Deal Me In

This is a column about some of the deals I'm in, and it's tricky. If I write it wrong, you'll think I'm rich. Nobody likes the rich. Or you'll think I'm poor. A poor financial writer is like a dermatologist with acne. Or you'll think I'm bragging. A couple of the deals have worked out. Or you'll think I'm bitter. Me? Bitter?

Much is written about the little liquid investments we can make--$1200 here, $4300 there--in stocks and bonds and options. And much is written about the big investments some people make--T. Boone Pickens buying Gulf Oil (almost) or Rupert Murdoch buying Warner Communications (not quite) or D. K. Ludwig blowing a billion dollars trying to cultivate Brazil. But where are the articles about the little deals? The $1,000,000 deals split 30 ways. The ones that may still be out of your league--you'd rather blow the $35,000 on a Porsche--but that you can be sure your anesthesiologist has a piece of.

Most of these deals are tax-motivated, but the guy presenting this one to you, whom you've known since you were sophomores together in college, says, hey, forget about the tax advantages!--he's putting his grandmother into this deal (and he probably is). She's got zero use for tax shelter, he says, but this deal's so good that even without the tax advantage, blah-blah-blah, blah-blah-blah, yuppety-yup-yup-yup.

Deal Number One--Your College Buddy's Grandmother

My first such deal had amazing credentials. There were, to begin with, my college buddy's grandmother and his Harvard Business School degree. Then there was the general partner. Years earlier, he had been at the top of his Yale Law School class. (When you or I invest from the comfort of our vibrating recliners, we are limited partners. The fellow we send our checks to, or the legal entity erected to protect him, is the general partner.)

And there was the sensible way the deal had been structured. Seven wells would be drilled, not one--low-risk development wells, not wildcats--to assure that the law of averages would be on our side. If the price of oil held firm or rose, we'd be flush. This deal wore sensible shoes.

The leverage in the deal came if the seven wells lived up to expectations. Then, secured by their value, we would borrow enough for a second set of seven. That would give us twice the tax deduction and, down the road, twice the royalties. We had to sign personally for the loans, but where was the risk? The cash would be borrowed only after the bank had been satisfied as to the value of the first set of wells.

Sure, the prospectus talked about potential conflicts of interest and at least 100 other reasons not to invest, but that's what prospectuses do. For the best deals and the worst deals, they all read maddeningly alike. What really matters are the people. A college buddy, a brilliant Yale Law grad, a grandmother. How could it miss?

What was truly extraordinary (hey, I was young) was that one of the seven wells had already been drilled, even though not all the money had been raised (I never did quite understand this), and-- wow!--it looked as if it could carry the whole program by itself. That was why my buddy was putting his grandmother into the deal.

Finally, even though the minimum unit was $50,000--it said so right in the prospectus--he thought he could get the general partner to make an accommodation and sell me a half unit. Sadly, he was right.

The wells were drilled; they looked promising just long enough to secure the bank loan; seven more wells were drilled; and then all 14 wells dripped and dribbled at a rate the general partner eventually admitted might get us out of hock to the bank in 14 years but would never return a dime of our investment. (In theory, the loan to drill the second seven wells would not be drawn down unless the flow from the first seven warranted it. But the bank was hardly going to quibble over geology when it had 35 financially robust signatures guaranteeing principal and interest at two and a half percent over prime. It was not loans like this that brought down the Penn Square and Continental banks. Don't blame me for the near collapse of the Western world.)

The important point to make is that, while some oil deals hit nicely (I'm in two) and while most bomb (I'm in four), this story is not unusual--it's the norm. As it turns out, they've always just drilled one of the wells, even though the cash has not all (continued on page 266)Deal Me In (continued from page 175) been raised, and--confidentially--it's always a zinger! What's more, these deals are made up mostly of grandmothers who need no tax shelter--or so it sounds (somehow, their names never wind up with yours in the list of limited partners).

And the funny thing is, your college buddy really meant to do well by you and took the commission he made selling you and the rest of the frat house and invested in a half unit himself. The general partner, too, was eager for you to succeed, not least because he retained a 25 percent interest in the wells. If they bombed, he made only a fee for drilling them and a fee for maintaining them and a fee for trying to rescue them and a fee for putting the deal together in the first place.

My college buddy has long since gone on to bigger and better things and last year made more money than the President of the United States. The general partner has moved to even plusher offices and sends us the bad news more or less on time every quarter. He doesn't write to us directly; he has a much-abused vice-president of investor relations for that. He's had five of them since we started.

Deal Number Two--Paper Castles

Some real-estate deals are erected entirely on tax opinions. I avoid the ones that promise a three-to-one write-off (invest $60,000, write off $180,000, save $90,000 in taxes), in part because they'd make me feel slimy and in part because I haven't the faintest notion whether or not the tax opinions will ultimately stand up. The prospectus goes on endlessly about there being "no assurance" the IRS will allow the deductions; the tax-shelter promoter goes on endlessly about all prospectuses' having to say that ... but.

I also avoid deals marketed by the major investment houses. The imprimatur of a huge brokerage firm suggests legitimacy, and that's no small thing. But one somehow feels that the choicest deals will not be reserved for the retail accounts and that only part of the motivation in structuring the deal is to make the investors rich.

I've been a tiny partner in a couple of New York City co-op conversions, where by doing some paperwork and paying some attorneys' fees (and being patient), you turn a $350,000 brownstone with five rental apartments into exactly the same brownstone with five cooperative apartments that you sell for $600,000. (This is not a $250,000 profit on a $350,000 investment, it's a $250,000 profit on a $100,000 investment, because the rest of the purchase price is financed by the bank.)

But by and large, I feel more comfortable seeing my dollars go actually to build something. This can be risky. We took a run-down eight-story building, gutted it, put in a new elevator and eight new apartments, sold them--which was not easy in 1982--and, after two and a half years, barely broke even. Such was the leverage in that deal (the bank having put up most of the money) that had we just hung on for another year before selling--which, by gritting our teeth a little harder, we could have afforded to do--we would have gotten 30 percent or 40 percent more for each apartment and, instead of breaking even, tripled our cash.

Another deal involved building 200 rental units in Longview, Texas. I've never seen Longview, Texas, but the deal came highly recommended by someone I trust. And to the substantial credit of the general partner, the project was built on time, on budget; the units were fully rented on time, on budget; and the first checks we received were in excess of projection. Then a nearby steel mill laid off 3000 people. There have been no cash distributions since. However this investment ultimately turns out, the point is that we did at least build 200 attractive housing units. (Well, a bunch of hard-working guys I've never met built the units; but we paid them.)

Deal Number Three--Your Ship Finally Comes In

Research-and-development deals are another fine way to feel good losing money. Almost all these deals fail, but you get to write off your investment in the year you make it, much as if it were a charitable contribution; and any money that should come back (dream on, sucker) is likely to come back as a lightly taxed capital gain. More than that, you have the feeling that, technodunce though you may be, you've attempted something worth while. The development of a more efficient electric engine, the construction of a revolutionary ultralight graphite fuselage, the design of an improved solar collector, the development of a machine that eats tires and excretes energy, the development of specialty silicone lubricants (for diffusion pumps, not recreation), the development of power-transmission fault indicators (we had a big order from Argentine Electric just before the Falklands war forced cancellation; since then, business has been slow), and so on.

I'm in a few of these deals and retain distant hopes for the tire eater, but otherwise my success has been limited to one venture--and even that was limited. A group of us who had only the vaguest idea what monoclonal antibodies were put up $1,800,000 so that a handful of people who knew as well as anyone in the world what they were (and who had several months earlier invested $500,000) could develop a new kind of diagnostic kit. The kit would assist hospital pathologists in making rapid analyses of suspect tissues. Not only was the cause worth while, if it succeeded, we were guaranteed three times our money back or (at our option) twice our money back and ten percent of the company. It was the latter option that made the deal particularly intriguing, because although only a tiny percentage of high-risk deals like these succeed, those that do can succeed on a grand scale.

This one was succeeding on only a fairly grand scale and was running out of cash just as some powerful competitors were bestirring, when, happily, after a mere 18 months, Johnson & Johnson agreed to buy it for $18,000,000. This may or may not have been the most acute strategic move Johnson & Johnson ever made, but it was a blessing for us.

Now, here was the rub. For all its girth, the sheaf of papers underlying our $1,800,000 investment did not specifically deal with how such an $18,000,000 prize should be split up.

Obviously, the folks who had invested $500,000 and, more to the point, their extraordinary talents deserved the lion's share of the bonanza. They were the entrepreneurs; their brains were prime assets. All we had done was risk $1,800,000 to pay their salaries and expenses, which hardly seems like much of a contribution after a deal has turned to gold. (Try raising it beforehand, however.)

So the general partner decided it would be fair to split the $18,000,000 this way: We would get back our $1,800,000, plus a $900,000 profit; he and his colleagues would get back their $500,000, plus a $14,800,000 profit. For us, a 50 percent return on our money; for them, a 2900 percent return.

After much howling by the limited partners and much pointing to what would appear to have been his contractual obligation to give us at least three times our money in the event of success, he upped our return from one and a half times our investment to double--two dollars back for every dollar risked--but no more.

Double your money in less than two years, with tax advantages to boot, he felt was more than an adequate return. Many of the limiteds (certainly, those of us who are suing the son of a bitch) felt that, while marvelous in the abstract, such a return was unfair in context. If nine out of ten such deals fail--and the number is probably higher--then when you finally have one that hits big, the return has to be awfully high to justify the risk.

All we really wanted him to do was live up to the terms of the prospectus. But as the prospectus did not deal specifically with a buy-out, it is something he has not yet had to do--and perhaps never will.

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Now, I know what you're thinking. You're thinking, Where does he find such great deals? Where can I find such great deals?

As I've tried to suggest, it's not at all clear that you should be looking. But chances are, if you can afford them, they'll be looking for you. Your accountant will be suggesting them, your broker will be suggesting them, friends who can't afford a full unit themselves and want to split one will be suggesting them; and once you go into one deal where your name shows up down at the courthouse as one of the limited partners, even strangers will be calling to suggest them to you.

Did you go to college? Did you have buddies in college? Are their grandmothers still living? If you can answer yes to all three, you should be all set. The prospectuses should be pouring in. Even so, the three basic rules of tax-advantaged investing are worth repeating.

1. Never go into a deal that isn't attractive apart from tax considerations.

2. Never go into a deal you don't feel you, or your advisor, are truly competent to evaluate. (And that eliminates most of them.)

3. Never go into a deal out of desperation at the end of the year. They know you're desperate. That's figured into the price.

a timely accounting of timeless principles of personal finance

"Research-and-development deals are another fine way to feel good losing money."