It is possible that private market capital raising will be less of a "Wild West" arena than some think it has become. The SEC in the US has flagged a number of problems. The question is whether those advising HNW investors appreciate fully what may be coming.      

The Securities and Exchange Commission is turning its sights on private capital fundraising, arguing that too many “unicorns” and other entities are not giving enough information to protect investors.

Whatever the specifics of the SEC’s ideas, given in a speech in late January by Commissioner Caroline A Crenshaw, the US watchdog is certainly wrestling with a major issue. And from where I sit as a financial journalist, it is plain that wealth managers who have understood the sales pitch about private market investing need to be prepared for more rules and regulations. The easy days could be over.

The bankruptcy in late 2020 of cryptocurrency exchange FTX, the fraud around Silicon Valley health tech business Theranos, and the valuation collapse of offices space group WeWork have, along with other events, ignited worries about private companies’ disclosure. A proliferation of special purpose acquisition companies, aka SPACs, has also fuelled concern about the quality of disclosure. 

An issue is that many firms have gone private, or avoided public markets, precisely because they don’t want heavy regulatory and investor scrutiny, particularly since the US Sarbanes-Oxley accounting legislation enacted more than 20 years ago after the Enron accounting scandal. Quite a lot of the shift to private markets looks like a form of regulatory arbitrage, akin perhaps to people flocking to states such as Florida and Texas that don’t have state income taxes, or people in other countries using offshore centres. At some point, there’s going to be pushback.

As wealth managers know, the current “hotness” is for private markets: private equity, credit, infrastructure, and real estate. Investors are enticed with promises of superior returns to compensate for lower liquidity. The rise of such investments also raises questions about access, an area that is seeing new firms enter the space to surmount this challenge. Another dimension is that as more firms go private or stay that way, it is arguably less “democratic,” unlike a public firm where shareholders can vote their stock and hold bosses to account on issues such as pay and weak performance. (The rise of “passive” entities such as exchange-traded funds has also contributed to this disconnect.)

Crenshaw’s speech pointed to what is at stake. According to the most recent SEC data, for the 12-month period from 1 July, 2021 through to 30 June, 2022, exempt [ie, private market] offerings accounted for about $4.45 trillion in capital raising; whereas during that same period, publicly raised funds accounted for roughly $1.23 trillion in fundraising. That’s roughly 3.5 times more capital raised in the private markets than in the public markets. As Crenshaw noted, initial public offerings, once the main form of going public, accounted for $126 billion of that capital raised. 

“Companies no longer need to go public to raise enormous amounts of capital,” Crenshaw said, noting that the current state of play is far from when federal securities laws arose.

“Private markets were meant to be the exception to the proverbial rule. But, through decades of legal, regulatory, and market developments, private companies now have access to increasing amounts of private capital, inflating their sizes and significance to investors and our economy, and all without the concomitant safeguards built into the public markets,” Crenshaw said. 

Crenshaw’s speech focused on Rule 506 of Regulation D (“Reg D”). It is the primary exemption relied upon by large private issuers to raise essentially unlimited capital from an unlimited number of accredited investors in the US. Reg D was codified in 1982, in the early part of the Reagan administration, although US securities laws go back to 1933 and the Great Depression. Before the Wall Street Crash of 1929, in Crenshaw’s words, “all securities markets in the United States were private and thus, dark.”

However, while rules opened markets up to more scrutiny, the 1982 switch with Rule D, and other exemptions, have changed the picture entirely, Crenshaw argued. 

She said that “unfettered” access to capital through rules such as Rule 506 have had a “bloating effect on private issuers.”

“Whereas, in prior decades, small private issuers who grew and grew had to turn to the public markets to sate their capital needs, now Reg D, among other legal and regulatory mechanisms, has allowed for the development of pools of private capital sufficient to satisfy the needs of even the largest private issuers,” she said. 

And Crenshaw talked about "unicorns." “The clearest evidence of this may be the mere existence of the once-mythical (but now ubiquitous) “unicorns,” or private issuers purportedly valued at over a billion dollars. When the term was first coined in 2013, there were 43 unicorns. There are now roughly 1,205. That is an increase of about 121 unicorns in less than one year since I last spoke on this topic. Those unicorns have rough purported overall valuations of about $4 trillion,” she said. 

“These unicorns have consistently relied on Rule 506 of Reg D to raise billions of dollars in US capital. Make no mistake, Reg D has helped pave the way for the advent of the unicorn. Not only can the companies rely on Reg D to raise capital as small businesses, but they can keep raising capital, and keep growing, indefinitely while staying in private markets. The exception is no longer narrow,” she continued. 

Sophisticated?
Crenshaw warned that investors aren’t protected in private markets as they are in the public sphere. The test of being a “sophisticated” investor is not the protection that it is supposed to be, she said. As long as I have been editing this news service, the term “sophisticated investor” has been a definitional fuzzy area. 

And this issue is all the more important because, as Crenshaw noted, a good deal of money flowing into the private markets space is not in a typically “sophisticated” form. 

“As private companies have gained increasingly large market power and as the pool of accredited investors has expanded – including venture capital, private equity funds, mutual funds, pension funds, and individuals that meet the requisite wealth thresholds – the de facto presumption that accredited investors need no disclosure isn’t panning out,” Crenshaw said.

So what can we expect? Well, Crenshaw said that regulators could reform certain rules, such as Form D, to give “essential information to all private investors, to the public markets and to the regulators, which leads to healthier markets overall.” Large private issuers could also carry “heightened obligations.”

Of course, quite a lot of this could be derailed if there is a change of administration in 2024, but wealth managers would be unwise to bet the house on it. Across the political divide in the US, there’s no great love lost for private market investments that blow up. And outside the US, we should be mindful that where the US leads, other jurisdictions follow. The ironies abound: at precisely the time when the air is full of talk about private markets, the regulatory climate threatens to cool down. Advisors had better be ready.