Is the Private Equity Industry Ready for the Small Investor?

• Author: Isadora Lee
• Position: Graduate of the Washington College of Law At American University
• Pages: 06

Yat-Sye Isadora Lee is a 2005 graduate of the Washington College of Law At American University, where she was a member of the Administrative Law Review. Ms. Lee received her BA in Economics and in English Literature and her MA in English Literature from Stanford University. Ms. Lee hopes to pursue a career in securities law or intellectual property law.

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WITH HALF OF ALL AMERICANS currently investing in equities,¹ and over 91 million Americans investing in mutual funds,² one may well ask whether it is just a matter of time before the "small investor" will get a chance to engage in private equity investment. In a private equity transaction, a private fund usually raises capital from a limited number of sophisticated investors in a private placement and divides the profits that the fund generates among the fund managers and capital providers on a pre-negotiated basis. Since the 1940s, private equity investment primarily has been the domain of wealthy families and institutional investors. Despite the public¥s interest in greater investment returns, the private equity industry has rarely, if ever, seen the small investor as a potential source of capital to be tapped for start-ups, leveraged buyouts, and turn-around investments. The current collage of securities laws, combined with the Securities and Exchange Commission¥s (SEC) heightened scrutiny of the hedge fund and mutual fund industries makes it unlikely that the SEC will permit the small investor to invest directly in private equity or venture capital anytime soon. A number of considerations may help to evaluate whether enhancing the role of the small investor in the private equity sector is feasible.

I The Current Regulatory Regime

TO THE MANAGERS OF PRIVATE EQUITY FUNDS, the "small investor" does not have the qualifications of pension funds, private and public employee benefit plans, insurance companies, university endowments, and very wealthy individuals; namely, the small investor is not "accredited," "qualified," or "sophisticated." ³ For the SEC¥s regulatory purposes, the "small investor" is likely to be the unsophisticated investor without sufficient capital and market experience to evaluate properly and assume the risks associated with private equity. More than half a century of interactions among securities laws, investors, and fund managers has shown the difficulty of harmonizing the goals of all those involved in the private equity sector. From a regulatory perspective, the SEC¥s goal is to protect individual and institutional investors and the integrity of the markets through mandatory disclosure of important information.⁴ From the private equity investor¥s perspective, the goal is to achieve high investment returns that are commensurate with the significant risk of investing in an unproven company. Within this context, private equity managers have structured their partnerships to avoid the SEC¥s regulatory hurdles by limiting the investment in their funds to sophisticated institutional investors and wealthy individuals deemed not to need all of the protections of SEC mandatory disclosures.⁵ Because private equity managers issue partnership or shareholder interests in the fund to raise investment capital, and normally invest in private portfolio companies, they must comply with the 1933 Securities Act (the "1933 Act") and the 1934 Securities Exchange Act.⁶ Private equity funds usually rely on statutory exemptions such as ß 4(2) and Regulation D, under the 1933 Act, to avoid the costs and delays imposed by registration procedures and public disclosure requirements.⁷ Most private equity funds rely on Regulation D¥s Rule 506 exemption, which restricts each offering to an unlimited number of "accredited investors," and only 35 non-accredited investors who must be sophisticated or use a sophisticated purchaser representative.⁸ An "accredited investor" must have an individual or joint spousal net worth of more than $1 million, or have more than $200,000 in annual income in each of the two most recent years, or joint income with a spouse in excess of $300,000.⁹ The small investor is unlikely to meet the "accredited investor" requirement. Thus, he is precluded from directly investing in private equity. "The common perception is that the small investor is not prepared for the illiquidity of private equity investments . . . the potentially high degree of leveraging, and the probability of great returns and devastating losses."

Private equity funds also fall under the purview of the Page 47 Investment Company Act of 1940 (the "1940 Act"), which requires the registration of an investment company.¹⁰ Private equity firms frequently use the ß 3(c)(1) exemption in the 1940 Act.¹¹ The ß 3(c)(1) exemption essentially compels the funds to structure themselves as limited partnerships with fewer than 100 investors, which ultimately promotes the access of the wealthiest investors to venture investing.¹² Private equity firms also rely on exemptions for investment funds that provide financial or managerial assistance to businesses as long as relevant conditions are met. "All the investors must be accredited investors as defined in ß 2(a)(15) of the Securities Act of 1933."¹³ The same is true for investment companies whose securities are owned by "qualified purchasers" and are not publicly offered.¹⁴ Under the latter exemption,¹⁵ for an individual to be a "qualified purchaser," he must own at least $5 million in investments.¹⁶ Thus, within this regulatory scheme, the typical private equity fund will err conservatively by excluding the small investor who does not meet the definitions of "accredited" or "qualified" in order to maintain the exemptions from the 1933 and 1940 Acts, and thereby minimize the costs associated with compliance.

II Why Exclude the Small Investor?

THE SMALL INVESTOR¥S GENERAL LACK of both investment expertise and significant capital reserves compels most private equity professionals run the other way. The common perception is that the small investor is not prepared for the illiquidity of private equity investments, the 10 to 13 year investment horizons, the absence of dividends, the potentially high degree of leveraging, and the probability of great returns and devastating losses.¹⁷ Moreover, the typical small investor who is familiar with stocks and bonds may not be ready for investment vehicles for which daily performance updates and stock prices are impractical or nonexistent. The waiting period between the acquisition and the investment¥s liquidation may be too unpleasant and unpredictable for the small investor to bear for more than a few years.¹⁸

Given the existing regulatory framework and the assumptions regarding the small investor¥s lack of sophistication and disposable capital, his inclusion would hinder the efficient operation of private equity funds. Alternatively, by inducing private equity managers to eschew the small investor, the current regulatory regime creates a vicious cycle that has deprived the small investor of the investment experience necessary to understand the mechanisms of private equity. Suppose a private equity firm relying on a Regulation D exemption were to include the small investor in the investment of a portfolio company. The small investor would lack not only the capital, but also the experience and knowledge, to negotiate adequately favorable terms for himself as a limited partner, or engage in due diligence and undertake a contractual liability scheme that would counteract any tendency on the part of the issuer to ignore the mandatory disclosure provisions of the securities laws.¹⁹

More significantly, the small investor is unlikely to be able to properly assess a start-up s real potential and associated risks. He may not comprehend how much time, money, and expertise it will take to achieve optimal liquidity. If disappointed, he may take legal action against the company, other investors, or even the company¥s managing partners. As a consequence, the private equity professionals may find his inexperience and threats to sue inconveniently burdensome in subsequent financing rounds. The potential for liability cuts into the efficient operation of the private equity firm.²⁰ The inclusion of the small investor upsets the scheme to which private equity managers are accustomed. In this scheme, the investors are assumed to be sophisticated enough to negotiate favorable terms and conditions in the partnership agreement, and then sit back during the unsightly "in-between" periods of the investment. Furthermore, given the 100-investor limit that is necessary for the fund to maintain the ß 3(c)(1) exemption from the 1940 Act, from costly and time-consuming registration requirements, seasoned institutional investors who contribute most of the funding for such investments typically do not want "individual co-investors other than very wealthy families"²¹ who are deemed "accredited" and "qualified" Page 48 investors. To the extent that the SEC maintains its stance that non-accredited investors need the protections of the securities laws, and to the extent that the private equity community equates the small investor with a lack of disposable investment capital and sophistication, the small investor will be an impediment to the smooth running private equity machine.

III Would Private Equity Professionals Want The Small Investor¥s Money?

IN ONE CAMP, THE CYNICS HOLD FAST to the notion that even if the small investor were a wealthy individual, unless he is a "wellconnected multimillionaire," no recognized venture capital fund will solicit his investment.²² The small investor¥s relative inexperience...