Hello, everybody. It's Sam from Financial Samurai. And in this episode, I'm going to talk about private funds and why I invest in private funds and why you might want to invest in private funds as well. So, so far in 2022, the public stock market has done terribly, right? It's down about 10% at the time of this recording.

Nasdaq's down worse. There are individual stocks like MetaFacebook, Roku, PayPal, so many of these tech names that are really popular, have been really popular over the past several years, have completely round-tripped over the past one, two years. Now, we all know that investing in the S&P 500, the Nasdaq, the Dow Jones, the basically major indices, generally tends to do well over the long run.

And if you can invest in a low-cost index fund or ETF, even better, right? Because those fees really drag down returns. And when you invest in a private fund, for example, I invested in a Kleiner Perkins Venture Fund, actually invested in two funds, the Kleiner Perkins 20 and the Kleiner Perkins Select 2 Fund.

Now, this is venture capital, early stage growth investing. So risky. However, it's very different from the public markets, right? You're investing at a different stage in a company's growth curve. Now, investing in these two private funds does not come cheap. The management fee is 1.5% to 2.5%. But it fades over time.

And the funds charge 20% to 30% of profits. It's called carry. And that increases after a return hurdle has been met. So in other words, if you want to make a lot of money, folks, you had best become a venture capitalist with a lot of assets under management. Join one of the big firms.

You're probably going to do very well because, frankly, the limited partners, that's what I am, investors in the fund won't really know how well you're doing until maybe year 5, 6, 7, 8, 9, 10. By then, you've collected a lot of fees, and you probably have opened up another fund.

But this is not a podcast episode on where you should work to make the most amount of money. This is an episode to talk about why you might want to consider investing in private funds in your diversified portfolio and net worth. So let me just share seven reasons. The first reason diversification and potential outperformance.

The majority of investors should invest 80% to 100% of their public investment capital in low cost index ETFs or funds. At the end of the day, it's very hard to outperform any index, roughly 80% of active fund managers underperform their respective indices over a 10 year period. However, if you just invest in index funds, you're never going to be able to outperform index fund investors and building wealth is about trying to outperform your peers.

So you can use that money to improve the quality of your life and buy more things, I guess. If you invest in a private fund, let's say venture capital fund, who knows it could find the next Google or Facebook, and you could have outstanding returns or an outstanding IRR for the life of the fund.

But if you don't invest in such funds, you're never going to be able to outperform. Sure, the chances are low that you're going to outperform, but you're never going to outperform if you just hug the index. Two, more gains are accruing to private investors. This is actually very important.

Private funds like venture capital funds are investing in earlier stages of a company's life. And if the fund is able to identify a promising company early, the returns could be massive. Companies are going public, they're going IPO later and later in their company's life cycle. So for example, Microsoft went public for $777 million in 1986.

That's equivalent to about 1.9 billion in market cap in today's dollars. Meanwhile, Uber went public in May 2019, with a market capitalization of 82 billion. And if you look at a company like Stripe, the fintech payments company, it's roughly valued at 100 billion, but some people have told me it's valued at 200 billion.

Now, as a retail investor, you're going to go buy the company valued between 100 to $200 billion, with growth rates not as fast as they were in the beginning years. I would say good luck to that. Good luck to that. I own Amazon stock. It's one and a half trillion market cap company.

It is highly unlikely it's going to be a big outperformer going forward due to the large numbers. I'd rather invest some capital in smaller companies that could take market share or reinvent the market altogether. All right, let's look at the third reason why you might want to invest in private funds.

Dampen portfolio volatility. The more capital you have, the more you worry about loss. As a result, you seek to dampen your portfolio's volatility with private investments. Since private funds do not have a daily market value update, unlike publicly traded stocks, you may go under the illusion that your private fund investments are more stable.

As a private fund investor, you're going to get a monthly, quarterly, and at least yearly update. So it's not every single day. And that can really put a damper on your psyche, on your day to day mood. If you have a lot of money invested in the stock market, for example.

For me personally, the reason why I have no more than 35% of my net worth in stocks is because any more and I start really getting bummed out because I've already done the math and I've gone through many bear markets before since 1997, the Asian financial crisis. And I know myself.

So you've got to know yourself. And if you don't like volatility, especially as you get wealthier, private funds help really dampen that volatility. All right, reason number four, you gain access to investments you simply don't have. So any of us can buy any stock and pretty much any bond we want to for no fees, you know.

However, not everybody can invest in a promising private company without connections and a glowing reputation. There's a ton of liquidity out there chasing the best private companies. And by investing in a private fund with experienced operators, you gain access to their deal flow. So paying that fee is gaining access to people's connections that you otherwise don't have.

Our fifth reason to invest in private funds, the opportunity to co invest. So sometimes when a private fund invests in a company, the company may offer up the opportunity for the limited partners to co invest. Co investing is when the limited partner directly invests additional capital in the company alongside that fund, right?

It's a co. So for example, let's say, you know, the client of Perkins 20 fund leads a 40 million series A round in a hot fintech startup in San Francisco. And then the fintech CEO asks, you know, KP 20s managing partner whether his fund has any limited partners who could be very synergistic and help him or her grow his business.

And then the managing partner says, Hey, I know this guy named Sam who runs financial samurai, a well read personal finance site with a million readers a month, who could help promote your product if he sees a good fit. They connect me to the founder, I like the business, I write about it, and it's just a win win.

And I just disclosed I'm an investor in this company. So if you are also a savvy investor, and you believe, wow, the fund has really identified a great individual investment, you can add more capital to press your bets. All right, that's sixth reason to invest in private funds. And this is something I don't think many people think about, you have more opportunities to network.

I personally don't really like networking for networking sake, I just like to meet people who I, you know, when I play tennis or softball. But once you invest in a private fund, you join a family of limited partners with similar goals, right goal is to make money in that fund.

But goal is to invest in the things the fund cares about. If you need some advice, want a warm introduction, or need to get some deal done, you might have an easier time getting some help from another limited partner. Heck, if COVID ever goes away, which I think it soon will in 2022, fingers crossed, there might even be a holiday party for the limited partners.

So being a fellow limited partner acts as a screening mechanism, right? One, you need enough capital to invest in the fund. Two, you need to know people to be able to invest in that fund. So it's kind of like being more responsive to alumni of your school, they seek your help, you know, through a cold email or whatnot, you're probably going to be more likely to respond, right?

Because you want to help the community that helped you. It's just natural human nature. And if the private fund actually does well, you have the immediate ability to invest in the next fund and in the next one. So imagine if you started with Sequoia, which is the preeminent VC fund, and you started investing in them when they first started, you could have invested in every single one of the funds and you would have crushed it because they have crushed it.

And the thing is, nobody very few people can allocate capital to Sequoia funds because they've done so well, there's just too much demand for their funds. So if you are still aggressive in your financial independence journey, you know, you're working a day job, you want to network more investing in private funds is very powerful, you can network as much as you want, or as little as you want.

For me, I'm just to stand back, right? Who cares? But for you, if you're trying to build a business or do something that limited partnership club could be very valuable to you. All right, the seventh reason for investing in private funds, it forces you to keep on investing over several years during bull markets and bear markets.

After committing a certain amount of capital to a private fund, not all of it is called at once. Instead, your commitment may be called over a one to three year period usually, these are capital calls, right? So for example, let's say you commit $100,000 to a fund, you might have a capital call of 20% of the 100,000 or $20,000 when it closes or the first quarter after it closes, and then followed by 10% capital calls, you know, every quarter for the next eight quarters.

So capital call schedule keeps you invested through good times and bad times. For me, I really like that because it forces me to invest no matter what. It's like I don't have to think about Oh, you know, the stock market's down 10% should I be allocating 10% of my cash, 20% 50% all that stuff takes a lot of energy.

But if you have a capital call schedule, where you just have to follow it because you have agreed to be a limited partner. It's, it's very stress free, just okay, I'm going to send that money in, they are going to invest the money how I see fit. I've already done the due diligence on the managers and their track record.

It's very freeing. This is something I can't really explain. But it's just very freeing when you let someone else manage your money that you trust. All right, I know I said there were seven reasons to invest in private funds. But here's an eighth reason for good measure. Investing in private funds forces you to hold for the long term.

They generally have five to 10 year life cycles before your capital is returned to you. Therefore, you're forced to invest for this period of time, the longer the investment time horizon, the greater your chance of making more money. If you're investing in public securities with zero cost to liquidate, it's much easier to panic sell.

I'm sure plenty of people did in March 2020. I'm sure plenty of people did in 2018 2019 is just human nature. Public investments can be a tantalizing source of capital every time there's a downturn or some type of emergency. Whereas when you invest in a private fund, you are committed for the duration of that fund.

You can access the capital without getting a lot of backlash, a lot of stink eye, you're committed, they're committed. Now, obviously, there are negatives to investing in a private fund. Biggest one are the high fees, the fees are so high compared to index fund. I mean, it's like 10 x 20 x higher.

But the hope is you're going to have higher returns. But the reality is oftentimes these private funds don't return as much as a respective index fund. So you have a double whammy there. Another negative is tax time come tax time, you've got to keep track of all your K ones for these private funds.

If you do it yourself, it's a lot of work. If you pay an accountant do it, every single K one filing costs money. The final negative is a lack of liquidity. Yes, you can stop meeting the capital calls. Nobody can force you to do anything, but you're going to be blackballed from the fund in any future funds.

And then you might work word might get around that says, you know what, you don't commit to what you sign, and you're not going to be invited to future funds. So if you want to invest in a private fund, make sure you allocate only the capital you're willing not to touch for the duration of the fund.

Personally, I love long holding periods. Every time capital comes in, you know, it feels good. But if you have an investor mentality in a high inflation environment, you kind of start stressing you start wondering how am I going to reinvest this capital so it doesn't lose too much purchasing power from inflation.

And then you start thinking, well, if I invest in this stock, or this bond, or this asset, it's going to do well, it's not going to do well. And with private funds, you've already just decided, okay, this is where you want to allocate your capital with some smart, hopefully people, and they're going to do the work for you.

So you don't have to stress about it as much. Currently, I invest about 10 to 15% of my capital into private funds. And I plan to continue going forward, I might increase it to try to manage volatility and risk. For those of you wondering how to gain access and invest in private funds.

Well, there's really no easy way to do it. There's no like centralized website. And you know what there probably is, but I don't know of one. Here's the strategy if you want to invest in a very promising private fund. One, you either need to have to have worked at the fund or work at the fund, know someone who works at the fund, get introduced, proactively reach out and see if there are any synergies you can provide, or come from one of the companies the fund has invested in.

A lot of private funds have quote anchor investors from institutional funds, endowments and ultra high net worth individuals. Once the anchor investors are in the fund managers and anchor investors invite smaller investors. It's just how it goes. It just goes from top to the bottom. And so imagine if you're like a whale and you invest $10 million or $50 million into a billion dollar fund, but you have friends from high school or college who are interested in investing 50,000, 100,000, 200,000.

They can probably get in because you are the anchor investor. So again, it's a lot to do with who you know, a lot of these private funds have what they call friends and family round. So that's where the opportunity for most of us lie. And here's the thing, the jobs act that was passed in 2012 has helped democratize access to private funds.

You know, you've seen a plethora of real estate crowdfunding platforms, some like fundrise, for example, rise to over 210,000 investors managing over $2.5 billion under management. In the past, investors like you and I couldn't invest in high quality commercial real estate, unless we had millions and millions of dollars.

And now we can. And you also see other platforms where you can invest in art, in wine, in all sorts of things, thanks to the passage of the jobs act. Of course, then it's up to you to carefully do your research and vet these private funds. Because frankly, everything tends to sound great before you invest.

And of course, not everything will make you money. So that's all folks. I hope you enjoyed my talk on private funds. If you enjoyed this podcast, I'd love a positive review and a subscription. Tell your friends. It's the way I get motivated to keep on recording and keep on writing.

Thanks so much.