Has private market regulation failed?

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Private markets are hot. Really hot. This raises a host of tricky questions, as SEC Commissioner Caroline Crenshaw pointed out in a speech Last week.

It’s worth skimming over the array of eye-catching facts that Crenshaw presented at the University of Chicago Booth School of Business on April 14; like how private market fundraising has tripled over the past decade to a record nearly $1.2 billion last year, or how public markets have atrophied to the point that l he Wilshire 5000 index now has only about 3,500 members.

But for the U.S. Securities and Exchange Commission, the big questions are whether this private market boom is “really facilitating capital formation” — to use its favorite phrase — and whether the interests of U.S. investors are truly being served. As Crenshaw said:

My ever-present fear is that the capital formation rules we put in place pay lip service to the needs of everyday American entrepreneurs, but actually serve another master. And because of less stringent disclosure requirements in private markets, they do so at the expense of real, substantial, and meaningful disclosure to investors, stakeholders, and regulators.

There is an inevitable conflict between expanding small businesses’ access to capital and protecting investors from hesitation. In recent years, regulators have been mostly concerned about the dearth of listed companies, so they have tried to ease the burden of listing on the stock exchange, while expanding access to private markets.

In August 2020, the SEC expanded its definition of a “qualified investor”, and three months later passed another rule titled “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets”.

The understandable concern was that many of the juicy gains that private companies have made in recent years go mostly to venture capitalists and their wealthy, well-connected investors.

But Crenshaw is skeptical whether these efforts have actually done much to improve access to capital OR protect investors in private markets. In particular, she fears that the lighter disclosure and compliance enjoyed by private companies will only transfer costs and risks to investors and markets. Two excerpts from his April 14 speech:

. . . The influx of capital to the private side of the industry, coupled with the severity and frequency of misconduct our agency uncovers (even with the limited information we are able to collect) suggests to me that our recent regulation does not may not have been the right approach to serve our goals. The incomplete visibility we have in private markets tells me that we need more information to regulate and ensure that every American can save adequately for their children’s education and their own retirement. Quite simply, we need more insight, more education, even more data, to be able to effectively protect investors, before big frauds happen.

. . . Unicorns may prefer not to provide the kind of information about their business that publicly traded companies must disclose, but the result is less public data about what actually works and what instead just shifts the burdens. towards those who are less able to bear them. So I’m concerned that not only are we not advancing access to capital for the companies that stand to benefit the most, but also that the current system is not providing standardized information that all investors can rely on to make decisions, reporting frameworks that form the basis of corporate accountability, and the industry data we need as regulators to inform our decisions.

The private equity boom is clearly a hot topic at the SEC. Last year Commissioner Alison Herren Lee raised some relevant questions in a great speech on the subject. Earlier this year, the SEC’s examination division published a “Risk Alert » highlight concerns about private fund managers, such as misleading track records. Dodgy reviews and outright fraud are another concern. Chair Gary Gensler also has private markets in its sights.

Here, for reference, are the questions Crenshaw posed to the Chicago academics:

  • Where do retail investors place their funds and are there adequate protections in place?

  • What are the comprehensive and systematic implications of the growing size of our private markets and the presence of so many so-called unicorns? Are there any unintended implications when unicorns go public, including how they might use their privately accumulated capital to influence the IPO process and their governance structure?

  • What are the barriers to accessing public markets today, and how can we mitigate these barriers without eroding investor protection and increasing the already significant information asymmetry?

  • Should we take immediate action to better protect employee-investors of private companies, who are particularly vulnerable to the liquidity and valuation challenges that accompany private companies?

  • Are there minimum standards of corporate governance and code of ethics that should apply to all companies, public and private?

  • Are there other areas of our Exempt Bid Framework that could be improved or better calibrated? For example, Regulation D and the definition of accredited investor?

  • Should we revisit the rules in Section 12(g) of the Exchange Act?

Like Crenshaw, Alphaville has more questions than answers. But we know that this will be an extremely important debate to follow in the years to come. If you have any good answers to the above, leave them in the comments below.

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