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How We Approach Investing In Start Ups5 min read

and Other Special Situation Investments

Oct 24, 2018 - Max Osbon ( 8 mins to read)

Max Osbon

Osbon Capital manages client investments like a college endowment would be managed: with capital preservation, growth and longevity as the primary goals. Nearly all of our investments are in highly liquid major publicly listed securities because they fit well with these client goals. However, from time to time unique direct investment opportunities can arise, and when they do, they can represent a good opportunity for a client to step outside of their traditional allocation. Here’s how we look at special situation investments:

Risk-return profiles

Venture capital funds, derivatives traders and poker players find their advantages within skewed risk and return profiles, investments where the expected upside exceeds the maximum downside. An attractively skewed investment could have an expected return of 300% and an expected maximum loss of 100%. If you invested in two such investments with one loss and one gain, you would still double your investment. Attractively skewed investment opportunities allow you to be wrong multiple times and still come out ahead.

This is how successful venture capital firms operate. They take advantage of the skewed risk profile when they invest in 10 to 15 early stage companies, knowing that just three successful outcomes will outweigh all of the combined losses. In the right circumstances, private individual investors can use the same mathematics for their benefit.

Warren Buffett maxims apply

The majority of our clients are engineers, entrepreneurs and executives with deep industry expertise. Over the past five years I’ve witnessed many clients participate in unique investment opportunities where they personally knew an emerging team, had a unique insight into a new opportunity, or they were starting a new business themselves.

The more successful outcomes tended to fit the Warren Buffett maxim: “Invest in what you know.” Buffett also advocates a “20-slot rule,” where you invest as if you have a lifetime limit of 20 or fewer best idea investments. Investors that pair these two concepts end up matching patience with diligence, a powerful long-term investment strategy.

Some examples

Special situation investments are often startups but don’t have to be. It pays to be creative and open minded so that you don’t overlook new ideas as they present themselves. They can be real estate related, like data centers, modern agriculture facilities or underdeveloped local real estate (qualified opportunity zonesmap). Certain private equity funds can be considered special situations. Bitcoin counts, too, and has the added benefit of allowing for minimum purchases as low as $1.

The right size

Given our clients’ goals of capital preservation, growth and longevity, we limit special situation investments in scope and number. Any investment that puts at risk the capital base that’s used to fund your quality of life or your retirement is probably not a good fit. Calculating your baseline financial requirements is an important exercise. That number is often a moving target that’s dependent on how much you spend annually. We can help you find your unique number.

When you know how much excess capital you have available to invest in riskier special situation growth assets, you can start sizing each opportunity. Rather than starting with how much money you stand to make, start with the maximum potential loss you could handle and work your way back. Assets that have a potential 100% loss, like angel investments, should be smaller than investments where a complete loss is unlikely.

Keep in mind that leveraged real estate can go ‘underwater’ and in worst case scenarios losses can be more than 100% of the original investment. Major publicly traded stocks can also go to zero, but they rarely go to zero all at once and you almost always have time to sell when prices fall to a level that make you want to exit.

Source, team, industry

When we evaluate special situation investments, we start by evaluating the source of the opportunity. Where did we first hear about it? Who in our network brought it to our attention? This is a crucial step because it keeps us from having to compete against major deal makers with preferential access. Next, the team is crucial because it speaks to the capabilities and unique advantages inherent in the opportunity. It’s best to invest in teams with experience, a track record and demonstrated subject matter expertise for their given domain. When we look at industry, the third component, we’re looking at the recent comparable outcomes of other investments in that same space. Is it a winner-take-all outcome? Is there potential for multiple winners? What is the average result for the winners and losers?

A local example

Most of what I learned about how to approach these opportunities has come from personally witnessing how our clients approach their special situation investments. Last year I structured the initial friends and family round investment in the local fintech regulation startup, Hummingbird. On Monday Hummingbird officially announced its most recent $3m raise from the fintech venture industry’s top firms Homebrew, Omidyar Network, TTV and Designer Fund. The future returns on this investment are unknowable and the company is still very much in the “proof of concept” phase. A funding round does not spell the success of a private investment, nor does a private investment experience a return until an opportunity to exit presents itself somewhere down the road. The Hummingbird investment opportunity came from our personal network, allowing us to get in before it caught the attention of major venture funds.

Osbon Capital’s Role

We apply the same rigor to special situation investments that we apply to the construction of all client portfolios. We look for risks that manifest from details buried in the fine print, pricing that doesn’t make sense, representation mismatches, structural issues, tax efficiency, and many other factors. This process is crucial for avoiding mistakes that don’t need to happen. Most opportunities don’t make it through this evaluation.

Special situation investments are not a good fit for most investors because the risk of loss is high and most investors aren’t comfortable with that outcome. In the unique cases where special situation investments do align with client goals, they can be powerful wealth generators. If you are interested in learning more, please ask us.

If you have a special investment opportunity from your personal network and are interested in sharing the details with us, we’d love to hear from you.

 

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