Private equity placements provide an opportunity for investors to buy into tangible opportunities without the volatility of the stock-market, in exchange for some more company specific and liquidity risks. That being said, because of the way in which these investments are usually required to pay investors a much higher rate of return than a public company would, one needs to ask why it is that companies would choose to pursue this kind of financing due to its level of yield expense. With that in mind, this article is going to discuss all of the benefits that smaller companies realize by pursuing private equity placements, even if they do need to pay a substantially higher yield to their investors.
Companies will often choose to pursue private equity placements before they go after public funds because of their surprisingly cost effective nature. Since listing a stock on the public markets can cost enough to eat up a great deal of the issuance itself (10-25% of the value raised in underwriting fees, assuming the IPO performs admirably), companies will often provide private investors with a very good deal (usually in terms of some form of distribution), because it still saves the company money against a public issuance.
However, even though companies are willing to provide investors with a premium on their funds raised, the investor is taking on that return with the added liquidity risks associated with a private placement. Since the funds are not listed on the public markets, there is not really much of a way for the investor to sell their position in the private company, and so they are stuck hanging onto their position until the company vests out its positions (assuming that ever happens). As such, investors are often encouraged to use a payback period calculation to determine the benefits of liquidity against the attractive payout that they are receiving.
Aside from the savings that companies can realize on their underwriting costs, those companies that are financing expensive assets (such as real estate or buildings) will often receive a discount on their interest rate from their bank if they include third-party investors into the project. The amount of third-party equity required as a part of the deal depends, but I’ve seen companies get by with as little as 15% of their capital structure as being composed of this function. This means that paying out a handful of third party investors a few thousand dollars in dividends can save the company tens or hundreds of thousands worth of interest payments to the bank, and therefore improves the capital structure of the company.
As such, private investors should look to make sure that they are being paid a fair return for their placements, given the capital structuring benefits that the company is likely receiving. If a real estate development company offers to pay an investor a 5% yield on a private placement, they should probably be told to take a hike, because that is likely the same rate that they would need to pay their bank for debt without third party investors. The company should instead be willing to pay out 8-20% (depending on how many investors they are taking on and the size of the project), because of the way in which their interest-rate savings will more than cover the amount of risk that you mitigate as a third party investor.