the investor's paradigm

Today, the situation private individuals in search for direct SME investments are facing, reminds me a lot of my visit to Havana in the early Nineties. Grocery store shelves were mostly empty, and Cubans needed to show a special permit in order to gain entrance to exclusive stores that used to cater for the needs of the Cuban elite, diplomats and foreigners.

Even in the world of Private Equity, it takes a special permit to enter its exclusive stores. If you happen to be a wealthy individual, someone private bankers consider to be a “high or ultra high net worth individual”, you can declare yourself as a "qualified"or "accredited investor". Among other requirements, a high net worth and salary are the paramount preconditions for any membership in business angel networks or exchanges. In Switzerland, in order to qualify as angel, individuals need to declare an individual net worth of >$1m (can be joint with spouse) and an annual income of >$200k (or >$300k if joint with spouse). In addition, the invested sum per individual investment has to be $100k at the minimum. Once accepted as a member, you can directly tap into a flow of investment opportunities: many angel networks and exchanges have excellent connections with local university incubators and maintain close ties with its international sister organisations. 2006 figures indicate 290 individuals organized in Swiss business angel networks.

Qualified business angel or not, the majority of direct investments on the part of private individuals originates from family, friends or personal business contacts. This is what Cubans call the "economía sumergida" - it works, but not very efficiently. Far from being a reliable source of deal flow, this situation clearly indicates a lack of liquidity and transparency in this market. Consider yourself lucky, if you’re among those who were personally approached with a high-quality SME investment opportunity that meets your needs.

Elite aside, like most Cubans, ordinary investors like myself can’t help the feeling that what’s on offer for ordinary people is not only limited but also just not exactly what we are looking for. Let’s look at the few SME products that made it onto the shelves.

If you don’t care whether to lend debt or invest equity, you could use an existing online lending service (aka social funding or crowdfunding). The first generation of lending services however was mostly focusing on people-to-people lending (aka peer-to-peer lending) - among those are Prosper, Zopa, and Lending Club. In addition, services tailored to the funding of charitable and development projects were launched - among those are Kiva, Fundable and MicroPlace. There are, however, some new kids on the block, dedicated to facilitating lending to businesses, such as 40billion. So far however, only a few people have gained experience with online lending, given the limited number of providers and a restricted regional and product scope.

Which leaves us with indirect options of investing equity. Private individuals can buy shares of (globally around 250) listed private equity firms (LPEs), such as 3i Group, Blackstone or KKR. They can invest in private equity funds, offered by companies such as the Carlyle Group or Partners Group. And last but not least, they can invest in funds of funds, managed by players such as Pantheon or Conversus. The portfolio of SMEs they invest in, however, is entirely in the hands of the respective asset manager.

Read part 3 on the investor’s paradigm, addressing common arguments on why direct SME investment possibilities are limited.