This blog is the second of a seven-part series on Investing. The third post covers steps to developing a sound investment strategy and I’ll share additional essential investment insights in the next four installments.
In the first blog we covered six different perspectives I have learned as I’ve grown my investment portfolio over the years. If you haven’t seen my first post on investing, I suggest you start here.
By way of recap, the first six key perspectives discussed in the blog are:
- Diversification is critical
- Invest in what you know and understand
- Understand the risk-reward ratio
- Do a Stress Test
- Avoid black box investments – even though the sponsor has a good track record
- Don’t be impressed with who else is investing.
In this second blog we will be looking at another five key viewpoints to have when investing.
7) SKIN IN THE GAME
It’s important to determine if the sponsor of the investment has put real money into the deal. Sweat equity is not enough, it must be real cash they earned elsewhere, paid tax on and is significant to them. It doesn’t need to be a large amount; we typically look for at least 5% of the total investment from the sponsor. If they don’t have at least 5% of their own money in the deal, then that becomes a concern for us. Five percent (5%) is a good figure as it’s usually more money than they stand to make in fees from the deal. If they put in 10% or anything above that, it is very good.
We look close at any cash coming to the sponsor out of the deal structure by way of fees – from that we can identify the net cash invested by them. If they’re only putting in what they’re making off the deal – it’s not enough. They need to put their money where their mouth is.
8) DON’T SIGN PERSONALLY ON ANY DEBT
I encourage you to work hard and reach a point where you don’t sign personally on any debt – if debt is involved. When one initially starts a business, they often have to personally guarantee a loan. As the business grows, you usually can get to the point where you don’t have to personally guarantee the loan any further. This could be dependent on how much equity you have in a deal, your experience in the business or even your relationship with your bank. Factors may differ but the goal is to remain sensitive to how much you personally guarantee and develop the mindset over time to have less and less exposure to a personal guarantee. It’s impossible to start debt free, but it’s possible to move there over time. I’ve seen personal guarantees come back to bite people.
When I started my business, I had to personally guarantee my first line of credit as a mortgage banker, and I continued to do this up to several million dollars. After five years, I met with my banker, and told them I wanted to get out of personal guaranteeing. Based on my prior performance and retained earnings, the business could stand on its own and I was no longer required to sign personally. The business line of credit continued to grow exponentially. Therefore ,it’s important you develop a strategy for how you can get out of personal debt. It’s highly unlikely for your bank to come to you and say they no longer need a personal guarantee; so you need to be proactive and take the lead. Bottom line, don’t ever sign personally for any loan where you don’t have complete control over the investment.
Another area to factor in is any additional debt you may take on. There will be times in life when you will have to consider taking on debt. For any debt you plan to take on, you should have a game plan on how you’re going to pay it back. Think about the time frame, your game plan for that debt, and if your world turned, would you still be able to pay back the debt? The key is to have multiple strategies for how you will get out of debt.
This includes non-recourse debt, if you don’t pay it back it will have an impact on your credit rating and your ability to borrow again in the future. Maintaining an outstanding credit rating has always been critical to me and it has paid a lot of dividends.
Don’t be tempted to use a recession as an excuse either, when everybody is defaulting and it seems okay and it’s not your fault; the penalty may be less, but you will still suffer the consequences.
The book of Proverbs reminds us “the borrower is a slave to the lender”. In good times, debt is easy to get, and the options look attractive, however it can quickly turn into a noose. Broadly, I’ve always believed that investing should come from the money you’ve earned and what you’ve been able to save and not with money you’ve borrowed.
9) PAST SUCCESS DOES NOT ENSURE FUTURE SUCCESS
Indeed, success does breed success. Do take into consideration prior successes of the sponsor in previous similar ventures. Consider – is there anything about their past experience and structure of the deal that mitigates risk and increases the likelihood of success? A key point to note however, previous success as a sponsor doesn’t automatically guarantee future success. Factors are different, the time is different, markets change, the variables are too many. Don’t overweigh your decision based on the past.
A lot of investments I have made are with people I know and have done business with, but still, that is no guarantee. Not too long ago we concluded a deal that resulted in an equity loss with a long-term partner, with whom we had previously made ten prior investments – nine of which were highly successful. This final one, however, delivered some hard-earned lessons.
10) LIQUIDITY AND CASH FLOW
I’ve seen investors get very frustrated because they didn’t understand the liquidity of the deal. This is not always self-explanatory, so ensure the sponsor explains this properly. There are some investments where you can get out early, while there are others you may need to take a discount to do so. It’s important to understand liquidity in the investment.
Closely related to this is knowing the cash flow and understanding if the investment will generate cash flow.
It is important to manage cash flow closely to ensure you have adequate cash for all needs. Managing anticipated cash inflows and outflows can be very complicated. Therefore, I’ve put together an excel model that helps track all sources and uses of funds. Please see the handout titled Mentee – Cash Flow and Forecast and refer to it as you read through this blog.
There are two sheets included in the Mentee – Cash Flow and Forecast handout, one titled Cash Flow which shows a 12-month historical perspective; and the other titled Forecast which gives a 12-month forecast. In the top section of both sheets, we cover all inflows. You will see separate line items for different sources of funds and a total cash line. For outflows, also on both sheets, you will see a section for expenses, giving, extraordinary expenses, investments, etc. You will also see a line that shows you your current net cash position for last month which is your beginning cash position for this month. It’s important in the forecast that every time you make a commitment to fund something in the future it is included in the model. Even if you have to guess the amount and month in which funds will be used. One of your objectives, in the forecast, is to look for any month in which you do not have sufficient funds to cover all outflows.
Based on the nature of your business/investments, your cash flow analysis will likely look different; however, I encourage you to start with one that meets your needs. Your goal is to not run out of cash and be prepared for when the next home run investment opportunity presents itself.
Another source of cash can be any liquid investments you maintain, which you could cash in if you need money quickly. Consider also adding a line to your cash flow analysis that shows liquid assets that could be available. You will also see on the analysis I track any borrowings I have against my line of credit or margin accounts. Any short-term obligations you have could be considered as a draw against existing cash or at a minimum the repayment should be included in your 12-month forecast.
Remember in almost all situations, cash is king.
I hope you find these two handouts useful, keep making adjustments to your own Cash Flow and Forecast until they meet your goals. If you have any questions or comments about these two handouts, please do email me at paul@paulslifelessons.com.
As you develop your investment portfolio, begin to factor in the time and focus to maintain a reasonable cash flow for both short-term and long-term goals. The liquidity of your portfolio can change as the market and opportunities also change. Therefore, having enough liquidity available to meet your commitments is important to the health of your portfolio.
Managing Cash Flow Requirements
The timeframe of all the investments in your asset allocation must fit together. Liquid assets can always be turned to cash within days. However, the illiquid assets in your portfolio must also be planned out to ensure you have cash to make capital commitments, allowance for new investments, provide for donation commitments and provide for additional investment or personal overhead spending. An “overarching cash flow” is therefore needed and should be planned for.
Below are some useful notes to consider when managing your cash flow:
- Have a clear indication on cash commitments outstanding and when they may be due.
- Keep track of your annual cash-on-cash receipts for each investment.
- Don’t over-commit capital when there are other near-term requirements for its use.
A Final Note: Determine upfront the type of reporting and frequency you will receive from the sponsor. Ensure the information to be provided is concise, accurate, valuable and submitted on a regular basis.
11) WATERFALL AND PREFERRED RETURN
When it comes to direct investments, typically you will find that profits are shared between the sponsor of the investment and the investors. The formula for sharing profits is referred to as The Waterfall.
Depending on how attractive the investment is and its risk reward ratio, these will both have an impact on where the waterfall starts. An investment that has an average upside might start where the investor receives 80% of the profit and the sponsor receives 20%. For opportunities where there’s more of a value add component and greater returns, the sharing might start 70% to the investor and 30% to the sponsor, or even 60/40. I’ve only done a few investments where it’s been a 50/50 sharing. This was only because the return was significant, and the sponsor was uniquely adding value to the opportunity.
Most investments will have a preferred return where 100% of the return will first go to the investor. Today, preferred returns are typically within the 7 to 8% range for a good investment. After the preferred return is funded, then profits are shared in accordance with the waterfall. Once in a while you might see a sponsor requesting that they catch up on the preferred return themselves, but this is not very common.
Typically, the waterfall improves for the sponsor by 5 to 10% after the overall investment achieves a set hurdle rate, which can range between 12 to 18%. Thus, if the waterfall started at 70% to the investor and 30% to the sponsor, any return greater than the 18% would be shared on a 60/40 basis.
12) Benchmarks
When we hire professionals to manage our investments – whether in equities, domestic or international bonds, or hedge funds, we always try to identify a benchmark or index that reflects the type of investment we’re making. This helps us compare actual performance against a standard, so we can assess whether the manager is on track or outperforming.
If you hire a professional, you expect them to outperform the market, however, most experts in the equity world don’t. It is hard to pick the winners and avoid the losers and it typically comes with much higher fees when you’re hiring somebody to do that.
Benchmarks are important because they give you a way to measure performance. You may not always get the perfect benchmark but having a couple to compare against is still very useful. We review our benchmarks on a quarterly basis. Over time, this consistent tracking becomes valuable in identifying performance trends. It is therefore worth the time to find the benchmark to compare your actual performance to.
ACTION STEPS
In investing, I always believe it’s better to walk before you run. Don’t be satisfied with what is presented on the surface. Look deeper. Prove it out, model each opportunity as it presents itself and see the return. It’s better to miss an opportunity and not put money in, rather than rush and end up possibly losing it all.
These are eleven crucial areas of focus when considering an investment. This list is by no means exhaustive but can be used as a guide when faced with an opportunity. I have also attached a handout with a comprehensive list of all my investment learnings – including others not covered in this blog. Please do take time to review these additional learnings. As you grow through experience, you will develop a richer perspective and define your own points of focus.
Please share with me any questions or additional pointers you look out for when making an investment – in the comments section. I’d love to hear from you. Your comments help others learn too.
