Jobs Act - Installment #2- What Kind of Alternative Investment Opportunities Are Available to Accredited Investors?
By: Vanessa Schoenthaler and Jonathan Friedland
One in a series of articles explaining why and how Accredited Investors will likely change their investment strategies because of the JOBS Act of 2012
Installment #2- What Kind of Alternative Investment Opportunities Are Available to Accredited Investors? The very point of being an accredited investor is that there is a whole world of alternative investment opportunities available to you that are not available to non-accredited investors. And, if you are an accredited investor, it would be irrational for you to not at least consider including some of those alternative investments in a well-balanced, diversified investment portfolio. However, before you can properly consider where, if at all, alternative investments fit into your portfolio, you must first understand what the world of alternative investments looks like and where to access such opportunities.
Defining Alternative Investment Opportunities There are many different ways of categorizing the alternative investment opportunities available to accredited investors; no one universally accepted approach exists. That said, for our purposes, we group alternative investment opportunities into the following four overarching categories:
Private Equity Strictly speaking, the term “private equity” can apply to any investment into the ownership of a private company. Accordingly, private equity, in its broadest sense, encompasses everything from angel investments to venture capital to leveraged buyouts.
The more common meaning, and the one we subscribe to, is this: private equity refers to an actively managed pooled investment in the equity (or equity-linked securities) of an established private company. In particular, either a in an established private company.
Often, but not always, such investments are “control” investments. A control investment is exactly what it sounds like: one through which an investor gains control of a company, typically by acquiring a majority ownership interest in it (and control of its board of directors).
An established private company is one that has a financial track record (generally, but not always, including positive EBITDA), a quality management team, an addressable market, and strong future growth prospects.
Most private equity investments are conducted by “private equity funds.” A private equity fund is like a mutual fund except that (a) instead of accepting investment funds from just about anyone, PE funds only accept investment funds from accredited investors; and (b) instead of pooling the money from their investors to buy large stakes of publicly traded companies, PE funds invest in (or buy outright) privately held companies. Another common- perhaps universal- practice of PE firms is that they always employ leverage when they make investments. In other words, some significant portion of what a PE funds pays for any given acquisition is paid with money that is borrowed. Indeed, another name for a PE firm is “leveraged buyout’ firm.
Venture Capital Like private equity, the term venture capital also refers to an actively managed pooled investment in the equity or equity-linked securities of a private company. However, unlike private equity, venture capital investments are generally minority investments instart-up or growth companies.
A minority investment is one through which an investor acquires a minority ownership interest in a company. In the context of venture capital, a minority investment generally takes the form of preferred stock with additional control rights and appropriate downside protections.
There is no universally accepted definition of a start-up company. For our purposes, we use the term to mean a company that has passed the concept stage but has a limited operating history. Astart-up company is operational but in the early stages of development; it may have a completed prototype, initiated production, developed customer relationships or even secured initial sales.
Again, there is no universally accepted definition of a growthcompany, however, few use the term to mean a company that has transitioned from the early stages of development to one with more formal organizational and management structures. A growth company has established a proven business model and is on its way to becoming or already is sustainably profitable.
Anatomy of a Private Equity and Venture Capital Fund Private equity and venture capital investments are made through close-ended funds. Close-ended funds, in essence, are professionally managed pools of money that are invested over a finite period of time (in the case of private equity and venture capital funds, typically ten to twelve years, with an option to extend that term for up to three consecutive one-year periods).
In the traditional fund model (the “committed” or “blind pool” model) a management team or “sponsor” will organize a fund and serve as its general partner. The sponsor will then raise binding capital commitments from a group of passive investors (who will make up the fund’s limited partners) in a private placement of the fund’s ownership interests. Typical fund investors might include public and private employee benefit plans, university endowments, insurance companies, banks, sovereign wealth funds, family offices and individual accredited investors.
From an investor’s prospective, a fund’s life cycle can be broken down into three somewhat overlapping periods: the investment period, the holding period, and the divestment period.
During the investment period, once a fund secures capital commitments, it will begin to source and evaluate investment opportunities with the assistance of an investment management firm or investment advisor (who may be an affiliate of the fund’s sponsor). As the fund executes investments, the sponsor calls on investors to contribute capital in accordance with the terms of their binding capital commitments. The investment period typically spans the first three to five years of a funds life.
Following the investment period, and during the holding period, a fund will maintain the investments in its portfolio for a period of five to seven years while they develop and appreciate in value. A fund will also sometimes make “follow-on” investments during the holding period. A follow-on investment is an additional investment into an existing portfolio investment. Lastly, during the divestment period, a fund will liquidate its portfolio of investments and distribute proceeds to its investors.
The traditional model is only one example of how you can structure a private equity or venture capital fund. A variation on the traditional model, one that has recently gained popularity, is the “pledge” or “fund-less sponsor” model.
Structurally a pledge fund can be very similar to the traditional fund model. The key difference, however, is that in the pledge fund model investors’ capital commitments are non-binding. So, after the sponsor identifies an investment opportunity, it must go back to the pledge fund’s investor base and raise capital specifically for that opportunity. Thus, rather than having a readily available pool of investment capital to draw from, as in the case of a traditional fund, a pledge fund sponsor must raise capital on a deal-by-deal basis.
As an aside, it is possible, though rare, for an individual accredited investor to invest directly into a growth stage or established private company, rather than investing through a fund. In such a scenario, what typically happens is that the private company will conduct a private placement of securities (as described below) and the individual investor will participate in the offering alongside other accredited investors (typically institutions, funds or both). Such an investment, where several unrelated investors come together to participate in one transaction, is referred to as a “syndicated investment” or “club deal.”
Where Does Angel Investing Fit In?Angel investing can really be thought of as a subcategory of venture capital investing. Angel investors are individual accredited investors that invest their own funds directly, as opposed to through a venture capital fund, into nascent seed and early start-up stage companies. Oftentimes, angel investors are themselves former successful entrepreneurs and in addition to monetary support they provide nascent companies with both mentoring and networking opportunities.
A seed stage company is one that is just getting off the ground with a concept, product or service; it may not yet be operational and usually only raises small amounts of money (generally between $50,000 and $1 million).
Much of the hoopla you have been reading about regarding equity crowdfunding is about angel and seed opportunities. The JOBS Act of 2012, among other things, permits (a) non-accredited investors to invest in such companies, to a limited extent; and (b) such companies to broadly advertise the opportunity to invest in them. It is these two changes to the securities laws that are the reason why equity crowdfunding is such a hot topic these days.
A Word About Private PlacementsIn addition to angel investments, individual accredited investors also participate directly in all manner of private placements. A private placement is a private sale of securities to an individual or group of accredited investors. Securities sold in a private placement can be in any form, including equity, equity-linked and debt, and can be issued by any type of entity, including funds, private companies and even public companies (usually in private equity-like transactions called PIPEs, an acronym for a private investment in public equity). This is to say, private placements are not reserved solely for use by private equity or venture capital investors. Rather, a private placement is a means through which any entity can raise private capital from a group of investors.
Hedge FundsHedge funds, like venture capital and private equity funds, are actively managed, pooled investment vehicles that invest the funds of several types of investors, including individual accredited investors. Unlike venture capital and private equity funds, hedge funds invest in a range of assets classes, including public and private securities and derivative instruments, with most hedge funds typically focusing on assets that are free from restrictions on transfer and which have fairly liquid trading markets.
Structurally, hedge funds differ from private equity and venture capital funds in a number of important ways. For starters, hedge funds are open-ended funds. Meaning that, subject to any limitations set forth in their organizational documents, hedge funds can accept new investors and redeem the interests of existing investors at any time. What’s more, open-ended funds are not typically subject to a specific term, so once formed a hedge fund exist indefinitely. Another important structural difference is in the way investors contribute funds. A hedge fund investor makes their entire capital contribution when they are admitted to the fund, rather than committing or pledging to contribute capital in the future as in a private equity or venture capital fund.
Hard AssetsIn addition to private equity funds, there are a number of private equity-styled investment vehicles that pool and invest the funds of several types of investors, including individual accredited investors, into alternative assets. Examples include fine art funds (e.g., The Fine Art Fund Group), rare coin funds (e.g., CAMI’s coin funds), wine funds (e.g., The Wine Trust fund), commodity pool funds and non-traded real-estate investment trusts.
NEXT INSTALLMENT: The JOBS Act in a Bit More Detail
About the Authors:
Friedland is founder and chairman, and Schoenthaler is general counsel, of DailyDAC, LLC, which owns and operates AIMkts. Friedland practices corporate law in Chicago at the Levenfeld Pearlstein law firm; Schoenthaler maintains a private practice in New York City, where she focuses on securities law.
This article is copyright©2013 by DailyDAC, LLC.