A vital component of any investment is whether the one proposing the deal has “skin in the game.” While assessing risk, rate of return, and other aspects is imperative, skin in the game is often the deal-breaker.
Don’t Get “Skinned”
“Skin in the game” refers to having the potential for loss if something goes wrong. In old times, this often literally meant suffering bodily harm if a professional’s work didn’t go as predicted. For example, the designer of a new bridge was expected to live underneath it for a few days, putting his life on the line, before it opened for public traffic. According to financial author and professor Nassim Taleb, the ancients used such tactics to ensure that professionals didn’t cut corners, placing others at risk. Today, skin in the game is merely financial, but it can still help investors gain trust in their investment managers. The sharing of financial risk helps ensure that investment promoters will propose reasonably secure deals and then do their best to see them through.
Two Deals, Very Different Structures
To illustrate, consider two proposals. In one, the investment promoter and manager, Reuven, needs $100,000 to buy and renovate a house which he says will then sell for $200,000. He plans to put in $20,000 of his own money and wants the potential investor, Shimon, to put in the rest. For his efforts and expertise, Reuven expects a bonus fee of 25% of any profits (on top of his 20% in cash invested). This deal setup would mean that if the gain is indeed $100,000, Reuven gets $40,000 (25% bonus fee plus his share of 20% as the financial investor: [$100,000 x 25%] + [$75,000 x 20%] = $40,000). Shimon would get the balance of $60,000. On the other hand, if there were a complete loss of the investment, Shimon would be out his $80,000 and Reuven would lose his $20,000. The potential for both risk and reward is shared between the investor and manager. After some research into Reuven’s reputation, it’s likely that Shimon will choose to invest.
Contrast that with Levi’s proposal. He, too, plans to buy and renovate a house for $100,000 and sell it for $200,000, but he expects Shimon to put in all the money. For his efforts and expertise, Levi expects a bonus fee of 25% of profits, plus he is charging an immediate $10,000 “acquisition fee” (meaning Shimon needs to put in a total of $110,000, and the maximum profit is only $90,000). In this scenario, the risk and reward are skewed in favor of Levi, the manager. In the full-profit scenario, Levi gets $32,500 ($10,000 acquisition fee plus 25% bonus profit fee: $10,000 + [$90,000 x 25%] = $32,500), whereas Shimon gets $67,500 (75% x $90,000). Should there be a full loss, while Shimon is out his entire $110,000 investment, Levi, who put no skin the game, actually still comes out with a gain of $10,000 (the acquisition fee). The risk-versus-reward split now heavily favors the manager and is a structure that is a recipe for trouble and frustration for Shimon.
The Problem with Skinless Managers
Because Levi is guaranteed to make money immediately, he can be lax about doing the research required to ensure that the deal is a good one. (I reviewed a real estate deal where the promoters, who were not experienced and had no skin in the game, expected a $500,000 acquisition fee, which means that even if the deal was an immediate bust they would still do very well for themselves!) But even without the acquisition fee, because he faces no risk, Levi, whether consciously or subconsciously, may be focused on just doing as many deals as possible, regardless of their chances of success. Even knowing many will probably fail, he will make tons of money on the winners and risks nothing on the losers.
Furthermore, even if a deal initially looked good, many deals end up getting bogged down. When that happens, and especially when losses loom on the horizon and the profit bonus incentive disappears, a manager like Levi, who has no cash in the game to protect, will probably become scarce, leaving the investors holding the bag.
As a rule, investors should not place money with cooks who won’t eat the food they cooked themselves, and should avoid deals where the managers stand to make significant fees regardless of the investment’s success. As with every rule, however, there may be exceptions. For example, an acquisition fee that is used primarily to cover sums that the manager personally laid out may be justified. Also, an investment manager who commits to invest all of their focus and energy for a specified time period into the success of a project (rather than throwing deals at the wall and hoping they’ll stick,) can justifiably argue that their “sweat equity “ represents skin in the game. But whatever the form, ensuring that promoters have skin in the game is a vital component for investment success.
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