May 19, 2024

Wealth Matters: An Investment Asks, How Much Can You Afford to Lose?

At the beginning of the year, wealthy investors were abuzz over a private placement investment in Facebook, the social networking site. But deals that large are not the norm. Most private offerings, or placements, are smaller — with minimum investments of $25,000 as opposed to the reported $2 million in the Facebook offering — but carry the same high risks and high fees.

“We’re starting to see more of it because more and more of our clientele are having the ability to invest in these sorts of things,” said Drew Kanaly, chairman and chief executive of Kanaly Trust, which manages $1.8 billion. “This is where they’re going to see better returns going forward, but the pros and cons are tough.”

Jeffery and Linda Knippa, who now live in Point Venture, Tex., found this out the hard way. After coming into a modest inheritance and selling their home in Houston, they made two investments in private placements, in 2005 and 2007, that totaled $80,000. They say they did so on the recommendation of their broker, Don L. Devens, a registered representative of the broker-dealer Capital Financial Services. Their goal was to keep their money safe, they said, until they returned from Colombia, where Mr. Knippa was sent to work as an oil field engineer.

Instead, they lost their $80,000. The Knippas filed an arbitration claim against Capital Financial Services in November 2009 and are waiting for a hearing.

“We knew him through the Lutheran church, so we put our trust in him,” Mrs. Knippa said.

Mr. Devens declined to comment. John Carlson, chief executive of Capital Financial Services, said he could not comment while the case was pending.

Regardless of the size of these deals, investors need to weigh many factors before getting in, including their willingness to lose the money they put in. Here is a look at the considerations:

LIKELIHOOD OF LOSS The reality is the Knippas should never have gotten into such a high-risk investment. They did not have the net worth to be what the Securities and Exchange Commission calls “accredited investors” — those with at least $1 million in net worth or a $300,000 annual salary for a couple. Nor did they understand the potential downsides.

“We had no financial experience,” Mrs. Knippa said. “That was the reason we sought out Don.”

She said her husband was now working at an oil field in Baku, Azerbaijan, to rebuild their nest egg.

While private placements represent a tiny share of all investments, the number of arbitration cases involving limited partnerships, which is how some private placements are structured, has nevertheless increased in the last few years, to 80 in 2010 from 19 in 2007, according to Financial Industry Regulatory Authority.

Andrew Abramowitz, a lawyer in Manhattan who has worked with both buyers and sellers of private placements, said every investor should approach a private placement skeptically.

“As long as the expectations are, ‘I can lose this and I may not be able to sell it,’ then nothing goes wrong,” he said. “That may not come to pass. People who are savvy about this do a bunch of them and hope one will pop.”

For those who do not understand this, the experience can be life-altering. “We miss that $80,000 every day,” Mrs. Knippa said. She said the remainder of their money was now in low-yielding certificates of deposit.

MEMBERSHIP IN THE CLUB There are many reasons the S.E.C. tries to limit private placements to accredited investors, but one of them is surely that they can afford to lose money.

Yet Andrew Stoltmann, a securities lawyer in Chicago who is representing the Knippas, said that there was not necessarily a link between wealth and financial sophistication, which would give you a fighting chance to assess one of these offerings.

“I know a lot of people who have $1 million or $2 million in net worth, but they don’t know anything about investing,” Mr. Stoltmann said. “Think about a football player who signs a $30 million N.F.L. contract: he’s an accredited investor, but he’s not sophisticated with finance.”

These placements, then, are best reserved for a small group of people.

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