With over $1 trillion in annual offerings, the U.S. market for issuing private securities is an exceptionally large, yet relatively unfamiliar asset class. What is a private security? How does this market operate and why don’t I know more about it? The following White Paper attempts to shed some light on this opaque marketplace for both issuers seeking to raise capital and investors looking for new opportunities. So why now? Because the private capital markets are in a transformative state. Understanding the dynamics behind this asset class is an imperative for all market participants. This ACE Portal White Paper covers the following topics:
- Defining a private security
- Explaining why private securities should matter to you as an investor
- Outlining key market challenges
- Explaining how a private offering works
- Covering the historical evolution of this market
- Discussing recent changes and catalysts for private securities
Click here to download the full paper: Navigating Change in the Private Capital Markets.
Private Markets Overview
With over $1 trillion in annual offerings, the U.S. market for selling private securities is an exceptionally large yet relatively unfamiliar asset class. This paper attempts to shed some light on an opaque marketplace by answering some common questions:
- What is a private security and how does it work?
- What are some of the key market challenges right now?
- What’s changed to open up new opportunities in private securities?
- Why should I care?
The sector has been growing at a 15% compound annual growth rate, while public alternatives have plateaued. These developments are due in part to the first significant regulatory changes made to the sector in more than 30 years. As the transformation takes form, new innovations are emerging that will enhance the marketplace while also evoking some new concerns. Understanding these dynamics will enable issuers, investors, and agents to take advantage of the opportunities this growing asset class presents.
With over $1 trillion in annual offerings, the U.S. market for selling private securities is an exceptionally large yet relatively unfamiliar asset class. What is a private security? How does this market operate, and why don’t I know more about it? The following paper attempts to shed some light on this opaque marketplace for both companies seeking to raise capital (“Issuers”) and investors looking for new opportunities. So why now? Because the private capital markets are in a transformative state. Understanding the dynamics behind this asset class is an imperative for all market participants.
What is a Private Security?
Generally, any sale of securities that is not registered with the SEC.
In the U.S., any offer to sell securities must either be registered with the SEC (i.e., a “public offering”) or satisfy certain exempt qualifications in order to remain unregistered, or “private.” The most commonly cited private exemptions are outlined under Regulation D (“Reg D”). Reg D consists of various rules that govern the qualifications needed to meet SEC exemptions and are available to any issuer without regard to public status. The majority of Reg D offerings are filed under the following rules:
A blue sky law is a state law that regulates the offering and sale of securities. They are designed to protect the public from fraud. The specific provisions of these laws vary, but they all require the registration of securities offerings and sales. As can be seen in the chart below, Rule 506 is by far the most commonly cited exemption because it pre-empts compliance with these disparate requirements.
Why Are Private Securities Important?
Because private securities are a growing asset class with an attractive track record.
Private securities offerings represent an exceptionally large asset class. In 2012, the market for Reg D offerings alone was approximately $905 billion. These offerings run the gamut from small, early-stage seed rounds to multi-billion dollar corporate issuances and alternative investment funds (e.g., Private Equity Funds, Hedge Funds, and Venture Capital Funds). In the U.S. alone, there are approximately 128,000 private companies with more than $10 million in revenue and over 17,000 private funds. From an issuer’s perspective, the addressable investor universe for private offerings in the U.S. includes more than 40,000 institutional buyers, over 3,000 single family offices, and nearly 8.6 million other qualified purchasers and individual accredited investors.
According to a study conducted by Duke University and Ohio State University, private equity returns have surpassed the broader public market by double digits over the last 25 years. Some would argue that such performance is due to the fact that private companies are unburdened by public administrative costs, free from the volatility and distortion generated by high speed trading platforms and dark pools, and more focused on generating long term value instead of managing to quarterly performance estimates. Others might suggest that more structural influences are at play, such as buying in at a liquidity discount and selling at an M&A/IPO premium. In either case, the results have endured.
From an issuer’s perspective, private capital markets are an increasingly attractive alternative for capital formation. This is due in part to a combination of legislative and regulatory changes (including Dodd-Frank and Sarbanes-Oxley legislation) that are compounding the already significant costs associated with issuing public securities. These changes increase uncertainty and create a barrier to entry for small to mid-cap companies that cannot absorb the legal, financial, and administrative overhead associated with public compliance. In addition, these companies receive limited attention from public research analysts and large investors, which reduces demand for their securities. As a result, companies are seeking alternatives to raising capital in the traditional public forums.
What are some of the Key Private Market Challenges?
Private securities are usually sold to a restricted investor community, which limits funding sources.
Until recently (i.e., prior to the JOBS Act), in order for a securities offering to remain “private,” Issuers had to be careful not to engage in a “general solicitation” of their securities. So what is a general solicitation? While the SEC has actually never defined this term, a series of SEC no-action letters indicate a staff view that general solicitation occurs when a nexus between an issuer and its potential investors does not exist, or as the SEC puts it, a “substantive pre-existing” relationship does not exist. Additionally, with limited exception, only “Accredited Investors” are permitted to invest in a private placement. Finally, prior to the JOBS Act, the total number of investors in a private company generally was limited to 500 before such company became a public reporting company. These restrictions have limited the size of the potential investor community, making it more difficult to raise private capital.
Restricting access to financial professionals and sophisticated investors makes sense given the intrinsic risks in private securities. What are these risks? First, private securities possess an information gap. Without the degree of formal oversight that exists in the public markets, transparency is limited, and there is increased potential for asymmetric information between buyers and sellers. Basically, sellers are in control of what information they share with buyers. This makes conducting proper investment due diligence challenging and often requires professional assistance. Second, private securities do not trade openly in a large secondary market. This means that investors are unable to look to the market for price discovery and have limited liquidity available to them should they choose to sell their private securities. Finally, private securities are not sold through a centralized market infrastructure. This makes it very difficult for investors to compare pricing and other deal terms across different offerings.
As can be seen in the diagram below, private companies tend to be smaller firms with shorter operating histories and limited available information. These factors increase the cost of capital and limit funding sources for private companies.
How Does a Private Offering Work?
Typically through an inefficient, labor-intensive, and opaque process.
Until recently, Issuers were restricted from making general solicitations, or engaging in public marketing efforts. Instead, a closed process has been run, often by enlisting the services and guidance of financial professionals (“Placement Agents”). These Agents conduct due diligence on the Issuers, structure the offering terms, prepare marketing materials, contact a limited number of targeted investors, manage the investor diligence process, and ultimately negotiate the entire capital raise. While Placement Agents add expertise to this capital raising process, they are not required to manage a private issuance. Large alternative investment funds for example, often possess their own internal resources and bypass Agents altogether.
Whether using a Placement Agent or internal resources, all Issuers rely on a very manual process. They must individually contact each targeted investor, confidentially brief them on the proposed offering, and then guide interested investors through a series of administrative / regulatory hurdles before revealing specific offering details (including the name of the Issuer). Only then do investors receive formal investment materials to review and begin their diligence. This entire process is managed through a series of phone calls and emails, all of which must be tracked and recorded. Given the labor-intensity of this process, investor reach is inherently limited and success rates are lower than they might otherwise be.
For investors the situation is even worse. First, they must network with every investment bank and broker/dealer they know just to find private deals in the market. This requires navigating some very large institutions in an effort to find the “privates guy.” Depending on the firm, this could be someone in capital markets, industry coverage, or both. Then, the investor has to describe their investment objectives, and see if the firm currently has anything in market that fits. Finally, the investor must sit back and wait for the phone to ring. Some investors will receive many opportunities and some will not even receive a return phone call. The entire process is riddled with inefficiencies and lost opportunities. Given all the technological advances made in most other industries and the trillion dollar size of this asset class, this inefficiency is quite remarkable.
What is the Impact of Such Inefficiency on Private Markets and Companies?
More limited access, higher costs, and lower success rates.
The aforementioned labor-intensive, one-to-one marketing efforts are a byproduct of these regulatory impediments. As shown in the chart below, the result is that a large universe of qualified investors are never introduced to private placements. Investors miss out on attractive opportunities, and companies have a harder time raising capital.
In effect, the private securities market has been left to depend upon the telephone as the state-of-the-art technology for raising capital. This limits market reach, increases transaction costs (i.e., no effective leveraging of technology), reduces chances of success, and ultimately constricts capital flows. These factors have also driven a bifurcation in the marketplace where only large institutional investors capable of writing big checks are ever contacted by the Agents on an offering.
How Have Private Markets Remained So Inefficient?
Because restrictions governing the marketing of private offerings have deterred innovation.
As previously mentioned, both Agents and Issuers are restricted by the safe harbor guidelines under Reg D. Prior to the JOBS Act, these guidelines prohibited general solicitation, (i.e., soliciting investors with whom a substantive pre-existing relationship did not exist), and limited private company shareholders of record to 500 before having to make public filings. Changes to these regulations have been slow. In fact, prior to the passing of the JOBS Act in 2012, no significant change had been made to these regulations for more than 30 years! During this time, securities laws surrounding the marketing of private securities were very unclear. Specifically, they were (1) based on numerous no-action letters, (2) subject to the current thinking at the SEC, and (3) subject to a facts and circumstances based analysis. This uncertainty has lead most Agents to deploy limited, direct marketing campaigns where they can control dissemination, rather than building out widespread distribution networks. The ultimate ability of the JOBS Act to alleviate these issues remains to be seen.
What’s Changing In Private Markets?
The private capital markets are in a transformative state.
New legislation addressing the capital raising process for private companies has been passed with the intention of alleviating certain regulatory hurdles and removing marketing limitations that have heretofore restricted market access. This is a sea change that, combined with market trends towards seeking alternatives to public capital, will drive the adoption of new technologies and innovations.
On April 5, 2012, the Jumpstart our Business Startups Act (“JOBS Act” or “Act”) was signed into law. The objective of the legislation is to stimulate growth of small to mid-sized companies by facilitating access to capital. Changes under the Act include: (i) raising the threshold for mandatory registration and public reporting (under the Securities Exchange Act of 1934) from 500 shareholders of record to 2,000; (ii) permitting general solicitation (i.e., ability to contact investors who you do not already know) in connection with Reg D offerings made under new rule 506(c), and (iii) registration exemptions for limited-size offerings sold in small amounts to a large number of investors (“crowdfunding”).
New Opportunities for Private Issuers and Investors?
New opportunities yes, but also new risks.
The alleviation of certain regulations under the JOBS Act has helped stimulate new business models in the private securities market. While this trend is a positive step towards more efficient markets, investors should proceed with caution when evaluating new opportunities. Early stage, start-up companies for example, are being acquainted with a multitude of crowdfunding platforms. These innovative models have the potential to greatly expand capital flow at reduced costs. Crowdfunding platforms, however, do not require regulated third party intermediaries to prepare and diligence the companies raising money on these platforms. This has the potential to introduce bad actors and fraudulent offerings on an unsuspecting public.
For larger, more established private companies and alternative investment funds, online fundraising platforms have emerged with the goal of improving market access and efficiency by establishing the much-needed centralized technology infrastructure. Private platforms can reduce the search costs for both investors and Issuers, automate the compliance and tracking portions of the process, facilitate timely disclosure of information, and create economies of scale that bring efficiency to private capital markets. However, not all platforms are created equally, as each adheres to different philosophies and business models. In evaluating the alternatives, both Issuers and investors need to understand the platform’s perspective on a number of factors, including transaction independence, the role of Placement Agents, the due diligence process, confidentiality, and transparency. Some of these factors have the potential to create conflicts of interest.
The private capital markets are opening up and market participants are taking note. The sector has been growing at a 15% compound annual growth rate, while public alternatives have plateaued. These developments are due in part to the first significant regulatory changes made to the sector in more than 30 years. As the transformation takes form, new innovations are emerging that will enhance the marketplace while also evoking some new concerns. Understanding these dynamics will enable Issuers, Investors, and Agents to take advantage of the opportunities this growing asset class presents.