Game Plan

by Kevin D. Freeman

  Financial assets are also called “paper assets” because you buy a piece of paper that represents an agreement. Investopedia’s online dictionary defines a financial asset as one “that derives value because of a contractual claim. Stocks, bonds, bank deposits, and the like are all examples of financial assets. Unlike land and property—which are tangible, physical assets—financial assets do not necessarily have physical worth.”26 Alternative assets that fit in this category include private equity and alternative loans.

  Private equity is ownership of corporate stock that is not traded on public stock exchanges. When you buy shares of stock on an exchange, the price is publicly quoted, and you buy through a broker. The investment is highly liquid—you can usually sell your investment any time you want. Shares of Facebook are public equity; they have been publicly traded since May 2012. In its initial public offering (IPO), Facebook raised $16 billion of new investment capital in a day.27 Facebook had shareholders before its IPO, however. The lucky few who got in early made fortunes. They enjoyed returns of about 1,000 percent within four years.28

  With gains like that, who wouldn’t want to dive into private equity?

  Private equity comes in all flavors and varieties. It can be a small personal investment in your cousin’s bakery. Or it can be taking a very formal stake in a pre-IPO company like Facebook. There is always the potential for gain, but there is also the potential for complete loss. You can invest in private equity on your own or through a manager or private-equity fund. There are many private-equity firms that act like a combination of hedge funds, and there are venture capital firms focused on true start-ups. These firms charge relatively high fees to oversee a portfolio of private-equity holdings on behalf of their shareholders. The investment can be in an early-stage start-up or a later-stage investment to provide working capital or growth opportunity for a business that is already operating. It is best to seek professional guidance from someone who understands your personal situation and goals, thoroughly reviews the opportunity, and appreciates the economic situation and economic warfare risks.

  The more exotic (and high-risk) options for private-equity investments include Broadway plays and feature films. The New York Times reported about such investments, “[F]or some amateurs, being part of the film festival circuit, let alone making it to a big Hollywood premiere, can be glamorous. For a serious investor, with more at stake, there are many ways to make money in films that have little to do with box-office success.”29 It takes more than a few million to take a stake in a major Hollywood project, but smaller independent filmmakers might accept as little as $10,000.

  Other outlets for the glamour-seeking investor are racehorses30 and NASCAR teams.31

  Private equity is riskier than public equity. The disclosure requirements and regulations are less stringent. Companies listed on an exchange are established businesses. Public shares are more liquid. As a general rule, the risk of complete failure is much greater with private equity.

  Only licensed broker dealers are allowed to sell equity, even private equity, for compensation.32 A word of caution is in order. Although having an advisor is highly recommended for a private-equity investor, make sure that your advisor is sitting on the same side of the table as you. It is common to offer “finder’s fees” for capital raising, which creates incentives for the advisor that can run contrary to your interests.

  One way around this problem is for the advisor to negotiate the greatest possible incentive and then require that the company raising capital return that fee to the client directly. This eliminates the conflict of interest and simultaneously creates a better deal for the investor. Finder’s fees can be 5 percent or more of the investment, so the client ends up with a 5-percent discount and trust in his advisor.33 Be certain to ask if your investment includes finder’s fees or other commissions.

  There may be circumstances in which a finder’s fee is appropriate. In those cases, the advisor must be a properly licensed broker dealer, and the commission on the sale of the private investment should be in lieu of advisory fees. Finally, the client must fully understand the implications of the finder’s fee.

  There are some real advantages to private equity:

  1.The upside can be substantially larger. Imagine if you were one of Steve Jobs’s early supporters and bought even a few thousand dollars’ worth of Apple pre-IPO.

  2.Private equity is not subject to the daily pricing whims of the markets. You don’t have to worry about what others think of your investment as reflected in the daily tick of the market. On the other hand, your investments aren’t so liquid that you can sell them on a moment’s notice.

  3.Your investment in private equity won’t be directly affected if the stock exchange is hacked or prices are manipulated.

  4.With private equity you can have a greater influence on management and company direction.

  The benefits of private equity can make it a reasonable investment option if you have professional support in evaluation and monitoring, objectivity, and a long-term horizon.

  Microinvesting is a recent innovation that allows investors to take small stakes in companies. It used to cost $50,000 or even much more to get in on a start-up, but microinvesting lets you invest as little as $250. The risk with microinvesting, according to MicroVentures CEO Bill Clark, is that “seeing a return could take five to seven years. And you could also lose all your money. It’s high-risk.”34

  Warrants, Options, and Other Incentive “Kickers”

  Sometimes companies issuing private equity will attach other instruments—usually “warrants”—to make the investment more interesting. Options are usually given to employees of start-ups as a part of their compensation. They allow employees to take an ownership stake in the company if the shares become more valuable. An option is the right to buy shares at a predetermined price for a limited time period. A warrant, on the other hand, is usually given to investors. It is not compensation but rather a “sweetener” for those taking a stake early. An early-stage company might, for example, offer fifty warrants for every hundred shares of stock purchased. The warrants would allow the investor to buy additional shares at a predetermined price for a set period. The warrants themselves have value and can be sold separately in some cases.35 Both warrants and options have tax implications.

  Private Debt

  Private debt is to the bond markets what private equity is to the stock markets. Many of the same rules apply.

  Private debt can be informal, such as loaning money to a sibling to buy a car or open a coffee shop. Or it can be formal, such as participating in a private offering from a larger company. As with private equity, there can be finder’s fees and warrants. Private debt can contain “conversion” privileges that allow the debt holder to convert the balance due into another form of security of asset. A mortgage is an example of a convertible debt.36

  Both entrepreneurs and investors like convertible debt. It can be flexible, but there are three critical choices to make. First, what event will trigger the conversion? It is usually a financing event, such as a revenue or financing threshold. Second, what discount, if any, will there be upon conversion? If there is no discount or it is too low, investors might back away; if the discount is too high, investors in the next round might factor the discount in when they value the stock. Third, what happens to the investment if the conversion event never occurs?37

  You might consider a species of private debt known as microloans, fixed-interest loans given to small-business owners in developing countries. Minimum investments can be as small as twenty dollars, but the yields can be 1 to 6 percent annually.38 For lending to people who, because of their poverty, normally would not qualify for a loan, the microlending pioneer Muhammad Yunus, the Bangladeshi founder of Grameen Bank, won the 2006 Nobel Peace Prize. The “security” for microloans is the good name of the borrower’s family.39

  Hard-money loans, which usually return 10 to 12 percent to the lender, are secured against an asset. An investor,
for example, might offer a mortgage to a real estate buyer who is short of cash or needs bridge financing.40

  Tangible Investments (“Stuff”)

  In contrast to paper investments (financial assets), tangible investments are essentially investments in “stuff.” The range is huge, from land to diamonds, from food and wine to comic books and stamps. Each has unique attributes and pricing. Each has unique costs and quirks. But all have one thing in common: you own stuff.

  Sometimes buying stuff involves a paper investment. For example, when you invest in an oil well, you are really making a private equity investment in a venture. You can also buy mineral rights or production royalties.

  In most cases, you will own a piece of paper that entitles you to an income stream or other payout. It is a “tangible” asset because the underlying investment is a thing rather than an idea or service. The value of the investment, if successful, will be based on the value of the stuff it represents.

  Tangible investments include real estate, commodities, fine art, stamps, oil and gas properties, precious metals, guns and firearms, antique cars, and equipment that can be leased. We can break these tangible assets down into three categories: property, commodities, and collectibles.

  Property

  Property can be real estate (undeveloped or developed) or equipment. You might own a rental home or a stake in a shopping center.41 Your investment can be direct or pooled with others. One way to invest in property is through a real estate investment trust (REIT), which is often publicly traded on an exchange. REITs invest in a great variety of commercial properties.42

  REITs pay dividends and shield investors from some of the liabilities associated with direct property ownership. They are convenient and liquid and don’t require much money to invest. You are not personally responsible for maintenance, and you can diversify your investments. At the same time, REITs, when traded on exchanges, are subject to the daily ups and downs of the market. If you own investment real estate directly, you manage it yourself, and you can get additional tax benefits.43

  There are many considerations in real estate investing. The famous aphorism is that only three things matter: “location, location, location.” But it’s more complicated than that. Without going into detail about real estate investing, let’s mention some of the plusses and minuses.

  As an investor in real estate, you have leverage. You can take advantage of the appreciation and cash flow of the investment while using a small amount of money on a large investment. You have more security than if you were flipping houses, you reap tax benefits, and you control the investment, as opposed to a stock, where you are at the mercy of the company’s directors.44 There are choices ranging from single-family homes, with their attendant ease of financing; small multifamily properties, where two or four units protect you if one of the families moves out; and large multifamily properties, which can give you higher cash flow.

  But there are risks to investing in real estate. Christopher J. Mayer, a professor of real estate, finance, and economics at Columbia Business School, warns, “There is a lot of idiosyncratic risk associated with rental income. That is the word that economists use for when a lot of things can go wrong, even if on average they don’t go wrong very often.”45 Home values can decline, your money is concentrated in one place, your rental property might sit vacant, and the upkeep is your responsibility.

  In all cases, having professional advice can help with property investing. It is especially important to have an awareness of global economic factors and how they may affect your property investments.

  Commodities

  I have already devoted a whole chapter to precious metals, which are a subset of commodities. But you might also invest in rare gems and diamonds, food, timber, or energy. You can purchase commodities directly, on the futures market, and through funds and ETFs. You can also invest in companies that produce the commodities. I will briefly describe each of the investments and then run through the mechanisms.

  Diamonds: Investing in “ice” has become hot. Diamonds and other rare gems are universally appealing, contain a great deal of value in a small package, and can be easily stored and transported. They don’t wear out or go bad,46 and diamonds produced a higher rate of return than equities between 1999 and 2010: white diamonds yielded 6.4 percent, while stocks and bonds returned 0.1 percent and 3.3 percent, respectively.47

  Business Insider gives eight rules to follow when investing in gems:

  1.Either buy the gems themselves or invest in a company such as a mining company that is part of the gem industry.

  2.Make certain that your average rate of return matches the rate of inflation.

  3.Know that gemstones are not liquid. You can’t look up the “going rate” for diamonds as you can for gold; there are many factors determining the value of a diamond.

  4.Try to buy the stones below retail.

  5.Get professional help.

  6.Keep your eyes open for fraud.

  7.Remember that selling the gem will be as difficult as buying it.

  8.Remember that capital gains taxes apply.48

  Food: One problem with diamonds and precious metals is that you can’t eat them. The necessity of eating makes food an interesting alternative investment. And there are multiple ways to invest in food:

  1.You can grow your own. Of course, this requires land, seeds, know-how, fertilizer, and luck for weather.

  2.You can buy food someone else has grown. In this case you will need storage and maybe processing capabilities and distribution.

  3.You can buy food someone else has already processed. Again, you still have to store and distribute.

  4.You can buy contracts for food delivery and then sell the contracts prior to delivery. This is usually how the futures market operates.

  At some point, for the food to have value, it will need to be delivered to a consumer. Food is mostly perishable, although the shelf life can vary greatly.

  Many people buy food futures. Futures are not for the average investor, especially without professional help. I won’t go into all the specifics, but there are plenty of dangers to watch out for. High-pressure brokers or inadequate capital can lead to trouble.49 The futures market is so unpredictable that you could lose your entire investment, and possibly more than you even invested. Futures are not covered by the Securities Investor Protection Corporation (SIPC).50

  A friend of mine recently devised a unique and beneficial way to invest in food. Richard Lackey—a great investor in his own right with experience as a trader and fund manager, and a bestselling author—established the Global Food Exchange, now the world leader in strategic food reserve development.51 “Over the past decade,” Lackey observes, “communications technology, transportation technology, power systems and food manufacturing technology alike have improved; and yet record numbers of people around the globe are dying because we are not able to get adequate quantities of food and clean water to victims following a natural disaster.”

  Lackey predicts that because of the massive quantities of food needed and the lack of funds by governments to maintain stored food, food prices will be higher ten years from now.52 Already, funds are forming to pool investment capital for investing in food through the Global Food Exchange.53 Investors may soon be able to buy and hold meals that can be stored for the long term and sent as needed for disaster relief. You can invest in these meals when food is plentiful and sell when it becomes scarce. This type of food storage also enhances national security.

  Industrial metals, raw materials, and energy: Industrial metals are commodities used in construction and manufacturing, such as steel, copper, lead, aluminum, nickel, and tin.54 The prices of these metals rise and fall because of two things: supply and demand. The best time for these metals is when the economy starts to grow after a lengthy slow period. The slow period will have reduced production, keeping supply low, and new growth will increase demand sharply. Because mining operations have a long lead time, demand grows much more
rapidly than supply. Late in the growth cycle, the opposite is true. Supply will be coming on line as demand wanes. Metals are thus considered cyclical investments. As with most commodities, you can invest “long” or “short.” Long investments profit from price gains, and “shorts” benefit from falling prices. If you don’t understand shorts, you need to be educated and have professional support before you invest in commodities.

  Exchange-traded funds (ETFs) are one way to invest in commodities. An ETF manager buys and sells the commodity on behalf of the shareholders. The fund is also responsible for storage and protection. This is a direct way to own copper, for example, and the price of the ETF will rise and fall with the price of copper.

  You can also buy shares in mining companies, whose fortunes also tend to rise and fall with the price of what they are mining.

  There is a lot of talk recently about the importance of rare earth minerals for things like hybrid cars and iPhones. China controls the market, and many developed countries no longer mine for elements such as neodymium, dysprosium, or cerium.55

  There are ways to invest directly in minerals, but I caution against that. It would be a nightmare to store, keep track of, and later sell such an investment. The market is simply not mature enough. The only rational way to make such an investment would be buying shares in a company that produces them. An expert from Forbes agrees with that assessment.56

  Investing in timber is another option. This commodity’s fortunes are tied to those of the housing market.57

  You can buy timber through ETFs and REITs as well as through the paper companies. Timber has outperformed the S&P 500 ever since 1910. In the quarter century after 1987, the NCREIF Timberland Index grew about 15 percent per year, while the S&P 500 averaged about 11 percent. In 2008, the S&P plummeted 38 percent; Timberland rose by 9.5 percent.58 Timber can be a helpful diversification play that works in times of inflation, and even depression if the circumstances are right.