The Direct Private Investments Show
Securities Explained
Timestamps:
00:01:30 Basics of Securities: Debt vs. Equity
00:02:30 Importance of Accounting Knowledge
00:05:30 Understanding Debt Securities
00:06:30 Understanding Equity Securities
00:07:30 Offering Both Debt and Equity Securities at Carofin
00:09:00 Risks Associated with Debt and Equity Securities
00:09:30 – High-risk securities and debt restructuring
00:10:00 – An example of debt restructuring during COVID-19
00:10:30 – The relative risk in debt and equity securities
00:11:00 – Debt repayment in bankruptcy scenarios
00:12:00 – Target returns for diverse types of investments
00:13:00 – Thresholds for early stage venture and private equity
investments
00:14:00 – Equity returns for real estate investments
00:14:30 – Key takeaway for private debt and equity investors
00:15:00 – Age and investment goals considerations
00:16:00 – Closing thoughts and advice for investors
Introduction
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.).
Debt Securities
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
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.
Conclusion
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.
If you are building your private investment portfolio and are looking for
opportunities, please visit our website here.
