In a recent episode of the Direct Private Investments Show presented by Carofin, Matt Brown and Bruce Roberts, a seasoned investor in both private equity and lending markets, demystify the world of private securities. This article explores the key differences between debt and equity and is featured in our latest video, Demystifying Private Securities: Debt vs. Equity.
Before diving into the world of securities, it is important to have a basic understanding of financial accounting, particularly the role of a balance sheet in the financial management of a business. The Balance Sheet is a “snapshot,” taken at a specific moment, of a company’s assets (what it owns), Liabilities (what it owes to others), and Shareholders’ Equity (the value left after repaying its liabilities). Knowing where a potential
investment resides on the company’s Balance Sheet – and, for that matter, whether it’s ahead or below in the “capital stack” – should inform an investor’s decision. For a quick overview, Indeed has drafted an explanation which should help any reader come to understand basic concepts.
What is a Security?
A security is a financial instrument that represents a contractual agreement between a party that needs capital and a party that has capital. Securities are issued by legal entities, such as corporations (the “Issuer”), to raise capital through purchases by investors who, typically, are expecting to profit from the exchange.
Private placements are discrete offerings of any types of securities that are not publicly registered with the U.S. Securities and Exchange Commission (the S.E.C.) before being available to investors. A private placement will offer one of two main types of securities: debt or equity. Debt securities are loans, while equities represent an ownership interest in a company (see The SEC: Its Role with Private Equity and Private Finance for more information.).
Simply put, debt securities are, essentially, loans that the issuer is obligated to repay with interest. Debt securities are usually expressed in the form of a Promissory Note (or Note) that is accompanied by a Loan and Security Agreement. It includes details relating to the Issuer’s obligations for the Note. The principal is specified, along with the interest it pays to investors, the name of the investor owning the Note, its maturity date (when all Note principal repayment becomes due) and the major provisions protecting the investor.
Notes can be secured or unsecured, with the former involving collateral to back the loan. With a secured loan or Note, the investor has two means of repayment – the general obligation of the company and the collateral backing the loan. Conversely, unsecured loans offer only one means for repayment, should the Issuer default. The maturity of the debt should match the circumstances of the issuer and the useful life of the asset being financed. As company liabilities, Note principal repayment obligations are ahead in liquidation preference to obligations due to equity holders. For more risk-averse investors, an issuer’s debt securities are safer investments that the same issuer’s equity securities, although they bear the risk of default or company bankruptcy and adequacy of collateral value.
Debt securities are typically more appropriate for companies with sufficient cash flow from operations to repay the interest and principal (see “Why Do Companies Use Debt Financing” here). Investors in private credit should carefully evaluate a company’s cash flow to determine its ability to meet its debt obligations. Depending upon factors such as the size of the issuing company’s profits (EBITDA), Note yields can vary from the mid-single digits to the high teens. Private lending for companies with under $2,000,000 in EBITDA can often yield between 11-15% interest rates due to the associated risk (rates are greatly affected by the asset quality, the nature of revenues, and financial covenant strength).
Equity securities represent ownership interest in a company. Investment gains are usually achieved through an increase in the value of the equity (i.e., share price appreciation, usually a “capital gain” for tax purposes) and through distribution of Issuers’ after-tax profits (ordinary income for tax purposes). These securities are more suitable for venture-stage businesses, as they do not generate operating cash flow. Investors seek potential capital gains instead of current income with equity securities.
Equity investments generally are riskier than debt securities, as they do not have collateral backing and rely on the success of the company for returns. If your investment priority is to generate greater profits – and you are willing to accept more risk (bankruptcy or total loss of principal) – an equity investment has the potential to generate greater returns and may be more suitable for you.
An investor in early-stage venture investments should target a 58% internal rate of return (10x return in five years) to account for potential losses in the portfolio. Private equity investments in later-stage companies, however, should aim for a minimum of 25-35% return, while real estate equity investments typically offer high teens to low twenties returns.
Choosing between Debt and Equity Securities
Carofin, like many other investment banks, offers both debt and equity securities. For the Issuer, choosing between these two types of securities depends on the stage and cash flows of the company. Investors should focus on their investment preferences and personal circumstances. Some investors seek current income, have lower relative risk profiles, and are willing to accept a cap on the investment’s return. This aligns with debt investments.
Others may seek higher potential returns and be willing to accept higher risk and, generally, longer tenors. Equity investments may align more with their interest. When deciding between debt and equity, investors should consider their personal financial goals, risk tolerance, and investment objectives. Take into consideration multiple factors, such as age / time horizon, tax status, and generational wealth planning. For more information about the differences between debt and equity securities, see Carofin’s “Debt & Equity Investment Overview” here.
For more information about anticipated investment returns, please see “Alternative Investments & Their ROI’s – What should I be getting from these investments here.
Securities play a vital role in the world of finance, connecting those who need capital with those who have it. Understanding the basics of debt and equity securities, as well as their associated risks, can help investors make informed decisions and entrepreneurs choose the appropriate type of financing for their businesses. With a strong grasp of these concepts, you’ll be better prepared to navigate the complex world of securities and investments.
Watch the full video to learn about the risks associated with each type of security and how Carofin tailors its offerings to suit the unique circumstances of its clients.
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