The COVID-19 outbreak provides fertile ground for sweeping regulatory changes. On May 19, 2020, for example, President Trump issued “Regulatory Relief to Support Economic Recovery Executive Order 13924”, which prompted the U.S. Securities and Exchange Commission (“SEC”) and Department of Labor (“DOL”) to promulgate new rules to protect investors and facilitate capital formation. The SEC adopted amendments aimed at harmonizing and improving the “patchwork” exempt offering framework, while the DOL announced that 401(k) plan fiduciaries have the ability to invest in private equity funds.
The primary purpose of these changes is to democratize and equalize access to the private market. These policies address the concern that retail investors are missing out on investment opportunities due to fewer listed firms, fewer initial public offerings (“IPOs”), the increasing role of private markets in raising capital, and the soaring number of unicorns: private companies valued at $1 billion or more. Large investment firms, such as private equity funds, may also be interested in getting access to the individual investor market.
Despite regulators’ best intentions, their policy changes may not help investors, retirees, and entrepreneurs, and may even put them at greater risk (see here). In a new article, Alternative Venture Capital, I detail these concerns, take a look at the new policies, and argue that many of them fail to provide necessary protections and should never have been adopted.
The central issue is that policymakers must consider the rise in alternative venture investors and the ways in which those investors affect a unicorn firm, its capital needs, and the lack of disclosure of information, which affects future investors. In the last few years, new, non-traditional, deep-pocketed investors have made notable investments in large private technology companies, which have historically received much of their funding from venture capital investors. Institutional and high-net-worth investors, such as SoftBank, mutual funds, hedge funds, corporate venture capitalists, private equity, and sovereign wealth funds (together, “alternative venture capital” or “AVC” investors) are turning their attention to private markets in the hopes of capitalizing on the high returns of unicorn firms before they do an IPO.
The interest of these deep-pocketed investors has reversed the competitive landscape of unicorn funding. Rather than unicorn firms competing for a limited pool of funding, they are able to attract a nearly limitless pool of funds, leaving the deep-pockets to compete for the chance to invest. This reversal substantially alters the governance structure of unicorns and the nature of the relationships between these companies and their investors. Rather than investors shopping for a firm, unicorns are now allowed to pick and choose their investors, often to meet the desires of their controlling founders. This alone presents serious issues, given that founder objectives may not be aligned with the best interests of the company. Further exposing retail investors to such risks should be reason enough to give regulators pause.
Currently, retail investors, researchers, and regulators do not have detailed information on the identity of these new investors in our private markets, their incentives, risk tolerance, the contractual terms they negotiate, or other relevant data that would be helpful in understanding the new developments in the private markets. My article helps fill that gap.
AVC investors are focused on financing unicorns because of unicorns’ potential to disrupt the market, transform entire industries, and add value to the investors’ portfolios. In some instances, AVCs are even outbidding traditional VCs for opportunities to invest. Unicorn founders and AVCs have common interests. Unicorn founders want to continue controlling their firm by keeping it private longer and not subjecting themselves, their management decisions, trade secrets, or strategy to public market scrutiny. For unicorn founders, AVC is a new and very attractive path to allow early equity investors and talent to exit by providing liquidity for shareholders that are locked in, without requiring a traditional trade sale or IPO.
AVCs are further interested in investing in unicorns thanks to recent changes to our securities laws, the decline in IPOs, the extended period of low interest rates, a blend of financial and strategic incentives, and other geo-political considerations. They may bargain for different contractual rights than traditional VCs when investing in unicorns, and those rights include aggressive redemption rights and post-IPO pricing “ratchets.” These contractual mechanisms are designed to protect them from down-rounds and lower post-IPO valuations.
To illustrate, as Professor Coffee notes, WeWork’s S-1 filings (and revised filings) with the SEC indicate that the company’s AVC investors obtained new contractual rights that protected their expected rate of return (rather than monitoring rights) at the expense of other shareholders, including future investors. These IPO ratchets are contractual rights that give alternative investors additional shares in the last round of financing in case the valuation following the IPO falls below the pre-IPO valuation.
Should regulators encourage retail investors to invest in private firms such as WeWork, which were previously limited to sophisticated and wealthy players, such as accredited individuals and institutions? There are many risks associated with investing in illiquid assets or monitoring private fund investment advisers. To illustrate, the SEC recently issued a risk alert about investigations and enforcement actions against private fund investment advisers on lack of disclosures of potential conflicts of interest, excessive fees, and failures to implement policies on insider trading.
My article explains why the remedies offered to this problem are flawed. It also sheds light on the increasing array of new investors that policymakers must consider when making policy decisions regarding the capital needs of private companies. The power of these investors to dictate favorable terms for themselves, aimed at mitigating their own risk, exacerbates the information asymmetry between private firms and retail investors.
The new rules may encourage both sophisticated and non-accredited investors to invest in illiquid securities of high-risk private ventures. They may also diminish the already limited investor protections in private markets. The entire securities regulatory scheme is centered on the concept of disclosure of information to improve price discovery and efficiency and reduce information asymmetry. Without more disclosure, non-accredited purchasers will not be able to make informed decisions, especially concerning the risks associated with investing in privately-held firms.
The reality is that traditional investors in private markets, VCs and PEs, are now competing with non-traditional AVC investors over investments in unicorns. Raising large amounts of capital in late-stage and very-late-stage financings is the new norm for a unicorn. By making changes that allow firms to stay private longer, regulators have approached this problem from the wrong direction. Rather than encouraging more disclosure and forcing these companies to go public if they want to continue to raise capital, they have opened the door for retail investors to stumble through the darkness, while allowing large, sophisticated actors to quietly slip out and close the door behind them. Policymakers and regulators should consider ways to enhance our public markets and investor protections rather than trying to find substitutes for them.
This post comes to us from Professor Anat Alon-Beck at Case Western Reserve University School of Law. It is based on her recent article, “Alternative Venture Capital: The New Unicorn Investors,” available here.