Earlier this month, we launched a blog series on private placements, looking at Regulation D itself in Part 1, and distribution waterfalls in Part 2. Let’s continue our discussion of private placements by approaching them from a reference point most of our clients are familiar with, and compare private direct participation programs to their public, non-traded cousins.
The three most commonly identified differences between public and private DDPs are:
- Transparency—greater transparency for public programs because of regular SEC filing requirements, and lack of such reporting for private programs
- Liquidity—typically less liquidity for private placements, even though non-traded program shares aren’t even listed
- Governance—typically greater opportunity for investor participation in company governance in public programs than private
Of course, transparency, liquidity, and investor rights should be three of the most important considerations in making investment recommendations to investors. Much has been written about these. However, there are differences between private and public programs in other deal aspects that broker dealers and registered investment advisors need to understand. Here, we’ll consider regulatory restrictions (or the lack thereof) with respect to leverage limitations, valuations requirements, and investor limits.
Do private programs have leverage limits?
One significant difference between private programs and public, non-traded programs is that public programs often have leverage limits imposed by various securities regulations. For example, the Investment Company Act of 1940 restricts leverage for ’40 Act closed-end funds to no more than 33% of gross assets for debt leverage or 50% for preferred equity. Additionally, business development companies, BDCs, which are also regulated by the Investment Company Act of 1940, cannot exceed a debt-to-equity ratio of more than 1:1.
However, there are no regulatory restrictions on leverage for private investment programs. Therefore, because leverage can amplify risk, it is particularly important to review governance documents to determine whether the program has self-imposed limits on leverage used in acquisitions or the portfolio at large. Further, one must ascertain whether the company can exceed those limits under any circumstances.
Are private investment programs required to obtain annual valuations?
Another major difference between private and public programs is the lack of valuation requirements for private programs. For example, private programs do not have to aid broker dealers in compliance with FINRA rules articulated under Regulatory Notice 15-02, which addresses the valuation of public direct participation programs and non-traded REITs. This means that private programs do not need to engage any third party valuation expert, nor are they required to value each asset at least annually. And, most private programs that FactRight has reviewed have no self-imposed requirement for providing an estimated per share valuation and do not engage an independent firm to assist in determining asset or share valuations. Because of this, management of private programs often have significantly more leeway in determining the value of the company’s assets or the value of investors’ interests, relative to public programs. Further, this also often means that a private program does not amend the offering price of their shares over the course of an offering, which presents a risk that earlier or later investors may be diluted, depending on the actual performance of the company and changes in the value of its assets.
Can private programs raise capital from an unlimited number of investors?
Did you know that investment programs with more than $10 million in total assets that wish to remain exempt under Reg D are limited to 2,000 investors? If a private investment program exceeds these thresholds, it is required to register under the Securities Exchange Act of 1934. This limit is particularly important because public reporting requirements may place significant costs on an investment program.
The 2,000 investor threshold generally limits, in practice, the maximum offering size for a private placement. While there is technically no maximum offering amount an issuer can raise in a private placement, we typically see maximum offering amounts for private funds of between $50 million to $100 million, although maximums can vary significantly, based on the strategy of the program. Additionally, we often see minimum individual investment amounts between $25,000 to $50,000 per investor. The existence of a high minimum investment amount is key, because if lower investment amounts are permitted, it increases the likelihood that the program will exceed the investor limit and be required to publicly report. And while a program could theoretically raise an unlimited amount of capital from a small group of investors, higher minimum investments than these amounts in reality limit the pool of investors willing to commit so much capital to the program, which could hinder the program’s ability to raise capital. So, these typical investment minimums represent a “sweet spot” for issuers.
Don’t forget the non-customary risks
The next time you review a private placement, I’m sure you’ll consider the customary risks that arise out of relative lack of transparency, liquidity, and investor rights. But your due diligence also requires focus on the nuances of other features that may differentiate the private placement from your typical public program: leverage, valuation, and investor limits.
In our next post, we’ll discuss customary fees in the private investment programs that FactRight reviews.