Category: Fundraising

Harmonization of Securities Offering Exemptions

or all you ever wanted to know about private placements

The Securities and Exchange Commission is stepping into the meeting point of its mandates by looking to “simplify, harmonize, and improve” the framework for private placements. The SEC is looking to expand investment opportunities while balancing investor protections and the promotion of capital formation.

The 200+page release provides a summary of the various private placement regimes in one handy guide. As Chairman Clayton noted, its an “elaborate patchwork.”

Note that twice as much capital is raised from private placement than capital raised through registered offerings. On page 16, the SEC notes:

In 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion that we estimate was raised through exempt offering channels.

Exemption2018 Amount Raised
Rule 506(b) of Regulation D $1,500 billion
Rule 506(c) of Regulation D $ 211 billion
Regulation A: Tier 1 $ 0.061 billion
Regulation A: Tier 2 $ 0.675 billion
Rule 504 of Regulation D $ 2 billion
Regulation Crowdfunding; Section 4(a)(6) $0.055 billion
Other exempt offering$1,200 billion

This has been true for at least the past decade, despite the elaborate patchwork. 506(b) offerings alone exceeded registered offerings last year.

As I’ve said in the past, private placement investments are not necessarily more risky than investments in registered offerings. The risk is one of liquidity. There is no market to buy or sell the investment so there is no ready exit.

If you had invested in Uber prior to the public offering, you had little choice but to sit and wait for a liquidity event. Now, you can liquidate your Uber position the same day.

The Concept Release is a great document to summarize the various ways to raise money privately, with the pros, cons and limitations of each.

The SEC has limited abilities to make wholesale changes. Many of the exemptions are driven by statute and would take Congressional approval. Nothing is passing in the Congress right now.

The SEC can make some changes around Regulation D that could be useful. The SEC should be careful that it does not disrupt the most widely used way to raise capital.

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We Select Best-in-Class… of those that pay us

Deutsche Bank marketed a robust, independent due diligence process to identify, evaluate, and select best-in-class asset managers.  But failed to disclose that it only recommended hedge funds that shared their management fees with the bank.

DB disclosed that it might receive revenue sharing and actually disclosed the amount it received in the subscription agreement. DB can recommend only its own products to its clients, as long as there is good disclosure.

However, the SEC felt that DB did not have good disclosure. The marketing for the fund failed to disclose that it was only recommending funds that agreed to pay a kickback to DB. 

The SEC has been focusing on these “retrocessions.”  What is interesting about this case is that the bank was not a registered adviser or broker-dealer. The bank was charged with violating the Securities Act’s anti-fraud provisions (17(a)(2)).

This is not the first time this has happened. JP Morgan paid a $267 million settlement to the SEC in 2016. The bank was investigated for steering high-net-worth clients toward its own proprietary investment funds that could cost more rather than those managed by other institutions.

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Pre-existing, Substantive Relationships and General Solicitation

As cryptocurrency issuance declines, the Securities and Exchange Commission is continuing to clean out the fraud, mis-steps, and foolishness of coin promoters. These actions have carried over to the services and investment managers involved in coin offerings.

Usman Majeed wanted to make his money by running a fund that invests in cryptocurrency. He ran into the same mistakes and ignorance of the securities laws that coin promoters stumble over. His platform was Mutual Coin Fund, with an approach that is “purely quantitative and involves algorithmic trading with intense backtesting…” and develops “new trading strategies involving artificial intelligence and machine learning through neural networks.”

That sounds like a lot of the same gobbley-gook for a crypto-fund offering that you hear for a coin offering.

That aside, he still managed to raise over $500,000 from investors from August 2017 to May 2018. Then managed to lose 62% of it by March 2019.

From the SEC order, it sounds like enforcement decided to focus on the marketing failure. Mr. Majeed and the fund didn’t have a pre-existing, substantive relationship with the investors. The fund engaged in general solicitation through its website and media interviews.

The fund could have engaged in general solicitation if it checked the 506(c) box on its Form D. But it checked the 506(b) box.

Of course, with 506(c) the fund would have needed to take reasonable steps to confirm that investors were accredited investors. But at least one investor was not accredited according to the SEC order.

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Failure to Launch Means Cancellation

The SEC cancelled the adviser registration of an internet investment adviser because it never launched its website.  

Kevin Ajenifuja registered his firms with the SEC by filing its Form ADV on May 28, 2015. He stated the eligibility for registration was because the firm was an “Internet Investment Adviser.”

Internet investment advisers typically are not eligible to register with the SEC. They do not manage the assets of their clients and therefore do not meet the statutory threshold for registration with the SEC. That would mean they would have to register in the states where they do business. For an internet investment adviser that would mean as a practical matter having to register in all 50 states. The SEC passed the internet adviser exception to fix this problem in 2003.

A year and a half later, in September 2016, the SEC contacted Mr. Ajenifuja because it thought he should withdraw the registration. He was still developing the website. The SEC said he should he withdraw and apparently he said he would do so.

The SEC gave notice in December 2016 that it intended to cancel the registration. Ajenifuja challenged the cancellation and had a hearing a year and half later in April 2018. He apparently still did not have an operational interactive website.

Mr. Ajenifuja argued that the internet adviser exception allows a grace period for development. In the adopting release the SEC “recognized the need for internet investment advisers to register with the Commission early in their development and testing phase in order to obtain venture capital.” Further that “many of these advisers may not even be fully operational 120 days after the registration has been granted.”

The SEC conceded that an internet adviser may be allowed some leeway beyond 120 days. However, there is no explicit grace period after the 120 days. The SEC would consider an extension based on facts and circumstances. Clearly, the SEC is looking for a firm to “reasonably expect to have a fully functional interactive website within a relatively short period” to prevent de-registration.

This decision may be the first time that SEC has said that internet advisers may get more than 120 days to launch so long as they can demonstrate significant progress. 

Unfortunately for Mr. Ajenifuja, the SEC found that three years was too long to still not have an operational website.

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Do Private Equity Funds Manipulate Reported Returns?

Some do, and it backfires.

In a working paper by Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan they studied cash flows and NAV reports for a sample of 2,071 buyout and venture funds. The study was motivated by the potential incentive for fund managers to exaggerate performance to attract investors to a follow-on fund. They looked for evidence consistent with funds manipulating their self-reported net asset values around the time commitments are raised for a next fund.

The results of this analysis suggest that exaggerated NAVs are associated with lower probability of raising a follow-on fund. When they examined performance of funds that are unsuccessful at raising a follow-on fund, they observed clear evidence of performance reversals toward the end of fund life that is consistent with investors seeing through attempts of performance manipulation. Furthermore, they saw that conservative reporting and credible signaling (via distributing capital back to investors) have, on average, stronger effects on fundraising-odds than market-adjusted performance. The results were similar for both buyout and venture funds.

The study concludes that top-performing fund managers may try to safeguard their long-term reputation from bad luck by reporting conservative NAVs.  They are more likely to do this when it does not jeopardize their high relative performance rank. Correspondingly, limited partners punish fund managers for the appearance of overstated performance by not providing capital to subsequent funds.

The findings corroborate the evidence in another study that private equity fundraising outcomes are largely determined by sophisticated counterparties.

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When Your Model Doesn’t Work

Don’t sell it if it doesn’t work right.

That’s an easy lesson learned by Aegon USA, its CIO and Director of New Initiatives. Unfortunately, they were a subadvisor to Transamerica, who had to pay the biggest fine out of the bunch.

Transamerica offered, sold and managed quantitative-model-based mutual funds, variable life insurance investment portfolios, variable annuity investment portfolios and separately managed accounts, which were marketed as “managed using a proprietary quant model” and promised that these quantitative techniques were “emotionless,” “model driven” and “model-supported” and provided descriptions of how the quantitative models were to have operated.

Unfortunately, the models didn’t work as intended and Transamerica didn’t look at them close enough to confirm that the models worked and didn’t disclose the risks with the models.

Aegon had developed the models in 2010. The person who developed the model was an analyst who recently earned his MBA, had no experience in portfolio management, had no formal training in financial modeling, and no training in developing quantitative models for use in managing investment strategies. Aegon and Transamerica named a senior manager as the portfolio manager even though the analyst was the sole architect of the model. That analyst was so significant to the product that internal audit attribute “key person risk” to him.

To its credit, internal audit found that Aegon did not have a process in place to validate its models or conduct peer reviews. Unfortunately, this was after Aegon had launched ten versions of the product. A high level peer review found glaring errors. Those were fixed, but the models were not subject to formal validation until 2013.

During the summer of 2013, Aegon determined that its allocation models contained material errors. For example, Aegon found that the model contained “numerous errors in logic, methodology, and basic math” and concluded that these errors rendered it to “not be fit for purpose.”

In the end, they were pushing a product that didn’t work the way they said it would and oversold the experience behind the product.

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Lower the Wealth Standard for Investing in Private Placements

With the reduction in the number of public companies and larger companies staying private, the Securities and Exchange Commission is once again talking about loosening the “accredited investor” standard.

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get past the red velvet rope and into the VIP room to buy securities through a private placement. That VIP room is full of fraudsters and high rollers. You get to decide who is who.

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

The biggest risk is the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With that investment in Pets.com, you have the chance to sell your stock and get some money back before it goes bankrupt.

The same is would not be true for Pets.com as a private company, like with one of today’s unicorns.  With a private placement, the investor will have a limited ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

In his statement a few weeks ago, Chairman Clayton broadened his thoughts on private placement to not just the accredited investor standard, but the entire private placement regime. He lumped them all together in the “exempt offering framework.” He calls it an “elaborate patchwork.” I agree that a broad restructuring of non-public security sales should be implemented that makes it clear how companies can raise capital with a clear framework for protection and disclosure of risks to investors.

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Monster’s ICO

Before all my music was digital and playing out of bluetooth speakers, I was a big fan of Monster Cables for connecting my audio and video equipment. Now those cables just sit in a plastic bin in the basement. I hadn’t thought about Monster Cables until the SEC has published the first “bedbug” letter on EDGAR and it was aimed at Monster. The letter from the Division of Corporation Finance is in response to a proposed monster money offering by Monster Products, Inc. Rather than providing a detailed examination and issuing comments, the staff letter to Monster suggests trying again.

Public company filings are not in my area of expertise so I’m not sure what the SEC was concerned about.

What caught my attention was the crazy scheme that Monster is trying to put together. Monster wants to offer up to three hundred million of its to-be-created Monster Money Tokens (“MMNY”) for gross proceeds of $300,000,000.

Monster plans to use the Ethereum blockchain technology on its E-commerce website to create the new Monster Money Network where consumers may use either MMNY Tokens or fiat currencies to purchase Monster products and services. The company intends to utilize the blockchain technology to its marketing, accounting and audit, internal control and shipping management functions.

In the event of an “ICO Failure” investors in the tokens may convert them into Monster common stock at the rate of four tokens per share of stock. The “ICO Failure” means that i) MMNY Tokens not have been traded on a cryptocurrency exchange or a U.S. stock exchange by June 30, 2020 because either this registration statement is not declared effective by the SEC or MMNY Tokens are not approved for trading on any such exchange market; or ii) MMNY Tokens have ceased trading on or before June 30, 2020 due to legal or administrative enforcement actions by the SEC, the CFTC, or any other government authorities.

The ICO seems a Hail Mary to turn the company around. It was acquired by a blank check company earlier this year. It as unable to timely file its latest 10Q. It fired its auditor. It replaced its CFO.

Monster trying something new by basically pre-selling Monster products and services through the MMNY offering. It’s issuing gift certificates, tarted up with blockchain.

I saw this at the same time I saw the UBI Blockchain fraud. That company was originally JA Energy, but reincorporated as UBI Blockchain Internet. Its business was to encompasses the research and application of blockchain technology with a focus on the internet of things covering areas of food, drugs and healthcare. UBI had no revenues and has yet to develop any products for sale. The stock price shot up from $3.70 per share to over $87 at one point on a surge of buying just because the company had blockchain in its name. The SEC temporarily suspended trading in UBI Blockchain stock earlier this year due to concerns about the accuracy of assertions in its SEC filings and unusual and unexplained market activity.

Unlike UBI Blockchain, Monster has an operating business. It’s just not doing well. As a turnaround, it proposes to sell tarted up gift certificates for products that are mostly in bins in the basement.

What type of monster is it?

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Restructuring and Adviser Performance Track Record

The Securities and Exchange Commission has been skeptical of registered investment advisers using advertisements. The default position is always that it’s likely to be fraudulent, deceptive or manipulative and therefore a violation of Section 206 of the Investment Advisers Act. The level of skepticism has been even higher for performance advertisements and even higher for performance advertisement of a predecessor.

That has lead to the problem of an investment adviser carrying over his or her performance when joining a new firm. Since this happens often, the industry has been able to get the SEC to commit to some clear standards.

The SEC has laid out a five part test for an advertisement that includes prior performance results of accounts managed by a predecessor entity

  1. The person or persons who manage accounts at the adviser were also those primarily responsible for achieving the prior performance results
  2. The accounts managed at the predecessor entity are so similar to the accounts currently under management that the performance results would provide relevant information to prospective clients
  3. All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance,
  4. the advertisement is consistent with staff interpretations with respect to the advertisement of performance results, and
  5. the advertisement includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

The latest guidance from the SEC on this involves a restructuring of an investment adviser firm. South State Bank owned South State Advisory and Minis & Co., each of which were separately registered as investment advisers. The Bank wants to merge Minis and South State Advisory together for some operational efficiency. This triggers the performance advertisement from a predecessor entity concerns.

The Bank proposed that Minis would merge into the other advisor, but operate as a division within it. The SEC said it was okay to keep the performance track record based on the facts.

  1. the Minis Division will operate in the same manner and under the same brand name as Minis
  2. the Minis investment personnel, as well as the management, culture, and processes that helped to give rise to Minis’ track record, will continue after the merger
  3. The same management team that currently manages Minis would manage the Minis Division
  4. the Minis investment committee would continue to have responsibility for the Minis Division’s investment decisions and recommendations
  5. Minis’ performance track record by the Minis Division would be accompanied by appropriate disclosure

Minis pointed out the obvious flaw in the SEC position with the performance track record.  Personnel, management, culture and processes will evolve over time at any firm. Minis merely point out that none of those things are happening immediately as part of the restructuring.

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What is Pre-Marketing?

In establishing a new investment vehicle, a sponsor needs to find a pool of interested investors. Given the varying rules around fundraising in different jurisdictions, the sponsor may chose to look for support in one place over another. The big problem is the time and cost it takes to get a proposed investment registered in a jurisdiction may not be worth that time and money if no investor from that jurisdiction ends up being interested.

This is a particular problem with private equity funds when the terms of the fund may still be fluid in the early days of the fundraising process. The terms of a private placement are more often negotiated with prospective investors than a registered offering.

The question in many jurisdictions is what constitutes activities that amounts to marketing, triggering the registration process.

In the US the activities are fairly clear. You need to only direct the discussions to accredited investors and it can’t be so broadly distributed that it could be considered general marketing or general solicitation. Generally, for a private fund sponsor’s formation efforts, the sponsor wants to keep the number or prospective investors small to get a sense that the terms are right and that there is market for the product.

The European Union had been more difficult under the AIFMD rules. As much as the EU is trying to standardize the AIFMD rules across its member countries, the requirements still vary widely from member country to member country.

Last month the EU indicated that it’s looking at defining pre-marketing under the AIFMD rules. Currently, AIFMD regulates “marketing” to investors. It does not specifically regulated “pre-marketing”. Without any specific rule to base it on, member country to member country has been setting general framework on where the line is between marketing and pre-marketing.

The new regulatory regime could be good or bad for fund sponsors. If it’s drawn too narrowly, it will keep fund sponsors away from. It will disproportionately affect smaller sponsors who are not prepared to spend the money with uncertainty of potential investors. Larger sponsors will have more time and money to comply.

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