Alternative investments like these can help diversify your portfolio, but while the payoffs can be bigger, the risks are a lot bigger, too.
The wealthy have access to investments unavailable to the rest of us. But at least one type — direct investments — is now within reach.
Direct investments enable investors to take stakes in non-public companies whose shares don’t trade on a stock exchange. A company — say, a brewery or a software developer — will offer qualified or accredited investors the chance to buy an equity stake. The payoff can be bigger, but so are the risks.
Direct investment opportunities for the average investor aren’t common, but they’re growing in popularity. High-net-worth individuals have in recent years begun skewing their investments toward alternative investments, including direct investments, to diversify their holdings from stocks and bonds. That has led to a trickle-down effect to other income classes in the U.S.
Financial advisers are evaluating ways to make direct investments available to a broader set of investors. Some advisers get access for their clients by teaming up with private equity firms that have bought more shares of a company than they need.
It’s possible to make a direct investment for as low as $25,000 if you can qualify. To get in on a deal, a buyer needs to meet certain requirements set by the Securities and Exchange Commission, the main U.S. regulator.
There’s a high bar to accreditation: The SEC’s definition of a qualified investor is someone with a net worth of $5 million or more, excluding the value of a primary residence. Still, it’s possible to become an accredited investor with as little as $1 million in investable net worth. Financial professionals, because they’re deemed sophisticated by the nature of their jobs, can be accredited investors.
Little research available on private companies
Direct investments are risky because private companies aren’t compelled to disclose a breadth of information by the likes of the SEC. In addition, there’s little research on private companies, unlike publicly traded companies that are tracked by analysts at banks and investment firms. Private companies also are illiquid, meaning their private shares don’t trade freely. An investment can take years to pan out.
Someone who invests directly in a private company needs to be prepared to hold on to the stake for five to 10 years, enough for its value to rise sufficiently. That’s a big commitment, considering you won’t have access to that money if you need it for, say, unplanned house repairs or a child’s wedding. So it must be money you can afford to part with.
Private equity firms have the resources to dig into companies’ financials and determine whether a direct investment is a good bet. Individual investors don’t have access to that information, but they may take a leap of faith and follow private equity’s lead.
Huge rewards can come with direct investments
For all the risks, direct investments can offer huge rewards. Amazon and Uber, for example, started off as private companies. And when they went public — by selling shares on a stock exchange — private investors cashed in.
But for every Amazon or Uber, there are many more failures. If you’re going to commit to an investment, whether it’s $25,000 or $1 million, you probably should be putting the same amount into at least another 10 or 15 companies. Diversification is key.
Likewise, diversification is important for a well-balanced investment portfolio. These types of alternative investments should typically not make up more than 10% of an overall portfolio. The rest can be stocks, bonds and real estate.
Statistically, a private company has a greater chance of failure than it does of success. A fintech company may have developed a great payments technology, but it may be put out of business a year later when another company creates a better, less expensive version. No one can predict which company will be the next Amazon.
Fees can be a downside of direct investments
A downside of direct investments is typically high fees. Fee structures are different from traditional investments. There might be an upfront fee of as much as 10%, in addition to annual fees of up to 2%. At the end, there might be a participation fee, or tail fee, on gains that might be as high as 30%. So if you invested $100,000 in a company and you were able to liquidate your investment at $1 million, you could be hit with a 30% fee on that $900,000 gain.
With all the downsides, it makes sense for an individual investor to do a deep dive into a company before committing to a direct investment. But that’s typically not an option. If you’re comfortable following the lead of other investors who may have a good sense of a company’s ultimate worth, a direct investment could be something to consider.