In his new article, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, Adam Pritchard argues that the current transition between private and public company status is awkward and inefficient. Pritchard suggests that these inefficiencies can be reduced through the implementation of a two-tier market system for transitioning from private to public status. In this post, I analyze the implications of Pritchard’s suggested system on the Private Equity community.
Pritchard argues that the separate enactment of the Securities Act and the Exchange Act created a mismatched dividing line between public and private status. The Securities Act draws the line in a manner that focuses explicitly on investor protection, while the dividing line under the Exchange Act reflects the attempt to balance investor protection, interests in capital formation, and practical ease of application. Congress has shifted the point at which companies must go public through the JOBS Act, which gave the SEC new authority to exempt offerings from the requirements for registered offerings and authorized the SEC to adopt less demanding periodic disclosure from companies who benefit from this new offering exemption. Pritchard contends that the JOBS Act reforms have the potential to create a lower tier of public companies and to blur the line between private and public companies.
The Two-Tier System
Pritchard offers a different solution; one he believes unifies the public/private dividing line under the Securities Act and Exchange Act. Pritchard’s solution involves a two-tier market for both primary and secondary transactions, where the primary market would be limited to accredited investors, while the public market would be accessible to all. Under this regime, all public offerings would be seasoned offerings with a price informed both by full disclosure and a pre-existing trading market. Issuers would be able to choose whether to sell in the primary or secondary market and companies would become eligible for the primary market after reaching a certain quantitative benchmark (he suggests $75 million in market capitalization, the threshold currently used by the SEC for shelf registration).
Under this system, issuers below the quantitative benchmark would be limited to selling their securities to accredited investors. However, contrary to the current system, those securities could not be freely resold after a minimum holding period, but would instead be sold to other accredited investors on an established secondary market (similar to SecondMarket or SharesPost except expanding eligible purchasers from Qualified Institutional Buyers to all accredited investors).
Elevation to the public market would be completely voluntary. Issuers unable or unwilling to meet the obligations associated with access to the public market would be allowed to remain private. Once a company chose to go public, a seasoning period would follow with the filing of requisite 10-Q’s during which the shares would continue to be traded in the private market. This seasoning period would allow the trading price in the public market to be informed by the prior trading in the private market as well as the new information required to initiate the “going public” process. Only after the company graduated to having its shares traded in the public market would the company be free to sell equity to public investors. This two-tier system relies on the pricing efficiency of the markets.
Impact on Private Equity
Pritchard’s suggested model would impact the private equity market in multiple dimensions. First, companies looking for late stage investment to expand their brand could continue to seek private capital, without having to cross the public divide. Consequently, the amount of firms seeking private equity would likely expand, creating more opportunities for private investment.
Additionally, Pritchard’s plan would essentially create a liquid market for private equity investors. While similar markets already exist, see SecondMarket and SharesPost, these markets are limited to “qualified institutional buyers” (investors with more than $100 million under management). Pritchard’s secondary markets would include accredited investors, individuals with at least $200,000 in annual income or $1 million in assets. This increased participation in the secondary market would allow the market to establish a trading price.
Lastly, Pritchard’s plan would eliminate the need for marketers to create demand when a firm decides to go public. Instead, the secondary market, supplemented by the required filings to go public, would establish a trading price. The underpricing dilemma of IPOs would essentially disappear. Thus, private equity holders participating in the company’s transition from private to public would receive greater returns.
In summary, Pritchard’s two-tier market plan would create new opportunities for private equity investment, create a liquid trading platform, and help ensure that investors exiting the market when a firm elects to go public receive proper returns. Such a market system would be advantageous to private equity investors; it should be given serious consideration.
 Adam C. Pritchard, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good (University of Michigan Law & Econ Research, Paper No. 12-010, 2012), available at http://ssrn.com/abstract=2103246 .