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Three Things Investors Should Know About Private Equity

Back to Basics

Mar 10, 2022

Private equity (PE) is a type of alternative investment that provides the ability to gain exposure to companies that are not traded publicly. Previously, private equity was only accessible to individuals and businesses with high net worths. While PE funds have historically outperformed the S&P 500 by significant margins, access has been unevenly distributed.1,2 In the last decade, that has changed in three significant ways.

Let’s review a brief history of private equity as well as how new regulated fundraising strategies can help businesses offer non-accredited investors opportunities to participate in private equity.

Private Equity 101

Private equity is an alternative investment available on private capital markets, largely outside of public markets like NYSE and NASDAQ where public companies are traded. The advantage of private equity is that it provides the potential for greater returns on early investments in exchange for those investments being locked up for longer periods of time.

Today, businesses more commonly experience the most value growth when they are private. What’s more, private markets are growing at double the pace of public markets but only see 1/300th of the trading. So, there’s more value locked up in private equity than is currently traded.

For markets to be liquid, there needs to be a buyer on the other side of your trade to sell your PE shares to. With Morgan Stanley3 forecasting private market growth to reach an estimated $13 trillion in assets under management by 2025, more liquidity can be expected to enter the market. This emerging trend along with recent regulatory changes have the potential to change modern private equity.

Modern PE

Private equity in its modern form dates back to at least 1946 with the development of the American Research and Development Corporation (ARDC). When ARDC invested $70,000 into the private company Digital Equipment in 1957, it had a long-term conviction that the investment would pay off. Eleven years later, when Digital Equipment went public, ARDC earned the equivalent of $355 million.

This example of outsized reward is just one of many across the PE landscape. While the potential reward of PE can attract investors, liquidity, market and regulatory risk should be considered as well.

Investor Protection

In response to the Great Depression, the U.S. Congress and Securities and Exchange Commission (SEC) passed and oversaw several pieces of key legislation to protect people and businesses from investing more than they could afford to lose. From 1933 to 1940, Congress passed three Securities Acts, which sought to protect investors by creating new investor classifications (such as "accredited" or "qualified"), by establishing protections against bond defaults, as well as protections against securities fraud. These three pieces of legislation defined what can be securitized, who can access the securities, and what the rules of the road are for investing in securities in general.

Like the Constitution continues to guide the U.S. government, these key securities regulations continue to shape how domestic investments are made. For instance, while the terminology describing what new financial instruments may change over time, the SEC’s existing guidance still encompasses how these instruments need to operate to remain within the rule of the law. Of course, parts of the system are evolving.

Technological & Regulatory Evolution

New technologies have improved the efficiencies of securities issuance, management, and oversight, and in one case with Securitize, have enabled access and compliance all from one platform. For the private markets, this technological revolution is being led by the capabilities that blockchain technology enables through transparent, efficient record keeping. By automating PE trades using blockchain-based smart contracts instead of manually updating spreadsheets, digital asset securities can connect all the dots with fewer intermediaries. This technological evolution is helping lower the barrier to participation in coordination with new regulations.

Whereas before high net worth was a major tool in the investor protection toolkit, today new regulations and accreditation metrics are paving the way for more equitable participation in private equity. The prerequisites to participating in PE deals used to restrict access to individuals with at least $1 million dollars in net worth, or the proven ability to take in an annual salary of $200,000 for two consecutive years or more. And changes to the JOBS Act in 2012 have further expanded the population who can invest.

Regulation Crowdfunding (Reg CF) and Regulation A enable companies to offer and sell securities to non-accredited investors through an SEC-registered broker-dealer. Even Regulation D, while it excludes retail investors, enables accredited investors to participate in private placements and equips companies to raise an unlimited amount of capital. These changes in legislation create more opportunities for more individuals to participate in funding private companies that previously would have been out of reach.

A separate update to regulations expanded the requirements to include securities license series-holders. Instead of solely relying on net worth and income thresholds as a measure for accreditation status, the 2020 changes enabled U.S. persons holding Series 7, 65, or 82 licenses to invest in private equity and other accredited offerings as well.

Trend Spotting

The value of private equity comes from investors who want to capitalize on great ideas. It also comes from the amount of money that’s investable. With private market growth expected to more than double in value by 2025, more great ideas will see investment opportunities. How these opportunities are unlocked will depend on education and accessibility.

Initially, capital requirements were established to prevent everyday investors from making risky investments that could upend their livelihoods. Today, there are new opportunities for Series-holders and other qualified investors to participate in private equity without cumbersome intermediaries.

As participation in private equity expands across new communities of investors, new preferences are being expressed. There is a big opportunity for technology to democratize how these preferences can be translated into investments now and into the future. For those who want to learn more about private equity trends and trend-spotting tools, subscribe for updates below.

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1:

Past performance is no guarantee of future results.

2:

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.

3:

Morgan Stanley Research, “How Long Will The Golden Age of Private Markets Last?”, October 12, 2021.

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