I recently received a question from a listener who sold a portion of their business and now has about $12 million invested, with $1.5 million set aside specifically for private investments. They’re considering putting $750,000 into an oil well investment that the sponsor projects will deliver a 15 to 20% IRR, with capital locked up for seven to 10 years.
First, congratulations on the business sale. Having $1.5 million allocated to alternatives out of a $12 million portfolio is not crazy. You’re looking at somewhere in the 10 to 15% mark for alternative investments, which is reasonable. So the allocation itself isn’t the issue.
The Concentration Risk Problem
The real issue is that you’re going to take half of that alternatives bucket and drop it into one investment. And it doesn’t have to be oil wells. It could be anything. Any investment where you’re dropping half of your alternative allocation into one particular asset ends up having a significant amount of concentration risk that we’d want to try to avoid.
A better approach would be to look at your alternatives bucket and ask: out of this $1.5 million that I’ve allocated to alternatives, what assets do I want to invest in? Do I want some to go to oil wells? Do I want some to go to real estate? Do I want some to go to private equity? Break that up first, and then plan to deploy that over the next couple of years. That way you have a little bit of diversification from a time perspective and type of alternative investments as well.
In your case, you’re throwing $750,000 in right now, all in one investment, at the exact same time. That’s where the risk compounds.
Understanding Projected Returns
Whenever you’re dealing with private investments, they can play a little fast and loose when it comes to IRR projections. When they start saying 15 to 20% projected, that is just projected. That doesn’t actually mean that’s what you should anchor your decision on.
What’s risky about that is 15 to 20% sounds really good if it shows up. But if it doesn’t show up, you just dropped half of your alternative investments into one oil well.
The Oil Well Opacity Issue
Unless you’re a fourth generation wildcatter who knows everything about oil wells, this is one of the most opaque areas when it comes to alternative investments. You get shown a map, and somebody says we’re thinking about well number 167 right here, and that’s the one that you can invest in today for $750,000. They’ll give you X percent of the stake and tell you they’re looking at this having a 15 to 20% return. Who knows what that actually means.
Unless you have any background in the oil industry to know whether or not that well will produce, this is truly a crap shoot. If you really want to get into the oil investment area, that’s fine, but don’t put it all in one well. Anyone who does well in oil wells will tell you that you need to diversify this out, not only from a geographic perspective, but the types of wells.
If I showed you two maps, one of Oklahoma and one of Texas, and told you to tell me where the best place for an oil well is, if you can’t answer that, then it’s probably not a good idea for you to take three quarters of a million dollars and go buy an oil well for yourself.
The Illiquidity Question
The illiquidity is kind of an interesting one to point out. They’re showing the capital will be illiquid for seven to 10 years. Be a little worried there of what that actually means. Generally, these oil well investments are long term. My guess is that’s a projection based on IRR. If you have 20% return every year, you’re going to get all your money back in that seven to 10 year time horizon. But those are some definite red flags.
What to Do Instead
The first thing you should do before writing a check for $750,000 into a single oil well is to look at that overall asset allocation. Find out what your ideal alternative investments portfolio looks like, and then start to piecemeal that out and invest in a variety of different asset classes.
This post is adapted from a recent episode of the Scholar Wealth Podcast. For more perspective on evaluating alternative investment opportunities, listen to the full podcast episode here.