Your brother-in-law tells you this Company is going to revolutionize the (…pick an industry). And these people are incredibly experienced in this field. “Let’s invest together,” he tells you.
Well … let’s take a deep breath and think about private investing and what it might mean for you.
Risks of Private Investments
Investors must be aware of the additional risks associated with investments they make which are part of private placement offerings. These risks include:
- Illiquidity – Private Placements are “buy and hold” investments. Secondary trading (i.e. selling the security before its maturity or before it is redeemed) is not allowed; broker/dealers do not make secondary markets in Private Placements.
- Unaudited financial statements – Issuers of private Securities are not required to provide audited financial statements by an accredited accounting firm. Investors are relying on the accuracy of Company provided statements.
- Inconsistent Issuer Reporting – Public securities must report to the S.E.C. on an ongoing basis at least quarterly. Private companies are not required to by law, though it is common for the Summary of Terms associated with a private offering to specify the Information Rights of the Issuer is committing to.
- Inconsistent pricing of similar securities – Since there are no trading markets, the pricing of private securities carrying similar risk can vary significantly.
- Difficult to determine the ongoing value of the investment – The lack of Secondary Markets makes it more difficult to determine independently the ongoing value of the investment, which is necessary for use within personal financial statements and for estate-related transfers.
Risk versus Return
Evaluating the risk of a potential investment arguably is the most important aspect of any investing activity, whether as part of a private Securities Offering or for a publicly registered investment. No investment is without risk, and, inevitably, losses will happen within a portfolio. Limiting losses and achieving the projected returns of performing investments is, therefore, critically important.
Private investment offers the potential for compelling attractive returns, but Investors must evaluate each deal both for its individual merits, as well as how it complements their overall investment goals and risk tolerance.
Private investments, because they have virtually no ability for secondary sales, are priced at a premium to comparable publicly registered Securities. This offers the opportunity for incremental yield to private Investors, but it severely limits Investors’ ability to actively manage their investment portfolios.
The key to consistent, successful private investing is to build a diversified portfolio (no more than 10% exposure to a single transaction) where each investment has been subjected to comprehensive due diligence. This should include independent testing of all the Issuer’s disclosures and the underlying business drivers of the Company being financed (see Seven Key Questions for Investing in a Private Company.)
As a rule, private investments in total should constitute a minority (say 5% to 30%) of an Investor’s overall portfolio, with publicly registered investments and money market funds comprising the balance.
Private investments should be made with Investors’ discretionary funds — that is, cash resources which they can lose without affecting their important personal obligations, e.g. mortgages, college tuition, retirement, etc.
Your brother-in-law may be the nicest guy in the world, but, before you step up to the plate, tell him that you need to take the investment through your traps and see how it will fit within your overall investment strategy. You’ll be glad you did!