How Have Private Markets Evolved Over the Years?

If you think about it, there are several reasons why the private markets have historically enjoyed a degree of regulatory flexibility compared to their public counterparts. The very nature, after all, dictates a certain degree of discretion.

It is, after all, a transaction that is taking place between two parties. Why should anyone else have a role to play in this case? If you had made an appointment with a realtor, for instance, to discuss the purchase of a new property, would you want to broadcast all the details on your social media channels?

Regulations in the private market have been quite lax in the past. However, as more and more investors have started participating in these markets, the scenario has changed. This once lightly regulated industry is drawing increasing scrutiny from governments and regulatory bodies.

In the previous chapters of this module, we have explored the evolution of the private markets. From the earliest instances of barter to the current complexities of modern M&A, we have certainly come a long way.

In this chapter, we’re going to explore how regulations in the alternative investment space in the US have changed and grown over the years.

At the core of the matter — regulation in the venture capital and private equity space has to balance on a tight rope suspended 50 feet in the air.

If you slip and fall on the left side, you’ll stifle innovation with too much red tape and reporting requirements. As for the right side, there’s nothing right about it either. If you take too lax of a stance, your economy will become too weak and your investors may lose out on their money.
In the US, the private market space is regulated by the Securities and Exchange Commission (SEC). This was set forth by the Investment Advisers Act of 1940.

This act played the role of a guardian ensuring that advisers uphold the sacred trust of acting in their clients’ best interests. Not just that, it came complete with a shield of disclosures to fend off any conflicts of interest.

Historically, of course, the Act only extended to larger firms who were managing a few billions in assets. Most money managers and private investment advisors were exempted from registering with the SEC.

Now, however, only advisers exclusively to venture capital funds and those advising private funds with less than $150 million in assets under management in the United States are exempt. Everyone else must compulsorily register with the SEC.

The regulatory framework established by the SEC serves three main purposes. First, it acts as a protector for investors, guarding them against the perils of the market. Secondly, it ensures fair play and keeps the market integrity intact. New investors or anyone else on the sidelines can feel safe enough to dip their toes in the water without being nipped by piranhas. Thirdly, it maintains transparency in the financial markets.

Compliance with these regulations is not just a legal requirement but something deeper. It builds the foundations of trust between venture capital and private equity funds, their advisers, and the investors whose capital they manage.

The JOBS Act

The Jumpstart Our Business Startups (JOBS) Act of 2012 marked a shift in private market regulations. Its mission was to pave smoother roads for startups and small businesses in their quest for capital. With the stroke of a pen, crowdfunding emerged from the shadows, and a softer path for initial public offerings was laid out for emerging growth companies.

The JOBS Act wasn’t just about easing the journey — it was about fuelling the dreams of the next generation of innovators. It made it easier for them to reach for the stars while maintaining investor safeguards.

Registration and Reporting Obligations

Investment advisers who find themselves within the registration requirements must follow the rules outlined by the Investment Advisers Act of 1940 and any subsequent amendments adopted by the SEC.

To register, they can use Form ADV, which requires advisers to disclose general information about the private funds they manage. This can include organisational or operational details or even information about the service providers.

For those advisors with at least $150 million in private fund assets under management, additional reporting on Form PF is also mandatory. This is filed on a non-public basis and requires annual reporting of general information like fund types, size, leverage, liquidity, and investor types.
Larger advisers, of course, are subject to more rigorous reporting requirements. They have to share a complete rundown with the SEC on how they manage their operations and the performance of the funds.

Limitations on Participation

Not everyone can participate in the private markets — it is only accessible to accredited investors. The SEC defines accredited investors as individuals or entities that have a net worth exceeding $1 million (excluding the value of one’s primary residence) or an annual income above a certain threshold for the last two years.

The rationale is simple. It is assumed that accredited investors have higher access to the experience and resources required to traverse the labyrinth-like landscape. In other words, if the investment takes longer than expected to grow, or even if it fails entirely, these investors will not suddenly struggle to make ends meet and put food on the table.

Illiquidity and Risk Associated with Private Market Investments

There is also the fact that private investments are known for their illiquid nature. After all, you can’t ask a startup to speed up its innovation process so that you can exit from your investment.
Assets in private markets cannot easily sold or exchanged for cash without a significant loss in value. In most cases, there is already an exit strategy in place to ensure optimal returns. Of course, investors in private markets often require a premium for this illiquidity, which can lead to higher expected returns but also increased risk.

The Debate Over Transparency and Investor Protection

Transparency and investor protection in private markets have been subjects of ongoing debate. For instance, the California Consumer Privacy Act, effective from January 2023, aimed at increasing the protection of personal information, impacts how private equity (PE) firms handle data, thus indirectly affecting investor protection measures.

Moreover, regulations like the proposed rules by the FTC to prohibit non-compete agreements reflect broader regulatory scrutiny that could influence private market operations and the freedom of movement for talent within the industry.

Public markets are at the other end of the spectrum. These markets have always been prone to high regulatory and reporting requirements. After all, this is the home of the retail investor, the average workers who save up for years to invest their money for the long term.

The story of public market regulations begins in the shadow of the 1929 stock market crash. This was a cataclysm that plunged the nation into the depths of the Great Depression. From these dark times, a beacon of reform emerged. Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934.

The former introduced the concept of mandatory securities registration, with clarity and honesty from issuers to protect investors. The latter gave birth to the Securities and Exchange Commission (SEC) to oversee and regulate the securities industry.

A Legacy of Evolution

As decades unfolded, the landscape of public markets and their overseers adapted to the heartbeat of the US economy and its challenges:

• The Investment Company Act of 1940: A response to the need for oversight of mutual funds, ensuring they operate within a framework of fairness and transparency.
• The Sarbanes-Oxley Act of 2002: This Act rose from the ashes of corporate scandals, tightening the reins on corporate governance and financial practices with a clear message—transparency and accountability are not optional.
• The Dodd-Frank Act of 2010: Born from the financial crisis of 2007-2008, this comprehensive reform aimed to shield the economy from future collapses, weaving a tighter safety net around financial practices and consumer protection.

Open Accessibility

The principle of open accessibility is central to public markets. This means that, in principle, anyone with the means to invest can buy and sell securities. The markets are structured to be inclusive, catering to a wide range of investors from individual retail investors to large institutional entities.

This inclusivity is essential for the liquidity and depth of the market, ensuring that securities can be traded efficiently.

Regulatory Disclosure Requirements

Public companies must adhere to a comprehensive set of reporting obligations set by the SEC. These requirements are crucial for maintaining transparency and allowing investors to make informed decisions.

Companies must file annual reports (Form 10-K), quarterly reports (Form 10-Q), and current reports (Form 8-K) for any significant events that might affect their financial status or share price.

• The annual Form 10-K requires companies to disclose their corporate history, financial statements, information on subsidiaries, executive compensation, and key financial metrics like earnings per share (EPS).The form is divided into parts that cover the business overview, financial data, management discussion, and financial statements, ensuring a comprehensive view of the company’s performance.
• Quarterly reports (Form 10-Q) serve as a condensed version of the 10-K, providing updates on the company’s financial performance for the quarter. These include unaudited financial statements and insights into any significant changes in financial condition or operations.
• Current reports (Form 8-K) are used to report significant events like acquisitions, leadership changes, or financial status updates, ensuring that investors have the latest information on events that could affect their investment.