Note to a Newly Liquid Entrepreneur

Congratulations!

Whether your company has IPO’d, was acquired, or just gave you the chance to take some money off the table, you are now well off. You’re about to receive a lot of advice about how to do things correctly – how to balance risk, how to earn exciting returns, how your friend’s startup is the next Facebook, etc.

I’m going to talk with you about how investments can go wrong.

I’ve seen many situations where an entrepreneur makes money the hard way, brick by brick, and then loses it due to a bad investment decision or, worse, a scam. Just as bad as the money lost are the emotions that come with it – embarrassment, shame, and a loss of trust that may keep you from working on your next project. Let’s take a few minutes to save you from that anguish.

Here are five lines of questioning to consider:

1) Alignment – How is the manager compensated? Is the manager invested alongside you?

2) Strategy – Can you articulate why the investment strategy will work? How does it bring new information into the market?

3) Risk – What would cause your investment to fail? Is the manager intellectually honest about (and working to mitigate) the downside risks?

4) Fraud – How can you tell if they’re a fraud? Are they offering special access or risk-free returns?

5) Trust – Do you trust your manager?

Alignment

How is the manager compensated? Is the manager invested alongside you?

Finance is an odd business. It’s like manufacturing, except every few years the manufacturers accidentally blow up the factory. This keeps happening because the participants are driven by misaligned incentives.

There are three main incentive structures in finance: transactional (commission on initial sale), management (% of assets under management), and outcome (% of profits). Every financial institution faces an internal struggle between these factions. When the transactional group wins out, the institution may focus too much on trading commissions and not enough on good investment outcomes. That’s when you get the potential for a spectacular blowup.

Incentive Structures in Finance

Source: Lembas Capital

You can mitigate the industry’s misaligned incentives by having the manager invest alongside you, but even that is no silver bullet. A GP co-investment with the LP does not prevent an aggressive strategy from failing (see LTCM).

Still, if your manager is willing to sell you a product but isn’t willing to personally invest the same way, you should think very carefully about investing. Even if the manager has different financial goals or if there is a good reason why the manager can’t co-invest in the same fund, you may learn a great deal by asking why.

Strategy

Can you articulate why the investment strategy will work? How does it bring new information into the market?

As I wrote in Lembas’s credo, capital markets are information markets. An asset’s price is comprised of (1) an asset’s cash flows and (2) the capital flows of other investors in and out of that asset. Successful investors bring new information to the market about an asset’s cash flows or capital flows. That’s what people mean when they say they are looking for investors with an edge.

Your advisor should be able to articulate why they think their strategy has worked in the past and why it should keep working in the future. How are they sourcing new information? You should be able to understand it sufficiently such that it’s not a black box to you. Or, if it is a black box and you still want to make the investment, just recognize what you’re doing and then size your investment appropriately.

Risk

What would cause your investment to fail? Is the manager intellectually honest about (and working to mitigate) the downside risks?

A prudent investor tries to anticipate future risks and to stay resilient in the face of unforeseen catastrophes.

What would cause your investment to collapse? Generally speaking, the main risks for long-term strategies are thesis (did they properly analyze the cash flows and capital flows?) and structure (can they get forced to sell too soon, even if they are right about the long-term thesis?). In contrast, the main risk for short-term strategies tends to be operational (what is their current market-making and/or research edge, and why will that continue to hold 3+ years down the line?).

Your advisor should be forthright about these risks – both for your sake and as a signal that they are vigilant in their own risk management. In particular, an intellectually honest advisor won’t play games with portfolio marks that mask the underlying risk (e.g. make sure that no one convinces you that illiquid assets are less volatile just because there aren’t publicly available mark-to-market prices).

Frauds

How can you tell if they’re a fraud? Are they offering Special Access or Risk-Free Returns?

I’ve seen frauds come in two main flavors: special access and risk-free returns.

Special access fraudsters claim that only they can get you into the best private deals. They tend to prey on people who don’t live in the region or don’t work in the industry where those opportunities originate (e.g. selling Chinese monopoly stories to South Americans or selling Silicon Valley stories to Europeans). The best private investors often do have access advantages, the difference being that those are legitimate. You can sort one from the other by doing reference checks and by looking to see if other smart people in the ecosystem are also investing. For instance, virtually none of the top SF investors were taken into Theranos or Nikola.

The risk-free returns fraud is more insidious. It’s so hard to earn that initial capital that you will naturally be protective of it. Every wealth manager will tell you to keep a portion of your wealth in low-risk, low-return investments. Someone may approach you to tell you about a way to earn a little bit of a higher return with no added risk, month in and month out. It sounds too good to be true. It sometimes is.

The soft version of the risk-free returns fraud is a misrepresentation of an investment strategy. Many funds generate returns by selling insurance (aka short volatility). They collect premiums every month like clockwork. There’s nothing wrong with the insurance business, so long as you are amply compensated for the risk you are insuring. The problem is that, someday, the bill will come due. You shouldn’t evaluate that kind of fund without recognizing what kind of major risk is being insured and what the true downside scenario entails.

The hard version of the risk-free returns fraud is simply made-up returns. Bernie Madoff is the prime example here. Many Jewish charities in the New York and Palm Beach communities were ruined by the promise of steady, low-risk returns that were just a bit better than the standard low-risk low-return options.

To give you a taste of what to watch out for, here’s a snapshot of how Madoff presented his Sentry fund to his clients. You can easily imagine how he sold the story — do a bit better than the market with none of the downside, long track record of steady returns, lets you sleep soundly.

Bernie Madoff’s “Risk-Free Returns”

Source: Bernie Madoff’s Sentry Fund

Unfortunately, even the most prestigious private banks have little to offer but an apology when you invest in a fraud through them. Here is Union Bancaire Privée’s statement to their clients after Madoff was uncovered. The good news is that an experienced fund manager could have spotted the problem immediately (Ed Thorp’s take is my favorite).

If you’re approached with dubious special access or an opaque structured product / volatility selling strategy, make sure that you understand the true risk profile or that you speak with someone who does. Many of those structures are fine, but the dangerous ones are the ones that blow up the factory.

Trust

Do you trust your manager?

The best advisors will want to build a lifelong relationship with you.

They’ll strive to earn your trust, and they’ll be figuring out how much they can trust you too. Outcome-driven investors look for clients who will back them to deploy capital during market downturns, just at the exact moment when others are uncomfortable doing so too. Great clients really do help investors earn great returns.

There’s no special trick to tell. I’m sure you had to figure this out in your own business, and I don’t think it will be any different here.

What’s Next?

It’s always exciting to see a project come to fruition, and it’s just as exciting to start the next one. I hope you can build on your success as a source of strength, not as a burden to be carried.

Wealth ownership can be a significant life transition. There are libraries of material to read. If you wanted to narrow it down to two selections, I would recommend The Destructive Power of Family Wealth by Philip Marcovici (a book on wealth planning by the former chair of Baker McKenzie’s wealth management and tax practices) and Letter to a friend who just made a lot of money by Graham Duncan (an essay on managing yourself and selecting a wealth manager by the head of a major family office).

Those should cover the basics, and I’m happy to go into more detail as specific questions come up. From there, you just have to pick and choose what works best for you.

Can’t wait to hear what you’re up to next,

Luke

This essay was inspired by conversations I had with two friends who recently came into wealth – one a young SF tech executive whose company was sold, one a middle age Middle East entrepreneur who took a dividend from his family business. As with everything open to the public, these are my personal opinions and not to be construed legally as financial advice. Please select your advisors with care and consult with them directly.

Thanks to my friends in wealth management who helped me first learn these lessons, and credit to Benn Eifert for the factory analogy.