No PE in my PA

earthwalker7's picture
Rank: Human | 10,394

I am never investing in a PE deal again out of my personal portfolio. Ever. Not VC, not angel investing, not growth.

Background: I'm a PE professional, and I went down the path of personal investment in PE because it was what I felt I understood. Plus my former shop was printing high IRRs which made public equities seem silly.
I mean, why settle for a historical average 8-12% return, when you can generate >30% IRRs plus influence the outcome thru activist investment in PE, right? Bad idea. So I co-founded a hospital chain, and put my own money in that as a partner in the opco, and also separately invested in a number of smaller illliquid PE positions. I regret that, and offer this as a cautionary tale.

  1. Negative Selection Bias: Unless you're Peter Theil or Warren Buffett, or at a major PE shop which is 24/7 immersed in an industry, no one is showing you great private deals. That means there's an inherent negative selection bias. PE funds screen several hundred deals a year, and do only a small handful. My old shop had a >98% rejection rate. But getting that kind of deal flow, and running that thorough a screening process means having a brand to attract dealflow, and running a team to sift through the volume. As an individual, you just can't do either. Simply put, if you're seeing a private deal - it's likely a bad deal.
  2. Illiquidity: PE funds and their LPs can stomach illiquidity. I thought I could but turns out I can't. It takes institutional time horizons to be in PE. If you're an individual investing out of your PA, how will you manage it if the investment doesn't exit for 5 years? Or 10? Want to buy a house to put your family in? Too bad, your money is stuck in a PE deal. Want to participate in the stock market rally? Too bad, the money's locked up.
  3. Never an exit / You might fund someone else's lifestyle: a variant on the above is the scenario in which the company does well, your investment thesis is validated, but the company can't/won't exit. Making the leap from private to public company is something that most companies will never do - and mostly likely you'll invest in a company with no exit. I invested in one tech company that became the leader in its niche, revenues are too small to IPO. Example 2 - 5 years in I'm still trying to sell the hospital platform I helped build. It's grown a lot, but finding a buyer is difficult. Most PE deals won't find an exit.
  4. PE is lumpy: The nice thing about public equity is it's easy to take a few thousands dollars and invest. It scales nicely. PE? Not at all. Minimums on PE deals even as a co-founder are hundreds of thousands. It's lumpy, and that concentrates the risk in your PA.
  5. You're a fuckable midget: In most deals - whether you're investing alongside a fund or going in as an equity participant in a business you start - you're a small player participating alongside giants. That means you can be crammed down, squeezed out, and in general just bullied and abused. Even if the company is a success, you can still find yourself on the losing end of the deal.

Comments (51)

Feb 4, 2020

SB'ed

Interesting post and curious to hear what others' experiences are like. OP - when you invest in minority growth deals, don't you typically negotiate for pref dividend/redemption/QIPO (even though might be many years down the line)? This is coming from the perspective of a late stage growth investor, but then again, these PA investments might be too small to have these terms properly negotiated.

Most Helpful
Feb 4, 2020

At this point I've invested in SAFE notes, a couple CBs, and the hospital I co-founded was structured as a partnership in which I am an LP. As a minority investor, I don't have much ability to dictate terms. That's reason #6 as to why not to invest in PE as an individual. In the case of the CBs and SAFEs I did convert to preferred stock which does have a coupon, but that coupon is accrued and isn't paid. I didn't have the ability as a tiny minority to negotiate particularly good redemption rights. I just had to take the agreement everyone else signed.

I could in one case put the equity back to the founder, and get paid the principle + coupon - legal fees. But coupon is just 8%, and so after legal fees it's quite dismal returns. Meanwhile there was another round at 2x my cost 3 years ago. But when will I ever see liquidity?

And the hospital I co-founded.... there's zero liquidity until we get acquired. We've been trying to sell the company for 2.5 years no. Not a ton of buyers running around for big chunky assets like that. I'd have done much better had I invested in public equity, and I'd have liquidity to boot.

Mind you, I'm not against PE as an institutional asset. If you as an LP have the long-term view, it's awesome. If you get with a fund that has a real edge - some unique secret sauce - you can make way better returns than public market.

But as an individual investor, I have gotten quite cynical. So I put together this post both to warn others about the risks of putting PE in your PA, but also to remind my idiot self of why I'm not going to make that mistake again, when the new-new-thing comes around.

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Feb 5, 2020

Take ur safe to a liquidity fund? They will give you .25cent on the dollar as a loan against it

Feb 5, 2020

Yep these things are awful to get out of unless you get lucky. The lack of control is a serious issue. You have a 100k in a deal and it's decent money. Something goes wrong? Can't hire a lawyer or it's costs everything you put in. Even if not playing with giants others will have more power in the structure and legal remedies won't do much more than costs everyone money and time.

Also I think you way overestimate the returns for pe. Once you factor out leverage small cap premiums etc and IRR being juicy but never being fully invested the returns aren't that great.

With capital calls it's like I can pick a day to buy and a day to sell a stock. I could show some juicy returns of had a ton of money to just pick entry and exit points and not have to sit in cash for a while.

Array
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Feb 5, 2020

Hey!
First off wow! I was about to ask a question about becoming a M&A advisor & about what education/experience I'll need to invest successfully in private firms but after reading your post I have a few questions! Coincidence? Maybe.

I found the business broker/M&A advisory industry very interesting and wanted to hear what experts had to say.

Background:
Currently at a not so good Canadian business school (BUT will be transferring into a top 5 business program soon) - studying finance & accounting
Minoring in Applied Statistics & Computer Science (will also be going through a great coding bootcamp soon)

I'm currently debating on either going into Commercial real estate brokering (sales) or getting into M&A advisory. But I'm still confused on which to go through.

What would your take be? Hope to hear from you soon, Thank you & have an awesome day - GOOD LUCK on getting out of the deal you're in.

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Feb 4, 2020

Great post but two questions:

1) You didn't mention any fees you took on close (not on exit...), AUM, "portco monitoring" or any of the other BS fees that typical PE investors extract on all deals, good, bad or ugly. Did you take any of those? If so you've forfeited some right to complain.

2) You describe illiquidity as a totally unsolvable problem, but a pretty big industry - secondaries... - has sprung up to solve it. There are funds to cover everything from tiny employee stock option positions to multi-$billion LP stakes. Yes, you might sell at a discount to FMV, but you might not given how crowded the asset class is getting.

Feb 4, 2020

1) there were no BS hidden fees
2) my point precisely was that I'm too small for such exits; there's no secondary player that will bother to buy my $xxxK stake in any of these
3) I'm not complaining I'm sharing my experience with others and writing an admonition to myself publicly so I don't F- this up in the future. I find public self-admonishment to be the best way to etch lessons on my brain.

Feb 5, 2020

The secondary is a tiny industry. The secondary market is not gonna buy your $100k investment, that's ludicrous. They are here to get a teacher's of california pension out of their $10m+ investment in a fund.

Feb 5, 2020

that's exactly my point. Hence the illiquidity

Feb 4, 2020

Eh, cut the bullshit. If these deals (eventually) make you rich you're plowing your money right back into PE. You're one of my favorite posters on here, btw.

Feb 4, 2020

From your mouth to God's ears; I sure would like any of these to make me rich. Heck, I'm just praying for return of principle, and I'll be happy. Being a small minority of an illiquid asset isn't helpful to my bank account at all.

Feb 4, 2020

You bring up a good point that applies to angel investing as well. People forget that any individual who is not in the ultra wealthy category generally has zero negotiating power. In angel deals especially, even if you get it right on a unicorn, you can get blown out in subsequent rounds if you're unable to continue funding your pro-rata.

Feb 4, 2020

5 is the biggest one in my opinion. The first four are also important, but all are addressable with the right level of dedication/patience/risk tolerance.

5 can only be addressed by setting aside a big legal budget which will kill IRR for any smaller investor.

I've done 4 angel deals. 2 of them have already required investor litigation relating to matters where a lead investor tried to screw everyone else out of their positioning. Thankfully we were able to get a decent settlement because I invested as part of a large angel group and we could spread the legal bill across all of us. Without that I'd have to take a zero even when the underlying business still has promise (if you think failure sucks, try accepting a zero before failure has even happened).

That's 2 litigations out of 3 deals, because the 4th is so recent it hasn't had an opportunity to get ugly yet.

Feb 4, 2020

Thanks for the insight. Jason Calacanis wrote a good book on angel investing called Angel (really creative title) , and several point his home:

  • the only place to be an angel investor is Silicon Valley. Anywhere else there just isn't enough volume of dealflow for you to see the best deals. If you live anywhere else (as I do) you see the SV rejects, and your just the sucker at the table
  • If you're broke (or at least, not very rich) you should try to be a 'broke angel' where you're providing sweat equity in exchange for participation in the company's equity. At this stage I'm ok giving my time to projects I believe in much more than I'm willing to give capital and lose my principle. My time I can make back, but I need the $ to raise my family and buy less risky assets like real estate
  • You need to spread your angel seeds far and wide, and then double-down on the winners. Being a small minority investor in PE deals makes that impossible. One of my b-school alumni is a super-angel, and he's done VERY well for himself. But he invested in the angel round of more than 30 companies and exactly one of them went gangbuster. 3 others did ok and he maybe made some $ back when he was bought out. The other 25+ were zeros. The one deal that he was in that did well, he kept re-investing his pro-rata, it became a unicorn, and his stake was worth several tens of millions. But he only got there by taking loss after loss, for more than a decade, until he hit a winner. That takes some serious staying power. In his case, he was a previous exited entrepreneur, so he had his own previous money and reputation to get him into deals, and he just kept plunking down $100k, over and over, until one hit. I don't have the money or stamina to do that.
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Feb 4, 2020

Re litigation - that's a great point. We're in process of suing one group right now. The only ones getting rich are the lawyers, and at every step this is an exercise of weighing costs of litigation vs. potential recovery. This is my first litigation, and from day 1 I knew I never wanted to do this again. It F-s up your day job for you to be interviewing lawyers, putting together info packs for the court, organizing the other small investors to pursue, dealing with each of your fellow investors having divergent interests and differing ideas on how to proceed, and then you've got to wrangle them up to pay their pro-rata of legal fees. I never want to do this again. And this is just to get a portion of the principle back.

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Feb 4, 2020

A lot of search funds do what you describe though.

Feb 5, 2020

Fantastic post.
Although I can tell you the same about public market and how am getting smoked :)))) Just kidding, liquidity to get in and out is completely under-rated. Especially today in some industry (real estate) public equity is trading at a discount to private deals (sometimes)!?

In terms of deal, again you are talking real PE, if you do real estate PE you can source good stuff - just so many more assets and you just have to get chumy with the brokers. They'll market to everyone they know if they know there is a chance you'll buy.

Liquidity is an issue in real estate as well - trying to sell one of my flats at the moment. No one is here hitting the bids...

    • 1
Feb 5, 2020

Real estate is far more standardized than lower mm pe or angel.

The lawyers are cheaper and the work more standardized. The bigger issue in repe is the lower returns combined with sometimes high transaction costs of 4-8% and figuring how to amortize those.

Array
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Feb 5, 2020
earthwalker7:

You're a fuckable midget

Nicest thing anyone ever said to me.

  • Analyst 3+ in HF - EquityHedge
Feb 6, 2020

I don't understand if this is a compliment or a backhand....

Feb 6, 2020

Just a joke, a little self deprecating humor.

    • 1
Feb 5, 2020

You're first point is spot on. Unless you have a direct connection to a great deal, which as Bud Fox knows only gets you so far, if a small fish is seeing a deal it likely sucks. I have a buddy that tries to show mean the deals he "sees" and my first response is always, if its such a great deal wtf has it trickled down to you. Does this mean that you can't find good deals, no, but in all likelihood they've been passed over by everyone worth their salt.

All the other points are good as well - but if the deal itself sucks, they are kinda irrelevant.

Feb 5, 2020

Great thread and very interesting insights. Could you please add some color on how you're getting bullied by larger funds on terms? Co-sale, anti-dilution, redemption, pro-rata...etc.

Also, its my understanding as an angel, even if you cant fund pro-rata, you own a smaller piece of a bigger pie. Assuming your pre-money $ increases meaningfully, aren't you still economically better off?

Would love to hear details on what terms are being litigated in light of whats written in the SHA.

Background is I'm considering a minority deal and stumbled across this thread, thanks.

Feb 6, 2020

To be clear, I am still a fan of doing PE as a proper fund management company, with a dedicated sourcing and DD team, patient capital, and enough resources to take your sweet time before plucking that 1 deal out of a 100 to invest in. But I'm really against doing PE as an individual.

In terms of how you can get screwed - the ways you can get pushed around as a minority individual investor are countless. You have no vote or BOD seat, so you're at the whims of both mgmt and bigger investors. They will almost certainly do things differently than you would have, and you can't do a thing about it. They may turn down acquisition offers, insult potential investors, decline partnerships, and put off / decline getting acquired.

Some examples include:

  • CEO repeatedly forgets his meetings with investors I set up for him. I've had him be belligerent to investors and argue them down.
  • CEO paid himself a nice salary, and just coasted for years. No exit on that one, and he's living a nice life, so what does he care if I want an exit. He's got salary, lords it over 100 employees, and life goes on.
  • I made a seed investment in a company that became a unicorn. I had been structured into a special class of advisor shares because I was providing consulting + capital. Well the VCs who came in later had the BOD buy back all those shares at the last round's valuation BEFORE they would invest. So I got a bump in my valuation, but didn't fully participate in the company's success.

I could go on. I don't remember a public stock f'ing me over like this.

    • 2
Feb 6, 2020

Thank you, this is immensely helpful and the reason I keep on coming back to WSO.

On Point 2 - I presume the majority shareholders (PE?) would be even more unaccepting of the lack of focus on growth, as they have more capital invested than you (and LPs to answer to). How is he still the CEO (e.g. runs business efficiently and majority is fine with this being a cash flow play with dividends paid out each year)?

On Point 3 - Wouldn't it be written in the SHA you agreed to upon investment that the majority can force a sale on this special class of shares? I'm having a hard time thinking of a mechanism that wasn't foreseen, that would force you to sell shares in an invest vs. acquisition scenario. Supermajority amendment to articles to force minority sales?

RE your China hospital play, hats off to you. I spent 2 years as an expat there and got the fuck out, business is very different than the US, and not in a way that's attractive to me. Is there a path forward where this is a light touch, cash flow play, thus not necessitating a buyer?

Feb 7, 2020

Angels can easily be flushed or egregiously diluted through pay-to-play rounds where they're forced to convert to common, higher liquidation preferences, participating preferred shares, attached penny warrants, lots of ways. You can file an oppressed shareholder lawsuit or some silly move like that, but you'll just spend a bunch of money to get nothing.

Feb 6, 2020

Where is the hospital system primarily located?

Feb 6, 2020

We own two hospitals, both in a tier 2.5 city in China's greater bay area. We use a Kaiser Permanente-like model, where we sell healthcare plans to corporates, who then have their employees be our subscriber/patients. We have >50,000 patients, serve >1,000 corporates, and have >1,000 beds. Want to buy it? We can negotiate a good price ;)

We made a couple of tactical errors which took this seeming winner into a problem child. 1) we own the physical assets, which has sucked up our capital, 2) we bought a second asset before fixing up and stabilizing the first hospital, and which further sucked up our capital. The moral is don't over-reach. And be super conservative on how you spend your cash.

Seriously, do you know of any buyers?

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Feb 6, 2020

I was asking because I know a few hospital CEOs that are looking at acquisitions, but only in the US. To be honest, after looking at hospital acquisitions in general, quite a lot of hospital systems seem to lose money. I am mostly a tech investor, but I advised the CEO of a large Midwest hospital system against buying another hospital in his main region of operation. This was a few years ago and he bought it anyway. The CEO retired, the CFO left to join another system and the Chief Investment Officer is still pissed that he has yet another black hole sucking away the money from his endowment AUM. Out of the 17 hospitals in that system, all of the cash flow comes from just 3 hospitals. The others either break even or operate at a loss. They're a top 10 teaching hospital attached to a top 10 medical school, so you can guess which hospital generates all the money.

In any case, I wish I could be more helpful with your sale. Best of luck finding a buyer.

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  • Analyst 3+ in HF - EquityHedge
Feb 10, 2020

Isn't land in China worth a lot / gone up in value?

Feb 26, 2020

Very interesting, thanks for sharing your experience.

1) You mentioned you own the physical assets as a detriment to the investment (big capital checks) - how would you have done it differently the next time around? I'm not familiar with the hospital sector but would you have a 3rd party own the facility, you operate it via lease, and then on top you have contracts w/ patients/corporates?

2) When you said the first hospital was unstable for a period of time, what do you mean by that?

3) Any hospital sector-general advice you could share? Always interesting to hear from someone with direct operating and investing experience.

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Feb 6, 2020

I'm sorry to hear this, and thanks for sharing your experiences.

Have you thought of investing in a PE fund vs in a private company?

Feb 6, 2020

Oh don't be sorry. We fail, learn, adjust, and win. I'm not trying to complain but rather to self-teach thru sharing where I've failed, and getting the perspective of others.

I'm contemplating investing in some deals directly with a couple of funds that I've gotten to know and do advisory for. Such a strategy would still suffer from some of the above problems - illiquidity, to an extent being vulnerable to gamesmanship (ie. being a fuckable midget). But at least if you're investing in a decent fund they should be seeing the best deals and screening them well.

The question then becomes - are you investing on the same side of the table as the PE fund, or are you their tool? That is, are they charging you carry and mgmt fees, or will they do you a favor and let you invest without fees? Are they gaming their IRRs (many funds play funny games)? How are their DPIs (real money paid back to LPs)? Are they a small and high performing fund, or an asset aggregator? That's important because you want to be with small high performers who can grow your capital, rather than a megafund who just hits mediocre returns and gets fat on your mgmt fees. How disciplined is the GP (manager)? Does the firm's past strategy still apply in the current / future market?

I was previously at a fund that did triple-digit IRRs with high DPIs/realizations. We were just killing it as a small fund. The CEO got greedy, grew the fund to >$15bn, and now the funds don't even return the principle back. Caveat emptor. There's a lot of smart LPs that got burned with that one.

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Feb 6, 2020

What are your thoughts about investing in the funds of the company you're working at?

Seems very attractive, especially for those at top-quartile funds showing consistently solid returns and with "preferential" treatment (no carry or no management fees for employees...etc). Liquidity issue still applies but overall I see very few reasons against it.

Feb 6, 2020

Oh absolutely. If you can get in with no fee, no carry, and it's a decent fund, it's one of the biggest incentives for working in a PE fund. Co-investment in specific deals is even better because you can cherry-pick. In most of the funds I've worked at, they didn't allow either fund investment or cherry picking. When you're recruiting, be sure to ask about this. I've found most MDs at PE funds to be greedy and not share. But there are enlightened funds out there for sure.

Fun story, one of my mentors was an MD at a PE fund, and his salary was fine, but he made >$100mn by directly investing in one of their star deals, and he went all-in with all of his chips. It went from less than $0.50 per share to >$100 per share. That's definitely how winning is done. (punchline, he invested in a 70 person startup that is now one of China's largest financial services companies with over 800,000 employees.)

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Feb 6, 2020

Not in PE but always appreciate these self-reflective posts. Great read top to bottom.

Feb 6, 2020

Interesting. Would you agree that this is why a lot of angel / VC investors with experience emphasize that they only invest in companies that they can positively impact and/or companies that they could run themselves if things go tits up?

Feb 6, 2020

The trade off is usually minority control but high liquidity (stocks) or majority/considerable control but low liquidity (senior exec/mgmt/board).

Having minority control with low liquidity is always a bad idea, and your stake is essentially worthless no matter how the company does. In bad times, you're screwed. In good times, they'll simply pay themselves more / buy random shit for the office and you're still screwed.

That's why even search funds take majority control, at least the CFO seat so you hold the purse strings. Otherwise stick to stocks so you can dump anytime.

Feb 6, 2020

In the meanwhile, as I try to extract myself from these private deals, I'd be keen to get the group's advice on public equity investing. If anyone here has ideas, resources, good books, Youtube videos, coursework, etc., I'd love to learn more.

Aside, now seems an expensive time to jump into he market, but who knows if anything can slow down the American juggernaut. Maybe I should be buying ETFs and the occasional cherry-picked stocks and let things ride.

    • 1
Feb 7, 2020

No offense, just sounds like bad investment decisions based on your personal financial priorities (which seem to be liquidity and control). I've had completely different experiences investing in PE in my PA.

Feb 7, 2020
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  • Managing Director in VC
Feb 15, 2020