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Are Private Placements Liquid?

Are Private Placements Liquid?

Typically No. Private Placements are not liquid. Some investors find wealth enhancement from equity private placement issuances where liquid assets are provided to slack-poor companies. This result runs counter to the expected Jensen’s (1986) excess free-cash-flow problem, where the predominant findings of numerous studies include negative wealth effects from externally financed liquidity enhancements. We also find greater announcement-period returns for smaller firms and firms with better recent performance. Investors appear to view either of these factors, together with the private investor’s willingness to provide additional liquidity, as an asymmetric information release on the firm’s viability and likelihood of improved performance.

Privately placed securities are those that are sold directly to institutional investors instead of being offered for sale to the general public. Privately placed securities are usually bond issues, including corporate bonds; they also include other debt instruments as well as equity securities. Privately placed securities are issued primarily by smaller companies, although even Fortune 500 companies occasionally make use of the private placement market. The major purchasers of privately placed securities are life insurance companies, with other institutional investors such as mutual funds, pension funds, banks, savings and loan associations, and limited partnerships also participating in buying private placements. Certain securities offerings, including privately placed securities, are exempt from the registration requirements of the Securities and Exchange Commission (SEC). These include securities that are purchased for investment rather than for distribution. Exempt securities must be offered through direct communication with the purchaser without general advertising.

Such investors are assumed to have access to significant financial information concerning the issuer and the issue and thus do not require the guarantee of full disclosure afforded by SEC registration. Accordingly, exemption from SEC registration applies to the sale of securities involving a limited number of financially sophisticated purchasers. While companies may not need to register their private placements with the SEC, they must comply with the SEC’s Regulation D, which governs the private placement of securities. Instead of registering a prospectus with the SEC, companies prepare a private placement memorandum (PPM) for prospective investors. The PPM typically includes a description of the business, with a scenario covering anticipated business conditions and financial projections.

Privately placed securities are generally considered less liquid than comparable public issues. That is, it is easier for a purchaser to resell publicly issued securities than privately placed securities. This is due to the conditions under which private placements are issued as well as the restrictions that exist on resale. As a result of this liquidity risk, privately placed securities generally pay higher rates of interest than comparable public issues.

In 1990 bonds represented 87 percent of all privately placed securities, with equity securities accounting for the remaining 13 percent. Approximately $87 billion of privately placed bonds were issued in 1990, representing 29 percent of the $299 billion of new bonds issued in the United States that year. The $87 billion in privately placed bonds represented a decline from the high of $128 billion issued in 1988. One factor accounting for the decline was the desire of life insurance companies, the primary purchaser of private placements, to find more liquid investments to better cope with changing financial conditions. Private placements proved to be very popular in the 1990s, as low yields in the public market sent investors to private placements. According to Securities Data Co., the market volume of private placements rose to $201 billion in 1996, a 50 percent increase over 1995. During 1995 44 percent of all private placements were led by investment banks, with commercial banks leading in 33 percent of the transactions. Private placement offers several advantages to both borrowers (issuers) and lenders (purchasers). Since private placement is based on direct negotiations, it is possible to tailor the loan terms to fit the needs of both parties. Direct negotiation also makes it easier to structure complex offerings that would not be easily understood by the public.

For lesser-known firms and smaller companies, private placements may represent their only source of long-term capital. For larger firms, private placements offer less expensive borrowing than with registered public offerings. Private placement also provides the issuer with some confidentiality regarding its financial records. In the case of public offerings and SEC registration, sensitive financial data must be disclosed. Restrictive covenants are commonly used in private placements to protect the lender and ensure that the borrower conducts its business in a manner that will protect the value of the privately placed securities. While covenants are also written into loan agreements affecting public issues, they are generally more detailed in private placements. Among the areas covered by covenants are provisions for collateral to the security, delivery of financial data to the lender, and restrictions regarding the amount of additional long-term debt the borrower may take on. In addition the loan agreement may contain provisions limiting the issuer’s ability to call in the security during times of falling interest rates and other restrictions designed to protect the purchaser’s investment. Debt issued via a private placement does not require a public credit rating. However, the National Association of Insurance Commissioners (NAIC) assigns a private credit designation, if the private placement instrument is held by an insurance company. As of 2015, 93.4% of the private placement securities held by insurers were investment grade (i.e. NAIC rating 1 or 2).
Due to the scarcity of publicly disseminated information, private placement issuances are generally less liquid than exchange traded instruments. This lack of liquidity might be reflected in the higher yields that sometimes investors ask to buy the security. Since private placement debt is information-intensive, typical investors in the private placement space are insurance companies and pension funds that can provide long-term financing that might be unavailable or too expensive via public sale or from traditional lenders like banks. On the other hand, typical issuers are mid-sized companies that do not have a public credit rating or that do not need to raise funds frequently or in sizable quantity.

Advantages to Borrowers

One of the main advantages for borrowers is that these securities offer the long-term lending of corporate bonds with the confidentiality of a bank loan. Notably, private placements are characterized by a limited disclosure of financial information and an ongoing relationship with the lender, but at the same time they have an average maturity between 7-12 years. Companies that decide to take the private placement route also enjoy lower costs due to the absence of expenses, such as the registration with the SEC and the need to obtain a credit rating. Furthermore, the lack of regulatory constraints allows borrowers to finance themselves in a shorter time frame. Typical investors in this asset type (insurance companies and pension funds) usually follow a “hands-off” approach and do not interfere in the decision making of the company.

Advantages to Investors

Frequently, these debt securities include covenant protections that are more stringent than those found in the public issuances. These securities are also often secured by predetermined collateral. These features coupled with investors’ sophistication have resulted in historically lower default rates and higher recovery rates for this asset class compared to publicly traded bonds.

The valuation of private placement debt securities presents many challenges. Probably the most prominent one is how to model an appropriate credit curve for the security. CDS spreads are not always available for entities that issue this type of debt, as issuers that are active in this asset class do not tap investors on the public side. Even when CDS spreads are available, we implement several adjustments to account for the bespoke nature of the issuance. While covenants and contractual protections help in managing the deterioration in credit quality and enhance the credit protection for the investor, they also increase the complexity of the valuation of the instrument. Among others, embedded options (issuer’s call, investor’s put), the compensation to be paid to the investor in case the bonds are prepaid (e.g., make-whole provisions), credit ratings and change in control clauses. Some of these features require interest rate modeling apart from credit risk modeling. In some cases, the securities might be part of a more complex repack structure, where there is a precise match between the cash flows paid by the underlying assets and the notes. These repack notes might also involve dual currency features where the coupons are paid in the investor’s domestic currency and the principal is paid in the issuer’s domestic currency. Finally, to determine an appropriate liquidity discount for the security (or the portfolio in aggregate), we constantly monitor if there is a statistically significant premium between public and private issuances. If a statistically significant premium is found, we then apply it idiosyncratically to the security or globally to the portfolio, depending on the type of statistical relationship discovered.

A private placement is a sale of a company’s securities to a limited number of qualified investors. They are not offered to the general public and are exempt from the registration requirements of the Securities and Exchange Commission (SEC). Securities sold can take different forms, but they are usually either equity or debt. There’s been a tricky new development. Under new Rule 506(c) of Regulation D, a private placement could actually be generally solicited and advertised while still being considered a private placement. The securities, however, may only be purchased by investors who have been verified as accredited investors.

Risks of Private Placement Investment

These types of investments always carry a high risk. The reasons for this are varied. Companies looking for private placement investment are usually less established. Private placement securities are also less liquid and may be subject to holding requirements. Investing in private placements requires a high tolerance to risk, as well as low concerns over liquidity, and a willingness to take on long-term commitments. Investors should also be prepared for the worse case, although not uncommon, scenario, which is that they lose their entire investment.

• Do your homework – find out as much as you can about the company and the industry within which it operates.
• Understand the exit strategy – be prepared to have your capital tied up for a long time, but ask yourself how and when you will liquidate your securities.
• Talk to your advisor – find out the risk factors, and ask how well this investment dovetails with others in your portfolio.
• A well-known method for companies to raise capital is an Initial Public Offering (IPO), in which the company sells its stock publicly for the first time. As opposed to IPOs, many business entities use “Private Placements” as an alternative route to raise capital. (The term Private Placement is a catch-all term, that can also refer to Private Equity, Illiquid Alternative Investments, Direct Placements, Limited Partnerships, non-traded REITs, and a variety of other terms.) While many of these entities seek funding primarily from commercial/institutional investors, the Private Placements that seek capital from individual investors are often concentrated in the oil and gas, real estate, and equipment-leasing industries.
• It’s important for investors to understand that Private Placements differ from IPOs in significant ways, from how they are regulated by the Securities and Exchange Commission (SEC), to the amount of information that must be disclosed to investors. If you believe you were sold an unsuitable Private Placement investment, or that you may even be the victim of fraud in connection to your purchase of a Private Placement, you should speak to an experienced FINRA arbitration lawyer about filing a claim for compensation. Read on to learn more about risky Private Placement investments, how FINRA is related – and how investors can get help.

How Do Private Placements Work?

In the financial industry, the term “securities” refers to assets like equity (such as stocks), debt (such as bonds), and derivatives (such as options). Under most circumstances, securities must be registered with the SEC, whose job is to protect investors’ rights while keeping the marketplace fair and transparent. One of these exceptions pertains to Private Placements. Under an SEC rule known as “Regulation D,” or simply “Reg D,” businesses may lawfully sell unregistered securities, provided such businesses do not exceed federal limits capping the number of investors to whom the securities may be sold. These limited number of investors must also generally be higher net worth and/or more experienced in investing than the general public. In other words, Reg D makes it legal to sell unregistered securities to small pools of select investors. This system can pose serious financial pitfalls to individual investors who are not extremely sophisticated. Unfortunately, some investors are unaware of this fact until it is already too late – in large part due to the threadbare regulations that control Private Placements.

Risks of Private Placements

All investments carry some degree of financial risk. However, for many investors the risks may not be worth the potential rewards when it comes to Private Placements.

High Upfront Sales Commissions and Fees

Many Private Placements contain eye-popping upfront fees. Often, the investor must pay a sales commission to a broker, generally ranging from 5% to 10%. In addition, the investor usually pays an upfront fee to the company (or its affiliates) sponsoring the Private Placement, which may total another 3.5% to 10% (or even higher). These fees vary wildly and can be difficult to determine when reading the “offering plan” or “memorandum” that describes the investment. What many investors discover after purchasing a Private Placement is that a $100,000 investment has been reduced to an $80,000 (or smaller) stake in the company, after all of the upfront fees and commissions have been added up.

Unaudited and Self-Reported Numbers

To decide whether to buy a Private Placement, an investor is supposed to receive an offering plan or memorandum detailing the investment. This document usually includes impressive forecasts of how the investment is expected to perform, and numbers detailing how well similar investments/funds have performed in the past. However, these figures may not be wholly accurate. Because these documents are not subject to careful regulation, the company sponsoring the investment is free to publish self-reported figures. While (hopefully) not fraudulent, these numbers may be massaged or used in a selective manner to paint a rosier picture than is justified. Further, they are often not audited or verified by a neutral party. So, these self-reported numbers are akin to those a friend gives while bragging about his or her income. They may be based in truth but skewed to an overly optimistic outlook.

Questionable and Secret Due Diligence Reports

The broker who sells a Private Placement is required to conduct due diligence and have an informed basis for recommending the investment as suitable and appropriate for the investor. This places a legal obligation on the broker to research the Private Placement, understand the risks involved with the investment, and to be familiar with the investor’s financial profile. However, instead of conducting a careful, independent investigation into a Private Placement, many brokers simply rely on a “due diligence report” generated by a third party. Unfortunately, these reports are often paid for by the same company that sponsors the Private Placement – creating a conflict of interest.

Distribution Payments: Return Of Capital Or Return On Capital?

A common issue with Private Placements is the confusion over how investors recover their money. Generally, investors receive a distribution check from the Private Placement, either monthly or quarterly.
Overconcentration: how much money should be placed in Private Placements?
If an investor is willing to purchase a Private Placement, how much is a prudent investment? There is no strict rule of thumb, but many states have their own rules or guidelines. Some states essentially advise that their residents should not invest in Private Placements. Other states recommend (or require) that their residents should not invest more than 10% of their net worth in Private Placements. In our firm’s view, investing more than 10% of your liquid net worth is a recipe for trouble. Despite these dangers, some brokers routinely sell Private Placements to individual investors in amounts that far exceed the 10% net worth ratio. These aggressive sales may be due to the high sales commissions, or perhaps reflect the brokers’ own fundamental misunderstanding of these risky investments.

Should elderly investors purchase Private Placements?

A younger investor, with financial sophistication and a high net worth, may legitimately decide that investing up to 10% of his or her liquid net worth in a Private Placement is worth the risk. However, these investments almost never make sense for an elderly investor. Why? In addition to their extraordinary risks, Private Placements usually pay out slowly, over a period of 7 years or more. And if an investor cannot wait to see if they make a profit over those years, selling a Private Placement can be difficult or impossible. Some Private Placements flat out forbid the investor from selling. Other Private Placements will repurchase the investor’s share, but often only under very limited circumstances and at a deep discount. Even if there are no restrictions on a sale, there is generally little or no secondary market for Private Placements.

Private Placement Lawyer

When you need legal help with a private placement offering or a Reg D, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.

Michael R. Anderson, JD

Ascent Law LLC
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506

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