How to Think About Illiquid Investments
Today, he is writing about illiquid investments, a common type of investment among physicians. The screen is yours, Dave.
How to Think About Illiquid Investments
By Dave Denniston, CFA
Today, we are focusing on one of them.
In this guest post on PhysicianOnFire, we’re going to be tackling deadly sin number six- investing in weird, illiquid investments.
What are illiquid investments? They are those things that you can’t sell easily. You may have to hold onto them forever and ever and ever. They aren’t stocks, bonds, mutual funds, or ETFs that you can sell and get all your money in trade plus 3 business days.
Common examples include:
- Surgery Centers
- Imaging Centers
- Online Businesses
- Oil & Gas
- Equipment Leasing
- Residential Real Estate
- Commercial Real Estate
- Raw Land
- And so on and so forth
In my opinion, this is where many physicians get screwed over. Literally losing hundreds of thousands, and in some cases, millions of dollars. You can also learn about my rocky experiences with illiquid investments and Why I Can’t Retire by 45. (Hint: It involves a seven figure investment and some very painful lessons)
On the other hand, illiquid investments are where many physicians make out like bandits and multiply their wealth many times over- like PhysicianOnFire and what I admire about him.
Which of these investments are good and which ones are bad?
What’s the difference between the illiquid investment that generate wealth and those that lose fortunes? How can you tell the difference?
I want you to imagine that I brought with me a science experiment here today. Imagine that I have in front of me a beautiful bouquet of red roses. Those lush red roses look gorgeous and are in full bloom. Don’t they smell lovely?
Alternatively, you could find a beautiful vase and put it in some water and food to keep them lush and beautiful. Perhaps you could choose to plant more roses — a whole garden. You have many choices, right?
Let’s do an experiment, shall we? Imagine that on my right hand side- I have a tank of liquid nitrogen. A nice, big fat metallic tank.
Take a deep smell of that rose. Take it all in. Smells great, right?
Now, with the right protection and long pair of tongs, I’d like you to dip it into the tank of liquid nitrogen.
Feel that cold… brrrr! Now, pull it out now.
Dead, solid frozen.
Let me ask you a question… do you think this rose is going to be able to grow anymore? No, absolutely not.
What happens if you drop it? It shatters into a million pieces.
This is what happens my friends to many physicians with money. They go and they have this beautiful rose of their savings and then they go and invest in something that freezes it up in a weird illiquid investment.
Rich Dad, Poor Dad or Poor Dad, Poor Dad?
Let’s talk about Robert Kiyosaki for a little bit. I’m sure that you know that he is the author of Rich Dad, Poor Dad. If you haven’t read it yet, I highly recommend you check it out and let me know what you think.
However, there’s some ways that this sage advice can be taken and twisted and turned. I like to call it the light side and dark side of Rich Dad, Poor Dad.
The Light Side of the Rich Dad Force (What I Agree With)
One of the best pieces that I absolutely agree with is creating multiple streams of income. Don’t just rely on your portfolio to create wealth! You certainly can, but you have a better chance of experiencing FIRE and having more flexibility if you have more than one or two income sources.
Where I see physicians doing well is when they’re involved in the business of an illiquid investment. They are making business decisions and have their hand in the profitability of the business.
By far, the most common example that I see working out well is a physician is working in a private practice. As part of the practice, they own the building where they practice as well as a piece of the surgery center that they do surgeries in.
They know the building well. They do surgeries there. They know most of the physicians who use the surgery center. They make decisions on upkeep and equipment. They help make decisions on distributions and cash flow. Just as importantly, they know the profit and loss like the back of their hand.
I have seen these investments give double digits returns, sometimes very high double digit returns just with cash flow.
One day when the physician retires- they often sell the building or their portion of the building for six figures, sometimes seven figures.
In terms of digital assets, there are many, many ways you can make money there as well. Check out my blog for more details on my latest experiment with digital assets.
I can think of no better example of physicians crushing this space than PhysicianOnFire and The White Coat Investor. They have both done this through creating blogs and generating money off of ads and affiliate offers on top of their practicing income.
They spend a tremendous amount of time creating posts. They know the site in and out. They partner with others. They know how much they get in ad revenue and what their expenses are. They know the business in-and-out.
Here’s another example…
Let’s take physicians that invest in real estate. They’re overseeing the real estate. They may hire a manager, but they know the tenants. They know the rent. They know the expenses. They know what is a good buy and what is a bad deal.
Many of these folks have started with one or two properties and were doing EVERYTHING themselves. Once they mastered it, they bought another property and another property and another property. They know their process inside and out and weren’t afraid to ask for help of a manager who could do things their way once they started running out of time. However, even though they hire a manager, they know exactly what it takes and could manage it themselves if they need to.
The Dark Side of The Poor Dad Force (What I Don’t Agree With)
Where I see doctors messing up is where they hand the keys over to someone else and they don’t know anything about the investment opportunity — they may not even understand the concept that they invest in and how it could make money or even worse, lose loads of money.
Let’s take an example of an equipment leasing company. They lease servers or ‘big yellow’ tractors or building equipment or they lease gigantic copiers to corporations. They might be structured as a private placement or a limited partnership. A financial advisor comes around with an idea of investing in an ‘alternative’ asset class that isn’t a stock or a bond. The fund is paying a whopping 10% distribution. Amazing! You start crunching the numbers- this could get me back a 50% rate of return.
You think it sounds like a pretty sweet deal. You don’t really get it, but you agree with the principle that diversification is a good thing and you don’t want to screwed over by another stock market crash.
What the financial advisor doesn’t tell you is that he is going to get paid a 7% commission, his broker-dealer is getting paid a 3% commission, and the fund company takes a slice of another 5%. After everything is said and done, there is only 85 cents on the dollar remaining to invest. Then on top of that, the fund company charges management fees and fees for this and that and this and that each and every quarter.
They may keep up the 10% distributions for 3 years or 4 years or 5 years or 6 years if you are lucky. By this time, you haven’t even scratched the principal that you initially invested. Then, the financial reality comes crashing down. They are running out of cash. The distribution gets cut. Then it gets cut again. At the end of the day, you get left holding the measly scraps of your investment, just hoping to get close to getting your money back.
Unfortunately, in many cases, it is long gone. The broker spent those commissions years and years ago.
More Tales from the Dark Side
Other common examples that I’ve found include:
- Oil and gas partnerships
- Private real estate investment trusts
- Tax shelters
- Wineries in the Cayman Islands (no joke! Seriously!)
- Coffee plantations in Panama
- And so many more examples I’ve seen over the years
In every one of these examples, the unsuspecting doctor has given up control of their money. They’ve given up the idea of managing wholly to someone else without knowing about the business themselves. They aren’t involved in it whatsoever and they typically have no idea what the heck it is.
The unsuspecting doc does not look at the financial statements. They don’t understand the balance sheet nor even take 5 minutes to glance at it. They don’t know the amount of debt being used. They don’t know the commissions or management fees that are being paid. They just simply… invest.
It’s like Anakin turning into Darth Vader. This person who presented the opportunity appeared to have been good. In reality, they turned out to work for the dark side of the force. What happened? Darth Vader (a.k.a. the Equipment Leasing Consortium) tried to take a huge slice of the unsuspecting physician’s hard-earned money. In the process, Darth Vader whittled down their money with fees, fees, and more fees (and commissions too).
Nooooooo…. You are not my father!!!!
Anyhow, I digress.
Know Your Illiquid Investments
I just want to encourage you when you look at the Rich Dad, Poor Dad strategy the idea of investing into different things and having multiple streams of income… be involved in the process!
Know the business in-and-out. Understand what it would take to be profitable. Demand a rate of return from the investment in the form of cash flow. Know the customer. Be on the board of directors or be an ACTIVE partner or just simply own the whole thing. Help make decisions on costs like marketing and staffing and research and development.
Simply… Don’t invest in stuff you can’t have a say in.
With that my friends, let’s close this out with several rules that I would like you to apply when considering an illiquid investment:
Rule# 1: Do you have control of this investment?
Meaning… could you have the power to manage it yourself if you choose to? Subbing it out is fine, but what if you want to take over the illiquid investment and manage it yourself. Can you be on the board of directors? Can you be the ‘CEO’?
Rule# 2: Can you sell it in the open market and get close to the market price?
Could you actually find a market for it and sell it, maybe not immediately, but within a reasonable timeframe?
For example, rental real estate or raw land or even online websites generating revenue like PhysicianOnFire can be sold in an open market (check out empireflippers.com). In stark contrast, take an example of timeshares. Timeshares cannot be sold on the open market except for pennies on the dollar.
Timeshares are not investments my friends. Fun, yes. Investment, no.
Rule# 3: For any financially related product with a financial advisor, I highly recommend that you go to www.finra.org and use broker check to do a background check on any financial advisor.
Most of us advisors are located there, myself included. You can go and see whether or not the financial advisor has a history of complaints. You can see whether they have had a criminal record or declared bankruptcy or whether they’ve skipped from firm to firm.
For RIAs (registered investment advisors), you can also go to SEC’s website and look for similar instances.
Rule# 4: Finally, run an illiquid opportunity by your personal board of directors.
Your board can be a financial advisor, a CPA, a good doctor friend that is business knowledgeable, or even family. Just make sure that these people have EXPERIENCE in investing in illiquid investments and even more importantly in RUNNING illiquid investments.
Let me leave you with this thought…
A curbside on surgery with an undergraduate pre-med student probably isn’t a good idea, right? They might be super bright and they might have some good ideas. Unfortunately, they’ve never been in a surgery room before & their closest experience was probably Grey’s Anatomy.
Be with someone who has been in the trenches and gotten bloodied. That’s where the wisdom is.
I would love to know from you. Have you ever invested in an illiquid investment? Would you consider one? What are the lessons that you’ve learned along the way?
About the Author
Dave Denniston, Chartered Financial Analyst (CFA), is an author and authority for physicians providing a voice and an advocate for all of the financial issues that doctors deal with. He also has 1 wife, 2 kids, and a bunny named Black Snow (which is a lot better of a name than Yellow Snow).
If you’ve enjoyed this guest post, you can learn more about his adventures in illiquid investments & much more nonsense by finding his latest blog post and videos by clicking here.
Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.
The views expressed are those of the author and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation
[PoF: In addition to property (we close on 7 acres of waterfront tomorrow!), I’ve also invested in a couple of breweries. I have a 4% equity share in one. I am not involved in managing the business, but I have stopped in each of the last three days to sample their wares (my liquid dividends in an otherwise illiquid investment).
I also loaned money to another brewery, as covered in this post about an intentional bad investment, and that taproom opened last month. The two breweries represent about 1% of our net worth, and I think it’s a good idea to keep these risky but fun investments to a small percentage of your portfolio. That might be a good rule #5: limit these investments to “play money” of no more than 5% or 10% of your investments.
Have you made any of these alternative investments? Any grand successes or utter failures you’d like to share with us?]