Beware risks of private placements

Published May 25, 2011

The lure of huge returns from these products is strong but invest in them only if you can afford to lose the money, reports PAUL SULLIVAN

INVESTOR interest in private equity and debt offerings continues to increase a mere three years after these illiquid investments caused a lot of anxiety, if not substantial financial losses. The problem is there is little sign that investors are any more aware now of the risks involved in these deals than they were then.

In an investment maze: There is little sign that investors are any more aware now of the risks involved in private equity and debt offerings than they were before
At the beginning of the year, wealthy investors were abuzz over a private placement investment in Facebook, the social networking site. But deals that large are not the norm. Most private offerings, or placements, are smaller - with minimum investments of US$25,000 as opposed to the reported US$2 million in the Facebook offering - but carry the same high risks and high fees.

'We're starting to see more of it because more and more of our clientele are having the ability to invest in these sorts of things,' said Drew Kanaly, chairman and chief executive of Kanaly Trust, which manages US$1.8 billion. 'This is where they're going to see better returns going forward, but the pros and cons are tough.'

Jeffery and Linda Knippa, who now live in Point Venture, Texas, found this out the hard way. After coming into a modest inheritance and selling their home in Houston, they made two investments in private placements, in 2005 and 2007, that totalled US$80,000. They say they did so on the recommendation of their broker, Don L Devens, a registered representative of the broker-dealer Capital Financial Services. Their goal was to keep their money safe, they said, until they returned from Colombia, where Jeffery Knippa was sent to work as an oil field engineer.

Instead, they lost their US$80,000. The Knippas filed an arbitration claim against Capital Financial Services in November 2009 and are waiting for a hearing. 'We knew him through the Lutheran church, so we put our trust in him,' Linda Knippa said.

Mr Devens declined to comment. John Carlson, chief executive of Capital Financial Services, said he could not comment while the case was pending.

Regardless of the size of these deals, investors need to weigh many factors before getting in, including their willingness to lose the money they put in. Here is a look at the considerations:

Likelihood of loss

The reality is the Knippas should never have gotten into such a high-risk investment. They did not have the net worth to be what the US Securities and Exchange Commission calls 'accredited investors' - those with at least US$1 million in net worth or a US$300,000 annual salary for a couple. Nor did they understand the potential downsides.

'We had no financial experience,' Linda Knippa said. 'That was the reason we sought out Don.' She said her husband was now working at an oil field in Baku, Azerbaijan, to rebuild their nest egg.

While private placements represent a tiny share of all investments, the number of arbitration cases involving limited partnerships, which is how some private placements are structured, has nevertheless increased in the last few years, to 80 in 2010 from 19 in 2007, according to Financial Industry Regulatory Authority.

Andrew Abramowitz, a lawyer in New York who has worked with both buyers and sellers of private placements, said every investor should approach a private placement sceptically.

'As long as the expectations are, 'I can lose this and I may not be able to sell it,' then nothing goes wrong,' he said. 'That may not come to pass. People who are savvy about this do a bunch of them and hope one will pop.' For those who do not understand this, the experience can be life-altering. 'We miss that US$80,000 every day,' Linda Knippa said. She said the remainder of their money was now in low-yielding certificates of deposit.

Membership in the club

There are many reasons the SEC tries to limit private placements to accredited investors, but one of them is surely that they can afford to lose money.

Yet Andrew Stoltmann, a securities lawyer in Chicago who is representing the Knippas, noted that there was not necessarily a link between wealth and financial sophistication, which would give you a fighting chance to assess one of these offerings.

'I know a lot of people who have US$1 million or US$2 million in net worth, but they don't know anything about investing,' Mr Stoltmann said. 'Think about a football player who signs a US$30 million NFL contract: He's an accredited investor, but he's not sophisticated with finance.' These placements, then, are best reserved for a small group of people.

Karl Wellner, president and chief executive of Papamarkou Wellner Asset Management, said one of the things his firm did for clients was arrange 'clubby deals from time to time'. These are private placements in their original form: led by people who have already made significant money in the area where they are investing and see an opportunity that requires them to raise money quickly.

Right now, his firm, which manages several billion dollars for 150 families, is helping to arrange a private placement that will invest US$150 million in farmland in the US. The attraction is the promise of steady returns in an asset class that has historically done well in both uncertain and inflationary times.

He arranged something similar after the construction markets collapsed in 2008. The firm put together a deal to buy and store various noble alloys used to make steel stronger. Their prices had fallen by 60 to 80 per cent when construction dried up. But the family leading the deal had made its money in metals and believed the price would rebound.

Within two years, the 15 to 20 families who had contributed a total of US$65 million had received a 40 per cent return. 'There is a very real attraction to unique, boutique, clubby transactions that we often have access to,' said Thorne Perkin, managing director at Papamarkou Wellner. 'But we're in the stay-rich business, not the get-rich business.' Mr Perkin has a point: If his clients lose millions in an investment, they still have plenty of money left. When a couple like the Knippas loses US$80,000, their lifestyle changes.

What to look for

Of course, investors will be attracted to promises of high returns just as surely as moths fly to a flame. When should they take a chance and when should they walk away? Every adviser will say researching the deal and examining the track record of the managers are essential. This is easier said than done when limited information is available.

Mr Kanaly said potential investors should make sure that the general partners had their own money at stake - from one to 5 per cent of the deal - and also understand how they will be paid out. 'You want to see a preferred rate of return for you until they meet their objectives,' he said.

Mr Abramowitz said investors should not have any illusions that they will have a say in how their money is managed. One warning sign is if the company is widely promoting its private placement. Such marketing violates SEC rules.

Still, the lure of huge returns is strong. 'You can tell them it's illiquid, but making them understand that the money is locked up and gone is difficult,' Mr Kanaly said. 'Even if the return is higher, that lag to the first drink of water can be years. You have to be pretty wealthy to wait that long.' - NYT