Don’t Fall For Investment Scams – Part 2: Passive Investments

Co-produced with Philip Mause

Part One of this series dealt with bank deposits, brokerage accounts, and insurance company products – which we shall call the “Big Three”. These investments can be viewed as relative “safe harbors”. However, there are all sorts of ways in which investors can experience loss in these three – especially when inflation is considered.

This Part Two will deal with other passive investments – this means investments that generally do not depend on continued work by the investor (those shall be dealt with in Part Three – “Business Opportunities”).

In this Part, we shall examine investments that promise to provide passive cash flow of some sort as opposed to collectibles and other “investments” dependent entirely on the prospect of selling to another buyer (they shall be dealt with in Part Four).

At the outset, it should be noted that there is an almost infinite variety of investments in this category, and there is no way that we can cover them all. Instead, some general principles will be presented, and some typical investments will be examined.

The Five Questions

Because passive investments often look and feel like publicly traded stocks and bonds, investors often approach them using the same tools of analysis and neglect important intermediate steps. In assessing non-publicly traded passive investments, investors must take care to answer four key questions:

1. The first question is, “who is the sponsor/manager?”. This is vitally important because the honesty and competence of the sponsor is a key issue in determining whether one can believe various representations that are being made and whether the plan will be executed as described and without embezzlement or self-dealing. Investors should take extra care if the sponsor is someone who is not previously known to the investor (e.g., a cold caller, etc.). Even if the sponsor is known to the investor, investors should be aware that there have been all sorts of horrible frauds involving affinity groups, church members, and even family members. The most successful fraudsters are experts at building trust and close relationships.
2. The second question is also very important. “Exactly where is my money going?” If a check or wire transfer is going into an account somewhere, the investor should be very clear on whose account it is. One ingenious fraud occurred in the 1980’s when tax shelters were popular. The fraudster sent out a very well-structured brochure with supporting opinions by top law firms and accounting firms. It was all very convincing. In fact, it was identical to the materials sent out in connection with a perfectly legitimate tax shelter program sponsored by a large and reputable brokerage. The fraudster changed only one thing – the address and name of the recipient for deposit checks. It actually took several years for this to be discovered because tax shelter investors did not typically receive any distributions for the first five years or so. Be extremely skeptical of any “investment” that uses some kind of intermediary to handle the money.
3. The third question is, “Exactly how does the deal work for me?” An investor should have a very clear understanding of the terms of the deal. Frequently, real estate partnerships provide passive investors with a “preferred return” in the form of an assurance that they will get their investment back and, in addition, receive a preferred return of, say, 7% from the time their money goes in before the sponsor takes his share of additional profits. Hedge funds have had a “2 and 20” (2% management fee and 20% of profits) structure. Whatever the structure is, an investor should be sure that he understands it and that the documents he signs reflect it accurately.
4. The fourth question concerns the merits of the investment plan. How exactly will the investment make money for the investor? If it is a business, what is the business plan, and what is the exit strategy? It is often the case that small businesses raise money from investors solely to enable them to continue to operate at a loss for a longer period of time. For this reason, it often makes sense for an initial investment to be in the form of debt combined with an “equity kicker” in the form of warrants. This gives the investor leverage to get his money back and a better position if the firm goes bankrupt. One investor has said that “I don’t like to start with equity” which implies that, although he will start with debt, he often winds up with equity.

There is another fifth question that shouldn’t be overlooked. It is: “what is the exit process for the individual investor and for the investment vehicle?” This includes the question of whether the investor’s interest is transferable in a secondary market, whether and under what terms it can be tendered back to the sponsor, what term is expected for the investment, etc. This can be an important issue. If there is a secondary market, an investor should examine the performance of this market and try to determine whether he is better off by buying into the secondary market.

Investors should consult with trusted attorneys and accountants in considering significant investments outside the Big Three. They should do research online and use research tools to determine exactly who they are dealing with. As a general rule, investors should be reluctant to enter into any investments with a sponsor unless they have first-hand knowledge of that sponsor.

Ponzis

In the current relatively moderate interest rate environment, investors should be especially careful of Ponzi schemes. Named after a notorious fraudster in the early 20th century, a Ponzi scheme essentially uses money from new investors to pay interest and/or principal to existing investors.

There are two basic kinds of Ponzis. The first is a pure or naked Ponzi. This is a scheme in which incoming funds are simply placed in a bank account, and no investment activity actually takes place. The multi-billion dollar Madoff Ponzi took this form after starting out as a kind of hedge fund. This Ponzi has significant advantages from the point of view of the operator. He can describe his investment activities with complete freedom – tailoring his description to the current market. He can say he is investing in real estate, stocks, collectibles, futures contracts, etc. and then describe how he is making consistent profits without any constraint grounded in reality. He mails out account statements showing huge and consistent gains and receives a steady stream of new investment dollars to pay off old investors who choose to cash out. He can give investors assurances of security which are backed up by a history of reliable payments. The end usually comes suddenly as the notional value of accounts enormously exceeds funds on hand, leading to payment delays and a mad rush for the exit.

In the “hybrid” Ponzi, the sponsor actually invests some of the funds in real estate, securities, operating businesses, or other assets. He overstates his performance and provides payments or account statements which grossly exaggerate actual results. New investors pile on based on “performance history” and assurances of reliability based on actual payments to investors.

Sometimes hybrid Ponzis start with honest sponsors who experience bad investment results and decide that they cannot break the bad news to investors but will send out false statements instead. This may actually be the way Bernie Madoff got started. The gap between notional performance, as reflected in periodic statements issued to investors, and actual performance grows over time and leads to the same ending that ensues with pure Ponzis.

In the current low, relatively moderate rate environment, investors should do a thought experiment. Think of what would be an ideal investment in this atmosphere. Whatever that is, it will probably appear in the form of a Ponzi scheme because Ponzi schemes are designed to appeal to whatever investors are seeking at a particular time.

Owned Real Estate

Investors can, of course, choose to simply buy an income-generating piece of real estate – a single-family home or condo, a small commercial building, etc. This has advantages and disadvantages. The advantages are that investors generally do not have to worry about considerations 1-3 above. The American system of title recording generally ensures that an investor buying real estate directly with a competent closing attorney will actually receive what he thinks he is buying.

Even if the seller is a scoundrel, the investor is generally protected if the title is good. Added protection can be had if financing is obtained because then the bank will perform due diligence. The property can be appraised, and the building can be examined by an expert.

Of course, it is always possible to pay “too much”, but these safeguards tend to limit that risk. An investor obtaining fee simple title does not have to worry about “deal terms” – he simply becomes the owner. Another very big advantage is that, in the early years, cash flow may be sheltered because taxable income is usually less than cash flow due to depreciation. As the year’s pass, there may also be the opportunity to extract tax-free funds through a refinancing if the property appreciates in value.

The disadvantages fall into several categories. Without a management company, the investment is not really “passive” but instead requires marketing and management effort by the owner. For many investors, the minimum size of a real estate investment is a large part of their portfolio, putting them at unacceptable risk if something goes wrong. Real estate also frequently requires unpredictable follow-on investment in terms of repairs and renovations. Finally, an owner who does not set up a limited liability entity through which to own a property is theoretically liable for damages in the event of loss or damage to tenants.

Adding it all up, the actual direct purchase of real estate by an investor with a large enough portfolio to shoulder the risk and with a knowledge of local neighborhoods, trends and valuations can be a very attractive portfolio strategy.

However, for those who don’t want to put in the legwork, don’t have any experience in real estate, or want to gain exposure to real estate portfolios that are larger than they could afford on their own, investing with a group sounds like a very appealing option.

Limited Partnerships

At the outset, it must be noted that we are not covering publicly traded limited partnerships here. Limited partnerships are often used to acquire real estate or operating businesses. The “limited” feature limits the liability of the passive investors if the deal is properly structured. Another advantage is that through either a number of these deals or one deal covering several properties, an investor can gain exposure to a real estate market without having to advance the relatively large sum needed to buy a property outright.

A typical structure provides the sponsor with a management fee and a share of the profits after the passive investors get their funds back with a preferred return. In many cases, the sponsor itself invests “side by side” with the passive investors by buying a limited partnership interest. Compared with a REIT, the investor may get superior tax treatment by participating in depreciation. On the other hand, the investor cannot sell his shares on the open market unless the terms of the deal permit it, and even then, there is not likely to be a liquid aftermarket for this type of investment.

The merits of these deals depend heavily on the quality of the sponsor/manager and the nature of the assets or business buying acquired. Once again, due diligence is necessary. Limited Partnerships can fail due to incompetence, poor execution, or bad luck, even with honest sponsors/managers.

Crowd Funding, Peer to Peer Lending, etc.

There is nothing magic about the internet or electronic investments. The same five questions listed above have to be addressed. In some cases, insight can be gained if the sponsor or some other entity involved in the deal is a publicly traded company. In this case, the SEC filings of that entity can be examined to get a better picture of exactly what is going on.

One issue we have seen lately is the question of periodic valuations of investor interests combined with performance claims. If the assets are real estate, the question that must be asked is, “how are the real estate interests being appraised each quarter, and how reliable is that methodology?” You can hire two professional appraisers and get different opinions of value on the same real estate. That’s why real estate appraisers call their results “opinions”.

It is also important to determine whether investors are getting a true real estate interest (a partnership in an entity that owns real estate) or an investment contract with the sponsor. This could make a material difference when things go wrong, and it is something many don’t find out until the deal fails.

Peer-to-peer lending includes the risk of default, and it is important to diversify one’s exposure and to carefully examine past performance. On the other hand, credit markets have been difficult to project as there are periodic waves of default in various sectors that can be devastating. In the big picture, default spikes rarely occur but are sudden and significant. As a result, investments that were reliable for a decade plus could suddenly become large losers.

Investments in Small Companies

There are various ways to invest in start-ups and other small companies. In general, it is important to have an exit handle so that one is not left tied up in a slow boat to nowhere. One way to achieve this is for the investment to be in the form of a debt instrument with an equity kicker or a conversion feature. This way, the investor can exert pressure to exit if the company does not appear to be on track to go public or otherwise mature into a liquid asset. The conversion feature allows the investor to have the best of both worlds by permitting him to profit if all goes well and the company is a bonanza. All of the five rules listed above should be followed with these investments.

Starting up a business isn’t easy, and even among start-ups that have a venture capital deal, approximately 75% of them fail. When I watch “Shark Tank” on TV, I amuse myself by googling the business after a deal is struck to see if it appears successful. While the show loves to tout its successes, many of the companies that struck a deal go nowhere as the contract never made it through the due diligence stage, or the Shark decided it was better to eat the loss after becoming involved.

If you are in the fortunate position to be an “Angel Investor” (or a Shark!), it can be a very personally rewarding endeavor. But from a return standpoint, understand that for every success you have, there will be half a dozen or more failures. Deciding on when to back up a business that just needs a little more and when to pull the plug on a doomed business will make a huge difference to your profitability. This can become very complicated by emotion, as it is easy to become emotionally involved, and personal relationships can be damaged by the harsh realities of business.

Oil and Gas Drilling Deals

Investors are often solicited to invest in oil and gas drilling deals. This activity generally peaks just at about the time that oil prices peak, and stories abound about people making a fortune in oil and gas. These deals can be legitimate and can work out well. However, unless an investor knows something about the sector and also has reliable information about the sponsor, great care is in order. There is a tendency for money to go into these deals at the worst possible time when drilling is expensive, and prices are at their peak. By the time the oil is pumped, prices are often much lower, and the deal can sour.

One More Thing

The school of hard knocks teaches us several important lessons. The first is to ask the five questions above. The second is to be very cautious about investments that “find you” through some aggressive solicitation effort. Preference should be given to investments that “you find” rather than investments that “find you.”

Another thought about “cold calls”, email solicitations, and advertised investment opportunities: It is always possible that one will find a real gem this way, but it is more likely that these channels will lead to loss.

The reason is that products are pushed based on a perception of the public mood. By the time the public is in the “mood” to buy an asset class at the drop of a hat, the easy money has already been made, and an investment will likely turn out badly. There is a serious argument that “cold calls” are actually a powerful contrarian indicator – for example, cold calls selling gold often coincide with peaks in gold prices. One of my very close friends actually received a cold call from a broker seeking to have him open an account with a short position premised on the notion that the market “had” to keep going down. The call came in early March 2009 – one of the best times to go long in the market (and worst times to go short) in the past century. Additionally, fraudsters will always be aware of what is hot right now and will tailor their scams to take advantage of what is really popular right now.

Taking the various problems with these types of investments into account, it is almost always more prudent to simply invest in reliable dividend stocks which produce both a nice stream of cash flow as well as (in at least some cases) the potential for price appreciation.

As pointed out in the first article in this series, the public stock market in the United States is regulated and requires levels of disclosure that investors will typically not be able to obtain with respect to these alternate investments. This disclosure does not eliminate all risks, and there is still the potential for price decline as well as (in unusual cases) misrepresentation of the facts. However, in the U.S. stock market, the presence of active and aggressive regulation minimizes the risk that an investor will be blindsided by a risk due to a blatant misrepresentation of a material fact.

If you do decide to get involved in these alternative investments, make sure you are putting extra effort into your due diligence and following up with your investment. If you don’t understand it, that is a huge risk. With any investment, make sure the amount you have invested is an amount you could lose 100% of without a materially negative impact on your life.

At High Dividend Opportunities, we like to focus on publicly traded high-dividend stocks that are liquid and provide a high and recurrent income for investors through a model portfolio yielding +9%. A diversified portfolio of high-dividend stocks can provide you with a large yield and help investors get recurrent income whether the markets are up or down. Importantly, they have great liquidity that investors can sell in case it’s needed, and they are regulated by the SEC.

If you liked this article, stay tuned for the 3rd part of the series.