In today’s investment landscape, it has become especially important to understand private equity risks. For the first time since a stagnancy in 2022, private equity (or “PE”) investment trends are rising, with PE firms seeing their strongest quarter of activity in two years as of Q2 2024. PE capital deployment has nearly doubled over the past year, rising from $100 billion in Q1 to 122 deals valued at $196 billion.
However, not every private equity offering translates to financial gain for its investors. Many PE options are opaque, expensive, and higher-risk undertakings that should only be attempted by suitable investors. A private equity lawyer can help determine if your lost funds are actionable under the relevant US securities regulations. Click here to set up a complimentary consultation with our experienced investment fraud attorneys.
What Is Private Equity Law?
Private equity refers to an investment class of privately held securities that do not trade on a public exchange. Private equity investments are often created as investor pools to finance the acquisition of companies (i.e., buyouts). In exchange, investors receive a return on their investment based on the revenues generated by target companies.
The objective of a private equity investment is to acquire a significant amount of assets to eventually be sold to a larger company at which time investors will receive a return of principal. Private Placements are issued under Regulation D under the Securities Act of 1933. Regulation D provides exemptions from the more rigorous Securities and Exchange Commission (SEC) registration requirements and allows companies to offer and sell securities without extensive disclosures.
Private equity acquisitions do not always add value to a company; they may also seek to extract it before exiting the investment. These kinds of acquisitions often thrive during times of low interest rates and higher stock prices. Payouts are not available for set periods of time, often at least five years, but at times for the entirety of the finite investment period.
Private Equity Investment Risks | What To Keep In Mind
Private equity is a complex and high-risk undertaking. Investments are categorized by their limited liquidity, as well as a strong potential for misrepresentation. Many private equity buyouts can include “carve-outs” where only a portion of a company is purchased. They can also lean on dangerous debt financing or attempt to speed up returns with dividend recapitalization, by making payments to investors with borrowed money.
There are no guarantees associated with private equity investments. Investors can lose the entirety of their investment. The SEC does not require comprehensive financial disclosure and, accordingly, private equity investments are not “marked to market” each day. This means that investors do not know the true value of their private equity investment on any given day. The lack of disclosure also breeds securities fraud.
Even the most knowledgeable investor isn’t expected to go it alone when it comes to making decisions on what securities to buy. While broker-dealers offer their clients public securities, which most investors are familiar with, broker-dealers may also offer private placements, an important part of the investment landscape with unique risks and rewards. When brokerages offer private placements, they are required to conduct appropriate due diligence of the issuer, management of the issuer, and affiliates of the issuer in order to ensure that the securities are suitable and appropriate.
While private securities may be exempt from some common securities regulations, this doesn’t relieve broker-dealers of their responsibility to act in their clients’ best interests at all times. Financial Industry Regulatory Authority (FINRA) Notice to Members 10-22 sets forth the due diligence requirements of brokerages with respect to private placement securities offerings. NTM 10-22 can also be helpful information for investors who want to better understand broker-dealer roles and responsibilities in the private placement of securities.
What Are Private Placements?
Under specific circumstances, broker-dealers may offer their clients securities called private placements. Private placement offerings are generally issued by smaller companies, with a limited aggregate value of these securities offered in a 12-month period. Typically, private placements are best offered to institutional investors with preexisting knowledge of the market, as well as a net worth that can sustain a significant loss or delayed returns. However, private placements may be offered to both accredited and non-accredited investors.
Accredited investors meet –or are reasonably believed to meet by the broker-dealer– minimum net worth or income thresholds. These investors are also expected to possess a competent understanding of how investing works in order to make a reasonable and reliable judgment on the potential risks and rewards of a given investment. While issuers are required to provide certain documents to potential non-accredited investors, they are exempt from providing these documents to accredited investors. According to FINRA, issuers typically make private placement memorandum available to non-accredited and accredited investors alike.
Private Placement vs. Public Offering
A private placement investment is typically by invitation-only, as opposed to a public offering. Private placements do not involve the same level of financial disclosure or accountability to the SEC regulations. Private placements are usually offered to investment banks, pensions, and mutual funds, and are not subject to the same securities registration as is necessary with an IPO.
Private Equity and Private Placements: Common Issues
Here are some of the common concerns with PEs and private placements that investors should be aware of:
- Breach of fiduciary duty: Brokers must have an informed basis for recommending an investment opportunity to their clients. Unfortunately, many brokers cut corners and rely upon “due diligence reports” sourced by third parties. In some cases, these reports can be a conflict of interest, as they are funded by the same company that sponsored the private placement. When information in due diligence reports is false, inflated, or when a broker fails to examine an opportunity thoroughly, they may not only be breaking their professional commitment to a client, but also the law.
- Lack of transparency: Private placements are by nature exclusive and often secretive investment opportunities. Mergers and acquisitions done through private placements often involve the exchange of confidential and privileged information to only a few parties. While brokers can access financial reporting through due diligence reports, this information is often restricted from investors.
- Misrepresentation or fraud: An offering plan or memorandum for a private placement often involves self-reported figures that are not subject to third-party scrutiny. These numbers can mislead investors about a company’s viability, structure, or other salient details. Not every private placement is misrepresented to investors, but there is an unprecedented amount of “freedom to fudge” that comes into play in a less regulated offering.
- High costs and fees: Private placements often pass on unnecessary additional fees to investors. Besides a 5% to 10% broker fee, an investor may often pay an upfront fee to the company or its affiliate sponsor in order to access the offering.
- Delayed or disguised distribution payments: Distributions from a private placement are not necessarily income or even profit. They are made at the discretion of the manager, and may represent a partial return of the originally invested funds. This can make it appear as if an investment is profitable or stable when in actuality, an investor is simply paying their broker commission fees to hold onto their initial investment for some time. Private placements can be riddled with these kinds of complexities, making it difficult to understand for the average investor.
GBP Capital Holdings: A Case Study On Private Equity Fraud
In a recent example, GPB Capital Holdings, a New York alternative asset management firm formed in 2013, issued a variety of securities to retail investors, such as:
- GPB Automotive Portfolio, LP
- GPB Cold Storage, LP
- GPB Eurobond Finance PLC
- GPB Holdings II, LP
- GPB Holdings, III, LP
- GPB Holdings Qualified, LP
- GPB Holdings, LP
- GPB NYC Development
- GPB Scientific, LLC
- Armada Waste Management, LP formerly: GPB Waste Management Fund, LP.
GPB embarked on an aggressive capital-raising campaign, incentivizing numerous brokerage firms and financial advisors to sell GPB funds in mass to their retail clients. They offered commissions as high as 8% and reportedly paid over $100 million to brokerage firms and financial advisors who sold their funds.
These numbers were too good to be true: GPB turned out to be a Ponzi scheme. The internal expense ratios of the GPB funds were as high as 20%, making profitability for investors a near impossibility. The founders were siphoning money to pay personal expenses and using new investor money to pay dividends to existing investors. Brokerage firms that sold GPB failed to conduct appropriate due diligence and uncover red flags and conflicts of interest. Had they done so, they would have seen that GPB had insufficient revenue to pay the stated distributions. In 2020, the SEC brought an enforcement action against GPB and its founders. Criminal actions were also brought against many of the bad actors. Investors were left without an income stream and large principal losses.
What Is a Brokerage Firm’s Obligation For Conducting Due Diligence?
Brokers are supposed to conduct due diligence in order to present only suitable opportunities to their clients for investment. What is suitable is determined by a client’s investment goals, portfolio, market experience, age, liquidity, risk tolerance, and other factors surrounding their needs. Brokers must not only examine the details surrounding a private placement, but also the context in which they make suggestions to their clientele. Failing to do so is a leading cause of broker misconduct. There must be a reasonable belief that securities have met minimum standards as to worthiness on the part of the broker-dealer.
Contextualizing Due Diligence
While broker-dealers are not always bound by fiduciary standards, there remains a long-standing regulatory and legal precedent that assigns broker-dealers some degree of responsibility when recommending securities to their customers. According to the FINRA, the broker-dealer has a “special relationship” with customers and in making recommendations to them. Even in the cases of private placements to accredited investors, broker-dealers cannot trust that even the affluence and sophistication of accredited investors relieve them from the responsibility of due diligence. When broker-dealers fail to uphold this standard, it may be considered fraud and a violation of FINRA Rules 2010 and 2020, which govern just and equitable principles of trade and bar manipulative and fraudulent devices.
The level of due diligence to be carried out by broker-dealers can vary by issuer and the type of securities; in some ways, broker-dealers are left to their own judgment as to what may be considered a red flag for their clients. However, there are some overarching principles that guide broker-dealers. For example, they are supposed to independently verify issuer claims, identify and investigate red flags, and follow suitability rules when making recommendations to their clients. They should consider any association or affiliation with the issuer; broker-dealers must carefully consider any possible or potential for actual or perceived conflict of interest. Broker-dealer supervisory procedures must establish minimum standards in line with regulatory requirements for due diligence, and they should also hold onto all records documenting their due diligence activities.
Brokerage Firm’s Obligations Regarding Due Diligence of Private Placements
The risks of private equity should never be taken lightly. It is a broker’s responsibility to ensure that the investments recommended to their clients are sound, legitimate, and appropriate. The following are some of the most important tasks in conducting due diligence:
- Investigate the issuer and the company’s management, including company history and background, and the qualifications of the management team to conduct relevant business. This includes reviewing governing documents, bylaws, historical financial statements, audits, and internal audit controls. Broker-dealers should identify any trends based on financial statements, interview the issuer’s customers and suppliers, and review the issuer’s leases and mortgages.
- Research affiliates of issuers to the extent that affiliates’ needs may influence the issuer. Explore any previous securities offerings from the issuer, along with pending litigation, regulatory issues, disciplinary problems, management expertise and compensation, and long-term business plans.
- Review the issuer’s assets and consult with industry experts as needed to make a proper assessment of an issuer’s securities.
Any deviation from these due diligence requirements can form the basis of a cause of action for, among other things, breach of contract, breach of fiduciary duty, and negligence. Failed due diligence may also cause the brokerage to make misrepresentations and omissions in connection with an offering.
What Are the Legal Options for Investors in Private Equity Disputes?
PE legal issues are usually resolved through either securities arbitration and/or litigation. An investment loss attorney is qualified to represent their client through either avenue of recovery. With claims of misconduct or misrepresentation, FINRA arbitration may be the fastest and most discrete method for recovery. Filing a FINRA complaint is usually the first step down this road.
A FINRA attorney can help you structure your claim so you can bring your concerns to a panel of one to three independent arbitrators. The arbitrators, typically industry regulators, will review the evidence presented from both sides and make a binding determination of an award amount.
Private Equity Dispute | How Can an Investment Loss Attorney Help Me?
Wolper Law Firm brings a unique level of insight, expertise, and professionalism to financial fraud prosecution. Partner Matt Wolper built his career defending big banks before pivoting and leveraging this early experience to fight on behalf of defrauded investors. At Wolper Law Firm, we have a 99% success rate and accept cases involving breach of contract, breach of fiduciary duty, negligence, misrepresentations, and omissions in connection with an offering, as well as other claims associated with PE disputes.
What You Can Recover From a Successful Private Equity Claim
A private equity lawsuit has the potential to win a client recoverable damages such as the amount of their initial investment and/or a percentage of their overall loss. In some cases with SEC intervention, a company may be ordered to disgorge their profits resulting from illegal action, which may be redistributed back to investors through the establishment of a Fair Fund.
Private Equity Lawyer: FAQs
What Do Private Equity Lawyers Do?
At our PE law firm, we assist clients who are recovering from financial losses due to fraud, misrepresentation, and broker misconduct. We do not process private equity deals, but instead bring our experience to bear helping clients who have been misled or otherwise harmed by inappropriate investments.
What Percentage of Private Equity Investments Fail?
Private equity is statistically correlated with an increased risk of investment failure. PE portfolio companies are 10 timesas likely to go bankrupt as companies not owned by private equity. These risks are due to the nature of the investment’s short-term push for profits, heavy reliance on debt structuring, higher fees, as well as reduced legal regulation.
Is My Financial Advisor Ripping Me Off?
Financial advisor negligence can happen in many ways. If your broker-dealer misrepresents financial information to you, recommends an unsuitable offering, puts their own commissions or fees ahead of your interests, or otherwise does not fulfill their fiduciary duty, contact an investment fraud attorney at once to review the details of your situation.
How Does Arbitration Work for Private Placement Disputes?
A private equity lawyer may recommend the arbitration process for private placement disputes. FINRA arbitration tends to be faster, more confidential, and more successful for many investors’ needs. The process typically lasts for on average 16 months, and can in some cases, take less than a year. Results are legally binding and are presented before independent arbitrators who act like trial judges to sift the evidence and hear both sides’ perspectives.
Concerned About a Recent Investment? Speak To an Experienced Private Equity Lawyer Today
Among the many disadvantages of private equity, a main issue is the way that it both allows and incentivizes corrupt brokers to take advantage of their clients. The reduced transparency, higher fees, regulatory exemptions and exclusive nature of private offerings can all bring out the worst in a company as well as an individual. If you need help with your claim for recovery after private equity fraud, contact an investment fraud lawyer with Wolper Law Firm today. We can review your case and advise you about the best pathway forward.