Replay: Intro To Venture Capital & Private Equity Investing - Aspen Funds
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Replay: Intro To Venture Capital & Private Equity Investing

Originally published September 30, 2021.

This week we take a deeper look at private equity and venture capital as we look to emulate the strategies and investment vehicles that the ultra-wealthy use to generate better returns and diversification. Average investors have historically been under-allocated to these asset classes, but for many ultra HNWIs, their allocations to private equity are equal to their allocations to real estate. Learn the key strategies for investing in private equity and venture capital, and the different structures and their pros and cons.

Connect with Bob Fraser on LinkedIn https://www.linkedin.com/in/bob-fraser-22469312/

Connect with Ben Fraser on LinkedIn ⁠⁠⁠⁠⁠⁠https://www.linkedin.com/in/benwfraser/⁠

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Transcription

Ben Fraser: Welcome back to the invest like a billionaire podcast. We’re really excited about this episode. We’re going to be talking about private equity and venture capital. 

Private equity is actually a very big holding of these institutional family office wealthy investors. And as we’re doing the research, even larger than I had previously seen.

Bob Fraser: And so our continuum shows basically that most investors, retail investors, are pretty much entirely in stocks and bonds, very under allocated to alternatives. Yeah. As soon as you get up into the wealthier categories of investors, They start getting into private real estate and even the bigger guys and more sophisticated guys are getting more into private equity and hedge funds.

So it’s a continuum, the more sophisticated, the more assets to deploy, the more you’re into these other strategies, but it doesn’t have to there’s no reason why guys that aren’t billionaires can’t emulate their allocation methodologies and get their outsized returns. 

Ben Fraser: Exactly. And so the continuum here. 

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Level one is the stocks, bonds, mutual funds, standard portfolio. Level two, we talk about real estate investing. That’s where a lot of investors’ next step is real estate. And then third here is private equity. And, we have some cool data from Tiger 21 and this is a group of ultra wealthy investors.

You have to have at least 10 million of investable assets to be a part of this group, and they survey their members, which is over 700 members. So this represents at least 70 billion ultra wealthy investors’ portfolios and a huge portion of it is in private equity and it is just about equivalent to real estate.

So this is a big deal. This is a big part of what investors are looking at and. I think a big part of what the average high net worth is probably not as much. So this is something I’m really excited to dive into. And a little bit of background on Bob and I. So my background before the private equity world was as a banker and as an underwriter and a lender for several years and did quite a bit of M& A or mergers and acquisitions.

Did several leveraged buyouts. Also did some distressed financing. 

Bob Fraser: So you’ve seen all these strategies we’re talking about basically. Yes. 

Ben Fraser: So I’ve seen a lot of these strategies at play and it’s very cool. We’ve seen a lot of people make money and then you see a lot of poor deals as well. And so it’s really important to understand what the strategy is, where we’re at in the cycle and some of the different things that impact the strategy and the returns.

And then Bob and I share a little bit about your background as a tech entrepreneur. 

Bob Fraser: Yeah. So I am a computer scientist by background. And started a tech business in the late nineties that we got in one of the larger VC VC companies in the Midwest and the United States. It became one of the fastest growing companies in the Midwest United States in the late nineties.

And won the Ernst and Young Entrepreneur of the Year Awards. I’m very familiar with venture capital and also with hedge funds because I also was a hedge fund manager for a while. So yeah, so it’s a great space to be playing on and let’s dive in. Okay, 

Ben Fraser: perfect.

So first off, it’s helpful to talk about what private equity is, right? This is a term that a lot of people have heard and it can mean a lot of different things. And so very simply in the way we’re going to describe it is these are investors that are raising capital usually in a fund structure that they are investing in.

Private companies with the goal to either IPO or do a public offering at some point or to sell and be acquired to a larger competitor. And so very simply that, that’s what the strategy 

Bob Fraser: is. Really, it’s the Shark Tank, right? Exactly. That’s private equity. So you’re basically buying a stake.

In these companies, private equity is generally speaking passive. So you have managers who would deploy your capital. So if Mark Cuban had a shark tank fund, you would invest in his fund and he would deploy it for you. So that’s the idea. But within that, there’s a huge gamut of opportunities.

Ben Fraser: Yeah. And just as a quick aside, a lot of people say real estate, private equity, and that, that is technically true. And what we talked about in the last podcast, that is a subset of private equity, but it’s so large, it’s its own animal. And so we’re talking about investing in businesses and companies, not real estate.

Bob Fraser: So these are operating businesses. This is not a piece of real estate, necessarily it’s an, it’s a business that’s doing some kind of operations and producing income. 

Ben Fraser: And if you’re new to this space as well, why should I be invested in private? Equity versus public equity, which is stocks and, we found some great research from Bain Company, a large consulting firm, and they’ve done pretty exhaustive research in comparing the returns of private equity companies and their comparable benchmarks in the public markets.

And there, the returns over the past 30 years on average have been over 13%. Annual. 

Bob Fraser: Annually. That’s it. 

Ben Fraser: Darn good. Very good. And then the comparable benchmark for that in the public markets was in about 8 percent return. Still good. Which is still great. And that’s, a lot of times people quote that number as the long term average of the S& P of, over the past 100 years or so.

So that’s within that range, but this is substantial outperformance and we’re going to dive into what these strategies are. And it’s obvious… You’re pretty clear why investors like these strategies, right? The biggest drawback, and we’ve talked about this in prior episodes, but is usually going to be liquidity.

And that’s for any kind of private market investment, that’s going to be the biggest drawback. So you’re giving up liquidity for 

Bob Fraser: meaning you can’t get your money back when you want it. It’s locked up for a, it’s in prison for a period of time, but it’s in a very gilded prison.

Ben Fraser: And the reason it’s locked up is these companies that execute these strategies generally have longer time horizons to execute the full strategy. 

Bob Fraser: You got to go do your IPO or find your buyout. Now you talked about these returns but what you didn’t mention is that in the last few years, the returns have not been that good.

Ben Fraser: Yes. If you look at the last 10 years, the outperformance is much less compared to the benchmark. And it makes sense. The last 10 years, the public markets have been on a tear, right? The annualized return has been very high. But, there’s a few things there. One, on the long term average, the stock market has not sustained those levels of returns.

So if you look at it in a broader, scope, 

Bob Fraser: It’s not fair competing against the S& P 500 for the last decade because it’s been ripping. But 

Ben Fraser: the other side of it is because of these returns, it has attracted more capital. And just like we’re talking about now to introduce these strategies to newer investors the regulation changes have allowed a.

The floodgates of capital flow into space. And so it is important to look at these with a little bit of a grain of salt and realize that, its timing is important and there’s a lot of capital looking for a good return. With that, let’s jump right in and the way we’ve broken this down is the easiest way we think to describe it is really by the business cycle.

So if you have a business background, you understand kind of the stages of business at a large scale, right? It’s the early stage, your startup stage. Growth stage, mature stage, and then declining distress stage. And, over the long haul, most businesses go through some level of the cycle. And there’s different strategies involved with each stage of the 

Bob Fraser: cycle, right?

Different strategies that apply to businesses in that stage, right? 

Ben Fraser: So let’s just jump into the first stage, which is the early stage. And so this is where most people hear the term venture capital. That’s most of the time where they’re going to be playing is in this early stage company. It’s going to be a pre-revenue company many times.

They may have some level of a prototype of a product or software, but it hasn’t been fully tested on a large scale and they go to raise money from. Venture capital firms, angel investors with the hopes of making it big. So talk a little bit about this kind of strategy here. You have some experience here.

Bob Fraser: Yeah, so it’s minority ownership. So the idea is a venture capital investor generally does not take over the company. They just simply add a board seat. Usually there’s multiple rounds. So actually different within this early stage, there’s actually a different stage of venture capital.

You have venture capital that love seed stage, which is literally two guys and an idea, all the way to the mezzanine stage or pre IPO stage. And it’s all considered venture capital. They invest different amounts of money and usually get larger over time and at higher valuations, but less risk.

Exactly. And so typically what they’ll do is they’ll come in and do an A round, a B round and a C round. There’s three separate rounds of financing that are generally a year or more apart. And the idea is each one is bigger, higher valuation and preparing you for your eventual exit, which is either a strategic acquisition or an IPO.

So these are generally fairly high risk companies. And so the strategy is basically to, to get to go for a shoot, go for moonshots. So I, the very first guy that invested in my business, was actually a very well known venture capitalist and was with one of the very early venture capital firms in the eighties and was one of the most successful.

And he said this was their strategy, that they look for one in 18 of their investments in their fund. One in 18 has to hit. And they only look for companies that have a potential of doing a 100X investment. So it’s a moonshot. And that’s their strategy. And basically, if they get a double in any of their companies, they get a double or a triple it’s a wipe.

They couldn’t care less. They’re only looking for you’re looking for a hundred Xers and pretty much everything else. They just X out of, it’s irrelevant. It’s immaterial to them. And so that’s the strategy to look for one in eight, 18. And they had super high returns during their heyday.

They were returning over a hundred percent per year to, to investors. Now those returns haven’t been sustained but if you look at the top quartile according to Cambridge research, the top quartile of venture capital firms have produced around over the last 10 years or so have produced between 15 and 27 percent annual returns.

So yeah, on the other hand, the bottom quartile, the underperformers. They’re single digits. Sure. So it’s typical in this stage, there’s a lot of the good guys, the guys who are very good at this are just killing it. And so very high returns potentially, but also, a fair amount of risk.

I will point out it’s very cyclical too, so almost all of them rely on a very Active and hot public market. Even if the strategic exits, they’re looking at the strategic players. So the big strategic buyers usually are accessing public funds. So if the market just had a big crash, you see all of this fall apart.

So what happens is in the business as the business cycle. The broader business cycle continues, the time to invest in VC is at the beginning of the business cycle, near the bottom of the business cycle, or is it we’re just emerging into a growth phase. During March.

2020 COVID pandemic, there’s nobody doing IPOs. There’s nobody, there’s not a lot of activity. Everything is just seized up. The markets are just seized up. Same as in 2008, 2009, 2010, there is no activity. VCs are not, they’re basically sitting on their capital trying to figure out what to do because of that kind of thing.

So those are actually good times to get started knowing that in five years. You’ll have a good exit as the markets recover, potentially. So you want to be early to mid cycle in investing in VCs, in my opinion. 

Ben Fraser: It’s just a quick sum up. So in this, at this stage, it’s higher risk because, these are early companies, haven’t been proven at a larger scale, but the returns can be very substantial.

A lot of times that one or two winners will pay for all the ones that didn’t work out. And usually. Above what you did not capture on that. So the next stage here is really a growth stage. And this is still, I would consider venture capital because it is more minority ownership.

And maybe it’s a later stage of the fundraising a series B, a series C. And the idea here is it’s a company that’s been proven. So they’ve got revenue coming in, they got customers, they’re growing healthfully, but they want to scale faster. And so if it’s in a particular industry where it’s harder to protect your IP, if it’s tech or something like that.

It’s beneficial to scale faster to partner with a growth equity firm that will come and invest alongside and usually, again, in a minority way and help them scale faster. And so one of the things in both of these stages is a concept called cash burn. You want to break down what cash burn means in these stages?

Okay, I can’t. So cash burn is effectively the, these investors come in and add more capital and the goal is growth. So they’ll go and hire more employees. They’ll go and spend more in marketing and they’ll basically load up the expenses to where they’re running at a net operating loss.

But the hope is that they’re generating, trying to generate top line, and generate enough revenue. And then at some point that’ll catch up. And you won’t need the capital that funded the cash burn for a while. So that’s very common here and something that, you know, in your experience, with this VC firm and your past company was the strategy, right?

You’re growing. Oh yeah. 

Bob Fraser: Yeah. You start hiring everybody you can and the burn rate just goes to the moon, but also the revenue does. So yeah, that’s the strategy. And it’s, so it’s either you land on the moon or you flame out, there’s no middle ground, but that’s their model, 

Ben Fraser: right?

So a lot of times the firms at this level can be a little more creative in the types of financing. So if it’s a more well established company, maybe it’ll come in as a debt partner or as a mezzanine debt, which we’ll talk about in a minute. But they’re not taking as much of the upside, but they may charge higher interest rates to the companies, but then they don’t have to give up as much equity.

And so you see different strategies at play here. One, one kind of a very common strategy is what is called the roll up strategy, which is a cool concept. And you want to break that down a little bit? Yeah, 

Bob Fraser: So it’s very common. So when you have a fragmented industry, I’ve seen several strategies here that just are great winners. That happened with accounting firms, lots of little accounting firms and CBS came in and started buying all these little accounting firms to build really what’s to become an accounting giant.

Sure. At this point. And then now, so you take these small firms and they’re heavily discounted to the market. So if this little accounting firm was actually public, if it was 100 times bigger and public, they would get much higher multiples in revenue, right? Or earnings. Yep. Okay.

So private companies are heavily discounted and their multiples are very low. So a typical private company multiple might be five or seven X means they’re, the company is valued at five or seven times. Earnings in the public markets, it’s 20 to 30 to 40 or if you’re Amazon 93, a thousand.

So the, so when you access public markets, you get a lot, the value of the company goes up dramatically. So the idea here is to roll up smaller companies and use the private company discount to assemble a stable of very good smaller companies. And so one, one strategy was, like I just said, the accounting firms, another one I’ve seen these guys hired there.

They basically bought the leading car dealership. These are high cash flowing businesses, but too small to go public. They bought the leading one with the best systems, the best processes, the best automation, the best everything. And they paid a higher multiple for that company.

And then they went and did an acquisition strategy to buy all the little smaller guys at much lower multiples. And then use the management team of the first one to basically replace the management or the operations of these other little ones and to build a very large conglomerate of car dealerships that had the excellent.

Operating characteristics of the first one they did. And it’s basically a finance play. It’s a finance engineering play. You have access to this fine, cheap financing to buy all these companies. You create a nice exit for these mom and pop operators, but you create a huge amount of value.

You could create hundreds of millions and billions of dollars in value just by doing this strategy. So it’s called a rollup strategy. Very common. If you pick the right industry and you have the right timing, great money can be made there. 

Ben Fraser: Yeah. So it’s obviously a little bit less risky than the early stage because these are established businesses.

So you’re not necessarily banking on the home run, and one of 18 or whatever. Moreover, I’d call good solid doubles. You’re hitting really good doubles. And a lot of value can be created as you achieve that scale, not only do you. Get more operating income, but you also expand the value based on the multiples that are being paid at the larger level.

A lot of firms play, play in that stage the next strategy is what we’ll call the mature stage. And so these are large companies. They are not high growth at this point. They’ve either kind of achieved market saturation. They’re well established brands.

A lot of times they’ll even be publicly traded. Businesses that then get taken private but they have strong cash flows. And so because of the cash flows, you can do a lot of things with it. And if you have a strong cash flow in business, then it can attract a lot of cheaper financing from banks.

And so a lot of times what they’ll do, the strategy here is usually twofold and it’s either financial engineering. 

Bob Fraser: So this is a leveraged buyout is what you’re 

Ben Fraser: describing here. So the most common way that they execute a strategy in a mature business is a leveraged buyout. And so effectively what that means is, if you understand real estate, it’s a very similar concept where you are buying a company with both equity and debt.

You bring the equity and then you work with a debt partner like a large bank. 

Bob Fraser: And because there’s cash flow in this business, you’re using the cash flow of the business you’re buying to basically get a lot of cheap debt. 

Ben Fraser: Yep. Get a lot of cheap debt. You can already cover the debt payments from that.

And then any increases in value that you create have a multiplying effect because of that debt isn’t taken to the upside. And so it’s a multiplying effect on equity. Just if 

Bob Fraser: you bought real estate on, and that real estate has a 5 percent return, but if you leverage it up and you only put 20 percent down you got a way higher than a 5 percent return because of the leverage.

So it’s that kind of a deal. 

Ben Fraser: Exactly. Exactly. So that’s the financial engineering side of it. And the other side of it is, operational efficiency. So a lot of times these companies get big, they can get bloated with the expenses and, staff and technology, other things.

And you can bring efficiencies if you have an experienced management team in a certain vertical or certain business segment that they’ve done this before and they can. Operate these businesses and the other kind of big differentiator at this stage is when they’re doing a leveraged buyout They’re not coming and taking a little piece of the business a minority stake They’re actually buying the whole business and operating it, right?

And so it’s a very different set of risks because this is a full operational strategy, right? And so generally you want to find sponsors and funds that have experience in certain verticals. And because of that, a lot of them will specialize 

Bob Fraser: in certain verticals. And I’ve actually seen where a lot of these bring their own management teams.

Yeah. So they have the guy that’s done, X number of years, who’s the awesome food guy. Or the awesome IT guy or whatever he is in this industry that knows this whole business. And so it’s like a full on head transplant here, right? , where you go in, throughout the old guys bringing the new team and take this to the, take it to the moon.

So depending on these strategies, there can be some great wins here as well in the L B O space, 

Ben Fraser: yeah. And then that kind of leads us to the next part, which is the decline and distress stage. A lot of times, the mature stage there, they haven’t, they’re not on a downward trend, but they’re not having huge growth.

But at this next stage, this is really where companies are maybe past their heyday, right? And they’re looking for some help, right? Do we, how do we turn the ship around and right this ship? And it’s a lot, it’s again, I’m in majority ownership generally.

Absolutely. And it’s, you’re operating the business and you have to turn around a company. So as an underwriter, I’ve seen several of these and it’s risky, right? Because what is the current management doing that is not working? And what’s 

Bob Fraser: the new management going to do that’s going to change all 

Ben Fraser: that?

It’s going to change all that. But it depends on where you’re at and what the business cycle and what types of businesses you’re going after. But one thing is interesting. Concept I’ve seen in this space is there’s a guy who is raising capital for a fund that is going and buying well known retail brands.

So he’s buying things like Stein Mart, Radio Shack, these names that everybody knows, but are on their last legs and he buys them for pennies on the dollar. And then his background is as an e-commerce business doing a lot of e-commerce business and helping businesses scale online.

And so 

Bob Fraser: he’s So he does a high tech turnaround for these 

Ben Fraser: things. Exactly. So he uses the existing brand awareness and leverages that online to help turn his businesses around and he picks them up for super cheap. And the goal is to get a nice multiple when these businesses.

Pick back up. And so that, that’s another very interesting strategy that, that some will play in. It’s obviously, again, gonna be very specialized in the business segment you’re gonna be in and make sure you can 

Bob Fraser: operate a business, but you can make money in any and all of these strategies.

The key is finding great operators and Right as an investor knowing, hearing the story and believing the story that this is the right timing for this kind of opportunity. 

Ben Fraser: Yeah. Yeah, we’ve said it all along, these strategies can be applied to a variety of industries and a lot of times there’ll be multiple industries that you can use different strategies in, it’s not just the big high tech companies.

Its manufacturing is a very commonly targeted PE focus because it’s a boring business. It’s high cash flow and it’s generally not going to go anywhere anytime soon. There’s a lot of ways that you can play in this space. Let’s talk a little bit about structure. So this is, we’ve talked about the overall strategies and how firms execute them.

Next question would be how do I invest in these? What are the best ways to get involved in private equity? And that’s what we want to talk about now. So really the first kind of easiest way to get in, I would say is angel investing, right? It’s, that’s a term maybe some have heard, and it’s very simply, Generally individuals, sometimes groups of individuals that are going to go and invest in a company.

And a lot of times it’s going to be an earlier stage at this point because they’re writing not as big of checks as maybe a big P. E. Firm would. But they are going to come in as an advisor a lot of times if they have experience in this type of business and a little more hands on. And, a lot of times there’s local angel investing groups, local groups that you can get involved with that you can invest in local companies.

And so it’s a really cool way. If you want to be more actively involved, angel investing is a great thing. We know a lot of people that are actively involved, that are investors with us in Aspen and They’ve hit a point where they’re financially set, but they want to give back and help other people be successful and in their businesses.

And so it’s really a cool mentorship, but also financially rewarding way to invest. Yeah. 

Bob Fraser: The problems are there, you get in a high cash burn business and you bring in a little bit of money and you realize that they need a whole lot more money. And you realize that, so you’re not the be all and end all and you don’t have a controlling interest.

So a lot of these, a lot of these don’t have good outcomes, and so if you’re going to do individual angel investing, you better know the deal and you better have a pool of these things, a large group. Because a lot of times this is not, doesn’t have good outcomes in my 

Ben Fraser: experience.

Yeah. So tread carefully. And obviously if you’re going to be investing in the individual companies, you lose diversification, right? It’s a principle of investing where you don’t want to have all your eggs in one basket. And it’s important if you are doing these kinds of individual investments, do smaller amounts and spread it 

Bob Fraser: out across.

And I would only touch areas that you’re actually familiar with. So if you’re a biotech guy, then. Do that. If you’re a tech guy, then do that. If you’re not any of those things don’t touch them because you’re really probably should let someone who’s qualified do those kinds of deals.

So yeah, you can make it, and it can also be a time sink. You can, it can take a lot more time than you really want to put in. These are generally very needy businesses and high stress businesses. 

Ben Fraser: Yeah, the next level would be crowdfunding. If you have ever looked into angel investing, a very common place that people look now is AngelList.

This is basically an online platform where businesses that are looking to raise money will go and put their business deal up there with their valuations, how much they’re looking to raise and try to attract individual investors. 

Bob Fraser: And AngelList actually has experienced VCs Who are on their own little funds and you can put money into them.

So to get with the big boys, the guys at the top quartile probably have to write a much larger check and it is very difficult to get in those things. But AngelList has some less known VCs who, I don’t know where they would fit in the return range, but there’s literally, they have their resumes up there and their returns and you can.

There’s dozens of them. You can pick, okay, I’ll follow this guy and you can even do monthly subscriptions. They call them the rolling funds. So, a small player’s way to play in the angel world. And they also have their own fund. They’re on the AngelList sponsored fund that they 

Ben Fraser: do.

So obviously benefits of doing that, at AngelList they have a very wide array of options, right? If your deal flow is limited, because you’re not in this space actively. It’s a great way to see a lot of different types of deals, how they’re raised, how they’re being valued.

And like you said, you can invest alongside experienced VCs. So you can use that as, hey, if all these guys are jumping, it’s probably. Probably got some potential. But some of the downsides are, you’re gonna, it’s gonna be harder to do due diligence on a company that’s at that level.

And you’re usually going to be a smaller player, a smaller fish in the pond. So you’re going to have less impact on the overall financial decisions and operational decisions. You’re going along for the ride, and can have some great outcomes there. And that kind of leads to the next way to invest.

What is SharesPost? SharesPost. Yeah, I found this one the other day. So this is a similar deal, but it’s basically you’re investing alongside VCs. And you can be a small sliver of the capital stack. And so I think it’s similar to an angel. This other one is known to our crowd.

I found recently that it’s very similar. So all of these are different made parts of 

Bob Fraser: Now where’s the one, there was one where people had options and shares of pre public companies. We’re actually listing them for sale. I thought that was shared. Oh, interesting. I think that was shares post maybe that was, yeah, that’s, so that’s, if you wanna buy a share of Dropbox before it ever went public, you could buy it, but you don’t know, that’s risky too.

Because they might have a stinky I P O or they may not have an I P O, but Right. You can buy the shares usually 

Ben Fraser: had a discount to a park as if person needs liquidity, and so they’re willing to trade or at a premium 

Bob Fraser: because they’re greedy. , either way, you never know, but, 

Ben Fraser: Yeah. Yeah, the other one is probably the most common way, if you want to get in this as more of a passive investor, which is really what we’re targeting with our audience, right?

Is that how we diversify across a lot of different asset classes passively and not have to have the brain damage of operating these deals? Yeah. And this is generally the way 

Bob Fraser: to go if you get a super experienced operator who has a very well defined strategy, clear target. All the staff and analysis to do this right.

And those are the guys that win generally. Yeah. 

Ben Fraser: Yeah. So this is again, investing directly with a private equity fund. And so again, you’re going to leverage the experience and the expertise of a sponsor that has a great track record. That’s been in this particular space for a while. They get all the deal flow, they get all the best terms and financing there.

Have all the staff in place to help execute these strategies. And that’s. Generally going to be the best way to go as you’re getting into this. And again it’s more passive and a lot of times they’re going to raise a fund. It’s going to invest in a lot of different companies, right?

Anywhere from a handful all the way up to a dozen to two dozen. And so you get a lot of diversification that way too. When these firms are investing and spreading across several that are going to. 

Bob Fraser: Yeah. All right. Excuse me. You’re going to pay their fees, but generally they’re worth it.

If you get the right guy, they’re bringing a massive amount of expertise and they’re going to create a massive amount of value through their expertise. Yeah. And you get to sit back and watch and get some passive returns. 

Ben Fraser: Yeah. And the numbers we quote earlier on the Bain company’s research.

Was net of fees, right? So it’s clear that even with paying maybe an asset management fee or whatever fees they’re going to charge are going to be, it’s going to be worth it, from a net standpoint. Some of the cons though is, if they’re raising it in a fund, a lot of times it’s a blind fund.

You don’t know what target. Companies they’re going to invest in and so you don’t have a lot of visibility into the exact portfolio companies that they’re going to be. It’s a blind pool. It’s a 

Bob Fraser: blind pool. So you either do all your own due diligence or you find the team and let them do it and you pay them to do it.

And so it’s really your risk profile. What do you want to do? You kick the tires kind of guy, or are you a, I’m going to hire the right guy and let them kick the 

Ben Fraser: tires. And really the next way to invest in, in, in private equity is really, a subset of investing with PE funds because this is a fund of funds.

And so the concept is you invest with a manager that has a fund that then goes and invests in other PE funds, right? It’s not even investing directly in companies. They’re investing in other funds. And so this is even another level of diversification. To where it’s not only Diversification across the portfolio companies, but also different strategies.

So maybe they’re going to do some leveraged buyouts, maybe do some early stage and they can mix and plug and play 

Bob Fraser: where they want. And you would think, gosh, why would you add another layer of fees? But again, in my research, these guys can do a really good job. They actually do a better job because one, they know who the better players are.

Yes. They also have a macroeconomic view, so they may say based on our timing of the IPO market, we need to heavily wait towards this type of fund or this type of fund. And I know who the managers and operators are, the sponsors in those areas. And so it’s not, it’s, they generally. Earn their keep by making their general, these are more of the super brainiacs who are doing the real analysis and of all these different funds and they can generally get pretty good deals.

We know how much sponsors sometimes give sweetened deals for capital. Yeah. And so it’s, you could, they could be, you’re out in layer fees, but you’re getting a discount from what the other investor so it’s not a, it’s not an automatic don’t do this. In fact, I would say it’s a great strategy, generally probably it’s the larger investors that are going to go for the fund to fund guys.

Sure. But it’s a good option there. And I’ll say this too, as we’re, wrapping up on this, that, I had my, my venture capital friend he said here’s our investment axiom is we always invest not on the horse. But we don’t bet on the horse, but we bet on the jockey.

Yep. So they’re looking primarily for an operator that has a certain profile and track record, et cetera, versus that particular business plan or that particular deal. Yep. And I would say really through. Help this whole, all the strategies, all the structures. That’s really the best strategist.

Find the jockey you believe in, not necessarily the vehicle you may one particular deal more than another particular deal, one particular investment or something else but really the best way to pick. In my opinion, it is to find the best operators and let them do their thing.

And so that’s just a common axiom that’s time tested. Yeah, 

Ben Fraser: absolutely. Absolutely. It is really the last point we want to make here. We addressed this in the last episode. In real estate investing, and it’s very similar, the capital stack of this can be overlaid across any strategy that a particular, 

Bob Fraser: It’s like a 3d chess network plan.

So our continuum is more like. 3Ds 

Ben Fraser: and 4Ds. Yeah. So there’s so many ways you can slice and dice this but generally, there’s going to be, the equity funds that are going and playing on the equity side of the capital stack. 

Bob Fraser: That’s where your shareholder or an owner in the shares of the business, who’s the last guy to get paid.

Yep. Generally. Yep. Or you can go up the capital stack to the debt side as well. So there’s venture debt and there’s growth debt and mezzanine 

Ben Fraser: debt. Yeah. There’s senior debt as well as junior debt. Mezzanine debt is generally going to be junior debt, and they will charge a high interest rate, but they also may take some of the upside, but it’s not going to be as much upside as an equity investor.

And if you are looking at these types of funds, pay attention to where they’re at in the capital stack, because obviously the higher up you are, the closer you are to debt. The less risk there is because your first money out, you get paid first and the farther you are closer to the common equity, the more 

Bob Fraser: risk you have.

And I would say too, it’s like the more sophisticated investors are, the more they like the debt space. And, the less sophisticated investors love equity. Hey, let me play for the upside but the reality is the debt guy’s structure deals so that they always get paid.

They get paid first and they get paid most. It’s just, it’s paying me. And they take far less risk and they can earn really good returns and then they can take a chunk of the upside too. The deals they caught are sometimes crazy good. And where there’s far less risk.

And almost equity level returns and yeah they don’t not do a debt fund because you don’t think there’s enough upside. 

Ben Fraser: So yeah, if you compare a debt fund as opposed to debt and a real estate property. They’re very different. Debt funds and private equity can be making double digit returns, both from the interest rate they charge, as well as any carried interest in the profits.

And 

Bob Fraser: So just for example, let’s take a private equity, growth, private equity company, and you’re doing a mass debt. Maybe you’re getting 10 to 15 percent on the mass debt, maybe it’s junior debt but you understand how many assets are in play here. So it could be that your debt is a hundred percent secured.

By the building that they own and the, you follow me? So you’re earning almost the same level of returns but far less restless and you understand, you understand the senior mortgage or the senior debt in front of you. You understand. So even if the jockey doesn’t.

does a lousy job. You’re going to make money because you’re going to be able to take the assets. And so it’s not a, it’s not a, Hey, don’t look at this just because it’s debt. In fact, it’s the other way around. So I find the more sophisticated players are, the larger players are, the more they love the debt space and the more they take on debt.

They basically. Change, change the debt around. I had, I remember arguing with my venture capital guys, back in the day and they, and I would argue for a certain valuation or see, you don’t want to, how you always want to argue for the entrepreneurs to argue for a higher valuation. The investors are in for a lower value valuation to put the money in at.

And I remember one of the venture capitalists laughed at me and said, tell me what valuation you want. I’ll give you whatever valuation you want as long as you let me write the terms. . Exactly. That’s, and so then put all these different covenants and terms Yep. And levers and triggers and other things.

And I, it’s where the evaluation was Exactly. And I learned a thing or two. Yeah. So these guys are financial wizards, a lot of the guys that are structuring this stuff. And they, it’s structured that, heads, I win tails, you lose, kind of deal. So from an investor’s point of view, there’s some huge wins in the debt space and mass debt space.

Yeah. 

Ben Fraser: And the last thing I wanted to hit here real quick is you mentioned this at the beginning is that a lot of these strategies work better earlier in the economic cycle. And so what would you say, where we’re at in the economic cycle and what areas of this would you.

Jump into or would you wait, would you see if, we are arguably at the later end of a business cycle, there are a lot of things happening with the federal stimulus and other things that are prolonging this economic run. 

Bob Fraser: And this is a very, it’s a great question and a very weird cycle.

And every cycle is different. That’s why this isn’t a, this isn’t checking the boxes. In type investing and requires thinking and really the business cycle kind of bottomed in 2008, 2009. And we’ve been on a tear pretty much, ever since of course we had a very slow growth where you saw the, the, just looking at the unemployment rate did not recover during the Obama years.

And. And just, we could barely, so it was not much of a recovery. So I would say we were still in the bottom even through, 2013, 2014, 2015 timeframe. So then what happened is things really started to shift and all the stimulus started really trickling down and it started working.

So we were early, early, early stage of the business cycle there. Then COVID hits March. March 2019 and everything crashed. And so it reset the cycle again. And so we’re still now as we’re in recovery, we’re in early, we’re in the bottom cycle with a caveat that there is a ton of money because of the stimulus in the public markets.

So it’s an early stage, but hyped. I think really, honestly I think all these strategies would, it’s a good time for these strategies. The IPO market is still hot as can be. We’ll see if that continues. We, again, my, my forecast is we’re going to see upward bias in the markets, but a lot of volatility in public markets.

And since that’s the source of all the capital, generally for everything used in all these strategies, if there’s a hiccup, things generally slow down. But at this point I think we’re not yet at the end of the cycle and simply because of the one, we had the COVID reset and then we had this massive stimulus happening.

In addition it’s putting more fuel on the fire. 

Ben Fraser: And a lot of these strategies can be executed in shorter time frames, three, five, seven years. And so especially if the strategy is on the shorter end of that, your risk from a cycle standpoint is limited as well. Yeah. So awesome. Was a lot of information.

Hopefully that was helpful to break this down. In the future we are going to be interviewing guests that are operating in this space that either run. Funds that are doing private equity strategies, venture strategies. And so we’re pretty excited to get some of those guys and gals on board and talk more about this.

Stay tuned for the next episode. We’re going to be talking about hedge funds. This rounds out our big three on the alternative investment continuum and we are breaking down what those look like. And thanks for joining. Yeah.

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