How Private Placements Boost Investor Returns
Investments in private placements (i.e., private investments) offer the promise of the type of returns ideal for building and maintaining wealth – the type of returns not found on Wall Street.
For example, compare the profit potential from private equity (i.e., private company stock or partnership investments) vs. mutual funds:
What does this chart tell us about mutual fund investing vs. private equity investing?
First, while mutual fund investing is less risky (less variance), the return potential is also dwarfed by the profit potential from private equity.
While private equity investments typically entail more risk, savvy investors are undeterred. Why? Because they know that the differentiating factor between high-risk and low-risk private equity investors all lies with management.
Private equity risk can be mitigated significantly without sacrificing returns by partnering with experienced and knowledgeable managers. It’s no secret that savvy investors are drawn to private investments for the potential for high returns.
Just look at the following chart to see the value of allocating a portfolio to private investments. The data demonstrates that the more a portfolio is allocated to private investments, the better it performs:
According to the chart, an allocation near 50% towards private investments in a portfolio yields an average annual return near 12%. The 20-year average annual return from the S&P 500 is 5.9%. Returns from private investments nearly double returns on Wall Street.
How do private placements generate double-digit annual returns? Many private placements invest in tangible assets to leverage TWO profit-generating components: Income and Appreciation.
With private placements invested in hard assets, investors can expect income from two business activities:
Income generated from operations is the income generated from the day-to-day activities of the business. For example, Tesla makes money from selling cars, real estate companies generate cash flow from rents, and the lending company makes money from interest.
Now, while a successful business distributes profits to its investors, the investors are quietly benefitting from the appreciation of the underlying asset. Successful cash-flowing business with a track record of success will demand a higher price upon sale than when it started. Investors profit from this appreciation upon disposition (sale, acquisition) of the asset.
Distributions from operations are typically made periodically (i.e., quarterly, semi-annual, annual), and of course, distributions of cash flow from a sale are made when the asset is sold.
Many private placements take distributions from operations a step further by offering a hybrid equity/fixed income component – giving investors priority to first dollar cash distributions called preferred returns – similar to interest payments on debt investments.
Preferred returns are distributions from cash flow calculated by taking a predetermined fixed percentage and multiplying by the amount of the investor’s investment (i.e., investment capital). Investor preferred returns are given priority and are made before any other distributions of cash flow.
In summary, here are typical distributions investors can expect from a private placement:
- A preferred return of x%.
- After preferred return, x% of remaining cash flow.
- Upon a disposition, investors receive x% of cash flow after paying any unpaid preferred returns and after a return of their capital.
Net Cash Flow from Operations (Year 5): $100,000
Preferred Return Rate: 7%
Investors % of Cash Flow from Operations: 40%
Investors % of Cash Flow from Sale: 40%
Accrued but Unpaid Preferred Return at the end of Year 10: $0
Net Cash Flow from Disposition at the end of Year 5: $4,000,000
Total Investor Capital: $1,000,000
Number of Investors: 10
Distributions from Operations (Per Investor):
Preferred Return: $1,000,000 * .07 / 10 investors = $7,000
40% of Cash Flow After Preferred Return: ($100,000-$70,000)*.40/10 = $1,200
Total Year 5 Return: $8,200
Year 5 Rate of Return: 8.2%
Distributions from Sale (Per Investor):
Cash Flow from Sale: $2,000,000
Unpaid Preferred Returns: $0
Return of Capital: $1,000,000
Distribution from Remaining Cash Flow: ($2,000,000-$1,000,000)*.40/10 = $40,000
Average Annual Return from Appreciation: $40,000/5/$100,000 = 8%
Let’s say year 5 was a typical year for the fund in terms of returns. If you take the average annual return from operations of 8.2% and add the average annual returns from an appreciation of 8.0%, the investment delivered an average annual return of 16.2%.
Is It Realistic?
Most investors would be happy with just an annual preferred return of 7%, but what is the likelihood of reaching the annual 8.2% return from operations?
To answer that question, we need to work backward to see how we arrived at the cash flow number and how likely it is for the fund to achieve the 8.2% target or any other annual return target.
Here are the foundational accounting concepts that we need to understand:
Scheduled Gross Income – The scheduled gross income is the total gross income that the company can earn from operations in a perfect world. This assumes no contingencies such as supply deficiencies and labor stoppages.
Effective Gross Income – Of course, we don’t live in a perfect world, so we have to consider contingencies. Effective gross income factors in potential obstacles for obtaining the scheduled gross income.
When analyzing a deal, you need to examine whether the sponsors are realistic about the contingencies:
- If they are projecting gross income without factoring in deficiencies, be very wary.
- If they are projecting contingencies, do they seem realistic? Are they overly optimistic?
Operating Expenses – These are the day-to-day company expenses. As above, if the sponsors are projecting to reduce expenses, do they have a realistic plan for doing so? What efficiencies, skills, or expertise do they bring to the table for reducing expenses?
Annual Operating Expenses – These are annual expenses incurred by the company, including taxes and insurance.
Net Operating Income: NOI = Effective Gross Income – Total Expenses (Operating + Annual).
Interest Expenses – The servicing costs of any debt incurred in connection with the business.
Cash Flow: Cash Flow = NOI – Interest Expenses.
To determine whether the returns projected by the sponsors of a private placement are realistic, a potential investor needs to dig deep into the financial projections and the sponsor’s business plan for achieving their goals.
Be wary of overly optimistic projections. The more detailed and conservative the projections and the more detail the sponsors provide for arriving at their projections and goals, the better.
Annual returns from private placements above 11% are realistic, but not every company can achieve this.
The difference is the experience, knowledge, and expertise of management. In the right hands, double-digit returns from private placements are highly realistic.