How Alternative Investments Can Go Wrong for Average Investors

(Illustration by Matt Williams)

The writer is the founder and former CEO and chairman of RWA Wealth Partners, a registered investment advisor. His comments and opinions are his own.

Lots of financial advisors and pundits are throwing their two cents into the debate about private investments and their coming role in millions of investors’ portfolios and retirement accounts.

But given their unabashed cheerleading, I’m betting that most have little to no personal experience investing in the private sector. By contrast, I have put my money in dozens of private deals—and I have the profits, the losses, and the K-1s to prove it. After decades of managing money for countless others as the founder and former chairman of an $18 billion-asset wealth management firm, I can count on fewer than 10 fingers the number of people I think would be able to stomach the ride I’ve been on.

Private equity, venture capital, private debt, real estate investment trusts, and their deformed spawn are the current rage, in large measure because the gates are opening for smaller investors. At the same time, the thrill seems to be gone for many institutional investors who have had their fill of these illiquid, opaque, and often poorly performing alternatives to equities, bonds, mutual funds, and exchange-traded funds.

Even the institutional leader in the alternatives investing arena, Yale Investments, is selling. Under the direction of David Swensen in the mid-’80s, Yale plowed a good chunk of its endowment into “privates.” It earned stellar returns. Alternative investments became a must-have for universities and pension funds.

But today, Yale’s $41.4 billion endowment is selling almost $3 billion of its alternative stakes. That is 7% of its portfolio and probably an even higher percentage of its alternatives’ value. Yale is putting a positive spin on the sale. But others have suggested that it reflects a belief that private equity and its ilk have seen their best days.

Here’s the thing: While the discussion around making alternative investments available to the little guy—something proponents call “democratizing”—is in the news, little is said about the risks that mom-and-pop investors could face.

Let me give you a front-row seat on how these investments work in the real world.

First, private debt. The reality is that some of the investments I’ve made, despite big promises and quality teams behind them, didn’t pay me back for many, many years. One private-debt group that I thought had a smart and proprietary loan structure estimated it could generate a 30% internal rate of return, or IRR, and deliver a two-to-three times cash-on-cash return over six years, with invested cash returned by the end of year three.

More than three years in, we had received only 65% of our capital back. Ten years on, the general partners said that we had earned a cash-on-cash multiple of less than two times and a net IRR of 14.3%, and that they were establishing a liquidating trust to hold a handful of remaining investments that may never pay out.

Venture capital? I’ve been lucky, and I’ve been unlucky. The unlucky investments went to zero—full stop. Others were better. One in particular is up more than 70 times since I invested eight years ago. (Before you get too excited, the same group that got me involved in that investment also got me into two others that returned zero.)

I used to say that no advisors were worth their salt if they didn’t eat their own cooking. I took that to heart when I got into the restaurant game. It’s an old saying that most restaurant investors are happy if they get a return of their money and ecstatic if they see a return on their money. I’ve experienced both. The pizza was tasty, and the shrimps a la plancha were marvelous, but the greatest return I got was supporting some incredible entrepreneurs, regardless of whether they made me a profit.

With all of these private investments, the bad ones went bad fast or just meandered. The good ones took much longer to come to fruition than expected. Over the course of each, the amount of information I received ranged from detailed quarterly accountings to one-page letters and sometimes nothing but a K-1 at tax time. I still have money tied up in private companies I barely hear from. Whether I will ever see a dime back is an open question.

As far as my returns go, my winners have more than outpaced my losers. But taxes have also taken their toll. I still have lots of money riding on my “alternatives,” and if some of them hit home runs I’ll be thrilled. But if most of them end up so-so, I might have been better off sticking with good old mutual funds and ETFs.

If you think that I have simply had some bad luck and the “experts” will somehow do better, I’ve got a bridge available. The thing is, you won’t know where the pros went wrong until the numbers are produced years down the road.

The pundits who say that investors will improve their returns and reduce their risks by adding alternatives to their portfolios are working with numbers that I believe are highly suspect and have no basis in the reality that most investors face.

If anything is true, it’s that illiquidity and opacity are big risks you face with private investments. The biggest risk, however, is that your retirement suffers as a result. That’s a surety you can take to the bank.

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