Cape May Wealth

The Volatility Laundering Misconception 🔀 I recently spoke to an investor who made a rare career move in the investing world: They started out as a quant investor working for a public equities-focused hedge fund before moving to an alts-focused investing role for a family office. Why is that a rare career move? Because most quant-focused investors seem to detest private assets. While public markets see any market information perfectly and fairly reflected in prices on a daily basis, private markets show just monthly, quarterly, or even less frequent prices, which are (according to quant funds) not set by supply and demand but by the private markets investors themselves. The key term here is volatility laundering, coined by AQR’s Cliff Asness: By having to post as little as four price points a year, which private equity investors or other GPs can (allegedly) partially influence, alts such as private equity undersell their volatility, and thus their risk. To be clear: I fully understand, and (as you will see below) agree with, the allegations behind volatility laundering. As I outlined in The Quantitative Approach to Private Equity, I detest the private equity “chart crimes” in which GPs show slight outperformance but significantly lower volatility, simply because PE has fewer price points. Anyone thinking that private equity or private debt are less risky than traditional public equities or fixed income should probably stay away from any investment, private or not. But I think that the volatility laundering debate is overblown: What started out as a rational debate turned into a screaming match in which quant investors cry wolf about topics that alts investors never really disagreed with. Want to learn more? Make sure to follow me here on LinkedIn - or already read it in the Cape May Wealth Weekly newsletter. Link in the comments. #privateequity #hedgefunds #assetallocation

Direct investments in venture capital is not worth the effort for most family offices. 🖐 Why? First, venture capital is very competitive. 🏃♂️ Unless you are well connected in your local ecosystem, it is likely that the best deals never cross your table. Adverse selection is real. Second, many family offices don’t understand the venture capital ‘power law’. 📈 They are too focused on downside protection, leading them to miss out on winners due to a lack of risk tolerance. Third, and perhaps the biggest miscalculation: Even if you can get access to good deals, and structure your portfolio right, the absolute return might not be worth it. 💸 Yes, an investment of 100K€ might turn into 1M€ or even 5M€. But if venture is just a tiny allocation (<5% of your overall portfolio), even a good return might not be worth the effort. So why am I telling you this? Because this way of analyzing venture capital direct investments (admittedly, your view might differ) can, and should, be equally applied to any other asset class that you aim to invest in. It’s the question of where, and how, you can generate Alpha: Identifying where you as a private investor, family office or even institutional investment firm can generate outsized excess returns on your financial and time investment. Let me take you through the framework that I used to find my Alpha, and that I apply when I work with my clients - this week on the Cape May Wealth Weekly newsletter, and of course also here on LinkedIn. Link in the comments! #venturecapital #assetallocation #wealthmanagement

Liquidity and Illiquidity: An underestimated risk, and an underrated opportunity? When I left Goldman Sachs, I had a binary view of liquidity. To me, there were liquid investments such as equities or fixed income that could be sold in the market on a short-term basis. Everything else was illiquid. That view changed pretty quickly when I joined the world of family offices. My first family office job was for one of Germany’s most famous tech entrepreneurs. For him, liquidity was not the function of whether an asset is tradeable, but of its quality: Focusing primarily on venture capital-backed start-ups, he had the view that he could always sell a stake in a well-performing start-up at a good price and on reasonably short notice. For the same reasons, he was also skeptical of funds. Since they consist of well- AND worse-performing investments, he saw them as harder to sell. But what is liquidity? If you are ‘liquid’, it means you have sufficient easy-to-sell assets, such as cash or stocks, to meet your financial obligations. Those obligations come in many forms, ranging from essential living costs and mortgages to investment-related obligations, such as capital calls in private equity or venture capital funds. Interestingly, it’s affluent investors, not retail investors, who face more challenges with liquidity:  While retail investors are limited to traditional investments such as funds or individual stocks, which can usually be liquidated at short notice, affluent investors invest in RE, PE and VC funds, or directly into companies. These are inherently illiquid investments, which either offer very limited liquidity, or which cannot be liquidated at all prior to the end of the investment period. They are also less straightforward in terms of how capital is actually invested: If you want an ETF, you can just buy it. But if you want to invest in a fund, capital is called over time, which increases complexity. A common school of thought — perhaps driven by the rise of the Endowment Model — is that you should maximize the percentage of illiquid investments in your portfolio. And I agree, to an extent. If you are not reliant on liquidity from your investments, it's almost irrational to not invest as much as you can into illiquid investments, provided that they (are expected to) offer higher returns than its liquid counterparts. The problem is, many investors underestimate the challenges of liquidity. What does that look like? More on that on Wednesday - and in the meantime, of course, in the Cape May Wealth Weekly newsletter: https://lnkd.in/eA9CEiUE Subscribe to Cape May Wealth Weekly: https://lnkd.in/e4P9v-Si #wealthmanagement #familyoffice #privatewealth #personalfinance

The Aspirational Investor Framework (Part 1) This week's Cape May Wealth Weekly newsletter was just sent to your inbox. As mentioned last week, I am re-sharing a few of my favorite pieces of writing of 2023 - all with the goal of helping you become a better investor. This week, we cover my favorite investing framework, The Aspirational Investor. But before we dive into that, let's actually focus on a different matter: The shortcomings of asset allocation models / frameworks used by banks and wealth managers. To be clear: private banks and wealth managers mean well, and they can really help you think about how to invest (I had more than one "eureka!" moment working with them). But from my experience, their frameworks bring three issues: 👨🎓 They are too theoretical - they don't take into account the realities of investing, i.e. on how to switch from 100% cash to your target allocation 🗻 They are too static - they don't consider how risk and return assumptions change with market movements 🙅♂️ They are too inflexible - they set out to define a target allocation for the client to use forever, without taking into account the "learning phase" of someone who is just starting to invest I yet have to find a wealth manager that offers a working solution. So when I launched Cape May Wealth - and eventually, I found one that fits with my own investing philosophy. That's where the Aspirational Investor Framework comes in. What is the framework? How does it work, and why do I like it better than other frameworks? All of that in the second edition of the Cape May Wealth Weekly newsletter - link to the article, and a link to subscribe to get the next edition right into your inbox right here: https://lnkd.in/e4P9v-Si #wealthmanagement #familyoffice #privatewealth #personalfinance

Defining Your Investment Objectives (Part 1) I am starting off my newsletter Cape May Wealth Weekly by re-sharing (and sometimes re-working!) a few of my favorite pieces of writing in 2023 that some of my newer followers might’ve not seen last year. For the first few weeks, we’re going “back to the basics” of the world of investing - I want to help you ask yourselves the right questions, and introduce you to the right frameworks, to become a better investor, even before you make your first investment. We’re kicking it off by helping you define your Investment Objectives - but to do so, let’s first as ourselves the question: What is an Investment Objective, anyways? 🤔 To me, the Investment Objective is the overall goal that a client is looking to achieve through their investing activities. While there are many objectives that you can set for yourself, the three options that I like to present to my clients are the following: 📈 Capital Appreciation: Focusing on growing your assets in order to reach a certain portfolio size - for example, saving for retirement or saving for your down payment. 🛡️Capital Preservation: Maintaining a specific portfolio size under consideration of costs and inflation - for example to be prepared for imminent expenses, planned purchases, or inheritance purposes. 💸Capital Income: Maintaining required distributions from your portfolio - for example to fund lifestyle expenses or contractual obligations. So how do you set the right goal for you? Can’t they kind of overlap as well? And once I’ve decided on a goal, what other things should I think about? All of that in the first edition of the Cape May Wealth Weekly newsletter - link to the article, and a link to subscribe to get the next edition right into your inbox, in the comments. 🚀 #wealthmanagement #familyoffice #privatewealth #personalfinance

Private Equity Math 101 (Part 5): From single fund, to fund portfolio In the final post of our series, let’s look at the holy grail of PE LP investing: The fund portfolio. Using fund-level assumptions from our prior posts, we now assume that we’re not only committing once, but annually. (As always that's simplified - in practice, you wouldn’t just commit to one fund per year.) First, how much money do we need to commit? Remember that for the single 25M fund, we had to actually pay “just” 22.5M, i.e. 90%. With the fund portfolio, this effect is even more pronounced: While we commit a total of 250M (25M x 10 funds), we benefit significantly from the staggered timing, requiring us to only put up 105M (42%) to serve all capital calls before they are offset by distributions. Second, cash flows. For our single fund, we saw cash flow break-even after year 6 (i.e. after the investment period). With a fund portfolio, that takes longer: While the individual funds distribute from year 6, the distributions of earlier funds are offset by capital calls of later funds. Accordingly, our break-even gets pushed back to year 9, which is also when the NAV of our fund portfolio (excl. cash) peaks at ~1,5x of our required cash (155M peak NAV vs. 105M paid-in cash). Third and last, performance. Over the lifetime of our fund portfolio, our fund-level IRR matches that of our individual funds, i.e. 10,62% p.a. However, our annualized return (including cash) is lower at “just” 6,45% p.a., driven by the previously explained “cash drag”. Daniel and Oskar kindly pointed out that while it’s realistic to include cash in the ramp-up phase, you wouldn’t include it in the distribution phase. While not pictured here, I did make that check, assuming that after break-even, we distribute all cash from distributions in the following year. That does boost returns - but “just” to 7,95%, still more than 2,5% lower than the IRR figure, which many mistake for returns. Once again the question: Is that good, or bad? 🤔 My performance figures here were purposely on the lower end to highlight how a seemingly good-looking PE double-digit IRR actually underperforms public equities. Put together now in a portfolio without the cash drag and not assuming PE re-investment after our 10 funds, we get a figure that is almost 1% better than public equities, even with somewhat disappointing fund-level performance. Whether that is good enough is a question of your personal goals, needs and preferences. But that’s for another post. What I want you to take away from this, however, is not to be dazzled by IRRs. Do the math - and see if the percentage return is good enough for you, especially in comparison to public equivalents. A few people have asked me whether I can share my calculations - and yes, I can - but more on that on Friday 😉 Make sure to follow Cape May Wealth and me not to miss out! #privateequity #buyouts #privatewealth

Private Equity Math 101 (Part 4): Don’t underestimate the impact of cash on PE fund returns In our prior post, we explained the math behind a PE fund. As a reminder, our fund’s performance stood at a 1,76x net multiple on invested capital (after fees), and an “internal rate of return” (IRR) of 10,62%. Is that… good? First, let’s explain IRR: It’s the return at which the capital invested through our capital calls has to compound to produce subsequent distributions. Our fund IRR of 10,62% might look good on first glance - after all, public equities have generated long-term returns of ~7% p.a., almost 4% lower than our PE fund. But don’t be tricked: IRR and annualized returns are not the same. There are two ways to make numbers comparable. First, the so-called “public-market equivalent”, where you assume that cash flows invested into a PE fund are instead invested into a comparable public benchmark.. However, as we cannot forecast equity returns, we instead rely on another method: Using a money- and time-weighted return for a portfolio consisting of the PE fund AND the cash required to serve the capital calls. To do so, we first forecast the net asset value (“NAV”) of our fund, and subsequently, the combined portfolio. Starting with our committed 25M€, we see cash move into the PE fund, and even assume interest income on residual cash. We’re almost fully invested in 2027, shortly before the PE fund’s NAV peaks in 2028, before seeing substantial distributions. Eventually, we reach 47.5M€ in cash after the fund is fully liquidated. Using those values, we can now calculate our time- and money-weighted returns: While PE returns are lower in the first years (the famous “J-Curve”), annual returns reach double-digit levels in 2027-2030. But year-by-year returns are not meaningful - it’s the annualized return that counts, and that’s where we really see the truth: Our 10,62% IRR turns into a 10-year return of ~6,6% p.a. - actually slightly below the often-quoted 7%. Realistically, cash would not stay idle, but be reinvested into PE or into other asset classes, thus reducing “cash drag”. Nevertheless, there are two big takeaways: First, that we shouldn’t be dazzled by IRRs but calculate how our actual cash-on-cash returns look like. Second, that fund-level IRRs actually need to be higher than one might assume: In my model, it takes a 1,81x net fund multiple (and a ~11,5% IRR) to match the 7% public equity return - without even taking into account illiquidity. You might argue that if your PE portfolio generates the returns highlighted here, it’s not worth it, and I agree - but they are not so far away from the median, and actually above long-term bottom quartile returns. We all say we only pick winning funds, but nobody can guarantee it. In the final part of our series, let’s dive into how things look at the portfolio level - make sure to follow Cape May Wealth and me not to miss out. #privateequity #buyouts #privatewealth

Private Equity Math 101 (Part 2): Understanding deal-level return drivers - in practice! In the prior post of this series, I outlined to you the three deal-level return drivers of private equity: Use of debt (and its repayment), EBITDA growth, and multiple arbitrage. To help you better understand the impact of those three factors, let’s give you a practical example. (Thanks to Frederik and Mirko for their critical review of my little model - I am quite aware it’s more on the simple side.) Cape May Private Equity (fictional - for now 😎) is acquiring Dackel Industries 🐕, a small industrial company. Dackel generates 10M€ in revenue and 1.5M€ of EBITDA. After CAPEX (0.5M€ p.a.) and taxes, D.I. generates 0.55M€ in cash flow. Mr. Dackel is willing to sell Dackel Industries at a 4x EBITDA multiple, meaning CMPE has to pay a purchase price of 6M€. CMPE is funding this through a combination of 4M€ in equity and 2M€ in debt, repayable over 5 years, with annual interest cost of 8%. Let’s remember our three value drivers: Repayment of debt, margin expansion, and multiple expansion - and let’s see them in action, separately and individually: 1️⃣ Our simple scenario of no change in financials, but just repayment of debt, results in a 1,53x multiple on invested equity, driven by the increase of equity value as debt to fund the acquisition is paid down. 2️⃣In a scenario of repayment of debt, no margin expansion, but a slight increase in exit multiple from 4x to 5x (CMPE has some great negotiators), our financials remain steady, but growth in enterprise value benefits our equity. As a result, the multiple on invested equity increases to 1,90x. 3️⃣In a scenario of debt repayment and slight margin expansion (1% revenue growth per year, 1% decrease in expenses per year) delivers a 5,5% EBITDA margin expansion, which grows EBITDA by almost 0.75M€. At a constant multiple, our exit multiple increases by almost a whole turn to 2,79x. 4️⃣Finally, taking all three value drivers together (repayment of debt, margin expansion, multiple expansion), we not only see an increase in EBITDA but also an increase in EV, resulting in a 3,39x multiple on invested equity. One thing that I as an LP (as opposed to GP) thought was worth pointing out: If you tweak the numbers just slightly (i.e. change interest rate, change the acquisition multiple, add CAPEX which impacts cash but reduces EBITDA), it can have a profound change on the model. Depending on my tweaks, cash flows quickly turned negative - giving me a first-hand look of the challenges our PE GPs face daily (and then I’m not even taking real life into account, where growth and margin can change rapidly.) So now we know what PE looks like at an asset level. Let’s continue our journey from asset- to fund-level view - in our next post. 😉 Make sure to follow Cape May Wealth and I not to miss out. #privateequity #buyouts #privatewealth

Private Equity Math 101 (Part 1): Understanding deal-level return drivers PE has seen massive growth over the last decade. But as institutional investors find themselves overallocated given the recent market downturn, GPs look to find new sources of capital. One of such sources are affluent individuals, served directly or through private banks. It’s also the group of clients that I serve with Cape May Wealth - and accordingly, one frequent question is whether affluent investors should consider PE. …and with this series, I want to answer this question. However, let’s start with the basics: The math of private equity. Today, we start with deal-level performance drivers. 🧑🏫 PE firms typically aim to acquire majority stakes in established, profitable companies. While they could do so purely through the use of equity capital, they frequently use debt to fund the purchase price, which is repaid over time with the company’s cash flow. Use and repayment of debt is the first return driver: Assuming constant enterprise value, repayment of debt means that an investor’s equity value increases. Also, the less equity invested, the higher the (percentage) return on equity from a later increase in value through repayment of debt. The second return driver is operational, namely revenue growth and/or margin expansion. Assuming constant multiples, GPs would expect to receive a higher price for a business as its financial conditions improve. PE-backed firms typically are valued based on EBITDA, which increases as revenue grows and/or as margins expand. In an ideal case, both happen. The third return driver is “multiple expansion”. Absolute multiples tend to be higher as companies become larger and more institutionalized. Accordingly, a PE firm might receive a higher multiple than the one they paid simply because their PortCo has grown in size, revenue or sophistication. Creating processes and structure can pay off handsomely - the “worse off” a company is initially, the bigger the later increase in multiple. Another equally important form of multiple arbitrage comes from acquisition of other companies. If a company (in this case, the so-called “platform”) is able to acquire smaller competitors at a multiple lower than its own purchase multiple (so-called “add-ons”), one would assume that the combined company is valued at the platform company’s multiple. Lastly, multiple arbitrage may also be the result of proper sourcing and sales processes: GPs may be able to source proprietary deals at below-market prices, while later realizing above-market prices through a structured sales process. So now you know what factors drive the deal-level returns of a PE fund. But what does that look like in practice? More on that later this week in a concrete example. Make sure to follow Cape May Wealth and I not to miss out. #privateequity #buyouts #privatewealth

What mistakes do affluent investors make on their investing journey - and what can not-yet-affluent investors learn from them? 🕵♂️ Most of my content is unsurprisingly aimed at the challenges and objectives of the affluent individuals that I serve with Cape May Wealth. However, I frequently get asked by my not-yet-affluent friends and colleagues what advice I would give them to become better investors and to build their wealth. Leo and Business Insider Deutschland were so kind to let me share some of my thoughts and observations. Link below (in German) - I hope you all find it insightful! #wealthmanagement #assetallocation #investing