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Tuesday August 03 2021
Private-to-Public Investing
  Articles by Dion Friedland
  Protection Against An Aging Bull
  Reducing Market Risk with Merger Arbitrage
  Interview with Dion Friedland
  Taking the Mystery Out of Hedge Funds
  About Special Situations Fixed Income
  The Kingdom of Hedge Funds
  Distressed Securities Investing
  The Case for Convertibles
  Private-to-Public Investing
  Global Macro Investing
  Market Neutral Long/Short Equity Trading

by Dion Friedland, Chairman, Magnum Funds

A general rule in investing is that the earlier in the life of a company you invest, the greater the potential reward. Venture capitalists investing in embryonic companies receive far more equity for the cost than those who invest later on at the initial public offering stage (IPO). In return for this premium, however, venture capitalists incur far more risk, too, as it is difficult for them to exit their investments until these private companies are either purchased or taken public.

One strategy for achieving private-stage, if not venture capital-style, premiums without the associated degree of risk is to invest in late-stage private offerings. In this stage, companies are more established than during the seed-, start-up-capital stage, and therefore present less of a risk. And their valuations, while they are still private, tend to be far lower than during the IPO and thereafter, bringing opportunities for high return. There is still the risk of owning non-tradable, illiquid shares that are difficult to value until a company goes public or is sold. But the investor who buys with the appropriate due diligence and diversifies the portfolio to increase the chance of "home runs" and buffer against losing investments has the opportunity for large returns.

Private offerings are limited to investors "in the know"

Private offerings are sales of securities issued by companies that don't wish to go through the cost and delay of issuing securities on public markets. As a tradeoff, the securities are subject to restrictions as to how many, and what types of, investors can buy them. In the U.S., private companies (as well as publicly held companies) that sell $1 million to $5 million in securities within a 12-month period are exempt from SEC regulations if the sales are made only to "accredited investors" and no more than 35 such investors are involved. Accredited investors include institutional investors, company insiders, and wealthy investors (with more than $200,000 individual annual income or, individually or jointly with their spouse, with a net worth of over $1 million). Such investors are considered better able to incur - and understand -- the risks associated with private placements than the general investor.

In this $1 million-$5 million range as well as in still larger private offerings in the U.S., the offering cannot be advertised except through a private offering memorandum that fully describes the company and the risks associated with investing in it. Thus, the investor must not only be sophisticated in terms of wealth and the ability to incur risk, he or she must also be well enough connected in the investment world to learn about such investment opportunities - and learn about them soon enough to get in as one of the accredited 35 investors. Not surprisingly, investors best positioned to capitalize on private-to-public investments tend to have relationships with large investment houses that underwrite offerings.

An investment by way of a private security in a company can take many forms, but the primary vehicles are straight common stock and convertible preferred stock. Convertible preferred stock functions initially like a bond, paying interest, until the holder chooses to convert it to equity at a predetermined price. A slightly safer investment than common stock, convertible preferreds are paid back to the investor before common stock in the event the company goes bankrupt. Less common are private bonds, which can be secured debt (the least amount of interest), subordinated debt (higher interest, plus warrants, but less guarantee in case of default), mezzanine debt (short-term, high-interest-paying bonds, even lower on the bankruptcy claim totem pole), and bridge notes (very short-term, 3-6 month bonds).

"Active" investor role can protect the investment

As investors incur more risk in private versus public offerings, they can sometimes negotiate with the issuing company to gain more attractive redemption rates, coupons, and accumulated interest, among other terms of the securities. Further, to ensure an orderly growth in the business and a profitable exit, investors can negotiate measures to give them a greater voice in how the company is operated. Among these measures are "super voting rights," whereby their shares hold more voting weight than typical shares; negative covenants, in which shareholders are granted certain additional rights if the company fails to meet certain goals and hurdles; and board seats.

"The days of the silent investor are over," says Lorne Caplan, manager of the Trenton Small Cap Fund, which invests in private placements. "Often, the product or technology is viable, but the company lacks the right people to turn this into sales. Witness the more than 1,300 public biotech companies, only a handful of which are turning a profit from approved products. As an investor, you try to gain a voice to ensure that the product or technology is backed up by quality management."

Ronald Koenig, chairman of International Capital Growth, Ltd., an investment bank that specializes in late-stage, private-equity investments, agrees. "Investment success, particularly in the private placement arena, comes down to the fund manager's ability to bet on the right people to run the company. There is absolutely no substitute for top managerial talent. I would implore prospective private placement investors to seek out those hard-to-find fund managers who, along with other obvious talents, are successful `people pickers.'"

With management the number one variable that can make or break an investment, company managers are the prime focus of due diligence efforts. Well before committing to a private investment, any investor should examine the following questions:

  • Is management sufficiently motivated? They should be shareholders in the company they are managing in order to have a stake in its success or failure.
  • Are they team players? Some senior managers tend to be solitary napoleons, but the best are those who can delegate. Ask yourself if they can nurture and build a team of managers and staff that share in their vision and strategy.
  • Are they willing to recognize their weaknesses and accept "active" financial partners? Management needs to be willing to accept your support and guidance in areas where your expertise may be greater than theirs, such as in relationship building (i.e., joint ventures or strategic partnering), accounting and law firm assistance, and business plan development. If, for example, revenues and earnings are not rolling in quickly enough, the financial partner may wish to assist in revising the direction of the company, and management should be receptive.

Once management passes the initial test of character, background and commitment, the investor should then take a hard look at the business and the technology. This involves, first and foremost, knowing the industry or region. The most successful private-to-public investors stick to their areas of expertise. Caplan's fund, for example, targets the technology, biotechnology, and health sectors. Another fund that has successfully invested in private placements, the South Africa Omni Fund, capitalizes on its expertise in the South African region. (Both funds also benefit from their association with established underwriting firms.) If you do not have the depth of knowledge in a specific industry but nonetheless feel you should pursue the investment, get professional assistance through your personal contacts.

No substitute for basic fundamental analysis

Once you have established a comfort level with the industry, basic fundamental analysis should be followed. This sounds obvious, but many people chase the rainbow of promising new industries and technologies without studying the fundamentals. Witness the venture funds and other private sources of capital that threw wild amounts of money at environmental companies in the 1980s merely on the news that the U.S. Environmental Protection Agency, with its "Superfund," was ready to spend lavishly. While some environmental companies received government contracts, the overall returns were dismal, and most funds that invested in the environmental sector while being completely "green" to its fundamentals have since left it.

Assessing competition is a key part of fundamental analysis, and this involves competition at various levels of the business: sales, replacement management (the possibility of losing and replacing your valuable senior management asset), merchandising and marketing, R&D, controls and information technology, and the product or service and its proprietary nature. There is no substitute for calling clients, competitors, agents, distributors, brokers, and others familiar with the company's products or services to get biased but easily condensed views of the company. Among the questions to examine:

  • Will the products continue to be competitive?
  • What is the competition? What are the profit margins? Can they be improved?
  • Who buys the products now, and who will in the future?
  • How rapidly is the industry changing, and what are the company's competitive advantages?
  • How does the company make money, or how will it make money after developing the product further?

When querying outside companies, however, always remember to put the information in the context of who you are talking to. For example, once when questioning suppliers of a consumer product company in which he wanted to invest, Caplan received answers that encouraged investment only to learn later that these suppliers wanted an infusion of capital into the company so they could get paid.

The next step is pouring over the financials and conducting an in-depth, line-by-line analysis of the income and balance sheets. Pay close attention to the notes to the company's financial statement and be sure that management's rewards are tied to performance over a two-year transition period in order to mitigate any hidden surprises. If the investment is a buyout, appropriate discounts should be given to any contingent liability, heavy goodwill asset, or other intangible effects. Who are the accountants? Are the financials audited? If not, what are the reporting and controls like?

A case in point

The fruits of due diligence and active investing are witnessed in a recent investment Caplan and his fund made in Advanced Plant Pharmaceuticals Inc. (APPI), a processor of extracts and whole plants. From the start management was dedicated to reinvesting cash flow into expanded capacity, quality control and additional staff in their labs. At the same time, management recognized they had improvements to make in the sales department and in their products, some of which were too trendy. Financials were audited and there were no inter-company transfers or financial shenanigans. Management, furthermore, was tied into the shares of the company.

Caplan's knowledge of the industry enabled him to assess who the competition was and how APPI stood up, and, satisfied with the products, technology, manufacturing facility, quality orientation, and client list, he invested in a private placement in straight common equity. APPI was valued on a cash-in basis (whereby investors receive a proportionate share of the total cash investment in the company) with a bonus share return to current shareholders if management came within 20 percent of performance projections. Investors had a board seat so that they could be informed daily, if need be, and there were several negative covenants to ensure proper compliance with a shareholders' agreement that required reporting on all large expenditures. APPI, which was a non-reporting electronic bulletin board company at the time, has since been listed on the Nasdaq exchange, and its stock has risen from $1 to $5 in the space of a year.

For every APPI, Caplan estimates there are at least five failed investments. Due diligence and active investing can't always uncover deceit, anticipate bad luck, or simply guarantee that growth will be sustained enough to prompt a buyout or successful public offering. That's why he advises diversification. One winner out of six can be enough to provide a healthy portfolio return, as "winning" can mean a public value at many times its private cost. And with the number of private placements on the rise -- according to Securities Data Company, 1997 saw a record volume of $353.5 billion of private placements issued globally, up nearly 75 percent from 1996's then record volume of $203.4 billion - fund managers now have a growing range of opportunities for building diverse portfolios of promising, late-stage, private-equity investments.

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