We get calls every week about another alternative investment opportunity. Maybe you do, too.
Before investing in alternative investments, it might help to understand certain limitations and challenges in doing so.
- Complexity of Alternative Investments: Alternative investments are not cookie-cutter securities. Yes, on the surface, they might appear similar. But each offering can be complex on its own and is often as unique as the opportunity itself. That is one of their advantages – the structure of the investment might be perfect for a small audience, unlike most public securities that need to cast a broad net. Each might have its own characteristics, e.g., can the issuer pre-pay and retire the security? What happens if the issuer declares bankruptcy? Do you have some or any protections in place via the deal structure? Before jumping into an alternative investment, you should plan to conduct your own due diligence.
- Determining Fair Value: We’re talking about private investments. Determining what is the operating company’s true value, or the value of a pool of operating companies, is more of an art form than a science. While most investment banks will try to identify companies with which to compare the one raising private capital (just like “comps” in real estate), a good comparison may be hard to find, if possible at all. When one isn’t available in the current market (a relatively common occurrence), you may need to create a comparison based on information gathered from various sources, and over a longer timeline. We rely on our investment bankers’ experience over the timeline of their full careers across numerous industries. You can also draw on professional resources that aggregate data on public and private transactions for a more educated stab at a company’s value. Why is this important? Because this valuation in an equity transaction will determine the price you pay for a very specific amount of ownership in that company. To this equity investor, a fair valuation is important, because determining an investor’s share of the company depends on the funds invested as well as the overall business value. Note, however, that the smaller the company, the more difficult it is to determine a realistic value.
- Illiquidity: Speaking broadly, there is no secondary market for most alternative investment vehicles. Regardless of the form of investment, an investor antes up, and that money stays in the investment either until its maturity or until it is redeemed by the issuer. As an asset class, alternative investments like private equity, real estate and others are long-term investments by nature. However, there is a growing market that provides investors with the ability to buy and sell interests called the “private equity secondary market.” This type of trading was first introduced in the 1980’s and has grown considerably due to the credit crisis that began in 2008. Investors, primarily institutions, were seeking means of selling their investments whose value had dropped considerably (think pools of real estate mortgages) and were in need of a way to sell their positions. Additionally, there has been a rapid growth in the last decade of liquid alternative investment vehicles that provide daily liquidity. So, what used to be a 99.9% illiquid market – at least for individual investors (an institution sometimes could find a buyer of its private investment) — is still largely illiquid, but the market is changing.
- Reporting: Other articles have noted that, under a Regulation D offering, the reporting requirements are less stringent than are those that public companies follow. So, expect limited disclosure when evaluating the investment and less thorough reporting of the progress of the investment over time than with a standard investment.
- Purchase and Sale Costs: Minimum investments typically have been much higher for alternatives than their traditional security equivalents (Carofin’s minimum investment size is usually $25,000), and, where an investment can be sold, there may be associated fees.
Finally, most alternative investors are required to be accredited investors, despite the recent entry of crowdfunding into the private capital marketplace.
Having noted these challenges, remember that alternative investments frequently offer low correlation to traditional stocks and bonds, which can help manage the risk that volatility poses while potentially increasing return when compared to standard investments.
If you’d like to learn more about alternative investments, please turn to “Accredited Investor Verification Guidelines,” “What Securities Laws and Regulations Govern Private Placements?,” and “Why Invest in Alternative Investments? Here are 3 Reasons.”
As always, contact us with any questions you have.