Since becoming Chair of the U.S. Securities and Exchange Commission (SEC) last April, Gary Gensler has embarked on an ambitious policymaking agenda complimented by an aggressive stance toward enforcement and oversight of market participants.
The SEC has a number of policy priorities for 2022, including increasing public company disclosures around environmental, social, and governance (ESG) issues; reviewing market structure to promote competition and transparency; cracking down on special purpose acquisition companies (SPACs); and continuing to focus its attention on digital assets and the cryptocurrency markets. Additionally, a major focus of the agenda is rolling back reforms from the previous administration, many of which impact the regulation of private markets.
Last year, exempt offerings raised over $3.2 trillion in private market capital, nearly double the $1.7 trillion in capital raised in the public markets. In a search for yield, investors turned to the private markets, where returns have outpaced those of their public counterparts. Additionally, legislative and regulatory policy changes, such as the JOBS Act, bolstered capital raising opportunities at all stages in a company’s lifecycle, while the burdens of being a public company increased. Because of the abundance of private capital and increasing liquidity options, companies are able to stay private longer, with the number of companies globally surpassing the $1 billion “unicorn” valuation increasing from around 500 to nearly 1,000 over the past year alone.
As the private market ecosystem grows, so are concerns surrounding it. Policymakers and regulators are concerned by the degree of transparency for such a disruptive and influential swath of the economy. Unlike their public market counterparts, private companies are not subject to a rigorous disclosure regime or the scrutiny that accompanies it. Proponents of increased regulation argue that this lack of disclosure, combined with information asymmetries and the illiquid nature of the private markets, makes these investments riskier for investors. Additionally, because access to the private markets is generally limited to institutional, sophisticated, or wealthy investors known as accredited investors, retail investors—for the most part—lose the opportunity to share in the upside of the highest growth stage of company development, and have more limited investment opportunities as companies stay private longer and the number of investment opportunities in the public market declines.
The SEC plans to bring these “ dark” markets into the light. The SEC recently issued a proposal to require private fund advisers to provide more information about fees, expenses, and performance as well as and prohibit practices it views as contrary to the public interest and the protection of investors–changes that will likely have a material impact on the private fund industry. The SEC is also considering actions to increase disclosures, encourage more companies to move into the public space, impose additional requirements on companies seeking to raise capital through the exempt offering framework, and limit investor access to the private markets. If implemented, these changes would have a significant impact on capital formation in the private market ecosystem.
Enhanced disclosures
The SEC is considering policy changes that would require private companies to regularly disclose information about their financials and operations to investors. While the SEC did not extend disclosure requirements around climate risk directly to private issuers in its recent climate disclosure proposal, disclosures related to ESG—namely governance, sustainability, and human capital—will almost certainly continue to be a part of the conversation. These issues are not only top of mind for the SEC, but investors are increasingly demanding this information, as well.
Push to public markets
The SEC is also considering changes that could push more private companies into the public market. By statute, a company whose securities are held “of record” by more than 2,000 persons (or 500 individuals if nonaccredited) must register those securities with the SEC and provide periodic disclosures. For counting purposes, investment structures (e.g., special purpose vehicles, private equity funds, venture capital funds) generally only count as one shareholder. If regulations were to change, the SEC may require disclosures from these structures for the purpose of counting shareholders, in order to promote transparency and provide a more granular picture of economic ownership. Others have suggested using market capitalization, revenue, or a “public float” on a private trading venue as triggers to subject a company to the public reporting regime, though these changes may require additional authority from U.S. Congress.
There are a number of reasons a growth-stage company may not go public, including: intense scrutiny, higher liability, greater oversight, and the costs of complying with the extensive disclosure regime that comes with being an SEC-reporting company. Companies of a certain size may face trouble raising capital in the public markets, as today’s equity market structure was designed for the Fortune 500 companies. Traditionally, the regulatory regime recognized the benefits a private company structure can provide, and balanced reduced regulatory requirements with limited investor access to those deemed “sophisticated” under the accredited investor definition, allowing the company to choose which data it releases based on what makes the most sense for it and its stakeholders. These investors are better positioned to demand information necessary to make an informed investment decision; they do not need the same level of protection as the investing public.
Imposing additional requirements to raise private capital
The SEC is considering changes to the exempt offering framework, including imposing additional requirements on Regulation D—the primary exemption through which private capital is raised. Most of the potential changes impact Rule 506(c), which allows for general solicitation and advertising; the changes could require pre-filing Form D in advance of any sales, as well as require advertising materials to be filed with the SEC. The Commission could also condition the use of the exemption on a Form D filing and could expand information collected on Form D—all changes that are likely to introduce additional frictions in the private capital-raising process for businesses at every stage in their lifecycle.
Limit investor access
The SEC is also considering additional limits on who can access the private markets by narrowing the definition of who qualifies as an accredited investor. Generally speaking, only accredited investors can participate in private market activity, where the main criterion for establishing one’s accredited status is net worth or income. The SEC most likely will propose changes to index the threshold wealth and income levels for inflation, which will narrow the pool of investors eligible to participate in private offerings. Although investors are allocating record levels of capital to private markets, limiting capital supply may adversely impact founders and emerging funds that originate and operate in traditionally underserved regions.
With fewer investment opportunities in the public markets, however, nonaccredited retail investors lack opportunities to diversify their investment portfolios and may reach for yield in markets that have even fewer investor protections. With companies staying private longer, much of the growth potential has already been realized when and if they do eventually go public, limiting everyday investors’ opportunities to create wealth. Tightening the accredited investor definition will also diminish the supply of capital for investment in private companies for those outside of traditional networks. The impact will be particularly detrimental in minority and rural communities, as recently highlighted during a meeting of the SEC’s Small Business Capital Formation Advisory Committee.
With a Democratic-controlled SEC, any policy changes proposed through the rulemaking process are likely to be adopted. Given the SEC’s recent pattern of proposing shorter comment periods, this process could move quickly. Most of these items are included on the SEC’s Regulatory Flexibility Agenda, which means Chair Gensler intends to take action on them this year. In addition to the rulemaking process, the SEC could devote more resources to oversight and enforcement in the private markets. While these efforts are still in their early stages, it is important to begin engaging with policymakers to educate them about the potential impacts of the SEC’s regulatory and enforcement agenda on investors, capital formation, and the polarization of equity wealth.
While the scope and impact of the SEC’s actions are still unknown, changes to the private market regulatory framework are almost certain. CartaX has been ahead of the curve in designing a platform that supplies a range of liquidity solutions, with disclosure and access tailored to meet the needs of investors and companies at all stages of development. These measures help address many of the SEC’s transparency and investor protection concerns by offering transaction types that provide liquidity, periodic and symmetrical disclosures of financials and key performance metrics, and price discovery, all of which can help companies either stay private for longer or prepare for the public markets.
