Private equity contracts can be a problem area for personal investors that don’t quite know what they’re becoming involved in. They can be tragically short, or deceptively long, depending on the type of project being bought into. However, regardless of size, they all come with the same pitfalls that can leave an investor with a 100% loss on their allocated capital. As such, investors need to take the time to understand a few of the key major aspects of a relatively safe private equity offering, and a potential money pit.
The first thing that an investor should look for when reviewing the documentation behind a private equity offering is a detailing of the various liquidity events surrounding the investment. A liquidity event is some sort of situation that allows the investor to have a portion of their money returned to them, and can include everything from investments, buy-back clauses (often called ‘put options’), settlement periods, or options to convert the equity position into an equivalent form of debt.
Ideally, we want to see a combination of these events that have been tiered out across the various time periods of the project. For example, a company could start a development project, and not issue any sort of liquidity for the first year of development. After that first year, they could begin paying a dividend using funds that have come up from pre-sales of the units being constructed.
Throughout the period, the company might have an option to pay out investors in full with a fixed rate of return because of an early acquisition (ie. perhaps a larger company has decided to consolidate the project early on, and include it within their own portfolio). Alternatively, at the end of the project, or after a period of time after the completion of the project, investors should be allowed an opportunity to sell their shares back to the company in exchange for a premium, or to hang onto them in exchange for exposure to continuing (ideally larger) dividend payments, reflecting the profitability of the finished product.
Aside from liquidity event agreements, investors should keep an eye out for default resolution and mitigation mechanisms in their private equity contract. Ideally, this will be embodied in a personal guarantee clause for a smaller or medium sized company, meaning that the management of the company is willing to assume personal liability in the event that the company defaults on its arrangement with shareholders. From there, investors can benefit by seeing that they will have claim to the assets of the entire company, as opposed to those of the individual project which they are investing in.
Watch out for this point, as it can become an issue. A trick many companies will employ is to incorporate each of their projects (ie. each real estate project or oil well) as a distinct legal entity, and then keep them isolated from each other. In the event that one of these isolated projects fails, the shareholders in that particular project are out of luck, because they will not be able to sell any of the other projects’ assets to make up their losses. Vicarious liability across all of the project companies assures an investor that they are able to protect themselves from losses in the event of default.