Are Alternative Investments Right for You? Answer These Four Questions First.

02 Jul 2018·Alternative Investment Tips

We’ve made the point more than once in these articles: investing in an alternative investment, and particularly in a private Company, is a high-risk gambit.   

Where there may be rewards, there are most certainly risks.  So, do your homework and think about the following four questions carefully.  It’s crucial that Investors in alternative investments carefully evaluate whether the opportunity is SUITABLE

Consider these four key questions before investing in Alternative Investments. 

Question 1:  Are You Eligible to Invest? 

The type of security offering you are considering (i.e., the manner in which it is made available to you) will dictate whether or not you may legally participate. If a security isn’t publicly registered, it’s considered private, and whether you are eligible to invest gets a bit complicated. 

Public Offerings – If a security is publicly registered, that means it’s publicly registered with the U.S. Securities and Exchange Commission, and anyone can invest.  Some alternative investments, such as funds focused on real estate or commodity investments, are publicly registered.   

Title III Crowdfunding – Anyone can invest in what are now known as “Title III” equity Crowdfunding offerings, but the amount you can invest is limited by your net worth and annual income: 

  • If either your annual income or your net worth is less than $107,000, then, during any 12-month period, you can invest up to the greater of either $2,200 or five percent of the lesser of your annual income or net worth.  
  • If both your annual income and your net worth are equal to or more than $107,000, then, during any 12-month period, you can invest up to 10 percent of your annual income or net worth, whichever is less, but no more than $107,000.  

Crowdfunded offerings are available through regulated internet funding portals, but they often involve equity investments in very early stage businessesarguably one of the highest risk categories of investment. 

Private Placements – Virtually all other securities offerings which you may encounter are Regulation D private placements, and you must qualify as an Accredited Investor to participate.  To be Accredited, an individual investor: 

  • Either must have earned $200,000 individually or $300,000 as a married couple in each of the last two years and have reason to believe that the same will be true in the current year (aka the “income test”);   
  • Or must have a net worth in excess of $1 million in assets, excluding the equity value of their primary place of residence (aka the “net worth test”).

See the “Accredited Investor Questionnaire” for a more complete description of the other ways to qualify.   Proof of being Accredited can be required as a part of the offering either on a self-verified or third party verified basis (see below).

Assuming that you are an Accredited Investor, what can you invest in?  

  • Rule 506(b) Offerings: Cannot be advertised on any publicly available media (in regulation speak, “general solicitation”).  Therefore, you will not find them through the internet, a newspaper, the radio, etc. This form of offering makes up the vast majority of the private placement market and often involves FINRA-registered broker-dealers as “placement agents.”  To participate, you must attest in writing which of the accreditation criteria identified above pertains to you . 
  • Rule 506(c) Offerings:  Can be advertised.  If you listen carefully to ads for real estate investment on XM-radio, for instance, they will indicate that they are limited to Accredited Investors.  To participate, however, you must provide third-party verification that you are Accredited, such as by providing copies of your last two years of federal tax returns and a recent pay stub. 

For more information, see our “Accredited Investor Verification Guidelines.

Question 2:  Are You Willing to Risk Losing Your Money? 

You have to be willing to accept some amount of losses from time to time, or alternative  investments are definitely not for you.  Otherwise known as “risk tolerance,” your financial circumstances and/or basic personality may not be right for alternatives, as they are generally considered higher risk investments.    

While many Private Placements offer the chance to achieve an attractive return on investment, each alternative investment also has unique risks associated with it which could lead to the loss of some, or even all, of your invested capital.  Funds allocated to private investing must be “disposable,” so that any losses will not substantially affect your other financial obligations (i.e., paying your bills or requiring a material change your lifestyle). 

Question 3:  Is your Portfolio Diversified?

No single investment should ever make up too large a portion of your portfolio, and this goes double for Alternative Investments.  Private placements are generally issued by companies with weaker credit.  In other words, these are higher risk investments. 

While Carofin is not a Registered Financial Advisor, we suggest that no more than 20% of your overall portfolio be allocated to alternative investments and that this amount, whatever it is, be spread across multiple investments.

Question 4:  How Important is Liquidity to You1 

Private Placement investments are illiquid.  This means the investment has no “secondary market” and generally cannot be sold before it matures or is redeemed.  Investors should not have an urgent or specific alternative use for funds they commit to a Private Placement. 

Some other considerations… 

If you’re comfortable with the above questions, you might also consider the following additional opportunities and challenges associated with investing in private investments:

Challenges: 

  • Difficulty in determining the current market value of the asset;  
  • Costs of purchase and sale may be relatively high;  
  • Limited historical risk and return data;  
  • A high degree of personal investment analysis is required before investing in a specific offering;  
  • Limited disclosure regarding performance and status of investment when compared with publicly registered securities.  

Opportunities:

  • Higher returns, such as interest rate or capital gains, than those typically generated by traditional, publicly traded investments, e.g., stocks, bonds or mutual funds;  
  • Lower volatility in price and performance than traditional investments; 
  • Low  Correlation with traditional financial investments; 
  • Diversification of risk and performance from traditional investments.  

If you already know all this and are ready to get off the sidelines and onto the field, check out some of our current investments. 

  1. Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.