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Law360 (April 22, 2020, 5:54 PM EDT) --
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| Celia Bigoness |
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| Andrew Kingsbury |
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| Brandon Hanley |
As of late 2019, private equity firms had a whopping $2.3 trillion in dry powder.[2] But the pandemic, as horrible as it is for both the country and the world, offers private equity firms opportunities to use this stored powder to ignite investment opportunities.
Why have so much powder in storage? Well, fund managers have pointed to two critical concerns: (1) Company valuations were overvalued in a crowded M&A market, and (2) the frothy economic boom was nearing a peak, with a recession to follow.[3]
Unfortunately, through unexpected means, those concerns have now been turned on their heads. The coronavirus pandemic has transformed an 11-year bull run into a bear market almost overnight, and expert predictions on economic outlook look grim.[4] The economy has artificially come to a halt through social distancing and fear.
Just a few months ago, demand was so high that private equity firms were buying companies at multiples of 13 times EBITDA, as compared to 7 or 8 times EBITDA a decade ago.[5] Now, in the span of a month, companies have seen their values dramatically erased and are facing serious financial risk.[6]
Although this is surely not the outcome that private equity funds wanted, no crisis should go to waste. Private equity firms — with record levels of dry powder on hand — are in a prime position to capitalize on the impending discount on private company valuations.[7]
Given the coronavirus outbreak's devastating effects on public markets, investors of all kinds and types may reasonably find private markets a more attractive alternative. The dot-com bubble provided one early example of private equity funds' ability to outperform the public market in times of distress.[8] And there are good reasons to believe that the private equity industry is well positioned to respond to the current economic crisis based on lessons learned from the global recession of 2009.
In the last decade, private equity investors have (1) come to rely heavily on sector-focused specialists; (2) become comfortable investing on the basis of longer time horizons than the traditional three years, allowing private equity firms to model an investment's upside beyond a recession; and (3) developed credit arms that can support their investments.[9]
These reasons may help explain why institutional and wealthy investors have exuberantly committed vast amounts of capital to these funds in 2019, even as such capital went unallocated. But for retail investors, the U.S. Securities and Exchange Commission has walled off the opportunity to reap the rewards of the private market.
Yet economic crisis breeds another opportunity: an opportunity to change the regulatory regime.
The U.S. Senate passed an unprecedented stimulus package to help combat coronavirus's effect on the U.S. economy.[10] Economic uncertainty has long influenced both Congress and the SEC. Most recently, in 2012, Congress passed the Jumpstart Our Business Startups, or JOBS, Act to help fuel economic growth after the 2008 financial crises.[11]
The JOBS Act made two relevant changes to private offerings. First, it eased regulations on crowdfunding and permitted non-accredited investors to invest in entrepreneurial endeavors through registered funding portals.[12] Nonaccredited investors could invest the greater of $2,200 or 5% of the investor's net worth in startups through the funding portal, provided the investor certify that they understand the restrictions against selling securities obtained through the portal and that the investor understands the risks associated with investing in the startup.[13]
However, funding portals have been less successful in increasing opportunities for retail investors because of the increased liability for issuers, the expense associated with issuers having to prepare detailed disclosures, and the $1 million dollar crowdfunding cap.[14]
Another important aspect of the JOBS Act eliminated the prohibition against general solicitations for private offerings under Rule 506.[15] Eliminating the prohibition allows issuers to advertise offerings more broadly and across all media platforms; however, the law did not alter the accredited investors requirement for participating in Rule 506 offerings.
Accredited investors are individuals whose net worth is at or exceeding $1 million or whose annual income is $200,000 (or $300,000 if combined with a spouse) for the two years preceding the investment.[16] Thus, while Congress intended to increase access to information — thereby broadening financial inclusion — the practical effect of the JOBS Act rule change was limited.[17]
However, in late 2019, the SEC proposed a rule change that would broaden the accredited investor definition.[18] Currently, private investment markets are closed to most Americans other than those who are considered to be accredited investors.
The rationale is that investments in private companies — which don't need to provide the detailed disclosures to investors that the SEC requires of public companies, and which fall outside the scope of the SEC's purview in other important respects — should be limited to "those persons whose financial sophistication … render the protections of the Securities Act's registration process unnecessary."[19]
The SEC's recent proposals to broaden the definition of "accredited investor" arise from the SEC's view, according to the SEC commissioner, that the current definition "excludes investors who spend their days earning money."[20] The proposed rule change alters the definition of accredited investor to include people with professional certifications and knowledgeable employees as accredited investors.[21]
In effect, the rule change would expand the accredited investor definition to capture people who the SEC believes to demonstrate satisfactory competence.
This change is helpful, but it does not go far enough. Given the recent market correction, the SEC must seriously consider shifting the private market structure to both facilitate distribution of capital and provide investors with the means to recoup lost capital. With fewer companies entering the public market, retail investors need other means to make up for lost gains.
And despite the claimed protections provided to public company investors under the securities laws, recent events demonstrate that public company investors are also vulnerable — one need only look at the wide-spread credit downgrades during the 2008 subprime mortgage crises and the most recent correction.[22] Thus, the accredited investor prohibition does not eliminate even the most sophisticated retail investor's risk exposure.
Currently, most Americans lack access to high-growth investment opportunities. Commentators suggest that the SEC's new proposed rule indicates a trend to open private markets to retail investors.[23] The SEC is tasked with facilitating capital formation and, as the SEC commissioner noted, the SEC believes retail investors deserve more opportunities to participate in private markets.[24]
Industry similarly agrees. Prior to the SEC's most recent proposals, a Blackstone Group LP executive delivered a report to the SEC that explained the benefits of expanding retail investors' access to private markets.[25] This report follows a year in which private offerings outpaced public offerings in terms of dollars raised.[26]
Complete elimination of the accredited investor requirement would certainly increase risks. However, regulators must modernize access to private markets to democratize wealth, which is necessary given the current crises.
The SEC can achieve broader financial inclusion while preserving investor protections. While the majority of Americans fail to qualify as accredited investors, at least 64% of adults have some form of pension plan or individual retirement account.[27]
In light of this, regulators should consider a tiered asset test for investing in private markets, similar to the test imposed for crowdfunding under the JOBS Act. In doing so, regulators could permit retail investors to invest a portion of their retirement savings in private equity.
Such a change would preserve protections against higher rates of loss for retail investors while permitting a portion of the retail investors' portfolio to capture the higher gains yielded from the private market.
To achieve such a shift in retirement account structure, regulators must consider changes to the current investment regime. This would require changes to IRS regulations against prohibited transactions for IRAs.[28] Additionally, changes to Section 12 of the Investment Company Act would be necessary to permit commingling of retail investors' money.
Commingling of the retail investors' contributed capital would likely be required to comprise a single stake in a private fund. Alternatively, and to avoid retail investors' liquidity concerns, a new structure — similar to a closed-end fund — could be implemented to allow for open trading of shares at certain specified intervals. This would permit retail investors to capture the gains of private market investments while safeguarding liquidity needs for unforeseen events.
Regulators could achieve this change by mirroring the JOBS Act's regulatory rollback on crowdfunding.[29] Similar income-based restrictions could be used to create private equity funding portals to avoid the commingling of assets. Rather than commingling, retail investors could purchase a portion of the shares issued through the funding portal after acknowledging the risks associated with the investment.
Lastly, additional oversight is necessary to safeguard against self-dealing. While IRS rules already contemplate using IRAs as private lending devices,[30] increasing availability to private markets for retail investors exposes the system to greater levels of abuse. Tightening up the Regulation D exemptions likely mitigates these concerns, as companies must register private offerings with the SEC if the offering fails to meet an exemption.[31]
Easing regulations to expand access to private markets presents an opportunity to broaden financial inclusion. Given the shift toward companies remaining private, Americans need alternative means to recover losses. Private equity provides a unique opportunity to do so. The coronavirus pandemic will create financial winners, but there is no reason to exclude the masses from the financial upside.
Celia Bigoness is an associate clinical professor, and Andrew Kingsbury and Brandon Hanley are students at Cornell Law School.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the organization, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Mark Vandevelde, Kaye Wiggins & Arash Massoudi, Private equity firms target dealmaking opportunities amid turmoil, Financial Times (March 17, 2020), https://www.ft.com/content/7acbea18-6808-11ea-800d-da70cff6e4d3.
[2] McKinsey, A New Decade for Private Markets 23 (2020), https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review?cid=other-pse-gaw-mip-mck-oth-2002-lka.
[3] Bain & Co., Global Private Equity Report 3 (2020), https://www.bain.com/insights/topics/global-private-equity-report.
[4] Akane Otami & Karen Langley, Dow Jones Industrial Average's 11 Year Bull Run Ends, The Wall Street J. (Mar. 11, 2020, 10:33 PM), https://www.wsj.com/articles/global-markets-calmer-after-two-hectic-days-11583899913.
[5] Eliza Haverstock, In the US middle market, soaring valuations beget an add-on frenzy, Pitchbook (Dec. 20, 2019), https://pitchbook.com/news/articles/in-the-us-middle-market-soaring-valuations-beget-an-add-on-frenzy.
[6] Compare Kristen Leigh Painter, An IPO for Sun Country? The airline's owner explores options, Star Tribune (Aug. 28, 2019), http://www.startribune.com/an-ipo-for-sun-country-the-airline-s-owner-explores-options/558553362/ with Kristen Leigh Painter, Sun Country Airlines trims spring and summer flights amid coronavirus, Star Tribune (March 6, 2020) http://www.startribune.com/sun-country-airlines-trims-spring-and-summer-flights-due-to-coronavirus/568562002/.
[7] Yusuf Khan, Goldman Sachs Says That Every One of Its Private Equity Clients is Preparing for Recession, Business Insider (Dec. 5, 2019, 7:51 AM), https://markets.businessinsider.com/news/stocks/goldman-sachs-says-private-equity-clients-are-preparing-for-recession-2019-12-1028740448; Henry Sender, Private Equity: Apollo's Charge to the Top, Financial Times (Mar. 10, 2014), https://www.ft.com/content/dd3c8c42-a825-11e3-8ce1-00144feab7de.
[8] Bain & Co., supra note 3, at 84.
[9] Winna Brown, Andrew Wollaston & Peter Witte, Podcast transcript: Why Private Equity can endure the next economic downturn, Ernst & Young (Feb. 20, 2020), ey.com/en_gl/podcasts/nextwave-private-equity/2020/02/why-private-equity-will-thrive-in-an-economic-downturn.
[10] Brayden Campbell, $2T Virus Aid Bill Hikes Jobless Benefits, Offers Biz Loans, Law 360 (March 25, 2020), https://www.law360.com/employment/articles/1256933?utm_source=rss&utm_medium=rss&utm_campaign=section; Stephen Cooper, Trump Signs 2nd COVID-19 Relief Bill Into Law, Law 360 (March 18, 2020), https://www.law360.com/articles/1254633/trump-signs-2nd-covid-19-relief-bill-into-law.
[11] Lori Schock, Outline of Dodd-Frank Act and JOBS Act, SEC https://www.sec.gov/news/speech/2012-spch060912ljshtm.
[12] 17 C.F.R. § 227.400.
[13] 17 C.F.R. §§ 227.100, 227.303(b)(2)(ii).
[14] See Michael B. Dorff, The Siren Call of Equity Crowdfunding, 39 J. Corp. L. 493, 503, 508 (2014).
[15] Id.
[16] 17 C.F.R. § 230.215
[17] See Tom Zanki, JOBS Act's Lift Of Ad Ban Gains Traction With Small Cos., Law 360 (April 4, 2016), https://www.law360.com/articles/778634.
[18] SEC Release No. 2019-265, https://www.sec.gov/news/press-release/2019-265.
[19] Regulation D Revisions; Exemption for Certain Employee Benefit Plans, Release No. 33-6683 (Jan. 16, 1987) [52 FR 3015]; see also Investor Bulletin: Private Placements Under Regulation D, SEC (Sept. 24, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/ib_privateplacements.html.
[20] Paul Kiernan, SEC Proposes Giving More Investors Access to Private Markets, Wall St. J. (Dec. 18, 2019), https://www.wsj.com/articles/sec-proposes-giving-more-investors-access-to-private-markets-11576691685.
[21] SEC Release 33-10734: Amending the "Accredited Investor" Definition, at 10–11, available at https://www.sec.gov/rules/proposed/2019/33-10734.pdf/.
[22] Peter Schroeder, Mortgage giants Fannie Mae, Freddie Mac hit with credit downgrade, The Hill (Aug. 8, 2011), https://thehill.com/policy/finance/175867-fannie-freddie-downgraded; Jennifer Ablan et al., Wall Street closes lower in spite of Fed 'bazookas', Fin. Times (March 23, 2020), https://www.ft.com/content/0a7d86ea-6c9f-11ea-9bca-bf503995cd6f.
[23] Dave Michaels, SEC Chairman Wants to Let More Main Street Investors In on Private Deals, Wall St. J. (Aug. 30, 2019), https://www.wsj.com/articles/sec-chairman-wants-to-let-more-main-street-investors-in-on-private-deals-1535648208.
[24] Kiernan, supra note 21.
[25] John Finley, Expanding Retail Access to Private Markets, SEC https://www.sec.gov/spotlight/sbcfac/expanding-retail-access-to-private-markets-finley.pdf
[26] SEC Release 33-10734, at 113.
[27] Report on the Economic Well-Being of U.S. Households in 2018, FINRA, https://www.federalreserve.gov/publications/files/2018-report-economic-well-being-us-households-201905.pdf.
[28] IRS Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs), available at https://www.irs.gov/publications/p590a#en_US_2019_publink1000230855.
[29] 17 C.F.R. § 227.400.
[30] Retirement Topics - Prohibited Transactions, IRS (Jan. 9, 2020), available at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-prohibited-transactions.
[31] 17 C.F.R. § 230.500.
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