Thursday, March 2, 2023
Supercharging Private Markets Creates Risks for Ordinary People
A full court press to lower the gates to private markets has emerged. Last month, Duke's Gina-Gail Fletcher testified before the House Committee on Financial Services, Subcommittee on Capital Markets. The Committee titled the hearing: "Sophistication or Discrimination? How the Accredited Investor Definition Unfairly Limits Investment Access for the Non-wealthy and the Need for Reform." It considered a range of bills which would eat away at the accredited investor standard and allow broader access to private markets.
The U.S. Congress isn't the only legislative body considering whether to allow ordinary retail investors to buy private offerings. Nevada has introduced legislation which would create an intrastate offering exemption which would allow Nevadans making about $65,000 a year (Nevada's median income) to be sold illiquid, private placements. The Nevada proposal would create "Nevada certified investors" as an intrastate offering category. The proposal describes it this way:
“Nevada certified investor” means a natural person who is, or a married couple who each are, a resident of this State and who, at the time an offer to sell or sale of a security is made to the person or couple: 1. Holds an ownership interest of more than 50 percent in a business that has reported a gross revenue of more than $200,000 on each federal income tax return filed for the 2 immediately preceding calendar years; or 2. Has reported an income on the federal income tax return of the person or couple filed for the immediately preceding calendar year that exceeds the median household income in this State, as identified in the most recent data from the American Community Survey published by the Bureau of the Census of the United States Department of Commerce or as determined by the Administrator based on another source of data specified by the Administrator by regulation.
The Nevada proposal would allow investors to put up to 10% of their net-work per transaction into illiquid private offerings. Curiously, it deviates further from the federal accredited investor standard by including up to 50% of the investor's primary residence in the net worth calculation. I agree with Gina-Gail Fletcher that this sort of proposal is a bad idea. She wrote in to the Nevada legislature to highlight the same concerns as she did with the slate of pending federal legislation.
In my view, the legislation risks creating an intrastate highway for fraud. Private placements do not have any price discovery or real process for accurately valuing the securities. A Vegas bartender pulling in $80,000 a year would qualify. If the bartender had $100,000 in savings and $200,000 in home equity, the first transaction could take $30,000. When it comes time for the second transaction, how do you value the prior investment now held by the bartender? It isn't going to be a market price--because there won't be any market. That minor hurdle might stop a bank from lending on it, but it wouldn't stop a second transaction taking just as much or more of the bartender's investible assets.
Opening the door to fleecing retail investors with illiquid private offerings no one else would buy isn't going to move us closer to solving the retirement savings crisis. It's going to dissipate wealth in ill-considered ventures, scams, and general capital misallocation.
Correctly seeing the moment before us, the SEC's Investor Advisory Committee also tackled this issue today. The IAC heard from four panelists:
- Steven Neil Kaplan, Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance and Kessenich E.P. Faculty Director at the Polsky Center for Entrepreneurship and Innovation. Presentation
- Elisabeth de Fontenay, Professor of Law, Duke University. Presentation
- Tyler Gellasch, President and CEO of the Healthy Markets Association; Author of In the Public Interest: Why Policymakers and Regulators Must Restore the Public Capital Markets
- Faith Anderson, Chief of Registration & Regulatory Affairs, Washington Department of Financial Institutions, Securities Division; and Chair of the NASAA Corporation Finance Section’s Small Business/Limited Offerings project group, Written Statement
You can find much of their testimony or presentations echoing many of the same points.
When I think about this issue, the adverse selection issue for low-dollar private placements seems to almost entirely ensure that any offerings made to retail investors under lowered standards will be the dregs of the private markets. This could do real harm to real people.
If you're the sort that cares less about harm to particular individuals and more about overall efficiency, you would probably also prefer steering capital to public markets. As a society, our ability to effectively allocate capital depends on our ability to see the market. Allocators can't allocate if they can't see the market. When dark markets grow larger than public markets, it's going to become impossible to make reasonable choices between alternatives because you cannot see any of the alternatives.