Gambling through equity and debt financing

Since this website is about intelligent gambling, there has to be a lot of talk about equity and debt financing as well.

If you’re rich, this article will be good for you because you’ll know what to require of your financial adviser.

If you’re not, this article will be even better because you need to be aware of the best investment choices. You can’t afford the average investments because waiting too much for a return is a risk in itself: you might get sick, you might get old, you might die prematurely, you might not afford some life-extension pill or cryopreservation, your pension fund might go bust, your country might lose a war, a natural disaster might leave you without the house, the economic climate might change and so on. Predicting the future is impossible but what you can be sure of is that

[…] you need to be financially independent at some point, preferably with a certain abundance. Otherwise you won’t ever experience life and lack of obligations. Instead, you will experience working to live.


Only choosing what you catalog as safe investments and preparing for financial independence at sixty might make it too late for when it’s needed.

I am not rich yet therefore I would rather have a yearly 10 percent chance of losing my money when trying to double up, than a 99 percent chance of getting a five percent return. Of course, for someone who already has abundance, it wouldn’t matter. His time would be better spent scuba diving. There’s a certain level of rich after which getting more money doesn’t improve happiness. Graphs representing the logarithmic utility of wealth show that in an easy to understand way.

I removed from here a part of the article where I was showing the correlation between The importance of wealth accumulation rate and certain factors like Time until FI.

 

 

For rich people, the power of compound interest is a lot higher than for the 99%. The poorer you are, the more importance you have to give to taking risks and achieving a higher wealth accumulation rate. In order to be successful you will need luck and a lot of knowledge. You have little room for mistakes. You need more business acumen than a rich guy. When it comes to financial instruments, you need the best of the best. Here’s where the real article starts. You’ll thank me when you’re done with it. It will be a good read for everybody, even those that only have a few thousand dollars to gamble/invest.

Burgiss is a global provider of investment decision support tools for the private capital market. This is what they offer:

  • Software applications for portfolio monitoring and reporting, performance measurement and benchmarking, cash flow forecasting, document management, investor administration and exposure analysis;
  • Investment services, such as holdings and fundamentals transparency, portfolio reporting, data management and research, including model validation and simulations;
  • Data and analytics, such as benchmarks, performance, risk and behavioral data on the private capital market.

They serve:

  • Asset owners, such as endowments, foundations, pension funds, family offices, sovereign wealth funds and financial institutions;
  • Asset managers, such as buyout, venture capital, real estate and real asset funds and funds-of-funds;

Glossary break #1

Venture capital funds are easy to understand from the name. Buyout funds might be something new for most readers. This is how they work: the GPs buy a company or enough shares to gain controlling interest in a company; then they make it more valuable through investments and better management. The ultimate objective is to make a glorious exit as soon as possible. A normal lifespan for a buyout fund is around 5 years.

  • Financial intermediaries, such as custodians, investment consultants, and administrators. They claim to have over a thousand clients representing over $2 trillion of committed capital.

I’ve taken most of the last few rows from their website with little modification. On April 21, 2013, the director of Burgiss in cooperation with Robert Harris, Tim Jenkinson, Steven Kaplan and some other guy formed the advisory board of The Private Equity Research Consortium. Sponsored by the Uai Foundation, its purpose is to conduct and promote research on anything related to private equity. Notice the “private” from “private equity”; data related to this type of investments is not easy to come by.

Burgiss made available through the consortium what they named “The Burgiss Manager Universe”: a research-quality database that includes financial history for thousands of private capital funds. It is representative of actual investor experience because the data is sourced exclusively from the people that invest (limited partners – LP), which eliminates the natural biases introduced by sourcing data from people that do the investing and the managing (general partners – GP).

Glossary break #2

Most of the investment funds are structured as a limited liability partnership. A general partnership is an agreement between two or more people who share equally in profits and liabilities for the company. In comparison, a limited liability partnership offers the same tax advantages but also protection for partners’ personal assets by limiting their liability to that of their interest in the company only.

Here’s a snapshot of their “Universe” on September 30, 2014:

It has cash-flow data from huge investors in quite a lot of funds. The source is the back-office systems used by them for reporting and fund accounting. Even more, it is cross-checked across investors in the same fund, resulting in a level of data integrity and completeness never seen before. In the past, in order to assess the profitability of private equity investments, economists have used FOIA requests to the fund managers and an even more basic method: their publicly reported internal rate of return (IRR) and multiples of capital invested.

Glossary break #3

IRR is equivalent to CAGR (the compound annual growth rate) – the only difference is that it is calculated in another way. The cash flow in private equity investments is more complicated and the CAGR formula would have been insufficient. If you were to invest in a PE fund, you’d have to compare the IRR that they promise with the historical CAGR of an investment into an index of companies from the same area of activity as the ones that will be bankrolled by the fund. You should look for a premium of at least 5%, even bigger if the companies supported by the PE fund are in the early stages (which means you’d have to compare betas as well).

 

The meaning of “Multiples of capital invested” is quite obvious from the name. It is code for “I’ll give you X times the amount that I invest from the capital that you make available”. The return can be in cash or in stock.

The three names that I mentioned in a paragraph above have collaborated in the midst of 2013 to write a paper analyzing the performance of buyout and venture capital funds using the dataset from Burgiss: “Private Equity Performance: What do we know?”.

To understand the best table that came out of their work, you must understand the simple concept of PME – public market equivalent. It’s a set of analyses used in the Private Equity Industry to evaluate the performance of a Private Equity Fund against a public benchmark or index. In their work, they chose as reference the S&P 500. For example, if they would have found that the PME of a fund in a certain year is 1, it would mean that it mirrored the performance of S&P 500 for that year. A PME of 2 would have meant a two times better performance and 0.5 only half as good. Here is the table; look at the weighted average of buyout funds (Panel A), then at the weighted average of the venture capital funds (Panel B):

Study the table for a few minutes until everything is clear and you can draw your own conclusions. Basically buyout funds have managed to consistently outperform the S&P 500 which, by the way, is a much better investment than any hedge fund or mutual fund. The average outperformance is 27%. The venture capital funds have been OK in the 1980s, stellar in the 1990s but underperformed in the 2000s. My recommendations on what you should do based on this data will come at the end of the article. Their paper is important enough to deserve a summary:

In section 1, they discuss the data made available to them by Burgiss and they contrast it with data used for similar studies in the past. Theirs is better.

In section 2 the dataset is used in order to assess the performance of buyout and venture capital funds. A few tables are drawn, like the one above. The IRR and the investment multiple is calculated for each fund, by year. Even better, the PME ratios are calculated with alternative market benchmarks (pages 35-36): NASDAQ, Russell 3000, Russell 2000, Russell 2000 Value, four Fama French size deciles and leveraged versions of S&P 500. Again, buyout funds blow everything out of the water with consistency.

In section 3 they discover that the performance for buyout and VC funds decreases with the amount of aggregate capital committed to the entire asset class. This is usual: when too much people start doing the same money-making activity, the profit is lower for each of them. To exemplify with a current reality: when too much people invest in biotechnology, the best profit can be made by becoming contrarian in this asset class. For VC funds, they also found an extremely strong positive relation between size and performance. Funds that draw more money are more successful in their venture capital deals. It’s not easy to understand why this is the case but it’s certainly easy to speculate and good to know about.

In section 4 they examine the relation between absolute (IRRs, investment multiples) and relative performance measures (PME). They find that IRRs and investment multiples explain at least 90% of the variation of PME in most of the vintage years (the years when the capital is drawn down from the investors). As a result, researches can use shittier datasets without cash flow and their model in order to estimate the PMEs. They do that for some older papers in order to proof that they would have arrived at similar relative performance measures.

Beautiful work. Thank you Burgiss and thank you Robert Harris, Tim Jenkinson and Steven Kaplan.

In conclusion:

  • If you have over $250,000 and are willing to take bigger risks, put your money in a VC fund which has managed to draw a lot of attention and funds from other investors as well;
  • If you have over $100,000 and want to take the same risk as the one intrinsic to S&P 500, go ahead and put your money in a buyout fund; it will probably outperform the benchmark;
  • If you have below $100,000, learn the lean startup method, read a few other management and marketing books, buy someone’s company and lead it to greatness;
  • If you have next to nothing, start a business.

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