Bill’s reduced requirements might hurt faith in markets
By Hazel Bradford
Published: April 2, 2012
The regulatory E-Z Pass that Congress gave to emerging growth companies seeking public capital might make it easier for institutional investors to exit investments in emerging growth stocks or indirect stakes through private equity and hedge fund holdings, but it will require greater risk management.
Executives of pension funds and other institutions troubled by the legislation worry that reduced regulation and disclosure could also have the unintended consequence of weakening the public’s faith in the financial markets.
The JOBS Act — Jumpstart Our Business Startups — was approved by the House and Senate in March. President Barack Obama is expected to sign the legislation this month, and the law will take effect immediately.
The bill allows companies with up to $1 billion in annual revenue to sidestep some regulations on disclosure, auditing and corporate governance when launching initial public offerings or raising cash. It also lifts restrictions on advertising to solicit investors and permits raising capital through smaller pools of investors, or “crowdfunding,” with some restrictions. Firms could sell up to $50 million of shares in IPOs before registering with the Securities and Exchange Commission and could have up to 1,000 shareholders, double the current limit.
The reduced oversight period can last up to five years, or until the company hits $1 billion in revenue or $700 million in market capitalization. With an estimated 90% of IPOs covered by the $1 billion limit, “we’re talking about big companies,” said Jeff Mahoney, general counsel of the Council of Institutional Investors, Washington, whose pension fund members represent more than $3 trillion in assets.
“For a period of time, we’re not going to have the same information. It could translate into having greater risk. Institutional investors are good about managing risk, and they want to put that into their portfolio, but these risks may be systematic and thus not diversifiable,” Mr. Mahoney said in an interview.
Large pension fund investors are skeptical, especially with the raising of the trigger point for external audits to $700 million in market capitalization from $75 million. “For investors like CalSTRS, important statutory requirements over internal controls and advisory votes on compensation … are essential for us to properly assess the risks in our portfolio,” wrote Jack Ehnes, CEO of the $152.2 billion California State Teachers’ Retirement System, West Sacramento, in a letter to Sen. Barbara Boxer, D-Calif., as the bill was being debated.
Mr. Mahoney of CII said: “If you don’t have internal controls, there is going to be a greater likelihood of errors. Misstatement leads to underperformance, so you have to look at financial information more skeptically now. That’s going to take some time, and smaller funds will rely on their managers to do more. It impacts everybody.”
Easier capital formation could add value to portfolios of CII members and make it easier to exit privately owned companies, Mr. Mahoney acknowledged. But he worries that the respite from regulations, disclosure and auditing and accounting standards — the bill addresses both standards on the books and in the works at the Financial Accounting Standards Board and the Public Company Accounting Oversight Board — “is at least going to defer some best practices which, in our view, enhance long-term shareholder value.” Mr. Mahoney also noted that reduced market confidence could have a negative impact on returns.
These concerns were swept aside as proponents of the measure, who touted the potential for job creation, won an unexpected degree of bipartisan support from a fractious Congress.
While critics question the job creation claim, venture capitalists say that a new “regulation lite” process for startup companies will help reverse a trend that favored mergers and acquisitions — which often meant job losses. They add that launching more companies will mean more hiring.
“M&As don’t produce returns or jobs,” Kate Mitchell, managing director at Scale Venture Partners in Foster City, Calif., said in an interview. Ms. Mitchell, a former chairwoman of the National Venture Capital Association, also led an IPO task force convened by the Treasury Department in 2011 to address the problems associated with access to capital. The group’s report laid the groundwork for the first legislative proposal, which became the foundation for the JOBS bill.
A task force survey of more than 100 CEOs of companies considering an IPO found that only 9% considered the small-capitalization market accessible. “The SEC had “small’ or “extra-large’ (regulations). We want a temporary size “medium,’ ” Ms. Mitchell said.
According to NVCA data, the IPO market is starting to revive. 2011 had the fourth highest annual investment total in the past decade — $28.4 billion invested in 3,673 deals. That’s 22% more dollars and 4% more deals than in 2010. The largest gains were in clean technology and Internet-specific sectors.
Still, said Michael Greeley, general partner of venture capital firm Flybridge Capital Partners, Boston: “Our industry has really suffered in the last year or so on the ability to get access to public” money. Less than 100 out of every 1,000 VC go public each year. That needed to be fixed.”
Ms. Mitchell said she was sympathetic to concerns raised by SEC Chairman Mary Schapiro and others about the potential for risky or fraudulent investments. But she said there will still be protections in place. “We still want a high bar. We’re not going to back to Enron. It’s self-defeating if we promote that.”
One protection against emerging companies trying to fly before they’re ready or companies not quite legitimate is the “test-the-waters” provision in the legislation. That allows sophisticated institutional investors to access prefiling communications as well as any statutory prospectus, both of which are subject to anti-fraud liability. “There could be real value to permitting these types of prefiling communications,” Ms. Schapiro wrote to key lawmakers as the bill was being considered, if they don’t result in “uneven information” for investors.
The “test-the-waters” option is good for everyone, said Ms. Mitchell. Venture capitalists “really care about a company going out when it’s ready.”
If the new law works as intended, Ms. Mitchell and others predict more institutional investment in startups. “I think it will stabilize investor interest in this asset class. We do have to earn our way back into (limited partners’) portfolios.”
Karey Barker, managing director of Cross Creek Capital, a venture capital subsidiary of Wasatch Advisors in Salt Lake City with $11 billion in assets, said of a reduced regulatory environment: “We think it will be incrementally positive.”
— Contact Hazel Bradford at email@example.com