Today’s topic is a specialized but important one: investing in private placements.
Private placements offer accredited investors the opportunity to circumvent the stock exchange and buy shares directly from the issuing company. Their most attractive feature is that oftentimes, you can buy shares in a private placement for 5-25% less than the quoted market price.
For those unfamiliar with private placements, that might sound impossible. Why are such opportunities available in our ostensibly efficient market?
That’s what today’s guest author, Michael Kosowan, senior investment advisor at Sprott Private Wealth, is here to explain. Below, he shares a nice primer for investing in private placements.
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And now on to Michael Kosowan’s very interesting article.
Managing Editor of The Casey Report
Private Placements: Blood Transfusions for Zombies
By Michael Kosowan, Investment Advisor, Sprott Private Wealth
Watching the junior mining sector over the past three years feels much like witnessing the slow and protracted death of a good friend. Many industry professionals are reiterating that they have never seen conditions as dire and drawn out as those just witnessed. One could even be led to believe that the sector is bereft of life, the domain of zombies. Yet despite the doom and gloom, the junior resource sector remains one of the better options for investors looking to speculate for potential 5- and 10-fold returns even as it moves through this recent ghoulish phase.
Let me be very clear, speculating in junior resource equities is not for the fainthearted. Doug Casey is often quoted as describing stocks within this sector as “the most volatile stocks on the planet.” They have also been described as very risky, like matches, able to burn in an instant.
How else could one expect to garner these types of multiples and legendary returns without a bit of risk? Remember, potential reward is commensurate with risk. The current backdrop of fear and loathing for this sector lays the very foundation for the reasons one would consider not only investing in this sector, but more to the point, investing into it via private-placement offerings.
Private placements in junior resource companies provide life-giving blood transfusions to companies that have, for all intents and purposes, been wasting away in a zombie state under current market conditions. An injection of capital not only infuses some much-needed optimism into the sector, but also spurs further developments such as exploration and consolidations.
Restricted Investments in a Dead Sector—Really?
The junior resource sector is no stranger to creating great wealth for speculators. The advent of a new mineral discovery and technical de-risking of mineral assets provides a ready vehicle for amassing wealth for investors who successfully identify the winners.
A certain small junior with operations in Serbia was trading at 60 cents in June of 2012. The company, along with its joint venture partner made a major discovery; the stock currently trades around the $6.30 range. Its investors reaped an over-10-fold return.
Another “rags to riches” story involved an oil exploration company, which was down to $1.25 in September of 2011. Major oil discoveries in the East African Rift basin pushed the share price to its current level of roughly $8 per share, returning over 600% to investors. Of course, past performance is not always indicative of future gains, but the outsized returns and high potential of the sector have long been recognized by participants within the space; but I am not merely reporting on these tales of triumph, I have personally placed clients in both of these success stories.
Essentially, the reason speculators purchase private placements in the natural-resource space is to expose their portfolios to these types of exponential returns. In private-placement vernacular, investors purchase “units,” which consist of a share and a warrant packaged together. When you consider that the private-placement speculator is provided the opportunity to double down on their potential upside, you may be wondering why this type of investment isn’t the only kind sought after in this space. There are reasons for that, which I will get to later.
In the United States, direct equity investments into public companies are commonly identified by the acronym “PIPE,” which stands for “private investments in public equities.” In Canada, they are referred to as simply PPs or private placements. These financings are typically shares offered directly from a company’s treasury. In a PIPE transaction, the shares are not offered pursuant to a publicly registered prospectus and as such are not subject to the related rigorous regulatory and administrative burdens. As a result, the company is able to raise capital more efficiently. The issuer often passes along these cost savings to investors in the form of a discounted share price, a warrant, or sometimes both.
Buying stock at a discount always derives a high sense of satisfaction for our clients, but the bigger prize may in fact be the warrant. A warrant provides the investor the right, but not the obligation, to purchase additional shares at a predetermined price for a set period of time. Typically, warrant terms are set at strike prices 35 to 50% above the offering of the unit for periods of time ranging from one to five years into the future. The issuers’ apparent “generosity” with such favorable terms is usually a very clear indicator of the scarcity of capital and their level of need.
The warrant entitles the owner to double their position (assuming a “full warrant” is included in the placement) at a marginally higher cost to the original price. This added call option on the position enables the investor to assess the share price performance and technical developments surrounding the company over an elapsed period of time. Nowhere on Earth is there a better example of “having your cake and getting to eat it too”! This is a rare privilege indeed, especially when we reflect back to the high returns some investors have experienced in this sector.
The Hidden Benefits of Warrants and the Reptilian Brain
Selling presents a challenge for investors, especially when capital is flowing and stock prices are rising. It is a disciplined investor who can rationally participate in an investment that is galloping forward. An often overlooked benefit of the warrant is the fact that it enables rationality in an otherwise volatile space, which could mean the difference between winning and losing. The warrant position enables you to dial down your reptilian brain and control your fear and greed response when market conditions are chaotic and objectivity is in short supply. Note that these warrants run the risk of expiring worthless if the share price does not breach the exercise price.
Psychologically, the warrant position buys you the space and time for a calculated thought process. If the numbers make sense, an investor can take a gain early by selling shares while knowing they can buy back their position at a fixed price, if they desire, by exercising the warrants.
Another hidden benefit of the private placement offering is the financiers’ access to the company’s management team. Financiers at Sprott who engage in private placements regularly monitor and evaluate those companies on behalf of their clients. It is our role to keep close tabs on the company and evaluate whether they continue to be good stewards of the capital entrusted to them. It is generally in the best interest of the company to be honest and forthcoming with regards to their progress and developments in discussions with investors. This is because the most readily supplied source of capital for future financings is usually current shareholders.
Tiptoeing Through the Graveyard
Private placement investing is not without its risks and encumbrances. The most obvious risk involves selecting the wrong company. It is prudent to think of private placements as yet another form of investment, alongside purchasing shares in the open market. Speculators should always be aware of the inherent risks in exploration. So investors in private placements should plan to build a portfolio of different private placements for diversification, which spreads the exposure around several companies. Owning several quality companies with long-dated warrants will offer some degree of protection from the volatility of individual stocks in this space.
Other considerations for private placements are that they are typically set to a minimum of US$10,000 per position and limited to accredited investors. Additionally, your stock position from most private placements is restricted from trading after the close of the financing for four months in Canada, and six to twelve months in the US.
Due to the poor performance of natural-resource investments in the last three years, the perception of risk is running at all-time highs. This fear has lowered valuations on mineral exploration companies to record lows. Value investing will always require a macabre sense of tiptoeing through the graveyard of casualties, picking out the bodies that appear to have life left in them and leaving the corpses behind.
The Key to Private Placements, a Skilled Grim Reaper
As we mentioned earlier, you should not invest solely in private placements, despite their tantalizing return on investment. The availability of finding a suitable private placement is most often tied directly to current market conditions. Additionally, an investor would be well advised to seek the advice of a financial advisor who is highly attuned to this sector, someone with their finger on the pulse of this industry.
It is not enough to simply make connections in the industry to the companies that require financing, but to discern those prospects that are most likely to succeed. Look for an advisor who is experienced in financing requirements and is constantly scanning the pickings, waiting and watching, able to recognize an opportunity when one presents itself, and then seize it. Selectivity is key; in both your financial advisor and in the placement itself.
With this in mind, it is crucial that you have a thorough understanding of the company you own. Investors must keep a close eye on the fundamental milestones needed to achieve outsized returns and adjust their expectations to performance accordingly.
Come Armed with Courage…
At times such as these, when capital is scarce, competition low and aversion to risk is high, financiers are able to elicit the most favorable terms for investors. Current market uncertainty and trepidation—together with distrust of the junior resource sector—have come together to produce a grim but exceptional set of circumstances for capital investment. Now is not the time to be squeamish.
Michael Kosowan is a specialist in the junior resource market and a senior investment advisor with Sprott Private Wealth. If you have questions related to private placements, PIPEs, or other investments, feel free to contact him at [email protected], or call 1-855-943-4383.