Alternative Accesss - February 2020
Private Lending: What Your Collateral Says About You
In an era when interest rates have gotten lower and negative in certain parts of the world, the hunt for yield is as real as it is fierce. Enter debt funds. Debt funds provide income. Your investment is a loan to a borrower, and as a lender, you have a capped upside; the most you can make is the interest and fees you charge. You are collateralized, usually with rental income or real estate. If anything goes wrong, you’re going to get your money back before anyone else. We call this being senior in the capital structure. Equity funds, however, offer unlimited upside, but it comes with the explicit risk of total loss — think venture funds or real estate syndications. If the values go down because the rents aren’t there, then you’re getting an equity impairment, This article will discuss what debt funds are and how you should think of them through the eyes of a professional investor. I’m going to use two different examples of collateral: single-family fixer-uppers versus fine art. My experience, you ask? Well, I wrote the book on private hard money lending called “Making The Yield: Real Estate Hard Money Lending Uncovered.” It’s the handbook for making loans and starting funds around private lending against single-family home rehabs for interest income. Written several years ago, it once was the single most expensive book on real estate lending on Amazon. For the past few years, we’ve been involved in a segment of the industry called fine art-secured lending, a much smaller market where the collateral is more precious than it is prestigious — think Christie’s or Sotheby’s quality art. This is the collateral you post on Instagram to show your friends. which is a polite way to say your entire investment is at risk for a total loss.
It is insured for more than you lent on it by the world’s top insurers.
liquid. This means that loans on an average seven-month term are just as liquid. I mean, what’s the first thing historically stolen in times of war and political strife? The fine art. The gold bars are too heavy.
What’s your execution risk?
If your rehabber can’t finish the job, for whatever reason you’ve heard contractors tell you before, what is the plan?
What will your friends think?
The easier an investment opportunity is made available to the masses, the less valuable it becomes. In the era of crowdfunding, Bitcoin, and other conspicuously entry-level investments, what you invest in is the new form of legitimacy. There’s a big difference between the entry-level speculative investments popularized on “Shark Tank” and owning, say, a loan backed by a priceless piece of collateral. Showcasing a deal toy from a successful IPO or a video of a Class A office building offers the real legitimacy found today increasingly in asset classes that keep the Michael Kors crowd out and allow access only to those with strong and powerful social networks. “Statement asset classes are not only managed by world-class operators into world-class assets and brands but are also perceived to exhibit power and legitimacy and be ‘well-connected.’” It has to answer the question for the very wealthy investor with a low profile who will want to immediately know: “What will my friends think of me when I tell them I invested in this?!” Will they be proud to show off their prized, implicitly priceless Picasso painting in a hidden vault beneath Manhattan out of a “Mission Impossible” movie? Or is it a junker home in Kansas City? You tell me, slumlord. Remember, in an era of people trying to define their legitimacy through Instagram, the difference between the middle class and the 0.001% is the collateral.
You are the plan.
Fine art has no execution risk. You can’t fix fine art. The older it gets, the more valuable it becomes.
What’s your borrower’s credit quality?
Now, there’s lending, and then there’s lending. What you lend on and who you lend to determines everything you need to know about how or when a loan will be paid back. The difference between the middle class and the 0.001% is the collateral. For example, is your borrower a fine-art gallery with a 100-year family reputation and image to maintain? Or is it a rehabber who may have questionable credit and cash to begin with? What happens in the event of default? In a debt fund, you are the lender, and you take possession. In the era of increasingly expanding squatters’ rights, the landlord or private lender will have to work to get your money back. Dealing with judges and lawyers and today’s activists ... It’s messy stuff. Lend on a piece of fine art, and after the UCC-1 foreclosure has been quietly effected, your collateral has been foreclosed on before lunch. With single-family homes, if your borrower or tenant defaults, then you now have to fix it yourself or sell it for a commission, probably. Museum-quality art pieces and priceless works of art are not only perpetually status-enhancing and quite transportable but also surprisingly What are your rights and remedies? What’s your liquidity?
What’s your collateral?
If it’s a single-family home, that’s what it is. You don’t live in it, but we hope it’s close to where you live. It’s not pretty, but it will be, just like on television.
If it’s fine art, it’s securely locked away in a temperature-controlled, bonded warehouse.
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Lessons to Be Learned
4) As the years wore on, the results became ever more improbable.
Fraudulent investments are a challenge to unmask because fundamental lying makes uncovering the truth difficult. In such cases, evidence must be dug out indirectly with scant reliance on input from the principals. Nevertheless, Shinnecock did avoid Madoff despite the overweening temptation. Investors could have known a priori that this investment was too good to be true. What were some of the tip-offs for active due diligencers? To be fair, it would have been harder to avoid this mess in the early days given the shorter track record of heroic returns, but possible. 1) The option strategy was not unique and, deployed on its own, insufficiently robust to avoid declines or more volatile results. 2) Any asset manager unwilling to fulsomely describe what they are doing must be avoided. No one ever saw actual trading records, a critical step. No wonder, there may not have been any. 3) Inadequate service providers. The auditor was a “no-name” two-person firm. Moreover, there was no independent administrator to control cash and undertake independent investor reporting. 4) Family members were in critical control positions, clearly lacking independent objectivity. Later on, when there were significant assets under management, the true picture would have been even clearer upon careful examination. 1) As the asset size grew, it would have been impossible to deploy the strategy in the option markets without severe dislocations. 2) A tiny audit firm could never have successfully examined a fund of such scale, even working 24/7. 3) In general, the Madoff staff was too small to have managed the trading frequency ostensibly required.
The Aftermath
On June 29, 2009, Madoff was sentenced to prison. There were some recoveries,
estimated as approximately half of the capital, circa $31 billion. Funds continued to be distributed to the Madoff Victim Fund as recently as 2017, a long, sad wait for the defrauded investors.
Postscript: Chutzpah — On July 24, 2019, it was reported that Madoff petitioned the Justice Department for clemency from Donald Trump. Madoff remains in jail, serving a 150- year sentence.
Conclusion
After-the-fact analysis of a problem must resist glib conclusions. However, in this case, there were enough troubling facts to keep careful investors away. Always, we welcome additional insights, for we are shameless in our goal of trying to be ever better in this challenging business.
We must offer two mea culpas:
1) Have we avoided all sketchy investments? Alas, not, but once burned, twice shy. Learning from past mistakes is our destiny. With good fortune, we will live long enough to outrun these foibles or, at a minimum, have the courage to share the learning to help others.
2) Years ago, we had the good fortune to invest in Jim Simons’ Renaissance
Technologies, the best performing hedge fund of all time. Did we diligence it? Yes, yet was it possible to understand everything they were doing? No. Unlike Madoff, the experience of the principals involved was noteworthy given their relevant backgrounds, coupled with controls, blue-chip service providers, and no family members in vital positions. Sometimes, Lady Luck smiles on us, but it is unlikely we would make a similar investment now. Our conservatism and age have made us ever more risk-averse and willing to miss a hidden gem in order to protect principal.
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D I SAMB I GUAT ING BERNI E MADOFF The Background
As the year ends and a new one begins, now it’s time to reflect, yippee. We offer the following article to reassert key principles for any portfolio changes under consideration.
later on. It bought trading volume by paying undisclosed fees from the spread it earned, a controversial practice that became accepted over time (note: not unusual for Wall Street). Bernie was accepted, even welcomed, into theWall Street club, serving as Chairman of Nasdaq in 1990, 1991, and 1993. However, it was not enough. Leveraging his success, he founded a hedge fund allegedly using split-strike conversion option strategies to “collar” risk. The track record was phenomenal, generating consistent returns with little volatility. A gusher of money came from the Jewish community and many others (viz. Steven Spielberg, Kevin Bacon, Kyra Sedgwick, and the owner of the N.Y. Mets, among the notables). Much of the money came from charitable trusts and foundations seeking long-term gains with scant liquidity requirements, Genius Point No. 1. Since Madoff was recognized as a Wall Street “stud muffin,” investors felt lucky indeed to even be accepted into this money-printing machine. There was a total and willing suspension of disbelief in the guise of Aristotle’s Elements of
Theater (Genius Point No. 2). Our charismatic charlatan displayed all of the trappings of great success: private jet, penthouse, yacht, vintage watch collection, and vacation homes around the world. Regulators were blinded by charm and guile (Genius Point No. 3). Madoff embodied the old adage of keeping your enemies close. One scold, Harry Markopolos, was unrelenting but unsuccessful in outing this Wizard of Oz. Charles Ponzi in 1920 set the stage for Madoff, who followed in his footsteps. A Ponzi scheme is a form of fraud where belief in success is fostered by the payment of “returns” to the earlier investors via the capital contributions of later investors. As such, a growing capital base is required to keep the pyramid intact. The sharp and steady equity market decline of 2008-2009 did Bernie in. Capital inflows slowed to a trickle. With fear high, investors tried to withdraw. The jig was up. Some subsequently surmised that no trades were ever actually made, a truly incredible possibility.
Mr. Bernie Madoff
Most of the $64.8 billion in his hedge fund evaporated, which is the largest investor loss on record. Here was a man who was a genius, which may shock some, a chameleon-like psychopath, and sadly for his 16,000 investors, an unprecedented crook. He has been in the press since 1960 to the present and today resides in the steel hotel — jail. Rather than relitigate and rehash, we focus on the lessons to be learned from this mess.
The Backstory
Born on April 29, 1938, Bernie started his firm in 1960 with $5,000 he earned as a lifeguard. The firm’s growth was ferocious, starting with trading penny OTC stocks in its early days as a market maker, then expanding into blue-chip stocks
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