Adapted from an email to a friend. October 2020.

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 high 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 a few questions to consider when investing in a fund:

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 them?

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). Financial businesses face internal strife when different employees work under different compensation structures. 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 these 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).

But it's still worth asking about the GP coinvest -- even 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 driven by (1) an asset’s cash flows and (2) the capital flows of other investors in and out of that asset. An investor with an edge brings new information to the market about an asset’s cash flows or capital flows.

How does the fund source valuable new information? You should be able to understand their process 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.

Generally speaking, the main risks for long-term investors are thesis (did they properly analyze the cash flows and capital flows?) and trade structure (can they get forced to sell too soon, even if they are right about the long-term thesis?). In contrast, the main risks for short-term strategies tend to be operational (what is their current market-making and/or engineering 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, selling Silicon Valley stories to Europeans, or selling Canadian junior mining stories to everyone outside of Canada). But the best private investors actually do have access advantages. 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 (e.g. 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, and it often is.

The soft version of risk-free returns is a misrepresented strategy. Many funds generate returns by selling insurance (aka short volatility -- though sometime the fund itself is in denial about doing this). 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 risk-free returns is just actual fraud. For example, Bernie Madoff famously took in and ruined many charities in the New York and Palm Beach communities. His promise? 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:

Bernie Madoff’s “Risk-Free Returns”

Source: Bernie Madoff's Sentry Fund

The bad news is that wealth managers at investment banks can get taken in too. 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).

In sum, if you're approached with a special access or risk-free returns opportunity, make sure that you understand the true risk profile or you speak with someone who does.

Trust

Do you trust them?

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. The best investors want 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 their funds earn great returns.

But there's no special trick to tell whom to trust. 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 you can read. 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).

Happy to go into more detail as specific questions come up & can't wait to hear what you're up to next,

Luke

This essay was adapted from email conversations I had with two friends who recently came into wealth – one an SF tech executive whose company was sold, one an older Middle Eastern entrepreneur who took a dividend from his family's industrials 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.