Interested In Private equities? | The six key elements you need to know before investing
By: Maria Lizak, Ph.D
Don’t be fooled by great advertising.’ Everyone knows that. Yet secretly, we all hope that the promises made, or implied by, those ads are true. We really would like 20% guaranteed returns on our money. Everyone wants investments that make them money, without the risk of losing our hard-earned dollars.
Over the last few years, Canadian Advisors and their clients have been migrating toward alternative investments, seeking better returns than the public markets have provided. And in some cases, things have worked out well. Unfortunately, in many cases, investors have seen their share of Exempt Market investments that have not worked out the way they hoped, or the way their promoters claimed.
When projects fail and clients lose money, they do so for many reasons. Sometimes it may be due to factors beyond anyone’s control, like a sudden and prolonged drop in the value of the project caused by global economic factors.
More often however, it is because the structure of the deal was bad to begin with, or because the management did not have the experience or the strength of character to work through the challenges. Almost anybody can make money in good times, but what you really want are investments that can make their clients’ money even in difficult times.
While it is true that clients could lose all their money with many private equity investments, many of these opportunities also offer above-average return potential to enhance the client’s overall return and diversification – if the right product, coupled with an experienced management team, is behind the investment.
How is the investor supposed to know what to look for in a private equity deal? Many clients rely on their Dealing Representative to pick the investments for them. Others do the research themselves. Ideally, both the Investor and the Dealing Representative are working together to find client-aligned investments where the management team has every incentive to put the clients’ interests ahead of their own, and where the chances of success are maximized and the risks are minimized.
Structure of the Deal and Strength of the Management Team
When evaluating where to invest clients’ hard-earned dollars, remember to ask questions about the deal structure including cash flow options, industry in general, management’s compensation and experience with that industry, liquidity options, exit strategies and other risk mitigation features beyond the systematic risks. Most of this information should be found in the Offering Memorandum, although it may be difficult to discern. Six key questions to ask of any private equity opportunity, especially those based on Real Estate, include:
- Cash Flow Options: Are there options to receive distributions, interest payments or return of capital along the way? Even if clients don’t need the cash flow right now, their risk is mitigated if they are receiving payments on an ongoing basis. If the Issuer is offering cash flow options, you should also ask what is their capacity to make good on these undertakings? Is the project based on a cash flowing asset like a commercial or residential rental property that passes on the rental income to the investor? Has the Issuer set up an interest reserve account that is pre-funded in order to make the interest payments?
- Exit Strategies: How long before investors can expect to get their money back? What if things don’t go as well as anticipated? When market conditions change drastically, it may no longer be viable to complete the project. What is the exit or wrap-up strategy? If the assets have to be sold off before the project is completed, how much of investors’ monies have already been spent on marketing and sales commissions, management fees and other costs? Does the management have the capacity to sustain the project with their own capital during times of uncertainty?
- Management Compensation: How and when is the management compensated for doing their job? Do they get paid up front, along the way, or only when they make a profit for the investors? Are they charging ongoing management fees, acquisition fees or disposition fees and are those fees reasonable? If it’s a land deal, are they putting the land into the project at market value or are they selling the land to the project at an artificially inflated value (sometimes called a lift)? Unfortunately, it is common for some issuers to lift the land 2-6 times leaving the investors waiting years longer for the market to compensate for these lifts (and sometimes it never does).
- Client Alignment: Does management have their own personal cash at risk and at what stage have they invested? What incentive do they have to make the client a profit? Are they sharing the profit of the project with the investors (profit splitting)? Are they required to return a certain profit to the investors before they get compensated (sometimes called a hurdle rate)?
- Management Experience: Does management have experience in taking a project from ‘concept to completion’? Have they successfully exited from projects like this in the past? Who verified that and how? Have they also made money when times are tough and markets are down, or only when times are good and markets are up?
- Liquidity Options: Generally, investments in the Exempt Market are not liquid; however, this is changing with some issuers. Is there any provision for investors to redeem their money early? Where does the cash come from for these early redemptions and what are the penalties to do so?
Which Would You Rather...?
Clients, who invest in public markets through vehicles like Mutual Funds, Segregated Funds or ETFs, typically have no idea who their fund managers are, let alone who runs the companies owned inside their funds. When it comes to private equity investments, it is extremely important to invest with companies that have a strong and experienced management team and a successful track record. It is important to know who is looking after our clients’ money.
As an Exempt Market Dealing Representative let me ask you: Would you rather invest your clients’ funds in a project where the management gets paid no matter how things turn out or where management is not paid until there is a profit? Would you rather invest with a group that’s better at marketing than execution, or with a group that knows how to successfully move their projects from concept to completion?
Every client wants their investments to make money, without the risk of losing their original hard-earned dollars. As an Advisor and Dealing Representative, I like to offer a balanced mixture of insurance-based investments that come with guarantees (through my insurance license), and a portfolio of secured asset-backed private equity investments that offer a mixture of income and growth (through my Exempt Market license). I look for cash flowing investments and profit sharing opportunities with management teams whose interests align with those of the clients.