For this therapy session, we are going to talk about (what I mean by) “private equity”.
Over the past few years, a number of people have reached out to me for advice about a very particular predicament: “I have a lot of cash to invest, but the markets seem frothy. I don’t know what to do with my money.” When I hear this, I usually reply, “Have you considered donating it to charity?”
Neutered by progress
Back in the olden days, our ancestors lived nearly self-sufficient lives. People grew their own crops, sewed their own clothes, built and maintained their own houses, and sold what little they could in tiny general stores run out of their own homes. Back then, it wasn’t uncommon for people to work numerous side gigs on top of their primary professions because you had to learn new skills in order to survive when the going got rough. As a result of this, people of centuries past possessed much wider skillsets than we do now.
Modern society encourages people to pick one trade and master it. But that tactic only works in an intricate, carefully-engineered economy that can afford specialization. When the next recession hits, those of us who only know how to do one job are liable to find ourselves out of work and unable to replace our regular incomes.
So what does this have to do with private equity?
When we hear the phrase “private equity” (PE), we tend to think of large fund managers who buy a company, lay everyone off — err, “right-size” the company — invest in the company’s operations, and then sell the company (now loaded with debt) for a tidy sum.
I would like to redefine private equity as your ability to invest either your time and/or money into the real economy to earn cash or equity
. A few examples that come to mind are providing a business partner with capital to start a business
, building your own freelancing operation, investing money in a real estate deal to fix a property that can lead to increased rent yield, or investing in a startup that will use this capital to hire people, build IP, and hopefully turn a profit. Basically, you are making investments in the real economy, as opposed to “paper assets.”
What’s this real economy you speak of?
Back in college, my economics professor hammered the difference between capital investment and speculation into my head. He described how taking part in capital investment entails buying machinery and land and hiring people to produce goods and services that you can use to turn a profit. By this measure, you are taking part in capital investment whenever you partner with others to open a restaurant, set up a website to build your freelancing business, or purchase items to resell at your local flea market.
When you speculate, however, you are essentially trading pieces of paper that have claims on assets in the hope that you’ll be able to sell them for a higher price to other speculators down the road (the “greater fool” theory
). You’re speculating when you buy index funds, stocks, bonds, gold, etc. A balanced portfolio has the aforementioned assets and a component of “private equity.”
Put another way, the difference between capital investment and speculation is that capital investing sparks real economic activity, whereas speculation can promote movement in the financial economy.
What happens when the real economy is at full strength?
The real economy and the financial economy tend to diverge over time. The real economy generates profit that the financial economy uses to speculate, and in turn, the financial economy sometimes invests money back into the real economy (think venture capital and loans). Eventually, the real economy will begin to do so well that an unsustainable amount of capital will be pumped into the financial economy, and people will continue to bid up prices on speculative assets to the point that their valuations will reach near-perfection
. With the financial economy in such an alluring condition, some individuals who lack the ability to invest in the real economy will instead turn their prospects toward the financial economy and pump even more money into it
. So long as another speculator is willing to bail them out, they will be okay. But we all know that this cycle is unsustainable, and soon enough, prices will retreat.
Typically, the best time to invest in the financial economy is when it has already gotten ahead of itself and collapsed
. The old saying “the rich get richer” is based in part on the fact that the wealthy have real economy investments and are able to plow that money into the financial economy once they can buy assets for pennies on the dollar. A great example of this is when Warren Buffett bought dicounted shares of Bank of America and Goldman Sachs during the depths of the recession.
So why should I care about private equity?
When you don’t have private equity and the markets are priced for perfection, you can either choose:
Option 1: Buy more secondary market assets in the hope they go higher; or,
Option 2: Sit on cash and suffer inflation.
But when you have private equity, you have a third option:
Option 3: Funnel your money into the real economy and generate cash flow from the strength of the market.
Why don’t people develop private equity?
There are a lot of reasons why people don’t develop private equity.
It could be due to the following:
- They’ve never tried.
- They’re too busy or tired.
- They’ve gotten to the point in their career when starting to build private equity wouldn’t be worth their time.
- Or they’ve convinced themselves that the market knows all and their efforts in private equity will be in vain.
You can choose not to invest your time in private equity and that’s perfectly fine, but you have to be willing to limit your investment opportunities between option 1 or 2.
Private equity takes time to develop
Some investors might have fiddled with private equity before but found that the amount of cash they made from it was infinitesimally small compared to their other sources of income. If you let this deter you, then you’ve made a mistake! When you first start experimenting with private equity, you need to give it time to blossom and mature. Some private equity endeavors may fail, but what you will learn from those ventures will provide you with vital skills that will help you with your career and other investments.
The key is to start investing private equity early in your career so that you can build an operation that will grow with your net worth and adequately handle the incoming cash flows from your job and other investments.
Until our next therapy session,
P.S. - Don’t forget to share this letter with a friend :)