by Marc Halpern, Part Time Investors LLC
February 26, 2024
A reader asked an excellent question about my previous article last week on the income and growth considerations when building a portfolio of private placement investments. I will share here his question and my response.
Russ Walters commented and asked: “Great article. One aspect of your investment thesis that I did not see addressed, is where your investments sit in the capital stack? It seems like most of your investments are common equity (maybe some preferred) which means the only avenue you have for risk management is your deep due diligence process. If the sponsor does not perform, there is no recourse. A private placement fund holding senior/secured debt has the added safety that if the sponsor does not perform (defaults) the investment manager has rights to foreclose and sell the asset (usually commercial real estate). There is a tradeoff, the returns are not (typically) as high as the mid-teens, but your principal is protected.”
Following was my response.
Russ, you make an excellent point about the capital stack!
I have several answers to this important point. None of the answers guarantee returns for every investment and in my course on private placement investing I repeat the following phrase dozens of times “We can’t eliminate risk but we can minimize risk and manage risk.”
The first answer to your question about protecting principal in the capital stack is diversification.
My self-directed Roth 401(k) is currently invested in 11 private placement investments in 9 different sectors with 7 different syndicators, fund managers and project sponsors. This was not addressed in the article since the focus was on income and growth considerations.
This high level of diversification does not eliminate risk but it does help manage risk under the approach that assumes in advance that any single project or any sector or any sponsor can fail and if it does, then my portfolio as a whole still performs relatively well.
The second answer for protecting principal in the capital stack is that several of my private placement investments have no debt or the investments are the most senior debt.
An example of a fund in which my Roth is invested where our money is in first position on the capital stack is a land development lending fund (mentioned in the article) with a preferred return of 12% plus back end kickers of 2%-6% when the land developer sells a parcel to a national home builder.
My Roth also just invested in a commercial note payable in 6 months with 20 points (40% IRR) backed by a corporate guarantee. We made sure that the balance sheet can handle a major hiccup though you never can guarantee that the mother ship cannot crash in the future.
The three apartment complexes, the student housing complex and the self storage fund are indeed junior to the debt. If any of them fail, you are right that I have no recourse.
However(!)…
In four of these five cases, we made sure that the LTV of the senior position was low enough and had fixed financing or rate caps to cover the senior debt and our initial capital contribution in the worst case scenario.
In other words, I was willing to take the risk of default with no recourse after performing DEEP due diligence and feeling comfortable with the cushion created by the low LTV.
The short answer for these projects was “I’m willing to live with the risk.”
The worst lien position my Roth is in is a third position on a capital stack for a bridge loan secured by a neurocare facility until it is sold off in pieces as a DST. The rate is 20% per annum and the LTV is low enough for me to be comfortable.
The third answer is that 10 of these 11 investments by my Roth did not exceed 5% of my net worth.
In summary, position in the capital stack is definitely one of MANY considerations when constructing a private placement portfolio. My personal comfort zone is to manage risk by a combination of many factors. Some decisions entail more risk for higher return and other decisions trade some return for higher security.
Other than the land development lending fund at 12% plus back-end kickers, I do not invest in private placements that cannot justify a minimum 15% return after DEEP due diligence. This is why I rarely consider senior secured debt funds that all seem to fall into the range of 8%-11% (these days in 2024; mezzanine debt has higher returns).
Of course, each investor must determine for themselves with how much risk they are comfortable. Different investors are willing to educate themselves to varying degrees about the wide array of investments that are available, including private placements of which most investors are not aware.
If you are an accredited investor and want to learn about private placement investing, you should take my course “High-Return Private Placement Investing: Best Practices & Risk Management.”
Disclaimer: Marc Halpern and Part Time Investors LLC are not licensed financial advisors. Marc is simply sharing his perspectives based on his experience and his personal situation which are different from yours. Do not make any decisions or take any action based on any of the content of this article.
