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The Cost to Retail Investors and Public Markets of “Harmonizing” Securities Offering Exemptions

In June 2019, the U.S. Securities and Exchange Commission (“SEC” or the “Commission”) issued a Concept Release on the Harmonization of Securities Offering Exemptions (the “Concept Release”), which set forth proposals to expand the ability of retail investors to invest in private, un-registered securities.  Elisabeth de Fontenay (Duke Law) and I, joined by 13 other securities law professors, submitted a comment letter on the Concept Release on September 24.  Our full letter can be found here.[1] In our letter, we recommend that the commission ask crucial questions before continuing the decades-old trend of dramatically expanding exemptions from SEC registration.  In particular, the SEC should consider how a continued expansion could undermine the public markets that have served retail and institutional investors so well.

The remarkable growth in private capital has come at least in part at the expense of the public markets. The number of public companies has fallen significantly over the last 20 years,[2] and private capital-raising now outpaces public capital-raising to a substantial degree.[3] The decline in the number of public companies and initial public offerings is a complex phenomenon, with several contributing factors.[4] Yet the deregulation of private capital by Congress and the SEC over the last few decades—including the expansion of transaction exemptions—has clearly played a large role, by allowing even very large firms to delay or avoid going public. [The private and public markets are to some degree substitutes for one another, in terms of their ability to attract issuers and investors, and regulators should be aware of the tradeoffs involved in expanding private capital.  The 15 professors who signed the letter hold differing views on the appropriate level or nature of regulation of public companies and the public markets.  We all agree that the private markets cannot replicate what the public markets have achieved solely through private ordering.  Significant collective action problems and agency costs in corporate finance hinder price discovery, liquidity, and information quality in the absence of regulation.[5] Therefore, robust public markets are crucial to continued economic growth in the United States.

Private Securities Markets Pose Risks to Retail Investors

The Concept Release seeks public comment on various proposals to expand or create new exemptions from registration under the Securities Act or to loosen the restrictions on the secondary trading of private securities. These proposals would have the primary effect of allowing small-dollar retail investors to invest directly in private securities. Issuers are already permitted to raise unlimited amounts of capital privately from institutional and high-net-worth investors, without significant disclosure obligations.[6]  Some exemptions require no disclosure at all.[7]

Investing in private securities would pose considerable additional risks for retail investors, relative to investing in public securities, and existing research suggests that these additional risks would not be sufficiently offset by higher expected returns.  In fact, if retail investors are given more direct access to the private markets, they are likely to earn lower risk-adjusted returns overall than they do in the public markets, for several reasons:

A.  Evidence is mixed as to whether even large institutional investors achieve better risk-adjusted returns in the private markets than in the public markets; recent evidence suggests a convergence of returns in the two markets.

Retail investors are currently confined to public markets, for the most part.  The Concept Release inquires whether retail investors may be missing out on favorable investment opportunities in private securities that are available only to institutional and high-net-worth investors. The unstated assumption is that investors obtain better returns in the private markets than in the public markets.

The evidence does not support this assumption, however, even for institutional investors.[8] The most recent and comprehensive studies show that the returns from investing in the public and private markets have been converging, and any excess returns in the private markets have mostly dissipated.[9] Such convergence is the result one would expect, given how much capital has shifted to the private markets and how competitive private markets have become for investors.

Evidence showing outperformance of the private markets relative to the public markets are based on data from earlier decades, when private equity and venture capital were relatively new asset classes. Facing little competition for investments, many such funds could boast of market-beating returns. That is no longer the case:  The number of private investment funds and the capital that they manage have skyrocketed, leading to fierce competition and substantially lower returns.  Ironically, one of the most frequently cited studies for the proposition that the private markets outperform the public markets makes this explicit: The authors find that returns to investors in private equity funds with post-2005 vintage years have been roughly equal to returns in the public markets.[10]

Even this evidence overstates the returns to the average institutional investor in the private markets, however. Because studies of the private markets rely primarily on limited, voluntarily reported data, they cover the performance of only the largest and most successful institutional investors that invest in the largest and most successful investment funds. The best evidence suggests that, on average, even institutional investors may be doing no better in the private markets than they would investing in a broad index of public securities.[11] 

B.  Retail investors would be highly unlikely to gain access to the same issuers and investments in the private markets as institutional investors.

Capital is currently abundant and cheap in the United States, in both the public and private markets, due to our prolonged period of historically low interest rates.  Private firms have a seemingly bottomless supply of capital from institutional and high-net-worth investors, including venture capital funds, private equity funds, private credit funds, business development companies, angel investors, sovereign wealth funds, pension funds, and others.

The number of investment funds targeting the U.S. private markets has grown exponentially over the last few decades,[12] leading to vigorous competition for investments. Large operating companies are also eagerly competing to invest in private firms. These “strategic” acquisitions have long replaced the IPO as the primary exit for venture capital investments. In this highly competitive environment, capital is far from scarce. The notion that institutional investors may have passed over a large set of attractive private investments is therefore implausible. There is simply no evidence that issuers with reasonable prospects for growth and profitability currently lack capital in the private markets.

The private issuers that seek out direct investment from small-dollar retail investors are likely to be the smallest issuers with the worst prospects—the product of severe adverse selection, if not fraud.[13] It would be ill-advised to steer retail investors towards these firms, when decades of financial economics research suggest that they would be poor investments for retail investors and that such firms are not equipped to manage passive investments from dispersed equity holders.

This adverse selection faced by retail investors in the private markets has two further implications.  First, studies showing returns to very large institutional investors in the private markets are simply not predictive of what the returns to small-dollar retail investors would be; rather, such studies represent an unachievable upper bound on those returns.  Second, these investments would be highly unlikely to meet FINRA’s “suitability” standard and the SEC’s recently adopted Regulation Best Interest in order for brokers to recommend them to retail investors.[14] Given that, it seems particularly problematic that the SEC seeks to allow small-dollar retail investors to invest directly in such securities.

C.  Even if retail investors could gain access to the same investments as institutional investors, we would expect their investment performance to be materially worse, due to severe information asymmetry and greater liquidity risk.

Retail investors in the private markets would face a strikingly uneven playing field relative to corporate insiders and more sophisticated investors.

Information Asymmetry: Unlike in the public markets, where securities prices are believed to incorporate all available information, investors in the private markets must determine the value of securities themselves. The amount of information available in the private markets is very limited, and is distributed unevenly across investors, even in the very same firm.[15]  Private securities are also largely illiquid—that is, there is dramatically less trading than in the public markets.  The combination of these two factors means that there is generally no single “market price” at any given time for private securities, and there is no reason to believe that the pricing of private securities is efficient.

Accordingly, access to information is crucial for valuing private securities.  Unfortunately, even assuming that retail investors were sophisticated enough to value private securities, they would be unlikely to have access to the necessary information. Because they are not subject to the mandatory disclosure regime that applies in the public markets, private issuers are not required to disclose even the most material information affecting them, such as the loss of the firm’s largest customer, the departure of the CEO, or the initiation of a major lawsuit or government investigation.

For the most part, nothing prevents private firms from providing differential disclosure or no disclosure at all to their investors. While institutional investors with sufficient bargaining power typically negotiate for certain information rights from private issuers,[16] retail investors in the very same firms might have no information rights whatsoever.[17]

Liquidity Risk:  Retail investors have liquidity needs that institutional investors typically do not; retail investors cannot keep their capital invested indefinitely.  However, private securities are largely illiquid, in stark contrast to public securities.[18] First, investors in private firms may not be permitted to sell their securities at all, whether due to restrictions imposed by the securities laws or by the issuers themselves. Even when permitted to sell, they may be unable to find a buyer, given the lack of publicity and information about the issuer. If they are able to sell their securities, e.g., through a broker or a secondary market for private securities, the high transaction costs and bid/ask spreads could eliminate any gain on the sale. At the same time, opening up retail investment in private markets would place enormous pressure on resale restrictions, which could undermine the design of transaction exemptions including provisions that protect investors.

Dilution Risk: Even if retail investors managed to access the rare startup that ultimately proved to be a success, they would still have no guarantee of emerging with a large payoff. Emerging companies raise needed funds in stages, with progressively larger and more sophisticated investors at each round, until the firm finally has a liquidity event via acquisition or IPO. Experience confirms that earlier-round investors face substantial threats of dilution with each successive round of financing. Experienced early investors such as venture capital funds protect themselves against this threat through various private ordering devices. There is no reason to expect that retail investors would be sufficiently coordinated or experienced to protect their gains against future appropriation through succeeding dilutive investments.[19]

Lack of Recourse:  If a private firm is performing poorly, or there is misconduct by the management team or controlling stockholders, retail investors would likely be the last to be informed, if ever. And unlike in the public markets, there is little chance that they would have adequate recourse to correct the problem or to be compensated for their losses.  For example, while the prohibition on insider trading applies both to public and private securities, such trading is extraordinarily difficult to detect and to enforce in the private markets, due to the lack of mandatory disclosure and the absence of a continuous market price for the issuer’s securities. Thus, even if retail investors were able to invest alongside institutional investors in the private markets, they would be at the mercy of not only issuers and insiders, but also institutional investors with considerably more bargaining power, more sophistication, and more information.

Retail Investors Raise Unique Concerns That Caution Against Investing in Private Securities

Retail investors’ overall track record is not encouraging, even in the public markets.   Decades of finance research support the policy of encouraging retail investors to invest in low cost index funds.  The fact that we have finally achieved some success in steering retail investors’ 401(k) investments to low-cost index funds of public securities should be considered one of the crowning achievements in investor protection of the last decade.  It is worth noting, however, that it took decades to make progress on this front, during which time retirement investors collectively lost or passed up billions of dollars per year as a result of poor investment choices, excessive fees, and transaction costs, typically without ever realizing it.[20] Encouraging retail investors to invest directly in private securities would be fundamentally at odds with this achievement.   Encouraging investments in private securities would not only increase the risk for retail investors, it would also drain liquidity from public securities, which are the inputs to index funds.

Institutional investors often allocate a portion of their capital to the private markets on the theory that they provide additional diversification, because the returns in the private markets may not be perfectly correlated with those in the public markets.[21] This rationale does not apply to small-dollar retail investors. With limited funds to invest and limited opportunities in private securities, retail investors would almost certainly increase their overall risk and reduce their portfolio diversification by allocating funds to direct private investments.

Proposals to Increase Retail Investor Participation in Private Securities through Pooled Investment Vehicles Suffer from Misconceptions about Private Markets

As an alternative to direct retail-investor participation in the private markets, the SEC’s Concept Release seeks comment on various proposals designed to increase opportunities for retail investors to invest in private securities indirectly, through pooled investment vehicles such as open-ended investment companies (mutual funds), closed-end funds, interval funds, and tender offer funds. Other commenters have proposed allowing retail investors to invest in a fund-of-funds that would in turn invest in private equity funds or venture capital funds.

First, it is worth noting that retail investors can already access the private markets indirectly through channels such as (1) mutual funds that invest in late-stage private firms, (2) business development companies, and (3) publicly-traded private equity firms.

Second, these proposals implicitly seek a pooled vehicle structure for retail investors with features that cannot coexist in practice: liquidity for the investors; investment in illiquid private securities; investment in small issuers; broad diversification; good risk-adjusted returns; and, presumably, no need for retail investors to monitor the fund manager and the investments themselves. None of the current proposals for a pooled investment vehicle for retail investors would plausibly combine all or even most of these desired features.

For example, private equity funds often invest in no more than five to seven portfolio companies during their 10-year lifespan and so cannot reasonably be characterized as diversified.  This would represent a degree of risk that is unjustified for a retail investor with very limited funds to invest. A fund-of-funds that invested in multiple private equity funds could ameliorate the diversification problem slightly, but the fees charged by the manager of the fund would chip away at returns significantly. And these returns would vary substantially depending on the quality of both the manager and the underlying funds, something that retail investors are not suited to evaluate.[22]

Indeed, the proposal of a fund-of-private-equity-funds for retail investors appears to suffer from three common misconceptions about the private markets:

As discussed above, it is not clear that even large institutional investors earn higher risk-adjusted returns in the private markets today than in the public markets. The most recent evidence suggests instead that private-market and public-market returns are converging for institutional investors. A fund-of-funds for retail investors would add another layer of fees on top of that, further lowering returns.

The idea that accessing the private markets will allow retail investors to invest in “the next Google” is inaccurate for several reasons. In order to be assured of having access to the high-growth issuers that generate major returns, retail investors would not only have to invest in a diversified portfolio of private securities, they would have to hold “the market” portfolio—that is, a share of all private securities.  Indeed, in the public markets, just 4 percent of listed U.S. companies accounted for all of the gains of the U.S. stock market from 1926 to 2016.[23] Investors who did not hold shares in this vanishingly small set of issuers would have missed out entirely on the gains in the public markets. This is why market index funds are so beneficial to investors: They provide access to the tiny set of out-performers, without requiring investors to guess which ones the winners will be.

Yet there is no way to create such an index fund for private securities or to hold “the market” for private securities, even with a fund-of-funds. First, even regulators do not know the full universe of private securities outstanding at any time. Second, because private securities are relatively illiquid and generally subject to restrictions on resale, no investor is guaranteed access to any specific issuer’s securities. If all of the gains in the private markets are generated by a very small proportion of issuers (as they are in the public markets), investors hoping to invest in “the next Google” by investing in the private markets are most likely to miss out entirely.

Finally, a common justification for allowing retail investors to access the private markets is that they provide returns that are not perfectly correlated with the public markets, creating additional diversification for investors in the public markets.[24] As discussed above, the diversification rationale does not apply to small-dollar retail investors with limited funds to invest. Moreover, as the private markets continue to become more competitive, we should expect more correlation with the public markets. Private firms are subject to the vagaries of the business cycle, just as public firms are.[25] For similar reasons, claims that investments in the private markets are less volatile than the public markets are also likely inaccurate.[26]

The Need for Data

The initial step in designing rules to “harmonize” transaction exemptions, we believe, should be to require that issuers and securities intermediaries provide greater information to the commission about their use of transaction exemptions.  This information should then be made available to academics and the public for analysis and comment.  Collecting this information may require changes to filing requirements for existing transaction exemptions.  More data on the use of existing exemptions would help Congress, the commission and the public answer vital questions before the commission pursues any rule changes that would enlarge the scope of transaction exemptions.  We close our letter with a summary of the types of information the commission should collect, analyze, and disseminate with respect to the use of existing transaction exemptions before it seeks to “harmonize” them.


[1]  The letter draws heavily on Professor de Fontenay’s testimony earlier this month before the House Financial Services Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets.  Another signatory to the letter, Professor Renee Jones (Boston College) testified at the same subcommittee hearing.

[2] See Craig Doidge et al., The U.S. Listing Gap, 123 J. Fin. Econ. 464 (2017).

[3] See Scott Bauguess et al., Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009–2014 (2015),

[4] See, e.g., Xiaohui Gao et al., Where Have All the IPOs Gone? 48 J. Fin. & Quantitative Analysis 1663, 1677–79 (2013) (attributing the decline in IPOs to technological changes requiring small companies to achieve scale faster); Robert P. Bartlett III et al., The Small IPO and the Investing Preferences of Mutual Funds, 47 J. Corp. Fin. 151 (2017) (providing evidence that the sharp decline in small company IPOs was triggered by mutual funds’ preference for liquidity).

[5] See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717 (1984).

[6]  Moreover, existing exemptions also allow retail investors to purchase private securities.  For example, in 2016, the Commission amended Rule 504 of Regulation D to allow exempt issuances of up to $5,000,000 in securities in any 12-month period. Under Rule 504, offerees and purchasers need not be accredited investors.  Prior to the amendment, the cap was $1,000,000 in any 12-month period.

[7] For example, under Rule 506(b) of Regulation D, issuers may raise an unlimited amount of capital with no required disclosures to investors, so long as the securities are offered only to “accredited investors.” See 17 C.F.R. § 230.506(b).  Under this exemption, the issuer’s only “disclosure” obligation is the filing with the SEC of Form D, a simple two-page notice providing summary information about the issuance.

[8] In particular, the performance of private equity funds as reported by industry associations and much prior research is significantly overstated. See Ludovic Phalippou & Oliver Gottschalg, The Performance of Private Equity Funds, 22 Rev. Fin. Stud. 1747 (2009).

[9]   For studies documenting the decline in returns to private equity investors over time, see, e.g., Robert S. Harris, Tim Jenkinson & Steven N. Kaplan, How Do Private Equity Investments Perform Compared to Public Equity?, 14 J. Inv. Mgmt. 14, 15 (2016); Ludovic Phalippou, Performance of Buyout Funds Revisited?, 18 Rev. Fin. 189, 189 (2014); Ludovic Phalippou & Oliver Gottschalg, The Performance of Private Equity Funds, 22 Rev. Fin. Stud. 1747, 1747 (2009); Berk A. Sensoy, Yingdi Wang & Michael S. Weibach, Limited Partner Performance and the Maturing of the Private Equity Industry, 112 J. Fin. Econ. 320, 341-42 (2014).

[10] See Harris et al., supra note 10, at 15.

[11] Even if one could show that institutional investors earned superior returns in the private markets, the excess return would likely be compensation for the additional liquidity risk associated with private securities. Investments in private firms and in the private markets are considerably harder to sell quickly and with low transaction costs than in the public markets.  Institutional investors are well suited to bear liquidity risk; retail investors are not.

[12]See Javier Espinoza, Private Equity Funds Active in Market Reach All-Time High, Fin. Times (Apr. 25, 2018), b3 (describing record-breaking fundraising by private equity funds).

[13] We note that these adverse selection problems may exist even in other stages of the market cycle.  Institutional investors have more resources and longstanding relationships with market intermediaries than retail investors.  This affords institutional investors greater access to the most promising investments even independent of regulatory restrictions.  For an analysis of adverse selection problems in public and private securities offerings, see Merritt B. Fox, Regulating the Offering of Truly New Securities: First Principles, 66 Duke L.J. 673 (2016).

[14] See James D. Cox, Who Can’t Raise Capital? The Scylla and Charybdis of Capital Formation, 102 Ky. L.J. 849, 862 (2013) (“[I]t is difficult to believe that investing in a small business, and particularly one with little operating history and little liquidity for its shares, is appropriate for the investor who is neither accredited nor sophisticated.”)

[15] See Elizabeth Pollman, Information Issues on Wall Street 2.0, 161 U. Pa. L. Rev. 179, 235–36 (2012).

[16] See Nat’l Venture Capital Ass’n, Investor Rights Agreement 20–23 (“Information and Observer Rights”), (last visited Sept. 21, 2019).

[17] To illustrate this concern, consider that before it went public earlier this year, the car sharing service Uber was the largest of the private company unicorns. In January 2016, while raising additional equity capital at a $62.5 billion valuation, its shares were marketed to high-net-worth individuals who were not given any financial statements whatsoever for the company. See Julie Verhage, Here’s What Morgan Stanley Is Telling Its Wealthiest Clients About Uber, Bloomberg (Jan. 14, 2016, 6:42 AM), available at

[18] See Jeff Schwartz, The Twilight of Equity Liquidity, 34 Cardozo L. Rev. 531, 548-50 (2012) (describing the factors that render private company equity illiquid).

[19] Cox, supra note 15, at 854.

[20] See William A. Birdthistle, Empire of the Fund: The Way We Save Now 71-88 (Oxford University Press, June 2016).  Professor Birdthistle estimates the minimum annual fee revenue to the mutual fund industry to be approximately $100 billion.  See id. at 62. Of that amount, a conservative estimate would be that shareholders are paying tens of billions annually in fees for actively managed funds, rather than cheaper and better performing index funds.

[21] See SEC Concept Release at 173 (“Retail investors who seek a broadly diversified investment portfolio could benefit from the exposure to issuers making exempt offerings, as these securities may have returns that are less correlated to the public markets.”)

[22] As a comparison point, decades of research confirm that retail investors’ track record of picking mutual fund managers is poor. See Birdthistle, supra note 21.

[23] Hendrik Bessembinder, Do Stocks Outperform Treasury Bills?, 129 J. Fin. Econ. 440 (2018). See also Hendrik Bessembinder et al., Do Global Stocks Outperform US Treasury Bills (2019), available at

[24] See footnote 22 and accompanying text.

[25] Private equity returns, for example, are highly cyclical, which calls into question the view that private equity offers significant diversification benefits relative to investing in public equities. See, e.g., Viral V. Acharya, Julian Franks & Henri Servaes, Private Equity: Boom and Bust?, 19 J. Applied Corp. Fin. 44, 46 (2007); Andrew Ang et al., Estimating Private Equity Returns from Limited Partner Cash Flows, 73 J. Fin. 1751, 1751 (2018).

[26] See Andrew Ang et al., Estimating Private Equity Returns from Limited Partner Cash Flows, 73 J. Fin. 1751, 1782 (2018) (concluding that volatility for private equity is at least as high as for standard equity indices); Daniel Rasmussen, Private Equity: Overvalued and Overrated?, Am. Aff., Spring 2018, at 4.

This post comes to us from Erik F. Gerding, a professor and Wolf-Nichol Fellow at the University of Colorado Law School.

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