Private-Company Stock Markets Provide Alternative To Regulatory Costs

August 2007

Earlier this summer, Goldman Sachs launched a market for trading stocks of companies that do not want the scrutiny and regulatory burdens of going public. Goldman called its market GS TRuE, for Goldman Sachs Tradable Unregistered Equity OTC Market.

Soon thereafter, Bear Stearns (named Best Markets) and the NASDAQ stock market (named Portal) each opened their own private placement market for unregistered securities. JP Morgan is also working on a system, to be called 144APLUS.

Private-company stock markets got a big boost last week when five major financial institutions announced their competing private market. Citigroup, Lehman Brothers, Merrill Lynch, Morgan Stanley, and New York Mellon Corp announced their “Open Platform for Unregistered Securities” (nicknamed OPUS-5). Trading will begin next month. The founders invited other securities firms to join them.

For privately offered equity securities, each of these markets provides shareholder tracking/management, transparent pricing histories, and transfer facilitation for executed trades.

This is the next step in response to the rapidly expanding role of private equity firms. These new private stock markets will facilitate direct investments by the major insurance companies and other financial intermediaries that now rely on private equity firms for private company investment.

The additional liquidity provided by these private markets will naturally tempt money that is otherwise being allocated to public companies traded on the NYSE and other major markets. Once these markets become accepted, the New York Stock Exchange and Nasdaq market will face competition for new issues. Because of the requirement to sell to a smaller shareholder group, and the related impact on liquidity, shares on these private markets should trade at a discount to companies trading on the public markets. The underlying analysis involves whether the considerable costs of being public are less than the liquidity cost of trading on the private exchange with fewer investors.

What is Rule 144A?

Under each of these markets, trading occurs under Rule 144A of the Securities Act of 1933. Rule 144A provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private sales of restricted securities to Qualified Institutional Buyers (“QIB”). Generally, a QIB is an institution that owns and manages at least $100 million ($10 million in the case of a registered broker-dealer) in securities not affiliated with that entity. For a banking institution to qualify as a QIB, a $25 million minimum net worth test must also be satisfied. QIBs are usually insurance companies, investment companies, employee benefit plans, banks, savings and loans institutions, or an entity owned entirely by qualified investors.

To stay private, 144A offerings must have less than 500 investors. Otherwise, public company registration is required. For this reason, private stock generally cannot be used as acquisition currency, or to recruit/retain employees.

This same rule limiting the number of investors means that the private-company exchanges will need to be listed on only one such exchange, in order to manage and enforce the number of investors. Consequently, each trading platform will have only its own clientele, thus splintering the total private-company market.

A glimpse into the likely success of these private exchanges

Even without a market to facilitate sales, private equity offerings have exploded. According to Nasdaq, public offerings on the three largest exchanges (New York Stock Exchange, Nasdaq, and American Stock Exchange) raised $145 billion in 2006. For the first time, offerings of 144A offerings raised more than the public offerings, at $162 billion. This trend has continued into 2007.

These private-company exchanges are quite similar to Liquidnet. The only major difference is that Liquidnet focuses on public companies. Liquidnet grew rapidly from its U.S. launch in April 2001 with 38 Member firms. Now, Liquidnet operates internationally, has 424 members with a collective $15.3 trillion of equities under management, and trades an average of over 1.2 billion shares each day. Those billions of trades each day are completely private and unreported.

This growth occurred because of the same institutions to whom the newly offered private-company exchanges will cater. Major institutions rushed to Liquidnet to facilitate privately arranged, institution-to-institution trades of publicly traded companies. Institutions found this attractive because their large stock volumes are readily noticeable in the public, smaller-lot exchanges. By merely publicizing that a large block was available for either purchase or sale, the public-exchange prices moved.

Liquidnet solves this problem by avoiding the public exchanges. Liquidnet provides a private alternative market that institutions require to trade more cheaply and efficiently. With Liquidnet, traders match, buy and sell orders through negotiation.

Some suggest that the success of these alternate exchanges is a warning that the U.S. regulatory scheme is broken. An alternate explanation exists. Those with the sophistication and resources necessary to evaluate the increased risks of operating in an unregulated environment may incur the costs on their own to do so. In contrast, smaller investors deserve additional protection because they are more apt to rely on issuer representations and do not have the resources to perform the additional due diligence. An issuer who wishes to take investment money from smaller investors needs to provide the additional assurances that our public market regulators require.

Fulcrum Inquiry is a financial consulting firm that provides business valuation and appraisal services.