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Private Equity For All

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Mike Tyson famously said, “Everybody has a plan until they get punched in the mouth.” If the Securities and Exchange Commission isn’t careful, it may be investors who end up with a black eye.

SEC Chairman Jay Clayton said in an interview with The Wall Street Journal that the commission wants to make it easier for individual investors to invest in private companies such as Uber or Airbnb. The SEC will issue an extensive report known as a “concept release” in coming months, a process that will include seeking public comment on its proposed changes. But Clayton seemed to be eager to get changes in place as soon as possible.

Under Clayton’s guidance, the SEC has turned its attention to the shrinking number of public companies in the United States. In part because going public is an expensive and invasive endeavor, many successful ventures resist doing so for as long as possible, and the number of companies listed on U.S. exchanges is currently at its lowest point in almost 50 years. Clayton has vocally encouraged more companies to go public, but now he seems to be prepared to try a new tactic: letting more people invest in companies while they are still private.

Right now, not just anyone can invest in a private company. Most private companies can only sell stock to investors that the SEC considers “accredited investors” or “qualified purchasers.” The current definition of a sophisticated investor of either type is based on a straightforward criterion: money. The SEC defines an accredited investor as an individual with a net worth of at least $1 million or an annual income of $200,000, or $300,000 for married couples, for at least three years. A qualified purchaser is usually an individual or a family business with more than $5 million in investments, though other entities like trusts can also achieve the designation.

The idea is that big spenders are more likely to have experience, access to expert advice or both, so they can avoid making a major mistake through ignorance. But the values involved are necessarily arbitrary. Is an individual with $4.5 million in investments necessarily less qualified, or someone with an annual income of $199,000 automatically less worthy of accredited status, all else being equal? Of course not. In this sense, making the qualification to invest in private equity something other than an investor’s wealth is worth considering.

The question becomes what qualifications the SEC will use instead. We make people take a road test before we issue a driver’s license. Some sort of exam or licensing process before letting investors enter the more dangerous waters of private equity does not seem outrageous. In fact, Congress has already taken steps in this direction. The House passed the JOBS and Investor Confidence Act in July; if the bill makes it into law, it will expand the definition of an “accredited investor” to include registered brokers, investment advisers, and those with “demonstrable education and experience” relating to investments. The SEC, too, has said it may expand accredited investors to include individuals with relevant professional licenses or education.

On the other hand, if the SEC’s new requirements are flimsy – say, having an investor sign a waiver stating that he or she understands the risks – the commission could inadvertently create a free-for-all environment in which it is almost inevitable that some individuals will lose a great deal of money.

In order to have an initial public offering, a company must comply with various disclosure and transparency requirements. Private companies do not have to meet these same guidelines, which is why their shares are only available to investors who, presumably, have the resources and experience to properly evaluate the risks involved in a more opaque investment. Funds would offer greater built-in diversity, and thus less risk, than investments in individual companies, but would do nothing to mitigate the lack of transparency.

Private companies can and do go under, even those that were once rising stars. The Wall Street Journal reported that Theranos Inc. will soon dissolve, completing the startup’s long and public fall from grace. The blood-testing enterprise was once valued at more than $9 billion; many touted its founder, Elizabeth Holmes, as the next Steve Jobs, a perception Holmes actively cultivated. But journalists, and eventually investors and regulators, questioned Theranos’ underlying technology. Holmes and former president Ramesh Balwani were indicted on multiple counts of fraud in June. Theranos failed to find a buyer and recently breached the terms of a $65 million loan, and it now plans to pay unsecured creditors its remaining cash before closing its doors. Equity investors will get nothing.

In an opinion column for Bloomberg, Stephen Gandel argued that while hype for trendy startups can easily get out of proportion, rules restricting who can actually invest in them has limited the economic damage of such misplaced optimism. “The private market’s ability to limit hype and investment is a feature, not a bug,” Gandel observed. Done right, changing the rules about who can invest in private firms could allow access to investors with a good understanding of the associated risks, even if they have less cash. Done carelessly, it could be a recipe for a serious investment bubble, or an invitation for fraudsters to operate on a greater scale.

The rules that limit private equity investment to sophisticated investors aren’t perfect, but they exist for a reason. Congress created these rules in their basic form as a response to the Great Depression, before which most investors and firms were free to do as they pleased without oversight. Before moving forward, Clayton should consider who he is really trying to help: mom and pop investors or large private companies that need fresh capital. And the SEC as a whole should think carefully before removing any investor safeguards.

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