Grading the Regulators and Homework for the Teachers: Remarks at Symposium on Private Firms: Reporting, Financing, and the Aggregate Economy at the University of Chicago Booth School of Business

Thank you, Michael [Minnis]. I am humbled to be here today with such an impressive group of participants. The private markets and their role in the economy is an important topic and I’m glad to have this gathering of highly respected academics and industry participants thinking about the subject matter. I would also like to thank tonight’s host, the University of Chicago, whose faculty profoundly impact policy-making through their research and discussion.[1] Before I get too far, let me make the standard disclosure that the views I express today are my own and do not necessarily reflect the views of the Commission or its staff.

The Importance of Data

All of us have something in common – our belief in the power of data. I gave a speech a few months back about how important data are, and should be, in driving regulatory thought and action.[2] That may even have landed me the invitation I got to speak here today. Academia can play a huge hand in helping assess not only what needs to regulated, but how effective existing regulations are. Data should be paramount in our regulatory decision-making and sitting in this room are some of the most sophisticated thought-leaders on data in the securities markets in the world. Starting from the premise that the optimal number of regulations is not zero (and I recognize that there may be those who do not start from that premise), I want to enlist your help as we think through what is the right balance in regulating the private markets, and what those rules should look like.

Plus, this gives me the opportunity to assign some homework to the professors, which I intend to do today. Although we have brilliant resources at the SEC, those resources are also limited. So, I’d like today’s speech to be a call to arms of sorts – help us evaluate how the SEC’s regulations are living up to the stated goals of those regulations, and help us figure out where to go next.

Private Markets are Growing

Let’s start with the lay of the land. The private markets are growing at record rates. This is, of course, a trend that has been ongoing for some time. Since 2009, fundraising in the private markets has outpaced fundraising in the public markets.[3] Based on recent headlines, 2021 was no exception in terms of private market growth. In 2021:

• Fundraising in global private markets reached a record high of nearly $1.2 trillion, an increase of nearly 20% over 2020, and a threefold increase over the past decade.[4]

• Private assets under management reached an all-time high of $9.8 trillion as of July of this past year, an increase of ~33% from $7.4 trillion the year before.[5]

• U.S. private fund assets have increased 70% in just five years.[6]

The number of private companies is growing and they are staying private for longer. The term “Unicorn” has become ubiquitous – private companies with valuations of a billion dollars or more. As of February of this year, the size of Unicorns has grown and the number of Unicorns has reached over 1,000, perhaps making the term “Unicorn” a misnomer.[7] In 2013, the most valuable Unicorn was Twitter at $10 billion; today, it is ByteDance (the parent company of TikTok) worth $410 billion.[8]

That all stands in contrast to the public markets, which appear to be declining in terms of overall market share. Private companies seem to be outpacing public companies both in number and in fundraising.[9] From July 1, 2020 through June 30, 2021, nearly twice as much money was raised in exempt offerings as through public offerings.[10] Another data point is the Wilshire 5000 Index, which tracks the overall performance of the U.S. stock market by holding thousands of publicly traded stocks at any given time – significantly more than the S&P, NASDAQ and the Dow. To be included in the Wilshire 5000, companies must be publicly traded and have their headquarters in the United States. And, while there were 7,500 companies in the index as of 1998, today that number has dropped to about 3,500.[11]

Harmonization Was Supposed to Improve Access to Markets and Capital For Small- and Medium-Sized Businesses. Is it Working?

I was sworn into office as an SEC Commissioner on August 20, 2020. Six days into my tenure, against my vote, the Commission adopted a rule to expand the definition of Accredited Investor.[12] Three months later, the SEC passed another rule called “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets.”[13] (Brevity is not our strong suit at the SEC.) The shorthand of that rule was that it would improve access to private capital by simplifying, harmonizing and expanding the exempt offering framework. In other words, there would be more access to capital outside of the registered, public markets, because more money could be raised through exemptions. In particular, it was to create “a more rational framework that [would] facilitate capital formation for small and medium sized businesses and benefit investors for years to come.”[14] All laudable goals. To accomplish this, the rule gave greater leeway to issuers in allowing general solicitation of investors, it increased offering limits under Regulation D, Regulation A and Regulation Crowdfunding,[15] increased the frequency at which offerings could be made, and, coupled with the Accredited Investor Rule, it expanded generally the reach of exempt offerings to new investors, allowing them to access new markets. Conversely, it also provided those markets with new access to investors. But, importantly, it did so without the transparency, accountability and investor protections afforded by public markets. The adopting release also predicted that the rules would only have a marginal impact on the number of registered offerings.[16] But did the rule accomplish its goals? Will it?[17]

Last week, the SEC held its small business forum. It’s one of my favorite events. We celebrate the achievements of small business owners in this country, entrepreneurs share strategies and tools for fundraising, and we consider how we can better serve these individuals, hard-working people who, in many ways, form the backbone of our country and economy. I encourage you to attend next year.

But in certain recent speeches and reports, we have been hearing out of the Office of the Advocate for Small Business Capital Formation, both anecdotally and through these data, that the private market boom is not serving everyone equally. Companies appear to be staying private longer and engaging in more and larger funding rounds before they go public (if they go public), which is where it seems much of the private capital may be going.[18] Large, traditionally public institutional investors are investing in venture and private equity markets more than ever. So, for example, although traditionally public investors invested in 5.3% of venture deals by count, they made up over 36% of venture deal value in 2020.[19] The median venture round without crossover public investors hovered below $3 million; the deal size with crossover investors was over $60 million.[20] In other words, the private market boom isn’t necessarily a boon to our small and mid-sized businesses seeking capital. And, to be frank, I’m not sure we need regulation to help facilitate more capital going to Unicorns and other large private companies – they seem to be doing fine on their own. Meanwhile, smaller entrepreneurs are still struggling to get access to capital after the Angel investor stage.[21]

There may be a similar trend among private equity funds, with established names and mega-funds crowding out those seeking to break in to finance. Of the 2021 growth I described earlier, private equity funds grew the most, and represent $6.3 trillion in assets under management.[22] Many of the established names are successfully raising new flagship “mega-funds” funds with $5 billion+ assets raised.[23] However, it appears that emerging and first-time managers are having less success raising capital in this highly competitive market.[24] These newer and smaller managers are those most likely to invest in smaller and more diverse companies.[25] I worry that if they don’t have opportunities, it reduces the opportunities for others.

The trends I’m describing were set in motion before the most recent round of rulemaking. This private market growth did not happen overnight and was facilitated by perhaps many things, including the legal framework put in place a long time ago.[26] But regardless of how we arrived here, I think we really need to grapple with whether we are now where we want our markets to be. Are we really facilitating capital formation for small and diverse businesses, and if not, how do we do that better? I hope you will help us collect past and emerging data on this subject. My ever-present fear is that the capital formation rules that we put in place pay lip-service to the needs of everyday American entrepreneurs, but really serve another master. And because of the less stringent disclosure requirements in private markets, they do that at the expense of actual, substantive, meaningful disclosure to investors, stakeholders and regulators.[27] Unicorns may prefer not to provide the kind of insights into their businesses that publicly traded companies have to disclose, but the result is less public data about what is actually working and what is, instead, just shifting burdens to those less able to bear them. So I am concerned that not only are we not advancing access to capital for the businesses that could most benefit, but also that the present system does not provide standardized disclosure that all investors can rely on for decision-making, reporting frameworks that form the basis of corporate accountability, and the industry data we need as regulators to inform our decisions.

Which brings me to my next question…

Are we Adequately Protecting Investors in the Private Markets?

It may not surprise many of you to know that I opposed the rule in part because I thought it did not appropriately advance our investor protection mission.[28] And what concerns me most about the opacity of private markets is quite simple: the potential for fraud and other harm to investors.

Indeed, our staff in the Division of Examinations put out a Risk Alert earlier this year relating to deficiencies that they were seeing at registered private fund managers. The areas that they highlighted were worrisome, to say the least. In particular, the staff noted:

• Misleading material information about track records;
• Inaccurate performance calculations;
• Failure[s] to invest in accordance with fund disclosures regarding investment strategy;
• Failure[s] to obtain informed consent from Limited Partnership Advisory Boards or Committees Required Under Fund Disclosures;
• Lack of reasonable investigation into underlying investments or funds.

And, we are seeing a steady stream of private fund enforcement actions, including frauds relating to Ponzi-like frauds; [29] fee and expense frauds;[30] valuation practices;[31] among many other troubling cases.[32]

Retail investors, working Americans, are more exposed to the private markets than ever. Some are invested directly.[33] These investors typically do not have access to the bigger, less risky deals that big private funds and other professional investors have access to; and, they likewise may not have the reserves to withstand one or two unsuccessful ventures. The ability to have multiple investments fail in hopes of finding a winner requires both access to a broad range of promising investments and large amounts of money you can afford to lose, two attributes most small American investors don’t have.

Other middle-class investors are invested through their pension funds, which by some estimates make up over 20% of private fund investors.[34] In this debate over regulation of private markets, we often hear arguments that large limited partners (“LPs”) are sophisticated and have tremendous bargaining power when making investments in private funds and companies. Therefore, they can get access to whatever information, investments or investment privileges they want. But, we should not lose sight of the fact that not all LPs are created equally – the bargaining power of a sovereign wealth fund may be quite different from the bargaining power of the pensions of police, teachers or firefighters of small municipalities. And, while many of these pensions have requirements to allocate certain capital to the private markets, they may not have access to, or the ability to source, managers whose funds produce upper quartile returns, resulting in investments that do worse than the public indices.[35]

Further, working Americans also are invested through their 401(k) or other diversified holdings in mutual funds, which can invest a portion of their holdings in private funds and companies.[36] In short, a significant portion of the end dollars going into the private market comes from the retirement and the savings of our middle class. This heightens the importance of this dialogue about what level of transparency, accountability and oversight should be required in this market and whether it’s actually working for America’s working investors.

The influx of capital to the private side of the industry, coupled with the severity and frequency of misconduct that our agency is uncovering (even with the limited information we are able to collect) suggests to me that our recent rulemaking may not have been the right approach to serve our goals. The incomplete visibility that we have into the private markets tells me that we need more information to regulate and to ensure every American can adequately save for their children’s education and their own retirement. Quite simply, we need more insight, more education, indeed more data, to be able to effectively protect investors, before the big frauds occur.

Where to from here?

I think there is a bigger debate going on right now – both inside and outside this room – about what is the right balance between the public and private markets. I read an article recently that posed the paradox succinctly – you can have two firms that are virtually identical in every respect, including shareholder base, product, business models, employee counts, operations, enterprise value, and so on. Yet, those two companies can have completely different regulatory and disclosure obligations to investors and stakeholders. Public Company A would need to provide public disclosure about financial results, operations, trends, executive compensation, corporate governance, among other disclosures; would have to have management and independent auditors certify to the effectiveness of their internal controls over financial reporting; and, would have to put certain matters to shareholder vote. Private Company B would have none of those regulatory obligations, and thus their investors cannot rely on those protections.[37]

The costs of going public are obvious – you have to pay lawyers, bankers, underwriters, and then take on the expenses of ongoing compliance.[38] The benefits may be obvious to a company that now has more immediate access to capital. But there may also be other external benefits to public companies that benefit the entire ecosystem. And, likewise, perhaps the disclosure and compliance cost savings enjoyed by private companies are not really savings at all. Rather, are private companies really just shifting the costs and risks onto investors and markets?

So, here is my question to you – are we at the right balance? I know this is an ongoing debate, but I would like it to continue and crystalize into recommendations for us at the Commission.

• Where are retail investors putting their funds and are there adequate protections in place?
• What are the full, systematic implications of the increasing size of our private markets, and of having so many so-called Unicorns? Are there unforeseen implications when Unicorns do go public, including how they might utilize their privately accumulated capital to influence the IPO process and their governance structure?
• What are the barriers to accessing public markets today, and how can we alleviate such barriers without eroding investor protections and increasing the already large information asymmetry.[39]
• Should we be taking immediate steps to better protect employee-investors of private companies, who are particularly vulnerable to liquidity and valuation challenges accompanying private companies?
• Are there minimum corporate governance and code of ethics standards that should apply to all companies, public and private?
• Are there other areas of our exempt offering framework that could be improved or better calibrated? For example, Regulation D and the Accredited Investor definition?
• Should we revisit the rules under Section 12(g) of the Exchange Act?

On this last point, my colleague Commissioner Allison Herren Lee has recently suggested that we revisit the definition of “shareholder of record” in Section 12(g) to better reflect the actual beneficial ownership of companies.[40] I would like to hear from the academic community on that proposal and on others that might impact how we think about the private markets.

Finally, if you can’t give me answers to my questions – because there are insufficient data or for other reasons – can you give me questions that you can answer? Using randomized trials, natural experiments, event studies, and difference in difference – what do the tools allow you to conclude with confidence about the right regulatory framework.[41]

Conclusion

With that, I would again like to thank you for inviting me here tonight, to speak to such an esteemed audience. I’ve given you a lot of homework. I hope that you will weigh in and help us think about these important subjects and how we can best serve our important mandate at the SEC. I encourage you to reach out to us and engage us in this dialogue.