Understanding Off-Exchange Private Shares

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My column in the May issue of Lancaster County Magazine titled “Hedge or Hoax”, focused on the problems with hedge funds and how Wall Street promoted them as an investment for “sophisticated” investors. Many of these so-called sophisticated investments turn out to be long on promises, but short on results. They are also usually loaded with fees and expenses.

The most recent “sophisticated” investment seems to be the current love affair Wall Street has with private equity. Private equity transactions are the “Off Exchange” sale of non-public stock to private accredited investors. A broker dealer or underwriter will often engage in a private placement of a non-public company’s shares before or in lieu of a public offering for a variety of reasons. It’s difficult to estimate the size of the private equity market, because stock sales do not have to be reported. However, some estimates put the total transaction volume well into the billions.

Trading in private company stock remains largely unregulated and could potentially become the next financial mess much like collateralized debt obligations (CDOs) did with mortgages. CDOs’ value and payments are derived from a portfolio of fixed-income underlying assets. Investors were interested in trying to make a higher return and didn’t bother asking questions until the bottom fell out of the CDO market. The same can easily happen in the private equity market.

Interest in the private market is largely the result of weakness for public offerings and increased regulation. The 2002 Sarbanes-Oxley Act set stricter accounting standards and increased the costs for public companies. Entrepreneurs have turned to selling private stock as a way to turn their equity positions into cash.

There is a new trend in the trading and placement of private stock as Wall Street attempts to invent new investment vehicles to gain exposure to private companies and attract capital from rich individuals and big-name institutional shareholders.

Company-specific funds have been created, and a separate market has sprung up for trading off-exchange private shares. SecondMarket has quickly become one the largest traders for private shares.

Many are concerned that the lack of information between buyers and sellers could bring in regulatory action should some investors get burned. It may be necessary for private companies to share more information about themselves in order for the market to continue to grow. Right now, private companies have minimal disclosure requirements. In order for companies to remain private, they cannot have more than 500 shareholders. Once a company exceeds 500 shareholders the US Securities and Exchange Commission requires the disclosure of significant financial information.

Some investors believe that the fastest-growing, most interesting companies are the private ones. While there is a lot of truth to this it also comes with significant risk. Private companies may not succeed in their respective business, and the lack of disclosure requirements means that problems would not be a readily apparent as in a public company. Secondly, the market is expanding, but it is still very thin. You don’t have the liquidity that usually comes with a publicly traded company. Off-exchange private shares should only be considered for the most aggressive part of your investment portfolio.

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