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Intro To Venture Capital & Private Equity Investing

ILB 3 | Private Equity Investing

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.

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Intro To Venture Capital & Private Equity Investing

We are excited about this episode. We are going to be talking about private equity and venture capital. In the last episode, we covered the wide world of passive real estate investing. If you haven’t read that episode, I encourage you. It’s a high-level broad strokes view of real estate investing, what does that look like, how do you do that and what are the different strategies and structures involved. We are going to take a similar approach to private equity.

The whole concept of this show is investing like a billionaire and emulating the strategies and investment vehicles that the ultra-wealthy are using to generate better returns and diversification that the average investors have historically been very under-allocated to. The three big alternatives that these ultra-wealthy investors are investing in are real estate, private equity and hedge funds. The next episode will be on hedge funds. That’s going to be a fun one as well. The interesting thing is private equity is a big holding of this institutional family office of wealthy investors. As we are doing the research, even larger than I had previously seen.

Our continuum shows that most retail investors are pretty much entirely in stocks and bonds, very under-allocated to alternatives. As soon as you get up into the wealthier categories of investors, they started getting into private real estate. Even the bigger and more sophisticated guys are getting into private equity and hedge funds. It’s a continuum. The more sophisticated and assets to deploy, the more you are into these other strategies. There’s no reason why guys that aren’t billionaires can’t emulate their allocation methodologies and get their outsized returns.

The continuum here, Level 1 is the stocks, bonds, mutual funds and standard portfolio. Level 2 we talked about is real estate investing. That’s where a lot of investors, the next step to go to is real estate. The third here is private equity. We have some cool data from TIGER 21. This is a group of ultra-wealthy investors. You have to have at least $10 million of investible assets to be a part of this group. They survey their members, which is over 700 members. This represents at least $70 billion of ultra-wealthy investor portfolios.

A huge portion of it is in private equity. It is about equivalent as in a real estate. This is a big deal, part of what investors are looking at and a big part with the advertiser net worth is probably not as much into. This is something I’m excited to dive into. A little bit of background on Bob and me. My background before the private equity world is as a banker. I was an underwriter and lender for several years. I did quite a bit of M&A or Mergers and Acquisitions. I did several leveraged buyouts. I also did some distressed financing.

You have seen all these strategies we are talking about basically.

I have seen a lot of these strategies at play. It’s very cool. I have seen a lot of people make money and then you see a lot of poor deals as well. It’s important to understand what the strategy is, where we are at in the cycle and some of the different things that impact the strategy and returns. Bob, I shared a little bit about your background, which is a tech entrepreneur.

A computer scientist is my background. I started a tech business in the late ’90s. We became one of the fastest-growing companies in the Midwest in the United States in the late ’90s and one of the Ernst & Young Entrepreneur of the Year Award. I’m very familiar with venture capital and also with hedge funds because I also was a hedge fund manager for a while. It’s a great space to be playing on. Let’s dive in.

First off, it’s helpful to talk about what private equity is. This is a term that a lot of people have heard. It can mean a lot of different things. Very simply, in the way we are going to describe it is, these are investors that are raising capital usually in a fund structure that are investing in private companies with the goal to either IPO, do a public offering at some point or to sell and be acquired to a larger competitor. That’s what the strategy is.

It’s the Shark Tank. That’s private equity. You are basically buying a stake in these companies. Private equity is generally speaking passive. You have managers who would deploy your capital. If Mark Cuban had a Shark Tank fund, you would invest in his fund and he would deploy it for you. That’s the idea but within that, there’s a huge gamut of opportunities.

A lot of people say real estate private equity is technically true. What we talked about in the last episode was that it’s a subset of private equity but it’s so large. It’s its own animal. What we are talking about is investing in businesses and companies not real estate businesses.

[bctt tweet=”There’s no reason why guys that aren’t billionaires can’t emulate their allocation methodologies and get their outsize returns. ” via=”no”]

These are operating businesses. This is not a piece of real estate. Necessarily, it’s a business. It’s doing some kind of operations and producing business income.

If you are new to this space, why should I be invested in private equity versus public equity, which is stocks? We found some great research from Bain & Company, a large consulting firm. They have done exhaustive research in comparing the returns of private equity companies and their comparable benchmarks in the public markets. The returns over the years on average have been over 13% annually. The comparable benchmark for that in the public markets was about an 8% return.

A lot of times, people quote that number as the long-term average of the S&P. That’s within that range but this is substantial outperformance. We are going to dive into what these strategies are. It’s clear why investors like these strategies. The biggest drawback is usually going to be liquidity. For any kind of private market investment, that’s going to be the biggest drawback so you are giving up liquidity for the returns.

Meaning you can’t get your money back when you want it. It’s in prison for some time but it’s in a very gilded prison.

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

You’ve got to go to your IPO or find your buyout. 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.

If you look at the last couple of years, the outperformance is much less compared to the benchmark. It makes sense. In the last couple of years, the public markets have been on a tear. The annualized return has been very high but there are few things there. One, on the long-term average, the stock market has not sustained those levels of returns. If you look at it from a broader scope, it’s quite complex.

It’s not fair competing against the S&P 500 because it has been ripping.

The other side of it is because of these returns, it has attracted more capital. Like we are talking about how to introduce these strategies to newer investors, the regulation changes have allowed the floodgates of capital to flow into space. It’s important to look at these with a little bit of a grain of salt and realize that timing is important and there are a lot of capital looking for good returns. With that, let’s jump right in.

The way we have broken this down is the easiest way we think to describe it is by the business cycle. If you have a business background, you understand the stages of business at a large scale. It’s the early stage, startup stage, growth stage, mature stage and then decline, and distressing stage. Over the long haul, most businesses go through some level of the cycle. There are different strategies involved with each stage of the cycle

Those are different strategies that apply to businesses in that stage.

ILB 3 | Private Equity Investing
Private Equity Investing: The time to invest in VC is at the beginning of the business cycle, near the bottom of the business cycle, or as it is emerging into a growth phase.

Let’s jump into the first stage, which is the early stage. This is where most people hear the term venture capital. Most of the time where they are going to be playing is in this early-stage company. It’s going to be a company that many times are pre-revenue. They maybe have some level of a prototype of a product or software but it hasn’t been fully tested on a large scale. They will go raise money from venture capital firms and Angel investors with the hopes of making it big. Talk a little bit about the strategy here. You have some experience here.

It’s minority ownership. The ideas of a venture capital investor generally do not take over the company. They just simply add a board seat. Usually, there are multiple rounds. Within this early stage, there are different stages of venture capital. You have venture capital that loves seed stage, which are two guys and an idea to mezzanine stage or pre-IPO stage. It’s all considered venture capital and they invest different amounts of money. It usually gets larger overtime at higher evaluations but it’s less risky.

Typically, what they will do is they will come in and do an A-round, B-round and C-round. These are three separate rounds of financing that are a year or more apart generally with the idea that each one is bigger, higher evaluation and preparing you for your eventual exit, which is either a strategic acquisition or an IPO. These are generally fairly high-risk companies. The strategy is basically to go for moonshots.

The very first guy that invested in my business was a very well-known venture capitalist. It was with one of the very early venture capital firms in the ’80s and was one of the most successful. He said this was their strategy. They look for 1 in 18 of their investments in their fund has to hit. They only look for companies that have the potential of doing a 100X investment. It’s a moonshot and that’s their strategy.

If any of their companies get a double or a triple, it’s a wipe. They couldn’t care less. They are only looking for the 100X-ers. Pretty much everything else, they just X-out off. It’s irrelevant. It’s immaterial to them. That’s the strategy. Look for 1 in 18. They had super high returns during their heyday. They were returning over 100% per year to investors. Those returns haven’t been sustained. If you look at the top core tile of quartering to Cambridge research, the top core tile of venture capital firms has produced between 15% and 27% annual returns.

On the other hand, the bottom core tile, the underperformers are single digits. It’s typical in this stage. There are lots of guys who are very good at this that are killing it. It’s high returns potentially but also a fair amount of risk. I will point out, it’s very cyclical, too. Almost all of them rely on an active and hot public market, even the strategic exits. They are looking at the strategic player. The big strategic buyers usually are accessing public funds. If the market had a big crash, you see all of this fall apart. What happens is as the broader business cycle continues, the time to invest in VC at the beginning of the business cycle or near the bottom of the business cycle was just emerging into a growth phase.

During the March 2020 COVID pandemic, there’s nobody doing IPOs and not a lot of activity. Everything is seized up. The markets are seized up. It’s the same in 2008, 2009 and 2010. There was no activity. VCs were sitting in their capital trying to figure out what to do. Those are good times to get started knowing that in five years, you will have a good asset as the markets are covered potentially. You want to be early to mid-cycle in investing in VCs.

A quick sum-up, this stage is high-risk because these are early companies that haven’t been proven at a larger scale but the returns can be very substantial. A lot of times, that 1 or 2 winners will pay for all the ones that didn’t work out and usually well above what you did not capture on that. The next stage here is the growth stage. This is still I would consider venture capital because it is more minority ownership. Maybe it’s a later stage of the fundraising, a Series B or C.

The idea here is it’s a company that has been proven. They’ve got revenue coming in and customers. They are growing healthfully but they want to scale faster. If it’s in a particular industry where it’s hard to protect your IP, if it’s tech or something that it’s beneficial to scale faster, they will partner with a growth equity firm that will come and invest alongside, usually in a minority way and help them scale faster.

One of the things in both of these stages is a concept called cash burn. With cash burn, these investors come in and add more capital. The goal is growth so they will go and hire more employees. They will go and spend more on marketing. They will basically load up the expenses to where they are running at a net operating loss but the hopes are that they will generate enough revenue and then at some point, that will catch up. You won’t need to capital that funded the cash burn for a while. That’s very common here and something that in your experience with this VC firm in your past company was the strategy. You are growing.

You start hiring everybody you can. The burn rate goes to the moon but also the revenue does. That’s the strategy. It’s either you land on the moon or flame out. There’s no middle ground. That’s their model.

[bctt tweet=”If you have a strong cash flow in business, then you can attract a lot of cheaper financing from banks.” via=”no”]

A lot of times, firms at this level can be a little more creative in the types of financing. If it’s a more well-established company, maybe they will come in as a debt partner or mezzanine debt. They are 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. You see different strategies at play here. A very common strategy is called the roll-up strategy, which is a cool concept. Do you want to break that down a little bit?

It’s very common when you have a fragmented industry. I have seen several strategies here that are great winners that happened with lots of little accounting firms. CBS came in and started buying all these little accounting firms to build what it has become an accounting giant at this point. You take these small firms. They are heavily discounted to the market. If this little accounting firm was public, if it was 100 times bigger, they would get much higher multiples on revenue or earnings.

Private companies are heavily discounted. Their multiples are low. For a typical private company, multiple might be 5X or 7X. It means the company is valued at 5 or 7 times earnings. In the public markets, it’s 20X, 30X to 40X or if you are Amazon, 93X. When you access public markets, the value of the company goes up dramatically. The idea here is to roll up smaller companies and use the private company discount to assemble a stable of good smaller companies.

One strategy was the accounting firms. The other one is I have seen these guys hired, they bought the leading car dealership. These are high-cashflowing businesses but too small to go public. They bought the leading one with the best systems, processes, automation and everything. They paid a higher multiple for that company. They went and did an acquisition strategy to buy up all the little smaller guys at much lower multiples. They used the management team of the first one to replace the management or the operations of these other little ones to build a very large conglomerate of car dealerships that had the excellent operating characteristics of the first one they did.

It’s a finance-engineering play. You have access to this 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 the strategy. It’s called a roll-up strategy. It’s very common if you pick the right industry and have the right timing. Great money can be made there.

It’s a little bit less risky than the early stage because these are established businesses. You are not necessarily banking on the home run in 1 of the 18. I would call it more good solid doubles. You are hitting good doubles. 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 in that stage.

The next strategy is what we will call the mature stage. These are large companies. They are not high-growth at this point. They have either achieved market saturation. They are well-established brands. A lot of times, they will even be publicly traded businesses that then get taken private but they have strong cashflows. With the cashflows, you can do a lot of things with it. If you have a strong cashflow in business, then it can attract a lot of cheaper financing from banks. A lot of times, the strategy here is usually twofold. It’s either financial engineering or operational efficiencies.

A leveraged buyout is what you are describing.

The most common way that they execute a strategy in a mature business is a leveraged buyout. 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 or debt provider.

There’s cashflow in this business. You are using the cashflow of the business you are buying to get a lot of cheap debt.

You can already cover the debt payments from that. Any increases in value that you create have a multiplying effect because the debt is not taking it to the upside. It’s a multiplying effect to the equity roles.

ILB 3 | Private Equity Investing
Private Equity Investing: A principle of investing is not to have all your eggs in one basket. If you are doing individual investments, do smaller amounts and spread it out.

It’s like if you bought real estate on and that real estate has a 5% return but if you leverage it up and only put 20% down, you’ve got a way higher than a 5% return because of the leverage. It’s that kind of a deal.

That’s the financial engineering side of it. The other side of it is operational efficiencies. A lot of times, these companies can get bloated with expenses, staff, technology and other things. You can bring efficiencies if you have an experienced management team in a certain vertical or business segment that they have done this before and they can operate these businesses. The other big differentiator at this stage is, when they are doing a leveraged buyout, they are not coming and taking a little piece of the business a minority stake. They are buying the whole business and operate in it. It’s a very different set of risks because this is a full operational strategy. Generally, you want to find sponsors and funds that have experience in certain verticals. With that, a lot of them will specialize in certain verticals.

I have seen where a lot of these bring their own management teams. They have the guy that has done X number of these who is the awesome food guy, IT guy or whatever he is of this industry that knows this whole business. It’s a full-on head transplant here where you are going throughout the old guys bringing in the new team and take it to the moon. Depending on these strategies, there can be some great wins here as well in the LBL space.

That leads us to the next part, which is the decline and distressing stage. A lot of times, at the mature stage, they are not on a downward trend but they are not having huge growth. At this next stage, this is where companies are maybe past their heyday. They are looking for some help, “How do we turn the ship around and ride this ship?” It’s majority ownership generally. You are operating the business and you have to turn around a company. As an underwriter, I have seen several of these and it’s risky because what is the current management doing that is not working and what are you going to do?

What’s the new management going to do that’s going to change all of that?

It depends on where you are at, what the business cycle is and what types of businesses you are going after. One interesting concept I have 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. He is buying Stein Mart, RadioShack, these names that everybody knows but are on their last leg. He buys it for pennies on the dollar. His background is as an eCommerce, doing a lot of eCommerce business and helping businesses scale online.

He does a high-tech turnaround to these things.

He uses the existing brand awareness and leverages that online to help turn these businesses around. He picks them up for super cheap. The goal is to get a nice multiple when these businesses pick back up. That’s another interesting strategy that some will play in. It’s going to be specialized in the business segment you are going to be in and make sure you can operate your business.

You can make money in any of these strategies. The key is finding great operators. As an investor, hearing and believing the story that this is the right timing for this kind of opportunity.

We said it all along but these strategies can be applied to a variety of industries. A lot of times, there will be multiple industries that you can use different strategies in but it’s not just the big high-tech companies. Manufacturing is a very common targeted PE-focus because it’s a boring business, has high cashflow and can go anywhere anytime soon. There are lots of ways that you can play in this space. Let’s talk a little bit about structure. We have talked about the overall strategies and how firms execute them. The next question would be, “How do I invest in these? What are the best ways to get involved in private equity?” That’s what we want to talk about.

The first easiest way to get in is Angel investing. That’s a term maybe some have heard. It’s very simple generally individuals, sometimes groups of individuals that are going to go and invest in a company. A lot of times, it’s going to be an earlier stage at this point because they are writing not as big of checks as maybe a big PE firm would but they are going to come in as an advisor if they have experience in this type of business and a little more hands-on. There are local Angel investing groups that you can get involved with that you can invest in local companies.

[bctt tweet=”If you want to be more actively involved in your investments, angel investing is the way to go.” via=”no”]

It’s a 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. They have hit a point where they are financially set but they want to give back and help other people to be successful in their businesses. It’s a cool mentorship but also a financially rewarding way to invest.

The problems are there. You get in a high-cash burn business and bring in a little bit of money. You realize that they need a whole lot more money. You are not the, be all end-all. You don’t have a controlling interest. A lot of these don’t have good outcomes. If you are going to do individual Angel investing, you better know the deal and have a pool of these things in a large group. A lot of times, this doesn’t have good outcomes in my experience.

Tread carefully. If you are going to be investing in individual companies, you lose diversification. It’s a principle of investing where you don’t want to have all your eggs in one basket. It’s important if you are doing these individual investments, do smaller amounts and spread it out across with you.

I would only touch areas that you are familiar with. If you are a biotech guy or a tech guy, then do that. If you are not any of those things, don’t touch them because you probably should let someone qualified do those deals. It can also be a time-sink. They can take a lot more time than you want to put in. These are generally very needy businesses and high-stress businesses.

The next level would be crowdfunding. If you have ever looked into Angel investing, a very commonplace that people look at is AngelList. This is an online platform where businesses that are looking to raise money will go and put their deal up there or their valuation, how much they are looking to raise and try to attract individual investors.

AngelList has experienced VCs who run their own little funds and you can put money into them. To get with the big boys, the guys with the top core tile, you probably have to write a much larger check. It’s very difficult to get in those things but AngelList has some less-known VCs. I don’t know where they would fit in the return range. They have their resumes up there and their returns. There are dozens of them you can pick, “I will follow this guy.” You can even do monthly subscriptions or they call them the rolling funds. It’s a smaller players’ way to play in the Angel world. They also have their own AngelList sponsored fund that they do.

The benefits of doing that at AngelList are they have a very wide array of options. If your deal flow is limited because you are not in this space actively, it’s a great way to see a lot of different types of deals, how they are raising and how they are being valued. You can invest alongside experienced VCs. You can use that. If all these guys are jumping in, they’ve probably got some potential. Some of the downsides are going to be harder to do due diligence on a company at that level. You are usually going to be a smaller player or a smaller fish in the pond so you are going to have less impact on the overall financial decisions and operational decisions. You are going along for the ride but you can have some great outcomes there.

What is SharesPost?

This is a similar deal but you are investing alongside VCs. You can be a small sliver of the capital stack. It’s similar to AngelList. The other one is OurCrowd that I have found that’s very similar. All these were parts of the deal.

There’s one where people that had options and shares of pre-public companies were listing them for sale. I thought that was SharesPost.

Maybe that was.

ILB 3 | Private Equity Investing
Private Equity Investing: The operators with a very well-defined strategy, target, analysis, and staff are the guys that win.

You will see if you want to buy a share of Dropbox before it ever went public. You can buy it but that’s risky too. That might have a stinky IPO or they may not have an IPO but you can buy the shares.

Usually, it’s a discount to park as the person needs liquidity and so they are willing to try.

It’s with the premium because they are greedy. You never know.

The other one is probably the most common way. If you want to get in this as more of a passive investor, which is what we are targeting with our audience, is how do we diversify across a lot of different asset classes passively, not have to have the brain damage of operating these deals if it goes sideways?

Generally, the way to go is you get a super experienced operator who has a very well-defined strategy, clear target, all the staff and analysis to do this right. Those are the guys that win generally.

It’s investing directly with a private equity fund. You are going to leverage the experience and the expertise of a sponsor that has a great track record that has been in this particular space for a while. They get all the deal flow, all the best terms and financing. They have all the staff in place to help execute these strategies. That’s generally going to be the best way to go as you are getting into this. It’s more passive. A lot of times, they are going to raise a fund. It’s going to invest in a lot of different companies, anywhere from a handful up to 1 dozen to 2 dozen. You get a lot of diversification that way too when these firms are investing and spreading across several that are going to leverage.

You are going to pay their fees but generally, they are worth it. If you get the right guy, they are bringing massive amounts of expertise and create a massive amount of value through their expertise. You get to sit back, watch and get some passive returns.

The numbers recorded earlier on the bank company’s research were net fees. It’s clear that even with maybe an asset management fee or whatever fees they are going to charge is going to be worth it from a net standpoint. One of the cons though is if they are raising a fund, a lot of times, it’s a blind fund. You don’t know what target companies are going to invest in. You don’t have a lot of visibility into the exact portfolio companies that they are going to be. It’s a blind pool.

You either do all your own due diligence or find the team, let them do it and pay them to do it. It’s truly your risk profile. “What do you want to do? Do you kick the tires kind of guy? I’m going to hire the right guy and let them kick the tires.”

The next way to invest in private equity is a subset of investing with PE funds because this is a fund of funds. The concept is you invest with a manager that has a fund that then goes and invests in other PE funds. It’s not even investing directly in companies. They are investing in other funds. This is even another level of diversification to where it’s not only diversification across the portfolio companies but also different strategies. Maybe they are going to do some leveraged buyouts and move to some early stage. They can mix, plug and play where they want.

You would think, “Why would you add another layer of this?” In my research, these guys do a better job because they know who the better players are. They also have a macroeconomic view so they may say, “Based on our timing of the IPO market, we need to heavily weigh towards this type of fund or this type of fund. I know who the managers and operators are or the sponsors in those areas.” They generally earn their keep.

[bctt tweet=”The best way to pick an investment is to find the best operators and let them do their thing.” via=”no”]

These are more of the super-brainiacs who are doing the real analysis of all these different funds. They can generally get pretty good deals. We know how much sponsors sometimes give sweeten to deals for capital groups or capital piles. You could be adding a layer of fees but you are getting a discount from what the other investor gets. It’s not an automatic, “Don’t do this.” In fact, I would say it’s a great strategy. Generally, it’s the larger investors that are going to go for the fund-to-funds kind of guys but it’s a good option there.

I had my venture capital friend. He said, “Here’s our investment. An axiom, we always invest not on the horse, we don’t bet on the horse but we bet on the jockey.” They are looking primarily for an operator that has a certain profile and track record versus that particular business plan or deal. With all the strategies and structures, that’s the best strategy. Find the jockey you believe in. It’s not necessarily the vehicle. You may like one particular deal more than another particular deal or investment but the way to pick in my opinion is to find the best operators and let them do their thing. That’s a common axiom that’s a ton of time-tested.

The last point we want to make here is we addressed this in the last episode in real estate investing. It’s very similar to the capital stack. This can be overlaid across any strategy.

It’s like the 3D chess we are playing. Our continuum is more like 3Ds and 4Ds.

There are so many ways you can slice and dice this. Generally, there are going to be the equity funds that are going and playing on the equity side of the capital stack.

It’s like where you are a shareholder or an owner in the shares of the business who is the last guy to get paid generally. You can go up the capital stock to the debt side as well. There’s venture debt, growing debt and mezzanine debt.

There’s senior debt, as well as junior debt. Mezzanine debt is generally going to be junior debt. They will charge a high interest rate. They also may take some of the upsides but it’s not going to be as much upside as an equity investor. If you are looking at these types of funds, pay attention to where they are at in the capital stack because the higher up you are and the closer you are to debt, the less risk there is. With your first money out, you get paid first. The farther you are and closer to the common equity, the more risk you have.

The more sophisticated investors are, the more they like the debt space. The less sophisticated investors love the equity. “Let me play for the upside.” The other is the debt guys structure deals so that they always get paid. They get paid first and they get paid most. It’s like “Pay me.” They take far less risk. They can earn good returns and take a chunk of the upside, too. The deals they caught are sometimes crazy good where there’s far less risk, almost equity-level returns and not do a debt fund because you don’t think there’s enough upside.

If you compare a debt fund as opposed to debt in a real estate property, they are 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.

For example, let’s take a growth private equity company and you are doing a mezz debt. Maybe you are getting 10% to 15% on the mezz debt. Maybe it’s a junior debt but you understand how many assets are in play here. It could be your debt is 100% secured by the building that they own. You are earning almost the same level of returns but far less riskless. You understand the senior debt in front of you. Even if the jockey does a lousy job, you are going to make money because you are going to be able to take the assets.

It’s not a, “Don’t look at this just because it’s debt.” In fact, it’s the other way around. I find that the more sophisticated players and larger players are, the more they love the debt space and the more they tooled debt. They basically changed the debt around. I remember arguing with my venture capital guys back in the day for certain valuations. The entrepreneurs argue for a higher valuation. The investors are asking for a lower valuation to put the money in at.

I remember one of the venture capitalists laughed at me and said, “Tell me what valuation you want. I will give you whatever valuation you want as long as you let me write the terms.” It’s all these different covenants, terms, levers, triggers and other things. I learned a thing or two. These guys are financial wizards. A lot of the guys are structuring the stuff. They structured it as, “Heads I win. Tails you lose,” kind of a deal. From an investor’s point of view, there are some huge wins in the debt space and mezz debt space.

The last thing I want us to hit here is that a lot of these strategies work better earlier in the economic cycle. What would you say where we are at in the economic cycle? Would areas in these would you jump into? Would you wait? Would you see if we are arguably at the later end of a business cycle but there are a lot of things happening with the Federal stimulus and other things that are prolonging this economic run?

It’s a very weird cycle. Every cycle is different that’s why this isn’t a check-the-boxes type of investing that requires thinking. The business cycle bottomed in 2008 and 2009. We have been on a tear pretty much ever since. We had very slow growth. Looking at the unemployment rate, it did not recover during the Obama years. It was not much of a recovery. We were still at the bottom, even through the 2013, 2014 and 2015 timeframe. What happened is things started to shift and all the stimuli started trickling down and it started working.

We were in the early stage of the business cycle there and then COVID hits in March 2020 and everything crashed. It reset the cycle again. As we are in recovery, we are in a bottom cycle with a caveat that there’s a ton of money because of the stimulus in the public markets. It’s an early stage but hyped stage. Honestly, it’s a good time for these strategies. The ITIL market is still hot as it can be. We will see if that continues.

My forecast is we are going to see an upward bias on the markets but a lot of volatility in public markets. Since that’s the source of all the capital generally for everything using all these strategies, if there’s a hiccup, things generally slow down. I think we are not yet at the end of the cycle simply because of the one where we had the COVID reset and then we had this massive stimulus outlining in addition. It’s putting more fuel on the fire.

A lot of these strategies can be executed in shorter time frames like in 3 to 7 years, especially if the strategy is on the shorter end of that. Your risk from a cycle standpoint is limited as well. That’s 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 or do private equity strategies and venture strategies. We are pretty excited to get some of those guys and gals on board and talk more about this. Stay tuned for the next episode. We are going to be talking about the hedge fund. This rounds out our big three on the alternative investment continuum. We would be breaking down with what those look like. Thanks for joining in.

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