Alternative investments continues to grow as a percentage of my portfolio. I like alternative investments because they tend not to have any visible volatility. Further, I can make an investment not not have to think about the investment for many years. In this article, I'll discuss why I'm investing more in debt.
Alternative Investment In Venture Debt
A company can finance itself through a combination of debt and equity. The optimal capital mix depends on the cost of debt and the cost of equity.
If a company can borrow an unlimited amount at 0% forever, then going the 100% debt route may be a wise move. If a company's equity valuation is at absurdly high levels, then raising money by selling equity to undisciplined investors may be a better move.
Zynga insiders cashed out at $13/share and within a year the shares dropped to $3/share. Similarly, GoPro's insiders cashed out when the company had a $7B+ market cap. Today, GoPro's market cap is under $2B. It's all about finding suckers to sell to when your equity valuation is high as an owner, and not invest in funds who don't realize they are the suckers as a limited partner.
For greater risk adjusted returns, you want to deploy capital in the OPPOSITE WAY a company wants to raise capital. Yin to the Yang, remember? Venture capitalists who chased private company equity deals at the end of 2015 got crushed. Meanwhile, steady eddy debt investors are collecting their coupon payments provided their companies are still in business.
In this post, I will expand on an earlier Venture Debt investing post. I'm considering investing $150,000 in a second venture debt fund this Spring, and want to make sure I'm not missing anything.
If I can convince you that venture debt investing is a good investment at this stage of the cycle, then I should be able to convince myself to part with my money.
Why Venture Debt Investing?
There are many types of alternative investments. Venture debt investing is one of them. I'm investing $250,000 more in my friends third venture debt fund in 2021.
Here are the reasons why I'm investing in venture debt.
1) Decent risk-adjusted returns.
I believe making any sort of positive return in the public stock market will be difficult in 2016 and 2017. venture debt is an interesting asset class that generally pays an 8% – 15% annual return for the life of the fund. Loans with 2 – 4 year durations are made to companies with strong Venture Capital (equity) backing.
A founder would rather pay 8% – 15% than give up more equity. A lender just cares about getting paid back what was agreed upon, and is not looking for a home run. Think about venture debt as P2P lending for companies.
2) Someone managing a portion of my money full-time.
The older and hopefully wealthier I get, the more I'm willing to pay someone a fee to manage my capital. My friend and his partner have been investing in venture debt for over a decade each and will be completely focused on providing the best possible returns to limited partners if they want to build a good reputation, make more money for themselves, and raise another fund in the future.
While they focus on making a return for their investors, I'll focus my time making money through real estate, public equity, and mainly my online business.
I trust my friend because we were business school classmates at Haas 10 years ago. He's an MBA, CFA, and CPA, and I like the way he thinks about money.
3) Highest priority of repayment.
If things get really ugly, debtors get paid before equity holders. The people who get screwed the most are common (ordinary) shareholders who almost always get nothing if a company folds. Unfortunately, employee shares are usually at the bottom of the totem pole.
4) Exits are easier in debt than equity.
Companies no longer want to go public because they've seen what has happened to LendingClub, GoPro, Etsy, Box, Fitbit etc. Many companies that went IPO in 2014 and 2015 are now below their IPO price. For venture equity investors, if there is no IPO or buyout, there is no exit.
For debt investors, you don't really care about a big exit because you're lending a company money based on a 1 – 4 year time frame. Each year that passes, you earn an interest payment.
Let's say the interest payment is 15% a year for five years, but the company goes to zero in year five. After four years, you've collected 60% in interest, which counteracts a 100% decline in principal. Therefore, your real loss is “only” 40% instead of 100% for the equity investor.
5) Piggy back off well funded companies.
There's a bubble in venture equity funds, which is great for the survival of private companies. Given a record amount of capital has been raised by venture equity funds, a record amount of capital needs to be deployed. Limited Partners don't pay 2/20 (2% management fee and 20% of profits) in fees for funds to sit on cash. A lot of that money will be reinvested in existing private equity investments to help support their survival and growth. Foursquare is a great example.
In 2013 Foursquare raised $35M at a $650M valuation. The same investors: DFJ Growth, Microsoft, Silver Lake Partners, Spark Capital, Union Square Ventures and Andreessen Horowitz, recently invested another $20-40M in the company at a $250M valuation.
Clearly, in 2013 the investors made a mistake and are now hoping to salvage their investment at a more reasonable price. Foursquare probably should be dead. But thanks to venture capitalists flush with cash, it lives on!
6) Better cost structure, pricing, and deal pipeline.
This new fund has already identified over 15 potential investments over the next 1 – 2 years. As a result, the time and money spent sourcing deals is much less. Less time and money spent means better returns for LPs. Always be wary of investing in a brand new fund.
Given equity fund raising is expected to be more difficult in 2021, companies are looking to do more debt fund raising. When demand for debt funding increases, so do the terms of the debt investor. This is simple supply and demand economics.
7) Diversification of investments.
Only about 10% of my investable assets is in alternative investments. The rest is invested in the public market. I'd like to increase my alternative investment percentage to 20%.
I enjoy locking my money up in long-term funds so I don't have the temptation to spend the money. Investing over the long term also helps remove emotion out of investing and enables investors to better weather the cycles.
Notice how 17.8% of Yale's endowment allocation is with absolute return and 32% is with private equity. They believe that by taking advantage of relationships and dislocations in the private markets, greater returns can be made.
The public market has “more perfect information.” As a result, it's harder to gain an edge. But in the private market, you can use your relationships and private information to make better decisions.
It's one thing to invest in a specific private company's equity. I've only got a couple of such investments. It's another thing to invest in a venture debt portfolio of private companies, where the chance of making a return is much greater.
Increasing Venture Debt Exposure
I believe the three main reasons people don't invest in alternative investments are: 1) the investor is not accredited, 2) the investor has little understanding of the investment asset class, and 3) the investor does not want to tie up capital for 7 – 10 years.
The more capital you have, the more you welcome locking in the capital with a potentially high IRR (internal rate of return). It feels nice to have someone invest your money for you and not worry too much.
Favorite Alternative Investment
In addition to venture debt, one of my favorite alternative investments for the next 10 years is real estate crowdfunding. Real estate crowdfunding is a way for retail investors to invest in commercial real estate such as multifamily properties and industrial buildings. In the past, you needed to invest millions into one project.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eREITs. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the best way to gain real estate exposure with less volatility.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. For those of you with plenty of capital, you can build your own select real estate fund with Crowdstreet.
I've personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Alternative investments provide me more peace of mind so I can spend time being a dad.
Note: I also recently reviewed YieldStreet, a debt alternative investment platform which I found pretty interesting. It has investments in Legal, Art, and Marine.
30 thoughts on “Alternative Investment In Venture Debt For Income And Returns”
I’ve always known of venture debt but not being an accredited investor, hadn’t considered investing in it myself.
Looking forward to giving Wealthfront a closer look.
As a leveraged finance investment banker, really enjoyed this post! We look at debt financing for many companies and as the companies grow large enough for our time and effort (bulge bracket bank) we look at selling the companies on the merits of taking on institutional investor money rather than keeping more expensive BDC debt. The one piece of advice that I can’t stress enough is to read the credit agreement thoroughly! Not all covenants are created equally and we see companies default all the time. Good luck!
The problem is getting to the ‘accredited’ level. It’s honestly a huge scam set up by the government and big bankers. Regular folks can only invest in publicly traded companies, that you effectively showed often bilks people by the billions of dollars. You retirement money slowly gets squirreled away and they take a portion of your wealth every year in fees.
The highest returning and often safe investments are reserved for those of us who already have quite a bit of money or who are directly connected.
I highly recommend alternative investments, especially real estate, if you can afford it.
TLDR: I don’t have enough information to do a good comparison of, but here’s what I would be comparing it against when trying to decide which would be better for myself.
I don’t have enough first hand experience with the alternative investments you are describing above, so beyond what you have wrote, all I can comment is it would seem you are putting a lot of trust in whoever is your intermediary.
My personal investments that are probably outside the mainstream for most are individually purchased bonds (Corporates, MBS, REMIC, Preferred Stock, and Municipal bonds (both taxable and non-taxable)), and Charitable gift annuities.
The Bonds are all purchased on the secondary Market, so none are at Par (face Value). The downside is you need a broker, you cannot trade them like stocks, so it does require someone you trust (since they are doing a lot of the finding and analysis of the bonds). The other downside is, since they are individual companies, they can fluctuate ALOT. Upsides are, they can be insured (generally return less but sometimes you can find them poorly priced/valued), They can be margined (if they remain investment grade (they are margin-able to 50% I normally keep myself at half or below that just in case), they are a lot more liquid then P2P or BDC. The mix in my accounts look something like:
10% Preferred stock
35% MBS/REMIC (mortgage backed Securities/Real Estate Mortgage Investment Conduit)
40% Muni’s (I throw Tobacco Bonds in this category as well) (90% are tax frees, 10% are taxable)
5-10 YEARS 35%
10-15 YEARS 22%
15-20 YEARS 29%
OVER 20 YEARS 14%
Average face value yield on the bonds in the account is 5.42%
% by (purchase price) value of bonds in default – 2.15% (Recovery rate assumed 0, but probably will be higher)
68% of account are investment grades
32% of the account are Junk Grades
Returns look like
Year % Gain Loss
2008 -30% (REMIC and MBS don’t like housing crashes)
As the account has grown (2005 +/- 100k –> 2015 +/- 1.25m) returns have stabilized, and are lower, but most of the decline in % has been due to the continued decline in interest rates, and the recent increase in rates. (bonds traditionally move opposite of rates. Older bonds with higher yield values go up as rates go down (since you cannot find rates that high anymore), and as rates go up older bonds go down in value)
On the charitable gift annuities side they are regulated so there are calculators out there. Right now with the interest rates as low as they are, it isn’t as nice of a return as it used to be (the return is only part of the reason to do one obviously), but there are other advantages especially the higher your tax bracket.
The below is the current calculator for St. Jude’s Children’s Charities, but there are others out there.
The advantages are:
You are giving to a good cause
You get an immediate tax deduction today
Its a guaranteed money stream for life.
You can do it in relatively small amounts (low as $5,000), and can ladder it out if you choose.
You get your future paybacks partially tax free, and if you donated Stock/Bonds/IRAs/Investments that had made gains the income provided is split into long term capital gains and ordinary income (there is a formula in the calculator as well as on the IRS.gov site that determines the %ages)
The biggest one I see beyond the doing something good is the potential to Donate IRA funds without penalties, and then getting an income stream back that coverts something that would be taxed as ordinary income back as Capital/Tax Free.
You have given the money away, and future gains are not credited to you beyond the committed %age rate.
While possible to pass them on, generally beyond joint survivor clauses it gets very difficult.
I am not sure but I don’t believe you can change beneficiaries after the fact.
My family has a few both with St. Judes as well as a few others. 10-20 year deferrals on most. Rates of return sadly I don’t have calculated, but they were based off much higher interest rates at the time so the payouts were all in the 8-12% range per year. For me playing with the numbers now on the website calculators it looks like they are generally 5.5-8% (it all depends on age, and deferral length, immediate ones are available at lower payouts.)
Somehow this went on way longer then I planned. Hope it helps give possible alternatives .
Would you mind doing an in-depth analysis and discussion on how you were able to yield such high returns in the bond market? I don’t have much experience with bonds/fixed income but I do understand how the relative interest rates loosely affect the face-value of the bond (loosely in concept). So if you could go more in-depth and site the risks associated with it (because those are high returns) I’d love to learn about the topic and add another investment tool to my toolkit!
Any relevant links would also be appreciated! Thanks!
It’s actually very simple. Face value never changes. The price of a bond will change which affects the yield. Yield and price move in opposite directions. If a company has 8.00% Senior Notes trading at, say 94 (quoted as a percent of face value but without the %), the yield would be greater than 8.0% because the debt investor is buying the face value with 8% returns at a price less than 100% of face value.
Keep in mind the two primary debt classes–bonds and loans. Bonds are securities and registered with SEC. However, there are always exceptions like 144A and private placements. Bonds trade in line with the underlying equity (more volatile) and loans are much less volatile. To visualize this check out trading history chart of a BB bond index vs LSTA loan index.
The more seniority in capital structure, the less yield.
The is pretty simple, but things can get complicated when covenants, indentures, and guarantors (holdco vs opco) are mapped out.
This was a great comment. I looked into BDCs but it seems like investing in high yield corporate debt with much higher fees than typical open ended municipals. I thought about buying individual municipals as well, but decided to go with open ended mutual bond funds (VWLUX) and one from T. Rowe Price as well. The problem I see with individual bonds is you must have a very large amount of capital in order to be able to diversify risk. One challenge I think about with bonds in a rising rate environment is what will happen to bond portfolios, as they would typically lose value in rising interest rate environments. Part of the reason behind your stellar returns has (with the exception of 2008) has been the Fed dropping rates to zero. Of course, nobody really knows where interest rates are going, as the Fed is just planning on raising short term rates but is actually rolling over its quantitative easing bought treasuries (in that way buying one of every 2 dollars of government issued debt). Thanks for the link on St. Jude’s website, I have never looked into charitable annuities. It’s interesting, the income derived from it is almost like munis in its tax exempt status. Hopefully, you will be able to see outsized returns for the next 10 years, maybe the Fed will end up going negative, who knows.
Someone mentioned realty shares above. I use a competitor and have had a good experience so far. Just over a year in and I have about 8 percent of my wealth invested.
This competitor is honest enough to admit to concerns with commercial real estate and won’t make deals just to make deals. So, the opportunities to invest are fairly scarce at the moment. With the other platforms I was getting the hard sell to invest. That concerned me. Not saying they are not good firms
and the deals are not solid. I just had a strange feeling.
I have experience with P2P. I invested a small amount, $5,000, with Lending Club. I purchased, over time, about 300 loans which included reinvesting my interest. I started almost 3 years ago. I no longer reinvest. I will explain why in a moment. Here are the details:
1. My state was not on the approved list for Direct P2P. I invested through a trading platform called Folio FN.
2. The fees are numerous and add up. I figured it cost me 3 to 4 percent in return annually!
3. I focused mostly on high quality A and B loans. I looked at the credit score of each and the direction of the credit score. I did not focus on any borrowers story since I was investing based on the law of large numbers.
4. As a percentage, my charge offs for highly rated A and B loans exceeded this loans with a lower rating. However, I didn’t have enough low quality loans to make the comparison scientific.
5. Reinvesting interest actually cost money if you cannot invest direct. The bid ask spread, brokerage commission and the piece they take from your interest was an enormous part of the return.
6. Lending Club for quite a while was publishing a return for me that I knew from simple math could not be accurate. To their credit, right before going public, they adjusted this. My fantasy 7% return went to 3% on their system. This is still too high! Again, I think the returns are realistic if you don’t have to invest through an intermediary. Right now, I am not reinvesting. The reality is that over a 12 month period ending 6/30/15 when I was reinvesting I earned 1.75%. Now, I am earning about 1%.
7. Not the worst investment ever and I would think about doing it again if I could access the direct platform. There are better ways to invest your money if you are not in an approved state and need an intermediary.
This is a fascinating post.
I have to admit that I’ve never heard of venture debt investing before this post. If I had the a great amount of money to invest now, I would still weight the pros and cons of venture debt. While there is some sort of nice returns of venture debt investing, I also wonder what the opportunity costs are.
Are there other investment vehicles that I can put my money into and make more money than what venture debt investing offers? Or are there investments that provide the same returns (or around that ballpark) with less risks?
I have to admit that it’s really tempting to go into venture debt investing especially when I saw the chart or table about Yale and how it allocated its money towards the private market.
Mezzanine debt (Mezz Debt) either corporate or real estate. In real estate, it’s generally secured by a mortgage in second position to the first lender.
Mezz Debt on real estate is generally secured by a second mortgage on the property. Is that more risky or less risky, depends on your knowledge and understanding of the two industries and within real estate whether the Mezz Debt is on income properties or it is for development.
In general, when someone says are there other investments with the same or better returns with less risk, the individual is missing the point of risk | return. Specifically, when you want oversized returns, all else equal, you’re having to take on increased risks.
I’m going to have to check out Prosper, I don’t have $100,000+ to invest in the funds, so this might be a better route. Just gotta see if they have restrictions on investing from other countries.
I am a fan of mezzanine debt, whether it be venture based or real estate, but one has to understand it is high risk.
In your example, you earn 60% of interest and lose 100% of principal and the overall 40% loss is deemed better than losing 100% if you were in the equity position; however, if they go out of business in year 1 you’re out 100% as well.
Further, the upside of the venture debt relative to the upside is not comparable. You can earn your 10% to 15% coupon per year, while still being high risk, while the equity position is seeking higher rates of return and this bearing more risk.
The key being, after all, that we are being compensated for the risk we are undertaking.
Personally, most of my investment portfolio is invested in these assests. Approximately 20% real estate mortgages, through a MIC (returns ~ 10%), 25% in a REIT (returns ~ 15% to date), and 55% in real estate project financing (underwritten to a 20% IRR and expected to outperform). The one common thread between these assets is the high degree of risk and why our accredited investors sign off that they recognize they can lose 100% of their principal.
I hope your pursuit of your investment, if you decide to move forward, provides a great return and I’d only caution readers more on the risk of said returns, which you can bear more readily with your more stable investments.
Thanks for the article. I admit my knowledge of venture debt is pretty shaky, well if you don’t count hearing Mr. Wonderful’s deals on Shark Tank :)
It makes sense. Being an angel or a VC has always been my ultimate goal, but after working at a start-up that was surviving solely because of its VC funding, I’m learning that it’s not all puppies and rainbows. It depends on the startups burn rate. I think if I had millions and millions to invest I’d be less worried about one investment going south, but I’m not there (yet?)
Definitely going to do more digging into venture debt. Thanks.
I chose other as this article contains all the knowledge I have on venture debt – which was acquired as I read your article.
I don’t have enough capital (or connections) to even think about going down this path at this point maybe some day.
How much work is P2P lending? Do you spend a lot of time reading the profiles or just go off the credit rating?
What industries are you venture debt investing in?
Looking at your returns, I think I personally would prefer real estate hard money lending, since if there is a real estate crash then you still have claim over the physical property. I would be concerned holding debt in app based tech firms, that if the economy turns, there may not be enough physical assets that can be liquidated to recover the debt.
Fascinating! Sounds like you’ve really done your research on your potential investment. Venture debt isn’t something I have experience with, but I like the concept. I’d definitely pick venture debt over venture equity right now if I had to choose between the two.
BDCs are another option for debt investing…lots of midtier companies that are solid but arent public use commercial investing market for operating funds…less risky than betting on startup debt investing.
In the absence of complete faith in the fund manager, I would absolutely invest in a fund of BDCs before investing in a venture debt fund. The upsides of both are about the same–there’s only so much money you can earn off making unsecured loans to someone. But the downside risks are not the same. The well-run start up that doesn’t want to part with equity is exactly the start up you want equity from.
Love to have you guys explain more about the virtues of BDCs. Thanks!
Some things that spring to mind, in no particular order:
BDCs must report their expenses. So fewer surprises.
BDC underwriting standards at least exist–certainly they exist more than anything required of venture funds (this is where faith in your friend as fund manager can make a difference, though). They thus loan to companies the odds–in the abstract–say are more likely to pay the loans back. So there fewer downside surprises. Yet they still cater to the high yield investor seeking diversification.
You don’t need to risk $100K+ to splash around in the BDC pool. They offer a way to invest in small cap companies not otherwise available to retail investors.
BDCs both lend and invest. They do not only lend.
Look into Hercules (HTGC), TriplePoint (TPVG) and Horizon (HRZN) if you want to invest in venture debt BDCs. You can avoid being locked into a private venture fund and many are trading at discounts to NAV right now. Wait for better entry prices though and definitely do your homework on the managers, portfolios and fees first (just like with any investment).
Their 10-K/Qs are available on the SEC’s website, since they must make quarterly filings with full financials, including schedules of investments, just like other public corporations and they must pay out at least 90% of their taxable income each year (just like REITs) to avoid corporate tax [and at least 98% to avoid 4% excise tax].
I will not go into all the main points here since there are much better resources. Check out BDCBuzz and Nicholas Marshi on Seeking Alpha who have written numerous focused articles on BDCs, including their benefits and shortfalls.
Before this post, I was not aware of the mechanics behind venture debt investing. Given I’m still new to this scene and don’t fully understand it, I picked ‘other’.
You lay out some convincing arguments for the pro’s and con’s, but the real question you should ask:
What is your opportunity cost?
Without being able to weigh your other investment options, it is tough to agree that this is the right course of action. If your cash flows can replace your savings within months, then that would also factor in. The risk I’m considering is missing the chance to fire on another $150,000 opportunity while you’re stuck reloading your savings. I have a feeling this isn’t so much of an issue for you though.
5 years out the economy will be stronger, with higher earnings and likely, a higher stock valuation to reflect those earnings. Privately, I agree many of those they entered the IPO market have been burned, but there have been some exceptions (Facebook comes to mind). It’ll be interesting to see what Uber, Lyft & AirBnb decide to do.
Which fund do you recommend for alternative debt investments that has the $100,000 minimum? P2P is really not the same thing.
Sam, I’m not sure whether you created the chart with the seniority of a company’s sources of funding, but I would not call a revolving credit facility super senior. DIP facilities are usually reserved that.
An RCF depending whether is secured or not usually ranks pari passu with the other senior debt.
When a company gets into trouble, RCFs are fully drawn just before filing for bankruptcy.
Thank You. Interesting post. Do you have any opinion on real estate crowdfunding for debt investing? Is this a good option for accredited investors who are looking for debt investments without such a large investment requirement? Companies such as Patch of Land only require a $5000.00 min investment. In my situation P2P lending is not legal in my state so I have been unable to participate and real estate crowdfunding may be a possible alternative.
I would appreciate your opinion.
I went with the second Yes option. The only “alternatives” I hold are in Vanguard’s REIT index fund, which is at 10%. I’ve been thinking about moving some of that money into crowdfunded Real Estate debt, which seems to work in a similar way to venture debt, but the minimums are much lower ($5k & 10k).
Now that I’m approved by RealtyShares, I get their e-mails, and some deals are on an individual single family home, while others are funds for dozens of homes in a geographic area. I’m not sure which is a safer bet. Similarly, I’m wondering if your debt equity would be spread across a number of different notes, or if your eggs would be in company’s basket. I’m guessing your friend invests in multiple debt deals, and your money would be pooled with other investors, which would reduce your risk to an extent.
Of course, if these were totally safe bets, the returns wouldn’t be what they are, so there’s obviously risk involved.
I posted a comment, but it is under “moderation” all day today.
If you don’t want to directly do venture debt, a conduit in public marked outside of the BDCs is Silicon Valley Bank. SIVB.
BDCs can be shady, check out the book by Einhorn on Allied Capital. Fooling Some of the People All of the Time, A Long Short
The challenge in a lot of the BDCs is the constant share isssuance.
I woke up to read this and found it very interesting on a private investor model. There is a public bank that’s model is driven off venture debt financing and related services, Silicon Valley Bank (SIVB) https://www.svb.com/about-silicon-valley-bank/.
Venture debt investing is probably what I would think is a safer investment strategy into start-ups / early stage firms. I have seen this be a structure in many early investment rounds in the Midwest but am not sure on the West coast. Good diversification and chance for yield, particularly if there are warrants or other benefits attached to the debt instrument. 20% seems like a high allocation to this level of risk but I am conservative in my investment choices.
Hey Sam, How do you get into one of the funds if you are an accredited investor? Sounds like you need to know someone.