The SEC vs the $20 Trillion Private Fund Industry
Jake Hoffberg
Publisher @ Equifund | $80m+ raised for 19 issuers (and counting) on platform
The Shift From Public to Private Market: A Brief History?
In one of our previous issues , we talked briefly about the origin of securities regulations, and the enforcement agency, the Securities and Exchange Commission (SEC).
But to understand why SEC Chairman Gary Gensler has been actively looking to enforce new regulations on private markets…
It’s important to understand how the private markets went from an obscure alternative asset class to a dominant institution in capital markets.?
The Origins of Institutional Dominance in Capital Markets
The SEC likes to think of itself as the watchdog of capital markets, and the advocate for investor interests.?
Historically, this meant protecting everyday Americans looking for a way to build wealth (ie. “retail investors”).
How do they do this? Through two main, overlapping regulatory areas:
While the Securities Act of 1933 (the "Securities Act") largely locked retail investors out of the private markets, there were plenty of options in the public markets for retail investors to choose from.
In fact, by 1950, retail investors owned more than 90% of the public stock market, whereas institutional investors –?which are professionally managed funds, like pension funds and endowments, mutual funds, insurance companies, and now exchange-traded funds (or ETFs) –?made up a paltry 8% of total market capitalization.
But over the following decades, the financial markets became increasingly institutionalized, with more and more of the market controlled by large, pooled funds.
More specifically, with regards to the shift to private markets, the movement was arguably driven by the success of Yale University’s endowment; in 1985, David Swensen took over and shifted almost the entire portfolio to non-publicly traded assets.?
And this phenomenon –?plus some changes in regulation and legislation – triggered an evolution in modern day capital markets.
The Rise of Venture Capital and Buyout Firms
In the early 20th century, startups were funded mostly by wealthy families and individuals.
Later, the Small Business Investment Act of 1958 gave rise to something called a small business investment company (or SBIC).?
The main feature of this new vehicle? The government provided SBICs with cheap capital that could be leveraged by 4x… as long as it went into new and early-stage companies.?
By the late 1960s, the IPO market was hot. In 1967, there were 100 IPOs that had an average first-day “pop” of 38%.?
By 1969, there were 780 IPOs…
And to no surprise, we hit a recession, the bubble burst, and institutions grew wary of the risk of venture capital.
But, thanks to the 1978 Revenue Act, the 1979 “Prudent Man” rule, the 1980 Small Business Investment Incentive Act, and the 1981 Economic Recovery Tax Act…
Venture capital became more attractive for institutions, via lowered capital gains taxes and reduced regulation.
Then, the 80s happened (need I say more?).
In the 1980s almost all VC investments exited through an IPO.
In the 1990s, the internet happened, and people started going nuts over tech stocks.
By the end of 2000, one of every five publicly-traded companies was venture-backed, and those companies represented about one-third of the equity markets’ capitalization.
Then, the dotcom crash – and subsequent Enron and Worldcom scandals – led to the passing of the most significant securities regulation since the Great Depression:?The Sarbanes Oxley Act (SOX).
Just like in the aftermath of the stock market crash in 1929, Congress passed the new regulations to restore public trust in the capital markets through stricter controls and increased transparency.?
However, these increased compliance burdens imposed significant costs on public companies, as related to auditing, reporting, documentation, internal controls, and director liability.
In response, many companies, especially smaller and younger firms, chose to avoid these regulatory burdens by remaining or going private.
Freed from the heightened standards and scrutiny of the public markets, private markets could entice companies by offering more flexibility, lower transparency standards, and less oversight.
High growth startups found they could access ample late-stage private capital from institutional investors, rather than deal with the regulatory hassles of an IPO.
Wealthy investors shifted more assets to private markets, seeking higher returns amid declining small cap IPOs. Private equity and venture capital boomed, with their global net asset value far outpacing public market capitalization.
Additionally, funding in the form of venture capital and growth equity emerged as a preferable alternative to listing directly on the public markets.?
Eventually, this gave rise to what is called a Private IPO – which are private financings in excess of $100m – effectively replacing the need for a traditional IPO.
According to an interviewee cited in a Syracuse University study entitled Private Inequity: Private Markets and the Death of the Micro-Cap Stock :
There is no good reason to pay bankers and disclose financials when the money is waiting [in the private markets] at the same valuation.
As stated by former SEC chairman, Jay Clayton , the reduction in listed equities comes with “potential lasting effects... to the economy and society [that] are, in two words, not good.”?
Main Street investors, and all but the wealthiest Americans, are stuck investing in a diminished asset class, with little to no direct exposure to the private markets.?
Fast forward to the next financial crisis…
Following the 2008-09 Great Financial Crisis (GFC), Congress again needed to do something to restore investor confidence in the capital markets and passed the Dodd-Frank Act in 2010.?
Similar to previous crises, the GFC exposed major gaps in regulation of the financial system, especially with regard to over-the-counter derivatives, mortgage lending, and system-wide risks.
More specifically, the lack of transparency and oversight of complex derivative products known as “credit default swaps.”?
Most notably, Dodd-Frank mandated registration for advisers with over $150 million in assets under management, and introduced Form ADV and Form PF (short for private funds), in an effort to enable more transparency and expand SEC supervision of the historically opaque private funds industry.
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However, in 2009, we witnessed the beginning of the longest bull market in American history, which in turn, drove significant growth into private market strategies.?
As public markets recovered from the crisis, private equity firms raised large new funds to take advantage of declining asset values and profitable investment opportunities.
Private Equity firms went on an acquisition spree, leveraging massive amounts of cheap credit to acquire companies, spurring competition for their trademark “leveraged buyouts” and take privates.
Venture capital (VC) also attracted growing interest from investors seeking higher returns than struggling public markets, with VC fundraising hitting new highs.
Hedge funds took advantage of volatility and dysfunctions on Wall Street in the wake of the crisis, to find unique investment angles, raising record amounts of capital.?
Private credit markets expanded, as PE firms partnered with non-bank lenders, when traditional financing sources pulled back.
As trillions of dollars have flooded into these less-regulated investment vehicles, the impact of Private Capital can be felt across substantially every single asset class.
While private funds typically issue their securities only to certain qualified investors, such as institutions and high net worth individuals, individuals have indirect exposure to private funds through those individuals’ participation in public and private pension plans, endowments, foundations, and certain other retirement plans, which all invest directly in private funds.
The Commission staff have also observed a trend of rising interest in private fund investments by smaller investors with less bargaining power, such as the growth of new platforms to facilitate individual access to private investments with small investment sizes (i.e., crowdfunding portals like Equifund).
That’s why there have been increasing calls for enhancing regulations on this traditionally secretive – and less transparent – asset class.
The shift toward private markets in recent decades has brought us back to a familiar crossroads, one at which we must evaluate the opacity of large and important segments of the economy and what that opacity means for investors and our public markets.
We’ve been down this road before – twice, in fact. First, in the early 1930s at the inception of the federal securities laws, when lack of transparency had contributed to misallocations of capital and other market disruptions
Congress addressed this opacity in capital markets, and determined that it was in the public interest to create public companies and periodic reporting requirements for those listed on national exchanges.???
Three decades later, in the early 1960s, Congress recognized that opacity in capital markets had again become a problem.
The periodic reporting requirements applied only to exchange listed companies, and the over-the-counter (or OTC) markets had grown significantly in the intervening decades.
And here we are again watching a growing portion of the US economy go dark, a dynamic the Commission has fostered – both by action and inaction.
Unicorns, [private companies valued at $1bn+] are notable not just for their size, but for their transformational impacts on our way of life.?
They have, for example, changed the transportation and travel habits of millions across the globe, spawned billions of dollars in litigation, changed the legal underpinnings of entire markets, and launched civilians into space.?
Yet, despite their outsize impact, there is little public information available about their activities.?
They are not required to file periodic reports or make the disclosures required in proxy statements.?They are not even required to obtain, much less distribute, audited financial statements.
This has consequences for investors and policymakers alike, which in turn may have consequences for the broader economy.
Because most private companies tend to be small businesses, a lack of reporting requirement (outside of tax filings) is probably a good thing as it would just add another layer of costly compliance.
However, for the private companies that have raised hundreds of millions (or even billions) of dollars of investor capital, we agree that this lack of reporting is problematic.
This brings us to the current SEC Chairman Gary Gensler’s agenda
Gensler has made no secret about his desire to make sweeping regulatory changes to capital markets.?
And in many ways, he is responsible for the most significant reforms in securities regulation since the Dodd-Frank Act.
Not only has he pursued a rather aggressive ESG agenda (of which I think is a massive regulatory overreach)...
He’s been actively pushing for increased transparency from private capital, especially in the wake of the recent Crypto implosion and bank failures.
Here is a brief overview of key SEC developments related to private funds since Gary Gensler became SEC Chair in April 2021:
Since then, Gensler has been floating the idea of the now-adopted rules for private funds, of which the industry has been less than thrilled about.?
And while we find certain things problematic about Gensler’s actions as chair, we applaud the steps the SEC is taking to create a more level playing field for investors.
The rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors.?
These rules are likewise designed to prevent fraud, deception, or manipulation by the investment advisers to those funds.?
Specifically, the new rules require registered investment advisers to private funds to provide transparency to their investors regarding the fees and expenses and other terms of their relationship with private fund advisers and the performance of such private funds.?
The new rules also require a registered private fund adviser to obtain an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion or valuation opinion from an independent opinion provider.?
All private fund advisers are also prohibited from providing certain types of preferential treatment that would have a material, negative effect on other investors, subject to certain exceptions; and other types of preferential treatment to any investor in a private fund, unless the adviser satisfies certain disclosure obligations.
While there is some speculation the industry will seek to sue the SEC and challenge this ruling…
It will still be at least another year before these requirements go into effect.
We’ll keep you updated on any developments as this story progresses.
-Jake Hoffberg
Co-Founder & Publisher @?Equifund
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