(Note to Readers: I wrote and finalized this article on February 25, 2020. We placed it in our regular queue at that time for publication on March 25. In that short 30-day interval, the world has altered dramatically, beyond all conceivable imagination. We are proceeding with publication of the original article without edits as it contains themes and warnings that have largely gone unheeded in the past few years but that now are frightening in scope and implications for all investors in private securities. I believe we are now entering into entirely new and uncharted territory in terms of how sponsors, syndicators, crowdfunding platforms, and fund managers in the small balance and middle market real estate sector are going to handle the upheaval in the world. This is particularly true as it pertains to these groups’ recently greatly expanded relationships with investors in the private securities they offer. Fairway America and Redwood Real Estate Administration have deep domain knowledge and expertise in this market sector and will provide much needed leadership, guidance, and unvarnished truth to both sides of this highly fragmented industry during what is certain to be a very tumultuous and scary period in the coming weeks, months and maybe years. Hold onto your hats.)
In my last blog, I wrote about the world of private securities, sometimes also called “alternative investments” or “alts” (although these terms are not perfectly interchangeable). I have received several questions about private securities generally, several of which can summarized as, “What exactly is a private security?”
As I began to write this latest post, I searched “private securities” to see if I could provide a consistent definition. Unfortunately, I quickly came up with no fewer than a dozen different definitions – each with various nuances depending on the source of the defining – in just the first few clicks.
There were many more available and nearly all were more complicated (or perhaps I should say technical) than the typical high-net-worth (HNW) investor will find useful, in my judgment. So, let me offer my own definition – which admittedly is drier than I’d like, but such is the nature of the subject matter – that can set the tone for the discussion in this blog:
A private security is one that is being offered either a) directly by an issuer or b) by a broker dealer to investors through a registered representative, in either case, without registering that security with the Securities and Exchange Commission (SEC) for a public offering, pursuant to one (or more) exemptions from registration available to that issuer.
I find that there is a great deal of confusion among both issuers and HNW investors as to what is actually considered a security, which rules apply to the sale of these alts, how to adhere to those rules (and when it is necessary to do so), and what the implications are to each party for adhering (or not adhering) to them. This has been true as long as I have been in this business (which is longer than I care to acknowledge!) and has become even more confusing after the passage of the JOBS Act in 2013. But first, let’s go back to the Great Depression and some of the landmark securities legislation that came out of that event.
Since the mid-1930s, issuers who wanted to sell a private security either had to get a licensed registered representative (“RR”) to sell that security on behalf of an approved broker dealer (“BD”) or sell it themselves directly to investors under what is referred to as the “issuer exemption,” if they satisfy certain requirements. Going the former route potentially adds a huge amount of expense (or “load”) to the deal, often as much as 10-15% of the amount invested. This meant (and still often means) that an investor who invested $100 in a private security paid out of her initial capital investment (whether she knew it or not) as much as $10-$15 in commissions, fees and costs – thus immediately diluting her investment down to $85-$90. This in turn meant the deal had better be damn good, as it had to earn 10-15% profit (over and above additional ongoing costs and fees) in order to just break even for the investor after the initial load, and a lot more than that to produce a significant enough profit to warrant the cost and risk of the investment in the first place.
A tall order.
As a result of this, as well as other more nuanced considerations beyond the scope of this discussion, many issuers chose to sell (and investors chose to buy) securities directly under the issuer exemption and avoid the RR/BD path altogether. (Note: selling directly by an issuer was often and is often as much due to the general inability of private security issuers to even get broker dealers to accept their investment on a BD’s platform as it is to any altruistic desire on the part of issuers to avoid investor fees.) However, this course of action presented multiple practical limitations and challenges in raising capital due to the securities regulations imposed after the Great Depression, which were altered in some key respects in 2013 by the JOBS Act.
Namely, an issuer could only sell a private security prior to the JOBS Act to an investor with whom the issuer had a “prior business relationship (PBR).” As is typical with much legislation, there was no clear definition of what precisely constituted a PBR so issuers (and their attorneys) were forced to form their own opinions and take what they hoped were reasonably defensible positions as to how they determined whether a PBR existed with any given investor. However aggressive or conservative that position, issuers were clearly prohibited from publicly advertising or generally soliciting investors unknown to them for their securities. This limited issuers, more or less, to their immediate and perhaps extended networks and spheres of influence. For most, this fundamentally constrained their ability to sell securities, raise capital to grow their business (or offerings), and thus constricted the flow of capital into the private securities market.
Several decades later, along comes the JOBS Act of 2013 and with it the removal of the strict prohibition on “general solicitation and advertising,” subject to certain additional impositions on the issuer (including a limitation to only accept “accredited” investors and a requirement to verify that accreditation). This development coincided with a time where technology and the internet were evolving at an increasingly rapid pace and revolutionizing and metamorphosing entire industries. This piece of legislation nearly immediately gave rise to issuers (and platforms) selling securities online, aka “crowdfunding,” making available a far broader and more diverse number of alternative investment opportunities for HNW investors to consider.
Proponents of these developments espouse (rightfully) the greater optionality for investors and the increased availability of capital for private issuers across an entire range of offerings, including but by no means limited to real estate (although it has been a primary benefactor). Detractors caution (also rightfully) the increased risk of deceit, scams, fraud, misrepresentation, and just plain bad deals. Both are accurate.
The radically increasing pace of technological development has also created an environment for potential disruptors to pursue new ways of providing better, more convenient and faster services to the private securities world – online marketplaces, cryptocurrencies, coin offerings, instantaneous cash transfers, secondary market trading of private securities, electronic custodial services, and many more. Huge amounts of venture capital are being poured into these concepts with varying degrees of success to date. In addition to vastly greater awareness of and access to far more offerings, technology has greatly sped up investors’ ability to invest, spend, and in some cases unwittingly be separated permanently from their money. Welcome to the age of Financial Technology (FinTech).
My bias is not to attempt to render judgment on whether these changes are inherently good or bad, but to understand the implications these developments have on the various players involved in private securities – issuers, broker dealers, regulators, and especially investors. In many ways, as in many industries in the throes of deep structural changes, all the constituents are still figuring out how the changes impact them and are grappling to understand how to play given the new rules of the game. My focus here is on investors. I believe they should take steps to try to truly understand how these dynamics can both benefit and hurt them when it comes to considering investments in private securities, and to find ways to minimize chances of making poor decisions.
For many years, if you were not buying the security from a broker dealer (and paying handsomely for that privilege) but were interested in private deals, you had to personally know someone (i.e. have a PBR with an issuer) who was offering the investment. This necessarily limited the geographic reach of potential investments for most investors and tended to constrain options considerably. It also meant that you likely knew the issuer reasonably well and could form or had already formed an opinion as to her competency and trustworthiness. This did not remove all risk, of course, but it very arguably reduced significantly the chances of getting blindly ripped off. This is no longer the case and an entire universe, for better or worse, is now available, dramatically lowering the connection between issuer and investor.
Combine this with people’s tendency to judge a book by its cover and you have a recipe for deception. Effective marketing, branding, and influencing with slick look, feel, and words is an art that many people have mastered. This skill set is not the same as being able to effectively underwrite and evaluate risk. Unfortunately, average or poor deals being put forth often have beautiful packaging and persuasive narrative from charismatic marketers. Without the discipline or expertise to open the package and more thoroughly inspect its contents, it is easy for investors to get seduced by an exquisite wrapper. This is more prevalent than ever with the proliferation of online offerings. On top of all these developments, the real estate market generally has been on an uninterrupted ten-year-plus upswing. This extended upward trajectory of the economy and valuations have served to cloak some questionable deals and make nearly every issuer look pretty good, making it even harder for HNW investors to distinguish strong managers from the not so strong.
All of this said, investments are inherently risky and no deal, no matter how legitimate, is without its risk and no issuer is infallible. Even quality, honest, and capable operators cannot fully control all the variables that influence the outcome of any deal. But there is a big difference between a deal running into genuine issues in execution, market conditions, and other challenges that can arise, and pure incompetence, undue risk taking, and – at the extreme end of the scale – outright fraud.
I read an article the other day about the proliferation of unadulterated fraud and blatant theft in the cryptocurrency space. According to the article, more than $4.3B was simply stolen in cryptocurrency scams in 2019, more than 90% of that figure in just six well-orchestrated frauds. I am not picking on crypto, but I am saying that the environment for fraud is very ripe, and online schemes are relatively easy for bad actors to execute successfully.
Investors simply cannot be too careful about what they are doing. Take your time, ask lots of questions, and find someone you trust to ask for help in assessing whether something is legitimate or not. There are both great opportunities and plenty of risk in the world of private securities, which really isn’t so surprising when you think about it at a deeper level. There really is a dualism in the universe. The fire that warms our homes also can destroy them entirely when out-of-control. The water we need to survive can wreak havoc on everything in its path under other circumstances. More access (and options) is good, and it can also be very bad.
