Potential Traps in High-Finance Investing - dummies

By Consumer Dummies

Private investment partnerships aren’t for everyone. Even some of the people who have the money to invest in them prefer to put their money into investments with fewer restrictions. They want to know all about the investments in a fund and want to have the right to sell when they want to sell. Not all private partnerships tell these investors all they want to know.

In some cases, the fund managers just like the aura of mystery, but in most cases, these restrictions have practical reasons. These funds don’t buy and hold registered securities the way that a mutual fund does. Instead, they often buy shares in operating businesses or pursue unusual trading strategies. They can’t sell their investments easily, and they don’t want to share details of trades that could be copied by others.

These issues aren’t necessarily bad ones, unless they surprise you. Forewarned is forearmed, and what follows are some of the common drawbacks to private investment partnerships, especially those that invest in emerging markets.

Transparency issues

Investors in private partnerships should do plenty of due diligence before writing the check. Find out who the fund managers are, what experience they have, what banks and brokerage firms handle the money, and who will be providing legal and accounting advice. Also, get information on the investment strategy.

As a limited partner, you won’t be able to call the shots in the fund, and you won’t get a call every time the fund makes a trade. However, you should know what the fund is planning to invest in. Is the fund looking at providing venture capital to late-stage technology companies in all markets, emerging and developed? Does it invest in emerging market government bonds, including private placements on NGO-backed infrastructure projects? Does it trade currencies and interest-rate futures? You need this type of information before you invest in order to assess whether the fund is appropriate for you, and you need it afterward to evaluate the fund’s performance.

For example, many investors in Long-Term Capital Management, a now-closed hedge fund, were surprised to discover that the firm had huge exposure to the Russian bond market. When Russia defaulted in 1998, Long-Term Capital Management’s investments fell in value and the firm failed. No fraud was involved.

Private doesn’t mean top secret. If you’re going to invest in one of these funds, for yourself or on behalf of an organization that you’re involved with, be sure that you understand what the fund invests in and how it makes decisions. Bernard Madoff said he ran a hedge fund, but he was actually operating the largest pyramid scheme in history. When clients asked him about his investment style, he said that it was none of their business. He had something to hide.

In addition to knowing about a fund’s investment strategy, you need to know how often you’ll receive performance reports, what those reports include, and how often audits are done. The fund manager may not want to disclose actual investment positions; are you okay with that? In any event, you want information on the fund’s assets and liabilities, how its assets are allocated to different types of investments, and what its income and capital gains are.

Limits on liquidity

Liquidity refers to the ease of buying or selling an investment, and it’s a concern for private partnerships in two ways — the way it affects the fund itself and the way it affects the fund’s investors.

Liquidity and the fund

Many emerging markets don’t have enough securities or enough trading volume to make complex strategies work. (That’s one reason that many hedge funds use currency to invest in emerging markets; they can trade currency in big volume over a short time period.) If it’s hard to buy and sell the types of investments that the fund hopes to invest in, the fund may have trouble making a return for investors. After the fund makes an investment, it may not be able to sell it any time soon.

Venture capital and private equity funds usually can’t sell their investments until the company holds an initial public offering or is sold to someone else. It’s not unusual for these investments to be in place for five or even ten years.

Liquidity and the fund investor

Because private partnerships often have their funds locked away in different investments, they don’t always have the cash on hand to return to their investors. After you’re invested in a fund, you may not be able to get out for years. These funds are designed for the long run, so be sure that you understand how the fund’s general partners define that time frame before you invest. Some funds limit your withdrawals during the first year or so, a period known as a lock-up; after that, the fund may let you withdraw money once a quarter or once a year as long as you give advance notice. Some venture funds don’t return investments and profits until they’ve been able to exit all the fund’s investments.

Sometimes, a private partnership can’t find suitable investments for the money that investors put in, so it returns funds. You get your cash, but you have to go out and find another place to invest it.

Governance in a limited partnership structure

For tax reasons, investment partnerships are often based in an offshore financial center, so they may be governed mostly by the laws of the country of incorporation. They may also be governed by the laws of the country where the partnership is sold. For example, a fund marketed in the United States to U.S. investors has to comply with certain laws about disclosure and marketing, the most important being that the fund can be marketed only to accredited investors. If the fund is sold to investors in other countries, those laws may or may not apply.

Many larger funds are set up with a master-feeder structure. The main fund is based in an offshore financial center, and it operates a handful of feeder funds for investors in other countries. U.S. investors invest in the U.S. feeder, European investors invest in the EU feeder, and so on. This prevents problems with contradicting laws and ensures that each group of investors gets what it needs to be compliant with the laws of the group’s own country.

A fund may also be subject to the laws of the countries where it does its investing. For example, if a hedge fund operates a trading desk in Dublin, it has to comply with EU securities laws. If a venture capital firm finds solar-power start-ups in Kenya, it needs to comply with Kenyan laws to ensure that the investments are valid.