By Tim Dulaney, PhD, FRM and Tim Husson, PhD
Many of the riskiest financial products we have seen are sold as private placements. Generally speaking, private placements are investments sold directly to accredited investors, and are not registered with the SEC. Private placements include hedge funds, oil and gas partnerships, private real estate investment trusts, and other speculative investments.
Yesterday, FINRA released an Investor Alert on private placements. In it, they warn investors that sales abuses and even fraud have been found in some private placement offerings, and that as unregistered offerings, their disclosures and projections can be meager or sparse. In our experience, the private placement format enables poor reporting and questionable sales practices since neither the public nor the regulatory authorities can even observe what securities are being offered and how they are being represented.
Take for example tenant-in-common (TIC) interests -- private placement real estate investments that were sold in large numbers during the real estate boom. We have written a research paper describing the deficiencies in the financial projections distributed to TIC investors, including aggressively optimistic assumptions for future rental revenue, low vacancy, and projected sale prices. In reality, many TICs wound up in foreclosure, and many investors -- who were persuaded to exchange their business, ranch, or other income-generating property for large allocations to TICs -- faced significant losses.
But while those issues were endemic to TICs, they were not unique to them. We have seen other private real estate funds, oil and gas partnerships, etc. that project unrealistic and poorly supported distribution levels. The FINRA Investor Alert includes many helpful tips for spotting these deficiencies.
One last point to note is one we have been discussing since last year: the 2012 JOBS Act may soon allow private placements to advertise to the general public. We think this could open the door to a wide array of fraudulent private placement investment schemes. Also, the JOBS Act removes several investor protections, especially related to crowdfunded ventures. Given this loosening of regulatory policy, it's no wonder FINRA feels the need to warn investors.
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