Cash-Distressed Business Offers Investors Way to Follow Buffett 
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By Alexis Leondis


Oct. 22 (Bloomberg) -- John Edelman, a former business owner, is taking Warren Buffett’s advice by investing in what he knows: home furnishings. 

“I feel so much safer doing this than buying stocks randomly,” said Edelman, of Ridgefield, Connecticut, who sold his high-end leather supply business for $67 million in October 2007 and started investing directly in three private cash- distressed home-furnishing companies last year. “Smaller investors can have more power now because they’re buying at lower values and their dollars go further.” 

The potential for average annual returns as high as 25 percent is luring some investors who are putting money in struggling businesses that aren’t publicly traded and unable to access traditional sources of capital, according to Mark Hancock, senior managing director of New York-based Tiedemann Wealth Management. That’s because some investors became disillusioned with the returns on equity and fixed-income investments last year, he said. 

“Many wealthy investors retreated at the right time, built up significant cash hoards and now want to redeploy that cash in distressed situations,” said Hancock, whose firm advises on $5.8 billion of assets for high-net worth families and institutions. The focus is on investments within industries that families have specific knowledge of, said Hancock, who estimates 10 percent to 15 percent of the firm’s 70 clients are evaluating investments in businesses that they know. 

The 2.7 million millionaires in the U.S. and Canada had $1.3 trillion in cash in 2008, based on a survey released in June by Capgemini SA and Merrill Lynch & Co. Investors put $19.2 billion into 55,480 companies last year, according to the Center for Venture Research at the University of New Hampshire in Durham. 

Supply Funds 

Government efforts, including an initiative announced yesterday by President Barack Obama, to ease lending to small businesses are not workable and some businesses are having difficulty accessing capital from banks because of weak balance sheets, said Sam Graves, a Missouri Republican, and ranking member of the House Small Business Committee, in an interview. That means individual investors can step in and supply funds, Graves said. 

Eighty percent of U.S. companies with fewer than 500 employees said access to capital was a major issue compared with 67 percent a year earlier, according to a July survey of 300 firms by the Washington-based National Small Business Association, a trade group with more than 150,000 members. 

Purchase Equity 

Investors interested in distressed investments can lend money to the business directly or purchase equity, said Darell Krasnoff, managing director of Bel Air Investment Advisors in Los Angeles, who counsels clients with at least $20 million in investable assets. They can also form limited partnerships, which pool funds from several investors and may be managed professionally, said Krasnoff, whose firm’s clients include Lee Iacocca and Barbra Streisand. 

Investing directly in cash-starved businesses is appropriate for sophisticated investors with at least $500,000 in capital who have expertise in the industry, said Jospeh Massoud, chief executive officer of Compass Diversified Holdings, a Westport, Connecticut-based owner of manufacturing, distribution and business service companies. 

“Just like Buffett says, invest in what you know,” said Massoud, referring to the chief executive officer of Berkshire Hathaway Inc., who has overseen more than $50 billion in acquisitions ranging from insurance and ice cream companies to corporate jet leasing and power plants. 

Investor’s Payoff 

An investor’s payoff can be tied to the success of the company, which can come in the form of an initial public offering, operational improvement of the business, sale of the business to another firm or dividends, said Chris Hyzy, New York-based chief investment officer at U.S. Trust, Bank of America Corp.’s private wealth management unit overseeing $180 billion. 

Illiquid investments, which lock up cash for more than one year and include distressed investments, should be from 5 percent to 12.5 percent of an investor’s portfolio, according to Arun Bharath, director of research at Bel Air Investment Advisors. 

Investments in companies, not just those that are distressed, have returned 20 percent to 25 percent on average since 2004, said Jeffrey Sohl, professor of entrepreneurship and director of the Center for Venture Research at UNH. The returns take into account companies that have failed or filed for bankruptcy, Sohl said. 

In 2008, investors in the Standard & Poor’s 500 Index lost 37 percent and a composite of high-yield bond funds declined 26 percent, according to data compiled by Bloomberg and Merrill Indexes. 

‘Substantial Returns’ 

“It’s an industry I know and one that’s suffering -- my gut is, it’s bottomed, said Edelman, 42, referring to the luxury-furnishing business. “Ideally in four to six years, I hope to get substantial returns.” 

Investors should be aware that putting money directly in cash-distressed businesses is illiquid, labor-intensive and risky, said Jon Goldstein, co-chief executive officer of Constellation Wealth Advisors, which manages almost $4 billion in assets for clients who have a minimum of $10 million in investable assets. Investors should expect to have their cash frozen for at least three years, said Goldstein, who is based in Menlo Park, California. 

There were 64,554 commercial bankruptcy filings in 2008 and almost 67,000 through September, according to data compiled from court records by Automated Access to Court Electronic Records, a service of Jupiter ESources LLC in Oklahoma City. 

Concentration Risk 

Some clients are still risk-averse and thinking about how to protect and preserve wealth, said Krasnoff of Bel Air Investment Advisors. Lending money to a private business also comes with concentration risk, as significant amounts of money are tied up in one business, he said. 

Goldstein of Constellation Wealth says he has several clients who made their fortunes in the technology industry and are considering investing in startups. The difficulty new companies are having raising venture financing means these investors are taking advantage of low prices and their expertise, he said. 

The amount of venture capital provided to startup businesses dropped 33 percent in the third quarter to $4.81 billion in 637 deals from $7.16 billion in 994 deals a year earlier, according to the National Venture Capital Association and PricewaterhouseCoopers. 

Cash Reserves 

Richard Caruso, 66, is chairman and founder of Integra LifeSciences Holdings Corp. in Plainsboro, New Jersey, which manufactures medical devices. He invested $3 million last year in Colmar, Pennsylvania-based CeeLite Technologies LLC, a maker of flat-panel lighting products. CeeLite’s predecessor company didn’t have enough capital to manufacture and sell its products worldwide. 

“Entrepreneurs are not just investors, they are visionaries and like to actively get involved in something they know and believe can be successful,” Caruso said. 

The most attractive opportunities are in industries that have been affected by the decline in retail spending, which include consumer products and capital equipment, according to Massoud of Compass Holdings. 

“I could lose all my money and could be wrong that the desire for luxury will rebound,” said Edelman, whose leather adorns the chairs in Le Cirque, the New York restaurant. “But I’ve done this with proper cash reserves. If you can’t do that, you shouldn’t be in the game.”