Private equity investors may breathe a sigh of relief later this year if the Securities and Exchange Commission (SEC) adopts an enhanced Regulation A offering, as the agency is expected to do.
The offering, known as a Tier 2, provides a plethora of opportunities and advantages for private equity managers.
But first a bit of background on what current Regulation A does: it exempts companies from registering securities offered to the public if the offering does not exceed $5 million in any 12 month period and permits selling stockholders to sell up to $1.5 million out of that total during the same period. These paltry dollar limitations have caused current Regulation A to be only rarely used.
The Jumpstart Our Business (JOBS) Act signed by President Obama in 2012 made it easier for companies to qualify for an expanded Regulation A offering. First, eligible companies will have the opportunity to sell up to $50 million worth of securities – including equity, debt, hybrids or guarantees – during any 12 month period. Certain integration rules apply if other securities are sold during the 12 month period and so-called “bad actors” are disqualified. Securities can be sold for either cash or other consideration and the registration provisions of state securities laws are preempted.
Also pursuant to an exempt Regulation A offering, private equity investors and other equity holders will be able to sell up $15 million worth of securities every 12 months. In this scenario, the portfolio company is entitled to sell the excess of $50 million less the amount sold by the selling shareholders. (The $15 million limitation on selling security holders applies to each 12-month period. So for example, a private equity fund could theoretically sell up to $60 million worth of securities of a portfolio company over a four-year period.)
Moreover, the purchaser is free to resell any securities sold in the Regulation A offering, unless the purchaser is an issuer, underwriter or dealer.
In addition to these opportunities, there are various advantages the private equity sector will see if the offering is a success.
Under Tier 2, portfolio companies that previously didn’t qualify for the traditional IPO market – because their market capitalization would not exceed the minimum $200 million post-IPO valuation normally needed for institutional investor interest – now qualify for public financing. This eliminates pressure on the private equity fund to invest further capital into the company.
Furthermore, in contrast to the traditional IPO, Tier 2 permits the company to “test the waters” to determine if there is investor-interest before launching the offering. If the result is minimal interest from investors, the company avoids the legal, accounting and printing expenses that are par for the course with a failed offering.
More good news is that companies do not have to spend a fortune to complete a Tier 2 offering. Legal disclosure obligations are lighter and the SEC requires only two years of audited financial statements. And those financial statements can come from smaller accounting firms, as opposed to only the large, costly auditing firms registered with the Public Company Accounting Oversight Board (PCAOB). The statements, however, are still subject to PCAOB standards. In contrast to the draconian liability in a traditional IPO, legal liability of the company, its selling shareholders and controlling private equity fund is similar to a private placement, which should further reduce costs.
While there are plenty of opportunities and advantages for private equities companies to enjoy, there also are several disadvantages that must be noted.
First, there is no assurance that there will be a market for these Tier 2 securities or that a liquid market will develop after the completion of the offering. Advance arrangements must be made with a broker-dealer to make a market after the completion of the offering. Secondly, private companies may be less willing to accept private equity funds if they have the alternative of a Tier 2 offering because of the potentially higher valuation provided by public investors.
Thirdly, there is a limit to the amount of securities an investor can purchase in a Tier 2 offering to no more than 10 percent of the greater of the investor’s annual income and net worth (as adjusted). Fourth, private equity funds would be required to consider the public market price in valuing the securities of their portfolio companies.
Finally, after completing the Tier 2 offering, companies must fulfill annual, semi-annual and current reporting requirements. These requirements, however, are much simpler and less costly than following a traditional IPO. And even these costs can be eliminated after the fiscal year in which the Tier 2 was qualified once there are fewer than 300 shareholders of record. Once the duty to file reports is suspended, over-the-counter trading in the securities can continue, provided that the market-makers are furnished with certain limited information.
Despite these disadvantages, a Tier 2 offering is an important and positive development for the private equity industry. However, the success of a Tier 2 offering depends primarily on the viability and liquidity of the over-the-counter market on which these Tier 2 securities will be sold and traded.
Frederick Lipman is a Philadelphia-based corporate partner with Blank Rome, a law firm.