Since first writing about my plans to invest more in P2P through Prosper.com, I’ve been having a difficult time mobilizing a sizable amount of assets to make a difference in my passive income stream portfolio. When I say sizable, I mean more than $50,000. The main reason is that I’m just not absolutely comfortable making loans to strangers, no matter how good their credit ratings.
I realize if I invest in over 100 of the highest rated loans, the chances are high that I will be able to earn at least 5% vs. the 7-8% advertised through P2P. But there’s something about my desire to invest my money to help someone I personally know that keeps most of my money away from P2P.
The best reason to borrow via P2P is to consolidate your debt into a lower interest rate P2P loan. I also have a soft spot for lending people money over Prosper to pay off medical bills. Accidents happen all the time, and they are usually not the victim’s fault. Every single other reason to borrow money over Prosper does not gel with my lending standards, even if the interest rate is higher. (Read: The Main Reasons To Borrow Through Peer-To-Peer Lending)
So I’m faced with the dilemma of continuously lending money to strangers at a 5-10% interest rate to consolidate their debts or lend money to a friend who started a hedge fund and is looking to build his assets under management. I’d like for you to weigh in on this decision because $150,000 is at stake.
LENDING MONEY DIRECTLY TO A CREDIT WORTHY FRIEND
I’ve known my friend for the past 10 years. He was a client of mine when I worked at my last job in finance. He went to Cornell, got his MFE at Cornell, has a CFA, and his articles are published in the CFA magazine. One of the most important aspects as a CFA Charter Holder is the adherence to the code of ethical financial conduct. Do anything shady, and you will be stripped of your CFA designation which takes three exams and three or more years to achieve.
My friend left his money management job a couple years ago to start his own EAFE focused (Europe, Austrasia, Far East) hedge fund. He’s secured $1.4 million in private equity investments for working capital purposes for the next three years. He’s also looking to grow his assets under management and is willing to borrow money at a certain interest rate to reinvest the loan into his fund, essentially creating synthetic leverage. This is where I come in as I’m not quite comfortable enough to invest in his fund just yet.
In 2013, his returns were ~27%, outperforming the EAFE index by over 500 basis points. In retrospect, I should have invested in his fund at the beginning of the year when I had a chance! There are thousands of hedge funds today, and most of them fail just like any other business. But my lending duration is only for one year at a time, and I have confidence my friend’s fund will last for at least three years. (Read: How Do Hedge Funds Make So Much Money)
Lending money to friends and family is a very delicate situation. I dislike what money can do to relationships. I believe my friend is a financially savvy investor who has integrity. At age 35, he most likely has a net worth of around $1 million dollars thanks to the various convenience stores and rental properties he owns with his wife in the Seattle area. I assign a 3% chance of him defaulting on my loan or disappearing with my money to Mexico and a 70% chance I will be able to hunt him down and recoup my money if so. His hedge fund could fail, but he still has ample assets to pay me back if so. Despite such a low risk of default, I still have fear because of the amount of money I plan to lend him.
I absolutely HATE having money sitting in a money market fund earning less than 0.5% a year. Inflation is at least 2% a year and I don’t want to fall behind. Part of the reason why I’ve kept the cash in my bank is because I don’t want to raise my salary because of the dreaded payroll tax. If you own your company, you’ve got to pay the full Social Security and Medicare tax of 12.4% vs. only 6.2% if you are an employee. In case you are wondering, I have already maxed out 25% of my salary in a SEP IRA.
What I’d like to do is invest the $150,000 of my company’s funds and only pay taxes on interest or dividends received. This strategy will help keep adjustable gross income low enough so I can pay the lowest marginal tax rates possible while earning a reasonable return. The $150,000 is also part of the $100,000 I’ve agreed to not spend as dictated by the community’s demands that any spending of such money is deemed immoral, wasteful, and extravagant.
My friend initially offered the following terms for the loan:
* 4% for $100,000 with option for multi-year lockup with 10-year bond index adjustment for 2nd and 3rd year.
* 4.5 for $200,000 with option for multi-year lockup with 10-year bond index adjustment for 2nd and 3rd year.
* 5% for $300,000 with option for multi-year lockup with 10-year bond index adjustment for 2nd and 3rd year.
* 6% for $500,000 no option for beyond a one year lock up.
With only $150,000 liquid to invest, I was stuck at the 4% option, which is OK, but not great. After several rounds of negotiating I got my friend to agree to 5% for $150,000. I mentioned to him that I’ve got a wave of liquidity coming due over the next three years thanks to expiring long term CDs. These CDs have been my steady baby, with the majority of them giving off 4.1% interest a year. Unfortunately, the closest interest rate on a 7 year CD is now only 2.3%. (Read: CD Investment Alternatives)
THE BENEFITS OF LENDING TO A FRIEND VIA A PROMISSORY NOTE
My benchmark for a low-risk rate of return has been 4% since 1999. 4% is getting harder to achieve thanks to declining interest rates. The 10-year yield has rebounded to ~2.7% from a low of 1.4%, so that’s good for rate seekers. However, 2.7% just doesn’t seem like enough in this relatively healthy economic environment.
5% is higher than my benchmark by 1%, and 2.3% higher than the existing risk-free rate of return. In other words, I’m demanding a 2.3% risk premium over the risk-free rate to invest my money in my friend. If my friend were to apply for a loan via P2P lending, he would be rated AAA. Given I’ve known my friend for 10 years and have a decent idea of his net worth and character, I would rate him an AAA+.
To put things in context, a 5% return on $150,000 is an extra $625 a month or $7,500 a year in passive income. $7,500 is roughly a 7% increase in my existing passive income portfolio and inches me ever closer to the $200,000 a year passive income goal. If I had $500,000 liquid right now, I’d seriously consider lending the money to my friend for 6% to receive $30,000 a year doing nothing! Alas, I’ve got to wait until the CDs come due.
I’ve got about 22% of my net worth in CDs which I’d ideally like to mobilize in similar risk, but higher return investments. Originally I was thinking about investing $250,000 – $500,000 into P2P lending, but I just can’t get over the $50,000 hump just yet due to unfamiliarity with the borrowers. I see this 5% loan as a viable alternative, even if there is huge concentration risk of investing in just one person.
THE RISKS OF LENDING TO MY FRIEND
My friend could disappear once I cut the check. I’ll now no longer have $150,000 but also no longer have a friend. I can take a $150,000 hit, but it will feel like getting uppercut by Mike Tyson with a couple front teeth knocked out. I’ll feel like a fool for being so trusting and will likely go into a month long depression for wasting all the hard work I put into my online company since leaving my job in 2012. I’ll also feel embarrassed given I’ve written this post for all of you.
But if my friend does run, he will ruin his career in finance forever at the age of 35. I will also come after him like a bat out of hell. His hedge fund currently has $15 million AUM, which will therefore produce roughly $300,000 a year in revenue to pay for office rent, salaries, and other business expenses due to a 2% management fee. The big bucks starts coming in if he performs because he will take roughly 20% of the profits as well. It takes a 3 year track record of performance before he can get to where he wants to be.
The ideal realistic scenario is that he consistently grows assets under management and pays out 5% or more for loans over the next three to five years until he no longer needs working capital funds. After a consistent track record, I’d also consider investing straight into his fund for what will hopefully be much greater than a 5% return. But then again, most businesses fail after year three.
To clarify, there are three types of investments:
1) Private equity investment in his company to make equity money. You must be bullish on my friend’s financial acumen, entrepreneurial skills, marketing, and execution.
2) To invest money in his hedge fund to make returns based on the fund’s performance. You must be bullish on my friend’s stock picking abilities.
3) To lend money for synthetic leverage or working capital. You must be bullish on my friend’s integrity and ability to pay back the loan. This is where I’m investing. Options 1 and 2 are higher risk investments with higher returns.
Readers, I’m very serious about making the loan come the beginning of next year and I’d love to hear your thoughts about whether I should or not. What is the most amount of money you feel comfortable lending to someone? Have you ever been screwed? What kind of clauses in the contract or other guarantees should I include or look for? Any alternatives you see that provide similar amounts of risk based on my friend’s profile and a 5% return?
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About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.