The rules are very different in the private markets, and you should know the difference if you’re going to play the game.
We all know that you can trade public securities. The most well-known exchanges include the New York Stock Exchange and NASDAQ for U.S. public equities and the institutional “bond markets” for government and corporate debt.
Don’t expect to trade your investment in a private company. Public securities are traded on a secondary basis after they have been issued; private securities are usually not.
Essential infrastructure, including financial accounting standards for accuracy and consistency are required for publicly traded companies. However, audited financials are not required for private companies (even companies issuing securities to investors). Sometimes, private companies do produce audited, or, at least, “reviewed” financial statements, but that’s the exception rather than the rule.
Issuance, trading and ongoing disclosures to investors are tightly controlled and well defined for public securities — it is much less so for private securities (though they are still subject to U.S federal and state regulation and oversight with respect to fraud).
Market makers, e.g., broker-dealers, critical to public markets, buy and sell public securities; they generally do not exist for private securities.
Third-party analysis and valuation by securities houses for equities and debt ratings from agencies such as Moody’s, S&P, Fitch are readily available in the public markets. Ratings are rare for private securities.
On the other hand, many privately placed securities are highly structured, meaning they contain numerous investment terms which can affect the performance of the investment in ways you wouldn’t expect in normal public security structures. Be sure to understand all the terms in the initial documentation, as well as in the Summary of Terms or Term Sheet that is part of the Private Placement Memorandum (PPM) for each security.
- Equity dividends typically accrue when not paid currently, but they may accrue with or without compounding. Compounding makes a significant difference to the realized cash-on-cash return over longer periods (like 5 years or more for a venture investment!).
- Debt investments may pay interest currently or have it accrue for a period. If it accrues, does this accrued interest compound when not paid?
- How is principal repaid for a debt security – through mortgage-style amortization, after a period of interest-only payments or only at maturity?
- Do detachable equity warrants come as part of an equity or debt investment? Can they be put to the issuer at some date? What is the exercise price of any warrants?
The complexity and varied nature of private security structures further points to expected IRR’s, in most cases, as the best way to compare one investment alternative to another.
Public and private securities differ significantly. When considering private securities, take these differences into account: they don’t trade, audited financials are rare, valuations are more of an art form.
Alternatively, private securities usually offer higher returns, there’s less competition among investors, and less public market correlation. Furthermore, private investments are made with an expectation that a specific return (an “absolute return”) will be achieved, regardless of future public market conditions. In addition, Investor disclosures for private offerings should be more extensive than what a public issuer is allowed to reveal under S.E.C regulations.