Tweeduciary Duty

Eight tough questions to ask the private banker who wants to stick your money in a social-media investment vehicle.

When news of the Facebook-Goldman financing broke, many individual investors around the world no doubt were struck by this initial thought: I wish I were wealthy enough and connected enough to be invited into this deal.

Deal envy like this will only proliferate as each successive world-beating social media company privately raises untold millions on the way to a (hoped for) public listing. Demand for access to these deals is spurring the creation of investment products promising access. As such, it feels like we are witnessing an unfolding history that, if not repeats, at the least rhymes with, the original dotcom bubble.

Without question Twitter, Groupon, Zynga and Facebook are amazing businesses that have revolutionized their respective industries and even changed the way people live. But their recent financings feature two characteristics that when mixed should cause concern – to wit, dizzying valuations and retail investors, albeit wealthy ones.

It is not a normal state of affairs when large syndications of high net worth individuals and mutual funds are involved in later stage venture financings. It’s not alarming, necessarily, but it should be said that the last time this trend was seen on a large scale was during the last-days-of-Caligula 1999 internet market peak, when a number of closed-end mutual funds began putting investors in pre-IPO financings. You may also remember the ads run on CNBC at the time from private client services offering access to private financings. Remember the one with the guy standing outside the fancy restaurant, longingly looking in through the window?

Granted, this market is different from that market, as participants in both can attest. Groupon is no Boo.com. We haven’t even had a shock-and-awe IPO moment yet – Facebook is expected to go public next year. And clearly the market for private securities has evolved to the extent that investing in shares of relatively large, sought-after private companies like Facebook is not the same as investing in dinky, illiquid startups, and so perhaps the presence of so many individual investors at this stage represents a step forward for financial services. It could be that HNW vehicles become fleet-footed providers of big capital to the next wave of disruptive technologies.

And yet one wonders what many of the investors who clamor for access to high-profile social media financings think they are getting involved in, and what their advisors have advised them strenuously enough about abnormal it is for them to even be involved at this stage.

The Facebook financing now looks like it was just the start of a coming wave of many more social-media companies – many of which you’ll have never heard of – stepping up for big rounds of financing. The more typical later-stage participants are venture capital and private equity firms, but clearly these guys aren’t agreeing to the incredible valuations. Goldman Sachs’ private equity arm reportedly passed on the Facebook opportunity, for example. The deal terms are meeting less resistance from retail channels. There appears to be no end of demand from the high-net-worth, private banking world for these deals. JP Morgan, historically a prodigious provider of “feeder funds” to private equity, is reportedly creating a vehicle specifically to channel private-client capital into pre-IPO social media financings. This can’t be the only one in the works.

Once the first social media company goes public with great fanfare, this trend will only accelerate. The prestige of having been given early access to a Facebook or Twitter listing will gain a nearly fungible currency.

I realize it is boring and pedantic to poo-poo exuberance that has only just begun to show signs of irrationality. It is very likely that this first wave of pre-IPO investors in social media will make a killing. And yet, if you do find yourself in the privileged position of being invited into such a deal, here are a few questions you might consider asking, if only for sport:

“If I told you that the only reasons I was going to invest in this deal were to enjoy the giddy feeling of being part of history and to brag about it at my golf club, would you still take my money?”

While not advisable, it remains your right to invest based on emotion rather than fact. The thrill of telling your friends, “I’m in Facebook!” may have a social value that exceeds the overpayment for the underlying securities. However, investment advisors are supposed to sell securities based on appropriate risk/return preferences, not butterflies in the stomach. The clients who want to put money in a pre-IPO vehicle should be fully aware that there may not be an IPO, or that the post-IPO value may end up being much lower than expected. Without those risks fully acknowledged, marketing these deals based on normal standards of investment analysis becomes a kabuki dance.

“Without an IPO at an even higher valuation, does this investment make sense?”

The greater-fool theory of investment works wonderfully if there is in fact a fool greater than you to sell to. But if the momentum toward an IPO sputters, you as the investor in the last round of financing may end up owning private shares in an uber-hip, high-profile and quickly growing company that nevertheless may not match what you paid for it until sometime around 2017, if ever. If the logic behind an investment rests to heavily on IPO market activity, you should at least acknowledge this before signing on.

“How do the fees in this deal compare to fees for other products?”

Beware of premium fees being charged for hyped-up, premium access. A well-documented trait of financial service providers is that as a party heats up, most can’t control an instinct to charge a higher door fee. At the height of the venture capital boom in the late 1990s, for example, many fund managers moved up to a 30 percent carried interest rate (from the standard 20 percent). Granted, if the underlying investments end generating awesome returns, the fees won’t be noticed. But think of premium fees as an indicator of froth, and therefore a warning sign of rough waters ahead.

“Why have you come to me now with this unique social-media vehicle but haven’t previously offered to put me directly in other kinds of private companies?”

Private banks and similar institutions often make available to clients an array of so-called alternative investments, but these tend to be indirect vehicles that bundle clients into blind-pool funds managed by general partners. Feeder funds, for example, typically co-mingle HNW client money and become a single limited partner to a private equity fund. It is then the job of the GP to source, vet and grow a series of private investments.

This is very different from a vehicle that offers to place client money directly in certain kinds of companies and at a certain stage of life (pre-IPO). In these cases, questions about investment selection should arise – in the rush to provide “access,” is the investment manager rigorously screening the deals? Or will the vehicle merely be taking every opportunity it can get its hands on?

Finally, where are all the private-client oriented vehicles looking for pre-IPO financings of, say, health care companies? Well, the answer is that a large, sophisticated cluster of professional investors already exist to back worthy health care companies at that stage of life, and therefore billions in bundled HNW dollars are not needed. So then, why is all this private-client capital suddenly so important for big social media financings?

“How would this investment fit into my overall portfolio?”

There’s investing, and then there’s doing deals. The former is based on a pre-agreed framework, and the latter is often based on spontaneous and anecdotal factors. Many investors will have allocations for high-risk venture deals and one-off private capital opportunities. And yet it’s hard to know how to characterize an opportunity like Facebook, the high valuation of which has thrown its risk/return profile so out of whack that it bears little resemblance to other later-stage venture deals. Where is its logical spot in a portfolio?

“Are you putting your own money into this thing?”

An advisor who is investing personal capital alongside you on equal footing, and in an amount that if lost would be painful, can be considered a partner. Short of that, he or she is a broker.

“Where do I stand if there’s another round of financing?”

It is not necessarily the case that the company’s next step is a gangbuster IPO. It could be that another round of financing dilutes your stake. And it could be that the next round is at a lower valuation, which would hurt even more. It is important to understand what share class you are buying and what your options will be in the event that things go pear-shaped after you become an investor.

“Is anyone taking money off the table with this investment?”

Rounds of financing leading up to an IPO are supposed to provide capital for the further growth and grooming of the company, not so that its founders can become multi-millionaires ahead of a listing. Somewhat more acceptable is the desire on the parts of the earliest backers to partly cash out of their positions and lock in some gains on behalf of their own investors. But you’ll want to know exactly what level of cashing-out is taking place. You do not want to be the provider of an exit to group of people who know the market much better than you do. That would make you the greater fool.