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Ever been offered the “special opportunity” to invest in a private placement? You need to be 100% on guard when being pitched on these types of investments. Tom and Brendan discuss private placements and the essential facts investors must know about them in this week’s Mullooly Asset Management podcast.
Private placements involve the sale of securities to a relatively small number of investors as a way of raising capital. These are non-public offerings that aren’t regulated by the SEC. Investing in a private placement isn’t similar to buying stocks, bonds, mutual funds, or ETFs so don’t let anybody tell you otherwise. Private placements typically help small or start up companies find funding. They’re even described on FINRA’s website as, “risky and can tie up your money for a long time”. Read more from FINRA on private placements here: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/PrivateOfferings/P339650
Information on the company issuing a private placement may be difficult to obtain because a lot of these companies aren’t required to file financial reports. That means investors, as well as their investment advisor or broker, may have trouble finding out crucial information needed to assess the potential investment’s quality. Another thing to consider is that private placements are restricted securities. Meaning they cannot be resold without registration or an exemption. Good luck finding a buyer for a private placement you want out of. Even if you do find one, your odds of selling it for what you paid to get it are slim to none. These are illiquid securities.
Generally, investors must be accredited to invest in a private placement. If you aren’t familiar with the term accredited investor, here’s the definition: http://www.sec.gov/answers/accred.htm To summarize, you either have to be an institution, business, organization, or a wealthy individual. Sometimes a specified number of non-accredited investors are also allowed to invest in private placements. Why are they mostly offered to large or wealthy investors though? To put it plainly, they are more capable of absorbing a 100% loss of investment than the average investor.
While on the topic of private placements, we’d be remiss if we didn’t include Josh Brown’s Law of Product Compensation. The law states that the more a broker is paid to sell a particular product, the worse that product is for their clients. We completely agree with Josh’s law. Private placements typically pay between 7-10% commissions to the broker who sells them. You can read Josh’s thoughts on private placements here: http://www.thereformedbroker.com/2013/12/19/a-guide-to-private-placement-due-diligence-for-stockbrokers/ Private placements usually carry huge commissions for brokers, and that should be a gigantic red flag to any investor.
If you ever consider investing in a private placement, ask yourself, “Can I afford to lose all of this money or have it tied up for a very long time?”. If the answer to either is no, private placements are not for you. Don’t feel bad, they’re not for most.
A final thing to consider regarding private placements is really important. Why is this company coming to you for funding? If they were a solid company with a great business future, why would they have to pay a broker 7-10% commission to round up investors for them? Wouldn’t they have tons of potential investors if they had a great business proposition? A good business idea would have friends, family, venture capitalists, and angel investors chomping at the bit to get on board. Instead, they’re paying somebody to pitch their idea to you. Sound kind of shady? That’s because it most likely is.
Tune into this week’s Mullooly Asset Management podcast to hear Tom and Brendan talk more about private placements.