Debt or Equity? A Private Investing Primer

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Investors fleeing Wall Street for less turbulent waters are discovering the world of private investing.

And with the loosening of securities advertising rules and the increasingly growing use of the Internet and social media by entrepreneurs to raise capital, investors are discovering alternative private investing options in greater numbers and variety like never before. This has been especially true in the realm of real estate where investors have not only their pick of asset class and geographic concentrations but also the type of instrument in which to invest – debt or equity.

Traditionally, choosing between debt and equity has been a matter of risk-return preference.

Equity has historically been viewed as riskier than debt because equity holders are last in line if the business fails. In return for taking on the higher risk, equity holders are granted ownership in the venture, allowing them to benefit from profits and appreciation, which in the long-run can provide higher returns than from debt.

Debt holders, on the other hand, give up ownership rights to receive a fixed income. Debt holders have priority over equity to any company assets when a business goes south but do not benefit from profit sharing or appreciation if the business takes off.

Historically, it’s been an “either-or” proposition when choosing between debt and equity.

Those with low-risk tolerance opt for debt, and those with high-risk tolerance opt for equity. Those who want low-risk with a fixed return while foregoing ownership and appreciation opt for debt instruments and those preferring to roll the dice on the success of the business by taking on higher risk in return for the promise of future growth opt for equity.

With modern private investing, the choice between debt vs. equity is not as simple as choosing between security and appreciation.

Now, with the rise of hybrid offerings, the lines between debt and equity can be blurred. For example, equity offerings with preferred returns provide the fixed distribution benefits of debt while maintaining the profit-sharing appreciation advantages. On the flip side, hybrid debt offerings with a profit kicker can provide the security of debt, with the profit-sharing of equity.

Creative hybrid securities instruments are attempting to bridge the gap between debt and equity by providing a fixed return with profit participation.

Debt and equity will always be different fundamentally at their core. Debt will always have priority in a liquidation, and equity will always represent an ownership interest. However, with the rise of hybrid instruments, it’s possible to have the best of both worlds.

You’re wondering how equity can possibly provide the security of debt. And the answer comes down to the sponsors. After all, the supposed security debt provides is worthless if the sponsors promoting it are incompetent. Moreover, an overleveraged company burdened by debt and interest obligations may never have the cushion or find its footing to grow if it continually needs to allocate cash to meet its obligations as opposed to growing operations. In other words, debt in the wrong sponsor hands can spell doom for receiving a return on investment or, in a worst-case scenario, even a return of principal.

On the other hand, a preferred equity investment in a fund with trusted sponsors and management with a track record of success would provide more security than a startup offering debt.

With the right company and in the right management hands, it’s possible to enjoy the periodic and consistent income debt provides along with the profit and appreciation participation of equity.

Not all debt offerings are sure things, and not all equity offerings are high risk. Those opting for debt need to make sure they are dealing with reputable sponsors with a documented track record of success and also of paying their debts on time. Sponsors with deep pockets can provide a level of assurance that they will not default on their debt obligations. Equity investments with reputable sponsors offering fixed preferred returns can often provide the type of security debt offers along with profit splits and appreciation.

There’s no right answer for choosing between debt and equity. More vital to the success of an investment than the terms of the offering are the sponsors, their track record, strategies, asset class, and infrastructure. With a reputable sponsor invested in a reliable, recession-proof asset class, you can be confident that your financial goals will align with the fund’s objectives, no matter whether you invest in debt or equity.

With an unreliable sponsor, the debt vs. equity question is irrelevant…you risk losing everything either way. So partner with a reputable sponsor and enjoy both income and growth.