Key takeaways

  1. Be highly skeptical of private investments promising high returns with low or no risk, as this is a common red flag for unrealistic projections or potential scams.
  2. Unlike public stocks, private investments lack SEC oversight and detailed disclosure requirements, placing the full burden of due diligence on the individual investor.
  3. Always investigate the people and the business model behind a private deal; if the promoters cannot clearly explain how they and you will profit, it's a sign to walk away.
  4. When approached with a private investment opportunity, your default answer should be "no" unless you can rigorously verify every detail and feel completely confident in the deal's legitimacy.

The world of private investing can be challenging. There are some good investment opportunities out there, but there are also a lot of overly optimistic claims, false promises, and even outright scams. We happened to uncover an alleged scam when a Facet member asked us if they should invest in a certain private investment opportunity. For this article, I’m going to walk through how I approach analyzing private investment deals, and in the process show how we became suspicious that this particular “opportunity” wasn’t everything it claimed to be. Because there is an active criminal proceeding for the company involved, we won’t be using specific names, but the details we do mention are all real.

Too good to be true?

You should expect a private investment to offer attractive returns relative to public markets. After all, most private investments require you to lock your money up for long periods of time. You should get paid some extra return for being unable to liquidate the investment. Moreover, you are generally taking a greater risk of large losses on private investments. You also should get some extra return for taking that risk.

That being said, with any investment you should be asking yourself if the return projections are too good to be true. This is usually the most obvious sign that something isn’t right about an investment opportunity. In the case of the alleged scam I mentioned above, the investment claimed to have a 24% annual return on a 10-year investment.

That alone isn’t an automatic red flag. There are certainly some high risk/high reward investments one can make big returns if everything works right. However in this case, the company claimed the investment carried with it an insurance policy that would guarantee no principal losses.

Right away, that’s extremely suspicious. The return should be commensurate with the risk being taken. The idea that there’s an investment that could make such a large return with no downside risk just doesn’t make sense. In this case, it was the first clue that something was really wrong with this investment.

However, bear in mind that sometimes legitimate investments can still be marketed with overly optimistic assumptions. I have many times seen real estate investments that assume 100% occupancy 100% of the time, which never happens. Or perhaps rosy projections about rent increases. You should be able to get enough specific information from the company to ascertain how realistic these assumptions are. You should also try to project returns given less optimistic assumptions. A lot of times you find the return is only attractive if everything goes right. Don’t bet on perfection!

As I said, as soon as we saw the 24% return with no downside risk, we were sure this wasn’t a legitimate investment. However, the member had additional questions, and so we dug a little deeper. We asked the company for the legal docs related to the investment.

In private investing, you’re on your own.

There is a significant difference in legal and regulatory protections between public and private markets. Publicly traded investments, like stocks and bonds, are rigorously regulated by the Securities and Exchange Commission (SEC), which mandates extensive and standardized disclosures of financial performance, operational details, and potential risks. 

In contrast, private investments are largely exempt from these stringent registration and disclosure requirements, meaning investors often receive less transparent information and have fewer formal avenues for recourse if a deal goes sour. This places a much higher burden on the individual to conduct their own thorough due diligence, as the built-in protections of the public markets are simply not present.

The presumption is that you invest, you also represent that you are sophisticated enough to understand all the legal and financial documents you receive, that you also understand the risks involved, and that you can afford to take significant losses should they occur. 

In my career, I’ve reviewed hundreds of prospectuses, offering memorandums, term sheets, shareholder agreements, etc. for non-public investments. While all deals have certain nuances, there are a few standard things you expect to see in these legal documents. If there are a lot of unusual provisions or if the terms aren’t as comprehensive as they should be, that’s a huge red flag. At best, it indicates that the company hasn’t bothered to hire serious lawyers, showing some questionable judgement. At worst, it could indicate they are hiding something.

In the case of our alleged scam, the legal documents were clearly lacking. The company had sent two documents which were a total of three pages of text. Given how this transaction was structured, as a loan to the company with insurance backing, the legal provisions should have been quite complicated. I was expecting a relatively lengthy set of legal documents. Moreover, the documents looked more like marketing documents than legal agreements.

At this point, I was becoming increasingly concerned, and really wanted to convince our member to not do this deal. So we decided to treat this like we were going to do full due diligence on this investment. My next step would be trying to understand how the purported investment was going to work.

Who is paying who?

In any investment, you need to understand how your money will be used and how you can expect to be paid a return. 

Here’s an example. Say the investment is common stock, i.e., an ownership share in a company. The company should be outlining why they need the money. Maybe that company is trying to grow rapidly and will be using your money to scale up their production. From there, how will you make your return? You could make a reasonable projection about the value of the company if the expanded production allowed for more sales. 

In our case, the investment was a loan to the company. You should go through the same process: what are they doing with the money? The firm said they were using the loan to buy gold from small mines overseas who were unable to transport the gold to major markets. How am I going to get paid back? Supposedly the company was able to buy the gold at such a discounted price that they could transport it to some larger market, and then sell it at full price there.

In theory such a thing could be true, but when it comes to a loan you have to take it a step further. In this case, the company was paying investors 24%. The only way it makes sense for the company to be willing to borrow money at 24% is if they think they can make even more than 24% when they invest your money. So they are buying the gold, paying all the costs of transporting it, paying investors their 24% and still have money left over? Plus as I said above, they claimed they were also buying an insurance policy to protect investors from downside risk. That insurance policy isn’t free. 

Before making any investment, you should be able to put all the relevant numbers in a spreadsheet and figure out how both you and the company will be profiting from your investment. In this case, the company should be willing to give me enough information about how big the gold discount was, how much the insurance policies cost, how costly transportation is, etc. If you can’t get all that detail, that’s another big red flag. Don’t let someone tell you that the information is proprietary or a trade secret or the like. If they want your money, you should get all the information you need.

Since none of this was in their offering documents, I decided I would call the company myself. I wound up talking to the CEO. It really went downhill from there.

Are you investing with the right people?

Ultimately when you make an investment like this, you are handing your money over to someone else, usually unable to withdraw it for many years. There’s a lot of faith and trust required to do such a thing. In an extreme case, it could turn out to be a fraud, which allegedly was the case in our story. But it could also turn out that you’ve invested with people who didn’t have the right experience, expertise, connections, infrastructure, etc., to actually accomplish whatever it is they said they were going to do with your money.

I wouldn’t invest in a private investment without talking directly to the people involved as well as researching their background. Think of it like you are conducting a job interview. Would you hire this person to do this job? Or do you think there’s someone better out there? Ask about other similar projects they have done. Ask about what has gone wrong and what they learned. Make sure you get every question answered to your satisfaction. When you ask about details of the project, do they seem to know it well, or are they fumbling with the numbers?

When I spoke with this CEO, I asked about the insurance. He said they paid the insurance company 4% up front to get an “annuity” that covered the payments owed to investors. I happen to know a lot about the annuity business and that rate seemed absurdly low to me. I then asked about the gold. He said they were buying the gold at a 12-14% discount. I asked how he was making money if he made a 14% markup on the gold plus paid insurance 4%, then paid investors 24%. He said he wanted to “make a splash” by offering an above-market return to help grow his business. Note that the company didn’t collect any fees on the investment. So based on what he was saying, the company was taking huge losses in order to attract new investors.

That kind of logic might make sense in another context. New businesses often are willing to take losses if it helps them grow for the long-term. But in the investment world this doesn’t make much sense at all. 

Are you being sold?

The world of private investing is huge, with some $14 trillion dollars invested. Between hedge funds, billionaire family offices, financial advisors, pension funds, etc., there is no shortage of money looking for attractive returns. If you had an investment idea that could make a steady 10%, and you could convince these sophisticated investors that it was real, you wouldn’t have any trouble getting all the investment dollars you want.

The problem is those kinds of investors will put you through the wringer. They will demand detailed financials. They’ll pour over the legal documents. They will insist on several meetings with the team managing the investment. I know because this is exactly what we did before selecting any of the managers we use in our Alternative Income strategy. 

The reward for surviving this gauntlet is that professional investors can allocate large sums of money. So I’d argue that if an investment can survive this scrutiny they would. If they are trying to sell their investment idea to smaller individual investors, it is a sign that the pros were not interested.

In this case, the company was selling their 24% investment idea to individual investors with a $50,000 minimum investment. Why? Probably because they knew that more sophisticated investors would see through all of the holes in the story that I’m mentioning above. 

Whether the investment idea is actually a scam or not, I don’t want to bet my money on investments that professional investors wouldn’t touch.

The default answer should be “no”

If I could give only one piece of advice about private investments, it is that your default should be to say “no” to everything you see. Your analysis needs to prove that you should invest. If you can’t get every question answered, if you can’t get every piece of data, etc., then pass. Don’t be enticed by a big potential return. 

To take this a step further, if you feel you don’t know the right questions to ask or the right way to analyze the investment opportunity, then don’t invest. You don’t need to make these kinds of investments in order to meet your financial goals. Consider more diversified alternatives, like Facet’s alternatives strategy I mentioned above. Or just stick with traditional stocks and bonds. 

Ultimately, it is much better to pass on a good deal than to accidentally make a bad deal and suffer big losses. And remember, it doesn’t have to be a scam to be a bad investment.