David from Seattle asks. Within the realm of private placements, how should investors think about investing in a fund vs in a project? Funds pool money and share the risk across multiples projects. However, funds further separate investors from the actual assets and deals. For example, a passive investor can’t choose which individual project the fund may take on down the road, and it may be overburdensome for the investor to review the financial details of each project, if the fund shares those information at all. Given these complexities and layers of abstraction in a fund, it seems to me that one should generally only invest in funds managed by people they are most comfortable with (such as by seeing them perform in a single project before). Would love to hear your thought on this.
David, this is a great question. It’s one that we grapple with ourselves.
There can be multiple reasons to form a fund. One idea is diversification. The second is scale. Both could bring you greater safety.
Diversification would span multiple asset classes and multiple geographies. I believe that sophisticated investors don’t want a fund manager to manage their diversification for them. It becomes incredibly difficult to figure out how a fund is going to perform if its diversified. An exchange traded fund is an example of a fund that embraces diversification. By tracking the S&P 500 index, you are by definition embracing diversity. You have zero ability to perform due diligence on the underlying assets. They’re all in the fund whether you like it or not. Not only that, they’ve put the whole thing in a blender and made a pureed soup out of it. I do not embrace this approach.
I believe that investors want a fund manager to be the best at what they’re good at within a narrow field of specialty. You still want your fund to be resilient. If you’re in a medical office building fund, you only want medical office buildings, and you want them to follow a proven formula. If you’re in a self storage fund, then you want only self storage and you want that fund to invest in a manner that follows a proven formula. The resilience can come from scale. A single family home as a rental property is less resilient than a multi-family apartment building. If you have a vacancy in the home, you go from 100% occupancy to 100% vacancy in an instant. If you’re in a 100 unit building, then a single vacancy produces a very manageable 1% vacancy. There is resilience in scale.
A lot of investors who invest in funds believe that you should not invest in fund #1 with a company. They would rather you invest in fund 2, 3 or 4. That creates a startup problem. Rather than starting with a brand new fund from a blank sheet of paper, we’re considering forming the fund out of existing investments in the portfolio. The fund unit holders would come largely from the existing investors in individual projects. The advantage for investors in this scenario is to create a bit of diversification compared with just a single project. Even if you design all of your projects to offer a similar rate of return, there will be variation. A fund helps bring greater scale and more stability to the overall financial picture.
From the sponsor’s perspective, a fund can be beneficial because it puts the resources at your fingertips to go and get some great deals. There’s no delay in raising funds for a project. The downside is that the fund comes with an expectation of a rate of return. If you are holding onto money that hasn’t been put to work yet, it is earning zero, and the investors still have an expectation of a rate of return. Funds that are too large run into the problem of having to deploy funds simply to put the money to work.
I believe the same criteria should apply when you consider investing in a fund versus a single project. A fund is more difficult to evaluate.