Stock prices and bond yields are easy to find. But it’s challenging to confirm whether the terms of a direct investment in private placements are fair.
Given that the private securities markets (over $2.4 trillion/year raised in the U.S.1) are now larger than the public markets, we offer this framework to lend some perspective.
The pricing of private securities is complicated by several factors:
- Each company and security offered is unique. One might be a start-up and another a more established company; one may be technology-based and another could be in a more traditional industry. It may be a highly structured and complex security being offered or it could be something relatively simple;
- Third-party analysis — common to public securities — does not exist for private investing (think credit ratings like Moody’s, S&P, etc., or equity analysts at brokerage houses on Wall Street);
- Pricing norms for a given class of securities are the province of narrowly-focused private funds – they don’t often share this information with individual investors;
- Even professional investors in this market are somewhat “siloed,” typically investing only in a certain class of security (venture capital, subordinated debt, etc.).
This is a framework to help you set somewhat realistic expectations for ROI in the different categories mentioned below.
Venture Capital (“VC” – Equity Investments): An equity investment in a private company that isn’t consistently generating positive operating cashflow.
Valuation Considerations:
- Early stage VC: 60%+ IRR = 10x return on investment in 5 years (a “10 bagger”).
- Later stage VC: 35%+ IRR = 4.5x return over 5 years.
- A 35% IRR is a common target for venture capital fund portfolios.
Private Equity (“PE” – Equity Investments): While this includes any equity investment made privately, Private Equity Funds (“PE Firms”) invest only in companies with positive EBITDA . This is the world of leveraged buyouts, recapitalizations, acquisitions, etc.
Valuation considerations: Since so much capital is currently available, individual investors and PE Firms face a more competitive environment than VC, particularly for larger transactions. Here’s our take on the PE market (as of September 2019):
| Issuer EBITDA | Interest Rate Expectation | Pricing Rationale |
|---|---|---|
| < $2,000,000 | Around 35% | Much like later-stage VC. An inefficient market with sporadic demand |
| $2,000,000 to $10,000,000 | 25%+ | Many “middle-market” PE Firms are active in this market, so it has more competitive pricing |
| $10,000,000+ | 20%+ | Highly competitive among PE Firms |
Senior Debt (Loans & Notes – Debt Investments): The most senior form of security. In case a business fails, senior debt investors are first in line to be repaid either from operating cash flow or from funds raised through asset liquidation.
Interest Rate Considerations: The size and credit strength of the issuer will dramatically affect the interest rate it can command because so much capital has been assembled by “non-banks” (e.g., private debt funds). Like private equity, the bigger the enterprise, the lower the return offered investors. We view private senior debt market as follows (as of September 2019):
| Issuer EBITDA | Interest Rate Expectation | Pricing Rationale |
|---|---|---|
| < $2,000,000 | 9% to 16% | Greatly affected by asset quality (for use as collateral), nature of revenue/earnings, and financial covenant strength |
| $2,000,000 to $5,000,000 | 8% to 12%+ | Depends on asset quality, nature of revenue/earnings and financial covenant strength |
| $5,000,000+ | 7% to 10% | Highly competitive among Senior Lenders |
NOTE: While lenders to smaller companies can often demand interest rates above 16%, Carofin believes there is a limit to the amount of “current pay” interest a smart investor should expect an issuer to pay. With usurious interest rates, a default becomes much more probable. If more yield is justified for the risk, equity warrants, or a revenue share (for certain fast-growing companies), is a more appropriate approach.
Subordinated Debt (“Sub Debt” or “Mezzanine Financing” – Debt Investments): Cash-flow lending that is typically unsecured and junior in relation to senior debt in liquidation preference (these investors are second in line, or “subordinated,” to senior debt for repayment purposes, but still ahead of equity investors.)
Interest Rate Considerations: Like senior debt, the size and credit strength of the Issuer will dramatically affect the returns investors can expect.
The total return (again, the IRR) is usually achieved through a combination of an interest rate paid currently and a detachable equity warrant. The interest rate portion usually falls in the 10% to 14% range. The equity warrants, with their put option to the issuer, is sized, priced and timed to add 5% +/- in annualized return to the lender’s IRR. We currently see sub debt pricing as follows:
| Issuer EBITDA | Interest Rate Expectation | Pricing Rationale |
|---|---|---|
| < $2,000,000 | 16% to 25% | Historically achieved in all mezzanine lending — now only for smaller companies |
| $2,000,000 to $5,000,000 | 12% to 18%+ | An abundance of lender supply and a low interest rate environment has pushed down rates |
| $5,000,000+ | 10% to 15% | Highly competitive among mezzanine lenders |
Factors such as the stage of the issuer, type of security, and investor competition will ultimately drive a private placement’s return on investment. Like any other asset purchase (a house, car, etc.), a security’s valuation or interest rate will be propelled by what investors are willing to accept.
The expected ROI is lower for larger issuers than for smaller issuers whose market is much less efficient. Because they have fewer, easily sourced financing options, higher projected returns should be required by investors in these smaller deals.
