Who Needs Wall Street?
Public debt and equity issues fell to $1.07 trillion between 2009 and 2010, while private issues rose to $1.16 trillion.
A tectonic shift is under way in how companies raise money -- and it will have a profound impact on U.S. investors and markets. According to the Securities and Exchange Commission's most recent estimates, businesses have been raising more funds through private transactions than through debt and equity offerings registered under the securities laws and offered to the general public.
Overall public debt and equity issuances fell by 11% between 2009 and 2010, to $1.07 trillion, while private issues rose by 31%, to $1.16 trillion. This shift, which has been driven by the rising costs of public-market participation and regulation, will likely accelerate when the SEC implements reforms in the Jumpstart Our Business Startups Act, which the president signed into law last April.
The crowdfunding provisions in the JOBS Act are intended to democratize investment opportunities using the Internet and have attracted the most public attention. But another part of the law may have the most impact.
Here is the background. U.S. securities laws have a private-market exemption, called Regulation D, that allows companies to sell securities to accredited investors with high net worth (essentially more than $1 million excluding a home). The exception means the companies don't have to go through the SEC's costly and time-consuming registration and reporting requirements for public offerings. The securities can also be resold to financial institutions that hold a required minimum value of securities investments.
But the securities laws have also banned general solicitations for these private-market offerings -- and Title II of the JOBS Act lifts this ban. This means that a company, investment fund or seller now can publicize its offerings via the Internet or traditional advertising media, as long as the ultimate investors are accredited or qualified institutional buyers.
One of the most significant advantages that public markets have held over private markets is the ability to generate substantial market liquidity by advertising to a wider public. Once the SEC implements the legislation, that advantage will gradually fade away.
Until the JOBS Act, Regulation D effectively allowed companies and funds to raise capital only from investors with whom they already have a pre-existing relationship. So money typically flowed into a deal through broker-dealers or arbitrary social networks. This process shuts out a wide swath of prospective investors and, thanks to the lack of a robust trading market, results in lower prices for the securities.
By rolling back the ban on general solicitation, fund offerings and resales of unregistered securities can now flow through vast Internet-based broker-dealers and other finance networks, potentially giving a steroid shot to private capital markets. According to the Angel Capital Association, there are 8.6 million accredited investors nationwide, of which only 3.1% currently invest in business startups through private markets. The large pool of untapped investors and capital may result simply from a shortage of information regarding investment opportunities or concerns over private market liquidity. Thanks to the JOBS Act, private capital markets will enjoy increased transparency and therefore greater efficiency. They will also likely experience substantial new capital inflows due to the widespread advertising of offerings. If high-quality companies and funds have access to broad and deep pools of capital in private markets, then the question becomes why many of them would bother with the regulatory compliance and shareholder-management costs of public markets.
We anticipate a paradigm shift in how companies raise money, as they increasingly shun the highly regulated, costly and volatile public markets in favor of now deeper and more efficient private markets. This could be a boon for capital formation. But it could also mean fewer investment opportunities for the general public. The most promising companies may delay or never file IPOs and instead seek capital on private exchanges not accessible to those who don't qualify as accredited investors -- which is 97% of the U.S. population. Meanwhile, novice accredited investors may be bombarded with solicitations for private placement opportunities, without some of the regulatory oversight provided in public markets.
For lawmakers and regulators, however, perhaps the lessons from the success of private markets can help with a reform of public securities regulations, many of which were written nearly a century ago and, at least in part, are the reason for the continuing privatization movement.
Mr. Gorfine is legal counsel and director for financial markets policy at the Milken Institute. Mr. Miller is co-founder of Fundrise, an investment platform that enables direct investment in local real estate and businesses.
A version of this article appeared February 5, 2013, on page A15 in the U.S. edition of The Wall Street Journal, with the headline: Who Needs Wall Street?.