The so-called democratization of private markets is off to a bumpy start. Retail investors now have access to private assets through semiliquid funds that are both more expensive and less liquid than funds that invest in public stocks and bonds. What’s more, these vehicles are complicated to assess and unlikely to earn the outsize returns that private investments promise.
The next stop may be your 401(k), pending a proposal by the Department of Labor that would explicitly permit alternative investments in retirement plans, provided that fiduciaries document their assessment of six factors: performance, fees, liquidity, valuation, performance benchmark, and complexity.
That sounds straightforward, and it generally is when evaluating public securities. But not for private assets, as Morningstar’s multi-asset and alternative strategies analysts explain: “Private markets complicate all six, not only because of their own inherent complexity but also because of difficulties in evaluating performance, fees, liquidity, and valuations.”
Alexander Davis, editor of Morningstar and PitchBook’s Public Meets Private newsletter, shares these reservations: “It’s fair to wonder whether money managers are pushing too hard, and too fast, to pair everyday investors with hard-to-value, hard-to-trade alternative assets that are sometimes complex for even the most sophisticated people in the market.”
Untamed Unicorns Pose a Danger
Law professor Renée M. Jones also has concerns. In her recent book Untamed Unicorns: Why Startup Finance Is Broken and How to Fix It, Jones lays out how deregulation has eroded safeguards that were first put in place in securities laws passed in the wake of the 1929 stock market crash. While private companies worth at least $1 billion (“unicorns”) were once rare, they are now commonplace. Not only are private companies growing bigger than ever, but they are also avoiding the regulatory and public scrutiny that promotes good behavior and protects investors.
Jones teaches corporate law, securities law, and corporate governance at Boston College Law School. She also served as the director of the Division of Corporate Finance at the Securities and Exchange Commission from 2021 to 2023. I interviewed Jones for a feature in Morningstar magazine before her book was published in August. Our conversation has been edited for length and clarity.
Laura Lallos: Before we turn to private markets: Given your experience at the SEC, what do you think of the proposal to allow public companies to disclose twice a year instead of quarterly?
Renée M. Jones: I think it’s a disastrous proposal. Basically, the whole regulatory system, including a lot of the rules that I worked on, was based on quarterly reporting. If we take that away, investors are not going to get the information we had determined they need on a timely basis. This would exacerbate information asymmetries, and corporate insiders would know a lot more than the public and be able to take advantage of that information for an extended period.
And nobody really wanted this. This is a response to something the president posted [on social media]. The public response has been robust and uniformly negative.
Lallos: What prompted you to turn to private companies with Untamed Unicorns?
Jones: As private companies are getting larger, corporate governance problems are cropping up. I wanted to figure out why. What has changed? Startups are getting much bigger than they ever were before. When I started to look into it, there were about 400 unicorns, or billion-dollar private companies, and now there are more than 1,500. I realized that [as a result] the venture capital financing model has broken down. Venture capitalists don’t have control anymore.
Control had been the hallmark of the venture capital model: We’ll give you a lot of money, but we are going to insist on contractual provisions that ensure we’re in control. If we’re not happy with the founder, we can bring in somebody else who’s more competent. There are problems with that system: If you’re the founder, obviously you don’t like it, but it ensured that the people who had the money, the experience, and the maturity were the ones in control.
Looming Liquidity Crisis
Lallos: Why are companies staying private for so much longer? IPOs used to be the way VCs got their money back. How do they do that now—what’s changed?
Jones: The law is the biggest thing. The National Securities Markets Improvement Act of 1996 removed the cap on the number of investors a private fund could have [before having to register under the Investment Company Act]. Venture capital funds, hedge funds, and private equity funds started to grow enormously. The amount of money in private markets managed by these private funds ballooned from about $200 billion around 1996 to more than $17 trillion today. Money started to flow in from public pension funds and university endowments chasing better returns. The benefits of going public had been access to capital, but you could access that capital now in private markets.
With the 2012 JOBS [Jumpstart Our Business Startups] Act, Congress relaxed a requirement [of Section 12(g) of the Securities Exchange Act of 1934] that said if you had 500 shareholders or more, you had to pursue an IPO. Now, all bets were off. Startups could stay private indefinitely, and they have, for the most part. When SpaceX SPCX went public, it was over 20 years old. That was unheard of under the old model, where you would either be public, be sold, or be liquidated before you got anywhere close to 20 years.
And founders started to get more power. One of the things I argue in my book is that having to do an IPO gave investors a lot of power. If the founder, for example, resisted replacing a CFO, investors could say, “Well, we can’t go public without a reputable CFO.” That sort of persuasive power just dissipated. Also, former entrepreneurs who became very rich during the dot-com IPO wave became venture capitalists themselves, and they were very sympathetic to founders. They promised founder-friendly, hands-off financing, and the rest of the VC industry had to follow suit to compete to get in on the best deals.
Lallos: The industry is pushing to “democratize” private markets. Are you comfortable with private markets being added to 401(k)s?
Jones: I think it’s a horrible idea. The idea underlying all of these [disclosure] exemptions is that government should stay out of the way because sophisticated investors—venture capitalists, hedge fund managers, family offices—can protect themselves. When you’re talking about individuals’ 401(k) plans, those arguments for nonregulation or deregulation fail.
And there’s an approaching liquidity crisis in private markets. The average age of these private companies is well beyond what it used to be. Limited partners, university endowments, and pension funds want their money back. The solution is the trillions of dollars sitting in our 401(k) plans. That’s a way for these private asset managers to achieve the exits that their investors are demanding. To dump it on people who basically are struggling to save for retirement, to shove it down people’s throats through target-date funds … I think it’s very cynical. Those are the investors who most likely are the most passive and least informed.
Moving Fast and Breaking Things
Lallos: The positive take on staying private is that a company can focus on long-term growth without having to answer to short-term shareholders. (That’s also an argument often made for reducing disclosure requirements for public companies.) The flip side is that going public brings scrutiny, which promotes responsible behavior. You argue that deregulation has actually harmed startups themselves, because it’s created recklessness.
Jones: The quintessential startup model was lean and mean. Everybody’s working for lower pay. Everybody’s driven, committed to the project. They had to prove the sustainability of the business model and hopefully show profits before they went public. That paradigm doesn’t exist today, because now big investors are putting in huge amounts of money, and they want to see huge returns. There’s a growth-at-any-cost mentality that puts a lot of pressure on startups and their founders to just keep growing without paying much attention to costs. It’s revenue growth, not profits.
And that enables this [attitude of] move fast and break things. “We’re special, we don’t have to comply with the rules.” I argue that a disrespect for law develops in the startup stage, where you’re protected from public scrutiny. That disrespect is baked into the culture, and those problems continue after these companies go public. DoorDash DASH, Uber UBER, Airbnb ABNB, Meta META struggle with compliance issues long after their IPOs.
Lallos: You make a case that this aspect of private equity has societal costs. Many of us benefit from innovations such as Airbnb and Uber. But these innovations also created problems.
Jones: Airbnb is great for a lot of people. Maybe you have a big family and don’t want to stay in a hotel, for example. But it’s not necessarily great for the long-term residents that they’re displacing in these tourist areas. What are the costs, and who’s bearing those costs? Ubers were really cheap—they’re not anymore, but for a long time, they were. But what was that doing to taxi drivers and their livelihoods?
Lallos: Would you say that if a public company embarks on an endeavor like Uber or Airbnb, regulators would be more likely to step in early?
Jones: Probably, yes, because of public scrutiny, regulatory scrutiny, and disclosure obligations. There are more people watching, pouncing, ready to sue. Of course, public companies do things that aren’t appropriate, and I don’t think we’re ever going to solve all corporate responsibility problems through disclosure, but it gives everybody a better lens through which to look at how corporations are behaving and to take action.
Is This Really Venture Capital?
Lallos: As you and others have argued, the startup world is a mostly male culture of risk-takers that can breed a disregard for ethics. The homogeneity of that culture makes one wonder about the opportunities the VC industry is missing. They are looking for founders who fit their stereotypes. Who are they overlooking?
Jones: It’s very much a personal contact, networking type of environment. There’s no professional certification that you need to be a venture capitalist, and there’s certainly none that you need to be a founder. The mythology, at least in Silicon Valley, is that it’s a young college dropout who’s going to start the next Facebook. The research doesn’t really bear that out, but it’s a typology that’s taken hold. Mark Zuckerberg succeeded, so let’s look for the next Mark Zuckerberg. Let’s look for the next Steve Jobs. Elizabeth Holmes did such a great job of tapping into that—just looking like and acting like the next Steve Jobs.
There’s a selection problem in Silicon Valley. [Holmes aside,] more than 80% of VC funding goes to all-male teams, and 2% goes to all-female teams, and so that’s clearly a strong bias there. And for Black teams, it was only 0.4% last year. A lot of good ideas just never get the attention of VCs.
VCs are chasing fads. Right now, it’s AI. Before that, it was platforms and software as a service. We literally call it venture capital, but is it really venture? Is it really daring if 50% of the money that was invested last year went to AI, most of it to the largest AI companies?
A Call for Disclosure
Lallos: What remedies do you propose?
Jones: I focus on disclosure. Most of the money raised by venture capital and private equity firms and their funds is raised under Regulation D, a 1982 SEC rule. There is no disclosure requirement if all the investors are accredited. That doesn’t really make sense anymore. If you’re saying we don’t want red tape for small companies, we don’t want to make it difficult for them to raise money, I can agree with that. But with a multi-billion-dollar fund or company, the costs of disclosure are minuscule.
In the book, I look at startup employees who are working for lower pay [in exchange for shares in the company]. There’s an exemption for these transactions based on the idea that employees at a small company know what’s going on. That’s probably true if you work at a five-person startup, but not if you’re one of 20,000 employees in a multi-billion-dollar company. They’re not well-informed about the value of the company and the likelihood of an exit event.
Private trading markets have proliferated, where billions of dollars of private startup shares are trading every year. There’s no appropriate standardized disclosure in those markets, so I address that. I also argue that the 500-shareholder rule imposed significant discipline in the startup market, and that it should be restored. Even if Congress doesn’t restore that rule, the SEC has the power, through its rulemaking under that provision, to close loopholes. Investors are creating special-purpose vehicles that count as one shareholder, even though there could be dozens of investors. I argue that we should count them all.
Whether investors are investing in public markets or private markets, they should get the disclosure that they need to make informed investment decisions and to exercise appropriate oversight.