Private Stock Deals Are That Way for a Reason

Private share offerings occur every week in the United States. By one estimate, they are nearly as common as public security sales.  But news that Goldman Sachs would sell private shares in Facebook, the world’s largest social networking site and a private company, was met with some criticism that the offering was only open to the richest of the rich.

But that is the audience for all these private offerings. In reality, they are the only people who could — and should — invest in such high-risk private deals. Sure, the deals might offer phenomenal returns, but they might also be worthless. Only the wealthy can absorb that level of loss.

The private offerings “are often narrow or targeted investments,” said David Bailin, global head of managed investments at Citi Private Bank. “It’s a highly concentrated investment, probably not that liquid, but it’s how it’s designed.”

Yet both advisers and academics said the bigger issue with private placements was being overlooked in the hoopla over Goldman and Facebook — that private placements were not intended to be liquid like public securities, and people who thought otherwise could face unexpected losses.

Whether or not you were able to get into the Facebook offering, here is a look at the state of the private market and the risks inherent in it.

REALITY Private placements have various uses and names. Venture capital firms use them to raise money for start-up companies. Banks create feeder funds or special-purpose vehicles to give clients access to hedge funds or private equity offerings.

They are not required to have extensive disclosures, though many have prospectuses that rival public offerings in detail. But the allure is always the same: access to something that could offer high returns in exchange for high risk.

“We do these all the time with hedge funds and private equity, and they’re no different than what Goldman is doing with Facebook,” said Tony Roth, head of investment strategy and wealth planning at UBS. “We’re just giving them more information” than Goldman gave out on the Facebook offering.

On the contrary, John C. Coffee Jr., a professor at Columbia University Law School and director of its Center on Corporate Governance, said he found the information Goldman gave clients to be more than adequate. “They gave investors a 100-page memorandum, which they’re not obligated to do,” he said.

Much has been said about the high fees that Goldman is charging for the Facebook deal — a 4 percent placement fee and 5 percent of gains. A more standard placement fee is 1 to 2 percent. But Goldman has disclosed those fees, and investors can decide if they want to pay it and invest.

So what is the allure of the deal, since the profitability has been roundly questioned? Meir Statman, professor of finance at Santa Clara University and author of “What Investors Really Want” (McGraw-Hill, 2010), said people willing to invest in the Facebook offering were being lured by the “attraction of status.” He said investing in an offering with such a high, $2 million minimum investment conveyed to others that the investor was wealthy, just as hanging a Picasso in your house is more than a way to cover wall space.

“You won’t go out and tell people you invest for status, but you will go out and tell them that you’re a socially responsible investor,” Mr. Statman said. “It’s neither part of risk or return assessment, but some people care very deeply about it and they’re willing to give up return for it.”

AUDIENCE Private placements certainly are not for every investor. Nor should they be.

But the risk is that people who do not have enough wealth to absorb the potential losses are able to invest in them. To be considered an “accredited investor” by the Securities and Exchange Commission, a person either has to have a net worth of $1 million or an annual income in excess of $200,000 ($300,000 for couples) over the last two years. Mr. Coffee said there was a provision in the Dodd-Frank financial reform bill to increase these limits, but it was removed.

This was a risky deletion because the minimum to get into any private placement is $250,000. In theory, an accredited investor with $1 million in the bank could be investing alongside someone with $100 million. But losing that $250,000 investment is going to mean different things to those two people.

“If someone is worth $30 million and they spend $2 million on the Facebook deal and it goes to zero, you still have bread and butter on your table,” Mr. Statman said. “If I have $2 million and put it all in it, that would be stupid.”

Beyond status, there are rational reasons to go into or avoid a private placement.

It could be a good investment if the manager of the offering could exert control over the company’s direction, Mr. Bailin said. This is something that venture capital companies do all the time, though it is hard to imagine that Goldman will have much say in what Facebook does now.