Investing directly in private companies can give you more control over your investments, help small businesses across the nation, and add balance to your traditional investment-heavy portfolio. And it might also provide tax benefits.

Here are two things I hope you take away from this article:

Develop a basic understanding for Direct Private Investments (DPI) and the two primary forms of investment falling under the  DPI umbrella, equity and debt securities;

Appreciate why DPI can be an attractive complement to traditional investing, to real estate and to the other alternative investments you may make from your self-directed IRA (SDIRA).

Throughout this article, you’ll be offered links to more in-depth DPI-related educational material which our firm, Carofin, has created to support investor education.  Also, many of the financial terms used throughout are hyperlinked to a more common language definition.  For the entire library of Carofin educational material, all specifically to support DPI, see our Carofin Knowledge Base.

Introduction to Direct Private Investments

If you have an SDIRA or are considering one, you’re already aware of the investment limitations imposed by traditional IRAs.  Chances are you have set up an SDIRA because you’re trying to make an “alternative” investment.  It’s probably a real estate investment. Real estate comprises about 50% of alternative investments made from SDIRAs.

Good for you!  Your awareness of the benefits an SDIRA offers suggests that you are an actively engaged, informed investor.  There are many sectors included within alternative investments.  An SDIRA puts you in a great position to explore them all in a tax-efficient manner.

Direct Private Investments Defined

DPI, as the terms suggest, are direct investments in the privately issued equity or indebtedness of a specific business.  In other words, you evaluate, select and purchase a security, typically in the form of stock (equity) or a promissory note (a loan) issued by one company.

The alternative to DPI, Indirect investments, includes investments in funds.  In a fund investment structure, a professional investment manager selects the individual investments.  You give them full discretion to buy and sell securities on your behalf.

All DPI are sold privately by the issuer directly to investors, often with the assistance of a broker-dealer like Carofin. They are issued under a private placement exemption from registration with the Securities Exchange Commission (making them a Private Placement).  Well over $2 trillion of privately placed securities are sold annually in the U.S.  This is a greater amount than is issued publicly.  It’s a huge and highly varied market.

A word of caution… “private investments” also carry with them additional risks, in particular, “illiquidity.”  They don’t have an active secondary market and, so, are usually held by the investor until the underlying business is sold or recapitalized (for equity) or the loan you have made matures (see What should I know about private investments?). Due to these additional risks, only investors able to lose much or all of their investments should consider DPIs.

To summarize…DPI includes all private investing where you make the investment decision and the return on investment results from the performance of an individual equity or debt security issued by a specific company (the “Issuer”).

Small to Medium Business in the U.S. – If you’re not aware already, small to medium-sized businesses (SMB) collectively represent a huge part of the U.S. economy.  There are over 28,000,000 SMBs, representing 99.7% of all businesses, that generate about 44% of the U.S. GDP and about 60% of U.S. job creation (source: SBA.gov).

SMB’s seek growth capital through the private capital markets, which are enormous. SMB’s also are chronically underfunded (see below), so you can choose from a virtually unlimited selection of SMB-related investment alternatives.

Securities Issued for Direct Private Investments

As indicated above, DPI refers to a direct investment made through a private investment transaction. It can be in the form of an equity or debt security that a company issues.   From the perspective of the business, you would become a shareholder.  As such, you would share in the potential profits and equity appreciation of the business.  Or, you could become a lender to the business – an alternative to borrowing from a commercial bank (see Debt & Equity Investment Overview).

Equity investments – Companies typically issue equity privately for two reasons. Sometimes they need capital to generate positive cash flow from operations. Alternatively, they have a strategic opportunity available to them, such as relatively large plant expansion or acquisition.  Either scenario can compel the business to make ownership available to outsiders.  This, essentially, is a decision by the current owners to own a “smaller piece of a bigger pie.”

• Equity represents an ownership interest in a for-profit company where the Net Equity Value of the company (i.e., total assets less indebtedness) and any ongoing profits are owned proportionately by the holders of the equity.  Equity Securities are a form of permanent Capital for a company.
• Membership Interests or Equity shares can be in either common or preferred form.  Those rights are defined in the company’s Articles of Incorporation if the company is a C or S Corporation, or in the company’s Operating Agreement if the company is a Limited Liability Company.

• For a more complete explanation, see Equity Investment Basics.

Debt investments – Companies usually prefer to use debt to support their growth, rather than equity, because it is a less expensive form of financing. In other words, the rate of growth of the business’s equity value is greater than the debt’s borrowing cost.  But an enterprise must generate sufficient operating cash flow to “service” the debt’s interest and principal payment obligations. If it cannot, there could be severe consequences for the business.

Companies borrow funds from private investors because they can’t secure a loan from a commercial bank.  In this day and age, this is an all too familiar scenario for SMBs.  The day of the local banker, with direct lending authority, making loans to community businesses, is largely over in the U.S., at least by larger banks.   There are now fewer banks, and a banker rarely makes underwriting decisions locally.

Source: Federal Deposit Insurance Corporation, “Statistics on Depository Institutions.”

Private lending described

• Debt financing is raised privately by companies through the issuance of Securities called Promissory Notes,  Senior Notes, Senior Secured Notes, or Subordinated.  These terms indicated the underlying credit structure of a given debt Security and are described below.
• The amount of debt financing which can be raised by companies through Private Placement offerings ranges in amounts from less than $100,000 to well over $1,000,000,000.
• Maturities (i.e., when the Principal is due to be repaid) can be short-term (say 90 days) to over 10 years.  In many cases, when the company issues the debt security, it establishes the Amortizing Principal repayment.  Amortization involves the scheduled, partial return of Principal over the life of the debt Security.
• A debt Security’s repayment schedule should match the projected cash flow of the Security Issuer’s business while the debt Security is outstanding so the company can afford to repay the borrowed Capital when it becomes due.

• For a more complete explanation, see Debt Investment Overview

Why invest in Direct Private Investments?

After reading the above, you may be thinking that there’s a lot to understand and that the risks are greater.  You would certainly be right!

So, why consider DPI? 

Because DPI offers investors features they can’t find through investment in public stocks or bonds:

     Greater Investment Returns (potentially)

     More meaningful investments

     “Absolute returns” and “less correlated” to the public markets

Below I’ll briefly address each of these positive attributes.

Greater Investment Return (Potentially)

The very nature of DPI – their risk – should be offset by the potential for greater profit from this form of investment – a classic “risk versus return” evaluation (see Risk vs Return Considerations).

There are at least three primary factors that make the public securities markets (NYSE or NASDAQ) a more difficult environment for investors to capture value:

Investor competition – Record amounts of capital are now available for investment in the U.S., but this capital is chasing a shrinking number of public securities. In 1996, over 7300 stocks were publicly listed in the U.S.  Today there are about 3600 public stocks – but almost 8000 mutual funds and over 3500 hedge funds.  That’s a lot of competition and, so, equity valuations are sometimes stratospheric. For example, Tesla at its 950+ P/E multiple. Furthermore, interest rates are incredibly low (10-year high-quality U.S. corporate bonds now yield about 2.15%).

By contrast, now there are over 20,000 private placement financings each year in the U.S.  Because relatively few individual investors participate in smaller DPI offerings, competition is lower.  Therefore, they are usually priced reasonably (although not always; do your research!).

Information – Our information age has resulted, among many other things, in ubiquitous access to information that publicly registered security issuers must report. So, there are legions of professional portfolio managers and securities analysts pouring over this information with whom individual investors are competing as they make investment decisions.

Private companies are, by definition…private!   Investors can, AND SHOULD, inform themselves about any private investment before they make it.  However, the information needed to make an informed investment decision probably isn’t available through a Google search.  This informational “barrier to entry” is an inefficiency that actively engaged investors can benefit from.

Greater liquidity (the ability to easily sell the investment) – Better information about public securities fosters secondary trading by traders at larger financial institutions for most publicly registered securities. Liquidity for a given security, on average, drives higher valuations for equity and lower interest rates for debt securities.

More “Meaningful” Investments

Meaningful in this case means what you consider of significance, purpose or value.  Smaller companies – ones that your investment capital is vital to – often have stories to tell which are of special interest to you.

Maybe that’s a business that is supporting public health.  Or it is important to your community as an employer, or it puts food on our tables…

With DPI, you decide where your capital is going. You select which goods or services you wish to support. You choose the management teams you want to back and determine whether their values reflect your own.  And, not for nothing, you can make a healthy investment return.

If you invest in a mutual fund, an indirect investment, you’re trusting someone else to select those companies to support… using your money.

Absolute returns & less correlated to the public markets

This may sound a bit wonky…  But ”absolute” simply means the financial performance of the business issuer largely determines the investment performance an investor will realize.   “Less correlated” means that the day-to-day value of the security will be much less affected by movement in “the markets” (NASDAQ, NYSE).

With a public security, you are, to a large degree, going along for a market ride.  Often you will never understand the reasons until after the fact.  If there’s a crash, you’re probably going to see all stock prices decline.  If interest rates rise, the value of any lower-yielding bonds in your bond fund will decline.  So will the value of your investment in the fund.

Conclusion

I hope that the above has opened a new world of investing for you to consider.  Am I suggesting that you should now transfer all of your investments from publicly traded securities to DPI?  ABSOLUTELY NOT!

I am suggesting that DPI investments can be highly complementary to your more traditional security investments and to real estate investments you may now be making. Investing through an SDIRA is a great idea!

Carofin – Who we are

Carofin is a FINRA broker-dealer specializing in the private finance of small to medium businesses in the U.S.  Through over 200 securities offerings since 1996, Carofin and its affiliates have raised over $1.2 billion of equity and debt for smaller private businesses.  We’ve learned a lot about financing SMB.  Every security we offer to private investors reflects those lessons.  They are integral in our continuing investor support after they’ve invested in our offerings.

Recommended Reading

Forbes’ “How To Get Started With Direct Private Equity Investments In The Coronavirus Age”

Equity Trust Company’s “Working with an IRA Custodian”