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.  

But where there are risks, there may be rewards, so do your homework and think about the following four questions carefully, as it is crucial that Investors take the time to evaluate whether the private investment opportunity is SUITABLE.

It is very important that Investors participating in Alternative Investments evaluate their own SUITABILITY for what are generally higher risk investments which have no opportunity for a secondary sale before the investment either matures or is otherwise redeemed by the Issuer.

CFG is not a financial advisor or wealth manager.  However, FINRA-registered Broker-Dealers like us are responsible for exploring the following, among several factors, with each prospective individual Investor before he or she invests in a private security with a firm (See CFS Privacy Policy”).

  • Overall personal financial profile
  • Size and nature of the overall investment portfolio
  • Investment strategy relative to the Investor’s stage of life
  • Liquidity required of investments  
  • Whether a gives CFG private investment represents a prudent addition to the portfolio, based upon risk/return sensitivities.

Incorporating private placements, specifically, and Alternative Investments, generally, into overall investment portfolios is a complex and important issue, particularly since Investors must contrast the specific terms of a given private investment with their unique personal goals and circumstances.   Individual Investors are advised to consult with a financial planner or wealth manager as they consider Alternative Investments.

Some of the variables affecting personal investment choices include:

  • Personal income 
  • Liquidity (i.e. cash on hand) and the potential for needing to suddenly sell a Security to raise cash before it is otherwise scheduled to return the invested Capital 
  • The Investor’s age, employment status, state of health and dependents
  • Philanthropic goals and objectives
  • Tax considerations

Alternative investments include the following investment categories:

  • Privately placed debt of private companies
  • Privately placed equity of private companies (e.g. Venture Capital)
  • Hedge funds
  • Private equity funds
  • Mezzanine funds
  • Distressed debt funds
  • Natural resources (timberland, water, agriculture, oil, gas, minerals)
  • Real Estate
  • Commodity and financial futures funds

Let’s now explore the 4 key questions to consider before investing in Alternative Investments.

Question 1:  Are You Accredited?

Naturally, the first item to consider is whether you are eligible to invest in most private investments (see Regulation D ‘Accredited Investor’ Investor Questionnaire for a more complete description of who may invest).   

Here are the facts: For individuals, this will involve the confidential disclosure of Investors’ assets and liabilities or their income for the past two years and the expected current year.  If an individual does not meet these standards or is unwilling to make a representation that their Rule 501 financial profile exceeds these standards, they will not be able to legally participate in a Regulation D offering, either under Rule 506(b) or Rule 506(c) (see Title III for certain exceptions.)

For Investors wishing to participate in Regulation D, 506(b) offerings, they may self- verify that they meet one of the Rule 501 Accredited Investor standards (for individuals either the income test or the net worth test).

For Investors wishing to participate in Regulation D, 506(c) offerings, they must provide credible third-party verification for meeting one of the Rule 501 Accredited Investor standards (for individuals either the income test or the net worth test).

To be eligible, an Investor 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 (income test).  How likely is it that your level of income and employment status will remain the same?

Conversely, Investors must have a net worth in excess of $1 million in assets, excluding the equity value of their primary place of residence (net worth test).  One can be Accredited by one or the other test.  Please see CFG’s Accredited Investor Verification Guidelines for more information.

Question 2:  Is your Portfolio Diversified1?

No single private investment should be too large.  Private Placement Investors should strive to diversify even within this portfolio allocation by making smaller investments in numerous private transactions, with the nominal investment amount determined relative to the Investor’s overall Investor liquidity.

Question 3:  Are You Willing to Risk Losing It All?

While many Private Placements offer the chance for an Investor to achieve an attractive return on investment, each offering also has unique risks associated with it and the potential for a 100% loss of invested capital.  Private Placement risks are generally greater than those associated with public securities, and Private Placement Investors must determine whether they can afford to sustain potential losses on their investments. If a loss of Principal is unacceptable to the Investor, he or she should not participate in Private Placements.

As a general rule, Private Placement investments should comprise a much smaller portion of the Investor’s overall investment portfolio than would investments with more liquidity (i.e. a ready Secondary market, such as a publicly registered Security) and those issued by Issuers with stronger credit quality (such as those rated “investment grade” by nationally recognized credit rating agencies) … typically less than 20% of the total liquid assets of the Investor.

Question 4:  How Important is Liquidity to You?

Every Private Placement is illiquid.  This means the Investor, generally, cannot sell the investment before it matures or is redeemed.  Investors should not have an imperative alternative use for the funds invested in a Private Placement.  

Please note: In addition to the four questions listed above, alternative investments often pose additional challenges addressed in other articles:

  • 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. 

However, alternative investments and private market investments through Private Placements may offer the Investor:

  • Higher returns, such as interest rate or capital gains, than those typically generated by traditional, publicly traded investments such as 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 are comfortable with the answers to these four questions, then you might consider adding Alternative Investments to your portfolio.  Incorporating private business investment opportunities, specifically, and Alternative Investments, generally, into an overall investment portfolio requires careful consideration.  Individual Investors are advised to consult with a financial planner or wealth manager as they consider Alternative 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.