This week April 7, 2018, we discuss what to consider when investing in a relative’s start up company. We analyze how to decide as a worker living abroad how much to invest in one’s host country versus one’s home country.
Finally, we look at developments for upstream master limited partnerships.
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Welcome to Money For The Rest Of Us Plus. This is the companion episode to Episode 199: What kind of money is it? In today’s episode, we discuss a member whose 25 year old niece has asked that he and his wife invest in her company. So, how do you decide when it comes to unsecured lending to family members? Another member is trying to decide how much to invest in his native India versus the US where he currently resides with his family. Then finally, a discussion on upstream master limited partnerships. Something we’ve not talked about very much at all.
Investing With Family Members
So, first, this potentially unsecured loan to a member’s niece. She’s 25 as I mentioned. She is planning to produce and sell natural skincare products over the internet as well as wholesale to brick and mortar stores. She says she needs to raise another $30,000 to complete things such as getting the website running, packaging and product fabrication and marketing. She’s offering to pay 7.75% interest on the loan and wants to repay it in a maximum of 10 years. The member writes, “$30,000 would represent roughly 1.6% of our overall investment portfolio. We’ve not asked to see a business plan and do not have insight into the businesses finances. If she needs the $30,000 to finish launch, I would suspect that the business does not have much of a cash cushion.” (I think that’s a really good assumption).
“We would not normally be inclined to extend this loan, but would like to look at it with an open mind and learn more about this sort of investing. Since you have had unsecured loans in your personal portfolio in the recent past and you still list investment and relative startup venture in one of your holdings, I wanted to ask you some questions.”
So, his questions are how do you choose between making an unsecured loan or an equity share, but let me step back regarding … Here’s how I would look at it. This is high risk. This is a startup and when I have made high risk, basically unsecured loans to family members, I assumed the money was gone. I assumed it was a gift and maybe we structure it as a loan or as equity, but I have always assumed the money was gone and I wouldn’t be repaid.
So, I’ve roughly invested let’s say $35,000 at one point. That was a level and an amount that I was comfortable doing. When I have lent money to family members that didn’t have an estate per say, I haven’t done any paperwork which is one of his questions. What type of agreement? I didn’t do an agreement. Here’s some money. This is our term. For the equity investment that I did, there was I’m a member of I guess of an LLC. There’s an operating agreement and I’m a limited partne. So, I made the investment. So, there’s some documentation there. So, I know I have ownership, but it was high risk and investing is high risk and it allowed me to just sort of separate it out and not worry about it. So, I think in this situation when your question is should it be set up as a loan or equity. I think it should be set up as equity in this case because this is an equity like investment.
If it fails, the money is gone anyway whether it’s equity or a loan. So you might as well potentially participate in the upside if it goes very well. If you want to participate, I would do it as equity so that you have actual ownership so you can benefit from the upside. With a loan, there is no upside. There’s just the interest rate and if it defaults, then it’s not secured by anything. So, the unsecured lending I’ve done is more to be of help and in fact, one family member I recently wrote off the entire loan this past year and just because I just no longer felt comfortable collecting interest on it. So, that’s how I think you would have to approach it.
He asked what kind of documentation to sign. There have been times when I’ve lent on a down payment of a house or temporarily, I knew I was going to get the money back there or I’ve lent to other friends on a short term basis. I have signed documentation for that. His question is where do you get it. It doesn’t even have to be complex. You could Google it to find examples. The documentation for a loan, like to an in-law, is more to show that the loan exists. So if, for whatever reason, they pass away, we can still get payment out of the estate. So, it isn’t to take them to court. It’s just to show that there was this loan outstanding. I did this for example a few years ago. During that 2013, we were jumping houses trying to figure out where to live, I lent the down payment for … it was about a $100,000 down payment to a friend for a house he was buying that we were going to live in for six months.
Now, he did that so he didn’t have to get an equity line. Just made it simpler. In that case, we were living in the house. I knew him well enough to make it unsecured which was a risk, but have known him for years. We’ve done a lot together, but I did the paperwork and he signed a personal guarantee and mainly I signed it in case he passed away.
So, in terms of what sort of due diligence do you recommend, again, this is a gift. If you were doing it as an investment, you would look at the business plan, but the reality is, it’s really high risk. Particularly in cosmetics. Natural cosmetics. Even a business plan, it’ll be hard to assess. Hopefully she’ll do well. I guess that’s the bottom line is I would assume you can do due diligence, etc., but the reality is, she doesn’t know how it’s going to turn out. You don’t know how it’s going to turn out.
This is a family member. If you’re going to do it, do it as equity. Tell her you’d be happy to participate if you want, but then in terms of your mental account, just assume the money is gone and that you’re not going to see it anymore and invest an amount that you’re comfortable walking away from.
How Much To Invest In Host Country Versus Home Country
Next question, members is married and 35 years old. Both of them, he and his wife, work in the software industry and save a lot of money. They save 60%. Good for them. They’re maximizing their 401Ks, HSA and Roth contributions. They’re on a worker’s Visa H1B, so they’re fortunate in that aspect. So, they’re living in the US, they’re working in the US. They would like to settle here for the long term, but the current immigration debate as we mentioned, there’s a lot of uncertainty of where they will settle and retire. They say permanent residence is at least 10 years away for them. Currently, they have 78% of their savings in the US and 22% in India where they’re from.
The Indian investment, the investment is in India, they’re in the Indian rupee. They’re in fixed deposits at a well known Indian bank. They’re somewhat of a guarantee. It sounds, if I understood correctly, let’s see, effectively there’s some insurance. He says that it’s with the state bank of India. So, it’s a state bank of India. If it fails, it’ll be a large problems for India, but it is a possibility that … So, effectively I guess there isn’t insurance but it’s the biggest bank in India. His biggest concern then, so he’s earning 6 and a half to 8% on these Indian fixed deposits. He’s trying to figure out what should his split be between India and the US.
One way he’s thought about it is just save enough in case he would have to, for example, move to India on short notice, buy a house, have one to two years of expenses and so maybe that’s one way he’s looked at it. He’s concerned potentially about the currency risk if the Indian rupee should weaken significantly and he decides to stay in the US, that would provide potentially some harm. There’s not a right answer here as I’ve thought about it and it’s very, very difficult to … There’s just not a right answer.
A Daoist Approach
One of the audiobooks we listened to on this trip was the Tao of Pooh. It’s on Daoism. The Zhuangasi and some of the other concepts that I’ve talked about in earlier episodes really based on Taoism and one of the aspects is you let things happen.
Certainly you plan, but to decide you should have 36.3% in India and 66 or something percent in the US, you’re just never going to know. So, you sort of start where you’re at. Right now, you have 23% in India, 78% in the US. You seem to be comfortable with that. That’s kind of how I would start out and then just kind of adjust as your work situation changes, as the immigration environment changes, as the investment opportunity changes. One way you’re looking at it, which makes sense. You’re earning 6.5% to 8% on the investments in India. The inflation was 4% last year, 4 and a half percent so roughly you’re earning maybe 3% real. So, you sort of make adjustments as expectations change in terms of investment asset classes, as economics changes, and as your life changes.
But I wouldn’t make a major change from where you’re at now. Right now you’re sort of 78/28 in terms of the split. I assume you’re comfortable with that. I would continue to save in both areas and then adjust as the opportunity changes. What did surprise me, I did not realize this. He mentions so this investment is tax free in India. He doesn’t pay taxes on this in India. Somehow this is structured so it’s a tax free investment, but as a resident here in the US, he actually has to pay 33% taxes on that income he’s earning in India even though he’s a resident of India because he lives in the US. That’s just taxes I guess.
Next topic. A member lives in Midland, Texas and we were just near there. Didn’t realize we had members in Midland, Texas. He has a question on master limited partnerships. He says, “The Texas oil economy is heating up again,” and boy is it ever? When we went through Hobbs, New Mexico in eastern New Mexico, west Texas, there are oil rigs everywhere. There’s trucks everywhere. Absolutely amazing. The last time I’d been to that area was during the great recession in 2008 and there, not a whole lot going on. It’s heating up now. So, he mentions a local company called Midland Legacy Reserves. They’re an upstream oil and gas master limited partnership.
Typically when we’ve talked about master limited partnerships, we’re talking about midstreams. So oil and natural gas pipelines and storage facility which theoretically are less risky than upstream. So, upstream would be more the actual production of oil and the exploration. In other words, just getting the oil and natural gas out of the ground. Now, there’s different levels of risk when it comes to upstream investing. Much of what I have done on that has been through energy partnerships, private energy partnerships where they’re institutional, we’ve done the due diligence and usually not the … It’s where there already has discovered oil. So, there’s just different degrees of upstream, whether they’re just out trying to find it versus they’re actually have discovered it.
But what I thought was interesting about this article was they’re a master limited partnerships. One of the few upstream MLPs. There is only, according to this article, about 13 companies in 2014 doing business as upstream master limited partnerships. The president, Dan Wescott of Legacy says 11 of the 13 have gone away. They’ve either merged, they’ve gone bankrupt, or they have switched to a C-corporate structure. That’s what Legacy is doing. That’s what this article is about. They’re leaving the MLP space. They’re going to be a corporation and the reason they’re doing that is they believe that it’ll simplify their corporate structure and lower their overall cost of capital. Their cost in terms of their equity cost, in terms of rate of return, in terms of their debt cost. This reinforces the discussions we’ve had regarding master limited partnerships.
There’ll be less of them because with lower corporate income tax rates, it’s less compelling for a master limited partnership to stay that way because MLPs are tax free. Investors, the limited partners are the ones that are taxed. They’re taxed at the shareholder level. So, it’s becoming more compelling to be a corporate structure. In their case for example, the quote is that by “increasing access and streamlining our structure, we expect improvement in our cost of capital to fund our growth and address our liquidity profile.” So, they’re converting to a corporation because they believe their overall cost to access the equity market, to access the debt market will be lower.
It’s just interesting that there’s very few upstream master limited partnerships anymore. There are less midstream MLPs. Not that the sector is going away. There will always be some MLPs, but it’s becoming more concentrated. I continue to invest in MLPs. The dividend yield is 8.8%. It will be more concentrated. I don’t have them in the model portfolios anymore because of that concentration risk and the other uncertainty, but for now, I’m comfortable continuing to own them, but it’s just interesting what’s going on in the upstream space. There’s just not many upstream MLPs anymore. So, that is Plus episode 199.