Understanding Private Placement Investments
Private placements, also called alternative investments, are risky illiquid alternatives to the traditional stock market. Private placements include investments like non-traded REITs, business development companies and other “private equity” funds. Alternative investments are not safer than the stock market and have risks that are unique to the asset class.
Are You An Accredited Investor?
Private placement investments are generally only open to investors that meet the legal criteria for being an “accredited investor” under Security and Exchange Commission (SEC) Regulation D, Rules 506 (b) and (c). In order to be considered accredited, you must meet the following threshold criteria:
- At least one million dollars in assets, not including the value of your primary residence OR
- An annual income of at least $200,000 for a single person or $300,000 for a married couple, with the expectation that this income level will continue for a reasonable period of time.
The SEC has proposed amendments that would broaden the criteria for “accredited investor,” but the above rules remain in effect until new rules are enacted. Unscrupulous issuers of private placement investments may try to convince you that you qualify as an accredited investor even though you don’t meet the above criteria. This is a red flag that the investment may be a scam. Even if your net worth is well above the threshold, it’s important to thoroughly investigate any unregistered private placement investment.
Rule 506(b) vs. Rule 506(c) Offerings
The two main types of private placement offerings are under Rules 506(b) and 506(c) of the SEC Regulation D. Rule 506(b) places no limits on the amount of securities or the number of investors and allows up to thirty five “non-accredited” investors to participate. These “non-accredited” investors must meet the criteria for being highly sophisticated and must receive specific information about the offering that’s required under SEC Regulation D, Rule 502(b). Issuers 506(b) offerings are restricted from general solicitations such as broad advertising via television, print or electronic media, requiring reliance on brokers and informal business relationships to promote the investment. Rule 506(c) does allow general solicitations, but restricts the investments to accredited investors, requiring the issuers to verify the purchasers’ status. 506(b) offerings to “non-accredited” investors are the most likely type of private placement to be extremely risky or even fraudulent.
Why Private Placement Investments Are Risky
Businesses that choose to raise money with private placements offerings usually haven’t been in business very long, have small amounts of revenue or other problems that would scare off investors that read their financial reports. In most cases the claim that filing financial reports with the SEC is costly is just a cover for trying to entice unwary investors into shaky investments, pyramid schemes or scams. The North American Securities Administrators Association (NASAA) has found private placement investments to be the most common target of state security regulation authorities. These are some of the risks to consider before investing in a private placement investment:
- Illiquidity: Most private placement investments are not liquid, meaning that you should expect to hold them for a very long time and if the investment turns sour, you can find it very difficult, or even impossible, to sell.
- Lack of Regulatory Review: The absence of registration with state and federal regulators makes it difficult for these authorities to assess the background of the issuers and the risks associated with these offerings.
- High Risk: Issuers of private placements can promise very high returns without having to back those claims up with evidence.
- The Fine Print: In addition to not filing, private placement issuers are allowed to provide unaudited financial statements under Regulation D. They are required to provide a private placement memorandum (PPM,) but these documents often implement the use of intentionally confusing arcane terms and legalese that can only be understood by an experienced private placement investment attorney.
Investors should always apply additional scrutiny to any business opportunity that sounds too good to be true, especially if it is a private placement investment. That’s why due diligence by an experienced investment attorney must always be applied before putting money into a private placement.
How To Limit Your Risk When Investing In Private Placements
Issuers of private placements will often try to get you to fudge the numbers so that you can qualify as an accredited investor in order to get you to part with your money. If this happens to you, walk away from the deal and immediately notify state and local regulatory authorities. If you’re contacted about an individual selling private placements, be sure to confirm that they are licensed to sell securities and never put down any money until you speak to an investment attorney. Working with an experienced and reputable private placement investment attorney that performs due diligence and carefully scrutinizes every aspect of the deal on your behalf is the best way to limit your risk.