Murder Holes: Built to Fail

(I recently read Josh Brown’s Backstage Wall Street. Rather than write a plain boring review, I thought I’d talk about a few points in the book that I enjoyed and can relate to.)

Near the end of the book Josh writes about “Murder Holes,” or investments that should be absolutely avoided at all costs.  Here’s my favorite line from the chapter:

“Almost every private placement you have ever been pitched or will ever be pitched is a scam.”

I’ll say I agree wholeheartedly with Josh on this.  I have seen a lot of this junk come across my desk, and it is absolute garbage.  They come in many forms: illiquid REITs, tiny tech company offerings (so sexy!), oil & gas drilling programs (but the tax benefits!), the list goes on. The offering documents are usually a few hundred pages – do you think the broker slinging this stuff has read that?  No.  Josh makes another great point: think about why the company is choosing to raise money in this way.  It is the most expensive capital you can possibly raise – why not find institutional investors, commercial banks, angel investors, ANYBODY before you raise money this way.  The operating company probably gets $0.80 on the dollar raising money this way after paying selling brokers, firms, SEC filing costs, etc.

Here’s your first clue to avoid this stuff: 7-10% commissions.  If the offering company has to give a tenth of the proceeds to some less-than-scrupulous brokers to get the money raised, look out.

A lack of liquidity is another big no-no.  This actually gets sold as a FEATURE pretty often.  They say: “It’s non-traded, so there is no volatility.  That adds nice diversification to your portfolio.”  And they actually believe this!  Why anyone would choose an illiquid investment over a liquid one is beyond me. What they are really saying is “we don’t have to value this investment on a daily basis, thankfully.  There’s no real secondary market and your client will be stuck owning this thing until we can figure out how to unwind it or we go bankrupt.”

Some of these blowups have been in the news lately with non-traded REITs.  These products got pitched to retirees as “consistent dividend paying” investments.  Clients got a 6% immediate dividend on their investment and the broker made 7%. The problem is you can’t pay a 6% dividend (really about 6.5% after the broker’s commission) when real estate investments yield 5% and commercial loan rates are going up.  Dividends got slashed (or stopped completely) and REITs sold at $10.00 a share fell to $3-$7 per share with little to no income.  So much for your retirement cash flow strategy.

Every time oil prices start going up, oil & gas drilling programs start coming out of the woodwork.  These usually pay higher commissions than the REITs because there are real risks owning these products and they require a hard sell.  They get sold with the tax break that comes with Intangible Drilling Costs (IDCs).  But to get the IDCs as an investor you have to be a General Partner and subject to the full liability of the drilling program.  Not to mention these drillers are bidding for land rights against Exxon and BP and Chesapeake and everybody else in the oil game and punching dry holes in the ground all the time.

Here’s the deal folks.  That private placement offering is just not going to be the next Google or Exxon or Facebook. Do you think Facebook put together a private placement to raise funds?  No.  They went out and raised real money from private equity and institutional investors. That private placement exists to cash in on investor money and the only people making anything on the product are the broker, the distributor and the operating company.  Investors get left holding the bag.

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