7 Questions to Ask Before Investing in Private Markets

Introduction

If it sounds too good to be true…

I’ve had a few clients inquire about promissory notes lately, which is something that never really happened before the last couple of years.

I know why, too. Lately, there has been a proliferation of online investment offerings giving investors the opportunity to invest in things like promissory notes or private commercial real estate syndications. Before diving in, it’s crucial to know the right questions to ask before investing, ensuring you’re making informed decisions.

These “private placement” investments don’t trade on exchanges like stocks. Rather, they are private transactions with little to no secondary market, meaning that if you want to sell the investment, you may not be able to.

Investors are usually enticed, understandably, by the high yields and rates of return being advertised. One prominent sponsor of online security offerings advertises returns between 8%-12% per year. I’ve also seen real estate offerings advertising returns between 12% and 20% annually. That’s a lot!

Traditionally, private placement investments have been the domain of professional investors or the extremely wealthy, and the only way for mom-and-pop investors to access them was through intermediaries.

The sponsors of these online private placement offerings claim they are democratizing investing by cutting out the middleman and giving mom and pop investors access. I think there is some truth to that argument.

What to Consider Before Investing

But, before you rush out and load up on these high yielding investments, there are some things you should consider:

Click here, here and here to learn about recent private placement offerings that have
imploded, leaving thousands of small investors holding the bag.

What do each of those investments have in common? They were all presented as “can’t
lose” investment opportunities.

Hint: There’s no such thing.

Ask yourself if you are truly qualified to make this investment. If your ability to conduct
due diligence is limited to a Google search, let me suggest that the answer to this
question is “no”.

Moreover, if you have no ability to structure the investment in a manner that protects your investment, let me again suggest that the answer is “no”. A typical process manual used by intuitional investors for making private placement investments runs 30 pages plus. It includes doing things like running extensive background checks on investment sponsors; conducting a thorough review of the financials; placing liens on collateral; setting up a lock box on bank accounts so that funds can’t be diverted; and structuring deals in such a way that the investment sponsor takes losses before the investor.

Are you able to do these things?

Questions to Ask Before Investing in Private Markets

Now, let’s say that despite my warnings you are still convinced that you want to invest in a private placement offering. What are the questions to ask before investing in private markets?

1. What are the terms of the investment?

How long is your money going to be locked up? Is there a way to sell your investment
early? If so, what are the penalties? Will your capital commitment be drawn down over
time, or all at once?

2. What is the exit strategy?

For example, a common multifamily real estate exit strategy might be to renovate the
apartments over 2-3 years, increase rents, increase occupancy and sell after 5-7 years.
It’s your job to determine who realistic you think this is.

3. How much capital is the investment sponsor contributing?

This is a big one. If the sponsor commits only a small part of the total capital, how much
incentive do you think they will have to see things through if things start to go
sideways? Not a lot, right?

4. What is the market opportunity for this investment, why does it exist, and how long is it expected to continue?

Here again, it is imperative to use your judgement. Does this opportunity pass the “sniff
test”?

5. What are the risks associated with the investment?

Make sure to ask for a detailed list of the risks associate with the investment. There’s
really so such thing as a risk-free investment, and it’s up to you to determine which risks
are worth taking and which ones are not.

6. What sets the investment sponsor apart from its competitors?

Is it the pedigree of the team? Are they seasoned experts in a niche market? Do they
have a track record of success?

7. What are the fees associated with the investment?

This can be very confusing. Many private equity and real estate offerings are structured
so that there is a management fee on committed capital, typically 1.5% to 2% annually.
On top of that there is usually a profit split. Say, 80% to the investor and 20% to the
investment sponsor. Complicating matters, the investor is often entitled to recoup
his/her investment before the profit split begins but the sponsor is also entitled to a
catch up.

Using the 80/20 split referenced above, after the investor recoups his/her initial
investment, the sponsor would then take the next 20% of profits. Only then, would the
full 80/20 split of profits kick in for the remainder of the deal.

This is actually simplifying matters. There are also things like preferred returns, hurdle
rates, high water marks and tiered profit splits. It’s important to ask for an illustration
showing an example of how profit and expenses will flow during the course of the deal,
so you can follow along step by step.

And one more thing: If an investment claims that there are no fees, don’t be an idiot. Do
you really think these people are working for free?

Chances are that the investment sponsor has structured the deal so that they are
keeping the vast majority of profit in exchange for promising you a very nominal return

while structuring the deal as debt or preferred equity so they can claim there are no
fees.

Conclusion

This article merely scratches the surface of the questions you need to ask before investing in a private placement investment. The realm of private placements is fraught with both opportunity and risk. While the appeal of high returns may be compelling, it’s critical to proceed with caution. After all, the stakes are high, and your hard-earned money is on the line. Due diligence is not a phrase to take lightly here; it’s a comprehensive process that you must commit to if you wish to minimize risks.

Investing in a private placement is not like buying shares of a well-known publicly traded company. The opacity, illiquidity, and complexities inherent in these types of investments make them unsuitable for casual or inexperienced investors. Even savvy investors can get ensnared in deals that look good on paper but unravel in practice. Trust me. I’ve been there.

Therefore, it is absolutely crucial to consult professionals experienced in this investment class. That might mean paying for a lawyer to review contracts or hiring a financial advisor to scrutinize the investment’s merits.

Moreover, the democratization of private investment opportunities shouldn’t be confused with a guarantee of success or safety. The elimination of intermediaries might reduce costs, but it also removes a layer of scrutiny that could protect you from a bad investment.

You should also remain vigilant against the natural human tendency toward confirmation bias. Just because you want an investment to be a good opportunity doesn’t mean that it is. Always be prepared to walk away if the answers to your questions reveal inconsistencies, incomplete information, or even just a feeling that something doesn’t quite add up.

To conclude, private placements might offer high returns, but they come with an equally high level of complexity and risk. The questions outlined in this article serve as a primer, but they’re the starting point, not the end. Therefore, unless you’re equipped both financially and intellectually to undertake the comprehensive due diligence process necessary for these types of investments, it might be wise to steer clear or seek professional guidance.

The maxim “if it sounds too good to be true, it probably is” has endured for a reason, and it’s as applicable here as anywhere else in the investment world. And one final bit of advice: If you do decide that you will invest in these types of investments, never invest more than you could afford to lose if the investment were to result in a total loss.

What’s the fastest way to go broke? Stick all of your money into a can’t lose investment that ends up being a Ponzi scheme. You are already rich. Don’t be greedy.

Legal Disclosure

This article is for informational purposes only and is not intended to provide, and should not be relied upon for investment, financial, legal, or tax advice. The content is general in nature and does not take into account your specific investment objectives, financial situation, or particular needs. Any information or opinions contained herein are not intended to constitute a solicitation or offer to buy or sell any securities or other financial instruments. Past performance is not indicative of future results.

The author of this article is a Registered Investment Advisor. However, this article does not constitute an offer to provide personal investment advice. The views expressed in this article are the author’s own and do not necessarily reflect the views of any advisory firm with which the author may be associated. It is crucial to consult with your own qualified financial advisor, tax advisor, or legal counsel before taking any action based on the information provided herein. Investing in financial instruments involves a high degree of risk and may not be suitable for all investors. Before making any investment decisions, prospective investors should carefully consider their investment objectives, level of experience, and risk appetite.

The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with investing in financial instruments and seek advice from an independent financial advisor if you have any doubts.

The author has taken reasonable precautions to ensure the accuracy of the information contained within this article. However, the author, advisors, agents, and any affiliated parties make no representations or warranties as to the accuracy, completeness, or suitability of this information for any purpose, and disclaim all liability for the use of this information for any purpose.

Nothing in this article should be considered a solicitation or offer to buy or sell any specific products or securities. Furthermore, this article should not be considered as an endorsement or recommendation of any companies, products, or services mentioned within.

Remember, investing in private placements and other similar investments involves significant risks, which include, but are not limited to, illiquidity, lack of dividends, loss of investment, and dilution, and it should only be done as part of a diversified portfolio. Your capital is at risk.

Always conduct your own due diligence before making investments.