Traders looking for> new public companies to invest in have been hard up lately.
With rising volatility in the market, and rising concerns about the strength of the recovery, the pace of initial public offerings appears to be slowing again after picking up steam in the first half of the year.
After virtually coming to a standstill in late 2008 and early 2009, there were 24 IPOs in the first quarter this year, 31 in the second quarter, and 21 in July and August. But don t expect that pace to continue. With the exception of a few large offerings like General Motors and HCA coming down the pike, Morningstar reports few significant deals on its IPO calendar.
No one wants to price a deal during huge swings in the equity markets, says Bill Buhr, an IPO strategist at Morningstar. The new offerings that did come to market in the first half of the year haven t priced very attractively, leaving entrepreneurs with less incentive to take young companies public, he says.
Now, with the near-term outlook for underwriting uncertain, investors looking for new investment opportunities may want to consider businesses that haven t yet sold shares to the general public.
Of course, not everyone can get a seat at the table of a private company. For the most part, investing is restricted to what are known as accredited investors. These individuals (or married couples) must have a net worth of at least $1 million, or income of at least $200,000 for the past two years ($300,000 for couples), with a reasonable expectation of making the same amount in the upcoming year.
The Dodd-Frank financial reform legislation enacted this year narrowed the pool of such investors by prohibiting them from using their primary residence in determining their net worth. With their home equity excluded, fewer people are eligible for the most straightforward types of private-company investing.
Why the restriction? Essentially, the government assumes that people who have more money are more sophisticated, although of course that isn t necessarily the case, says John Gannon, the senior vice president for investor education at the Financial Industry Regulatory Authority.
Even for sophisticated investors, the risks involved in this type of investing are significant, Gannon says. Private companies don t have to make the same regular disclosures of key information that public companies do in annual and quarterly reports, making it difficult to evaluate their financial health. Public companies must also disclose material events like a key officer leaving the company, or a change in accountants (which can be a red flag for fraud). Fraud is more difficult to catch when there s less information available, Gannon says.
The major risk in investing in a private company is, of course, that it could fail. In 2009, 40% of angel investors exits from private-company investments were bankruptcies, according to the Center for Venture Research at the University of New Hampshire.
Investors should expect to have their money locked up for several years before an initial public offering or buyout creates a payday. And that payday is never a sure thing because returns are terribly volatile, even in success stories, says Jeffrey Sohl, the director of the University of New Hampshire s Center for Venture Research.
The best an investor can hope for may be a quiet acquisition because very few companies actually do go public, Sohl says. An acquisition doesn t get the press and the glamour of the IPO with everybody sipping champagne as the stock goes up, but it can be the simplest and quickest exit for investors, he says. Although it s a particularly slow period for IPOs now, even in boom years acquisitions always represent the majority of successful startup exits, he says.
For those willing to take on these risks, here are three private-company investment options for accredited investors, and two for investors of more limited means:
An early-stage investment in a new company is perhaps the most straightforward way to approach private-company investing. An investment of $25,000 says you re serious, says David Brophy, the director of the Center for Venture Capital and Private Equity Finance at the University of Michigan. Because there s so much less information available about private companies, and there s no stock price to help investors see what the collective intelligence of thousands of traders believes a company to be worth, investors have to take the time to thoroughly research a company and its founders to get a sense of its prospects. The terms of each investor s deal will be negotiated separately, so individuals should consult a knowledgeable business lawyer and accountant before committing to a purchase, Brophy says.
Joining an angel investing group can make the process easier and reduce risk by spreading cash among several different deals. Groups vary in the amount of money and time they ask from members, but a typical group might ask for between $25,000 and $100,000 and have monthly or quarterly meetings, says Marianne Hudson, the executive director of the Angel Capital Association, a trade organization for these groups.
The typical group investor is a white man in his 40s or 50s, although the community is becoming more diverse, Hudson says. Many angel investors are entrepreneurs themselves, corporate leaders, or doctors, she says. One benefit of joining a group of investors is the ability to draw on other members experience in their respective professional fields to help evaluate potential investments, she says.
Venture Capital or Private Equity Funds
Private equity is a high-risk, potentially high-return investment (also available only to accredited investors), so it shouldn t represent more than 10% of a total portfolio, says Carter Furr, the head of alternative investments for Signature, a wealth management firm based in Norfolk, Va.
Investors should carefully research a fund s management team, looking for a solid track record of past successes, Furr says. Even if the specific fund is new, investors should look for a management team that has worked together in the past and that can point to some accomplishments. The goal should be diversification, so investors should place money with managers who employ different strategies and target different industries, he says. Money will typically be tied up for about five years, so investors will also want to time their investments to come due at different points, Furr says.
Another option for accredited investors is to buy part of another investor s stake in a private company, or to buy shares from a company founder or employee who is looking to free up some cash.
Web sites like SharesPost or SecondMarket offer investors a chance to buy shares in sought-after private companies like LinkedIn, Twitter, eHarmony or Facebook. Shares of Facebook represent 40% of all the transactions completed on SecondMarket s private-company trading platform, according to a SecondMarket spokesperson.
SecondMarket will verify buyers and sellers identities, help to coordinate a sale, and take a commission that s split between the buyer and seller. Sellers can choose their buyers, and many prefer institutional investors or investors who are already active in venture capital, says Adam Oliveri, the managing director of the site s private company market.
Think of [private companies] as walled gardens that you have to knock on the door to be let in, Oilveri says. SecondMarket, which is also a private company, hopes to sell shares of itself on its own site later this year, Oliveri says.
The problems of doing sufficient due diligence on a private company would be compounded for investors buying in through a web site like this, Sohl says. They d be susceptible to buying on brand-name recognition without the ability to fully investigate the financial health of a company, he says. Investors would also essentially be buying a contract whose terms were negotiated by somebody else, so they d have little control over the fine print of how they d fare in a buyout, Sohl says.
Here s an option that s available to all investors. A special-purpose acquisition company, or SPAC, is a publicly traded company created to perform one buyout or takeover deal.
It s essentially a one-shot private equity fund, says Joel Rubenstein, a partner at the law firm McDermott, Will, & Emery who has worked on this type of deal.
The SPAC s managers promise to carry out an unspecified deal within a certain time frame. Investors who buy in get units comprised of common stock and warrants that allow them to buy more shares at a set price after the deal is complete. If the managers fail to find a deal, investors can redeem their stock for cash, but the warrants will be worthless. Investors also have a chance to cash out if they don t like the deal the team comes up with.
Because investors are buying in before they know what the deal will be, the key is to do careful research on the team leading the SPAC to assess their experience, Rubenstein says. If the SPAC is targeting a particular sector, look at the team s expertise in that field, he says. Management typically won t be paid unless a deal goes through, so investors should also look at how the team has structured that payday how many shares of the SPAC they own and whether they get a bigger payout for meeting specific targets, Rubenstein says.
Publicly Traded Private Equity Firms
Small investors can also buy shares of publicly traded companies, such as Blackstone Group or Fortress Investment Group, that have private equity arms. The PowerShares Global Listed Private Equity Portfolio tracks an index of these companies. However, common-stock shareholders shouldn t expect to capture the same returns as bigger investors who buy into the companies private equity funds directly, says Greggory Warren, a senior stock analyst at Morningstar who covers asset management firms.
Honestly, there s too much of a layer of difference between you and the core investors in those funds, Warren says. These companies are typically set up as limited partnerships, meaning general partners get the first bite at the apple before passing returns on to ordinary shareholders.
Many of these companies went public at the top of the market, and now the business model itself has come under pressure as capital for new deals has grown harder to come by, Warren says. The sector has a lot of cash on hand, less pressure to produce quarterly returns than traditionally structured corporations, and private-equity investors whose money is locked up, so managers can afford to wait for better opportunities, he says. But for smaller investors, that all translates to smaller returns for the immediate future.