Private Investigations

It’s easy to cash out investments in publicly traded companies; simply ask your stockbroker or investment advisor to execute a trade. But investments in private companies are generally illiquid. While limited markets for private investments do exist, the ability to convert these investments to cash must generally wait until an IPO, a leveraged recapitalization, or a liquidity event such as the sale of the company or real estate. Sometimes the promoters of an investment will commit to redeem or buy out an investor’s interest. But, as many private equity investors learned in 2008, such a commitment is only as good as the entity’s access to cash, and if too many investors seek redemption simultaneously, the commitment can be curtailed.

Private investments pose other risks. Compared to investments in public companies, which have federal reporting and disclosure obligations, private investments generally feature limited transparency. They also require greater dependence on specific employees—a charismatic founder, for instance—as compared to the management depth and redundancy often found in public companies. Moreover, it can be difficult to value these investments for tax, accounting and other purposes.

Because of these and other impediments to ownership, federal securities law generally requires that investors in private companies can sustain the loss of their investment and either have the knowledge to evaluate it or employ investment advisors who can. Even if the ability to evaluate an investment weren’t a legal requirement, it’s a logical one. Whether a client or an advisor is evaluating an investment, the proposition is the same: if you don’t understand it, don’t invest in it.

As basic as that test is, investors and advisors frequently violate it. Sometimes people don’t want to admit that they don’t understand the investment. Other times they’re too lazy to conduct the proper due diligence. And sometimes clients and advisors succumb to the marketing of the investment or a herd mentality—which is how investors fall prey to Ponzi schemes.

How should investors evaluate private investments? The client or someone with expertise in the type of investment being considered must carefully review the associated documentation. This material ordinarily includes an offering document providing disclosures about risk factors, the sources and uses of proceeds, prior performance of the principals and tax aspects of the offering. The materials should also include documents specific to the entity and its investors such as: the partnership agreement, operating agreement, shareholders’ agreement, investor rights agreement, articles of incorporation, bylaws and so on. These documents describe dilution, cash call obligations, tagalong and registration rights, drag-along obligations and other investor rights and obligations. Finally, there should be some form of subscription agreement financially obligating the investor and requiring his or her signature.

Understanding these documents is crucial. But it’s equally important to evaluate the investment’s risks and returns compared to comparable investments. Is the investment suitable for the investor’s profile and asset allocation? What might be appropriate for one type of investor might not meet the risk profile or suitability standards of another.

Before analyzing disclosures, suitability and the propriety of the documentation, the client or his trusted representative should look closely at the promoters and their business activities for red flags—suggestions of a potential infirmity in the investment or the integrity of management.