Should you invest in private equity?

Private equity is a high-risk, high-reward asset class, traditionally reserved for the well connected, institutions and large investors – leaving individuals with modest portfolios out of the picture.

Not so anymore.

Fintech developed over the last decade is changing the status quo, providing willing individuals the ability to try it out. In Canada, two online platforms – DealSquare and FrontFundr – allow retail investors to access private equity.

Canadian crowdfunding rules dictate that most retail investors can only invest a maximum of $2,500 per venture and $10,000 per year in total, according to the National Crowdfunding and Fintech Association. The regulators can classify investors with a high net worth as accredited, enabling them to invest more.

First, the platforms
DealSquare was founded in 2019 by the Aequitas NEO Exchange and Silver Maple Ventures. It is a business to business service that any investor can access through an investment advisor and serves as a way for companies to sell shares and raise money for ventures without having to go public. Fund manufacturers and public companies making a private placement can also list their offerings.

Going public, “comes with a cost for companies that are very young and should really be focusing, in my eyes, on building out their business,” says Jos Schmitt, the president of NEO. Due to the high cost of making public offerings, ventures are less profitable, and ”have an extremely high risk of failure,” Schmitt adds.

Silver Maple Ventures founded FrontFundr prior to DealSquare. It is similar, but connects private companies directly with investors, so you can invest without an adviser. Companies set the investment minimum, which is typically between $500 and $10,000.

There are no fees for users to view or invest with either platform. Both make money by charging companies fees to list their ventures. Shares sold on the platforms are “on book,” which means when a company goes public, pre-IPO investors will be able to trade on day one, says Schmitt.

Since its inception in 2010, FrontFundr has closed 44 deals and has 11 open, says says Peter-Paul Van Hoeken, CEO of FrontFundr and Silver Maple Ventures. DealSquare, which has been around for less than a year, has closed a handful of deals and has 10 open, with acceleration expected to take place, says Schmitt. In late February, Lendified’s pre-IPO raised over four million dollars with DealSquare and FrontFundr thanks, in part, to individual investors, Schmitt says.

What are the risks?
“You would go into private market investments, in part, for a higher return. That’s the extra reward you would expect for taking the risk of investing in private markets,” says certified financial planner and analyst Dan Hallett, vice president of research for Highview Financial Group. But of the risks, “There’s potentially a long list,” he says.

The risks of making a bad decision are worth considering.

1. Lack of standardization: Public investments, like mutual funds, have standardized offer documents. “Once you’ve looked at a certain number of mutual fund prospectuses, you know exactly what you’re going to find and where you’re going to find it. That is completely not the case with private investments,” says Hallett. Each private offering is unique; the documents are not organized the same way and the wording is not standardized. Retail investors could easily miss something material unless they read each of the offer documents carefully.
2. Liquidity: Another aspect to consider is liquidity – these investments are typically illiquid. Given the lack of liquidity, private funds are often held for 10 years or longer. If after that time the venture is successful, there will usually be an IPO, unless the company is acquired. Either event gives early investors the option to sell. “If liquidity matters to an individual, private equity is the wrong investment,” says Hoeken.
3. Diversification: A third risk is lack of diversification. Every healthy portfolio should be a mix of income and equity across multiple industries and countries, says Hallett. “You have to dig deeper and look at the underlying economic influences to see if you’re truly getting diversification from the portfolio you already have.”
   
   

You can, but should you?
“Don’t be in a rush to deploy money into private markets,” says Hallett. Begin by asking yourself, ‘What is this money supposed to do for you?’

“Is it going to give your portfolio a shot of growth, cash flow, or a combination? That will give you direction on what to look for. Otherwise, its very easy to get distracted with the products that you come across,” says Hallett.

If you do decide to explore this asset class, research is critical. “Informed” decision making, and proper due diligence can lead to a profit, he adds.

In a recent blog, Hallett describes his due diligence process as “guilty until proven innocent.” He recommends creating a “gross-to-net analysis”: a financial model that illustrates what gross return is required to deliver the minimum return you expect. The main purpose of this is to assess whether the promised return is realistic.

However, researching private investment opportunities is “boring stuff and the process is tedious,” Hallett says, so they are not right for everyone.

While the idea of investing in private equity might seem new and exciting, especially in these volatile times, it is imperative that investors stick to a plan, and invest as per their financial goals and risk appetites.

Morningstar’s head of behavioral science Stephen Wendel says an individual investor should arm oneself with a narrative, beforehand, to understand other people’s excitement to invest in certain asset classes. He suggests two tools – externalizing and friction: “Externalizing means to thoughtfully write out your own personal investing rules, when you are in a calm state, and then use the written version to guide your day to day actions. Friction is all about slowing you down: making it harder to act rashly in the moment, so that you might return to the issue with a calmer head.”