📈 The SEC vs the $20 Trillion Private Fund Industry

While there’s plenty of talk about India’s moon landing, Trump’s mugshot, and the alleged assassination of Russian mercenary chief Yevgeney Prigozhin…

The big story in the world of Private Capital is what could be the most significant update to securities regulation since Dodd-Frank.

On August 24th, the SEC adopted the long-threatened rules to enhance the regulation of private fund advisers, and updated the existing compliance rule that applies to all investment advisers.

In today’s Weekend Edition, we’re going to connect some of the dots for our readers about what makes this such a big freaking deal.

Let’s get into it,

-Equifund Publishing

The Shift From Public to Private Market: A Brief History

In one of our previous issues, we talked briefly about the origin of securities regulations, and the enforcement agency, the Securities and Exchange Commission (SEC).

But to understand why SEC Chairman Gary Gensler has been actively looking to enforce new regulations on private markets…

It’s important to understand how the private markets went from an obscure alternative asset class to a dominant institution in capital markets.

The Origins of Institutional Dominance in Capital Markets

The SEC likes to think of itself as the watchdog of capital markets, and the advocate for investor interests.

Historically, this meant protecting everyday Americans looking for a way to build wealth (ie. “retail investors”).

How do they do this? Through two main, overlapping regulatory areas:

• Regulation of the securities markets and the securities industry
  

• Regulation of corporate issuers (and information about issuers) to aid investor decisions

While the Securities Act of 1933 (the "Securities Act") largely locked retail investors out of the private markets, there were plenty of options in the public markets for retail investors to choose from.

In fact, by 1950, retail investors owned more than 90% of the public stock market, whereas institutional investors – which are professionally managed funds, like pension funds and endowments, mutual funds, insurance companies, and now exchange-traded funds (or ETFs) – made up a paltry 8% of total market capitalization.

But over the following decades, the financial markets became increasingly institutionalized, with more and more of the market controlled by large, pooled funds.

More specifically, with regards to the shift to private markets, the movement was arguably driven by the success of Yale University’s endowment; in 1985, David Swensen took over and shifted almost the entire portfolio to non-publicly traded assets.

And this phenomenon – plus some changes in regulation and legislation – triggered an evolution in modern day capital markets.

The Rise of Venture Capital and Buyout Firms

In the early 20th century, startups were funded mostly by wealthy families and individuals.

Later, the Small Business Investment Act of 1958 gave rise to something called a small business investment company (or SBIC).

The main feature of this new vehicle? The government provided SBICs with cheap capital that could be leveraged by 4x… as long as it went into new and early-stage companies.

By the late 1960s, the IPO market was hot. In 1967, there were 100 IPOs that had an average first-day “pop” of 38%.

By 1969, there were 780 IPOs…

And to no surprise, we hit a recession, the bubble burst, and institutions grew wary of the risk of venture capital.

But, thanks to the 1978 Revenue Act, the 1979 “Prudent Man” rule, the 1980 Small Business Investment Incentive Act, and the 1981 Economic Recovery Tax Act…

Venture capital became more attractive for institutions, via lowered capital gains taxes and reduced regulation.

Then, the 80s happened (need I say more?).

In the 1980s almost all VC investments exited through an IPO.

In the 1990s, the internet happened, and people started going nuts over tech stocks.

By the end of 2000, one of every five publicly-traded companies was venture-backed, and those companies represented about one-third of the equity markets’ capitalization.

Then, the dotcom crash – and subsequent Enron and Worldcom scandals – led to the passing of the most significant securities regulation since the Great Depression: The Sarbanes Oxley Act (SOX).

Just like in the aftermath of the stock market crash in 1929, Congress passed the new regulations to restore public trust in the capital markets through stricter controls and increased transparency.

However, these increased compliance burdens imposed significant costs on public companies, as related to auditing, reporting, documentation, internal controls, and director liability.

In response, many companies, especially smaller and younger firms, chose to avoid these regulatory burdens by remaining or going private.

Freed from the heightened standards and scrutiny of the public markets, private markets could entice companies by offering more flexibility, lower transparency standards, and less oversight.

High growth startups found they could access ample late-stage private capital from institutional investors, rather than deal with the regulatory hassles of an IPO.

Wealthy investors shifted more assets to private markets, seeking higher returns amid declining small cap IPOs. Private equity and venture capital boomed, with their global net asset value far outpacing public market capitalization.

Additionally, funding in the form of venture capital and growth equity emerged as a preferable alternative to listing directly on the public markets.

Eventually, this gave rise to what is called a Private IPO – which are private financings in excess of $100m – effectively replacing the need for a traditional IPO.

According to an interviewee cited in a Syracuse University study entitled Private Inequity: Private Markets and the Death of the Micro-Cap Stock:

As stated by former SEC chairman, Jay Clayton, the reduction in listed equities comes with “potential lasting effects... to the economy and society [that] are, in two words, not good.”

Main Street investors, and all but the wealthiest Americans, are stuck investing in a diminished asset class, with little to no direct exposure to the private markets.

Fast forward to the next financial crisis…

Following the 2008-09 Great Financial Crisis (GFC), Congress again needed to do something to restore investor confidence in the capital markets and passed the Dodd-Frank Act in 2010.

Similar to previous crises, the GFC exposed major gaps in regulation of the financial system, especially with regard to over-the-counter derivatives, mortgage lending, and system-wide risks.

More specifically, the lack of transparency and oversight of complex derivative products known as “credit default swaps.”

Most notably, Dodd-Frank mandated registration for advisers with over $150 million in assets under management, and introduced Form ADV and Form PF (short for private funds), in an effort to enable more transparency and expand SEC supervision of the historically opaque private funds industry.

• Form ADV is a requirement for registration with the SEC, or a state regulated oversight agency, which provides key information on their services, fees, owners, employees, business practices and disciplinary history. It consists of three parts.
  
  Part 1A provides key information about the adviser's business, owners, employees, clients, compensation, practices, and any disciplinary events.
  
  Part 2 outlines the adviser's services, fees, investment strategies, and conflicts of interest.
  
  Part 3 (a later addition to Form ADV) requires further disclosure of fees charged, services provided, and any conflicts of interest that may exist for the Adviser.
  
  Advisers must file annual updates, and more often, if information changes.

• Form PF was designed gather systemic risk data from larger private fund advisers, such as use of leverage, counterparty exposure, and performance
  
  Filed quarterly, Form PF helps the SEC monitor industry trends and risks that could impact the financial system

However, in 2009, we witnessed the beginning of the longest bull market in American history, which in turn, drove significant growth into private market strategies.

As public markets recovered from the crisis, private equity firms raised large new funds to take advantage of declining asset values and profitable investment opportunities.

Private Equity firms went on an acquisition spree, leveraging massive amounts of cheap credit to acquire companies, spurring competition for their trademark “leveraged buyouts” and take privates.

Venture capital (VC) also attracted growing interest from investors seeking higher returns than struggling public markets, with VC fundraising hitting new highs.

Hedge funds took advantage of volatility and dysfunctions on Wall Street in the wake of the crisis, to find unique investment angles, raising record amounts of capital.

Private credit markets expanded, as PE firms partnered with non-bank lenders, when traditional financing sources pulled back.

As trillions of dollars have flooded into these less-regulated investment vehicles, the impact of Private Capital can be felt across substantially every single asset class.

While private funds typically issue their securities only to certain qualified investors, such as institutions and high net worth individuals, individuals have indirect exposure to private funds through those individuals’ participation in public and private pension plans, endowments, foundations, and certain other retirement plans, which all invest directly in private funds.

The Commission staff have also observed a trend of rising interest in private fund investments by smaller investors with less bargaining power, such as the growth of new platforms to facilitate individual access to private investments with small investment sizes (i.e., crowdfunding portals like Equifund).

That’s why there have been increasing calls for enhancing regulations on this traditionally secretive – and less transparent – asset class.

According to Allison Herren Lee, who briefly served as acting chair of the SEC from January to April 2021:

Because most private companies tend to be small businesses, a lack of reporting requirement (outside of tax filings) is probably a good thing as it would just add another layer of costly compliance.

However, for the private companies that have raised hundreds of millions (or even billions) of dollars of investor capital, we agree that this lack of reporting is problematic.

This brings us to the current SEC Chairman Gary Gensler’s agenda

Gensler has made no secret about his desire to make sweeping regulatory changes to capital markets.

And in many ways, he is responsible for the most significant reforms in securities regulation since the Dodd-Frank Act.

Not only has he pursued a rather aggressive ESG agenda (of which I think is a massive regulatory overreach)...

He’s been actively pushing for increased transparency from private capital, especially in the wake of the recent Crypto implosion and bank failures.

Here is a brief overview of key SEC developments related to private funds since Gary Gensler became SEC Chair in April 2021:

• In October 2021, the SEC proposed new rules requiring significant additional disclosures by private fund advisers, including details on fees, expenses, preferential treatment of investors, and fund performance. The goal was to increase transparency and allow investors to make more informed decisions.
  

• In December 2021, the SEC proposed rules to eliminate the "up to three year" extension private funds have to register as investment advisers. This would require many previously exempt advisers to register with the SEC.
  

• In February 2022, the SEC proposed new rules prohibiting certain activities by private fund advisers, including unchecked preferential treatment of investors, and misleading claims about past performance. This aimed to strengthen investor protections.
  

• In May 2022, the SEC announced plans to increase scrutiny of private fund advisers, focusing on fees and expenses charged to investors. They signaled potential new rules in this area.
  

• In August 2022, the SEC adopted new rules requiring private fund advisers to improve their compliance programs and provide quarterly statements to investors detailing all fees and expenses.

Since then, Gensler has been floating the idea of the now-adopted rules for private funds, of which the industry has been less than thrilled about.

And while we find certain things problematic about Gensler’s actions as chair, we applaud the steps the SEC is taking to create a more level playing field for investors.

According to the Final Rule:

While there is some speculation the industry will seek to sue the SEC and challenge this ruling…

It will still be at least another year before these requirements go into effect.

We’ll keep you updated on any developments as this story progresses.