OPPORTUNITY ZONES/OPAL

There are reported to be 134 funds seeking to operate in the opportunity zone space, and about 80% of these are headed by people who have never run a fund before.

There was critical analysis of these investments.  Your money is locked up for ten years.  The advantage is that after ten years there is no capital gains on your profits but meanwhile you have no liquidity.  You still have a risk of achieving successful development, and the target yield was variously described as 9%, 9% to 12%, 14%, plus “300 basis points” for the value of the ultimate tax shelter.

There was no discussion of investing in companies (which is possible), only in real estate.  The expert panel thought that vertically integrated realty developers (who could put together the package of land, build the property and manage it) would be the safest bet.

The bottom line is that this is viewed as a long-term and safe cash flow play with no liquidity; it should not be entered into just by reason of the tax deferral but rather as a way to get a recurring and safer yield.

[This is the final post in the series based on discussion at the OPAL family office conference in Newport, Rhode Island held in late July.]

CANNABIS INVESTMENTS/OPAL

Most cannabis investing began in Canada where companies are publicly listed.  Everyone thinks that the United States will be a huge market in the near term with particular emphasis on places like Michigan, Massachusetts and California (with California hurt by a large black market, allegedly).

Some experts thought that investments in Canada were “played.”  The Canadian contingent sharply disagreed, claiming particularly that Canada was very well situated by way of geography and regulatory controls to be a source for growing and henceforth also a location for processing. 

Europe is perceived to be “a few years behind, although medical use is growing” and it is thought that the rollout in Europe will be country by country.  Expectation that Germany and Italy will be substantial markets. 

Some valuations for investments in cannabis related companies too pricey.  Counterargument is that as a multiple of future revenues, with future revenues growing quickly, these investments are not particularly overpriced.  There was noted a recent fallback in the price of Canadian public shares.

There has been difficulty in obtaining banking for cannabis, by way of both loans and deposits.  Recent newspaper articles indicate that some credit sources are opening up.  Everyone seems to expect that banks will “fall in line” within the next year or so, although there was no express definition of what “in line” might mean.

What about the prospects of a federal statute leaving the issue of legality to each State.  The consensus is that this will not happen, if at all, until after the next election but that thereafter, it is likely that “any new President” would be willing to undertake this unbundling.  Counterpoint: “Trump won’t sign anything from Liz Warren’s desk.”

People involved in playing the market in cannabis noted that the current confusion in terms of legality is not a problem for them; they believe in the long-term prospects, and the confusion reduces market prices today and creates a better opportunity for arbitrage.

In the long run, companies in the “sin” business (beer, alcohol, tobacco) are likely to be large acquirers, particularly since it is possible that their other businesses will fall off.  Pharma is reported as generally opposed to legalization.

General warning that there are “sketchy operators” in the marketplace and that one should invest in “professional best in class operations.”  This suggests the necessity for sophisticated investment advice.

What about the State by State legalization issue?  This is expected to be slow, sort of like States permitting gambling casinos.  Mention that the process overall could take years.

Finally, mention of an investment opportunity in “third party labs” necessary to do testing inherent in government-authorized marketing of cannabis products.  One has to look closely at the regulatory context of local labs.  Speculation that these labs would ultimately be the subject of rollups.

ALL ABOUT THE PRC/OPAL

Set forth below are comments concerning the China gleaned from several different presentations.  Some may seem to be, indeed some may be, either or both of counter-intuitive and somewhat contradictory.  A few of these comments may be woven into other posts on the OPAL conference, but I thought it interesting to just do a mind dump about “all things China.”

There is initial skepticism concerning investments in China’s brand-new Star Market, described as the equivalent of the NASDAQ market in the U.S.  It consists mostly of tech companies and was designed to provide access to outside investors, but the market was described as lacking in “depth.” 

In so-called “A Shares” (voting and generally for company management) issued by Chinese companies, there is a 10% withholding to extract the money.

Clearly U.S.-China relationships have deteriorated.  The trade dispute should be ignored.  The U.S. will not sustain very high tariffs, and this is in any event unimportant.  The point is that the United States no longer looks to build China’s economy, which was a post-WW II goal.  It now views China as a competitor and will push U.S. supply chains to be disassociated from China.

There are general qualms, if there is a further deterioration in relationships with China, that a future dictatorship might negatively impact the flow of invested funds out of the country.

China is running out of workers.  They still have a 6% growth rate but it is over a much broader base.  Demographically China is suffering from increased divorces and decreased marriages.

In terms of long-term macro analysis, as between the United States, China, Europe, and “the rest” of the world, the United States is “least ugly.”  China will end up with a 5% growth rate and may create more aggregate economic value, but the United States is a better investment bet.

The United States can successfully compete with China, it is not an existential threat. 

China sends so many people to the United States to get trained in Western technology because its population is getting older and there are fewer workers to support the balance (is this a non-sequitur?).  China hopes to build giant companies to threaten the U.S. economy.  The United States defends against this in part through recently-improved CFIUS controls which require substantive review of inbound M&A transactions with particular focus on Chinese buyers; recently Chinese acquisitions have fallen substantially.

United States stock markets will continue to go up, or not, based on reasons extrinsic to the China relationship and tech war between the United States and China.

The current U.S. Administration is using national security issues broadly, particularly when it comes to China.  This has to do with enforcement of CFIUS as well as trade sanctions, Department of Justice indictments, export controls and tariffs.  Recent litigation has indicated that the U.S. will reach out to punish Chinese companies even when theft of IP is not involved.

ALTERNATE INVESTMENTS/OPAL

At the Opal Family Office conference, a variety of alternate investments were discussed and sometimes pitched.  It was interesting to see that no “hedge funds” presented, nor were any recommended.  Herewith a checklist of alternatives discussed (without commentary as to the wisdom of any of them):

Cannabis.

Medical office buildings (described as stable tenanted real estate investments with tenants in a growth industry).

Development of fully-integrated residential housing communities with a focus on creating a “quality of life” environment.

Biotech: recommended at a fairly early stage, particularly in the oncology, neuroscience and rare disease spaces; big pharma is losing money as major drugs go off patent protection, big pharma has reduced internal research and therefore is relying on acquiring promising biotechs at early stage.

Facebook’s new “Currency” called Libra: this was described not as a digital currency but as a digital ETF; Facebook was described as “becoming a digital state” where all your information and data will be concentrated there.  (Discussion also of Bitcoin, also to no consensus.)

PE and VC Funds: with volatility of public markets and high expense of going public, growing tech companies are seeking direct investments from the private capital markets.  Additional benefit for family offices is potential pass-through under Section 1202 of the Internal Revenue Code (investments in small businesses held for five years escape Federal tax upon exit; beware AMT and State treatment, however).

Opportunity-zone investments (can be not only real estate but also operating businesses within a zone.

Gold, with an asserted preference for mining and processing companies which were said to have the benefit of being value-added to the underlying commodity; it was claimed that in the “last four quarters” gold has outperformed the S&P).

Investments in companies which emphasize ESG, the current euphemism for “environmental, socially impactful and governance” quality practices.  Today, need not be a code word for poor IRR.  But also perhaps this is not useful advice as, reportedly, 80% of the S&P 500 already purport to be following ESG practices.

FAMILY OFFICE PRACTICES/OPAL

Several presenters at the OPAL conference discussed matters of alleged importance to the operation of family offices and multiple family offices.

As with any enterprise, it is important to avoid cyber risk.  In 2017, reportedly 28% of family offices were attacked, particularly by phishing.  The greatest risk is penetration through third party vendors or employee failures.  A two-factor password protection is recommended.  You are not necessarily entirely safe in the cloud.

How to think about the U.S. political climate?  One investment advisor (not clearly of the majority view) pointed out that generally the public markets appreciate over time regardless of the person or party in power.  Although historically in U.S. politics the party in power is supremely advantaged by a strong economy, it is not quite clear that this is the current case as increased political partisanships may have promoted issues of governance and immigration even above the economy in the voter awareness.

There was a discussion concerning “drift” by advisors managing funds with a change in focus or in emphasized sectors.  To some degree, it was thought that you want a manager who is awake to trends.  In this regard, a couple of presenters noted that they always try to discuss, with potential fund managers where an investment is contemplated, the views of the younger people in the fund team to see what is going to happen in the future.  However, a drift in manager “style” may not be a recognition of requisite flexibility but rather a harder-to-analyze change in world view.

How else do you diligence a proposed investment in a fund?  You need to talk to all levels of management in the fund.  You need to talk to other investors to see if they pool their knowledge and diligence in order to provide broader insight.  Diligence is best done at the point in time that a fund is being formed as opposed to once it is up and operating.  Seemingly implicit consensus that a fund of funds is not how family offices should invest.  Indeed, there is some suggestion that family offices, at least if bonding together in “clubs,” can themselves handle their own investment decisions and avoid give-up of cash flow and equity to fund managers.

Check a fund manager’s ADV filings.  If a manager is involved in multiple funds, how are opportunities allocated, will the manager have enough time to spend on your fund, will you be afforded an opportunity to invest in parallel, in a side pocket (often reserved for people early to putting money into a given fund or for larger limited partner investments).

There was also discussion about assuring the independence of the LPAC (Limited Partner Advisory Committee which would resolve conflicts between the LPs and the manager), and how to handle the now-nondeductibility of the fees assessed by a promoter in setting up a new fund (a couple of ways work for this; giving the manager a profit interest instead, or paying the fee outside of the fund structure).

Key issues in due diligence on operating companies in which you are considering an investment:  Is there a clear plan of profitability?  Does the term sheet provide sufficient deal control to maximize preservation of principal?  Do the founders have “true grit?”  In evaluating companies, family offices were advised to have and completely follow their own due diligence protocols and due diligence questionnaire items, particularly in areas not covered by the PPM. 

Finally, consider the role and percentage of “impact investments” which have substantial social fallout; often a way to deeply involve children into the family office and business.  Consider flipping the standard family office emphasis on public market investments, which can be volatile and pricey; one presenter suggested at least 60% of investments should be in private deals.  Rely on public markets only for investments in volatile new technologies such as AI, genomics and cyber.  Consider using AI and machine learning to judge risk; in the market, most changes are usually for the negative and “velocity foretells losses.”  Keep two to five years cash available so you need not be forced to liquidate during dips, and so that you have dry powder for buying opportunities.

The Global Economy/OPAL

Introduction: This post is the first of a series (presently of indeterminate length) based upon information obtained from the recently concluded Opal Conference of family offices held in Newport, Rhode Island.  These posts will be denoted at the end of the title of each post with the word “/Opal.”  At this conference, presentations were made by experts in economics and government, advisers outside and within family offices, and persons suggesting (or directly offering) a variety of investment platforms.  All “Opal” posts are based upon my notes of the relevant panels and my personal reactions.  The data presented has not been verified by me.  Nothing in these posts constitutes investment or legal advice on the part of myself or my law firm.  My firm was one of many presenting sponsors of the Opal conference.  To the extent I may make reference to cannabis investment, be advised that one of my law partners chaired the panel on cannabis investment on behalf of our firm’s substantial cannabis practice group.  This introduction applies to all Opal posts but will not be repeated.

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Numerous panelists discussing numerous investment topics strongly concluded that investment in United States securities or opportunities was most prudent.

This in face of expressed fears that no one can tell where the economy in the US, or in the whole world is headed.  These fears came in two flavors: that the bull markets have gone on so very long and everyone knows that they are cyclical and at some point will fall either as a 10% correction or likely worse; or, there are identified fundamental signs that suggest that the markets must fall based on substantive business reasons. 

Specific citation to factoids indicating we are in for an adjustment or a recession some time soon (with no specific time horizon): trade wars; reduction in world trade; strengthening dollar harming exports; Chinese economic problems (aging demographics; debt; new American policy to consider China in the long term as a competitor and not an economy to be nurtured on humanitarian and US-profit grounds); European disunity (not limited to Brexit); rise of populist governments; European debt selling at a discount (“Europe is telling us something”); the gold markets (“Gold is telling us something”); return of quantitative easing on the part of central banks; central bank purchases of gold reserves; weaknesses in “other” markets; inability of other countries to generate unicorn giant companies with giant exits.

Not a lot of discussion of geo-political risk in specifics.  Not much emphasis on Brexit except as a symptom of national politicians needing to respond to local political and economic crises but being denied flexibility to do so by reason of “Brussels.”  Not much discussion of US national debt as a percentage of GDP.  No one mentioned robotics killing jobs or need for labor at all.

Specific citation to factoids indicating we are in excellent economic shape at least in the United States (you may note reasons directly contrary to some of the negative factoids): US technology and innovation; the American dream which will attract the best and the restless to the US over time to found innovation based on available investment capital and robust exit opportunities; the favorable US demographic future compared to other countries (a surprise item to me); lack of likelihood that tariffs will really be sustained at unacceptable levels and ability of the US to establish supply chains outside China (“Viet Nam is the next China;” less important supply chains for a service economy).

Most sobering thought, coming out of the ESG panel: an impassioned plea for companies and countries to address the nuclear weapons access situation: “If we don’t get this one right, nothing else matters.”

Who will lead the world?  The US and China (not a surprise) and very negative views of India (“70% of all cigarettes sold in India are by the single stick;” “the South may be fine but the North has majority of the population and no business”). 

Does seem to me that the dissing of India is a bit short-sighted.  India has vast populations and land mass and an edge into the English language and an entrepreneurial educated class.  It is a long life (assuming we survive the nuclear weapons issue) and it is hard to believe that India will not figure it out by planning or by accident or by dictatorship.

SEC Power Overseas

A couple of weeks ago, a three-judge panel of the United States Circuit Court (for the non-lawyers: the highest Federal courts except for the Supreme Court) decided the case of SEC v Scoville, which in effect held that the SEC has enforcement powers against alleged securities frauds which are primarily extra-territorial.

Attorneys and those wedded to arcane analysis should revert to the case; the facts are complex and the decision arguably does not resolve the question of how far the arm of the SEC reaches.  And, the minority justice on the panel simply said that the Dodd-Frank Act just granted jurisdiction to the SEC, period, a conclusion not clear from statutory history.  Further, a 2010 SCOTUS decision, Morrison, was widely understood to require misconduct connected with US transactions; that understanding seemingly still applies to private lawsuits, but not necessarily to SEC enforcement.  This bifurcated result is defensible based on legal analysis, but perhaps anomalous if your step back and take a logical look.

What is the impact of this decision?  First, we have not heard from other Circuit Courts and they may disagree with Scoville, setting up an ultimate Supreme Court resolution of differing Circuit decisions.  Second, certainly the SEC, long seeking authority to chase off-shore frauds, at least for now will be more aggressive in selecting the cases they bring.

In the late 60s and early 70s I recall arguing to the First Circuit Court of Appeals that US-based brokerages were not liable for acts outside the United States, period, even if involving US securities and even involving US citizens. Claimants replied that protecting US investors when they were living or just traveling overseas, and keeping US-based firms generally ethical, were valid exercises of SEC power (and indeed also a basis for civil liability on behalf of injured investors, which was a viable argument pre-Morrison).  The law today still bars private rights of action in most offshore cases, but Scoville clarifies a rationale for SEC activity and, thus, at least some recourse for the allegedly defrauded.

Talking Diversity and the SEC

Diversity is a huge issue in constructing boards of directors, and never is it so focused as for reporting companies.

Extant SEC disclosure rules contained in Regulation S-K already required disclosure of diversity information, to the extent consent from a director or director candidate agrees, including race, gender, ethnicity, religion, nationality, disability, sexual orientation or cultural background.  New guidance requires a statement as to HOW these characteristics were considered by the nominating committee or board.

Extant SEC disclosure also required a description of the process of nomination, whether it considers diversity and how.  New guidance requires an explanation of how it blended in consideration of other factors within scope of its diversity policy, including work history, military service or socio-economic characteristics.

Boards do discuss these issues, of course; one is compelled to if there is any sort of diversity program.  It is not clear to me what this new granularity has to add beyond eliciting an obvious response.  Perhaps the goal is to dig for detail to eliminate a suspected practice in some cases of tokenism?  Will we see disclosure other than a formulaic kind of recitation (“we aim for a board that is diverse, we needed a cyber expert, and  X turned out to be a widely recognized cyber expert and X also turned out to be a [pick a diverse category]!”).  Sharing the goals of diversity and preaching it in my own practice need not require government guidance on the obvious, and no board is going to say that they failed to look at all attributes of a director candidate.  Much SEC disclosure in response to ever-refined disclosure regimes results in a longer document but no increase in true qualitative data.

Today’s  Boston Business Journal carries an article about local company general counsel decrying lack of diversity in law firms while suffering lack of diversity on their own boards.  Aside from highlighting the intense topicality of board diversity, the article suggests an approach to disclosure: simple head count.  Should you care about process, or bottom line results.  As they say: “If you cannot measure it, you cannot achieve it.”

Stock Buybacks and the Wealth Gap

Most public observers note the wealth gap in the United States.  Liberal Democratic politicians for the past two years have suggested legislation to narrow it, and one theme is to prevent public corporations from buying back their own stock unless they have acted to close the wealth gap.

Bernie Sanders is re-introducing legislation that would ban buy-backs unless companies increase pay to a $15 minimum wage and provide paid sick-leave.  Similar controls would impact dividends.  The theory is that buy-backs enrich investors and executives, already wealthy enough.  A recent Times op-ed piece by Bernie and a California Rep was to the same effect.

Elizabeth Warren’s was more subtle, barring executive sale of shares for three years after a stock buy-back, although other provisions were more far-reaching (employees would name 40% of a public company board, a proposal so disruptive from a governance perspective as to be structurally unworkable even putting aside being a political non-starter.)

It is not my job here to engage in the ongoing un-civil political war we are now experiencing.  It does, however, strike me that the proposals of both Senators are very far from the mainstream of historical American social and political thought, as well as sure to create enormous resistance from business interests and business theorists.  To the extent one identifies and wishes to address wealth disparity, which indeed can be an existential risk to any government (at some point we cannot easily define for the US), a more limited practical approach in increments certainly seems more viable if you really want to see actionable legislation get passed and signed by someone living at 1600, Republican or Democrat.

Disclosure:  Bernie and I were classmates (class of ’59), and both writers for the James Madison High School Magazine, but at the time Bernie was writing about his track team and not about politics.  Same school attended by Chuck Schumer and Ruth Bader Ginsberg….

Rep Insurance in Acquisitions

A growing practice is for either a buyer or a seller of a company to insure the risk that there is a misstated warranty or representation in the acquisition documentation which triggers an obligation of the seller(s) to compensate the buyer for the damages arising from such misstatement.  This product offering has become more prevalent recently, as it facilitates reaching a deal rather than getting hung up on sorting out liability for unintentional misstatements.

As these policies have become more common, confusion has arisen about how efficacious they are.  This breaks into two inquiries: first, do they pay off or are the mechanics of proving a claim too arcane; second, just what is being insured against.

AIG, a major insurer in this space, has shared some experience about claims payment; seems almost 20% of all policies actually pay off with an average payment of about $4Millon; most claims arise in deals from $100M to $1B.  Most typical payments relate to misstated financials, tax obligations, legal compliance or contents of material contracts.

As to what is covered, that is really incredibly simple: these policies are widely varied and you have to read them carefully.  Law firms often say you need a lawyer to read them, and surely lawfirms can do this work and can pick up some difficult areas.  But there is no reason why any businesspeople cannot read the coverages and exclusions for themselves. For example,  all exclude active fraud and illegality, projections and matters in fact known to the insured party (typically but not always the buyer).

Areas where coverages vary, aside from amounts and premiums of course: the period of time in which a claim must be made; how large a claim must be before it is covered; whether the insurance pays first dollars of any claim or kicks in only once the seller’s indemnity obligations have been fully paid; whether particular areas are expressly excluded from insurance, such as particularized atypical representations.

As policy availability has moved down the food chain and become available for lower middle market deals, the market’s familiarity with this tool, beyond the PE fund acquirer, will no doubt increase.  These days, M&A counsel typically will at least alert clients to this deal tool on each side of a proposed transaction.