The New Private Securities Exchanges

The July 17, 2007 Wall Street Journal reports (here, subscription required) that private equity firm Apollo Management L.P. will (after selling a portion of the firm to the Abu Dhabi Investment Authority) be listing its shares on the new Goldman Sachs private securities exchange. The Apollo listing follows a couple of months after Oaktree Capital Management listed on the Goldman Sachs exchange.

The new Goldman Sachs exchange is one of several new private (or lightly regulated public) exchanges that have emerged in recent months. These developments raise some interesting (and potentially urgent) questions, such as: What are these new exchanges? Why are issuers and investors drawn to them? What are the implications for existing traditional markets? And what are the risks and exposures for the listing companies that access these markets?

What Are The New Exchanges?: The full name of the new Goldman Sachs exchange is the “GS Tradable Unregistered Equity OTC Market,” or GSTrUE for short. A good introduction to the GSTrUE can be found here. The idea behind the market is to allow private firms to raise money and create a way for their executives to cash out, without the burden, expense, delay – or scrutiny -- of registering shares or taking on reporting responsibilities. The Goldman Sachs exchange is private and unavailable to individual investors. The exchange is available only to institutional and other sophisticated investors.

According to news report (here), NASDAQ is preparing to introduce a new electronic platform called “The Portal,” to allow buying and selling of Rule 144A shares. The purpose of the exchange is to allow institutional buyers of the securities to have a market within which to later trade the shares, in the hope that the availability of a trading platform will improve investment liquidity and support improved valuations. The Portal is slated to launch in August (refer here). NASDAQ touts the Portal’s advantage over the GSTrUE exchanges as a neutral platform that is not restricted to customers of a single bank. NASDAQ's application for SEC approval for the trading platform can be found here.

In addition to these private exchanges, the London Stock Exchange announced on July 12, 2007 (here) that it will launch a dedicated market for issuers of specialized funds (the “Specialized Fund Market”) to create a separate market for alternative assets such as hedge funds and private equity vehicles. The market is designed to provide a trading platform and investment liquidity, in a structure restricted to trading professionals. The market is for issuers that wish to target institutional investors, such as single strategy funds, feeder funds, specialized sector funds, and specialized geographical funds. Commentators suggest (here) that the new LSE market , which unlike the GSTrUE and the Portal will at least be “lighly regulated,” is designed to compete with Euronext Amsterdam for listing alternative funds.

Each of these initiatives is different and each of them is designed to achieve different goals. What they have in common is that they each provide a way for issuer companies and funds to reach institutional investors through a trading platform on which their shares can trade without the need for full registration or the adoption of full reporting status.

What Does the Record So Far Suggest?: Prior to Apollo’s announcement, the only prior issuer to list on the GSTrUE was Oaktree. According to news reports (here), in May 2007, Oaktree raised $800 million by selling about 14% of the firm to 50 investors. According to today’s Journal article, “Oaktree listed at only a slight discount to the valuation it could have received on the public markets.”

At least based on Oaktree’s experience, the GSTrUE exchange (and potentially, The Portal) offer plausible alternative ways for firms to issue tradable shares without undertaking an IPO in the public securities markets. Specifically, the Oaktree and Apollo transactions seem to represent an alternative to the public offerings that Blackstone Group and Fortress Investment Group recently completed, with the advantage that Oaktree and Apollo could complete their offerings without the burdens and scrutiny of a public offering. The Portal provides a way for private companies to offer their qualifying investors a public market and enhanced liquidity for the private company investment.

While these private markets may offer issuers an alternative to the public markets, to the public markets these innovations represent yet another threat. As I have previously noted (most recently here) several blue ribbon panels have recently been concerned with the competitiveness of the U.S. securities exchanges. But the new markets represent an innovation that addresses needs that may not be possible to meet in the public markets. Like the forces of globalization that are encouraging new markets that compete with the U.S. based public securities markets, the need for innovation is yet another force stronger than the gravitational pull of the public securities markets themselves.

What is the Regulatory Context?: For the private exchanges to avoid SEC regulation, investors will have to be limited those with over $100 million in investable assets, and in order to avoid triggering reporting requirements, any listed U.S. entity will have to make sure it does not exceed more than 500 shareholders. These restrictions obviously put certain limitations on liquidity (as, it should be noted, does the likely absence of analyst coverage).

The absence of regulatory scrutiny and reporting requirements may act as a deterrent to some investors. The potential lack of transparency may even violate the investment policies of certain public funds or other fiduciary entities. In addition, the continued ability of these markets to attract investors will largely depend on the markets perceived trustworthiness. A scandal or report of a deceptive practice by one or more issuers trading on these private exchanges could undermine market trustworthiness and potentially the confidence of the investors. The incentives of the exchanges to maintain their integrity could potentially conflict with the issuers’ interests, or at least the interests of those issuers whose primary attraction to the exchange is a desire to avoid transparency and scrutiny.

What is the Risk Environment?: While the listing companies, if compliant with the requirements, will remain outside the reporting system, they will not be trading in a parallel universe to which the laws do not apply. Aggrieved or disappointed investors who believe they have been misled or deceived will identify any number of legal theories they might use to pursue legal claims against the private exchange listed firms, including, for example, common law fraud and misrepresentation theories. Of course, the institutional investors who are able to invest on these private exchanges would perhaps be less likely than retail investors to initiate litigation. But as, for example, institutional hedge fund investors have recently shown (here), given sufficient provocation, institutional investors are very willing to use litigation to redress concerns.

Issuer companies of the caliber of Oaktree and Apollo would enhance any market. But a market whose main attraction is lack of scrutiny and of reporting obligations could potentially attract participants whose presence may ultimately have a different effect on the market than enhancement. If that should happen, and unanticipated losses emerge, the lawsuit genie inevitably will escape from the bottle.

The point is that the issuers trading on these new private exchanges will not exist in a risk free environment. The perception of risk for hedge funds, private equity funds and venture capital funds has evolved in recent years; so too will the risk perception for issuer companies whose shares trade only on these private exchanges. The trading nonpublic company will represent a new category of risk. The arrival of private securities markets and of the companies whose shares trade only on their exchanges will require adaptation. To the extent the demand emerges, the insurance industry will likely need to develop new products designed to address the special needs and evolving risks of these companies.

But make no mistake, the continuing development of GSTrUE market and the anticipated arrival of the NASDAQ Portal, as well as the continued innovation in the public markets such as the LSE, represent categorically new developments that will require innovation and adaptation, particularly if their impact on the public markets is anything more than marginal.

Government Cash, Global Markets: The Abu Dhabi Investment Authority (here), with estimated assets of over $600 billion, receives the governemental revenue of Abu Dhabi's oil industries. ADIA is the largest of the new breed of governmental investment authority that is playing an increasingly large role on the global financial scene. In a prior post (here), I discussed the Norwegian Government Pension Fund (here), which at nearly $300 billion in assets is not only large, but is also playing an increasingly activist role in governance matters. Other significant governmental investment authorities include the Government of Singapore Investment Corporation (here). The very size of these entities make them important players in the financial markets. Their influence will only continue to grow as commodities scarcities dictate global cash flows. The unavoidable importance of these institutions is a looming omnipresence, that for good or ill will increasingly affect international investments in the years ahead. The political risk behind all this is a large and scary topic, but one that at least for now can be left for another day.

Location, Location, Location: Abu Dhabi, the largest of the seven emirates of the United Arab Emirates, and also UAE's capital, has a population of about 1.8 million people, about the same size as metropolitan Cleveland. But it doesn't have Lake Erie. Sure, sure, Abu Dhabi has lots of oil. But think about it. In the 21st century, fresh water could prove to be a lot more imporant than oil. I wonder if the ADIA will amasss enough wealth to be able to buy Lake Erie?