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Investor Insights Blog|What are Direct Private Investments (and Why Invest in Them?)

SDIRA Concepts

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

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The following was written by Bruce Roberts, Founder and CEO of Carofin.

Here are two things I hope you take away from this article:

  • Develop a basic understanding for Direct Private Investments (DPI) and the two primary forms of investments falling under the DPI umbrella, equity and debt securities.
  • Appreciate why DPI could be an attractive complement to traditional investing as well as real estate and other alternative investments you may make from your self-directed IRA.

Throughout this article you’ll find links to more in-depth DPI-related educational material which our firm, Carofin, has created to support investor education. Also, many of the financial terms used throughout are hyperlinked to a more common language definition. For the entire library of Carofin educational material, all specifically to support DPI, see our Carofin Knowledge Base.

Introduction to Direct Private Investments

If you have a self-directed IRA with Equity Trust or are considering one, you’re already aware of the investment limitations imposed by traditional IRAs. Chances are you have been compelled to set up a self-directed IRA because you’re trying to make an “alternative” investment, and it’s probably a real estate investment. Equity Trust has now enabled over 200,000 real estate investments for its clients.

Good for you! Your awareness of the benefits offered by a self-directed IRA suggests that you are an actively engaged, informed investor. There are many sectors included within alternative investments, and a self-directed IRA puts you in a great position to explore them all in a tax-efficient manner.

Direct Private Investments Defined

Direct Private Investments (DPI), as the term suggests, are direct investments in the privately issued equity or indebtedness of a specific business. In other words, you evaluate, select, and purchase a security, typically in the form of stock (equity) or a promissory note (a loan) issued by one company.

The alternative to DPI, Indirect investments, includes investments in funds. In a fund investment structure, a professional investment manager selects the individual investments. You give them full discretion to buy and sell securities on your behalf.

All DPI are sold privately by the issuer directly to investors, often with the assistance of a broker-dealer like Carofin. They are issued under a private placement exemption from registration with the Securities Exchange Commission (making them a private placement). Well over $2 trillion of privately placed securities are sold annually in the U.S., a greater amount than is issued publicly. It’s a huge and highly varied market.

A word of caution: “private investments” also carry with them additional risks, in particular “illiquidity.” They don’t have an active secondary market and, so, are usually held by the investor until the underlying business is sold or recapitalized (for equity) or the loan you have made matures (see What should I know about private investments?).

To summarize: DPI includes all private investing where you make the investment decision and the return on investment results from the performance of an individual equity or debt security issued by a specific company (the “Issuer”).

Small to Medium Business in the U.S. – If you’re not aware already, small to medium-sized businesses (SMB) collectively represent a huge part of the U.S. economy. There are over 28 million SMBs, representing 99.7 percent of all businesses, that generate about 44 percent of the U.S. GDP and about 60 percent of U.S. job creation (source: SBA.gov).

SMBs seek growth capital through the private capital markets, which are enormous. SMBs also are chronically underfunded (see below), so you have a virtually unlimited selection of SMB-related investment alternatives from which to choose.

15-Minute Guide to Private Entity Investing with a Self-Directed IRA

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.”

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:

Outstanding Small Business Loans 2005-2018

Outstanding Small Business Loans 2005-2018
Source: Federal Deposit Insurance Corporation, “Statistics on Depository Institutions”  

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:

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!

1

Can I buy stocks, bonds and mutual funds with a self-directed IRA?

Yes. Some IRA custodians only allow investing in stocks, bonds and mutual funds; however a self-directed IRA custodian, such as Equity Trust, allows those types of investments in addition to real estate, notes, private placements, tax lien certificates and more.

2

What investment options are possible with an Equity Trust account?

Some of the investments Equity Trust clients make using their self-directed accounts include real estate, tax liens, digital currencies such as Bitcoin, private lending, purchasing notes, private placements, precious metals, forex and other investment options that are permissible under IRS guidelines.

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.

FIND OUT MORE ›

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.

 


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