John Napolitano of Napier Financial takes a long look at the host of unusual investment opportunities available to your wealthier clients, and how to tell what will work from what won’t.

Transcription:

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Dan Hood (00:03):

Welcome to On the Air With Accounting. Today, I’m editor in Chief Dan Hood. More and more investments are available to more and more investors, but that doesn’t always mean they’re right for your clients. Here to talk specifically about the class of what’s called alternative investments. It’s John Napolitano, he’s the founder and CEO of Napier Financial. He’s a columnist for Accounting Today and an all around expert on these things. John, thanks for joining us. Maybe if you can give us a broad definition of how you think of alternative investments.

John Napolitano (00:28):

Yeah, today it sure is the buzzword and it’s being talked about by everyone on Wall Street, everyone in the financial planning world. I consider alternative investments as pretty much anything that you can’t open a newspaper and find out what it’s worth today. It’s something that’s generally illiquid, it’s private. The valuations are squishy meaning, so let’s say you invested in a company. Well, what’s it worth today? Who the heck knows? It’s worth what someone’s willing to pay for it. Now, we might have a good idea what it’s worth. Same thing with your real estate or what’s your house worth today? You have an idea, but you don’t know exactly what it’s worth. So I’d say alternatives are things that you can put a number on it. You can’t convert it to cash very quickly. So

Dan Hood (01:14):

It could be very

John Napolitano (01:15):

And has generally more risk,

Dan Hood (01:17):

But that’s pretty broad, right? So that could be, you said real estate. It could be a house, it could be art, it could be a company, ownership of a company. What else? What sort of concrete things could we throw in there?

John Napolitano (01:29):

Well, bricks and mortar is a good way. Most people own, not own. I’d say my wealthy clients all own real estate beyond their residence, and they either own a rental property or they own a business property, or they own a piece of a deal that is invested in residential, commercial, or whatever it might be. So that’s a really common way to do it. I’d like to though, just throw out a warning sign, A lot of alternative investments offered by brokerage firms, they’re crap. There’s a lot of fat in them. There’s a lot of fat in them. There’s many suits in between the investor and the deal, and everyone’s getting along the way, so they get to be kind of watered down. So I’ll just say I’m a skeptic when it comes to things that come in really fancy packages. So if you get a 200 page brochure that looks like it costs 30 bucks to print, that’s a sure sign that there’s a lot of suits and a lot of mouths to feed in between you and the brick and mortar that you’re investing.

Dan Hood (02:34):

At the very least, it’s $30. You’re not going to see.

John Napolitano (02:37):

Right? Amen. And if you think about it, most wealthy clients already have alternative investments. They just don’t consider it that. As I mentioned earlier, it might be the really, it might be this or that. So needless to say, real estate is one very common form of alternative investment. And everyone thinks, well, real estate never goes down. I mean, it’s the right thing to own. Well, unfortunately, firsthand, I can tell you,

Dan Hood (03:02):

Oh yeah,

John Napolitano (03:02):

It goes down because I owned real estate in the banking crisis. I owned real estate in the eighties, and it went down. It went precipitously at times. So it will go down. And the one thing to think about is not overloading. I meet a lot of people that are real estate professionals. They have 98% of their portfolio in real estate and almost nothing for liquidity. And I think that’s probably a little risky, even if it’s a low debt situation and there’s great cashflow from it, I probably wouldn’t want everything there. But beyond real estate, what else can you invest in? Well, you know about hedge funds, you know about private equity funds, those are also growing in popularity. And again, the key to remember here is they’re illiquid and they have a little bit more risk than let’s say your s and p 500 ETF, and you don’t know what it’s worth and you don’t know when you’re going to get your money back.

(04:01):

But on the other hand, it would be reasonable to expect a little bit of a higher return from that over the long run. And when you think about it, that’s why in general, I’m generally bullish on investing. I’m bullish on owning companies. I’m bullish on owning stocks, and I’m somewhat agnostic as to current conditions, whether it’s inflation, interest rates or whatever. And here’s why. Think about any company in America, anyone you want. They’ve got some really high paid people in there that are pretty damn smart. And when you get down to it, their job is to make sure that business does better next year than it did last year. And while it doesn’t always happen, you know what? And more times than not, it does do better next year than it did last year. So I do have confidence in the capital system. I do have confidence in the talent that people and companies hire to make things better.

(04:56):

So I’m not afraid of private equity. I’m not afraid of illiquid companies. I’m not afraid of small companies, and I think it’s appropriate to invest in that. Now, a broad disclaimer, if you will, alternative investments are not for everyone. So if your portfolio is a million dollars, you’re probably not going to get in on any good alternatives because most of them have minimum net worth requirements. And those minimum net worth requirements excluding the house are one to 2 million and up. And even then, so let’s say you have 3 million liquid, you’re looking at maybe 300,000, maybe 500 at most, that you should commit to alternatives. And if someone has a little bit of luck with alternatives, they want to add more to it because it’s so good. I’ll give you another example of an alternative. You hear a lot today of private credit. Private credit means investors lending to businesses and people.

(05:57):

And I think the quick credit funds that you’re seeing that are lending to businesses, they have their place, they’re helping fuel the economy, but you really need to know what businesses you’re lending to. And again, the large, I’ll call ’em, packaged products by Wall Street are so diluted by the time it gets to you, net return is going to be good, but maybe not as good as you had hoped for. And one area we’ve invested a lot of time in the last year is private credit for real estate developers and flippers. And how that works is if someone finds a property that they want to buy, develop up and sell, that process could take six to 12 months of bank to get it approved, get it funded, and get it rolling. They don’t have that kind of time to wait. So we actually started a private credit fund for developers and flippers where decisions can be made in two weeks.

(06:54):

Now these developers are paying two points upfront, 12, 13% interest rate. And you might think, why would anyone do that? Well, if you could be in and out of a deal in six or nine months as opposed to fighting with the bank for nine months and lose the deal, you take that. So in a credit fund like that, investors are earning 11 point a half, 11 point percent, and that’s pretty solid. And in this case in particular, and I get into the details of this because I think this is the level of diligence that a planner or an investor should do for their clients, the composition of the debt in those cases is first mortgages with an average loan to value of 60 or 65% on a one year note. So the protection is a 65% loan to value. So if the market tanks, well, the real estate has to go down by 35% or more before that loan is at risk. The second is, let’s say the borrower tanks and can’t afford to pay the interest. Fantastic. The terms of the note get quite stringent and quite costly in the event of a default. So that turns out to be even more profitable for the investors,

(08:09):

As ironic as it sounds. So that’s a good example of a private investment, alternative investment as well.

Dan Hood (08:17):

And the way you describe it, obviously one with a lot fewer hands in the till or a lot fewer hands packaging it and holding onto it, it’s pretty much the borrower’s, whoever’s arranging the structure and the lenders more or less.

John Napolitano (08:29):

Exactly.

Dan Hood (08:29):

I’m curious, and

John Napolitano (08:30):

Another interesting part, Dan, is on the diligence if I may, is so let’s say you have a buddy who’s got a track record in private equity and they float a deal by you that says, Hey, what do you think? We’re ringing 500 million and we’re going to invest in small company that are doing clean energy. And you’re like, okay, should I do it? Well, in broad terms, the market good because it’s obviously a hot space to be today. The numbers, who knows, they don’t own anything yet. So really what you have to drill down to is integrity of management and your gut feel for bull. So because you’re not making the choice on what companies they buy or what battery they’re investing in, they’re making that choice. So you really have to go deep on their track record, their past performance. And the SEC would be first to tell you, past performance is no promise of future results. Of course not. Of course not. But on the other hand, you have nothing else to go on. So integrity of management, prior experience, a timeframe, all that, that’s really important when it comes to doing diligence on an alternative

Dan Hood (09:39):

Investment. Now, as we’ve described this, alternative investments, right? You’ve gone through the big range of things that could be included in it, some more complicated and more packaged than others, but also some riskier and more difficult to access. When you look at alternative investments, it sounds like you obviously look at different types of alternative investments for different levels of investors, right? A super high net worth person with $50 million of disposable income is one has a very different set of alternative investment opportunities. There’s things they can invest in that mere mortals like me can’t even think about. But are there things for people who’ve got, you said if you’ve got $500,000 investible, you’re not going to get into one of those hedge funds, but are there things you can invest in? I mean, should you buy a house and rent it out? Should you buy rental properties? Or are there alternatives down at that low end of the market?

John Napolitano (10:28):

I hate to say it, but I don’t think so. I don’t think so, because again, if you buy real estate, and this is another misnomer, people want to invest in real estate because rents always go up. It’s going to be worth more next year. Dude, that’s a job, man. If you buy a three family, that is a job, you now have a business with three customers, and God forbid one of those customers craps out on you, your revenue stream just went down by 33% and it’s pretty expensive to lease up. And you’re going to pay a leasing agent. You may have to do some spruce up work or whatever. So if someone’s a retired maintenance person or landscaper, sure, knock yourself out. That’s second nature to you. But if someone wore a suit their whole life, I’m going to go out on a limb and say they’re probably not suited to own that type of high maintenance asset.

Dan Hood (11:18):

Yeah, obviously it’s a lot of work,

John Napolitano (11:19):

And as I said, I’ve seen those go down in value. There’s no guarantee they’re going to keep going up. And today, once again, people think, oh, that stuff’s always going up in value. It always goes up in value. Well, it does always go up in value as long as you leave a long enough

Dan Hood (11:34):

Timeframe across a long enough timeframe and across a large enough portfolio of properties. But as you say, there’s, you could talk to any landlord in the country and they’ll say, yes, I’ve had apartments trashed or buildings just destroyed by tenants living in ’em, et cetera, et cetera. So it is a full-time job. Exactly.

John Napolitano (11:51):

And within an alternative portfolio, just like a traditional portfolio, you want to diversify a little bit. So I used the example of a clean energy fund earlier. Well, if you’re invested in one clean energy fund, two clean energy funds, don’t do it a third time, do something different invested in healthcare companies, invest in technology companies, invest in ai, invest in something other than what you’ve already got invested in. And most of the candidates for alternative investments are already fairly wealthy clients and they’ve already got alternatives. So if you own a couple of hotels, chances are you don’t want to invest more money in the hospitality space as it relates to your alternative investment, maybe residential, maybe industrial, and look at commercial. You tell me, how’s it in lower Manhattan these days? It’s definitely not as vibrant as it was five years

Dan Hood (12:47):

Ago. That is true. So yeah, things are going to change. I’m curious, sorry. So you’ve talked a little bit about the fact that often what comes with this is more risk, which obviously means a potential for greater reward, right? I mean, I think that’s one of the things that people go for alternative investments for, but obviously you also talked a little diversification. How much do alternative investments or can alternative s provide in terms of diversification? Obviously, if all your alternative investments are in the energy space, then that’s not diversified, but are alternatives generally considered sort of a good bet as a diversification bet against stocks, bonds, et

John Napolitano (13:24):

Cetera? I think they are, Dan, because again, the alternative, so let’s use a venture capital or a private equity fund, for example, if markets are going sideways, public markets, the S&P, NASDAQ, all that stuff, that has really nothing to do with what’s happening inside that small company. Because when a private equity invests in a small company, they’re investing not because they feel the markets are going up, they’re investing, they feel like this company is onto something, they have a good product, a good process, something that with a little marketing or management know-how or capital can really grow exponentially. So yes, it is a diversifier in and of itself and within the alternatives themselves, yes, you can diversify. Typically in any one deal though, you’re not going to get a lot of diversity in a deal. So usually the sponsor of a deal as a specialty in this A space or B space, and that’s what they’re going for. So chances are you want to split it up a little bit. And the pain with that is each one of these deals usually comes with a K one at the end of the year, and you’re going to get 10, 12 K ones. And the other thing about getting all those K ones is guess what? They’re not all rolling out on March 15th. They’re coming out in July. They’re coming out in August. They’re coming out in September. So for the investor in alternative investments get used to filing your tax return in October.

Dan Hood (14:57):

Right? Well, one would hope if you’re deep into alternative investments that you’ve got a very highly qualified CBA or tax attorney or a tax repairer looking after your stuff. So you’re not having to do that yourself.

John Napolitano (15:13):

Absolutely. Now, earlier you touched on things like art and collectibles, and you read a lot of headline noises about, oh, Madonna bought this painting for a million and just sold 25. Well, that’s great. If you know a lot about art, yes, that could be a very good place to invest. Same thing with coins, numismatic coins, not just gold and silver. While gold and silver may be considered alternative investments, I kind of consider a mainstream because you can open the paper, see what it’s worth, you can walk down to a shop and sell it tomorrow. So it’s not much more difficult than a stock. But when you get into things like stamps, art, numismatic coins, things that have value, but it’s somewhat subjective, oh, well, is that a coin to MS 65 or an MS 60? And that impacts the price by a thousand percent. So if you’re going to invest in those kinds of alternatives, you better know what the heck you’re doing or have someone that really knows what the heck they’re doing.

(16:14):

And as I mentioned earlier about pricing in fat, I have friends that love coins, for example. I absolutely love them. I say to ’em, dude, that’s great, but when you sell it, what’s the haircut? Well, 10 to 15%, are you kidding me? In my world, you go to jail if you get 10 to 15% out of someone’s investment portfolio. So again, I take, they could be good. Sure. But again, you really need to know what you’re doing when you need to buy, right? If you buy right, that enhances your odds at making money in the collective world.

Dan Hood (16:50):

Obviously there’s so many different kinds of alternative investments. We could dive deeply into each one of them, but there’s some areas I want to talk about to focus maybe more on the type of investor. And in this case, maybe we’ll talk about high net worth and sort of family structures. Those can be a little bit complicated and bring some issues there. But we’re going to take a quick break. Alright. And we’re back with John Napolitano talking about alternative investments in the wild and wacky world of alternative investments. We’ve been talking about a lot of individual types of alternative investments from private equity to collectibles to real estate. But I want to focus a little bit more on sort of the investors themselves, the alternative investors, if you want to put it that way. You’ve talked a little bit about what you call satellite strategies for situations where it’s like sophisticated or complex family situation. Maybe you could talk a little bit about that.

John Napolitano (17:43):

Okay. Well, when I consider a satellite strategy, it’s something that is beyond the core. So how we like to consider an alternative portfolio is let’s say, and again, these are all wealthy families, Stan. It’s not the average millionaire next door. And they’ve got a portfolio of say, $20 million and they’re going to spend 400 a year. We say, well keep enough money in traditional stuff to support your 400 million a year. And then everything above and beyond that is eligible for alternatives. And that might be in what we call satellite kind of investments, not s and p. It would be real estate, it would be lending, it would be private equity. It may be some inflation hedges, whether it’s oil and gas or those types of partnerships. And what’s odd is the wealthier the client, the more they want alternatives. And they hate looking in the newspaper or hearing headlines every day that, oh, we’re down 3% today. They’ll look at you and say, so I lost 300 grand today. It’s like, yeah, you did on that portfolio.

(18:55):

They don’t want to hear that. So the wealthier family is the more that they really like all it is, and what you and I might consider a satellite, they want that to be their core. They want that to be everything they invest in. And I understand why, because they’ve had a lifelong of experience. It’s consistently delivered greater returns. And most of these people owned an alternative investment from day one. And what’s that? Their business, most of these people started a business. Most of these people owned a business, they owned the real estate the business was in, that’s an alternative investment. So for the 20 million I say,

Dan Hood (19:34):

And that’s sort of the core of their portfolio, is this alternative investment of the family business or the family property. Or in some cases, some bigger families may come with significant art portfolios. There’s not them, but still. So yeah, I mean, how do you handle that when their core really is that alternative investment, right? The business is where most of their value is. Yeah,

John Napolitano (19:56):

That’s truly a challenge to be honest with you, because these people have the mentality that, well, nothing’s going to do better for me than my business, so why would I ever want to invest in anything other than my business? And eventually they realize that you just have to, because your business is not guaranteed. It’s not forever. Stuff can hit the fan in the business. The business can get sued, the business can lose money, your market can crumble and fall apart. So typically the first order of business is to try and teach the wisdom to these folks as to why you can’t have all your rakes in that one basket. I mean, we’ve met clients that have net worth of a hundred million dollars with 4 million liquid. Everything else is in their business. And I’m talking businesses with 10, 15 million in cash in the business. Well, why do you leave that in the business?

(20:50):

Well, in case I need it, it’s safe there. I said, well, and what if that business gets sued? Oh, well, maybe you should take that money out and if you need it in the business, you can lend it back. And guess what? You just did another alternative investment. You did a private loan to your company, and you’re going to earn more than you would in a bank, and you’re just going to be the bank and you’re going to collect the rate of return that a bank might get on a business loan, which today is in the 8% range. Pretty good return.

Dan Hood (21:22):

I’m curious, as you look around for, obviously as we talked about high net worth clients, are the ones most likely to be playing in this space or playing regularly in this space? Do you look at different sets of alternative investments for them? How do you vary between who gets what kind of investment? Is it personal preference or risk tolerance, or is it what makes those successions? Great question.

John Napolitano (21:47):

It’s a little bit of both. It’s personal preference and risk tolerance. And then the third might be the source. How these people find out about alternative investments is through a buddy. So they got a friend who has a friend who did this and it worked out great, and they’re doing another one. Can you check it out for me? It’s very difficult for the planner to check it out for you because all you’re getting is 200 pages of legal documents. You’ll get to meet with the managers and the sponsors. You’ll get to assess for yourself their integrity. You’ll get to understand their past experience. But it’s really tough to come up with a hard from the ground up level of due diligence. So a lot of ’em comes from the client. We have taken a much more active role. So in our firm, for example, we’re constantly searching for good alternatives that are not traditional Wall Street alternatives. And when we find one, we know who our clients are that should be aiming in it, and we go and say, okay, we got one here. We think this is fantastic. You should do this.

Dan Hood (22:50):

And you can do that for, all right, you can present that opportunity to any of your clients that it’s reasonable for as opposed to the one that an individual client brings to you and says, Hey, check this out. Right? They’re the only client that’s going to be able to invest in it. They found it and they brought it to you for due diligence. But the ones you find, presumably you can then offer to any of your clients that it’s appropriate for.

John Napolitano (23:10):

Generally that’s true. But I will say that occasionally a clients have brought us a deal that I found so compelling that I asked the sponsor, Hey, do you mind if I have other clients that invest in this as well? And you know what their answer is? Thank

Dan Hood (23:23):

You. Yes, please.

John Napolitano (23:24):

That’d be fantastic. Yeah, very cool. So we have had it go both ways, frankly, but we like scouting them out ourselves and building them from the ground up because then we really understand it from the ground up and what’s going to happen. Again, we’ve done a few real estate deals with clients. One of ’em was an industrial property while industrial properties were hot post covid that we invested in, this deal turned out to make damn near a hundred percent in 18 months in and out. So that was just, we found it, we liked it, we jumped on it, and we committed dollar before we even knew which clients were going to go into it. And again, another word of caution, and I hate to be negative Nancy here, but your broker with a large firm can not do that. They can do that. All they can talk to their clients about are the deals that are approved by their large company.

(24:21):

And I can assure you, having had experience in those large companies, the only way those large companies approve the deals, if there’s enough compensation in it for the firm to make it worth their time, they do invest a lot of time on diligence. They do have extensive diligence teams, and they do want to CYA, so they don’t get in deep trouble. But that’s all very, very, very expensive. So I just want to throw a word of caution out to those clients that think they’re big brokers, doing them fine with alternative investments, not necessarily the case.

Dan Hood (24:51):

Right. No, it makes sense. There’s a lot more we could dive into. There’s a huge topic with a lot of moving pieces in a lot of ways to think about it, but unfortunately we’re running short of time. Do you have any final sort of final warnings? I mean, you’ve given a lot of great advice in terms of what you can and can’t expect from alternative investments and how you should approach ’em. But any final thoughts you would give people as we close up?

John Napolitano (25:12):

Yes, that is, if you haven’t done it, start slow. Don’t go commit a ton of capital upfront. Number two, know the players. Know who you’re dealing with, whether they’re intermediaries or sponsors themselves. Know what you’re doing. And number three is spread it out a little bit. Don’t invest in all of the same thing. Don’t do all private equity. Don’t do all real estate. Don’t do all private lending. Spread it out a little bit.

Dan Hood (25:35):

Perfect. Makes a lot of sense. That’s awesome stuff. John Napolitano of Napier Financial, thank you so much for joining us. My pleasure, Dan. And thank you all for listening. This episode of On the Air was produced by Accounting Today with audio production by Adnan Khan. Rate or review us on your favorite podcast platform and see the rest of our content on accounting today.com. Thanks again to our guest, and thank you for listening.