The sharp division between public and private securities was a major bulwark of financial regulation from the New Deal in the 1930s to the end of the 20th century. Securities that could be sold to anyone had extensive disclosure and investor-protection rules, while private securities that were available only to sophisticated institutions and wealthy individuals had limited regulatory oversight. For a quarter century, cracks have been appearing in the dam separating public from private. Now we appear to be poised on the brink of a complete dam break.
Deloitte estimates that within five years, US and European retail investors will hold $5.4 trillion of investment in private companies, up from under $1 trillion today, if recent trends hold. This will constitute a significant fraction of all retail investment.
Under current US rules, little of this will be direct. Instead, retail investors will have a menu of indirect offerings to choose from: exchange-traded funds from asset managers such as Invesco Ltd. and ProShares, special purpose acquisition companies, derivatives, mutual funds, interval funds, blocker corporation shares and other products. The race to tokenize exposure to companies such as SpaceX and OpenAI for retail investors made headlines recently. In addition, investors will get more indirect exposure via investments by their pension funds and other retirement instruments.
This raises two questions. Is the traditional distinction between public and private investments worth defending? And should regulators encourage an officially approved mechanism for investment or let the market experiment, relying on the survival of the fittest to produce the best result?
One issue is that the old regulatory structure was designed under the assumption that the pressure for private investment came from businesses wanting inexpensive retail capital without the trouble and expense of meeting public investment rules. The situation today is the reverse, the pressure is coming from retail investors, who want exposure to the hottest sectors, pushing money onto private companies that don’t want it. An equally important pressure is coming from intermediaries, anxious to earn fees with creative ways to force retail money on hot private enterprises.
The dam can only survive as long as the hottest private businesses do not want retail capital. Two-sided pressure — private companies that want capital and retail investors who want to supply it — cannot be resisted, especially with the funds management industry keen to accommodate both sides. Sooner or later, when private capital dries up or new private businesses form to accept retail capital, it will be impossible to stop. So, my answer to the first question is “no,” there is no hope of preserving the traditional distinction.
For the second question, the easy path is to let different methods of getting retail capital into private entities duke it out in the marketplace until one or more become standardized and the rest disappear. The trouble is that this forfeits any chance to build into the distribution mechanism some of the investor protections lost when retail investors get exposure to companies without rigorous disclosure and governance rules. If the intermediaries are public securities, such as mutual funds or ETFs, then regulators have a lever for rules. But if the mechanisms are crypto tokens or private contracts, the retail investor capital flowing to private entities is invisible to regulators.
A negative approach — outlawing retail investment in private companies that doesn’t flow through official channels — will fail. Prohibition won’t have much effect in a world where it’s easy to gain exposure to private companies with private contracts and exchange that for retail capital via crypto tokens. The only path likely to succeed is a positive approach that offers retail investors officially approved channels that are inexpensive, convenient and carry strong investor protections.
Any workable official channel will require the active participation of the private company. They must provide exposure directly. Retail investors must have direct recourse to the business holding their contributed capital, not to some intermediate derivative or special purpose vehicle that’s created without the permission of the private company. We must retain the idea that the company using the capital is an issuer, with responsibilities to the capital provider.
Since private companies are unwilling to provide the public disclosure and follow the governance rules required for public companies, the intermediary dealing with the retail investor must substitute some kind of oversight. For example, if someone creates an ETF to hold shares in a private company, the ETF issuer must be charged with due diligence responsibilities — and the private company must agree to give the ETF issuer access to the required information.
No doubt there are many other ways to design conduits for retail capital in private companies, but the good ones will have to follow these general principles. Trillions of dollars are going to move from retail investor wallets to private companies over the next few years, and we need a plan. The dam separating public from private capital will break. If we have no plan, a lot of value could get washed away in the flood.
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