October 3, 2023

How To Better Manage Your Private Investment

 

Recently, I temporarily went broke because I improperly managed my private investment capital calls. Because this happened, I thought I’d discuss some straightforward solutions to ensure you always have liquidity.

If you are a new private fund investor or plan to invest in more private funds to diversify your investments, please learn from my errors. Not only will you learn how to better manage your capital calls, you’ll also learn the process of how private funds reinvest capital.

What Is A Capital Call?

A capital call is when a private fund asks for a percentage of the capital you’ve committed to investing in their the fund, e.g. 10% capital call of $100,000 committed equals $10,000. Within three years, usually, all your committed capital will be called by the private fund as it takes time to find new investments.

A margin call, on the other hand, is when your brokerage asks you to deposit more funds to meet the minimum margin ratio due to a decline in the value of your margined stock. If you do not deposit funds, a brokerage may sell your stock to meet the minimum margin ratio.

 

How I Recently Went Broke

As an aggressive investor since 1999, I hardly ever have more than three-to-six months’ worth of living expenses in my checking account. Checking accounts generally pay terribly low interest rates. Most of my incoming money gets dollar-cost averaged into an S&P 500 ETF and private real estate funds.

However, after Treasury bond yields surpassed 5%, I decided to shovel my remaining cash into Treasuries. As a result, my checking account balance dropped to less than one month’s worth of living expenses.

My plan for maximizing my investment returns was going well until I got a capital call for $20,000. The venture capital fund hadn’t made a capital call in six months. It was time for me to scramble.

Capital Call for $20,000
10% capital call for $20,000

Coming Up With Funds To Meet The $20,000 Capital Call

To meet the “unexpected” $20,000 capital call, I transferred money from our joint checking account. This joint checking account is shared between my wife and me.

We set it up mainly as an account for our Lake Tahoe property vacation rental. Doing so, we can more easily separate the financial transactions associated with the property, such as rental income and property taxes.

After paying off the vacation property mortgage early, the joint checking account started growing quicker by $3,500 a month. Further, the 2022/2023 winter season so far has been epic, bringing in more snow and more rental income than average.

Luckily, the combined money from my account and our joint checking account was enough to cover the $20,000 capital call. I was good to go!

As a limited partner (LP), the last thing you want to do is not meet your capital calls. If you become an unreliable LP, much like an unreliable tenant who doesn’t pay rent on time, then you may not be invited back for the next fund.

I was feeling good until I got another surprise capital call from a different private fund! After a dormant 2022, the capital calls were suddenly flooding in!

Going Broke Trying To Meet A Larger Capital Call

This time, my capital call was for $61,351 from my fourth venture debt fund investment. It was a 20% capital call for my $300,000 commitment plus a true-up for management fees.

I have been investing in venture debt since my business school buddy opened up his own fund around eight years ago. I wanted to support his new entrepreneurial endeavor.

As his firm grew, I kept on investing in his new funds despite becoming a smaller and smaller fish. His main investors are now institutional investors.

$60,000 capital call

Unfortunately, I didn’t have enough to fund the $61,351 capital call from my checking account. Uh oh. What should I do?! I had five weeks until the money was due.

How I Cobbled Together $61,351 To Meet My Capital Call

Should I borrow money from friends? Nah. It’s best not to mix money with friendship.

Should I work extra hard on a side hustle for four weeks until the capital call was due? I could teach tennis for $100/hour. But that would take 614 hours if I didn’t have to pay taxes.

Should I get a J-O-B with a juicy signing bonus? Hmm, who’s going to hire this stay-at-home-dad of five years without a fancy pedigree in this environment? Nobody.

I was at a loss. So I did what anybody in my situation would do. I went looking for change in my sofa. Here’s what the process looked like:

  • Analyzed all 30+ financial accounts to see which had extra cash sitting idle to transfer over to my checking account.
  • Went through all my Treasury bond holdings to see which 3-month T-bills were set to expire within four weeks.
  • Told my wife to deposit a check my mother had sent her as a gift, which we did not plan to deposit. This made my mom very happy.
  • Ratcheted down expenses and paused investing any cash flow for the next five weeks
  • Increased my active income by doing more consulting, coaching, and business development

Where There Is A Will There Is A Way

The next five weeks were actually quite exciting trying to come up with the funds. Without my normal cash cushion, I felt vulnerable.

Could I survive for five weeks until I began receiving my various forms of monthly passive income (rent, dividends, coupon payments, distributions) and active income (online income, consulting)? The challenge was on.

This situation also opened my eyes as to how much idle cash a household might actually have that isn’t being optimized.

For example, you might discover that one of your taxable investment portfolios has idle cash due to an accumulation of dividends that weren’t reinvested. You might also find that one of your bonds matured long ago and you didn’t realize it until you looked.

Finally, I discovered I have the ability to make more money if I want to. The opportunities to coach or consult are endless. So are new business deals online. Having a purpose to make money feels great! I just haven’t wanted to until going broke because I had decided to go into decumulation mode in mid-2022.

You, too, might be surprised by your ability to make more money if you really need to. Hence, if you have a strong ability to make side hustle money, your need for liquidity may be less than you imagine.

Limited Partners Likely Won’t Get Penalized For Being Late

Having invested in private funds since 2005, I’ve been late meeting capital calls before. The main reason for the lateness is I simply missed the e-mail alerts. Generally speaking, I’m terrible with e-mails.

Every time I’m late, and get an e-mail saying that I’m late, I apologize and immediately wire the funds. Out of the five times I’ve been late over 18 years, I’ve never once been penalized.

In other words, if you’re having a difficult time meeting your private fund capital calls, you will likely get a 30-day grace period to meet your obligations after the deadline before problems may arise.

If you can pay your capital call by the deadline, I’d schedule the payment for the very last day. This way, you gain optionality in case something goes wrong. Further, you earn more interest income from your cash.

How Does A Capital Call Work From The Private Fund’s Perspective?

Under normal operations, a private fund will have a 60-90-day line of credit with a bank to fund deals. This way, a private fund can immediately invest in a company once the term sheet is signed. Winning deals is a hyper-competitive process.

This 60-90-day line of credit acts as a bridge loan for the private fund. Once the line of credit is drawn to make an investment, the private fund then makes a capital call to its limited partners with a four-to-six-week deadline. Once all the limited partner’s funds are received, the private fund then pays back the line of credit to its bank.

When there are bank runs, these bridge loans may stop. As a result, the funding of private companies may get more difficult. Operating private funds may also become more difficult.

Every private fund I’m investing in is currently diversifying its banking relationships to ensure the process of raising capital and investing in companies remains smooth.

Without bridge loans for private funds, limited partners will have to be even more vigilant in monitoring their cash and cash flow. Because once there is a capital call, there may be even less wiggle room to be late.

How Long Does It Take For Private Funds To Reinvest Proceeds Once Capital Is Called?

We just learned private funds have lines of credit with banks to immediately fund deals once the term sheets are signed. Therefore, as a limited partner, once you make the capital call, it’s usually up to the private fund to pay the line of credit back to the bank.

In other words, once the limited partner sends in the funds, the LP’s responsibility is over. The LP shouldn’t have to worry about their funds getting trapped at a bank and not reinvested into a deal because there’s a high likelihood the private fund, through the bank, has already made the investments.

I bring up this point because I had wired a sizable capital call to First Republic Bank two weeks before it started melting down. My concern was whether my funds would somehow be lost in the chaos.

However, after talking to one of the general partners of the private fund, he mentioned the majority of the funds from the capital call were already reinvested in several new companies. They had used their line of credit with First Republic Bank.

In this situation, if you are a limited partner who ends up never meeting your capital call, then you will face the wrath of the general partners. The GPs will have to make up for your shortfall somehow. They could withhold distributions you were entitled to earn until your capital call is met or they could even sue you.

Best To Always Honor Your Commitments As An LP

As is always the case, being an honorable person who promises to do what you say you will do is the best way. Being dishonorable with money, yet still getting rewarded is what enrages financial people the most.

By funding companies first, general partners are taking a risk its limited partners will honor all their capital calls. If limited partners don’t honor their commitments, then they will be blackballed from their fund and potentially the entire private fund industry.

I suspect some general partners will become more risk-averse and stop prefunding companies before all its limited partners have sent in their capital calls. If so, it will take between thirty to ninety days on average to reinvest proceeds once capital is called.

The positive of this is that the general partners reduce their financial risk. The negative is that the private fund becomes less competitive in winning deals compared to more liquid private funds.

How To Better Manage Your Private Investment Capital Calls

My latest capital call fire drill is another reminder that investing family money can feel like a full-time job. You’ve got to be extremely focused on managing every financial account. Otherwise, you will face potential penalties, miss out on future investment opportunities, or have an inappropriate asset allocation.

One of my main goals of investing in private investments is so that I don’t have to stress about how to invest my money. It’s also nice not to be reminded of the investment’s daily value, like stocks. This “out of sight, out of mind” investing philosophy is helpful only if one can properly fund them!

So here’s what I’m doing now to better manage my capital calls.

1) Organize everything in a spreadsheet

The more private investments you have, the more you need to be organized. Your spreadsheet should have the following columns:

  • Date Of Investment
  • Fund Name
  • Investment Commitment
  • Lifespan Range Of Fund
  • Estimated Capital Call Amounts By Year
  • Capital Call As Percentage Of Cash Flow
  • Capital Call As Percentage Of Investments

Once you create this spreadsheet, you should be able to better plan your funding.

2) Be realistic about your future income and cash flow.

When it comes to investing in private funds, I’ve found it’s easy to commit too much. This is because there is a timing difference between your capital commitment and when the money is actually called.

For example, when you invest $250,000, the $250,000 doesn’t all get invested immediately. Instead, the $250,000 gets invested through a series of capital calls usually over a two-to-four-year period.

Because you’ve identified an all-star investing team in an asset class you love, the time lag involved, and your optimism about your own income, you may be inclined to invest more than you should. Beware. Not everything always goes according to plan.

In 2021, many people invested in private funds when their income and net worths were at all-time highs. There is a natural tendency to extrapolate stronger income and more net worth growth over the years. However, the bear market returned in 2022 and now some investors are overcommitted.

This happened to me in 2007. I had made the most amount of money in my career. So I bought a $715,000 vacation property I didn’t need. Then the global financial crisis hit, my income went down by 50%, and so did the value of my vacation property!

Be realistic about modeling your future income, distributions, and net worth. Come up with a Base Case, Bear Case, and Blue Sky Case.

3) Be stringent with your capital allocation percentages.

Know your risk tolerance and your financial objectives. Then come up with a net worth allocation model and follow it closely. When situations change, adjust accordingly.

Investors regularly blow themselves up when they allocate too much capital to speculative investments. We saw this happen with cryptocurrencies, SPACs, NFTs, meme stocks, and unprofitable growth stocks. When times are good, these investments perform extraordinarily well. Not so much when times are bad.

My target asset allocation towards private investments is 10% of my net worth with a maximum limit of 15%. As the percentage creeps above 10% due to investment gains, I will start adjusting downward my allocation accordingly.

Don’t let investing FOMO make you invest more than you should. It’s very easy to want to give all your capital to rockstar investors, if you can. Great marketing materials are effective for a reason.

Take a look at Sequoia, the premier venture capital company in the world. If the company gave me the opportunity, I would have happily invested 50% of all my assets into several of their funds. After all, if Sam Bankman-Fried was willing to invest hundreds of millions in Sequoia funds, why shouldn’t I?

However, according to latest reports from Business Insider, supposedly half of Sequoia’s funds since 2018 have posted losses.

In other words, there are simply no sure things when it comes to investing in ANYTHING or with ANYBODY. As a result, diversification and discipline are in order.

4) Listen in on the quarterly updates and get to know a general partner.

If you read the quarterly updates and tune-into the quarterly video or voice calls, you’ll get a good idea of the status of the fund and its future investment plans.

If you know one of the general partners, you can easily get even more detailed insights into what the planned next investment is. Making an investment could take six months to execute. Therefore, you can get a much earlier heads up about when a potential capital call might come.

My problem is that I barely read or listen to any quarterly investment reports or calls. I’m more interested in writing on Financial Samurai, working on my next book, spending time with my family, and playing sports. The less time I spend staying on top of my private investments, the greater the Return On Investment (ROI).

I’ve already done the due diligence upfront by researching the asset class and the general partners. Once I’ve decided on the capital commitment amount, that’s it. There’s no turning back. No amount of work I do will change their investment decisions.

I’m willing go to pay the private fund fees to offload my investment mental load onto the general partners.

Embrace The Excitement Of Being Stretched Financially Thin

I’m glad these $81,351 worth of capital calls came in March 2023 and not at the end of 2021 or in 2022. Hopefully, this means the general partners have found better deals on both the equity and debt side.

This spreading out of capital calls is another positive of investing in private funds.

Bear markets generally last about 15 months. Hence, if the capital calls are spread over two-to-four years, there’s a lower chance limited partners end up investing most of their funds at or near the top of the market.

I have a “go broke to win big” philosophy. The philosophy states that so long as you feel broke, you will do everything you can to not feel broke anymore. Why? Because we are all rational beings!

Unfortunately, as we get wealthier, we get lazier.

When we feel rich, we happily let our cash sit in a 4.5% yielding money market fund instead of clicking some buttons to receive 0.5%+ more in Treasuries.

After 25 years working, we no longer have as strong of a desire to get in before everyone else and leave after everyone else. Face time is for the young!

After 20 years of marriage, we no longer bother working out and eating as well. We’ve already found our life partners who are too afraid to leave us for a better life.

The best way to feel broke is to invest as much of our cash as possible. By treating our investments like expenses, we will grow rich. And once we grow rich, the trick is to keep that hunger alive!

Reader Questions And Recommendations

Anybody else invest in private funds with many capital calls? How do you stay organized enough to always meet your commitments? Where do you source capital to meet your capital calls if you are short?

Check out Fundrise, my favorite private real estate investment platform. You can invest in private real estate funds that specialize in single-family and multi-family homes in the Sunbelt region. Thanks to technology and work from home, the demographic shift toward lower-cost areas is here to stay.

Pick up a copy of Buy This, Not That, my instant Wall Street Journal bestseller. The book helps you make more optimal investment decisions so you can live a better, more fulfilling life. You can pick up a copy on sale at Amazon today.

For more nuanced personal finance content, join 55,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009.

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