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
"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:
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.
- Is management sufficiently motivated? They should be shareholders in the
company they are managing in order to have a stake in its success or
- 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
- 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.
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:
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.
- Will the products continue to be competitive?
- What is the competition? What are the profit margins? Can they be
- Who buys the products now, and who will in the future?
- How rapidly is the industry changing, and what are the company's
- How does the company make money, or how will it make money after
developing the product further?
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
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,