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When hedge funds call Don Draper, run

Here comes the private placement rush even bigger than already is.

http://www.marketwatch.com/story/when-hedge-funds-call-don-draper-run-2013-07-12

July 13, 2013, 7:49 a.m. EDT

When hedge funds call Don Draper, run
Jaffe: What to look out for as SEC lifts 80-year-old ban on advertising
By Chuck Jaffe, MarketWatch
The late comedian Groucho Marx was reported to have said that he didn’t care to belong to any club that would have him as a member.

Were Marx — known for being a savvy investor himself — alive today, he would be adapting his philosophy to say that he wouldn’t invest in any hedge fund or private-placement that would have him as an investor.

That is the stance that most investors should be taking now that the Securities and Exchange Commission has lifted an 80-year-old ban on advertising by hedge funds, buyout firms and startup companies seeking capital. The rule was included last year in the Jumpstart Our Business Startups (JOBS) Act, which was seeking to give small businesses — and job creation — a boost amid economic stagnation and the lingering fallout of the financial crisis of 2008.

By the time the leaves turn this fall, investors can expect to see the first general ads for private offerings — a category that hedge funds and buyout firms, technically, fall into — with firms first sitting out a 60-day waiting period and then being required to give the SEC at least 15 days’ notice before beginning their solicitations.

The more advertising investors see, the more worrisome the SEC decision, because the regulatory body largely failed to put in safeguards, content instead to let the situation play out and then use problem cases and trouble signs to refine the rules going forward.

Proponents of the new rules like the simplistic approach here, noting that by limiting the general advertising to “accredited investors” — people with annual income of more than $200,000 in each of the last two years, or with net income excluding their primary residence of $1 million — unsolicited sales pitches for private placements will only wind up in the hands of sophisticated investors.

Also see: How to advertise your hedge fund

That is wishful thinking; you don’t have to read too many Bernie Madoff stories to know that the largest fraud in Wall Street history — a Ponzi scheme based on imaginary investments held in hedge-fund investments — hit a lot of people who fell below the accredited-investor line, and proved that “accredited” doesn’t necessarily mean “sophisticated.”

Click to Play Jaffe: How to achieve the American dreamAs the nation celebrates its birthday, it’s a good time to see how the American dream looks different now than for generations past. Chuck Jaffe joins MoneyBeat.

And for anyone who thinks the private-placement market doesn’t deserve much attention from the SEC, considering all it has to do to oversee public stock offerings and debt deals, consider that in 2011 (the most recent year for which numbers are available) the amount of money raised in private offerings was roughly $900 million, or three-quarters of the total raised in public stock and debt deals. That gap will shrink with the law’s new encouragement.

Barbara Roper, director of investor protection for the Consumer Federation of America, thinks the SEC just declared open season on investors. She imagined the sales pitch this week during an appearance on my radio show, MoneyLife: “Now you too can invest in these kind of investments that were once only available to the wealthy few.”

“Never mind,” she continued, “that the reason that access to these investments was restricted in the past is that most startup companies fail, that won’t be in the conversation. … If you live in a retirement enclave, a wealth retirement community, I would expect to start getting inundated with these kinds of offerings.”

Expect the private offerings and hedge funds to go that route because accredited investors represent just 7.6 million households, or 7% of the total, so mass-marketing via television or magazines likely will be seen as impractical, and will also hold the risk of attracting too many people who lie about their status in order to get in the door; more-focused solicitations at least give the impression that the ads aren’t casting a wide net, and that any average investor who gets snared in a bad situation got there more by accident than by being a targeted sucker.

Targeted or not, however, it is important to recognize that there is a good chance that anyone falling for this stuff almost certainly is playing the sucker.

No one is going direct to the public with private offerings because they think it is in the public’s best interest; they’re going this route largely as a last resort.

Said Roper: “The top offerings — the things you really want, the ones that are really attractive either because they are very successful hedge funds or very hot startup companies -- aren’t going to resort to this kind of marketing. The offerings that are going to resort to mass marketing are the ones that can’t raise sufficient capital through the traditional methods.

“So, by definition, this mass marketing is going to largely consist of the weakest offerings in this market.”

Even the supporters of the SEC’s action acknowledge that investors who pursue these deals will be heading into areas where the danger is particularly high.

Ryan Caldbeck, president of CircleUp.com — a crowdfunding/investment firm that works with startup companies in consumer and retail businesses — noted that “this won’t have an effect at all on the tech companies; it won’t be notable in the Silicon Valley because tech companies there have so many sources of funding and the companies know where to go to get it, so the only tech companies that will take advantage of general solicitation are the ones that have been passed over by the conventional channels.

“In other areas, however, where companies have to spend a lot of time trying to find investors because there isn’t such a well-defined support group, that is where general solicitation could help companies and where investors could find real opportunities,” he added. “But this is a high-risk illiquid asset class … part of the reason is that private businesses have a high failure rates … and investors who get these general solicitations need to realize that.”

In short, individual investors are being invited to join the club, to sit at the big table. It isn’t nearly as exciting as the solicitations likely will make it sound, and like the neighborhood poker game, players who can’t recognize where the “dead money” is in the game most likely can find the biggest fish at the table simply by looking in a mirror.

In time, general solicitation with limited investor protection may not prove to be the horror show that critics are suggesting, but savvy investors — accredited or otherwise — will watch that story play out from the sidelines, rather than rushing to join a club they most likely have no business being in