Hey,
Welcome back to Mechanics of Money.
Every week, I share what I've learned about making, investing, and using money, so you can better understand your financial options and make smarter financial decisions to build the life you want.
In this issue, I break down why private investments can have a much wider range of returns than public investments, and what that means for you as an investor.
Specifically:
Why two private deals that look almost identical on paper can produce completely different returns
Why smaller investments can sometimes offer much higher returns
What additional risks you take on in exchange for those potential returns
Let's get into it.
Why Private Investments Can Return 10x (or Go to Zero)
In 2018, I was working in tech sales, earning about $250,000 a year in a senior sales role at a software company.
Around that time, I started buying single-family rental properties to build passive income. Within about a year, I'd bought ten houses.
Each one brought in about $200 to $300 a month in cash flow after the expenses were paid.
Then, during a week when I was supposed to present my team's quarterly performance to senior leadership ahead of a board meeting, one of my tenants drunkenly drove over a sewer line while mowing the lawn.
My property manager kept calling me while I was supposed to be preparing for my quarterly review.
I'd been a top performer at my job, but now I was getting pulled away from work that paid me a quarter of a million dollars a year to deal with houses that were only making me a couple hundred dollars a month each.
The math didn't make much sense.
Eventually, I sold the houses. Over about nine months, I put my first million dollars, including what I'd made from the houses, into roughly 20 private deals as a limited partner, meaning I provided capital while somebody else managed the investments.
I was still investing in real estate and businesses, but I wasn't responsible for operating them anymore.
Instead, my job became figuring out who I could trust with my money.
And that's one of the biggest differences between investing in public and private markets.
Why private investments have a much wider range of outcomes
When you invest in an S&P 500 index fund, you're buying small pieces of roughly 500 publicly traded companies.
Over long periods, the S&P 500 has historically returned around 10% annually, although returns over shorter periods can vary considerably.
Most companies in the index are large, established businesses with audited financial statements, reporting requirements, and professional management teams.
Of course, individual public stocks can also return 10x or go to zero. The bigger distinction here is between owning a diversified portfolio of established public companies and putting money into individual private deals where outcomes can depend heavily on a single operator.
Compare that with a private investment.
You might be investing in a small real estate development managed by two people, or a large private equity fund with hundreds of employees.
One manager might turn your $100,000 into $500,000 over several years. Another might lose your entire investment.
There's an enormous difference in experience, resources, and operating ability between the people managing these deals.
That's why two private investments in the same asset class can produce wildly different returns.
But the same differences that create additional risk also create opportunities for much higher returns.
Why smaller deals can offer bigger returns
Imagine you're buying a single-family home in the Midwest.
The owner might need to sell quickly, might not know exactly what the property is worth, or might simply prefer a fast transaction.
If that house is worth $100,000, you might be able to buy it for $80,000.
Now imagine trying to buy a $100 million commercial property from a large institution for $80 million.
It's a much different situation.
Large institutional sellers generally have professional teams, sophisticated valuation processes, and access to competitive buyers.
They're less likely to sell something significantly below its market value without a good reason.
In my experience, a $10 million institutional property might trade somewhere between $9.8 million and $10.2 million. That's a relatively tight range.
Compare that with a smaller property worth $100,000, which might trade anywhere from $75,000 to $125,000.
That's a 50% spread relative to the property's estimated value, versus just 4% for the larger property.
Smaller markets can be less efficient, which means there may be more opportunities to buy assets at attractive prices.
We see a similar dynamic when buying paving companies.
In our business, we might buy a paving company for multiples of around three to four times EBITDA.
But multiples jump substantially as a company grows from around $5 million in EBITDA toward $20 million or $50 million.
Why would someone pay a higher multiple for a larger company?
Larger companies often have more established leadership, better systems, more resources, less dependence on one owner and typically better quality debt available to acquire them.
Investors are willing to pay more for those things because they can make the business more stable.
There are also fewer people bidding on small companies. The seller is often in his sixties with no succession plan, and there are three plausible buyers instead of thirty.
But if you buy a smaller company at three or four times EBITDA, improve its operations, and grow it into a larger business, you may eventually be able to sell it at a higher multiple.
You benefit from both the growth in earnings and the increase in what buyers are willing to pay for each dollar of earnings.
When we bought one paving company in Texas, it was also handling about $6 million a year of concrete work for its customers. It hired other contractors to do that work and charged customers exactly what those contractors charged, so it made no profit on it.
Our goal now is to acquire a concrete company within driving distance and bring that work in-house.
If we can capture that $6 million in annual revenue at a 20% EBITDA margin, that's potentially another $1.2 million in annual EBITDA.
And that's before considering any additional growth opportunities from combining the two businesses.
Of course, there's a reason the smaller company was cheaper.
It may have had fewer resources, weaker management, and a much greater chance of running into problems.
The takeaway: with smaller deals, you have more room to generate an outsized return, but you also have more ways to lose money.
What happens when you need your money back?
There's another important difference between public and private investments: liquidity.
If you own a publicly traded stock and need cash, you can generally sell it during market hours.
Maybe you invested $100,000 and the stock is now worth $92,000.
You might not like taking that loss, but you can sell and get your $92,000 back.
Private investments are different.
Depending on the deal, your money could be locked up for three, five, ten, or even fifteen years.
If you suddenly need that money, there may be no practical way to sell your investment, even if you're willing to accept a loss.
That's a real cost that investors should consider when comparing potential returns.
A private investment with a higher projected return isn’t necessarily a better investment if you might need your money before the deal has a liquidity event.
How I think about the risk of private investments
I've spent years investing in private deals and interviewing the people running them.
One thing I've learned is that evaluating the manager is just as important as evaluating the investment.
When my partner and I started buying paving companies, we both came from finance backgrounds. Neither of us could walk into a yard full of paving equipment and immediately tell which machines were in good condition.
Jeff, who built the paving company we partnered with, could do that within minutes.
That experience reinforced something I now ask before getting involved in any investment: Why are we the right people to operate this?
The same question matters when you're investing with somebody else.
Do they actually understand the business? Have they managed similar investments before? Do they have the resources to deal with unexpected problems?
And just as importantly, does the investment make sense for your personal situation?
I grew up without a financial fallback plan, so having a larger cash buffer matters to me.
I'll willingly accept a lower potential return if it means having more financial flexibility and less personal stress.
When I'm deciding how much to invest in a private deal, I think about my emotional tolerance for risk alongside my financial ability to absorb a loss.
The question I come back to is: If this investment went to zero, would anything about my life have to change?
If the answer is yes, I need to think carefully about how much money I'm putting into that deal.
The bottom line
I don't think private markets are inherently better than public markets.
There are opportunities in smaller businesses that you might not find elsewhere. But there's usually a reason those opportunities exist, and understanding that reason is incredibly important.
Before investing in a private deal, I want to understand who's running it, how they're compensated, what could go wrong, and when I can realistically expect my money back.
A higher projected return doesn't necessarily mean a better investment.
And sometimes, a simple public market index fund is the better decision.
Enjoyed this deep dive? Reply and let me know what topics you'd like to see covered next.
Talk soon,
- Sam Silverman
Silverman Capital
P.S. Want to go deeper on this? In my episode Real Estate Syndication Returns Aren't What They Look Like, I explain why two real estate investments advertising similar returns can produce very different results, along with five questions to ask a sponsor before you send them any money.