THERE’S NO SHORTAGE OF options for investors – stocks, bonds, ordinary mutual funds, closed-end funds, exchange-traded funds, bonds, real estate investment trusts. The list seems endless. But every so often a well-connected or lucky investor may get an unusual opportunity to get in on the ground floor before a new company goes public.
Some of the wealthiest Americans got that way through private placements, buying stock not yet approved for trading on an exchange. Initial investors often get in on the “friends and family” round when stock is offered to the founders’ personal contacts. Shares may go for less than a dollar, or sometimes even pennies.
If the company succeeds these early investors can score a bonanza. With the growth of crowdfunding, some private placements are available to ordinary investors, and this may seem appealing when listed stocks are struggling. But many experts warn against the siren song.
“Private placements are inappropriate for the average investor due to their extreme risk and the fact they can lock up an investor’s money for multiple decades,” says Joshua Escalante Troesh, owner of Purposeful Strategic Partners, an investment advisory, and business professor at El Camino College near Los Angeles.
“While private placements seem like sexy investments, for every story of one going well there are literally thousands of stories of companies no one has ever heard of where the investors lost 100 percent of their investments,” Troesh says.
“Private placements are best suited to investors who do not have an immediate need for their invested capital and can let it remain invested for five to seven years,” says Yousif Abudra, managing director at BENA Capital, a firm in San Ramon, California, specializing in private placements of real estate holdings.
Experts say ordinary investors offered first dibs on a new firm should proceed with caution and keep a number of things in mind before investing in private securities:
- Do you qualify?
- Do you have access?
- Do you want your money tied up in the company?
- What are the red flags?
Qualifying. To buy a private placement, one typically must be an accredited investor, one with net worth more than $1 million or annual income above $200,000 for an individual or $300,000 for a couple.
Historically, this allowed only wealthy investors deemed sophisticated enough to take big risks, but rules have loosened over the years and many ordinary investors now qualify due to rising incomes and asset values.
Access. “Private” means what it sounds like – you cannot just sign up with an online broker and get access to these deals. Though some are now offered through crowdfunding sites, in many cases, investors must be lucky enough to know one of the firm’s founders.
Robin Lee Allen, managing partner at Esperance Series, a private equity firm in New York, says private wealth managers such as U.S. Trust, Northern Trust, UBS and Credit Suisse “routinely provide access to private placements for their clients.”
“For those not able to qualify to open accounts with these institutions, banks like First Republic and City National cater to mass-affluent clients and provide a comparable level of service and access to opportunities in the capital markets,” he says, adding that Citibank now offers access through its Citigold centers.
But since private placements are not traded on exchanges, an individual placement may be available through one of these sources but not the others.
Tying money up. “Two of the main issues with private placements are their valuation and illiquidity,” says Braden Perry, a financial services attorney with Kennyhertz Perry in Kansas City, Missouri.
Without a liquid market as with listed stocks, investors have a hard time knowing what their shares are worth after the initial purchase.
“Ordinarily, only private data is used for valuation and performance, which means many metrics are not captured,” Perry says.
In addition, investors may be stuck with their shares for years because there is no market or way to sell until the company is listed, which may never happen. “Most private placements prohibit withdrawals by investors and are rarely allowed to sell their interests,” Perry says.
Private placements are suitable, therefore, only for investors who can afford to tie money up for the long term and survive a total loss, experts say.
“Ordinarily, investors in the space have been wealthy individuals looking for long-term investments and commiting to capital contributions, without annual returns for several years,” Perry says
Red flags. Assessing a private placement can be difficult. You probably won’t get as much information as with a listed stock, and the firm won’t have a long track record.
Jay Berkman, senior managing partner at The JLC Group, a Westport, Connecticut, marketing firm, and co-founder of Prospectus.com, a consultancy specializing in preparing private placement offering documents, urges investors to focus on the management team.
“Bet on jockeys, not horses,” he says. “Experienced entrepreneurs who have prior proven success are often reliable business plan executors.”
He also suggests looking for a firm insulated from competition.
“Investors should consider businesses that have moats – a barrier to entry – intellectual property, at least two or three revenue sources and an exit strategy,” Berkman says.
Exit strategies include selling to a bigger firm, being taken over by a private equity firm or investment group, or going public.
Berkman also warns about some red flags such as multiple share classes that benefit insiders at others’ expense, unrealistic revenue projections, concepts that are unproven or could infringe on other firms’ intellectual property. A private placement that has no management team other than the founder is also to be avoided, he says.
“Successful private placement investors will often invest millions of dollars across hundreds of companies to have a hope of finding one which becomes successful,” Troesh says. “They also pay for their own due diligence by hiring accountants, lawyers, financial advisors, and other professionals to pour over the company’s documents and plans before they invest.”