Co-Investing with Clients? Read These Pointers First.

March 26, 2019

One of the more satisfying things about being a lawyer is the opportunity to build deep, important relationships with your clients. Given those relationships, lawyers are often afforded the opportunity to co-invest alongside firm clients in private investment funds or directly in a private company.

For example, you have probably been approached with the opportunity to invest in a VC fund or directly in an early stage company.

While these opportunities indicate that you have built solid relationships with your clients, they also present a challenge. You need a process for evaluating these opportunities or you can end up with a disparate collection of private investments. So, how should you evaluate these investments, decide whether to invest and how much to invest?

Here’s a decision-making framework:

1. Focus on the Big Picture

Investments should be thought of as members of a team (your portfolio) with each member playing a specific role. Private investment opportunities are too often considered in isolation instead of in the context of your overall portfolio. For example, for a private real estate fund, you first need to evaluate what other exposures to real estate are already in your portfolio such as REITs or a commercial building.

Next, understand the primary purpose of the investment. Is it focused on generating current income or maximizing capital appreciation and liquidity through an eventual sale? Its primary focus will help you understand the role it will play in your portfolio

2. Evaluate Track Records

It’s been said that “history doesn’t repeat itself, but it often rhymes.” This axiom seems fitting for evaluating investment managers. When deciding whether to commit capital to a private investment, consider the Internal Rate of Return (IRR) for the firm’s prior funds as an indication of manager skill. If it’s a single company, you should consider the CEO’s previous experience and track record of delivering shareholder value.

If the fund or company manager has shown an ability to consistently deliver above-average returns for investors, there’s a greater likelihood (not a guarantee, of course) of that success continuing. If the manager has no verifiable track record, I would have a very hard time committing any capital to that opportunity.

3. Understand the Terms

As a crafter of contracts yourself, you know that the devil is in the details. Make sure you understand the terms of the investment you’re considering—namely liquidity and fees. Private investments, by definition, are not traded on a public exchange and are therefore illiquid, sometimes for several years.

The fees on private investments are typically more involved as well usually including an annual management fee (1.5 percent, for example) plus an incentive fee (15-20 percent, for example) if the fund delivers returns above a minimum or “hurdle” performance target.

There are myriad structures around fees, so make sure you understand the structure and that you’re comfortable with it.

4. Size Appropriately

A rule of thumb I’ve encouraged clients to use in determining how much money to commit to a single private investment is the “impact on your life” rule. This is particularly applicable with higher risk or single company investments. The rule is simple: if this investment went to zero how much would it impact your life? Obviously, the bigger the commitment the more significant the impact.

As a lawyer, when you get approached about co-investing with a client, you probably feel flattered and excited about the opportunity. Hopefully these guidelines give you a framework for how to evaluate these opportunities and to help you make sound decisions.

Justin Peacock, MBA, CFP® is an Owner and Wealth Manager at BDF.  He works closely with clients to design wealth management plans that take into account the full spectrum of their career and personal concerns.  Justin graduated from Illinois State University with a B.S. in Mass Communication and earned his MBA from Northwestern University’s J.L. Kellogg School of Business.