How To Be A Great Passive Investor

“Every battle is won before it’s ever fought.” – Sun Tzu

Michael Jordan is considered the greatest basketball player of all time with skills and abilities rarely seen in the NBA before or since his time on the court.

Everyone remembers the year he won the slam dunk contest when he took off from the free-throw line to glide gracefully through the air to slam the ball home to beat Dominique Wilkins and bring home the crown.

Michael Jordan was athletic but his six world championships with the Chicago Bulls didn’t come from pure athleticism. According to Tim Grover, Michael Jordan’s long-time trainer when he was with the Bulls, Jordan’s key to success was a laser-like focus and maniacal preparation.

It was everything he did before playing in the actual game that contributed to his success. Whether he was practicing with the team or working out on his own, his “Airness” only thought about improving on the hardwood.

“Michael would shut down everything outside of basketball and just train,” Grover explained in a recent interview with Basketball Network. “Three workouts a day: workout, golf break, workout, lunch, golf break, workout, dinner, bed. Every day. No commercial shoots, no promotional tours, no events. Just work.”

As in war and sports, so it is in the world of passive investing.

Becoming a great passive investor takes preparation. It takes doing all things leading up to turning your money over that will determine your success. It takes commitment and diligence just like in sports.

Central to passive investing is relying on someone else to shepherd your money.

So the key to becoming a great passive investor is choosing the right stewards, in the right markets, investing in the right assets that align with your own investment goals. The loftier your goals, the more you should demand of the promoters of a passive investment fund.

You often hear the most successful athletes talking about success starting from the person in the mirror.

It’s no different with passive investing. You need to establish clear objectives for what you’re trying to accomplish.

STEP 1 – What is Your Objective.
For finding your motivation for passive investing, ask yourself the following questions:

  • Are you dissatisfied with Wall Street? Is that why you’re exploring passive investments? What is it about Wall Street investments that are not meeting your expectations?
  • Are you more interested in security and capital preservation or are you more interested in building wealth?
  • Are you looking for an income stream?
  • Are you looking for appreciation?
  • What is your investment window? Long? Short?
  • What is your risk tolerance?
  • What type of returns are you seeking?

STEP 2 – Know How to Screen Deals.
Passive investment funds offer a variety of strategies, goals, compensation, and business structures to meet the needs of a variety of investors so it’s important for you to have a clear understanding of your own goals, objectives, and strategies to make sure they align with those of the fund.

If you seeking a cash-flowing business, but have a low-risk tolerance with a short investment window, a technology startup or commercial real estate fund are probably not good matches.

Picking the right fund requires asking the right questions like the following:

What is the experience and track record of management?
Because private investments are passive and investors will have no hand in management, the most vital step in the whole process is scrutinizing the managers, their experience, and track record.

Do they have the requisite experience and knowledge in the industry, geographic market, and asset class of the central business that they’re raising money for? Or is this their first rodeo for everything? In other words, is the particular business in the manager’s “wheelhouse”?

Be leery of managers undertaking a business they don’t have any experience with.

What’s the Expected Rate of Return?
Investors are in the game to make money. Analyzing the potential return on investment (ROI) is essential to weigh the capital commitment and opportunity cost against the potential benefits.

When estimating returns, be mindful of any fees or costs associated with the investment as any management fees or business expenses may diminish any expected returns.

Is there a defined exit strategy?
An open-ended investment is a sign of a lack of vision and a plan for executing that vision on behalf of the fund’s managers. Having a clear exit strategy is essential for investors to know when they can expect a withdrawal of their initial investment, along with any associated profits.

Are there adequate disclosures in the offering documents?
You’d be surprised at how many promoters there are out there soliciting capital without a formal offering document like a private placement memorandum (PPM).

The SEC says the lack of a PPM is one of the top 10 red flags that you’re being scammed. First of all, are the documents competently written? Does it have typos? Does it have false information? Is it coherent? If the documents don’t even pass this initial smell test, it’s time to move to the next opportunity.

If they pass the smell test, do the offering documents provide adequate disclosures for you to gain a sense of the company’s strategy, business plan, and the likelihood of success? Is there enough information about the company’s proposed business and adequate discussion about the industry and market trends to indicate management’s competency?

In other words, do they know what they’re talking about? Is there enough information to be able to see through the smoke and mirrors and weigh the facts presented objectively?

Do the Financials Make Sense?
The Projected Use of Funds and Financial Statements section of the PPM outlines in a spreadsheet or table format the company’s projected sources and uses of funds.

In terms of sources, is the company relying on other funding sources like debt for its acquisitions? Are the projected sources and uses detailed and outlined or are they vague? What is the compensation for management like? Is it excessive?

Included with most PPMs are pro forma financial statements showing the fund’s projected income for at least 3-5 years and sometimes longer. The failure by a fund to provide financial statements or coherent ones should be a red flag.

When evaluating these pro forma statements, make sure the revenue projections are realistic and not overinflated and that the expense projections are not overly conservative.

If there’s a leap in projected net income from one year to another, are these projections based on sound economic principles, or are they based on speculative factors? Beware of overpromising by the manager.

What are the risks?
Nobody wants to think about their investment tanking but it’s better to know the risks beforehand than to lose all your money. What are the market risks? Industry risks? Company risks? Management risks? Legal risks? Regulatory risks? Does management have any processes or steps for mitigating these risks? What is the worst-case scenario? Do the investors have any security or priority to funds in a liquidation?

STEP 3 – Due Diligence.
Meeting management and receiving the PPM isn’t the end of the road. Don’t turn over your money just yet. Now, you have to do the homework. The due diligence phase is the opportunity for a prospective investor to analyze the deal with a fine-tooth comb, run the numbers, scrutinize management, and to ask any relevant questions.

Most managers are accessible and are happy to answer questions about the offering, company, and management themselves during this phase.

Passive investments give investors tremendous opportunities to participate in potentially lucrative ventures uncorrelated to Wall Street. However, not all opportunities are created equal and investors should be mindful not to get suckered into just any deal. To become a great passive investor requires a ton of behind the scenes work and going the extra mile.

Here is some parting advice:

  • Commit. The lucrative world of private investments are not for the weak or flaky who are quick to change their mind. Most funds will require a commitment to a long-term vision of the management and investment windows of 5 to 7 years. Are you up to the task? If you like to jump from one investment to another .. this isn’t for you.
  • Communicate. Management should communicate with you regularly so be sure you stay in touch from your side. Discuss with management any issue or problems you have.
  • Be HumbleDon’t expect to know everything about everything. Trust the experts in their fields. If they know what they’re talking about then it’s time to step back and let them get to work.

To avoid bad deals, ask the right questions, and do your due diligence.

The more you do it the better you’ll get at analyzing deals and recognizing red flags.

All of this preparation and diligence will help you avoid bad investments and will lead you to become a great passive investor.

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