A conversation with Cameron Helewell, Michael Schwartz, Scott Lawlor, Louis Rogers, Cory Johnson, Edwin Stanton and Kirk Montgomery.
Introduction by Jennifer Dohrmann-Alpert.
Capital formation through private placements, particularly in Regulation D’s, has increased substantially since the onset of the financial crisis. Amounts raised through unregistered securities offerings have outpaced the level of capital formation through registered securities offerings during recent years. Revolutionary changes in the private placements market have given businesses the unprecedented opportunity to begin or expand operations by reaching new markets for their securities to quickly and inexpensively raise capital. The same kind of change that swept through the mutual fund industry, making investing in a fund a quick and easy process and bringing billions of dollars into the industry, is now impacting the world of private placements.
The following contributions from leading industry executives in the private placement space serve to explain the various definitions and applications of private placement Reg D vehicles.
In an effort to clarify terminology, please describe the difference between 506(c) and 506(b) offerings, as well as define a Reg A+ offering. Are there more suitable distribution channels for each?
Cameron Hellewell, Orchard Securities
Although both Rule 506(b) and Rule 506(c) of Regulation D provide exemptions from registration when selling to accredited investors, there are significant differences between them. The primary difference is that Rule 506(b) prohibits any general solicitation or general advertising to market the securities, whereas such marketing is not prohibited under Rule 506(c), provided that all investors are accredited and the issuer takes reasonable steps to verify that the investors are accredited. There are no limitations on how much equity can be raised through Rule 506 offerings.
Regulation A+ became effective in June of 2015 and also provides an exemption from registration. Unlike Rule 506 offerings, however, subject to certain limitations, nonaccredited investors may be admitted into a fund offered through Regulation A+, though there are limitations on what can be raised through Regulation A+ offerings — $20 million in a 12-month period on Tier 1 offerings, and $50 million in a 12-month period on Tier 2 offerings. Regulation A+ offerings are qualified by the SEC.
Bad actor disqualification provisions apply to both Rule 506 offerings and those made through Regulation A+.
Depending on the investors that an issuer wants to attract and the manner they want to solicit them, offerings conducted through any of these exemptions can be a suitable means to do so.
The adoption of nontraded investment vehicles like Reg D offerings by financial intermediaries has been increasing over recent years. What broad trends do you see with respect to the utilization of Reg D offerings? Do you see these trends as long lasting or temporary?
Michael Schwartz, SmartStop Asset Management
Wealth advisers are increasingly exploring opportunities to incorporate alternative investments into their clients’ portfolios, just as institutions have done for decades. Alternatives can provide greater yields than traditional investments like stocks and bonds, and they often offer attractive cash distributions that many investors seek to supplement their incomes. Alternatives also offer investment options that are not correlated to the stock market and can provide valuable diversification advantages that well-balanced portfolios rely upon.
Private placements are growing in popularity among high-net-worth investors for these very reasons. Individual investors and their advisers are growing more sophisticated every day and their comfort level with alternative investments continues to increase. More and more, individual investors are walking the path that large institutional investors have followed for many decades.
Among Reg D alternative investments, 1031 exchange private placements are growing rapidly — they may raise upwards of $3 billion this year. They are growing not only for the reasons previously stated, but also because IRC Section 1031 is a powerful tool to protect and create wealth via reinvestment of capital that would otherwise be consumed by state and federal taxes. The Baby Boomers have trillions of dollars in direct real estate investments, much of which will flow into Section 1031 exchanges over the coming years and decades, as they seek to divest from actively managed real estate into passive investments that continue to provide income and the potential for further appreciation.
How are Reg D private placement offerings being regulated? What are the risks and rewards for investors?
Scott Lawlor, Waypoint Residential
Recent regulatory changes have spawned a significant increase in the number of asset managers accessing retail capital through Reg D private placement offerings. Less informed industry constituents frequently cite freedom from the regulatory restrictions imposed on corresponding public offerings as the reason for the uptick. A closer look confirms that the independent due diligence is no less stringent than the due diligence on the public programs. Due diligence at the broker-dealer level is many times more stringent because of concerns over heightened regulatory scrutiny of private placement transactions. And while statement pricing, disclosures concerning distribution sources, the need for audited financials and periodic valuations are not dictated for private placements by the regulators, a meaningful and growing number of independent broker-dealers and RIAs require that those best practices be in place before they consider participating in a Reg D private placement offering.
There is a common belief that private placements represent more risk to investors than public offerings. My contention is that the integrity and expertise of the sponsor, the validity of the value proposition and the transparency around the risk disclosures are critical to any evaluation of risks and rewards and are independent of whether a private or public offering is being evaluated. The quality of new sponsors bringing Reg D private placement offerings to market, the expanded access to institutional-quality investment programs for retail investors and the enhanced transparency around the risks associated with these programs all bode well for investors in Reg D private placement offerings.
Crowdfunding programs have feverishly adopted the 506(c) offering structure. Will 506(c) structures become more widely accepted by financial intermediaries going forward? Where is the widest adoption anticipated to come from? Which asset classes are best suited for these offerings?
Louis Rogers, Capital Square 1031
The exemption under SEC Regulation D, Rule 506(c), is the future, and we should embrace it.
If, 10 years ago, you told me that an issuer could solicit and advertise to raise capital in a private placement, I would have suggested you have your head examined. However, the Jobs Act removed the handcuffs and permits solicitation and advertising, provided a number of strict conditions are satisfied.
To date, 506(c) has not been widely used outside of a relatively small group of crowdfunders in Internet-based offerings. However, subsection (c) has universal application for private placements, including real estate offerings. For example, Capital Square 1031 made the conscious decision to rely on the (c) exemption for its future Delaware Statutory Trust offerings for real estate investments. This permits advertising by the issuer and the salesforce of broker-dealers, registered representatives and investment advisers. The ability to advertise is a great benefit to the issuer and salesforce by exposing offerings to a very large pool of potential investors.
Some traditional broker-dealers have been reluctant to approve (c) offerings. They are concerned about satisfying the conditions to qualify for the exemption; other broker-dealers seem to fear losing investors to Internet sales.
Investors are increasingly using the Internet to locate investment opportunities. I believe it will be clear over time that broker-dealers and their representatives will benefit from use of the (c) exemption through access to a massive pool of new investors. By using the exemption, BDs and reps can grow their books of business, and issuers can gain access to large sums of new capital seeking a home. This is a win-win for all the parties, and supports the goals of the Jobs Act by removing major road blocks to raising new capital.
What are the general attributes of 506(b) products that financial intermediaries are seeking today? What is required to stay competitive in the 506(b)?
Cory Johnson, Pender Capital
There is an unlimited range of offerings available through Rule 506(b) of Regulation D private securities. The sale of these sophisticated alternative investments comes with extensive and complicated regulatory requirements, so work with a sponsor of these products you have strong confidence in.
To stay competitive in the 506(b) space a sponsor’s transparency is crucial. You need to ensure investors understand the fees, terms and redemptions involved for each product and how these are in line with the underlying investments. The sponsor should have a sound, investor-centric, long-term investment strategy that you fully understand and can communicate to investors. Sponsors of these products should provide audited financials, professional fund administration and managerial oversight. Additionally, sponsors should communicate in a timely fashion and set appropriate expectations.
506(b) products are best suited for sophisticated investors who are willing to commit to a sustainable long-term investment that does not need to be monitored daily. These offerings are generally uncorrelated to the public markets and offer valuable diversification benefits and potentially higher yields.
With a $50 million cap on Reg A+ offerings, is that enough deal size to make an impact in the industry? Which players stand to gain the most from these offerings and which investors are best suited for this type of an allocation? Will we see a continued rise in Reg A+ offerings and an uptick in sales in the next 12 months to 18 months?
Edward Stanton, HC Government Realty Trust
For some companies, $50 million will provide adequate equity to capitalize their business model, particularly given their total levered capital structure. Others may choose to use the offering as one of several managed vehicles. The limitation in offering size and the increased start-up, operating and reporting costs will ultimately restrict the number of companies that jump into the space, limiting the impact on the total capital that is raised in alternative real estate investments.
Smaller real estate companies interested in accessing retail capital will stand the most to gain, particularly if their long-term growth plan contemplates a major exchange IPO or listing event. Furthermore, there may be certain lower-risk property types that are better suited to Reg. A+ investments over private placements.
Reg. A+ opens up investment opportunities to nonaccredited investors that were historically prohibited from accessing alternatives. Individual suitability will depend on offering specifics. Such components as the underlying tenant credit and renewal risk and an individual’s liquidity needs will play an important role in their ultimate investment decision.
With access to nonaccredited retail investors, it seems logical to expect an increase in offerings, especially as various marketplace and distribution channels become better educated on Reg A+. Education will certainly improve offering specific sales. However, interest from potential offerors may be limited by the increased formation and operating costs over Reg D. We do believe the increased transparency provides significant value to the investor, and we expect to see other sponsors with well-established distribution platforms adding Reg A+ to their “suite” of products.
The Securities and Exchange Commission adopted final rules increasing the threshold for offerings made under Rule 504 of Regulation D and broadening the intrastate offering exemption afforded by Rule 147. These finalized rules facilitate crowdfunding efforts for smaller companies. Despite the unique features of intrastate offerings, both sponsors and investors alike have been slow to accept. What hurdles do intrastate offerings continue to face?
Kirk Montgomery, Kirk Montgomery Law
SEC Rules 147 and Regulation D 504 were adopted to provide more flexibility and cost efficiency for smaller private offerings. Rule 147 is an SEC “safe harbor” for intrastate offerings, unlimited in size and with the ability for Internet solicitation. Intrastate means that the investors must reside in the same state as the issuers “principal place of business.”
Rule 504 is an exemption for offerings up to $5 million during a 12-month period (with some restrictions on types of issuers). While limited in offering size, there is no restriction on the number of investors, no specially required disclosures, and, unlike Rule 506(c), in most states nonaccredited investors are allowed.
But despite being faster, less expensive and generally more marketing-friendly, why have Rule 504 and 147 offerings been so rarely utilized? The answers are that both are still subject to state “blue sky” regulations, which vary widely and in some cases may limit their appeal, and thus they are simply not very well known by issuers or investors.
Just keep in mind that for a smaller offering with accredited investors also looking to include some combination of nonaccredited friends, family, employees or others, Rule 504 should be considered.
Further, in the limited situations where you expect to raise all your capital within the specific state where you conduct your primary business, at least take a look at “intrastate offering” Rule 147 as an option for your fundraising strategy.
The overall popularity of both of these rules could certainly change when the definition of “accredited investor” is adjusted, as expected.