Centralized online access to the private capital markets.

Data Transparency Would Grow Private Markets

One of the biggest differences between investing in private companies versus public companies is the amount of information readily available. Publically traded equities have far more verified data available then private securities. The prevalence of this information together with the low-cost of obtaining it forms the very basis for the creation of efficient public markets because it facilitates comparing the risk/return profiles of different securities.

Agree or disagree with the market structure argument, few would dispute the micro-argument that without credible disclosure between company managers and prospective investors the efficient flow of capital would be impeded.[1] After all, most investors do not invest in something without knowing something about the opportunity. But for various reasons information flows within the private markets are often constrained. The end result can include more expensive capital for companies and a severely tilted information playing field for investors relative to management (or even relative to one another).

In order for the private capital markets to continue to become more liquid and more efficient (and thereby benefiting all involved parties) a standard for minimum acceptable information disclosure should be fostered.

Public Market Disclosures: Regulated & Regular

Within the public markets, financial reporting and disclosure is an important way for a firm’s management to communicate company performance, governance, and the risks and opportunities facing the firm.[2] Not only is a certain standard of information disclosure facilitated by requiring regulated financial reports—including financial statements, footnotes, management discussion and analysis—but capital markets participants on the public side have grown used to voluntary communication including management forecasts, conference calls, press releases, and various other corporate reports.

These voluntary practices have become so prevalent as to become their own standard. In other words, a company’s non-participation in these types of disclosures is often a red flag in and of itself. Thus any investor in the public space who noticed a lack of communication from management might immediately question why this was the case.

The credibility of public market information is also bolstered via the active participation of analysts, regulators, standard setters, auditors, and other intermediaries. These parties actively seek and collect information, evaluate performance, forecast future prospects, and issue buy/hold/sell decisions. All of these actions facilitate more rapid incorporation of information into stock prices.

Public markets are shaped by these information-driven activities. Private markets, on the other hand, are partially defined by the relative absence of such company-specific information.

Reasons for the lack of information in the private market are diverse and certainly include a degree of discretion on the part of market participants to protect their competitive advantages. I am not suggesting that a lack of information inherently indicates an inferior offering. A core advantage of staying private is guarding sensitive information while also not having to adhere to costly disclosure requirements.

With that in mind, however, issues of agency and information asymmetry can still come into play when the aggregate private capital marketplace lacks standardized information standards.

The Consequences of Less Information in Private Markets

Less information limits the pool of buyers. It can also further differentiate these buyers into informed and uninformed pools, even within the same investment opportunity. In fact, one source of the large returns enjoyed by VC and PE firms stems from their ability to deploy resources to uncover and conduct extensive due diligence on investment opportunities. Greater information disclosure will not eliminate these profit opportunities, but it will make it easier to conduct due diligence.

Furthermore, when buyers have little information (and/or little independently verified information) on which to base their purchasing decisions, it makes it difficult for all participants to differentiate quality opportunities from those that are less attractive. The potential for adverse selection inflates the information premium on these opportunities and is a core part of the reason private capital remains expensive. Basically, less information makes it much harder and much more expensive to determine a Ferrari from a lemon.

Investors, Agents, and Companies Would Benefit from Better Information Disclosure

The vast majority of private market participants would benefit from the standardization of greater information flow.

Quality private companies (and funds) should willingly embrace greater disclosure because that would effectively communicate to the market their above average prospects. This would in turn reduce their cost of capital and put pressure on other firms to also offer greater information.

Broker-dealers and agents would benefit from higher standards of information disclosure because reducing investment uncertainty would attract more investors to the space. More deals could be facilitated and more capital could be raised.

The benefits to investors would seem to be the most obvious. Standardized information disclosures would mark the evolution of the private capital markets into a more mature and efficient marketplace. Most investors would have a greater confidence in their ability to gauge a private investment’s prospects. More intelligent asset allocation decisions could be made and the entire sector would conceivably mature and grow as a percentage of investor portfolios. Given these advantages, why has the sector not evolved in a similar manner to the public markets?

So why the lack of information in Private Markets?

There are several reasons the information evolution within the private capital markets has not happened yet.

Apathy could certainly be one of these reasons. Prior to the JOBS act, interest in private capital raising was more limited, and the smaller pool of investors generally had the resources to conduct their own information gathering processes. Catalysts for greater growth in private markets dovetail with an increased need for better information standards.

A second reason is the historical lack of technology to control information dissemination. As mentioned above, a private company raising capital has to balance their need for protecting their competitive advantages with presenting enough credible information to attract investor dollars. Without strong controls over information sharing (which new technologies have made easier), companies and their representatives had to exercise extreme caution with broad sharing of information.

The final reason is perhaps one of the most interesting. Namely, the rules of the game surrounding private capital raising may have endured because some market participants stand to lose some of their competitive advantages as standards change. For example, firms with poor opportunities would find it more difficult to access capital if investors had access to more information about each opportunity. VC and PE firms on the other hand might lose some of their informational advantages and competing against a greater number of investors could also limit their leverage in negotiating terms. Both of these factors would theoretically reduce expected returns.

Summary

As regulatory changes (such as the JOBS act) and the rise of online platforms facilitate greater efficiency, access, and transparency in the private capital markets new questions around information disclosure are arising. The potential to transform the market to the benefit of all market participants makes this a conversation well worth continuing.

 

[1] Paul Healy & Krishna Palepu, “Information asymmetry, corporate disclosure and the capital markets: A Review of the empirical disclosure literature,” Journal of Accounting and Economics 31 (200), p.2.

[2] Paul Healy & Krishna Palepu, “Information asymmetry, corporate disclosure and the capital markets: A Review of the empirical disclosure literature,” Journal of Accounting and Economics 31 (200), p. 1.

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