Do the financial projections make sense? If it looks too good to be true, it probably is. The proverbial “hockey stick” forecast, which shows flat results followed by a sudden uptick, should itself be a major warning flag. Is the company coming off an unusually strong year at a frothy point in the cycle that will be hard to repeat? Was there a onetime event that caused earnings to jump? Is the company carrying debt? How is it servicing that debt, and when does the debt come due? Does the company have audited financials? If not, who prepared the financial statements? In the case of real estate, research must include evaluating metrics such as occupancy levels as well as rent and price per square foot relative to comparable properties.
Legal diligence. Never assume that a commercial enterprise actually exists or that a given entity in fact has title to specific real estate. Real estate title and corporate filing searches represent a relatively minor diligence expense that can save you major heartache down the road. If your lien is 10th in line, it is likely worthless, and there is no excuse for not determining this in the beginning.
All documentation received from the finder or management team should be independently confirmed to the extent possible, which means you should conduct site visits for real estate and confirm the commercial activity that has been represented for a business, as well as understand the sources of any data.
Deal terms. It is vital to fully understand the financial structure of what you are investing in, including whether you are taking common stock, preferred stock or some other security, and all the rights associated with that security (as well as the rights others have that you don’t). How are your investment and shareholder rights protected if things go wrong? It is also important to identify the other investors in a deal; less-experienced investors should be particularly concerned about deals not backed by a legitimate entity with a successful investment track record or dedicated deal team, warning signs that ought to prompt more extensive due diligence. If possible, the investors should consider structuring the investments as small tranches linked to verifiable milestones.
Key risk analysis. Before making any investment, it is crucial for you to take a step back and check the key risks that are being taken. For corporate assets, this list will emerge from the analyses we have mentioned; while it is difficult to generalize, common issues for companies include their operational risk, the risk they will face margin compression or the risk their business will become obsolete. In the case of real estate, interest rate risks and location risks always exist to some degree. Be sure to take a hard look at the downside case and understand how competitors and comparable properties have performed in past downturns.
All deals necessarily feature risks, and it is key to have a handle on these at first look if you are to objectively evaluate whether the investment presents an attractive risk-adjusted return.
It is difficult to overstate the risk involved in having individual investors make private direct investments. Putting aside deals actually designed to fleece investors, for every home run there are countless strikeouts, and even experienced investors who conduct intensive, professional due diligence can lose capital.
Qualified clients seeking private market exposure should consider diversifying these investments by using a fund, which offers the benefit of institutional diligence and active oversight. If a deal is rushed and information is scarce, proceeding with an investment is more like a roll of the dice, and if you do not have the ability to underwrite for the stated return targets yourself, a direct investment is probably not suitable.
Even if all institutional diligence boxes have been checked, it remains advisable to stick to industries in which you have experience—or to real estate assets in locations you are familiar with and have some prior knowledge about.
Do not be afraid to ask lots of questions and demand the information described here. Fundamentally, investors should never put more than 2% to 3% of their overall net wealth into a single deal, no matter what it is. Comprehensive due diligence on each opportunity is essential, but the bottom line is, do not invest more than you can afford to lose.