Two fruits. Both are round, but each delivers an entirely different taste sensation and benefits to your palate. In a recent episode of the Direct Private Investments Show, proudly presented to you by Carofin, Matt Brown interviews Bruce Roberts and Garrick Ruiz about the two primary categories of private investments, debt and equity.
This article draws upon the interview to help investors to understand how each investment is structured and the different benefits and risks each pose.
As investors diversify their portfolios with direct investments, they should ensure that the investment structures align with their goals, whether debt or equity. Specialist funds are often created to manage these types of investments, as they require different approaches to ensure a suitable structure both for the investors and the companies in which the investments are made. You can review a white paper called Understanding Private Securities here for a more detailed explanation.
Equity investments, higher-risk securities than loans, offer preferred stock which is junior to debt but senior to common stock. Often depending upon the stage of a company, it may offer different types of preferred stock, such as a participating preferred. Here, investors continue to participate in profit distributions of the Issuer as common shareholders after they have received a full return of their invested capital and any other preferred distributions to which they are entitled.
On the other hand, the equity being offered might be a convertible preferred. This form allows investors to receive dividends and to convert their shares into common stock at a fixed conversion ratio after a specified time, participating pro-rata with common stock.
Debt investments are comprised of three key elements: its maturity, interest rate, and the source of repayment. Maturity refers to the moment when the final principal payment for a debt obligation must be paid by the borrower/Issuer. Debt investments are generally shorter-term investments than equity and are designed with a current income component that is usually accompanied by an amortization schedule. These payments reduce investors’ exposure to the industry and the risk associated with the investment as the remaining principal is reduced, usually on a monthly basis.
As interest rates fluctuate, investors are likely to compare what is called the risk-free rate – that is, the interest an investor would expect from an absolutely risk-free investment over a specified period of time – to the rate being offered by a private debt investment. An investor should do this comparison to decide whether the rate being offered is commensurate with the risks the private debt represents.
The sources of repayment for debt investments can vary. Some will be from the company’s cash flow. While a preferred solution, it never hurts to augment the security‘s source of repayment with additional sources, such as readily sellable collateral and even a personal guarantee from the company’s owner. These may be attached to protect investors and help
them recover their investment in case of a default (see Private Lending to Operating Companies here for more context and a description of other forms of debt).
Investors, when considering private placements, should take into account their liquidity needs and risk tolerance. More conservative investors – or those with shorter-term liquidity needs – may find debt investments more suitable.
Investors with higher risk tolerances and longer investment horizons might feel comfortable with equity investments, which offer the potential for higher returns over time.
Understanding the security structures of direct private investments is crucial for investors to ensure alignment with their goals, risk tolerance and need for diversification.
While we’re not talking about fruit, each delivers an entirely different “taste” to your portfolio. By spreading investments across different asset classes, investors can mitigate risks and potentially increase their returns.