Private_Funds
00:00:00.000 | Hello, everybody. It's Sam from Financial Samurai. And in this episode, I'm going to
00:00:04.400 | talk about private funds and why I invest in private funds and why you might want to
00:00:10.040 | invest in private funds as well. So, so far in 2022, the public stock market has done
00:00:16.080 | terribly, right? It's down about 10% at the time of this recording. Nasdaq's down worse.
00:00:22.040 | There are individual stocks like MetaFacebook, Roku, PayPal, so many of these tech names
00:00:29.800 | that are really popular, have been really popular over the past several years, have
00:00:33.280 | completely round-tripped over the past one, two years. Now, we all know that investing
00:00:38.760 | in the S&P 500, the Nasdaq, the Dow Jones, the basically major indices, generally tends
00:00:45.260 | to do well over the long run. And if you can invest in a low-cost index fund or ETF, even
00:00:51.160 | better, right? Because those fees really drag down returns. And when you invest in a private
00:00:57.000 | fund, for example, I invested in a Kleiner Perkins Venture Fund, actually invested in
00:01:01.880 | two funds, the Kleiner Perkins 20 and the Kleiner Perkins Select 2 Fund. Now, this is
00:01:07.360 | venture capital, early stage growth investing. So risky. However, it's very different from
00:01:14.840 | the public markets, right? You're investing at a different stage in a company's growth
00:01:19.500 | curve. Now, investing in these two private funds does not come cheap. The management
00:01:24.240 | fee is 1.5% to 2.5%. But it fades over time. And the funds charge 20% to 30% of profits.
00:01:33.680 | It's called carry. And that increases after a return hurdle has been met. So in other
00:01:38.760 | words, if you want to make a lot of money, folks, you had best become a venture capitalist
00:01:43.520 | with a lot of assets under management. Join one of the big firms. You're probably going
00:01:47.400 | to do very well because, frankly, the limited partners, that's what I am, investors in the
00:01:52.680 | fund won't really know how well you're doing until maybe year 5, 6, 7, 8, 9, 10. By then,
00:02:00.400 | you've collected a lot of fees, and you probably have opened up another fund. But this is not
00:02:05.920 | a podcast episode on where you should work to make the most amount of money. This is
00:02:10.120 | an episode to talk about why you might want to consider investing in private funds in
00:02:14.880 | your diversified portfolio and net worth. So let me just share seven reasons. The first
00:02:20.640 | reason diversification and potential outperformance. The majority of investors should invest 80%
00:02:27.560 | to 100% of their public investment capital in low cost index ETFs or funds. At the end
00:02:33.080 | of the day, it's very hard to outperform any index, roughly 80% of active fund managers
00:02:38.160 | underperform their respective indices over a 10 year period. However, if you just invest
00:02:44.840 | in index funds, you're never going to be able to outperform index fund investors and building
00:02:51.360 | wealth is about trying to outperform your peers. So you can use that money to improve
00:02:56.760 | the quality of your life and buy more things, I guess. If you invest in a private fund,
00:03:01.760 | let's say venture capital fund, who knows it could find the next Google or Facebook,
00:03:07.120 | and you could have outstanding returns or an outstanding IRR for the life of the fund.
00:03:12.920 | But if you don't invest in such funds, you're never going to be able to outperform. Sure,
00:03:17.680 | the chances are low that you're going to outperform, but you're never going to outperform if you
00:03:21.480 | just hug the index. Two, more gains are accruing to private investors. This is actually very
00:03:28.720 | important. Private funds like venture capital funds are investing in earlier stages of a
00:03:33.440 | company's life. And if the fund is able to identify a promising company early, the returns
00:03:38.880 | could be massive. Companies are going public, they're going IPO later and later in their
00:03:45.200 | company's life cycle. So for example, Microsoft went public for $777 million in 1986. That's
00:03:52.600 | equivalent to about 1.9 billion in market cap in today's dollars. Meanwhile, Uber went
00:03:58.160 | public in May 2019, with a market capitalization of 82 billion. And if you look at a company
00:04:04.720 | like Stripe, the fintech payments company, it's roughly valued at 100 billion, but some
00:04:10.920 | people have told me it's valued at 200 billion. Now, as a retail investor, you're going to
00:04:16.960 | go buy the company valued between 100 to $200 billion, with growth rates not as fast as
00:04:23.400 | they were in the beginning years. I would say good luck to that. Good luck to that.
00:04:28.840 | I own Amazon stock. It's one and a half trillion market cap company. It is highly unlikely
00:04:35.200 | it's going to be a big outperformer going forward due to the large numbers. I'd rather
00:04:39.760 | invest some capital in smaller companies that could take market share or reinvent the market
00:04:44.440 | altogether. All right, let's look at the third reason why you might want to invest in private
00:04:48.480 | funds. Dampen portfolio volatility. The more capital you have, the more you worry about
00:04:55.200 | loss. As a result, you seek to dampen your portfolio's volatility with private investments.
00:05:01.200 | Since private funds do not have a daily market value update, unlike publicly traded stocks,
00:05:06.840 | you may go under the illusion that your private fund investments are more stable. As a private
00:05:12.280 | fund investor, you're going to get a monthly, quarterly, and at least yearly update. So
00:05:17.360 | it's not every single day. And that can really put a damper on your psyche, on your day to
00:05:23.360 | day mood. If you have a lot of money invested in the stock market, for example. For me personally,
00:05:29.680 | the reason why I have no more than 35% of my net worth in stocks is because any more
00:05:34.800 | and I start really getting bummed out because I've already done the math and I've gone through
00:05:39.640 | many bear markets before since 1997, the Asian financial crisis. And I know myself. So you've
00:05:45.680 | got to know yourself. And if you don't like volatility, especially as you get wealthier,
00:05:51.440 | private funds help really dampen that volatility. All right, reason number four, you gain access
00:05:56.240 | to investments you simply don't have. So any of us can buy any stock and pretty much any
00:06:02.320 | bond we want to for no fees, you know. However, not everybody can invest in a promising private
00:06:08.720 | company without connections and a glowing reputation. There's a ton of liquidity out
00:06:14.040 | there chasing the best private companies. And by investing in a private fund with experienced
00:06:18.760 | operators, you gain access to their deal flow. So paying that fee is gaining access to people's
00:06:26.240 | connections that you otherwise don't have. Our fifth reason to invest in private funds,
00:06:31.960 | the opportunity to co invest. So sometimes when a private fund invests in a company,
00:06:36.600 | the company may offer up the opportunity for the limited partners to co invest. Co investing
00:06:42.320 | is when the limited partner directly invests additional capital in the company alongside
00:06:47.360 | that fund, right? It's a co. So for example, let's say, you know, the client of Perkins
00:06:51.400 | 20 fund leads a 40 million series A round in a hot fintech startup in San Francisco.
00:06:56.840 | And then the fintech CEO asks, you know, KP 20s managing partner whether his fund has
00:07:01.880 | any limited partners who could be very synergistic and help him or her grow his business. And
00:07:08.720 | then the managing partner says, Hey, I know this guy named Sam who runs financial samurai,
00:07:12.840 | a well read personal finance site with a million readers a month, who could help promote your
00:07:17.760 | product if he sees a good fit. They connect me to the founder, I like the business, I
00:07:24.800 | write about it, and it's just a win win. And I just disclosed I'm an investor in this company.
00:07:29.540 | So if you are also a savvy investor, and you believe, wow, the fund has really identified
00:07:35.160 | a great individual investment, you can add more capital to press your bets. All right,
00:07:41.840 | that's sixth reason to invest in private funds. And this is something I don't think many people
00:07:46.240 | think about, you have more opportunities to network. I personally don't really like networking
00:07:52.600 | for networking sake, I just like to meet people who I, you know, when I play tennis or softball.
00:07:58.240 | But once you invest in a private fund, you join a family of limited partners with similar
00:08:03.040 | goals, right goal is to make money in that fund. But goal is to invest in the things
00:08:07.320 | the fund cares about. If you need some advice, want a warm introduction, or need to get some
00:08:13.840 | deal done, you might have an easier time getting some help from another limited partner. Heck,
00:08:19.160 | if COVID ever goes away, which I think it soon will in 2022, fingers crossed, there
00:08:24.000 | might even be a holiday party for the limited partners. So being a fellow limited partner
00:08:29.360 | acts as a screening mechanism, right? One, you need enough capital to invest in the fund.
00:08:34.360 | Two, you need to know people to be able to invest in that fund. So it's kind of like
00:08:38.880 | being more responsive to alumni of your school, they seek your help, you know, through a cold
00:08:43.680 | email or whatnot, you're probably going to be more likely to respond, right? Because
00:08:48.240 | you want to help the community that helped you. It's just natural human nature. And if
00:08:53.320 | the private fund actually does well, you have the immediate ability to invest in the next
00:08:59.360 | fund and in the next one. So imagine if you started with Sequoia, which is the preeminent
00:09:04.240 | VC fund, and you started investing in them when they first started, you could have invested
00:09:09.840 | in every single one of the funds and you would have crushed it because they have crushed
00:09:14.280 | it. And the thing is, nobody very few people can allocate capital to Sequoia funds because
00:09:20.840 | they've done so well, there's just too much demand for their funds. So if you are still
00:09:25.400 | aggressive in your financial independence journey, you know, you're working a day job,
00:09:30.320 | you want to network more investing in private funds is very powerful, you can network as
00:09:35.840 | much as you want, or as little as you want. For me, I'm just to stand back, right? Who
00:09:40.040 | cares? But for you, if you're trying to build a business or do something that limited partnership
00:09:46.120 | club could be very valuable to you. All right, the seventh reason for investing in private
00:09:50.960 | funds, it forces you to keep on investing over several years during bull markets and
00:09:56.680 | bear markets. After committing a certain amount of capital to a private fund, not all of it
00:10:02.000 | is called at once. Instead, your commitment may be called over a one to three year period
00:10:07.280 | usually, these are capital calls, right? So for example, let's say you commit $100,000
00:10:11.800 | to a fund, you might have a capital call of 20% of the 100,000 or $20,000 when it closes
00:10:18.280 | or the first quarter after it closes, and then followed by 10% capital calls, you know,
00:10:24.800 | every quarter for the next eight quarters. So capital call schedule keeps you invested
00:10:29.080 | through good times and bad times. For me, I really like that because it forces me to
00:10:33.800 | invest no matter what. It's like I don't have to think about Oh, you know, the stock market's
00:10:37.800 | down 10% should I be allocating 10% of my cash, 20% 50% all that stuff takes a lot of
00:10:43.960 | energy. But if you have a capital call schedule, where you just have to follow it because you
00:10:49.320 | have agreed to be a limited partner. It's, it's very stress free, just okay, I'm going
00:10:55.200 | to send that money in, they are going to invest the money how I see fit. I've already done
00:11:00.080 | the due diligence on the managers and their track record. It's very freeing. This is something
00:11:06.360 | I can't really explain. But it's just very freeing when you let someone else manage your
00:11:09.640 | money that you trust. All right, I know I said there were seven reasons to invest in
00:11:13.920 | private funds. But here's an eighth reason for good measure. Investing in private funds
00:11:18.520 | forces you to hold for the long term. They generally have five to 10 year life cycles
00:11:24.520 | before your capital is returned to you. Therefore, you're forced to invest for this period of
00:11:29.400 | time, the longer the investment time horizon, the greater your chance of making more money.
00:11:35.200 | If you're investing in public securities with zero cost to liquidate, it's much easier to
00:11:39.120 | panic sell. I'm sure plenty of people did in March 2020. I'm sure plenty of people did
00:11:43.680 | in 2018 2019 is just human nature. Public investments can be a tantalizing source of
00:11:51.760 | capital every time there's a downturn or some type of emergency. Whereas when you invest
00:11:55.760 | in a private fund, you are committed for the duration of that fund. You can access the
00:12:01.160 | capital without getting a lot of backlash, a lot of stink eye, you're committed, they're
00:12:06.920 | committed. Now, obviously, there are negatives to investing in a private fund. Biggest one
00:12:12.040 | are the high fees, the fees are so high compared to index fund. I mean, it's like 10 x 20 x
00:12:17.960 | higher. But the hope is you're going to have higher returns. But the reality is oftentimes
00:12:23.440 | these private funds don't return as much as a respective index fund. So you have a double
00:12:28.800 | whammy there. Another negative is tax time come tax time, you've got to keep track of
00:12:33.520 | all your K ones for these private funds. If you do it yourself, it's a lot of work. If
00:12:38.400 | you pay an accountant do it, every single K one filing costs money. The final negative
00:12:43.400 | is a lack of liquidity. Yes, you can stop meeting the capital calls. Nobody can force
00:12:50.040 | you to do anything, but you're going to be blackballed from the fund in any future funds.
00:12:55.040 | And then you might work word might get around that says, you know what, you don't commit
00:12:59.280 | to what you sign, and you're not going to be invited to future funds. So if you want
00:13:03.640 | to invest in a private fund, make sure you allocate only the capital you're willing not
00:13:07.760 | to touch for the duration of the fund. Personally, I love long holding periods. Every time capital
00:13:15.240 | comes in, you know, it feels good. But if you have an investor mentality in a high inflation
00:13:20.680 | environment, you kind of start stressing you start wondering how am I going to reinvest
00:13:25.520 | this capital so it doesn't lose too much purchasing power from inflation. And then you start thinking,
00:13:30.520 | well, if I invest in this stock, or this bond, or this asset, it's going to do well, it's
00:13:35.320 | not going to do well. And with private funds, you've already just decided, okay, this is
00:13:39.440 | where you want to allocate your capital with some smart, hopefully people, and they're
00:13:43.960 | going to do the work for you. So you don't have to stress about it as much. Currently,
00:13:48.120 | I invest about 10 to 15% of my capital into private funds. And I plan to continue going
00:13:53.720 | forward, I might increase it to try to manage volatility and risk. For those of you wondering
00:13:59.200 | how to gain access and invest in private funds. Well, there's really no easy way to do it.
00:14:04.600 | There's no like centralized website. And you know what there probably is, but I don't know
00:14:08.040 | of one. Here's the strategy if you want to invest in a very promising private fund. One,
00:14:14.240 | you either need to have to have worked at the fund or work at the fund, know someone
00:14:18.160 | who works at the fund, get introduced, proactively reach out and see if there are any synergies
00:14:24.480 | you can provide, or come from one of the companies the fund has invested in. A lot of private
00:14:30.320 | funds have quote anchor investors from institutional funds, endowments and ultra high net worth
00:14:36.240 | individuals. Once the anchor investors are in the fund managers and anchor investors
00:14:41.600 | invite smaller investors. It's just how it goes. It just goes from top to the bottom.
00:14:46.960 | And so imagine if you're like a whale and you invest $10 million or $50 million into
00:14:53.520 | a billion dollar fund, but you have friends from high school or college who are interested
00:14:58.440 | in investing 50,000, 100,000, 200,000. They can probably get in because you are the anchor
00:15:04.520 | investor. So again, it's a lot to do with who you know, a lot of these private funds
00:15:10.020 | have what they call friends and family round. So that's where the opportunity for most of
00:15:15.760 | us lie. And here's the thing, the jobs act that was passed in 2012 has helped democratize
00:15:21.400 | access to private funds. You know, you've seen a plethora of real estate crowdfunding
00:15:26.240 | platforms, some like fundrise, for example, rise to over 210,000 investors managing over
00:15:33.200 | $2.5 billion under management. In the past, investors like you and I couldn't invest in
00:15:40.000 | high quality commercial real estate, unless we had millions and millions of dollars. And
00:15:43.920 | now we can. And you also see other platforms where you can invest in art, in wine, in all
00:15:50.240 | sorts of things, thanks to the passage of the jobs act. Of course, then it's up to you
00:15:56.040 | to carefully do your research and vet these private funds. Because frankly, everything
00:16:01.920 | tends to sound great before you invest. And of course, not everything will make you money.
00:16:07.680 | So that's all folks. I hope you enjoyed my talk on private funds. If you enjoyed this
00:16:12.120 | podcast, I'd love a positive review and a subscription. Tell your friends. It's the
00:16:16.800 | way I get motivated to keep on recording and keep on writing. Thanks so much.