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Private Equity Secondaries

What are they and how do they work?  Private Equity Secondaries are funds that buy and sell the investor commitments that are within other private equity funds. The majority of private equity investments are illiquid and there is no active public market for them, however there is a an emerging secondary market giving investors the ability to sell their private equity investments.  The most common way this is done is through the transfer of an investor’s limited partnership interest. Doing so not only gives the investor the liquidity he/she desires but it also relieves him/her from any unfunded obligations to the fund.

The demand for private equity investing has been growing. There are a plethora of private equity funds available on the secondary market, including (but not limited to), growth funds, buyout funds, venture capital, distressed funds, and mezzanine funds. This burgeoning secondary market also offers a way for private equity firms to free up capital and provide a payout to investors who are seeking one.This demand on the buy-side and sell-side is fueling the demand for secondaries.

Locating investments and performing the necessary diligence on a company is costly and difficult and some investors may prefer to have this diligence already done for them, so-to-speak. Secondaries can give investors the private equity exposure they desire while limiting the many fundamental challenges. Furthermore, some investors may perceive a private equity secondary as less risky given that the subject company has been able to benefit from the support and guidance of the original investor. However, this very point can also be the primary disadvantage with such an investment. In many cases it can be difficult to create additional value, especially with respect to improving operations, streamlining costs, and other low-hanging-fruit.  Traditional private equity investors attempt to whip a flailing company into shape—to the extent a secondary can do the same thing (or continue to show marginal improvement) is hard to say since a secondary investor is coming into the firm at a more mature stage. However, the growth in the secondary market is undeniable and will continue to rise in 2014.  

Bonds, Bonds, Bonds!

Why is the appeal of corporate debt rising? Historically, inexpensive money has been the cause of most asset bubbles— case in point being: technology stocks, home prices, and mortgage-linked securities.

We are living in a low interest rate environment, and for that reason many investors are trying to  speculate on where the next bubble might occur. The corporate bond market, where yields have plummeted, is certainly one possibility (See chart for more: http://research.stlouisfed.org/fred2/graph/?id=BAMLC0A0CM).

There are some concerns for the corporate debt market. The market is not providing a sufficient enough spread over government-bond yields to compensate investors for default risk associated with corporate debt. From macroeconomic perspective, if the economy were to improve and growth and/or inflation rises sharply, bond prices will most certainly fall (as yields rise).  

Spreads are not yet at the lows they reached in 2007 when the credit bubble was at its height. There are two forms of risky debt issuance, which have reached the volumes seen in 2007: payment-in-kind (PiK) bonds and covenant-lite loans. PiK bonds are bonds when the interest payment take the form of a bond instead of a cash payment. Covenant-lite loans are loans with fewer protections for creditors against the deterioration of the borrower’s financial condition. The fact that these products have increased in popularity is a testament to the greater appetite for risk by investors.

With all these concerns, why is corporate debt so popular? This low interest rate environment are prompting investors to search for more and more alternative investments. As long as cash returns remain low (which they will unless the central bank has a sudden reversal in policy), bond markets shouldn’t see big outflows. Increased M&A activity is expected in 2014, which could result in increased borrowers and a bit more “inflating” of the potential bubble.  

Bitcoin as an Investment Class?

So what is Bitcoin? Well, it’s a virtual “currency”—you can exchange it for goods and services where bitcoin is accepted. Bitcoin is NOT legal tender, but it is a store of value. Speculation dominates the Bitcoin market, which is best seen by the herculean levels of volatility we have seen just this past year, with Bitcoin price movements climbing from $13 to $1,200 in 2013. Speculation in the Bitcoin market is borne from the fact that bitcoins are not tied to any underlying asset and its value can’t be supported by a say a physical commodity (gold) or a company security (equity or debt).  

Bitcoin has gotten a ton of attention as of late, and investors and money managers have taken notice. Interestingly, a New York-based firm launched the first U.S.-based investment vehicle dedicated to Bitcoin, called The Bitcoin Investment Trust. The trust is structured as an open-ended private trust whose shares will be available to accredited investors through SecondMarket.com (who is also seeding the trust with $2 million).  In a similar trend, in earlier 2013 the Winklevoss brothers filed to to raise a $20 million ETF, which would invest exclusively in bitcoins. The brothers are still awaiting approval.

The Bitcoin investment trust will allow investors to own bitcoins indirectly and the objective of the trust is to alleviate some of the problems of Bitcoin ownership. Conventionally speaking, there are three ways to obtain Bitcoins. First, individuals can (for a small transaction fee)  exchange money/dollars on an exchange such as Mt.Gox for Bitcoins. Second, individual merchants can exchange goods and services for Bitcoins. Third, individuals can find Bitcoins through “mining,” which is a complex procedure using a computer’s processing power to mine new Bitcoins.

So the question on my mind is, how will the trust affect the price of bitcoin? Investors are restricted from selling their shares in the trust until March 2014, so once the lockout period has passed, what will happen in the Bitcoin market? Since the barrier to entry to invest in bitcoins has been somewhat high, this “ease” of entry has the potential to increase speculation and drive up the the price — but it’s hard to say. Since the trust already owns its bitcoins, supply and demand of the virtual currency won’t be affected directly. But the spotlight is most certainly on Bitcoin right now, and I am on the edge of seat!

The Juice Craze!

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So I have been completely sucked into the juicing-craze. I’ve always known that juicing was good for me, but it was after watching Fat, Sick and Nearly Dead that I got the kick in rear that I needed to take action. For those of you that haven’t watched Fat, Sick and Nearly Dead, let me provide you with a brief synopsis  The documentary follows the hero and narrator of the film, Joe Cross, across a 60-day adventure where he travels the U.S. He follows a strict juice fast for the entire 60-day period in an effort to rid himself of several adverse ailments. According to Joe, the body has a strong desire to heal itself and juicing is one way we can super infuse ourselves with liquid vitamins and natural enzymes.

The Wall Street Journal just put an article out last week discussing the recent juice craze. According to the WSJ, retailers cannot keep up with this trend fast enough! Juicer sales have been up over 70% versus last year. Juicers can be lumped into three categories: “fast” “slow” and “whole food.”

Centrifugal are the traditional juicer most of use are used to seeing. This would be considered a”fast” type of juicer. They are loud, fast and leave behind a solid pulp. Slow juicers are somewhat new in the market. I own a slow juicer myself (the Omega VRT 350). These types of juicers crush or press juice out of fruits and vegetables and tend to do a better job juicing leafy veggies versus a typical centrifugal juicer. Whole-food juicing is the third category of juicer. These types of juicers do not seperate out the pulp, but instead you insert the entire fruit or vegetable into the machine in which the produce becomes completely pulverized. The most well-known whole-food juicer is the one produced by Vita-Mix Corp. The best part of this type of juicer is, you are able to retain the pulp and therefore all of the fiber. The downside, however, is the fact that you can’t truly juice in a large quantity of fruits and vegetables.

I have had used all three of the above types of juicers and ALL have their benefits.

Centrifugal

Pros: These machines fast and relatively easy to clean and are inexpensive.

Cons: They say the heat relased by these juicers will kill some of the enzymes in the juice.

Slow-Juicer:

Pros: Very dry resdual pulp. Since these juicers crush the juice out of produce, the result is a GREAT juice output. Juice produced by a slow-juicer is said to retain vitamins and enymes better versus a centrifugal juicer.

Cons: Slow juicers are, well, slow. My Omega is quite a pain to clean, but the higher juice output makes it worth it.

Whole-Food:

Pros: Since the entire fruit or vegetable is juiced, you get to keep all of the wonderful benefits (including the pulp). You can make delicious smoothies using frozen fruit (bananas are my favorite) too.

Cons: Like centrifugal juicers, whole-food juicers emit more heat versus a slow juicer, so there is risk of nutrition loss. Further, you only need a small quantity of fruits and veggies to make a serving juice. So if your objective is to drink extremely potent juice, then a whole-food juicer likely wouldn’t be what you’d use since the pulp adds a lot of mass.

So what should you think about before diving into the world of juicing? First, choose a juicer that fits in with your lifestyle. All of the above juicers are wonderful and the key is that you do it — truly at least everyday to see any benefits. You should prioritize what matters to you. Do you care more about easy cleaning? Or more juice output? Would you rather have more fiber or more liquid? Juicing certainly has its negatives. Produce can be expensive. Cleaning the machine everyday is exhausting. Preparing your machine and cleaning your produce throughly is also exhausting. I have been juicing for about a month now and while I can’t speak on the long term benefits, short term I must stay that juicing will continue to be apart of my daily routine. Yes, I have more energy. Yes, I feel better. But you already know about those benefits. The BEST benefit for me has been that the act of juicing, and visiting a farmers market every week has provided me with a consciousness about my health I never had before. The true benefit of juicing is that it will put you on a path to better nutrition.

The Fro Yo Craze

So it seems the number of Frozen Yogurt shops have been multiplying! CUPS, a popular froyo shop in Clifton, is opening up a new location in Secaucus. Love and Yogurt, a brand new entrant into the frozen yogurt market, just opened up their first location in Hoboken and are gearing up to open another in South Orange. Then theirs Lets Yo! which is new in Montclair (they are going for the hipster, techie angle) and of course theirs familiar Red Mango which seems to be also expanding into new locations (one in Hoboken is coming soon!).

CUPS is by far the most fascinating one in this bunch. CUPS consistently has lines around the corner every night. They even have red ropes to keep the line in check. It’s quite a spectacle. Do check them out the next time you’re in Clifton.

According to the Huffington Post:

Between the fall of 2010 and the fall of 2011, the number of retail frozen yogurt shops in this country climbed from 3,624 to 4,765 — a 31 percent spike. According to Tristano, sales reported by frozen dessert shops, in general, have hovered at $6 billion per year, but “consumers have just shifted from ice cream to frozen yogurt.” Frozen yogurt chains, in fact, have experienced some of the highest growth of any of the chains he tracks.


The question becomes, is frozen yogurt here to stay or is it just another fad? We all remember Cold Stone don’t we? Remember how exciting it was to mash an entire brownie into a scoop of ice cream?? Whatever happened to those days? FYI, Cold Stone now offers frozen yogurt.

I did a little bit of research on frozen yogurt franchises. This is quite a high risk business with a big bottom if the craze is indeed just a fad.

So lets examine my absolute favorite frozen yogurt spot: Red Mango.

Initial Investment: Around $360,000 (but could be higher depending the cost of the build-out)

Breakdown of those Costs (estimated by Businessweek.com and franchisedirect.com)

Initial Franchise Fee: $35,000  

Real estate lease: $5,000 to $10,000
Architect, engineer, drawings: $10,000 to $15,000
Permits: $2,500 to $5000
Interior leasehold improvements: $90,000 to $125,000
Signage: $5,000 to $10,000
POS System: $15,000 to $20,000
Equipment and furniture: $60,000 to $70,000
Inventory and uniforms: $3,000 to $5,000
Grand opening advertising: $2,000
Training expenses: $7,500 to $10,000
Lease and security deposits: $5,000 to $10,000
Insurance: $1,000 to $2,000
Legal fees: $2,500
Working capital (three months): $20,000 to $40,000

Other Ongoing Costs:

Royalty Rate6% of Gross Sales.

Advertising Fee: 4% of Gross Sales 

Also factor in training costs for staff, cost of website maintenance, franchise audit costs, and other costs.

You’ll also need: $200,000 liquid assets / $350,000 net worth


So what about Sales, you ask?

In 2010, the average store did $522,580 in gross sales, with the range being $139,036 to $1,315,246. Unfortunately, this is the latest available public data and no further detail is given in terms of the distributions of these sales (so its unclear the frequency of a $522,580 grossing store).

So lets take the data at face value, and say we can expect our Red Mango to gross $525,000. Lets do some quick back of the napkin math. Lets say it takes two years for our Red Mango to achieve average sales. 

Year 1:

Initial Investment: ($360,000)

Sales in Year 1: $250,000

Less Royalty: ($15,000)

Less Advertising: ($10,000)

Operating Expenses: My best guess would be 65% of sales, so ($162,500)

Net Profit in Year 1: $62,000

Net Cash Flow in Year 1: ($297,500)

Year 2:

Sales: $525,000 (Red Mango Average)

Net Profit in Year 2: $131,250 (assuming all the same margins)

Total Cash Flow in Year 2: ($166,250)

Payback period would about be 3.5 years if you could maintain these sales and profit margin levels. The payback period could be even longer if you consider the opportunity costs of keeping $200,000 of your assets liquid.

This type of payback period is quite common in most franchise businesses, but in this example we assume we can ramp up to average sales and then maintain that (big assumption). To put it in perspective, to generate $525,000 in frozen yogurt sales, that would mean you need about 87,500 people coming to your yogurt shop per year!! — assuming each person spends $6.00. That’s 240 people per day. Everyday. That sounds like a lot of people…but I love the fro-yo craze I hope it sticks around for good and I hope more and more entrepreneurs take on the risk! 

Boring Businesses with Lots of Cash Flow

In times like these, I want to park my money in cash flowing tangible assets. Between the insane volatility seen in equity markets between the Greek crisis, JP Morgan and Facebook debacles, I have very little faith that the equity markets can provide me with any sort of size-able returns relative to the risk I would be assuming.

There was a GREAT article in the Economist a few months ago that discussed the shrinking equity risk premia in the United States (one driver of this is the near zero interest rates we have had). Check it out: http://www.economist.com/node/21550273 

So its back to basics, we should do as Buffet does:

If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it’s worth. It doesn’t make any difference whether you sell yo-yo’s, hula hoops, or computers. Because there would be a stream of cash between now and judgment day, and the cash spends the same, no matter where it comes from. Now my job as an investment analyst, or a business analyst, is to figure out where I may have some knowledge, what that stream of cash will be over a period of time

I have spent some time researching three types of business opportunities:

1. The Laundromat

This one is tried and true. There are people that make absolute empires from owning slews of laundromats (or “mats” as people in biz call them). 

Pros:

-This business can be run entirely absentee. 

-Coin-operating mats have the benefit of being all cash businesses.

-There are ways to expand to find alternate revenue streams (introduce wash and fold service, keep vending machines or ATM machines on the premises, etc.)

-A good laundromat can provide about $100,000 in annual revenues. If you can target a 10% profit margin, that’s $10,000 more a year in your pocket for a relatively easily run business. If you can purchase a laundromat as well as the real estate it is operating in, all the better. 

Cons:

-Most mats that are for sale do not have reliable financials, so its up to you to do your own due diligence. This would involve understanding the demographics of a target location, competitors in the area, and locating sound and observable data which allows you to estimate weekly foot traffic.

-Maintenance costs can creep up. Machines have a tendency to break, but this can be mitigated with a solid service contract.

2. The Storage Facility

The demand for storage units is growing, both for individuals who have just run out of space in their residences as well as for small (growing) businesses.

Pros:

-This is a low overhead business and can be run semi-absentee. The largest expenses here are: 1) the cost of financing and 2) the cost of 1 or 2 employees to manage the space. Profit margins in self-storage range from 12%-15%.

Cons:

-Storage units for sale are difficult to find and you’ll likely have to cold-call storage units that interest you and gauge if the owner is willing to sell.

-There is always the risk your storage facility will be under-occupied, but with enough homework, you can make this a low probability outcome.

3. The Landlord 

The rental market is booming, and the cost of home ownership has never been lower.

Pros: 

-You can enjoy a steady stream of high cash flows if you can locate a multi-family (three or four units) home in areas with high rental demand.  The largest cost to you would be the cost of financing. I have heard of real estate investments with up to 30%-40% profit margins (note I’m not speaking in terms of returns, but rather profit margins [Cost of Ownership / Gross Rental Income].)

-Location. Location. Location. There are depressed areas of New Jersey where property values are significantly below market value. If you have a long-term point of view, you may be able to bet on the possibility that the home will appreciate in value and you can realize a size-able return upon exit.

Cons:

-Management is time consuming. I would highly recommend employing a property manager to manage the space. Of course, this would mean the returns on the investment would be lower.

-Real estate is highly localized, and you’ll need someone you trust in your corner guiding you to homes that are 1) under market, 2) have a high rental demand, and 3) have solid re-sale potential.

-Depending on the condition of the home and the quality of the tenants, there could be high costs to maintain the property. Things break in homes all the time. Just layer in a assumption for monthly capex in your analyses.

-The eviction process is expensive. Tenants’ rights are extremely strong in New Jersey and an eviction process can take up to 6 months and numerous court appearances. Background checks on tenants should help hedge this risk, as would locating tenants that have their housing subsidized (so your rental check would be coming from the city instead of the tenant).

The MBA and its Value

I recently completed my MBA at NYU’s Stern School of Business. I am a proud NYU alum, but as a business school student, former entrepreneur, current investor and member of society, I need to ask the question — was my MBA worth it?

There is a great debate as to whether or not the very expensive price tag of a Stern (or another top 10 university) education is worth it. The short answer is, it depends.

The Facts:

1. The most glaring downside of an MBA is the cost of the cache of a top tier university. Tuition, books, events — this is a SIGNIFICANT investment and one that will likely require large student debt. 

2. Executives with MBAs do earn more than their counterparts without one (about 11K a year more), and an MBA is definitely a graduate degree that should provide an instant bump in salary or compensation, which is in contrast to other graduate degrees which don’t allow for this.

3. There are a LOT of MBAs. I mean a lot. My graduating class (Stern Grad students Class of 2012) was about 1,000 students. An MBA does not set you apart and there are a plethora of us and more MBAs are being churned out every year.

4. I consider the MBA what an undergraduate business education was ten years ago. Most corporate jobs will require an MBA. It’s not a plus, it’s not a bonus, it’s a requirement. In order to compete at a level playing field with your counterparts, you need the MBA.

5. Despite point 4 above, you don’t need an MBA to be successful in a corporate environment or entrepreneurial environment. I know plenty of rockstars that are making waves in the world of business armed with just an undergraduate degree. Those are the people that inspire me the most.

The Reality:

1. The experience of earning my MBA was the most invaluable experience of my short life thus far. The people you meet during an MBA program are your network for most of your life. I have met some of the most dearest people throughout my MBA program who also serve as my professional network and I have every intention of keeping them close for many many years. 

2. An MBA will open doors for you. It will open your network to a wide variety of people. You will be presented with opportunities. Ultimately, the work doesn’t end there. You need  the MBA as a way to open the door, but YOU need to step through to the other side — there is no short cut for that. The MBA will get you the coffee meeting with an executive or the interview for a dream job, but the rest of the work is 100% you.

So back to my original question, is an MBA worth it? Well, for some yes and for some no.  An MBA alone won’t do anything — as with with most things, success in life comes right down to personal drive. Speaking from personal experience, NYU shaped my mind and gave me the tools to exploit my current ambition and for that it was well worth it!

Legal Beans: To Buy, or Not to Buy?

So I was inspired by Ankit Duggal and RER’s “Deal of the Week” and decided to create my own version of that right here!

Target:  Legal Beans in Hoboken, NJ: Click here to view the LoopNet listing http://www.loopnet.com/Listing/17301837/86-Garden-Street-Hoboken-NJ/

Description: Restaurant in Hoboken, NJ that caters to the Breakfast, Lunch, Brunch and Take-Out crowds and, from my observation, appears to have good reputation and plenty of customers. 

Purchase Price: $850,000, which includes the real estate (1,200 square feet), all the equipment in the kitchen and the business’ name (at least the Loopnet ad suggests the buyer can keep the name).

Sales/Operating Profit? This one we don’t get, which is too bad. As investors we are faced with imperfect information all the time, so we can make some inferences, do some back-of-the-envelope math, and determine if we want to explore the opportunity further.

Back of the Envelope Math:
Industry Standard: Full-Service restaurants sell for 30% Annual Sales plus inventory. Our purchase price has the price of the real estate embedded into it though. The listing suggests the real estate is worth $799,000. Feels overpriced. Comp data points to the real estate being worth closer to $600,000 or $650,000

Cost of the Restaurant: $850,000 minus $650,000 = $200,000

Estimated Sales: $200,000/30% = $666,667 per year.

Estimating Operating Profits: $666,667 * 3.0% = $20,000 per year.  (Industry standard suggests operating margins are typically between 3.0% and 3.5%) 

Estimated Financing Costs: If we put down 30% ($255,000), which is standard in commercial loans, we would need to finance $595,000. Using an interest rate of 7%, our estimated mortgage payments would be about $4,000 per month. We still need to account for taxes and insurance though. I assume my operating margin above includes this expense, since that 3.0% margin assumes the cost of leasing the space.

Let’s also assume we can also finance our down payment via a SBA loan, but we need to put down 10% of THAT amount, which would be $255,000 * 10% = $25,500

Estimated Value of Real Estate: This is probably the hardest one to figure out, and you might want to call the guys are RER to help out with this step, but for this exercise, lets assume the value of the real estate grows at 15% per year.

So what is our ROI in 7 years?

Upfront cost: $25,500

Present Value of Annual Profits: $102,000 (assuming a discount rate of 10%)

Present Value of Real Estate (which we assume is worth $650K at period 1): $810,000

Return on Investment: 102,000 + 810,000 - 650,000 = 262,000 

Annualized ROI = (262,000 / 25,000) ^ (1/7 years) - 1 = 40%. Not bad.

Thoughts and Conclusions: There are many flaws in the above math. We have not factored in the likelihood we will need to invest in considerable capex within the 7 year horizon. We have also ignored the start-up costs associated with assuming the operation. Our data is highly suspect, and we have not included the cost to insure the business, property taxes, etc etc. Our discount rate is too conservative as well (and should reflect the opportunity cost of our capital as well as the risk of the venture). We have also highly OVERSIMPLIFIED the calculation of our real estate investment.

Ultimately, more information would be needed for a better analysis. Also, the ability to finance this investment with a commercial loan and a SBA loan is KEY to making this deal worth it. Without the financing, we walk.

Disclaimer: The above post is 100% MY opinion and should not be interpreted as investment advice. 

The most beautiful thing we can experience is the mysterious. It is the source of all true art and all science. He to whom this emotion is a stranger, who can no longer pause to wonder and stand rapt in awe, is as good as dead: his eyes are closed.

Albert Einstein

Be a good listener.

Never had I seen such concentrated attention. There was none of that piercing ‘soul penetrating gaze’ business. His eyes were mild and genial. His voice was low and kind. His gestures were few. But the attention he gave me, his appreciation of what I said, even when I said it badly, was extraordinary. You’ve no idea what it meant to be listened to like that.

I re-read “How to Win Friends and Influence People” — absolutely one my favorite books. I always seem to grab a new lesson that resonates deeply with me every time I pick up this book. Dale Carnegie, for those who don’t know, was an american writer and lecturer. His book "How to Win Friends and Influence People", written in 1936, is still one of the most popular books specific to business communication in print. 

Listening skills are KEY to building relationships with anyone. Dale says we should encourage others to speak and we should listen to them intently and sincerely. Everyone wants to be heard and heard with enthusiasm! And according to Dale, there is no better way to be a GREAT conversationalist then to get the other person talking.

But how can you engage someone to point where they will start talking (and talking and talking)? Find out what matters to the other party. It could be their occupation, their love-life, their children — and once you find that hot topic, just sit back and listen.