One thing I've noticed about dramatic news out of Washington these days is that it’s often really just the President or Congress uttering platitudes and then telling someone to write a report on something. Although the initial headlines are usually misleadingly sensational, the subsequent reports do ultimately set the tone for actual policymaking in the years that come (or at least until the platitude utterers are replaced). Actual policymaking can significantly alter the incentives and competitive pressures in markets.
In early February, President Trump signed Executive Order 13772: Presidential Executive Order on Core Principles for Regulating the United States Financial System. Section 1 outlined some core platitudes. Section 2 told the Department of Treasury to write a series of reports on how the existing regulatory framework fits with said platitudes in Section 1, and what is being done about it. Section 3 basically reminded everyone that no laws had actually changed (yet). But as an executive order, it is legally binding on federal agencies.
Treasury’s most recently released report coming out of Executive Order 13772 concerned capital markets. It contains several very useful explanatory charts and graphs. Treasury also makes several key policy recommendations that would impact anyone operating in capital markets if implemented. Treasury specifically mentions several alternative investment product types that we cover. So instead of reading the entire 220+ page report yourself, let’s review some of the highlights.
Capital formation generally
Recommendations under the category labeled "Promoting access to capital for all types of companies, including small and growing businesses, through reduction of regulatory burden and improved market access to investment opportunities" point in the direction of more private offerings offered to more investors, more use of Regulation A+, and generally easier rules and disclosure requirements all around. Quoting the report:
Treasury's recommendations include numerous measures to encourage companies toward public ownership, including eliminating duplicative requirements, liberalizing pre-initial public offering communications, and removing non-material disclosure requirements, among other recommendations. Improperly tailored regulatory burden can benefit the largest companies, which are better positioned to absorb the costs, and discourage competition from new entrants. Treasury has also identified opportunities to ease challenges for smaller public companies, including scaled disclosure requirements.
Regulation D
The report had this to say about Reg D:
Public companies provide a useful investment vehicle for millions of retail investors who need investment opportunities to help save for retirement. If many successful new companies stay private, middle-class Americans may miss out on the significant returns they generate for investors. Treasury recommends a series of changes to open private markets for more investors, including revisiting the "accredited investor" definition and considering ways to facilitate pooled investments in private or less-liquid offerings.
…
These recommendations include maintaining an appropriate regulatory structure for finders, expanding the range of eligible investors, empowering investor due diligence efforts, and modifying the rules for private funds investing in private offerings. [emphasis added]
Reg A+ and other public markets
Of course, companies don't need to stay private:
To the extent that companies decide not to go public due to anticipated regulatory burdens, regulatory policy may be unintentionally exacerbating wealth inequality in the United States by restricting certain investment opportunities to high income and high net worth investors.
The listed-market ecosystem, in which prices are based upon information disclosed and processed by investors, securities analysts, market commentators, investment advisers, and the public, provides an important layer of transparency and price discovery which benefits investor protection. Valuations in the private markets are often based on public markets.
The report brings out the usual stats about declining number of IPOs and the good old days when companies went public early. It then made several recommendations to ease disclosure requirements for public companies.
This recommendation could have interesting implications for creative companies in need of financing:
Given that the SEC now permits all companies to file for IPOs confidentially, Treasury recommends that companies other than [emerging growth companies] be allowed to "test the waters" with potential investors who are QIBs or institutional accredited investors
Most importantly for our purposes, several recommendations very specifically concern Regulation A+:
Given the relatively modest use of Tier 2 since it became available in June 2015, particularly in comparison to other exemptions such as Regulation D, Treasury recommends expanding Regulation A eligibility to include Exchange Act reporting companies.
This modification will provide already public companies with a lower-cost means of raising additional capital and potentially increase awareness and interest in Regulation A offerings by market participants. Treasury further recommends steps to increase liquidity in the secondary market for Tier 2 securities. Although federal securities laws do not impose trading restrictions on Tier 2 securities, state "blue sky" laws may impose registration requirements. Treasury recommends that state securities regulators promptly update their regulations to exempt secondary trading of Tier 2 securities or, alternatively, the SEC use its authority to preempt state registration requirements for such transactions.
Finally, Treasury recommends that the Tier 2 offering limit be increased to $75 million. The JOBS Act requires the SEC to review the Tier 2 offering limit every two years and, if needed, revise to an amount the SEC determines "appropriate." The increase to $75 million is consistent with the House-passed Financial CHOICE Act (H.R. 10) and would allow private companies to consider a "mini-IPO" under Regulation A as a potentially less costly alternative to raise capital. [emphasis added]
BDCs
Treasury is also in favor of BDCs getting easier disclosure requirements. BDCs actually face many burdens that other 10-K/10-Q filers don't face. They are ineligible to be considered "well-known seasoned issuers", may not use the safe harbor for factual business information and forward-looking information, may not use the expanded communications provisions in connection with filing a registration statement, and may not utilize the "access equals delivery" model for prospectus delivery. Treasury recommends changing all this.
Interval Funds
The report also has this to say about BDCs’ ’40 Act cousins, the interval funds:
Treasury recommends that the SEC review its interval fund rules to determine whether more flexible provisions might encourage creation of registered closed-end funds that invest in offerings of smaller public companies and private companies whose shares have limited or no liquidity. For example, rather than requiring redemptions on a fixed time basis, the rules could permit redemptions based on a liquidity event of a portfolio company in a manner similar to a venture capital fund.
I’ve seen private Regulation D funds that have this approach encoded in their offering documents. If Treasury’s recommendation is implemented, it could encourage more asset managers to use a more widely marketable interval fund structure to invest in assets that start our illiquid, but eventually become liquid (e.g., venture capital, convertible securities, leveraged loans to the extent that they aren't extended). Of course asset managers can take a similar approach to redemptions in a regular closed end fund structure too. However, the interval fund structure makes redemption frequency a fundamental policy and assures investors that they will have the chance to vote on a change in redemption plan.
Up next
Up next, two more reports are forthcoming covering two other areas of the financial system, and both are likely to contain policy implications for the alternative investment industry:
- The asset management and insurance industries, and retail and institutional investment products and vehicles
- Nonbank financial institutions, financial technology, and financial innovation
Stay tuned to the FactRight blog as we track and parse these regulatory developments.
