For decades, investing privately has been reserved for the wealthy, and the wealthy have fully embraced private investments for their many benefits, including:
- Above-market returns through both cash flow and appreciation.
- Transparency and access to management.
- Less volatility due to non-correlation to the stock market and too long lockup periods preventing herd behavior.
- Access to asset classes that are prohibitive to individual investors.
- Access to companies in markets and segments with less competition allowing for value-add opportunities.
- Defined exits for most offerings.
- Significant tax benefits.
The exclusivity of private investing is due to the two-tier system of U.S. securities laws and regulations where securities are offered through public and private markets. Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available.
Registration (i.e., going public through an IPO) is expensive, time-consuming, and complicated. Still, the companies who successfully navigate the registration process can offer their securities to a large audience through a public market.
Companies wishing to offer their securities without the hassle of registration can offer their securities through a private placement. Private placements are not subject to some of the laws and regulations that are designed to protect investors, such as the comprehensive disclosure requirements that apply to registered offerings, such as the requirement to provide prospective investors with a prospectus.
The SEC approach to registered offerings vs. its approach to private offerings is very different. Because public investments are available to all, the SEC aims to protect investors through disclosure. This requires the public company to provide specific and comprehensive details and information about the company’s business, management, and financial statements to give investors as much information as possible to make an informed decision.
With private placements, because the issuer is not required to provide the same comprehensive disclosures to prospective investors, the SEC’s approach is less centered on disclosure and more on prospective investors’ qualification and financial sophistication. And this is why private investing has been and continues to be exclusive despite the JOBS Act opening up private investments to more investors through permitting advertising under certain circumstances and through crowdfunding.
The SEC has stated that:
private placements are appropriate only for those with substantial resources and who have the financial sophistication to understand the risks involved along with the means to withstand a complete loss of their investment.
The exemptions that private companies rely on the most for their private placements can be found under Rule 506 of Regulation D, allowing companies to raise capital with no offering limits and preempt state securities rules. Exemptions are available under both Rule 506(b) and 506(c). Rule 506(c) allows for limited advertising but is available to accredited investors only who must verify their accredited status through official documentation or third-party verification.
Rule 506(b) does not allow advertising or general solicitation but does not require third-party verification of accredited investor status. A prospective investor can merely self-verify that they are an accredited investor. Rule 506(b) is often preferred over Rule 506(c) because of the less red tape required around accredited investor status.
Companies relying on Rule 506(b) are foregoing advertising to reduce red tape in favor of soliciting interest in their offerings through their established networks, friends and family, word of mouth, and referrals.
This is why private investments have been exclusive to the wealthy. These types of deals would never be passed on to anyone who would not qualify as an accredited investor.
Although Rule 506(b) allows participation by up to 35 non-accredited investors in any single offering, the issuers are required to provide audited financial statements and to offer disclosures similar to the disclosures required for registered offerings. For this reason, the majority of 506 offerings under Regulation D are exclusive to accredited investors.
The whole point of a private placement was to avoid the time-consuming disclosure requirements and expense of audited financial statements required for a public offering. That is why most Rule 506 offerings are limited to accredited investors.
Accredited investor qualification is the single biggest reason private investing is exclusive to the wealthy.
According to the definition under Rule 501 of Regulation D, an accredited investor is defined as follows:
An individual will be considered an accredited investor if he/she:
earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year,
OR
has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence).
Private investments are exclusive to the wealthy because of the accredited investor requirement but also because of self-imposed requirements by issuers to limit the number of investors, such as establishing high offering minimums. Unlike public companies with thousands of investors, private companies prefer to deal with a limited number of investors.
Because most private offerings are structured as limited partnerships or limited liability companies, the idea of having thousands of investors is impractical. Private companies don’t want to deal with thousands of mom & pop investors investing $500 at a time. They want to deal only with smart and sophisticated investors who can invest $50k+ and understand the risks of their investment decisions but who are patient and invest with a long-view.
Issuers want to deal with investors who understand business and everything that goes into executing a business plan. They don’t need daily emails from thousands of investors inquiring about what’s going on with their money.
Private investments distinguish the wealthy from the middle class, and it’s the same reason they remain exclusive to the wealthy.
Companies offering their securities through private placements want to deal with investors with the investing habits of the wealthy and not with investors with short-sighted habits of the middle class.