Thursday 1 September 2016 7:00 am

No free lunch: The alternative investment lifestyle explained

“Alternative investing is a chance to take a bit of a gamble with the spare change you have left over at the end of the month”.

“It’s an easy way to invest a little in a business at the start and see massive returns when it floats five years later with no effort required”.

“It’s basically like being on Dragon’s Den, but without having to drill down into the minutiae”.

These are all statements I have heard in the last six months and, if you agree with any of them, serious alternative investments are probably not for you.

Alternative investments – and in this case private, “growth” companies – have significant upside potential (as well as pitfalls) and should only be considered as part of a diversified portfolio when approached with the same rigour as other investments.

Treat it like any other investment

In the same way you would expect your bank or stockbroker to report back on listed shares and fund performance, you need to ensure that you are able to monitor your investments in private businesses as well.

Even if you undertook significant due diligence initially, shifts in markets, consumer behaviour or black swan events can all impact a company. You will naturally want to analyse trading updates and news on a regular basis, to understand whether the business is performing as projected or isn’t achieving its targets.

Read more: How P2P is seducing the financial adviser

As such, it is important to secure ongoing access to company information, such as quarterly figures and future revenue projections, when investing. Unfortunately, such information isn’t always readily available to private investors who have a relatively small shareholding (even though it may be a significant sum for them). You should always make sure you understand your shareholder rights when making the original investment.

You could also look to invest via a structure that allows you to contribute alongside others to part of a much larger sum of money invested as one entity, such as a nominee structure, which will give the investor more leverage when negotiating shareholder rights and protections.

Probably not just a one-off

The reality of investing in a small company is that it will most likely require additional capital further down the line to scale up its operations. If the company is doing well and you want to avoid dilution, be prepared to invest in future funding rounds to ensure that the business you have backed is able to grow at its potential and achieve its goals.

Ongoing investment support from existing shareholders is incredibly important for small businesses. Not only does it mean that management can fully execute its business plan, but it also gives new investors looking at the opportunity further confidence that the business is worth backing.

Furthermore, as a new investor, identifying who is investing in the business, or continues to back the business, is important. For example, institutional investors, such as venture capital firms, will have undertaken significant due diligence and will most likely continue funding the company through its growth to achieve optimal returns.

Only invest what you can afford to lose

Even if you have done all your due diligence and kept following your money, sometimes businesses will fail. It’s important to try to minimise the risk by having a diverse investment portfolio – both in terms of the kinds of businesses and also through the types of investments you make – to ensure it includes traditional investments, such as listed shares, as well as other assets.

There is currently no true secondary market for alternative investments and it is unlikely there will be one any time soon, so it’s also important to understand the illiquid nature of this investment model.

While high risk, however, investing in growth businesses can offer high returns upon exit. More and more sophisticated investors with the means to do so are investing in these private companies on the understanding that, by putting in the leg work up-front and spreading your risk, you could see some hefty rewards.