‘Alternative’ Investments Require Extra Diligence, Caution
By Gary Miller
It is no secret the U.S. economy is performing poorly.
First-quarter 2016 gross domestic product, the broadest measure of economic output, advanced at a dismal 0.5 percent seasonally adjusted annual rate, according to the Commerce Department. It is the worst performance in two years. Both top and bottom lines for major U.S. corporations are being pressured, according to the Wall Street Journal. Apple Inc., Norfolk Southern Corp, 3M Co., Pepsi Co., and Procter & Gamble Co. all took hits.
With interest rates currently near zero, CDs, bonds and banks aren’t providing attractive yields. This is problematic for individual investors. Therefore, many investors are increasingly looking at “alternative” investments in search of higher returns or yields.
I believe that diligent homework and extreme caution are required. Truly, “the devil is in the details.” Anyone considering “alternative” investments should obtain the advice of trusted accountant, investment, legal and other professional advisers before making any investment decision.
What are “alternative” investments? Opinions vary to an exact definition but, to me, they are potential uses of funds other than for “traditional” investments, such as publicly traded stocks, bonds, ETFs and mutual funds.
“Alternative” investments include, among others, private real estate funds, nontraded REITs, oil and gas programs, startup companies, private equity and venture capital funds. They are extremely complex. Some of these “alternative” investments are legally available only to “accredited investors” defined by the U.S. securities laws.
A “private placement” is one type of an “alternative” investment. Under federal and state securities laws, “private placements” can fall within an exemption from SEC and/or state securities registration as a sale of securities “by an issuer not involving any public offering.”
“Alternative” investments require detailed scrutiny. Three overarching considerations are: 1) Each “alternative” investment must be evaluated individually; 2) The documents, disclosures and agreements for each must be received, read carefully and completely, and understood fully before moving forward (this will be time consuming; don’t rely only on presentations and representations provided by management); and 3) If you are asked to invest or commit any money without being provided with proper and complete legal documentation, walk away. Investing your hard-earned money is not a “handshake” deal!
The documents and agreements for a typical private placement generally include: 1) A “private placement memorandum” or “offering document” that contains important details and disclosures about the company, its business, its prospects, the applicable risks (internal and external to the company), use of funds, and the costs and expenses of the transaction; 2) A “subscription agreement” that contains the terms and conditions of the securities sale and purchase; and 3) information regarding the accredited or nonaccredited status of the investor.
The “securities” being sold can bear many names, including stock, shares, membership interests, limited partnership interests, convertible debt, warrants and options.
Below are eight considerations you should incorporate when doing your “homework” – your own due diligence. Remember, as a passive investor, you will have little or no say in the management of the entity in which you invest.
First, examine the management team’s professional qualifications, experience and past track record of investment performance. Determine if management is putting its own funds in the transaction. Be wary if management has no skin in the game. Check to make sure that management has no criminal or other disciplinary history.
Second, examine the risk factors of the product/service. Is the product/service new to the marketplace or is it a modification of an existing product/service? Would the product/service involve new or significant change in sales practices?
Third, does the entity have enough funds to execute its strategy? If not, the venture could fail quickly. In some transactions, you may be contractually required to invest additional capital in the future if capital calls are made by management.
Fourth, examine the anticipated internal rate of return in the context of the entity’s investment strategy. Is it realistic or is it pie in the sky?
Fifth, understand the duration of the investment. Many investments do not have redemption or “put” rights and are illiquid. Your money could be tied up for years.
Sixth, examine all management fees, costs and other expenses paid to management and others. Review the “use of funds.” A company must describe how it will use the net proceeds raised from the offering and the approximate amount intended for each purpose. Beware of vague statements like “the proceeds will be used for general working capital purposes.”
Seventh, closely examine the securities being sold. Understand the rights, restrictions and class of securities being offered, and management’s ability to change the capitalization structure. Sometimes, the founder or existing shareholders retain(s) full voting control of an entity.
Finally, if you can afford to invest, determine if you can afford to lose all of your investment should the investment crater.
A quote attributed to Will Rogers applies: “Be not so much concerned with the return on capital as with the return of capital.”
Gary Miller is managing director of SDR Ventures Inc.’s Consulting Division, where he helps middle-market business private owners prepare to raise capital, sell their businesses or buy companies, and helps them develops strategic business plans. He can be reached at 720-221-9220 or firstname.lastname@example.org.
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