Offering access to direct investments provides advisors with an opportunity to expand their service offerings to high net worth and entrepreneurial clients. But some experienced practitioners warn that the asset class is not always worth the risk.

Direct investments are gaining popularity among advisors with high net worth practices. A 2017 Cerulli study found two-thirds of advisors in that market expect their practices to increase allocations in direct and co-investment spaces. Such increasing interest may stem from family offices moving away from traditional private equity investments, says the research shop, with the study highlighting a combination of recent poor PE performance and increasingly high fees as driving the trend towards direct investing.

In this climate, direct investments have caught the attention of young, entrepreneurial clients who want more involvement in managing their family’s wealth, the study notes. And advisors are positioning themselves to capitalize on the increased interest.

Among the wealth manager entries to the space is $800 million AUM RIA Third Seven Advisors, which claims to specialize in placing direct investments as part of a core-satellite approach for HNW client portfolios.

And from the advisor’s perspective, it’s natural that retail and HNW financial advisors would chose direct investments over private equity funds to capture higher return expectations, says Mark Mirsberger, CEO of $7.1 billion AUA Dana Investment Advisors. For many FAs, he says low fixed income returns and yields may have forced them to seek more alternatives for income generation: “In simple terms, the upside is a higher return expectation.”

The asset class can also give investors greater influence over a portfolio company than would be possible with a publicly traded entity. Many entrepreneurial clients (conditioned to tightly control their own businesses) like to feel they are keeping their hand in the game when it comes to their investment portfolio, Adrian Cronje, CEO and CIO of $3 billion AUM Balentine says. And by investing in non-publicly-traded companies clients can exert greater influence over the business’s management.

Direct investments also often have low correlation to other assets in a client’s portfolio – especially equities – says Mirsberger. Smaller companies often do not trade on an exchange and thereby provide value by being unaffected by the daily moves of the stock market, he says.

Yet the ability to exert more control might be as much a negative as a positive. Among the risks posed by direct investing is the chance clients are entering investments for the wrong reason, says Cronje. Instead of treating the asset as one part of a diversified portfolio, clients may be interested in the space for its comparative “sex appeal” relative to other asset classes, according to Cronje.

Clients and FAs must avoid these illusions and be wary of the rate of failure associated with the asset class. Direct investments should be seen as a high risk portion of an otherwise balanced portfolio, many financial planners believe.

Arguably more than any other asset classes in which the average FA deals, due diligence in direct investments is crucially important; if an FA makes 10 direct investments into new companies with a client, you are doing well if three or four perform very well and five or six don’t make any money, Cronje says.

Ensuring you’re accessing the strongest companies for investment opportunities can be a definitive challenge, Mirsberger says. Due diligence in this space is difficult for FAs because information about privately-held companies isn’t as widely available as that for listed companies. Such a dearth of information can lead to investors having a poor understanding of what they are buying, he says. And even after understanding what's being bought, he says it can be difficult to obtain and understand the asset’s diversification relative to the portfolio.

Yet strong investment selection can help combat these problems, sources say.

For Third Seven Advisors, CEO Amit Dogra says due diligence on direct investment opportunities is a multi-step process.

The evaluation begins with candidate companies submitting to the firm’s investment committee and having a committee sponsor give a presentation on the investment’s merits. After presentations are complete, opportunities are evaluated. Opportunities can be:

  • Rejected outright
  • Required to subject to further due diligence before being accepted as a possible opportunity for clients
  • Accepted as a possible opportunity.

Most are rejected. Even those that are accepted might not ever be introduced to clients.

If an opportunity advances, it is assigned a lead investment banker from within the firm. That banker then meets with the business’s management to hash out what capital and resources the business needs, the type of relationship the company is seeking, and if the opportunity matches Third Seven Capital’s goals. Only after contract negotiations are complete is a new business introduced to Third Seven clients for direct investment.

But even finding good opportunities is difficult. Deal flow is a critical issue for financial advisors attempting to find gems for their clients. FAs screening direct investments should keep in mind the top startup companies often already have more than enough access to capital and are driven to find investors by what investors can add to a deal beyond capital, Cronje says. Rarely is that need filled by the individual clients of a financial advisor.

In the current business environment there is no shortage of capital for direct investment, Cronje says. Whether it be from private investors, investment banks, or venture capital firms, competition in the world of direct investment is stiff. And in such a competitive environment, it’s very hard for FAs to find good deals, so retail financial advisors can only find a small handful of deals, he says.


Third Seven Capital Projects

Here are four of Third Seven Capital's current and previous projects.

HFactor water aims to offer hydrogen infused water.Through chemical and magnesium-free processes HFactor seeks to infuse hydrogen into water, offering anti-inflammatory and anti-oxidant benefits. Sources: Third Seven Capital, HFactor

OVEND seeks to conveniently provide customers with hot pizza using a network of vending machines and an exclusive deal to distribute an Italian technology in North America. Sources: Third Seven Capital

NuCalm is a stress intervention system seeking to interrupt the stress response in the midbrain. By doing so it claims to transition uses from acute stress and alarm to relaxation within minutes. Sources: Third Seven Capital, NuCalm

Boat manufacturing company Hunton, builds power boats focusing on performance and luxury. Sources: Third Seven Capital, Hunton


Adding to the difficulty of direct investing are associated regulatory concerns. Regulatory authorities – particularly the SEC – are very strict about how firms can make available and allocate direct deals to clients, Cronje says. And among the SEC rules are guidelines on who can purchase securities as an accredited investor. Whether or not someone is considered an accredited investor depends on factors such as net worth, income, and investment experience.

As a result, Cronje says direct deals are often more burdensome than making public market equities available to clients. Despite his being at the coalface of direct investing, Cronje says from an RIA’s perspective it is a playing field fraught with business risk and difficult to navigate.

And, quite simply, FAs also must consider that direct investments are not appropriate for every client. In place of direct investments clients can also use other illiquid alternative assets, Mirsberger says. Because of the strong options available in other alternative asset classes, investors should not look to solely rely on direct investments, Cronje says, citing private equity funds and fund of funds as often better alternatives.

Ultimately, for direct investments to deliver their promised returns usually requires clients budget two to three times their initial commitment, Cronje says. Clients who want to capture the returns of successful investments must follow the investments through multiple rounds of funding, he says. And budgeting in advance to participate in those rounds is essential.

Despite the challenges, sources say direct investments do offer strong opportunities for advisors and clients – if used correctly. But it’s up to each advisor to determine if such opportunities are something their clients want, or even need.