(Article from Registered Funds Alert, January 2019)
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Over the past 20 years, the number of publicly listed companies has been cut in half and the public firms that remain are generally older, larger, slower growing and represent a larger portion of market capitalization. Today, there are fewer listed companies than there were in 1976, despite the fact that gross domestic product is three times larger now than it was then. The largest 1% of U.S. public companies represent 29% of total U.S. market capitalization and approximately 140 companies represent more than half of total market capitalization. In part to address the continued erosion of the available opportunity set for public equity investors, Securities and Exchange Commission Chairman Jay Clayton announced in August 2018 that the SEC staff is working on a concept release that will address retail investor access to private companies and the exempt offering framework. We believe it is imperative that the concept release address the ability of retail investors to access private companies through commingled investment vehicles.
Chairman Clayton has acknowledged the dwindling investable universe available to retail investors, stating during his confirmation hearing before the Senate Banking Committee that “our public capital markets are less attractive to business than in the past. As a result, investment opportunities for Main Street investors are more limited.” As a result of the shrinking opportunity set in public capital markets and the growth of private markets, individual investors have a limited ability to access the complete U.S. equity market. As many companies wait until they are more mature to go public, the public market offers limited exposure to younger companies with potential for rapid growth, so retail investors lose out on the opportunity for significant growth potential that young companies can offer. Since the public listing peak in 1996, the average public company is 50% older and approximately four times larger than it was 20 years ago. Over the same period, the number of companies in the S&P 500 with annual revenue growth of at least 20% has decreased by half (from 20% of companies to 10% of companies).
Because companies are staying private for longer, by the time of an initial public offering (the first time retail investors are eligible to invest directly), companies have achieved greater scale (both by revenue and market cap), which some commentators argue has a dampening effect on future potential for revenue and returns growth. Private start-up companies are frequently reaching billion-dollar valuations before opening up to the public for investment—as of April 2018 there were 103 privately held U.S. start-ups with valuations of over $1 billion and a total value of $385 billion.
Studies of private equity funds consistently find that private equity returns—net of fees—outperform public market alternatives while providing diversification, lower volatility and protection in times of market stress.[1] Based on an average private fund duration of five years, the outperformance of the most successful private equity funds (e.g., the top 25% of funds) is 7.3% over the S&P 500. To illustrate the issue for Main Street investors, consider that a $10,000 investment in a retirement fund that earned 7% annually from the S&P 500 over 30 years would result in an ending balance of $76,123. Alternatively, if the $10,000 had been invested in a private equity fund that earned 7.3% above the S&P 500 annually, the ending balance would be $551,299.
Previously, retail investors could access private equity investments through employer-sponsored retirement accounts. As of January 31, 2018, public defined benefit plans allocated 7.4% of their investments to private equity, which accounted for 35% of the global aggregate capital invested in private equity.[2] However, over the past several decades, employers have embraced defined contribution plans, such as 401(k)s, and shifted away from defined benefit plans. The departure from defined benefits plans is notable in light of evidence that defined benefit plans outperform defined contribution plans. For instance, a Boston College Center for Retirement Research study found that, from 2003 to 2012, private defined benefit plans with more than $100 million of assets outperformed similarly sized private defined contribution plans by 1.5% annually. Defined contribution plans typically do not invest in private equity. Given the strong performance of private equity funds and based on review of the Boston College study, the Committee on Capital Markets Regulation concluded that the performance of private equity funds is likely contributing to defined benefit plans’ outperformance relative to defined contribution plans.
Chair Clayton has flagged several potential areas of focus for the concept release, including whether rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of an investor, the amount of an investment, or other criteria rather than just the wealth of an investor. We believe registered funds and registered investment advisers should be key components of Chair Clayton’s goal to increase access to capital markets and level the playing field for retail investors. In this Alert, we suggest several areas of reform for consideration by the SEC staff.
Expand the Accredited Investor Definition
To invest directly in securities offerings of private companies and private funds, retail investors generally need to be “accredited investors.” In addition, retail investors can gain access to investments in private companies through registered funds that invest in hedge funds and private equity funds, but the SEC generally requires that such funds only be offered to accredited investors.
To meet the accredited investor standard, individual investors must have earned at least $200,000 in annual net income in each of the past two years or hold $1 million in net worth, excluding their primary residence. This high qualification hurdle reduces the ability of Main Street retail investors to gain exposure to private companies through hedge funds and private equity funds—a recent Wall Street Journal analysis finds that approximately 87% of U.S. households do not meet the accredited investor standard.
The existing accredited investor standard is based at least in part on the presumption that wealth is the only appropriate proxy for investor sophistication. However, even the SEC has acknowledged that “well informed investors who are not wealthy may be in a position to take on risks that they understand well.” One way retail investors can reach the requisite level of financial sophistication to understand the risks of investing in private companies is through expert advice from investment advisers and brokers. In fact, Regulation D indirectly acknowledges that access to expert advice can deem an otherwise unqualified investor de-facto sophisticated so long as the investor is represented by someone who “has knowledge and experience in financial and business matters that he [or she] is capable of evaluating the merits and risks of the prospective investment.”[3]
The SEC should consider expanding the definition of “Accredited Investor” to include any investor who is advised on the merits of making a private placement investment by a fiduciary or intermediary that has an obligation to act in the best interests of the investor, such as a registered investment adviser or broker.
Ease or Eliminate Restrictions on Closed-End Fund Access to Private Companies
Unlike mutual funds, which allow for daily redemptions, shareholders in closed-end funds generally have no right to redeem. As a result, closed-end funds are well positioned to invest in illiquid assets, such as private companies and private equity funds.
Certain closed-end funds registered under the Investment Company Act invest a significant portion (more than 15%) of their assets in private equity funds and other types of private funds. However, in disclosure comment letters to these funds the SEC staff has indicated its view that only accredited investors may invest in a public closed-end fund that invests more than 15% of its assets in Section 3(c)(7) funds.[4] The SEC has not stated the legal or policy basis for this position. The argument that Main Street investors should be excluded because they could not invest directly in such funds is less convincing when one considers that registered funds often invest in securities in which Main Street investors cannot directly, such as 144A offerings and other private placement transactions. Because the SEC staff’s blessing is required for such registered funds of funds’ registration statements to become effective, the industry has had no choice but to acquiesce to this requirement.
The SEC and its staff should consider allowing retail investors to invest in public closed-end funds that invest more than 15% of their assets in private equity funds (and/or should expand the definition of “accredited investor” as proposed above). Public closed-end funds are subject to extensive disclosure requirements regarding their allocations to specific private equity funds and fees associated with these investments. A public fund of private funds offers retail investors the opportunity to gain indirect access to attractive private fund opportunities that are otherwise only available to institutional investors, and public fund sponsors can offer expertise in selecting and negotiating private fund investments. As discussed above, retail investors need access to private companies to obtain adequate diversification and superior returns and commingled investment vehicles managed by investment advisers who owe fiduciary duties to such vehicles is one potential source of such access.
Easing Restrictions on Affiliated Funds of Private Equity Funds
In addition to the restrictions on closed-end funds of private funds discussed above, the affiliated transaction restrictions of the 1940 Act currently prevent a sponsor from managing a registered fund that invests in private funds managed by the same sponsor. Some registered funds (currently available only to accredited investors) focus their investments on private funds of a single sponsor, but the registered funds are managed by a third party unaffiliated with the private fund sponsor. However, the unaffiliated investment advisers to such funds each charge an annual management fee in excess of 1% even though the investment strategies contemplate that each fund will invest at least 80% of its assets in funds of a specific private equity firms.
A third-party adviser is one way to protect against conflicts of interest but the SEC should consider alternative options to permit affiliated funds of funds, subject to certain limitations. Investors will benefit by having access to a registered fund of private funds managed by an affiliated investment adviser that has the greatest knowledge of the investment strategies and investment characteristics of the underlying private funds. The SEC can address affiliated transaction concerns by imposing certain limitations, such as:
- The registered fund’s board of directors will only approve fund-level fees for services that are in addition to and not duplicative of services at the underlying fund level;
- The registered fund will not own more than 25% of any underlying closed-end funds;
- The registered fund will not own more than 25% of any underlying open-end funds and will be restricted from seeding open-end funds;
- The registered fund will not invest in other funds of funds and will not invest more than 40% of its assets in a single fund;
- The registered fund will vote its interests in any underlying fund in the same proportion as the vote of all other shareholders in a particular underlying fund; and
- The registered fund will receive most favored nation treatment with respect to all investments in underlying funds.
The SEC should consider providing greater flexibility to permit affiliated “fund-of-private fund” arrangements similar to fund-of-fund arrangements involving mutual funds permitted under Section 12(d)(1)(G) of the Investment Company Act and Rule 12d1-2 thereunder (as discussed later in this Alert, the SEC recently proposed Rule 12d1-4 which would rescind Rule 12d1-2 and related exemptive orders).
[1] See also David Robinson & Berk Sensoy, Cyclicality, Performance Measurement, and Cash Flow Liquidity in Private Equity, 122 J. Fin. Econ. 251 (2016); Robert Harris et al., Private Equity Performance: What Do We Know?, 69 J of Fin. 1851 (2014).
[2] Preqin, Global Private Equity and Venture Capital Report 1, 77 (2018).
[3] Regulation D limits the number of non-accredited, financially sophisticated investors who may invest in an offering to no more than 35. An offering to non-accredited investors is also subject to enhanced disclosure requirements.
[4] See also Wildermuth Endowment Strategy Fund, SEC Comment Letter (October 11, 2013); Cross Shore Discovery Fund, SEC Comment Response Letter, (Sept. 17, 2015); Resource Real Estate Diversified Income Fund, SEC Comment Letter (Oct. 19, 2012); Oxford Lane Capital Corp., SEC Comment Response Letter, (Aug. 17, 2015).