Thinking About a Private Placement? Think Again!

Wednesday, September 25, 2013 4,945 views

So says the Financial Industry Regulatory Authority (FINRA) in a recent press release and investor alert. A private placement is an offering of a company’s securities that is not registered with the Securities and Exchange Commission (SEC) and is not offered to the public at large. In general, private placements are available only to “accredited investors” who have a net worth of at least $1 million or income exceeding $200,000. Such an investor would receive a phone call or e-mail from his broker telling him how lucky he is to have access to this exclusive deal and how he must act now before his other clients jump in and buy up the whole offering.

Gerri Walsh, FINRA’s Senior Vice President for Investor Education cites liquidity and transparency problems associated with private placements, which make them somewhat dodgy for retail investors (and for many institutional investors as well). By no means is FINRA saying that investors should avoid all private placements, but they should exercise the appropriate due diligence before buying.

Our problem with that admonition is that very few investors are qualified to review a company’s financial statements and its competitive landscape in order to determine if the private placement has been fairly priced in light of the risks facing the company’s future earnings. And let’s be realistic—most stockbrokers are not qualified to do this either.

Although we do not have any data on the performance of private placements in general, we do have some studies on a close cousin—private equity. Private placements are one of the security types in which a private equity fund may invest. As we discussed in this article, the returns reported by public databases that track the performance of private equity funds are unreliable because the funds calculate their own asset values which tend to be upwardly biased (big surprise!) and only the funds that have done well tend to report their results to the databases. After addressing these issues, the authors of a study titled “The Performance of Private Equity Funds1 found that a dataset of 1,328 funds underperformed the S&P 500 Index by about 3% per year on an absolute basis and 6% per year on a risk-adjusted basis. A study2 from MIT’s Sloan School of Management found that the average return of 746 private equity funds over a 17-year period was approximately equal to the S&P 500. Considering all the additional risks involved in private equity, this is a terrible result indeed.

As we have said before, people who believe that managers and asset classes that are only accessible to “qualified” investors will provide above market returns are setting themselves up for disappointment.

 

Phalippou, Ludovic and Gottschalg, Oliver, “The Performance of Private Equity Funds,” The Review of Financial Studies, Volume 22, Issue 4 (April 2009), pp. 1747-1776.

2Kaplan, Steve and Schoar, Antoinette, “Private Equity Performance: Returns, Persistence, and Capital Flows,” MIT Sloan School of Management Working Paper 4446-03, November, 2003.

 

 

 

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