Investment ideas can come from everywhere but it is important to understand that public and private investments are as different as apples and oranges. Investment ideas from personal connections, private companies and structured schemes come to us. It is very tempting to put money to work thinking that we are getting good risk reward. But we must be very discerning.

Personal and private investments cannot be compared to what is publicly listed or legally verified instruments backed by the governments or large institutions. For example, we see a private investment our friend brought to us, or perhaps even endorsed by Temasek, Singapore’s sovereign wealth fund, because they have put money in, which shows 20% annual return on paper. We cannot say that this is better than buying DBS stock (Singapore’s largest bank), which can only generates 10% annual return (of which 4% is dividend).

There are a few important reasons:

DBS is the largest bank in Singapore and the 25th largest bank in the world. There is very low probability it would actually go bust. In Singapore’s context, it is too big to fail.

DBS is publicly listed and its accounts are audited by top accounting firms. It means the numbers are real. The cash on the balance sheet is real. Well almost. Nothing is 100% in the world of investing.

DBS is liquid, you can sell any time and take the money out if you need it.

In contrast, for a startup setup by your friend, or even and big private investment led by a Temasek linked company in which you somehow acquired an angle to participate, none of the above matters. The considerations becomes:

Can I trust the person executing the investment. What if he calls it a day at his startup or at Temasek, move on to do something else? What happens to the money committed?

Who audited the numbers? Can I trust the cash was used the way it was intended?

How long is this amount locked up for? What if I need the money some time in the future.

The answers are complex. For the first question, the answer would almost certainly be dunno. Even if you have 100% trust, shit happens. What if the friend gets hit by a bus. Or the lawyer who did the work ran away with the money? With DBS stock, such risks are all averted.

For the second question on auditors, it might still be the Big 4, then we have some comfort. And for the last question, if it would be locked up for 10 years, then you cannot put a lot because there is no liquidity.

So in order to make a good decision, we need to apply the right discount, we probably have to calculate the expected return using some high school math. So for DBS stock, the expected return is the same as the above because the probability that DBS will go bust is near zero and we can take the money out any time i.e. expected return is 10%pa.

But for the private investment, if the probability of default is not zero, we need to factor that into the return calculation. For a Temasek led private investment, it could be 30% default probability (0.3*0% + 0.7*20% = 14%).

For your friend's startup, it could be 70%. (0.7*0% + 0.3*20% = 6%) So using those no.s, the expected returns drops 14%pa and 6%pa respectively. Then we need to think about the liquidity needs. If it is locked for 10 years, then we cannot put like 10-20% of the portfolio or something big, like six figures. Who knows when we would need that money?

Case in point, Hyflux. It was publicly listed. It had strong links to Singapore government and Singapore Inc. Yet, it went bust. Thousands of convertible bondholders lost their shirts. Equity holders know their risks, we buy equity knowing it might go zero but we get the enjoy the upside, which could be 2-3x or even 10x. But bondholders have no upside. We bought thinking we can enjoy 6%. Yet, it went to zero. So even listed entities are not foolproof. Shouldn't we ask more questions if this is a private investment?

To conclude:

If you need to do a private investment, it is based on trust, can you trust your friend, the lead or the whole team executing it? The paper calculation on returns, business growth etc. matters little.

The returns have to be 30% or more if it to work well. Translating that to payback, it has to be 2-3 years. Anything longer would be too risky.

Put in an amount you are happy even if it goes to zero.

Hope this helps!

Original blog:

http://8percentpa.blogspot.com

*Huat Ah!*