Navigating Change in the Private Capital Markets
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1 MAR 2014 WHITE PAPER Navigating Change in the Private Capital Markets A look at the significance of private securities in light of recent regulatory and technological opportunities.
2 Introduction Withover$1trillioninannualofferingstheU.S.marketforsellingprivatesecuritiesisanexceptionallylargeyet relativelyunfamiliarassetclass.thispaperattemptstoshedsomelightonanopaquemarketplacebyanswering somecommonquestions: Whatisaprivatesecurityandhowdoesitwork? Whataresomeofthekeymarketchallengesrightnow? What schangedtoopenupnewopportunitiesinprivatesecurities? WhyshouldIcare? The sector has been growing at a 15% compound annual growth rate while public alternatives have plateaued.thesedevelopmentsaredueinparttothefirstsignificantregulatorychangesmadetothesectorin morethan30years. As the transformation takes form new innovations are emerging that will enhance the marketplace while also evoking some new concerns. Understanding these dynamics will enable issuers investorsandagentstotakeadvantageoftheopportunitiesthisgrowingassetclasspresents. 1
3 Withover$1trillioninannualofferingstheU.S.marketforsellingprivatesecuritiesisanexceptionally largeyetrelativelyunfamiliarassetclass. 1 Whatisaprivatesecurity?Howdoesthismarketoperateandwhy don tiknowmoreaboutit?thefollowingpaperattemptstoshedsomelightonthisopaquemarketplaceforboth companiesseekingtoraisecapital( Issuers )andinvestorslookingfornewopportunities.sowhynow?because theprivatecapitalmarketsareinatransformativestate.understandingthedynamicsbehindthisassetclassisan imperativeforallmarketparticipants. WhatisaPrivateSecurity? GenerallyanysaleofsecuritiesthatisnotregisteredwiththeSEC. IntheU.S.anyoffertosellsecuritiesmusteitherberegisteredwiththeSEC(i.e.a publicoffering )or satisfy certain exempt qualifications in order to remain unregistered or private. The most commonly cited privateexemptionsareoutlinedunderregulationd( RegD ). 2 RegDconsistsofvariousrulesthatgovernthe qualificationsneededtomeetsecexemptionsandareavailabletoanyissuerwithoutregardtopublicstatus.the majorityofregdofferingsarefiledunderthefollowingrules: Exhibit1. RegulationD SummaryRuleExemptions 3 Rule504:Maximumofferingamountof$1millionperannum o Nolimitonnumberofinvestors Rule505:Maximumofferingamountof$5millionperannum o Nolimitonnumberofaccreditedinvestors o Limitedto35unaccreditedinvestors Rule506:Nolimitationonofferingamount o Nolimitonnumberofaccreditedinvestors o Limitedto35unaccreditedinvestors o OnlyRegDexemptionthatprovidesfornationalpre\emptionofstateblueskylaws A blue sky law is a state law that regulates the offering and sale of securities. They are designed to protectthepublicfromfraud.thespecificprovisionsoftheselawsvarybuttheyallrequiretheregistrationof securities offerings and sales. As can be seen in the chart below Rule 506 is by far the most commonly cited exemptionbecauseitpre\emptscompliancewiththesedisparaterequirements. 1 DowJonesGuidetoSecondaryMarketIntermediaries2012.The$1trillionfigurereferstonewissuancesor primaryofferings. 2 UnderTitle17oftheCodeofFederalRegulations(17C.F.R etseq). 3 ThischartisasummaryoverviewofaportionoftheRegDrules.PleaserefertoSEC.govforacomprehensivereviewofallRegDtermsandconditions. 2
4 Exhibit2. RegulationDExemptionClaimedbyNumberofOfferings 4 WhyShouldICare? Becauseprivatesecuritiesareagrowingassetclasswithanattractivetrackrecord. Privatesecurities offeringsrepresentanexceptionallylargeassetclass.in 2012 the marketforregd offerings alone was approximately $905 billion. 5 These offerings run the gamut from small early\stage seed rounds to multi\billion dollar corporate issuances and alternative investment funds (e.g. Private Equity Funds HedgeFundsandVentureCapitalFunds).IntheU.S.alonethereareapproximately128000privatecompanies with more than $10 million in revenue and over private funds. 6 From an issuer s perspective the addressableinvestoruniverseforprivateofferingsintheu.s.includesmorethan40000institutionalbuyersover 3000singlefamilyofficesandnearly8.6millionotherqualifiedpurchasersandindividualaccreditedinvestors. 7 4 Doesnotincludenewlyestablished506(c)classification.PleaserefertoSEC.govforacomprehensivereviewoftheRegulationDtermsandconditions. 5 SEC CapitalRaisingintheU.S.:AnAnalysisofUnregisteredOfferingsUsingRegulationDExemption2009\2012 July Pitchbook: 4Q2012PrivateEquityCompanyInventoryReport. 7 WSJ WhoNeedsWallStreet? February2013.Familyofficesgroup.com TheFamilyOfficeReport
5 Exhibit3. AggregateCapitalRaisedintheU.S.byOfferingMethod($#in#billions) 8 $1250 $1000 Public 14.9%2CAGR Private $750 $500 (1.4)%2CAGR $250 $# Publicdebt Publicequity RegulationD Rule144A RegS+Sec4(a)(2) AccordingtoastudyconductedbyDukeUniversityandOhioStateUniversityprivateequityreturnshave surpassed the broader public market by double digits over the last 25 years. 9 Some would argue that such performanceisduetothefactthatprivatecompaniesareunburdenedbypublicadministrativecostsfreefrom the volatility and distortion generated by high speed trading platforms and dark pools and more focused on generatinglongtermvalueinsteadofmanagingtoquarterlyperformanceestimates.othersmightsuggestthat morestructuralinfluencesareatplaysuchasbuyinginataliquiditydiscountandsellingatanm&a/ipopremium. Ineithercasetheresultshaveendured. Fromanissuer sperspectiveprivatecapitalmarketsareanincreasinglyattractivealternativeforcapital formation.thisisdueinparttoacombinationoflegislativeandregulatorychanges(includingdodd\frankand Sarbanes\Oxley legislation) that are compounding the already significant costs associated with issuing public securities.thesechangesincreaseuncertaintyandcreateabarriertoentryforsmalltomid\capcompaniesthat cannotabsorbthelegalfinancial andadministrativeoverheadassociatedwithpubliccompliance.inaddition these companies receive limited attention from public research analysts and large investors which reduces demand for their securities. As a result companies are seeking alternatives to raising capital in the traditional publicforums. 8 SEC CapitalRaisingintheU.S.:TheSignificanceofUnregisteredOfferingsUsingRegulationDExemption February PrivateEquityinthe21 st Century:LiquidityCashFlowsandPerformancefrom1984\2010 July
6 Exhibit4. PrivateSecuritiesareanIncreasinglyAttractiveAlternative Regulatory+Environment JOBS%Act Dodd% Frank Sarbanes% Oxley Regulation FD } Increasing%costs%for%public%companies Heightened%uncertainty JOBS%Act%designed%to%improve%capital%access Market+Trends Convergence%of% Technology%&%Finance Trader %vs.% Investor % Focus% in%public%market Private%Market% Outperformance Impact%of%High%Speed% Trading%Platforms%and% Dark%Pools } Shrinking%Public%Market Investors%Seeking% Alternative%Investments Technology%driving%market%efficiency%and%access Private%markets%better%aligned%for%fundamental%investors Private%investments%historically%outperform%public WhataresomeoftheKeyMarketChallenges? Privatesecuritiesareusuallysoldtoarestrictedinvestorcommunitywhichlimitsfundingsources. Untilrecently(i.e.priortotheJOBSAct)inorderforasecuritiesofferingtoremain private Issuershad tobecarefulnottoengageina generalsolicitation"oftheirsecurities.sowhatisageneralsolicitation?while thesechasactuallyneverdefinedthistermaseriesofsecno\actionlettersindicateastaffviewthatgeneral solicitationoccurswhenanexusbetweenanissueranditspotentialinvestorsdoesnotexistorasthesecputsit a "substantive pre\existing" relationship does not exist.additionally with limited exception only Accredited Investors are permitted to invest in a private placement. Finally prior to the JOBS Act the total number of investors in a private company generally was limited to 500 before such company became a public reporting company.theserestrictionshavelimitedthesizeofthepotentialinvestorcommunitymakingitmoredifficultto raiseprivatecapital. 5
7 Exhibit5. AccreditationClassifications 10 InvestorClassification QualifiedInstitutionalBuyer(QIB) QualifiedPurchaser(QP) AccreditedInvestors Definition* Aninstitutionthatownsandinvestsonadiscretionarybasisatleast$100million insecurities(forabroker\dealerthethresholdis$10million).anindividualcannot beaqib. Individualswithanetworthof>$5millionininvestableassets.Institutionswitha networthof>$25millionininvestableassets. Apersonwhohasinvestibleassetsof>$1millionoranaturalpersonwithincome exceeding$200000ineachofthe2mostrecentyears($300000formarried couples)andareasonableexpectationofthesameincomelevelinthecurrentyear. *FortheexactdefinitionspleaseseeSECguidelines. Restricting access to financial professionals and sophisticated investors makessense given the intrinsic risksinprivatesecurities.whataretheserisks?firstprivatesecuritiespossessaninformationgap.withoutthe degree of formal oversight that exists in the public markets transparency is limited and there is increased potential for asymmetric information between buyers and sellers. Basically sellers are in control of what informationtheysharewithbuyers.thismakesconductingproperinvestmentduediligencechallengingandoften requiresprofessionalassistance.secondprivatesecuritiesdonottradeopenlyinalargesecondarymarket.this meansthatinvestorsareunabletolooktothemarketforpricediscoveryandhavelimitedliquidityavailableto them should they choose to sell their private securities. Finally private securities are not sold through a centralizedmarketinfrastructure.thismakesitverydifficultforinvestorstocomparepricingandotherdealterms acrossdifferentofferings. Ascanbeseeninthediagrambelowprivatecompaniestendtobesmallerfirmswithshorteroperating historiesandlimitedavailableinformation.thesefactorsincreasethecostofcapitalandlimitfundingsourcesfor privatecompanies. 10 PleaserefertoSEC.govforacomprehensivereviewoftheRegulationDtermsandconditions. 6
8 Exhibit6. TheCapitalLifeCycle 11 Firm%Continuum Firm%Size Available%Information Small%firms%little%to%no% collateral%and%track% record Small%firms%high%growth% potential%limited%track% record Med?size%firms%some% track%record%available% collateral Large%firms%known%risk% and%track%record Sources%of%Capital Insider%Seed%Money Commercial%Paper Short?term%Commercial%Loans Intermediate?term%Commercial%Loans Med?term%Notes Mezz?fund%Financing Private%Placements Public%Debt Private%Equity HowDoesaPrivateOfferingWork? Typicallythroughaninefficientlabor\intensiveandopaqueprocess. Public%Equity UntilrecentlyIssuerswererestrictedfrommakinggeneralsolicitationsorengaginginpublicmarketing efforts. Instead a closed process has been run often by enlisting the services and guidance of financial professionals ( Placement Agents ). These Agents conduct due diligence on the Issuers structure the offering termspreparemarketingmaterialscontactalimitednumberoftargetedinvestorsmanagetheinvestordiligence processandultimatelynegotiatetheentirecapitalraise.whileplacementagentsaddexpertisetothiscapital raising process they are not required to manage a private issuance. Large alternative investment funds for exampleoftenpossesstheirowninternalresourcesandbypassagentsaltogether. WhetherusingaPlacementAgentorinternalresourcesallIssuersrelyonaverymanualprocess.They must individually contact each targeted investor confidentially brief them on the proposed offering and then guideinterestedinvestorsthroughaseriesofadministrative/regulatoryhurdlesbeforerevealingspecificoffering details(includingthenameoftheissuer).onlythendoinvestorsreceiveformalinvestmentmaterialstoreview andbegintheirdiligence.thisentireprocessismanagedthroughaseriesofphonecallsand sallofwhich 11 TheFederalReserve TheEconomicsofPrivatePlacementMarket December
9 mustbetrackedandrecorded.giventhelabor\intensityofthisprocessinvestorreachisinherentlylimitedand successratesarelowerthantheymightotherwisebe. For investors the situation is even worse. First they must network with every investment bank and broker/dealer they know just to find private deals in the market. This requires navigating some very large institutions in an effort to find the privates guy. Depending on the firm this could be someone in capital marketsindustrycoverageorboth.thentheinvestorhastodescribetheirinvestmentobjectivesandseeifthe firmcurrentlyhasanythinginmarketthatfits.finallytheinvestormustsitbackandwaitforthephonetoring. Someinvestorswillreceivemanyopportunitiesandsomewillnotevenreceiveareturnphonecall.Theentire processisriddledwithinefficienciesandlostopportunities.givenallthetechnologicaladvancesmadeinmost otherindustriesandthetrilliondollarsizeofthisassetclassthisinefficiencyisquiteremarkable. WhatistheImpactofSuchInefficiency? Morelimitedaccesshighercostsandlowersuccessrates. The historic infrastructure underpinning the private marketplace is extremely inefficient. This impedimenthasenduredthankstoregulationsconstrainingthemarketingofprivateplacements andhencethe efficient flow of capital.the aforementioned labor\intensive one\to\one marketing efforts are a byproduct of these regulatory impediments. As shown in the chart below the result is that a large universe of qualified investors are never introduced to private placements. Investors miss out on attractive opportunities and companieshaveahardertimeraisingcapital. Ineffecttheprivatesecuritiesmarkethasbeenlefttodependuponthetelephoneasthestate\of\the\art technologyforraisingcapital.thislimitsmarketreachincreasestransactioncosts(i.e.noeffectiveleveragingof technology)reduceschancesofsuccessandultimatelyconstrictscapitalflows.thesefactorshavealsodrivena bifurcation in the marketplace where only large institutional investors capable of writing big checks are ever contactedbytheagentsonanoffering. 8
10 Exhibit7. InvestorAccesstoPrivateSecuritiesOfferings HowHasThisMarketRemainedSoInefficient? Becauserestrictionsgoverningthemarketingofprivateofferingshavedeterredinnovation. AspreviouslymentionedbothAgentsandIssuersarerestrictedbythesafeharborguidelinesunderReg D.PriortotheJOBSActtheseguidelinesprohibitedgeneralsolicitation(i.e.solicitinginvestorswithwhoma substantive pre\existing relationship did not exist) and limited private company shareholders of record to 500 beforehavingtomakepublicfilings.changestotheseregulationshavebeenslow.infactpriortothepassingof thejobsactin2012nosignificantchangehadbeenmadetotheseregulationsformorethan30yearsduring thistimesecuritieslawssurroundingthemarketingofprivatesecuritieswereveryunclear.specificallytheywere (1)basedonnumerousno\actionletters(2)subjecttothecurrentthinkingattheSECand(3)subjecttoafacts and circumstances based analysis. This uncertainty has lead most Agents to deploy limited direct marketing campaignswheretheycancontroldisseminationratherthanbuildingoutwidespreaddistributionnetworks.the ultimateabilityofthejobsacttoalleviatetheseissuesremainstobeseen. SoWhat schanging? Theprivatecapitalmarketsareinatransformativestate. New legislation addressing the capital raising process for private companies has been passed with the intention of alleviating certain regulatory hurdles and removing marketing limitations that have heretofore restrictedmarketaccess.thisisaseachangethatcombinedwithmarkettrendstowardsseekingalternativesto publiccapitalwilldrivetheadoptionofnewtechnologiesandinnovations. OnApril52012theJumpstartourBusinessStartupsAct( JOBSAct or Act )wassignedintolaw.the objectiveofthelegislationistostimulategrowthofsmalltomid\sizedcompaniesbyfacilitatingaccesstocapital. 9
11 ChangesundertheActinclude:(i)raisingthethresholdformandatoryregistrationandpublicreporting(underthe SecuritiesExchangeActof1934)from500shareholdersofrecordto2000;(ii)permittinggeneralsolicitation(i.e. abilitytocontactinvestorswhoyoudonotalreadyknow)inconnectionwithregdofferingsmadeundernewrule 506(c) and (iii) registration exemptions for limited\size offerings sold in small amounts to a large number of investors( crowdfunding ). WhatDoesThisMeanforPrivateIssuersandInvestors? Newopportunitiesnewrisks. ThealleviationofcertainregulationsundertheJOBSActhashelpedstimulatenewbusinessmodelsinthe private securities market. While this trend is a positive step towards more efficient markets investors should proceedwithcautionwhenevaluatingnewopportunities.earlystagestart\upcompaniesforexamplearebeing acquaintedwithamultitudeofcrowdfundingplatforms.theseinnovativemodelshavethepotentialtogreatly expand capital flow at reduced costs.crowdfunding platforms however do not require regulated third party intermediariestoprepareanddiligencethecompaniesraisingmoneyontheseplatforms.thishasthepotentialto introducebadactorsandfraudulentofferingsonanunsuspectingpublic. For larger more established private companies and alternative investment funds online fundraising platformshaveemergedwiththegoalofimprovingmarketaccessandefficiencybyestablishingthemuch\needed centralizedtechnologyinfrastructure.privateplatformscanreducethesearchcostsforbothinvestorsandissuers automate the compliance and tracking portions of the process facilitate timely disclosure of information and createeconomiesofscalethatbringefficiencytoprivatecapitalmarkets.howevernotallplatformsarecreated equallyaseachadherestodifferentphilosophiesandbusinessmodels.inevaluatingthealternativesbothissuers and investors need to understand the platform s perspective on a number of factors including transaction independencetheroleofplacementagentstheduediligenceprocessconfidentialityandtransparency.someof thesefactorshavethepotentialtocreateconflictsofinterest. InSummary Theprivatecapitalmarketsareopeningupandmarketparticipantsaretakingnote.Thesectorhasbeen growingata15%compoundannualgrowthratewhilepublicalternativeshaveplateaued. 12 Thesedevelopments are due in part to the first significant regulatory changes made to the sector in more than 30 years. As the transformationtakesformnewinnovationsareemergingthatwillenhancethemarketplacewhilealsoevoking somenewconcerns.understandingthesedynamicswillenableissuersinvestorsandagentstotakeadvantageof theopportunitiesthisgrowingassetclasspresents. 12 SEC CapitalRaisingintheU.S.:AnAnalysisofUnregisteredOfferingsUsingtheRegulationDExemption2009\
12 AboutACEPortal ACE Portal is a technology platform that provides investment banks and other placement agents with comprehensive transaction management and marketing tools for new issuances of private securities. ACE also provides institutional investors family offices and high net worth individuals with a centralized platform for identifying and confidentially engaging in private investment opportunities. All offerings listed on ACE are managedbysec\registered broker\dealerswhich ACE believes is essential to maintaining process integrity and regulatoryoversightforinvestorprotection. InSeptember2013ACEenteredintoastrategicpartnershipwiththeNewYorkStockExchange( NYSE ) withthegoalofbringinggreatertransparencyandefficienciestotheprivatemarketjustasthenysehasbrought tothepublicmarket.visitwww.aceportal.comformoreinformation. ACEPortalDisclaimer NYSE Euronext is a sponsor of ACE Portal which has produced this document for illustrative informationaland/oreducationalpurposesonlywithoutregardtoanyparticularinvestor sobjectivesfinancial situation or circumstances. Neither IntercontinentalExchange Group Inc. NYSE Euronext nor any of their respectiveaffiliatesofficersdirectorsemployeesoragentsrepresentorwarranttheaccuracyorcorrectnessof anyofthestatementscontainedinthisdocumentwhichhasbeenindependentlyassembledbytheauthorsand withwhomsoleeditorialcontrolrests.totheextentthattheinformationincorporatescontentfromspecified sourcesaceportal(includingitsaffiliatesofficersdirectorsemployeesandagents)disclaimsanyresponsibility for the accuracy or completeness of such content.ace Portal is not a law firm investment adviser or broker dealerandtheinformationprovidedinthisdocumentisnotasubstituteforanyoftheforegoing.furtherthis document is not to be construed as legal tax financial or accounting advice; a recommendation offer or solicitationofanoffertobuyorsellanysecurityfinancialproductorinstrument;oradvicetoparticipateinany particular trading strategy. Prior to the execution of a purchase or sale of any security or investment you are advisedtoconsultwithyourownadvisors. 11
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