigate risk factors in an investment opportunity, this creates a statistical advantage for you over the long term.
For decades, that “something else” has often been the Private Markets.
More specifically, investing in companies that are in what I call the “Alpha Zone” – the moment right before it enters into a period of hypergrowth.
Is early-stage investing a high-risk / high-reward strategy? Absolutely.
But if you can reduce your risk to a point where you may have a mathematical edge, just like a casino, you have a better chance to be profitable over the long run (assuming you don’t blow yourself up and go to zero).
All you have to do is invest in the right companies at the right time at the right price.
This, in a nutshell, is the portfolio theory that venture capital firms sell to their investors.
Returns in venture capital are distributed according to a Power Law with the lion’s share of returns earned from a small number of investments.
In short, VCs cannot reliably pick winners. They can, however, [attempt to] construct portfolios that consistently generate great returns.
Simply stated, more investments give a venture firm better odds of investing in an outlier company that can make a fund.
However, there are limits. Portfolio construction requires weighing the benefits of diversification against a VC’s ability to generate and support high-quality investments.
Striking the right balance separates great VCs from the rest.
According to Korver, this means the success of a VC fund is driven by one question: “What is the chance of an outlier in your fund?”
The answer is driven by two key factors:
- the probability of each investment being an outlier and,
- the number of investments in the fund.
The chart below sheds some insight on how these two factors can influence the performance across your entire portfolio.
Successful VCs need at least one outlier to have a well performing fund. The y-axis measures the chances of investing in at least one outlier as a function of the size of the portfolio (the y-axis) and the chance of an outlier with each investment for 3 different types of VCs (the colored lines).
Venture capital style investing sounds simple in theory, but there’s a big problem for small balance checkwriters looking to copy the VC investment strategy.
Aside from it being completely impractical for a non-professional investor to make 50-150 early-stage investments…
Anything that could become the next “Uber” or “Amazon” typically goes straight to the top firms – like Sequoia, Benchmark, and a16z – long before people like us would ever see them.
This means the only realistic chance you have to invest in the “next big thing” is to get in before institutional investors do, typically when there are still significant downside risks…
Or much later in the company lifecycle, when there’s significantly less upside potential.
Generally speaking, this means the only way to access these Alpha Zone investments would be to invest with a fund manager, and hope to get a “venture rate of return” of 3x your money after 10 years (a ~12% annual return).
But here’s the problem of putting money into a fund…
These funds typically have large investment minimums and charge a ton of fees/commissions for the privilege of investing with them – yet the vast majority of managers simply cannot deliver the expected returns!
Investors take 100% of the risk for only 80% of the reward while the fund managers earn a guaranteed 2% every year – PLUS 20% of the upside – all while taking virtually no risk (with some exceptions).
Sign me up for that Cheat Code right?
Not surprisingly, when you get a guaranteed salary to spend other people’s money on highly speculative deals, you’re just going to be careless about how you spend, take shortcuts and otherwise look the other way…
However, because there’s more and more money chasing after a finite number of industry-defining companies… it’s very easy to wind up overpaying, due to a fear of missing out.
Although the fund manager has plenty of incentive to perform, they are getting paid a salary to risk someone else’s money.
So let’s ask the obvious question. If only 5% of VC firms return more than 3x the invested capital…
And you, the average investor, have zero chance of getting your money into the top decile of funds that can deliver those types of returns…
Is there an easier way to target ~3x expected returns than making 50 – 150 seemingly random bets on unproven startups?
Answer: in my opinion, it is far easier to improve returns by reducing fee drag than it is to increase risk.
And in order to do that, counterintuitively, it means keeping name-brand VC/PE out of our deals for as long as possible.
Here’s why…
The Biggest Risk for Early-Stage Investors: Toxic Money
Everyone knows that if you have access to the best deals at the best terms, you’ve got a huge advantage over everyone else.
But getting your money in the deal is only the first step to seeing any gains. You also have to protect it once it’s in there.
Even if you are one of the chosen few who manage to get in early on the “next big thing” that goes up 10,000x…
The single biggest risk to your potential returns is every investor that comes in after you.
I know this sounds insane, but there is a very real possibility where you invest in a company at a $20m valuation… the company sells for $100m… and you could walk away with exactly $0.
How does that happen?
Founders – who often don’t understand how capital markets work, and aren’t experienced financiers – agree to minority control provisions as part of taking money from professional investors.
For example, it’s not uncommon for institutional-sized funds to ask for 2 of 5 board seats, preferred shares, liquidation preferences, and blocking rights.
Thanks to these “poison pill” control mechanisms, it means they are ONE VOTE away from legally taking over the company, selling it off for parts, and potentially grabbing 100% of the profits… leaving the founders, employees, and early investors with nothing.
That’s not to say we think all institutional money is bad.
Simply that money is a commodity, and there’s no point in overpaying for it…
Especially when we can arrange more favorable terms by raising capital from retail investors.
Sure, it might sound like a sign of quality to have a sexy name-brand VC firm on the cap table…
But in my opinion, more often than not, it is these exact same names who are the primary reasons why good businesses fail and early investors may get screwed.
I’ve watched the industry become a money-hungry mob. V.C.s today aren’t interested in the public good.
They’re not interested in anything except optimizing their own profits and chasing the herd, and so they waste billions of dollars that could have gone to innovation that actually helps people.
Remember: institutional investors, by definition, are not investing their own money. Their money comes from the infinite riches of pension funds, endowments, and governments.
Because it’s not their money, they want to take as much risk as possible. After all, the only way they can justify their fees is to promise huge rewards that inevitably require significant risk.
They don’t care how stressful it is for the founders and entrepreneurs. They care about what the spreadsheet says must happen in order to deliver the returns they promised to their investors.
The core of our entire investment thesis here at Equifund is to get in BEFORE the sharks do, so we can reduce the most predictable risks to early-stage investors – subordination risk.
And that, in a nutshell, is the reason why we’re seeing more companies who could raise money from institutions, instead choose to explore crowdfunding as a viable alternative.
Introducing: The Equifund Syndication Program
Equifund was built for a simple reason. Even with decades of experience in capital markets, we still had all the same problems retail investors have.
- Access to Opportunities: Can we get access to the best investment opportunities in today’s market?
- Underwriting: Do we have the skills and resources required to perform proper due diligence and negotiate terms?
- Check Size: Can we get our hands on enough capital to meet the minimum investment requirements?
As industry professionals, we certainly have better access to opportunities than the vast majority of investors and plenty of experience underwriting early-stage companies.
But the big problem was that even if we wanted to write a check, it simply wasn’t going to be large enough to meet the funding requirements of the company.
That all changed when Title III of the JOBS Act went into effect on May 16th, 2016.
For the first time ever, both accredited and non-accredited investors were allowed to invest in privately owned companies.
And more importantly, it gave us the opportunity to take advantage of the same wealth building strategies the wealthy benefit from.
It’s called an Investment Syndicate.
A syndication program, also known as an investment syndicate, refers to a group of investors who pool their resources together to invest in larger and often more expensive assets than they could afford individually.
This investment structure is common among various asset classes, including real estate, venture capital, and other forms of private equity.
Here’s a basic rundown of how a syndication program generally works:
- Formation of the Syndicate: This begins with a sponsor or syndicator, who is an experienced professional with expertise in the specific asset type. The sponsor identifies a potentially profitable investment opportunity and decides to form a syndicate to pool funds for the investment.
- Fundraising: Once the syndicate is formed, the sponsor begins the fundraising process. This can involve reaching out to individual investors, investment firms, or other financial institutions to contribute capital to the syndicate.
- Investment: After the funds have been raised, the syndicate then makes the investment. The sponsor typically manages the investment, making critical decisions about the property or venture, such as renovations, leases, or exit strategies in the case of real estate, or strategic guidance and business decisions in the case of a business investment.
- Distribution of Profits: Profits from the investment (such as rental income, dividend payments, or profits from the sale of the investment) are then distributed to the syndicate members, typically on a pro-rata basis depending on the amount each member invested.
- Exit Strategy: Eventually, the sponsor will execute an exit strategy, such as selling the asset or taking a company public. The profits from this exit are then distributed among the syndicate members, again typically based on the amount each member initially invested.
Normally, these syndication programs are organized using a Special Purpose Vehicle that comes loaded with management fees and carried interest.
For decades, the so-called “2 and 20” has been the price investors pay to get access to private markets.
But what if there was a way to invest directly in private market opportunities with no management fees, no commissions, and no carried interest?
That is our vision for Equifund.
While we can’t promise you will make money investing in any of our listings…
We strive to improve through due diligence the four traits – downside protection, cash flow, growth, and liquidity – by offering retail investors the chance to invest directly into private market opportunities.
Removing fee drag is one of the easiest ways to offer our members a better risk-adjusted return potential.
Also, because people can invest direct – vs being put into a fund – it means the moment there is liquidity, they can choose to exit their position (instead of waiting for distributions).
But none of that matters if the management team is unable to build shareholder value in the business and achieve a liquidity event in the first place.
Again, while there are no guarantees any of our issuers will reach a liquidity event or provide positive returns…
As our community continues to grow – and we’re able to support larger rounds as the company matures towards an exit – it means we can better defend the Cap Table from toxic money coming in and ruining it for the rest of us.
