The Jig Is Up - Time To Go Private

Written by Adam English
Posted October 20, 2016

The jig is up, and everyone in the know saw it coming.

Fees, commissions, and self-serving sales pitches masquerading as fiduciary advice are now fully exposed for all to see.

Investors are fleeing actively-managed funds for passive ones, and — though they'd rather keep quiet and lie low until it's their turn to move through the revolving door — even government regulators are being forced into action.

Yet as much as people talk about the shady side of the business, the cost is not the real cause. A handful of bad players have and always will be tolerated as long as the overall system isn't broken.

The problem is that the funds cannot generate returns that justify their existence. If people were seeing any sign of performance that matched sales pitches, no one would care one bit.

Both actively-managed mutual funds and hedge funds consistently fall well short of what passive funds return over multi-year time frames. Tag on fees, and it gets even worse.

The secret is out, and people are responding. A couple days ago, figures for September hedge fund redemptions pushed total outflows to $8.7 billion per year, marking five straight months of outflows, and the steepest year-to-date level since 2009.

As investors flee, fund managers and executives are doing the same. And the best of the best are finding prestige and better pay in jobs that most investors don't even know exist, in spite of controlling $3-4 trillion, as compared to just under $3 trillion in hedge funds.

They're going completely private, and moving into home offices.

Nothing But Advantages

Setting up home offices offers major advantages, though they come with a major caveat.

To put it simply, home offices manage wealth. Depending on the home office, it can affect all aspects, from investments, to payroll, to taxes, to succession planning.

On the investment side, the advantages are clear. Home offices are free from many regulations that make compliance expensive for funds that take in money from the public

They are free to chase returns without restrictions by sector, asset type, market capitalization, or any other criteria that typically restrict funds. And perhaps more importantly, they move on smaller scales without disclosure.

A major problem for large funds is their ability to take small positions and keep their good investments under wraps.

For a counter example, just look at the interest in what Warren Buffett holds in the Berkshire Hathaway portfolio. When he is forced to disclose holdings through regulatory compliance documents, it generates top headlines for days.

As Robert Discolo, a chartered financial adviser who recently joined the $1 billion multifamily office River Partners Capital Management as CEO and CIO, told Bloomberg:

“As hedge funds got larger and more institutionalized, it was much more difficult to find opportunities, because they had to operate within narrow investment and liquidity parameters to satisfy their client base. Family offices, for the most part, are opportunity-agnostic and will seek alpha anywhere and everywhere.”

As for that caveat, it is a doozy. If you aren't sitting on around $500 million in assets, you won't be able to reasonably bring everything in house.

Some families can go lower if they farm out some basic work to other companies, but that reduces control and increases cost.

Of course, that just applies to people who hire others to manage their wealth for them. The same ability to chase returns through private investments is available to anyone willing to invest on their own, with a much lower barrier to entry.

The DIY Approach

To open up your investments to the same opportunities that home offices take advantage of, there is just one step to take: You have to become an accredited investor.

To be one, you have to fulfill one of these criteria:

  1. Have earned income that exceeded $200,000 — or $300,000 with a spouse — in each of the prior two years, or
  2. Have a net worth over $1 million, either alone or with a spouse, excluding your primary residence, or
  3. Have a trust with total assets over $5 million, with some restrictions.

This isn't chump change, but it is a far cry from $500 million. Needless to say, a much wider group of people qualify.

If you meet one of these, you're in on the kind of deals that give home offices a distinct advantage over mutual and hedge funds in the market.

In particular, it opens up pre-IPO investments, especially private placements.

These are exactly what they sound like — opportunities to purchase a stake in companies before they expose themselves to public trading.

Here is how it normally pans out: Private companies are in need of funding, so they let the SEC know they're opening up a private placement, then they approach people tied into the industry, or analysts who cover a sector, to get an idea of who might be interested.

Obviously, industry leaders and analysts aren't going to blindly pass on names. They want to know how the company is performing, and what it will do with the capital it raises.

This information is shared with potential investors, these investors are given the option to contact the private company, and a contract is created if everyone is on board.

Two Advantages, One Disadvantage

The advantages are two-fold. First, the shares are often issued at a relatively low price with an option, or warrant, to purchase more at a later date at a set price.

The reason for the discount is related to the second advantage: These companies need capital to invest in themselves and create as much value for current shareholders as possible before going public.

Then there is the disadvantage — access to information. These potential deals aren't going to just get thrown at you by the companies you'll want to invest in.

You can find a list of companies offering private placements through the SEC, but you cannot get the information you'll need to determine if they're good investments through this list. The same strict disclosure rules that apply to publicly traded companies do not apply here.

Instead, you need to get access to an established analyst to then gain access to the information needed to identify the best private placements.

I'm not going to lie, this is the biggest hurdle. This is a big reason why home offices are poaching established managers and analysts from hedge funds.

Once you're in though, you have access to investments that simply don't exist elsewhere.

Nick Hodge's portfolio for his year-old service that includes private placements, Nick's Notebook, is full of examples.

Those who were able to subscribe have a closed year-to-date portfolio with over 680% gains, and an open portfolio with 80% gains.

Plus, a new private placement just opened up in a new private gold miner deal that will close in two weeks.

With those kinds of returns, no wonder the next big thing for ex-hedge fund managers, wealthy clients, and savvy DIY investors is to go private.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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