The Insider’s Guide to Deal Structuring
For small balance investors searching for “good” private investment opportunities…
But aren’t sure exactly what a “good” deal is, much less how to find one…
In my experience, the difference between a “good” deal and a “bad” one all comes down to how the deal is structured.
If structured correctly, it’s possible to generate an attractive return on capital betting on “okay” companies with “okay” products.
But structured incorrectly, it’s possible to lose money in a great company with incredible products.
So how do you know which one is which?
That’s the topic of today’s issue of Private Capital Insider.
-Jake Hoffberg
P.S. Interested in investing in an early stage, AI-powered oil and gas play? If so, Pytheas Energy is raising capital on the Equifund Crowd Funding Portal.
The Illusion of “Informed” Investment Decisions: Why (most) investors focus on all the wrong things in private market investments
After writing more than 1,000,000 words of investor education content over the past five years – and consuming several million more words in the form of books, articles, and videos…
What I’m about to reveal regarding the value of investor education material might come as a surprise.
Gathering more information – and by extension, the idea of being a more informed investor – doesn’t necessarily lead to better investment outcomes.
Why? It all has to do with the paradoxical phenomenon in sales – known as The Dummy Curve Theory – where salespeople find it easier to sell when they know less about their product vs being fully informed.
The idea behind this theory is that when you’re a newbie, because you don’t know what you’re doing, you keep things simple.
And if you’re a retail investor looking for ways to build generational wealth, you generally have to pick one of the following strategies.
- Accept the Default (Passive Investing): Dollar cost average into a low-cost index fund, and simply buy and hold and let compounding do the rest.This style of investing – made famous by Jack Bogle at Vanguard – appears to be the lowest “effort to results” strategy available to retail investors.
- Reject the Default (Active Investing): Take on higher risk for the chance of higher return.
For the vast majority of novice investors, the “default” strategy is the definition of keeping things simple; all you have to do is focus on increasing your savings rate and compounding it over time.
But as you become a more informed investor, something weird happens – you start to fool yourself into believing that more information translates into better results.
More specifically, you start to become more informed about higher risk strategies – for example, investing in private markets or actively trading stocks/options/crypto.
And as the saying goes… you know enough to be dangerous.
Also called the Dunning-Kruger effect, having more information may in fact make you feel more confident in your ability to outperform…
But it doesn’t necessarily make you more competent at finding opportunities, underwriting and pricing risk, and proper position sizing.
And if we believe that smart risk-taking involves positive asymmetric bets – which means the upside potential is greater than downside loss…
Overconfidence can often put you in situations where you are taking negative asymmetric bets – which is when the downside risk is higher than the potential reward.
In many ways, the worst possible thing that can happen is that you get “lucky” early on in a negative asymmetric bet and see positive results, which almost certainly causes you to “size up” your bets; because the math is “rigged” against you, you are guaranteed to lose the more you play.
Unfortunately, because self-directed investors tend to be intelligent people who are successful players in the Game of Business…
We tend to overestimate our skills and abilities in the Game of Money.
Even worse, if our experience in the Game of Business has led us to believe in a somewhat sports-oriented worldview of Capitalism – overcoming the competition through strategy, tactics, and good, old-fashioned hard work…
This need for “action” puts us in serious peril in the Game of Money.
And even though the idea that more data makes you more informed – and that being more informed leads to better outcomes – makes logical sense…
In my opinion, this narrative is more designed to sell data – and other “gadgets” and “toys” – for investors to play Fantasy Football: Investor Edition.
For example, here’s a recent headline from MarketWatch…
With so many economic indicators to watch, and information coming from all sides, it’s challenging for retail investors to cut through the noise to make informed decisions.
In an era of information overload and regardless of what is trending, one approach will never go out of style — studying data and using the analysis productively.
Data plays a pivotal role in all types of investing. It’s been the “special sauce” used by institutional investors, such as hedge funds, investment banks and asset managers, to generate alpha and identify trading opportunities.
Since the COVID-19 pandemic, retail investors have had more time to spend in digital forums with greater access to content, specifically financial information.
Coupled with the rise of zero-commission trading, and retail investing has proliferated. Since 2019, daily retail trading has doubled.
But hey, this is Private Capital Insider, not r/WallStreetBets.
And in private markets, what we’ve been taught to believe is that more due diligence leads to better investment outcomes.
According to the 2007 study, “Returns of Angels in Groups,” by Rob Wiltbank,
More hours of due diligence positively relates to greater returns.
Simply splitting the sample between investors who spent less than the median twenty hours of due diligence and investors who spent more shows an overall multiple difference of 5.9X for those with high due diligence compared to only 1.1X for those with low due diligence.
Sixty-five percent of the exits with below-median due diligence reported less than 1X returns, compared to 45 percent for the above-median group.
The differences become more stark when comparing the top and bottom quartiles of time dedicated to due diligence.
The exits where investors spent more than 40 hours doing due diligence (the top quartile) experienced a 7.1X multiple.
Seems like a slam dunk case that supports the “the more you know” paradigm of investing, right?
Maybe.
Except for two glaringly obvious problems:
- I have never seen the results of this study replicated, nor have I seen updated data from the original source.
- The study makes no mention as to the exact methods used to undertake this due diligence; only that “angel investors may positively influence their rates of return by making wise decisions about due diligence, avoiding ventures in unfamiliar industries, follow-on investments, and productively participating in the ventures post-investment.”
Let’s address the first point by highlighting a recent article in the Wall Street Journal, “Flood of Fake Science Forces Multiple Journal Closures,”
Fake studies have flooded the publishers of top scientific journals, leading to thousands of retractions and millions of dollars in lost revenue.
The biggest hit has come to Wiley, a 217-year-old publisher based in Hoboken, N.J., which Tuesday will announce that it is closing 19 journals, some of which were infected by large-scale research fraud.
In the past two years, Wiley has retracted more than 11,300 papers that appeared compromised, according to a spokesperson, and closed four journals.
It isn’t alone: At least two other publishers have retracted hundreds of suspect papers each. Several others have pulled smaller clusters of bad papers.
Although this large-scale fraud represents a small percentage of submissions to journals, it threatens the legitimacy of the nearly $30 billion academic publishing industry and the credibility of science as a whole.
World-over, scientists are under pressure to publish in peer-reviewed journals—sometimes to win grants, other times as conditions for promotions. Researchers say this motivates people to cheat the system.
Many journals charge a fee to authors to publish in them.
Publishers say some fraudsters have even posed as academics to secure spots as guest editors for special issues and organizers of conferences, and then control the papers that are published there.
If there’s one thing I’ve learned about marketing products and services – especially in finance and healthcare – it’s this:
You can find “peer reviewed studies” that support basically any position you want to take.
And this epidemic of “fake data” pushed by “fake news” is why I take all of these so-called “studies” with a grain of salt.
Why? Because the scientific method relies on replication of results from a disinterested third party.
As we’ve discussed in other PCI issues, this is why it’s critically important to have a proprietary source of data, versus relying on the same third-party sources of data everyone else is using.
And this brings us to what I believe is the most significant problem facing early stage investors today…
What ACTUALLY drives returns for small-balance checkwriters with non-controlling minority positions?
As a matter of professional curiosity – and a desire for networking opportunities and socializing – I recently joined a local angel investing group.
While there is a LOT I’ve enjoyed about the experience so far, one of the things I’m still skeptical about is the crowdsourced due diligence process.
Basically, every week, a bunch of companies come and pitch the local chapter… and in a somewhat “Bachelor” style elimination process, some Issuers get to proceed to the next rounds based on member interest.
Then, members are asked to join a four-week due diligence team where the final product is a report that is sent out to everyone else.
And when I attended an information session about how the due diligence process works, to no surprise, the “40 hours of due diligence” number was heavily promoted.
But seeing as how I have some relevant experience in underwriting and due diligence working here at Equifund – not to mention, I’ve actually read the study and know what it says…
I asked the question most people don’t:
What exactly do you think due diligence means?
And how does spending more time doing unpaid research on this company lead to the investment opportunity performing better…
When I have no ability to negotiate the price/terms, nor do I have any control features to influence the outcome?
Said another way… how does being more informed create Alpha for me as a passive investor in a non-controlling, minority position?
While I didn’t get an answer to my question, here’s my personal opinion on the matter – it doesn’t.
Why? It all has to do with the five problems all small-balance checkwriters face in private markets.
- Access: Getting access to the “good deals” is already hard for professional investors with hundreds of millions of dollars under management. You – the average retail investor – have almost no chance of getting invited into the “club.”
- Underwriting: Even if you did have access, you likely don’t have the time or resources required to perform any substantive due diligence. For that matter, you probably don’t have any clue how to price the risk either.
- Check Size: Even if you did have access and could underwrite the deal, you likely don’t have enough money to negotiate terms.
- Liquidity: Even if you could get your money in a deal on favorable terms, chances are you’re in REALLY early, and will be in the deal for a long time.
- Fees: There is a real cost structure to investing in private markets – regardless of whether you try to “do it yourself” or hire a manager to invest for you.For example, in order to produce a 15% net-of-fee return, an investor in a fund with a standard two-percent management fee and 20% carried interest, the fund would need to produce a gross-of-fee return of 22-24%+ (depending on a variety of factors).
But for the final kicker? Even if you did manage to get your money into a “winning” company, that doesn’t mean that YOU are going to generate any significant Alpha – or a risk-adjusted return that exceeds your benchmark (which, for many retail investors, is dollar-cost-averaging into a low-cost index fund).
And if you’re like me – and you DO NOT want your investment returns to depend on materially participating in the venture (i.e., a lot of unpaid labor)…
Your best bet is to invest alongside a “Banker” (or Sponsor/Lead Investor) who is actively originating, underwriting, and structuring deals.
Otherwise, if you’re not investing alongside the Banker, it probably means you’re on the other side of the Banker’s trade as they look to get their (and their investors) money out of the deal.
Looking for an AI-powered oil and gas play?
If so, you might be interested in checking out Pytheas Energy – an upstream oil and gas producer that is currently raising capital on the Equifund Crowdfunding Platform.
[Disclaimer: By law, Equifund cannot make any buy/sell recommendations, provide individualized investment advice, or otherwise “endorse” any specific investment opportunity – especially ones listed on the Equifund Crowdfunding Platform due to the obvious conflicts of interest. Please do not make any investment decisions based solely on the information published in this article.]
