Many investors may have fantasized about those “if only” investments. If only I had invested in Peloton. Or Uber. Or Lyft.
For most people, though, that’s not possible — and not just because they don’t have a million dollars to drop on a billion-dollar idea. Under current law, only individuals with at least $200,000 in annual income or $1 million in assets (outside of their home) are “accredited investors,” or those qualified to invest in private securities.
Now, the nation’s top securities regulator is contemplating how to let ordinary people get in on companies before they go public.
Jay Clayton, chairman of the Securities and Exchange Commission, has argued that smaller investors shouldn’t be shut out from these “potentially attractive” investments.
How that would be remedied isn’t entirely clear. One possibility raised would allow private investments inside target-date funds, a mutual fund whose investment mix shifts as a retirement date nears.
But such a change would be both complicated and risky. Other regulators, academics and consumer advocates argue that smaller investors could too easily get in over their heads. “These investments are complex, opaque and often carry risks that most mom-and-pop investors are unable to absorb,” said Andrea Seidt, the Ohio Securities commissioner.
The commission took its most concrete step in that direction last month. It passed a proposal — in a 3-2 vote — that, if finalized, would grant access to stockbrokers and investment advisers, even if they do not meet the income and wealth thresholds. The same would be true for certain “knowledgeable employees” of a private fund, including venture capital, private equity or hedge funds.
That part of the proposal wasn’t terribly controversial. But Clayton said to “expect more in this space” in the coming months.
“I believe it is our obligation to explore whether we can increase opportunities for Main Street investors in the private markets while maintaining strong and appropriate investor protections,” Clayton recently said before Congress.
Why is this idea gaining traction now? Partly, it’s because of how the investment landscape has changed over the past couple of decades. There are only about half as many public companies in the United States today as there were in the late 1990s. And promising startups are tending to stay private longer, with elite investors capturing even more of the biggest gains.
There are reasons companies decide to stay private — including the more relaxed rules they face compared with public companies, which are required to make disclosures intended to allow investors to judge their value.
That lack of disclosure is just one of the reasons consumer advocates and others are wary of the idea. They also point to high fees associated with private investment funds, and the slim chances that smaller investors have at gaining early access to the next Google or Facebook.
And in the end, it might not even be worth the trouble. Overall, the performance of private funds doesn’t look much better than your standard mutual fund.
Private equity funds returned 13.3% in 2018 and 11.6% for the past 10 years ending in September of 2018, after fees, according to PitchBook’s most recent private markets benchmark data. In contrast, investors who held mutual funds that specialized in small and midsize companies earned returns of 14.3% in 2018 and 9.4% over the same 10-year period.
But the spread between the best and worst performing private equity funds was much wider than for standard mutual funds: The top 25% performing private equity funds earned at least 16.2% over that 10-year period, while the bottom quartile returned at least 5.2% (the bottom 10% had negative returns). In the mutual fund world, the worst and best funds ranged from 9.8% (for the bottom 25%) to 12.2% (for the top 25%).
The SEC itself acknowledged that it doesn’t have a full picture of how investors have fared in private investments, which are also called exempt offerings.
“It is difficult to perform a comprehensive marketwide analysis of investor gains and losses in exempt offerings given the significant limitations on the availability of data about the performance of these investments,” the commission wrote.
The opaque nature of the private market also increases the risk for fraud.
Seidt, the Ohio Securities commissioner, told the SEC Investor Advisory Committee in November that there had been more than 100 state actions across the country involving private offerings in the prior two years. Over a thousand investors had total losses of more than $100 million, she said. And that was only a partial snapshot.
“These private offerings have been and remain the most common source of state enforcement action,” she told the committee. Before adopting any rules, she said, the SEC needs to produce research that illustrates how packaging private investments into a fund would be safe.
Even constructing such an investment vehicle would present challenges because private investments can take so long to pay off.
Some funds that are open to average investors already hold small stakes in private companies. Mutual funds are permitted to dedicate up to 15% of assets to illiquid securities, including private companies, but they often invest much less because those holdings cannot be easily be sold — that’s a problem for funds because they must have enough flexibility to pay shareholders who cash out.
For example, the $44 billion Fidelity Growth Company Fund, which owns pieces of late-stage private companies like Allbirds, Peloton and Sweetgreen, had less than 3% of its assets in private holdings as of Oct. 31.
It would also be difficult — and expensive — for investors to properly diversify their holdings, said Elisabeth de Fontenay, a professor at Duke University School of Law who specializes in corporate finance.
“Finance theory suggests that retail investors should be in broadly diversified index funds, and there’s no way to replicate that in the private markets,” she said. Creating a fund of private equity funds would help, she said, but “the fees involved are likely to swamp the returns.”
Even if regulators don’t further open the door to the private markets, more investors are already squeezing through.
The thresholds that regulators set to determine who was qualified to access the private market were never indexed to inflation. Last month’s proposal did not suggest changing that. The $200,000 in annual income requirement set in 1982 would translate into roughly $538,000 today, while the $1 million net-worth threshold is now equal to $2.7 million.
Back then, an estimated 1.6% of the American households qualified as accredited investors, according to the SEC proposal. By 2019, that climbed to roughly 13% of all households.
When regulators voted last month on the proposal to allow certain investment professionals to access private markets, one commissioner — Allison Herren Lee, a Democrat who voted no — said she believed the accredited investor definition already includes too many people.
“It appears that the failure to update these thresholds may be less about providing American investors access to lucrative private markets,” she said at the meeting, “and more about providing private markets access to potentially vulnerable American investors.”