Recent regulations and technological innovations have made it possible for accredited investors to more easily invest directly in private companies, especially start-ups and small businesses. Once the domain of only institutional investors such as private equity firms and hedge funds, the private placement market is now opening up to a larger universe.
Despite this development, most investors are clinging to traditional investments such as stocks and bonds due to a lack of private capital knowledge and expertise. For those considering allocating a portion of their portfolio to alternatives, here are three things they should know about investing in private companies or funds.
1. Private securities are less liquid than public securities. One of the reasons stocks and bonds are so popular among rank-and-file investors is that they are very liquid—meaning that they can be more easily converted into cash. This important mechanism allows investors to exit their investments if they either foresee a decline in value or need to raise cash for other personal needs.
In contrast, private securities are generally illiquid as there is currently no robust secondary market for buying and selling them. As a result, investors that may have committed capital to an exciting start-up that is now floundering are left with no recourse for selling off their stake before it becomes worthless. Investors considering alternatives such as private equity need to be comfortable taking this added risk, or have a means of reducing their risk by diversifying their overall portfolio.
2. Don’t expect your returns to equal industry returns. Investors looking at alternatives are ultimately going to be concerned with their returns. However, it can be dangerous comparing performance numbers across different asset classes or even within the same asset class. For example, the HFRX Absolute Return Index (an aggregate measure of hedge fund performance) has historically under performed the S&P 500. Yet, this doesn't mean that all stocks will outperform all hedge funds.
Venture capital and private equity are generally two of the highest-performing asset classes, but many of the investment professionals involved in those markets have the expertise to identify which companies are going to survive and the financial resources to make enough small bets that just one or two major hits will put them in the green. Most regular investors don’t enjoy these same advantages and so should proceed with extreme caution.
3. Private companies aren't subject to the same regulatory requirements. Another reason why stocks and bonds dominate mainstream investing is that public companies are under the constant supervision of regulatory agencies such as the SEC and FINRA. Public companies are required to regularly disclose financial information—information that is vital to making an informed investment decision.
Private companies, however, operate in a different environment. Any disclosures they make about revenues or growth projections can be infrequent and not necessarily consistent with public company accounting standards. As a prospective investor, this lack of transparency can be a major impediment to the due diligence process of vetting a company.
Securities offered through WealthForge, LLC. Member FINRA/SIPC. This post is an industry update from WealthForge. The message does not constitute a research report or recommendation and does not take into account the specific investment objectives, financial situation or particular needs of the recipient. This message is not an offer to sell or the solicitation of an offer to buy any security or interest in any fund, which only can be made through a private placement memorandum that contains important information about the risks, fees and expenses of a fund.
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.