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Installment 4: Alternative Assets and the “Average” Accredited Investor

Overview of the Alternative Assets Landscape

[Editor’s Note:  This is the fourth installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. Read Installments #1, #2 and #3.]

Subsequent installments in the series will dive into specific subcategories within the “alternative asset” asset classes. Think of those installments as the trees. This installment looks at the forest.

There are many different ways of categorizing the alternative assets; no universally accepted approach exists. In this series, we group them into the following four, overarching categories:

  • venture capital;
  • private equity;
  • hedge funds; and
  • tangible (aka “hard”) assets

[Editor’s Note: For more information, please see our webinar Options for the Accredited Investor.]

Categories of alternative assets

Venture Capital

There is no universally-accepted definition of “venture capital” but we agree with the U.S. Small Business Administration, which defines it as:

[A] type of equity financing that addresses the funding needs of entrepreneurial companies that for reasons of size, assets, and stage of development cannot seek capital from more traditional sources, such as public markets and banks. Venture capital investments are generally made as cash in exchange for shares and an active role in the invested company.

Most authorities distinguish between angel investing and venture capital investing. We agree that there is a distinction, but the line separating them is not stark.

This series addresses angel investing and venture capital investing in tandem, briefly in installment 5 and then more thoroughly in Installment 6, which is titled “Venture Capital.” While we recognize the distinction (which we elaborate on below, in the section titled “Investment Stages”) we consider angel investing to be a subcategory of venture capital.

[Editor’s Note: For more on venture capital, please see A Brief History of Venture Capital.]

Private Equity

The term “private equity,” in its broadest sense, could encompass everything from angel investments to venture capital to leveraged buyouts. More common definitions, however, distinguish between venture capital and private equity. The Business Dictionary defines private equity to mean:

Money invested in firms which have not ‘gone public’ and therefore are not listed on any stock exchange. Private equity is highly illiquid because sellers of private stocks (called private securities) must first locate willing buyers. Investors in private equity are generally compensated when: (1) the firm goes public, (2) it is sold or merges with another firm, or (3) it is recapitalized.

An individual investor can make a private equity investment along the lines described above and, technically, that investment would meet the definition. However, most private equity investments have historically been made by private equity funds and when the financial literature refers to private equity, it usually means private equity investments conducted by private equity funds.

We define a “private equity fund,” in turn, as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund, or venture capital fund and which does not provide investors with redemption rights in the ordinary course. This last point is very important and is characteristic of many alternative assets: most are not liquid; you cannot simply go online or call your investment advisor and sell your investment immediately.

Hedge Funds

Hedge 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, strictly speaking, open-ended funds. Meaning that, subject to limitations set forth in their organizational documents (and there are always limitations), 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 exists indefinitely.

Another important structural difference is in the way investors contribute funds. A hedge fund investor makes her entire capital contribution when she is admitted to the fund, rather than committing or pledging to contribute capital in the future, when a “capital call” is made, as with a private equity or venture capital fund.

Tangible Assets

We mentioned examples of “hard” (aka “tangible”) assets in installment 1: art and antiques, precious metals, fine wines, rare stamps and physical coins, and sports cards and other collectibles. Other examples include: apple orchards, banana farms, comic books, date farms, emus, and probably 10,000 other things.

[Editor’s Note: For more information on tangible assets, please see Introduction to Investing in Tangible Assets.]

But wait, you don’t have to be an accredited investor to buy any of these things. So why are we mentioning them in a series intended for accredited investors?

Well, while you do not need to be an accredited investor to invest in “hard” alternative assets directly, you do need to be an accredited investor to invest in a private equity fund or hedge fund that invests in “hard” alternative assets. And, for all the reasons discussed in installment 3, you will undoubtedly become aware of opportunities to invest in such funds.

Investment stages

Having sketched out the major categories of alternative assets in the prior section, we want to dive in slightly deeper with respect to the inter-relationship between two of them, venture capital and private equity, and discuss how they relate to investments in the stock market.

Rob Slee, in his book Private Capital Markets (Wiley, 2011), recognizes five stages of company growth, from an investment perspective: (1) seed, (2) startup, (3) early, (4) expansion, and (5) later or mature.

The following table provides a brief overview of each stage:

Stage Progress Likely Investors
Seed stage Concept or product development Personal savings, family, friends
Startup stage Operational but still developing product or service; no revenue; less than 18 months Personal, family, friends, crowdfunding; small angels
Early stage Product or service in testing/pilot production; maybe revenue; less than 3 years Angels, VCs, equity crowdfunding
Expansion stage Significant revenue growth, maybe profit; more than 3 years VCs and VC funds
Later or mature stage Positive cash flow, profit; typically more than 10 years PE groups and funds, family offices

 

A publication by investment banking firm Madison Park Group, does an excellent job of summarizing the various investment stages:

  • Start-up stage. Newly formed companies without significant operating histories are considered to be in the start-up stage. Most entrepreneurs fund this stage of a company’s development with their own funds as well as investments from angel investors. Angels are often- but not always- friends or family members who personally invest in a company. Any accredited investor can be an angel. Angels are the most common source of first round funding for technology businesses and angel rounds usually less that $1 million. They often will back companies that are at the concept stage and have a limited track record with respect to customers and revenue. These investors tend to invest only in local companies or for people that they already know personally. For more information on angel investing, see Section 6.2.
  • Seed and early stage funds. Seed or early stage rounds often involve investments of less than $5 million for companies that have promising concepts validated by key customers but have not yet achieved cash flow break-even. Organized groups of angel investors as well as early stage venture capital funds usually provide these types of investments. Typically, seed and early venture capital funds will not invest in companies outside their geographic area (usually 100-150 miles from the VC’s office) as they often actively work with management on a variety of operational issues.
  • Growth stage funds focus on companies that have a proven business model and either are already profitable or offer a clear path to sustainable profitability. These investments tend to be in the $5-20 million range and are intended to help the company increase its market penetration significantly. The pool of potential venture capital investors is very robust for growth stage investments, with firms across the United States willing to participate in investment rounds at this stage.
  • Late stage funds Late stage venture capital investments tend to be for relatively mature, profitable companies seeking to raise $10+ million for significant strategic initiatives (i.e. investment in sales & marketing, expansion overseas, major infrastructure build-outs, strategic acquisitions, etc.) that will create major advantages over their competition. These opportunities are usually funded by syndicates of well-established venture capital firms who manage large funds.
  • Buyouts and recapitalizations. Buyouts and recapitalizations are becoming more prevalent for mature technology companies that are stable and profitable. In these transactions, existing shareholders sell some or all of their shares to a venture capital firm in return for cash. These venture capital firms may also provide additional capital to fuel growth in conjunction with an exit for some or all of the company’s existing shareholders.

Take a moment to tie these five stages to the differences between venture capital (“VC”) and private equity (“PE”). The critical point for you to understand is this: today’s VC investment is tomorrow’s PE investment.

We mentioned earlier that some authorities view angel investing differently than VC investing. And, as the chart above suggests, we do too.

In a nutshell, and as the chart also suggests, the newest start-ups have tended to be self-funded and/or are funded by investments by “friends and family.” As a start-up progresses and gets closer and closer to becoming profitable, it can look to different types investors; younger start-ups have tended to look for money from angel investors whereas VC funds tend to invest in slightly more proven start-ups. But the line of demarcation, which was never that bright, is getting duller all the time and will soon become downright hard to see because of the changes the JOBS Act has brought (See installment 3).

If you are interested in investing some money in “start-ups,” there are a number of ways you can do that:

  • You can invest directly in one or more start-ups, as a stand-alone angel;
  • You can join an “angel group”;
  • You can invest through an AI-only crowdfunding site;
  • You can invest through a crowdfunding platform; or
  • You can invest through a VC fund.

You should also understand that “crowdfunding” sites and platforms are also a way to invest in PE. More on this in installment 5.

Private Placements

Recall our discussion in Section 4.1 about how one can invest in various tangible assets through a fund? Well, before you can do that, unless the offering is a registered offering with the Securities and Exchange Commission, the fund (that is, the “issuer”) will typically provide you with a “private placement memorandum” or “PPM” or with other disclosure materials designed to alert you to the risks of investing in their fund. This is because your investment constitutes a purchase of a “security” (see Section 3.1).

The same is true of any other security. If you invest directly in a start-up (or any company, for that matter) other than by doing so on a public exchange (i.e. the NYSE, NASDAQ, etc.) then you are most likely buying a security and doing so through a private placement.

And, if you are investing through a fund that, in turn, invests in one or more companies (or assets of any kind) then- unless you are investing in the fund by purchasing its securities on a publicly traded exchange then the issuer of that security (that is, the fund) is selling to you in a private placement.

In either case, you should be given a PPM. If the issuer doesn’t do this, then something may be very wrong and you should consider very carefully whether this is the investment for you.

Alternative Mutual Funds

The terms “alternative mutual fund” and “liquid alternative” refer to a publicly offered, SEC-registered fund that uses investment strategies that differ from the buy-and-hold strategy typical in the mutual fund industry. One does not need to be an accredited investor to invest in one. The past few years have seen a proliferation of them.

There are a number of factors to consider before investing in any alternative asset (and for that matter, like any potential investment). These include understanding the strategy of the fund, the track record of the manager, and how the investment fits into your overall investment portfolio.

An alt mutual fund is not a hedge fund.  Like any mutual fund, alt mutual funds are regulated under the Investment Company Act of 1940.  Hedge funds are not. This limits what an alt mutual fund can do. Among other things, an alt mutual fund is subject to:

  • limits on illiquid investments;
  • limits on leveraging;
  • diversification requirements;
  • daily pricing; and
  • daily redeemability of fund shares.

One final note: if you decide to look into alt mutual funds, you will see that there are two major types of managers: (a) managers of traditional hedge funds that have decided to move into the mutual fund space; and (b) managers of traditional mutual funds that have decided to move into using hedge fund-like strategies. Click here for an interesting discussion of this subject by Barron’s writer Beverly Goodman.

Who are ‘We’?

You will notice that throughout this series, I use the term “we.” This is done to acknowledge the great editorial assistance of the Financial Poise Editorial Team. This series is based on my book The Investor’s Guide to Alternative Assets: The JOBS Act, “Accredited” Investing, and You.

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About Jonathan Friedland

Jonathan Friedland views his role as a business lawyer simply: to help clients make money at every opportunity and to protect their interests at every turn. His national practice emphasizes corporate structuring, corporate governance, counseling on day-to-day business affairs, M&A, and corporate restructuring. Most of his clients are privately owned businesses and their owners, particularly…

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