What are Direct Private Investments (and Why Invest in Them?)

Securities Issued for Direct Private Investments

As indicated above, DPI refers to a direct investment made through a private investment transaction in the form of an equity or debt security that is issued by a company. From the perspective of the business, you would become a shareholder, sharing in the potential profits and equity appreciation of the business. Or, you could become a lender to the business – an alternative to borrowing from a commercial bank (see Debt & Equity Investment Overview).

Equity investments – Companies typically issue equity privately for two reasons. Sometimes they need capital to generate positive cash flow from operations. Alternatively, they have a strategic opportunity available to them, such as relatively large plant expansion or acquisition.

Either scenario can compel the business to make ownership available to outsiders – essentially a decision by the current owners to own a “smaller piece of a bigger pie.”

• Equity represents an ownership interest in a for-profit company where the Net Equity Value of the company (i.e., total assets less indebtedness) and any ongoing profits are owned proportionately by the holders of the equity. Equity Securities are a form of permanent capital for a company.
• Equity shares or membership Interests can be in either common or preferred form. Those rights are defined in the company’s Articles of Incorporation, if the company is a C or S Corporation, or in the company’s Operating Agreement, if the company is a Limited Liability Company.
• For a more complete explanation, see Equity Investment Basics

Debt investments – Companies usually prefer to use debt to support their growth, rather than equity, because it is a less expensive form of financing (i.e., the rate of growth of the business’s equity value is greater than the debt’s borrowing cost). But there must be sufficient operating cash flow generated by the enterprise to “service” the debt’s interest and principal payment obligations, or there could be severe consequences for the business.

Companies borrow funds from private investors because they can’t secure a loan from a commercial bank –today, an all too familiar scenario for SMBs. The day of the local banker, with direct lending authority, making loans to community businesses, is largely over in the U.S., at least by larger banks. There are now fewer banks, and underwriting decisions are rarely made locally by a banker.

This is reflected in the following chart:

Share of Business Loans by Size of Institution

Source: Small Business Administration Office of Advocacy

Private lending described

Debt financing is raised privately by companies through the issuance of Securities called promissory notes, senior notes, senior secured notes, or subordinated notes. These terms indicated the underlying credit structure of a given debt security and are described below.

• The amount of debt financing which can be raised by companies through private placement offerings ranges in amounts from less than $100,000 to well over $1 million.
• Maturities (i.e., when the principal is due to be repaid) can be short-term (say 90 days) to over 10 years. In many cases, the amortizing principal repayment is established when the debt security is issued. Amortization involves the scheduled, partial return of principal over the life of the debt security.
• A debt security’s repayment schedule should match the projected cash flow of the security issuer’s business while the debt security is outstanding so the company can afford to repay the borrowed capital when it becomes due.
• For a more complete explanation, see Debt Investment Overview.

Why invest in Direct Private Investments?

After reading the above, you may be thinking that there’s a lot to understand and that the risks are greater. You would certainly be right!

So, why consider DPI?

Because DPI offers investors features’ they can’t find through investment in public stocks or bonds:

• Greater investment returns (potentially)
• More meaningful investments
• “Absolute returns” and “less correlated” to the public markets

Below I’ll briefly address each of these positive attributes.

Greater investment return (potentially)

The very nature of DPI – their risk – should be offset by the potential for greater profit from this form of investment – a classic “risk versus return” evaluation (see Risk vs Return Considerations).

There are at least three primary factors which make the public securities markets (NYSE or NASDAQ) a more difficult environment for investors to capture value:

• Investor competition – Record amounts of capital are now available for investment in the U.S., but this capital is chasing a shrinking number of public securities. In 1996, there were over 7,300 publicly listed stocks in the U.S. Today there are about 3,600 public stocks – but almost 8,000 mutual funds and over 3,500 hedge funds. That’s a lot of competition and, so, equity valuations are sometimes stratospheric (e.g., Tesla at its 950+ P/E multiple) and interest rates incredibly low (10-year high-quality U.S. corporate bonds now yield about 2.15 percent).

By contrast, now there are over 20,000 private placement financings each year in the U.S., according to the SEC’s Division of Economic and Risk Analysis. Because relatively few individual investors participate in smaller DPI offerings, competition is lower and, so, they are usually priced reasonably (although not always, do your research!).

• Information – Our information age has resulted, among many other things, in ubiquitous access to information that publicly registered security issuers must report. So, there are legions of professional portfolio managers and securities analysts pouring over this information with whom individual investors are competing as they make investment decisions. Private companies are, by definition…private! An investor can, and should, be well informed about any private investment before they make it. However, the information needed to make an informed investment decision probably isn’t available through a Google search. This informational “barrier to entry” is an inefficiency that actively engaged investors can benefit from.
• Greater liquidity (the ability to easily sell the investment) – Better information about public securities fosters secondary trading by traders at larger financial institutions for most publicly registered securities. Liquidity for a given security, on average, drives higher valuations for equity and lower interest rates for debt securities.

Video: Investing in Private Entities with Your Retirement Account

More “meaningful” investments

Meaningful in this case means what you consider of significance, purpose, or value. Smaller companies – ones that your investment capital is vital to – often have stories to tell which are of special interest to you.

Maybe that’s a business that is supporting public health, or is important to your community as an employer, or puts food on our tables.

With DPI, you decide where your capital is going by selecting which goods or services you wish to support, the management teams you want to back, and whether their values reflect your own. And, not for nothing, you can potentially make a healthy investment return.

If you invest in a mutual fund, an indirect investment, you’re trusting someone else to select those companies to support… using your money.

Absolute returns and less correlated to the public markets

It may sound a bit wonky, but ‘absolute’ simply means the financial performance of the business issuer largely determines the investment performance an investor will realize on the investment. “Less correlated” means that the day-to-day value of the security will be much less affected by movement in “the markets” (NASDAQ, NYSE).

With a public security, you are, to a large degree, going along for a market ride, and often for reasons you will never understand until after the fact. If there’s a crash, you’re probably going to see all stock prices decline. If interest rate rise, the value of any lower-yielding bonds in your bond fund will decline, and, with it, the value of your investment in the fund.

Conclusion

I hope that the above has opened a new world of investing for you to consider. Am I suggesting that you should now transfer all investments from publicly traded securities to DPI? Absolutely not!
I am suggesting that DPI investments can be highly complementary to your more traditional security investments and to real estate investments you may now be making.

A self-directed IRA with Equity Trust is a great place to hold them!

About Bruce Roberts and Carofin

Bruce Roberts is the Founder and CEO of Carofin and has over 35 years’ experience as an investment banker and entrepreneur. 1987 – 1994, Mr. Roberts was at The First Boston Corporation (now Credit Suisse) in New York as a Director in the Investment Banking Department, supporting both corporate and government clients throughout the pacific region and raising in excess of $30 billion for his clients. He started his investment banking career at Bank of America in San Francisco in 1983. Prior to his investment banking career, he served as an officer in the U.S. Navy (UDT / SEAL).

Carofin is a FINRA broker-dealer specializing in the private finance of small to medium businesses in the U.S. Carofin and its affiliates have raised over $1.2 billion of equity and debt for smaller private businesses through over 200 securities offerings since 1996. We’ve learned a lot about financing SMB. Those lessons are reflected in every security we offer to private investors and in our continuing investor support after they’ve invested in our offerings.

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Bruce Roberts is not an employee of Equity Trust Company. Opinions or ideas expressed by Carofin, their affiliates and employees are not those of Equity Trust Company nor do they reflect their views or endorsement. These materials are for informational purposes only. Equity Trust Company, and their affiliates, representatives and officers do not provide legal or tax advice. Investing involves risk, including possible loss of principal.