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Caroline Crenshaw, a commissioner at the US Securities and Exchange Commission (SEC), has warned that inflated valuations of the once-mythical unicorns are, in part, the result of a regulatory gap and she proposes to fix it.
Large private companies are increasingly making use of an SEC rule that gives them access to unlimited capital without the need to go public and be subject to massive disclosure obligations.
According to SEC commissioner Caroline Crenshaw, the exemption provided under the so-called Reg D contributed to the rise in the number of unicorns, private tech start-ups that crossed the $1bn valuation. However, as lessons learned from 2022 show, those valuations are often highly inflated.
“Private companies now have access to increasing amounts of private capital, inflating their sizes and significance to investors and our economy, and all without the concomitant safeguards built into the public markets,” Crenshaw said.
“Like the children’s book, the ‘Very Hungry Caterpillar’, unfettered access to capital through Rule 506 [of Reg D] has had a bloating effect on private issuers,” she added.
Once-mythical but now ubiquitous unicorns
The number of unicorns has grown significantly in the last decade. Since 2013, when the term was first used, the number of unicorns has grown from 43 to 1,205 and their overall valuation is estimated to be about $4trn.
Of these 1,000+ unicorns, 252 are fintech companies, which together are valued at $880bn, according to CB Insights data.
Although pandemic-driven digitalisation prompted a sudden hike in fintech investments, many of the companies faced difficulties in raising new capital in 2022 and their latest funding rounds often ended with a significant cut in their valuations.
Earlier in January, Stripe, once valued at $95bn, was reported to be in talks with investors with a valuation of $55bn to $60bn. Elsewhere, Sweden-based Klarna saw its valuation drop from $46bn to $6.7bn in July, while in December, the UK’s Checkout.com adjusted its internal valuation lowering it from $40bn to $11bn.
Overall, the Financial Times estimated that in 2022 fintech unicorns lost $0.5trn in valuation as the threat of economic recession brought to light concerns about the lack of profits and untested business models at fintechs.
Raising money in the dark
Crenshaw said many of the bloated valuations in the US have been the result of the SEC’s Reg D, which gives private firms exemption from registering with the regulator while allowing them to raise “essentially unlimited capital from an unlimited number of accredited investors”.
As a result, many private companies chose not to go public or delay their listing and, in the last decade, securities offerings have grown at a significantly faster rate than public offerings.
The fact that companies can raise hundreds of millions of dollars without the need to go public and disclose essential information raises concerns relating to valuation, Crenshaw warned.
For instance, when private companies submit a filing under the exemption rule, the filing often includes check-the-box answers, according to the commissioner. In some cases, private firms decline to disclose their revenue or net asset value range and in general, there is little to no consequence if they even fail to file the form.
Inflated valuation is in everyone’s interest
Additionally, Crenshaw warned that there is “a set of endemic incentives” among institutional private markets to show growth in valuations.
Fund managers rely on the growth of their portfolio companies to charge higher fees, show healthy assets under management and distinguish themselves from other fund managers.
Portfolio companies are also incentivised to report continuously positive values to show not only the successes of their business but also to justify the valuations given to earlier round investors and to avoid their investors from having to suffer write-downs.
Eventually, the price of inflated valuations is paid by investors who lacked the necessary information to decide whether or not to invest.
“Consider FTX in particular — despite the reported presence of many elite and sophisticated investors capable of negotiating for information and protections, FTX was nonetheless described by its court-appointed, post-bankruptcy CEO as marred by ‘a complete failure of corporate controls’ and a ‘complete absence of trustworthy financial information’.”
FTX was valued at $32bn before it collapsed in November.
To fix these issues, the SEC commissioner proposes incremental reforms to Reg D.
“There should be more transparency to ensure a basic level of disclosure that allows investors, even the most sophisticated, to make informed investment decisions,” Crenshaw said.
Additionally, she proposes a two-tier framework for Reg D with heightened obligations imposed on large private issuers and large capital raises.
The topic is particularly timely, not only because fintech valuations have fallen during the last year, but also because public stock market volatility often prompts investors to put their money into private companies.
When there is volatility in public markets, “there is a tendency to drive money into the private markets, either to escape the volatility, or more cynically, simply to avoid the ‘visible volatility’ of the public markets”.
Crenshaw cautioned investors “should not mistake less price transparency, or less ‘visible volatility,’ for safer waters”.
