The Future of Family Office Investing: Investing in Tech & Private Credit
Part II: Income & Alternative Debt
When I took over our family office, we had two main goals: How do we create long term capital growth and how do we find income generating investments. I’ve discussed how we approach growth equity in Part I: Early Stage Equity & Venture Capital.
Income or cash generating investments are equally if not more important to us. Cash generating investments give us the optionality to reinvest cash flow into the same investment to compound our gains, or use it somewhere else, should another need materialize.
Cash flow can be used for another investment opportunity, expenses, or simply to build up our cash position. Ensuring that you have adequate cash on hand is the foundation of opportunistic investing — truly great long term opportunities don’t come along often, and when they do, you have to have the cash to capitalize on them.
There’s more out there than just the public markets, or what may be presented by a private wealth manager. There’s a rise in alternative investment platforms where one can generate income. Some present a solid and unique opportunity, while others are trendy and potentially more risky. In this post I’ll take you through the journey of how we explored multiple asset classes before finding a great fit for us.
The Importance of Income Generating Investments
Cash provides the option to invest in an opportunity when it presents itself. In investing, cash can be sourced from long term capital gains, or income generating investments. If you look at the stock market, the majority of returns come from income (dividends). Investing in assets that regularly generate income gives you an option- the option to reinvest and build your position in that asset, or use the cash for another purpose.
As they say, “cash is king.”
A Brief Example: Cash is King
In 2008, we were only slightly exposed to public equities. My family officially moved to the US in 2006 and still had a large cash position. My father started a family fund focused on investing in US equities. Timing was great, and having cash allowed us to take real advantage of the opportunity.
- We bought stocks that were undervalued.
- We used a covered call strategy where we would sell out of the money call options (the option to buy your stock position at a specific strike price) on our positions to create monthly income.
- We would give up potential upside, but we would lock in monthly cash income.
- This strategy worked well because expectations of volatility (approximated by the VIX index) were high during the tumult of the financial crisis between 2008–2010.
- When the VIX is below 15, the market is considered to be acting “rationally.” When the VIX was over 30, option premiums skyrocketed. We took advantage of that strategy during that time period, collecting 2–3% a month in income and still had upside.
- We could use cash to buy more stock, pay for expenses or just wait on the sidelines until a better opportunity presented itself.
The example above was a scenario where one particular strategy achieved both growth and income simultaneously. So, the question is how do you have access to your capital when you need it, but still allow it to grow? Some assets are focused solely on growth, while others are focused solely on producing current cash flow.
- This is a liquid investment — when you need cash, you can sell stock, but there’s no guarantee that you’ll like the what the market is willing to offer you when its time to sell, so its hard to depend on stocks as a consistent source of cash.
- Historical U.S. market (S&P 500) returns are 6–7% annualized.
- Public markets are right off all time highs, as are valuations. High prices today dictate lower returns in the future.
- Some stocks also produce income by paying dividends, but they tend to be very small (low single digit yields) these days.
Venture & Early Stage Equity
- Highly illiquid. Returns take 7–10 years to generate (if returns are generated at all).
- Top quartile managers, on average, generate 3X+ returns over an 8 year period or better, which is tremendous growth.
- For context, a 3X multiple on invested capital over 8 years equates to a 16% IRR (see chart below).
- It’s hard to pick emerging managers that perform in the top quartile, let alone get into the companies directly.
- No cash income.
- Not liquid, but can have short lock ups, generally 3 years or less, and can produce strong cash flows.
- The returns that are currently available in the asset class are actually meaningfully higher than public equity or real estate. Can be 10% or greater annually.
- Reinvesting these cash flows can produce attractive growth.
- This is not a liquid investment, but real estate typically increases in value over time, and generates income along the way by collecting rent.
- The minimum to invest in a single asset can be high, therefore it can take a large amount of capital to acquire a diversified collection of assets.
- Still very illiquid.
- Most private equity funds take 5–7 year to return principal, but do offer the potential for attractive growth.
Below is a chart that compares Venture Capital, Private Equity and Public equities (U.S. Large Cap) over a 10 year period.
Overall Portfolio Allocation
How we’re positioned.
15% Early Stage Equity: My previous post covered our approach, but we have been actively allocating to early stage equity and Venture Capital. What is unique about early stage investing is that returns are produced almost entirely by creating real growth. Of course, there is high variability in outcomes, and access is extremely important.
20% Alternative Debt: For income and cash flow, we have found that certain subsets of alternative credit are similarly isolated from other risk assets in terms of implied valuations. We look at alternative credit as a hybrid of growth and income, because the returns are high (greater than 12% per annum), compounding these gains by reinvesting the income produces similar if not better returns than early stage equity investments.
60% Public Equities: We’re using the liquidity offered by public equities to our advantage. We’re realizing our capital gains by selling down our positions as markets hit all time highs and valuations are rich in order to strategically allocate more of our portfolio to alternative credit. As a result, our allocation will decrease.
When I compare the returns we have realized on our alternative debt portfolio vs the uncertainty and long term lock up of early stage equity, we have decided that alternative debt is more attractive on a risk adjusted basis.
Our Approach to Alternative Credit — The Learning Phase
Just like our approach to get exposure to growth through early stage equity investments, we looked to the private market for income generating investments. As discussed above, we were dissatisfied with the publicly traded options as they offered risks that weren’t (and still aren’t) justified by their exceptionally low returns. We started with a hypothesis that private alternative credit is an often overlooked opportunity, so we focused our resources on developing expertise in the space. We started by exploring innovative online securities marketplaces to get a feel for private credit that promised attractive returns, before moving on and developing our own proprietary deal flow. Here’s what we learned.
Marketplace lenders constitute a particular subset of private credit that has received a lot of attention lately — the defining feature of this group of lenders is that they offer loans for sale through an online platform. These platforms attract interested borrowers, underwrite them, price the loans (ie set the interest rate) based on the perceived risk level of these borrowers, and then sell the whole loans to one or more investors through their marketplace.
Peer to Peer
Lending Club is the poster child for Peer to Peer (P2P) lending and alternative lending/marketplace lending as a whole. Prosper is a very similar, competing marketplace. Both of them focus on consumer debt while others like Ondeck & Kabbage focus on small business debt, and SoFi & Common Bond focus on student debt.
We have never felt comfortable investing in Peer to Peer loans for asset specific issues, on top of the the misalignment of interests:
- They have no skin in the game. In other words, they retain no risk. Once these marketplaces sell their loans, they take a fee and are home free. They have no downside if the loan doesn’t get repaid.
- Unsecured debt: This means there is no asset backing the loan. If the borrower defaults, and they do quite often (how often is related to their credit score and the broader economy), you can expect to lose approximately 80% of your investment (lending club loan migration statistics).
- Long durations: 3–5 years. Though this is relatively short term compared to Treasuries and corporate debt, we prefer even shorter terms (often less than 3 months). We don’t know when the current market cycle is going to turn, and we don’t want to risk being in the middle of it. We want the shortest term assets possible, so we can reduce our exposure if macro data suggests deteriorating credit conditions.
- Competition & defaults: Both unsecured consumer lending & small business lending have become highly competitive in the US. Increased competition bring yields down over time because everyone’s trying to acquire the same borrower.
- Goldman Sachs (and others) now have their own consumer unsecured loan product. Investors can’t compete with a bank’s cost of capital. It becomes a race to the bottom, where the lowest interest rate loans get the best borrowers, and the high interest rate loans attract the worst borrowers. This is called adverse selection and is a well documented issue in lending.
- Declining Yields: Often, declining yields correlate positively with declining credit quality. Competition pushes down yields, but also forces originators to extend credit to riskier borrowers to maintain growth. This is a lose-lose situation and one we’re actively avoiding by staying away from some of the popular marketplace platforms.
Real Estate & Specialty Finance
My first experience with real estate lending was on the borrower side of a bridge loan while purchasing a new home. Given that our family had limited credit history (as mentioned, my family moved to the US a few years earlier in 2006), we didn’t qualify for a traditional bank mortgage. Our only option was to take a bridge loan from a mortgage lender to fund the purchase of a new home while our existing home was on the market but not yet sold. Of course, that loan was collateralized by the home we were selling.
The terms of bridge loan were: a flat rate of 5.5%, for a maximum period of 120 days. I remember thinking to myself, that’s a hell of a deal. I want to be in that business! This was my first experience with alternative debt in general.
Real Estate Investment Platforms
We don’t have the operational expertise to directly buy or lend to properties, or enough capital to be properly diversified. I wanted to invest in a portfolio of properties that had already been thoroughly researched and underwritten, but where there was full transparency and fees were straight forward.
A number of real estate marketplaces have emerged in the last 4 years, including Fundrise, Realty Mogul and Realtyshares. I was close to the team at Fundrise and had a good relationship with them. We liked space for the following reasons:
- Invest directly into a portfolio of vetted properties with minimums you don’t typically find in real estate investing.
- Earn returns without the mess of multiple fees on fees. Platforms charge an origination fee and you’re still able to make returns ranging from 8–18%, depending on type of investment.
- Unlike publicly traded REITs, these investment don’t fluctuate with the overall market, have full transparency on what you own, and are fee efficient.
We liked investing in shorter term asset backed lending opportunities. There are lots of places where banks won’t participate and capital is provided by a speciality finance firm. I found some great opportunities with Yieldstreet, a platform for specialty finance investments. I got to the know the team well and felt comfortable investing in the following:
- Litigation finance- a third party provides capital for a plaintiff’s legal costs in exchange for a portion of the settlement.
- Hard money lending- a loan is backed by real estate.
- Ridesharing leases- a loan provided to fleet of ridesharing cars operating on Lyft, Uber etc. Loan is backed by the cashflow of the lease payments and the vehicles themselves.
The investments on the platform provided 12%+ annual returns, were short in duration and some level of asset backing which lowered the risk.
For all the above mentioned platforms, there are always risks when investing. I’m simply sharing my experience investing with them.
I looked at other platforms and realized I didn’t want to be spread wide across too many. I like the idea with sticking to the ones I know, developing a relationship and diversifying within them.
A couple of examples of ones I looked at:
- Franchise Debt: I get the concept. Underwriting is very important here because it’s not just about what franchise, it’s about who the franchisee is. Issues for me were the duration of the loans (3–5 years) coupled with the return (8–9.25%) just wasn’t as appealing to other deals I was seeing. Personally, I’d rather own a portfolio of franchise businesses for the cash flow. I have two friends who quit their PE jobs and now manage several Wendy’s, and are doing quite well. Lots of work…and Frosty’s!
- Solar Financing: I like the mission, and would need to know that team has a deep knowledge in renewable energy and how to structure debt around it. What I did like is that they were offering fully managed funds. I couldn’t wrap my head around the 8–10 year duration of the loans ranging from 6.5–8%.
Our Approach to Alternative Credit — Current Phrase
Conceptually, we liked the idea of alternative credit. We knew that with the right exposure, when structured properly, alternative credit could offer high returns through short duration, asset backed, contractually obligated cash flows. So we decided to take our approach to the next level.
We found an interesting intersection between our early stage equity exposure and our desire to get more involved in alternative credit. Technology companies focused on lending have begun to proliferate, combining their tech savvy with creative loan structures and underwriting to address unmet needs for credit for businesses and consumers.
Building out our Strategy
I’ve discussed that teams are important whether you’re investing in a company or a new fund. I needed increased sophistication and technical expertise to dive in to this asset. I was lucky to meet my current partner Rennick. Rennick spent a few years at Sanders Capital (a $24 billion global investment firm). He spent time diving into global banks, specialty finance, technology, real estate, macroeconomics and other subjects. Shortly after meeting in 2015, we started to invest together. I’d like to think I have a knack for investing in emerging managers, and Rennick is one of them.
Over the past two years, Rennick and I have been partnering with technology enabled lending companies to provide the capital they need to make loans. It takes a lot of time and effort to vet these companies and to structure our investments with them, but so far we have been rewarded with great returns. We’ve been lucky to have the opportunity to partner with amazing companies:
- Bond Street (we were part of the first debt capital Bond Street raised before Jefferies came in)
- Produce Pay
Our extended network of founders, VCs and investors granted us access to these companies. This is very important for our deal flow and understanding how these companies operate. Our friend Dave Eisenberg joined us as an LP and an advisor to help us asses opportunities. Dave brings expertise as an equity investor and a founder.
- Dave co founded Red Swan Ventures, where he and his team have invested in over 50 companies including Payjoy, Bond Street, Coinbase, and Jetty.
- My family is an LP in Red Swan, as mentioned in my first post.
- Dave also founded Floored, a real estate tech company which recently sold to CBRE.
Mark 2 Capital (Mk2C)
There is a new wave of fintech lenders addressing underserved markets and unlocking purchasing power for millions of people and businesses all over the world. These lenders are solely focused on their end borrower and are using data and technology to create better underwriting models and loan structures. Because they are addressing niche markets, these lenders will likely never build marketplaces to distribute their assets. Instead, they will utilize private credit facilities like those that we invested in personally.
As a result of our experience, to continue addressing private credit opportunities at scale, we formed an investment firm, Mark 2 Capital. Mark 2 is a vehicle designed to invest in and gain exposure to what we believe is a highly attractive opportunity that is significantly mispriced relative to the underlying risk. We structure bespoke credit facilities for each lender that we partner with.
Generally, we look for the following in our investments:
- Explicit alignment of interest — the lenders we partner with contribute their money as first-loss capital. If a loan doesn’t perform, they are first in line to take the hit.
- Limited competition/scarcity of capital — we look for lenders addressing unmet credit needs in novel ways, were competition is nonexistent or scarce, allowing for high interest rates. We actively avoid the me-too lenders copying existing lending models or operating in competitive markets (see Peer to Peer).
- Short duration — We prefer loans that are short term. Short term loans eliminate or reduce two key risks present in lending — interest rate risk and credit risk. The majority of our portfolio is made up of loans with terms of three months or less.
- Asset backed — Making loans secured by assets reduces risk significantly. Specifically, we’ve focused on loans that are backed by receivables or inventory. That means as long as the borrower is generating revenue, we’re going to get paid* (this is not the case with most loans-often refinancing or growth is required to get repaid, massively increasing risk.)
We are excited to focus on this opportunity. We believe that the technology community needs an updated credit investor — one that not only understands the markets these companies are serving, but understands the founder mentality, their equity investors, and the flexibility needed to provide them the appropriate funding model. We have seen the emergence of early stage, founder friendly investors like Floodgate & First Round in venture — their returns have served to confirm that they filled a void. We aim to do the same for debt.
Stay tuned for more posts from myself and from Rennick as well.
As always, please reach out to: firstname.lastname@example.org
Thank you to Rennick Palley for collaborating and helping me write this post. Thank you Alex Pack & David Weiner for your edits, comments and suggestions.