An Overlooked But Important Aspect of Private Investing
Today’s article focuses on a subject that, in my experience, many individual investors place little if any emphasis on. This lack of emphasis leads to misperception when properly assessing the true risk of a private investment product. The term bankable will be described, along with it’s relevance, and examples will be provided to demonstrate its importance.
Merriam-Webster defines bankable as:
- Acceptable at a bank (bankable currency)
- Sure to bring in a profit
What does it mean to be acceptable at a bank? We must recognize that major lending institutions, such as banks, only lend money when they have a reasonable degree of confidence that they will be repaid. As anyone who has applied for a loan can attest, the bank first gathers every item of information about you, then makes an assessment regarding your ability to repay. For business loans, many times the bank will require personal guarantees and additional covenants, and sufficient collateral to cover the amount borrowed in case of default. Traditional lending institutions such as banks will also tighten criteria during challenging economic times.
Basically, if you or your business qualifies for financing, the bank has given you a certain seal of approval. You become bankable.
How Being Bankable Applies to Private Investing
Consider a small private investment project. The project manager may consider themselves an expert in, say, real estate development. They want to raise $5 Million from investors, and obtain bank financing of an additional $10 Million to proceed with the project. As an investor, some extremely key clues are revealed as to the amount of risk you are taking:
- Did the manager shop the project around to a number of lenders and was turned down by most?
- Or perhaps there were a number of financial institutions competing for the opportunity to finance this project. Obviously a good sign.
- Is financing conditional upon certain factors, such as pre-leases, or the raising of a minimum amount of investor funds?
- Is management willing to place personal guarantees on the financing? This demonstrates skin in the game as well as commitment to the project.
- What are the terms of financing? Interest rate paid? These leave clues as to the level of bankability.
In my experience, these inquiries are rarely made by the average investor, despite their major importance.
Private Investment Examples of Bankability
I have found that real estate development projects seem to have the most risk in terms of financing and making the project bankable. Examples abound of development projects, in which the financing is conditional on a certain amount of pre-leases, with 40% being a common minimum threshold. During the initial sales pitch, management may have originally presented the ability to obtain the projected minimum leases in one year, for example. If that year passes, and the 40% is not met, the project is not yet bankable. Until the minimum is met, the project is stalled, and investor funds can be tied up for much longer than projected. As an investor, whenever this type of development project is presented to you, be aware that your funds could very well be tied up for much longer than initially projected.
On the other hand, there are private projects which do not carry the same level of financing risk, because they are bankable from day one. I have witnessed projects in which management has a combination of the following factors:
- History of successful investment outcomes
- Demonstrated expertise
- Existing asset base which the bank is willing to lend against
There is a particular oil and gas project which demonstrates the risk mitigation involved in being bankable. This project, a project with no assets to speak of, was able to raise investor funds at essentially the same time as arranging bank financing. The combined funds were used to purchase production assets for approximately 4x cashflow. Banks typically do not lend to private projects in their early stages, especially blind pools. In this case the project’s ability to be bankable was a testament to management being of exceptional quality.
Other private investments may start off without being bankable. The lending institution will insist that they acquire assets and prove out the business model prior to financing. As time goes on, assets are acquired and the balance sheet improves, the company may make an announcement that they have now been granted financing from a major institution. The fact that the project is now bankable, and the bank has given it a thumbs up, can mean many positive things:
- The bank sees the assets as being marketable even though they do not trade on a stock exchange
- Proof of business concept
- The project has been de-risked as compared to day one.
- The investment can be considered safer to purchase now
Although risk is certainly not eliminated entirely, the fact that a project is bankable can serve as a guage to the amount of risk an investor is taking, so make sure you pay attention and ask the right questions.
Too many investors, quite frankly, pay attention to the wrong things when considering private products to purchase. Glossy brochures, high yields, and a great sales pitch can lead to losses if more important factors are not considered. One of these factors is the ability to be bankable and the terms surrounding bankability. Make sure you do everything possible to place a particular investment’s risk in perspective by finding out if it is bankable.
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