Wednesday, October 14, 2020

Commissioner Lee extols virtues of public offerings as SEC emphasizes expansion of private markets

By John Filar Atwood

Steps the SEC has taken recently to facilitate exempt offerings and reduce disclosure requirements for public offerings could lead to a continued decline in the quantity and quality of public offerings, to the detriment of all investors, according to Commissioner Allison Herren Lee. In remarks at SEC Speaks, she urged the Commission to consider carefully the interplay between the public and private markets—and the impact on companies’ incentives to go public—before it continues to loosen restrictions on both.

Lee discussed the state of public offerings, a topic she says often takes a backseat to considering how to expand the private markets, despite the fact that the private markets already account for about 70 percent of all capital raising. She reminded listeners that U.S. public markets are the envy of the world in large part because the federal securities laws provide strong registration and reporting requirements that create a comparatively level playing field for investors.

The hallmark of public offerings is standardized, accurate disclosure, especially audited financial statements that underpin investors’ confidence in the public markets, she said. Moreover, investors have more ready access to liquidity in the public markets and provide reliably positive risk-adjusted returns for investors over time, she noted.

A frequent criticism of the public market is that it cannot offer the returns that investors, in exchange for heightened risks, may realize in the private market, according to Lee. She cited recent research that casts doubt on the extent to which the private market actually offers superior returns for investors, noting that retail investors can expect to do worse in the private markets due to, among other things, unequal access to the most lucrative opportunities and information asymmetry. In her view, the SEC should protect the public markets for the benefit of all investors, particularly retail investors.

Public offerings also provide benefits to issuers, not just investors, Lee continued. Companies typically have been willing to take on the registration and reporting requirements because the public market provides them access to a large pool of capital. She acknowledged that due to major changes in the nature and size of the private market, that advantage is less clear.

Decline in IPOs. Lee went on the address the declining number of IPOs over the past few decades, particularly smaller offerings that provide higher growth potential for investors. The decline is often attributed to burdensome regulations imposed on public companies, but Lee believes there is a more complex mix of factors involved.

She pointed to research that suggests that small companies may find it more beneficial to be acquired by a larger company in the same industry rather than going public and to evidence that a decline in small company IPOs was triggered by a decrease in demand for small IPOs among the nation’s largest mutual funds. She also cited research by former SEC Commissioner Robert Jackson that suggested that underwriters effectively impose a "middle-market IPO tax" on smaller companies, charging higher fees and consistently underpricing the offerings. The study indicated that underpricing may leave a substantial amount of money on the table, and the underwriter may capture an outsize spread of the smaller-than-necessary offering proceeds, she noted.

Data-based approach. In response to this complex mix of factors, Lee urged the Commission to proceed with care in its approach to promoting public offerings, rather than simply blaming overregulation. Reduced regulation may be needed, she said, but the Commission should take a balanced, nuanced approach based on data rather than intuition, she advised.

Lee noted that the SEC has steadily facilitated exempt offerings but has repeatedly failed to take steps to gather data about the private markets to provide reliable data to both the public and the Commission about their operation. At the same time as it has promoted exempt offerings, the agency has steadily reduced disclosure requirements for public offerings, she said.

Consequently, the Commission has chipped away at important distinctions between public and private markets from both sides, she stated, which disincentivizes companies from going public because of access to private capital and degrades the key protections that public offerings provide. If the SEC stays on this path, it will likely see a continued decline in both quantity and quality of public offerings, she stated.

A bright spot in the public markets of late has been innovations such as direct listings and specified purpose acquisition companies (SPACs) that could help issuers address certain of the challenges involved in going public, she said.

Direct listings. In Lee’s view, direct listings—a process that allows owners of a private issuer’s securities to sell their holdings directly on a stock exchange rather than hiring an underwriter and launching a traditional IPO—can offer advantages to issuers seeking a less expensive path to the public markets.

For starters, a company does not have to hire an underwriter, leading to lower expenses. Second, offering shares directly on an exchange allows an issuer greater ability to sell at a price that reflects market forces, reducing the potential for significant underpricing, she noted. Third, the availability of direct listings as an alternative to traditional IPOs could introduce competitive forces to the pricing of underwriting services for issuers that choose that traditional IPO route, she added.

Lee sounded a note of caution about the possible risks of direct listings. She said that while the omission of a traditional underwriter could reduce the cost of going public, it is crucial that the financial advisers and legal counsel involved in the due diligence process for a direct listing are properly incentivized to perform their role with great care. Also, direct listings appear to create issues related to Section 11’s tracing requirement that bears watching as the matter evolves in the courts, she said.

SPACs. With regard to SPACs—a shell company that raises capital in the public markets with the intention of merging with a target operating company—Lee noted that they have the potential to bring private issuers into the public market more quickly than would be possible in a traditional IPO. They also allow issuers may avoid much of the advance work, such as the roadshow, involved in an IPO.

Lee said that as co-investors in the deal, SPAC sponsors have an economic interest in the long-term success of the acquisition target. She believes that the entry of established firms in this space may benefit SPAC investors by offering experienced management at the helm of a SPAC in both identifying a worthwhile target and as a potential adviser or executive in the post-merger operating company.

In her view, as it continues to evaluate this space, the Commission should focus on how SPACs disclose the relevant risks and sponsor compensation. In addition, the SEC should consider whether there are ways to further align the interests of sponsors and investors to ensure that sponsors are incentivized by the quality of any potential target, she said.

She noted that in many instances, a SPAC is required to return capital to investors if it has not identified a target company within 18 to 24 months of raising capital, but a significant source of the sponsor’s compensation is comprised of shares in the post-acquisition operating company. As a result, the requirement to return capital to investors may create an incentive for sponsors to pursue a less-than-ideal acquisition in order to secure that compensation, Lee warned.

The existing rules require certain holding periods, and SPAC governing documents may impose additional terms on sponsors, she noted. However, she hopes that investors will offer feedback to the Commission about whether additional protections are needed in this area.