Calculating the odds: Market forces alternative investment, crowd fund investing

Read the article in the Cayman Financial Review Magazine 

“There is nothing more difficult to take in hand, more perilous to conduct or more uncertain in its success, than to take the lead in introduction of a new order of things, because the innovator has for enemies all those who have done well under the old condition, and lukewarm defenders in those who may do well under the new.”

Machiavelli

In 1966, the father of hedge funds, Alfred Winslow Jones noted that certain approaches require trending markets; others work in higher volatility environments, still others in improving credit markets. He was beginning to feel his way down a dimly lit path toward what today would be considered a factor-based approach to portfolio construction.

Jones’ patience paid off for the industry but negative trends in recent years resulted in change – increased competition, an unstable economic environment, a wave of new global regulation and far more demanding investors.

Then came the post-Lehman and post – Madoff carnage in which the market had to adjust to an even more negative period of change, primarily driven by restructuring, restrictions placed on funds – limiting the amount of withdrawals from the fund during a redemption period, irate investors trying to redeem and difficult to price illiquid securities – this cycle continues and increasingly, the finance industry continues to experience difficult times and uncertainty.

What is new and interesting in the field of finance?

In 2013, the JOBS Act which includes Title II (Regulation D 506(c) and 144A) and Title III (Crowdfunding) is expected to create two themes in finance investing that are positioned to unleash a burgeoning movement that may actually help to correct the markets. First, ending the prohibition against general solicitation and advertising on start-ups and investment funds under Rules 506 and 144A offerings that the Securities and Exchange Commission proposed on 29 August, 2012.

The proposal also applies to private investment funds, including hedge funds, venture capital and private equity funds whereby the only people eligible to purchase such interests are accredited investors, but sellers would no longer be restricted in terms of advertising and other forms of marketing. Removing these restrictions offers transparency and choice for the industry by ending the ban on general marketing of such securities as private company stock.

However, though the provision provides flexibility in determining the meaning of “reasonable steps to verify” the accreditation status of investors by issuers, clarification as to what constitutes “reasonable steps” in 506(c) offerings remains open. By not clarifying the application of “reasonable steps”, the Commission and the public may garner results that were not intended, thereby stifling economic growth and job creation opportunities for start-up and emerging business in our nation.

Secondly, crowdfunding provides a plethora of opportunities for start-up and emerging companies to gain access to the capital markets by launching Web 3.0 using Web 2.0 (social network) to raise capital and create jobs, opening the doors of investing to the non-accredited investors. The Jumpstart Our Business Startup Act (JOBS Act), Title II and III, modernises regulations that were put in place almost 100 years before; among other things, it facilitates the ability to conduct online transactions and services for equity and debt based crowd fund investments. Under the JOBS Act, start-up and emerging companies are defined as companies whose revenue is less than $1 billion the prior fiscal year.

What does all of this have to do with the recent financial crisis? This is simply offering a different perspective of facts, which has usually been ignored by those with a recognised voice. The financial industry can now be reformed purely by innovation and a quest for new ways of seeing and thinking – innovation trends – not trendy, new technology and the market.

Investment freedom leading to economic growth

Americans were naturals at applied
science, improving many ideas that were already in existence and bringing them
to fruition with resources newly available during the Industrial Revolution. Crowdfunding
should be no different with extending the framework of reward and donor based
transactions to equity and debt investing.

For consideration, crowdfund investing
should not be viewed as an invention but – a discovery of a law of mathematics,
not trendy. It is a very sophisticated perspective that removes the vanishing
point that had reduced the non-accredited investor to a static mathematic
point.

Imagine a network of self sufficient communities,
investing and building their wealth beyond the reach of what government thinks
they should have; capable of following the laws, norms and social rules. Led by
pioneering individuals, these societies could become the blueprint for a new
way of life – one that is more equitable, tolerant and entrepreneurial. It
sounds far-fetched but crowdfund communities are rapidly becoming a reality.

Massolution, a research company revealed that crowdfunding
platforms raised almost $1.5 billion, funding over one million
projects
in 2011. This is
driving ideological libertarians and entrepreneurs to want to further the establishment
and growth of permanent equity and debt-based crowd fund communities while
making entrepreneurs less dependent on traditional means of capital formation
in order to survive and thrive.

Some spectators see it as a sign that
today’s non-accredited investors and entrepreneurs are growing up and etching
their place in history and the capital markets. Others take the view that
today’s generation want to stand alone and want to cast the past aside in order
to validate themselves because of the current financial system failings.

This is likely to make little sense to individuals
brought up to think that an efficient market rewards those who take more risk.
In fact, the market is full of anomalies, and success seems to come from
exploiting opportunities and not focusing on the obstacles, which are those
frightful things that are seen when the eyes are taken off of the goal.

Regulatory decisions looming

The regulatory framework for both the United
States and Europe is mired in the bureaucratic decision making process. In the
US, two major milestones were expected to have been met before the end of the
year, lifting the ban on prohibition of general solicitation and advertising
under Title II by July 2012, which was placed on hold for an extended public
comment period until 5 October, 2012. We are still waiting for a final ruling.

This
change to the law will open access to billions of dollars to the investor and
issuer communities. Also, the 270 days rulemaking process is underway for the
Title III and one of the pressing rules is the qualification for the Registered
Funding Portals.

Instead of imposing heavy regulations that are likely
to become more confusing between US states and EU nation states, government should
look at crowdfunding intermediaries passing qualifications criteria focused on
certain categories such as operational and financial transparency, security of
information and payments, platform functionality, customer protection and operational
procedures.

Regulation is critical. However, we are not advocating
regulation for regulation’s sake.

Instead of imposing heavy regulations that are likely
to become more confusing, we should look at crowdfunding intermediaries passing
qualification criteria focusing on the following categories: operational and
financial transparency, security of information and payments, platform
functionality, customer protection and operational procedures.

While a Crowdfunding Directive does not yet exist in the
EU, the European Crowdfunding Network (ECN) envision one similar to the Payment
Services Directive and Electronic Money Directive, defining a role of a “crowdfunding
provider“ – maybe similar in concept to the US Funding Portal, established
under the JOBS Act but detached from a specific financial instruments. Here the
notion of single European passport for this role could create legal certainty
to be able to operate on an across-border basis without facing new compliance
costs and procedures.

The European Crowdfunding Network (ECN) has authored a
whitepaper called “A Framework for European Crowdfunding”, that outlines areas
where there might be room for open collaborative self-regulation and accreditation,
ultimately signalling a level of credibility to funders, entrepreneurs and
other stakeholders. Those areas are as follow:

·        
Openly
adopt a transparent code of conduct and communicate this to the public and
stakeholders. Establishing a code of conduct early on will have a positive and
stabilising input on the future of the industry.

·        
Establish
transparent reporting guidelines and documents, such as generic term-sheets and
subscription agreements. Moreover, entrepreneurs should be asked to provide
automated reporting to their funders on a timely basis.

·        
Address
customer protection and generate reasonable and fair guidelines relating to the
financial interest, exposure and diversification of funders and investees
across multiple crowdfunding business models. This needs to provide guidance
around fraud, risk explanations and potentially the testing of funders’
knowledge.

·        
Customer
identification is a key issue with both projects and funders; this includes
know-your-customer, customer due diligence procedures and anti-money laundering
aspects. The industry needs to create a relevant dialog and approval processes
for best practices for customer due diligence.

Enabling a regulatory framework could aid significantly
in development and help economic growth through resulting innovation and
entrepreneurial activities. Public authorities should have an interest in
supporting the development of crowdfunding in order to remove barriers to
entrepreneurship and to facilitate a favourable legal framework, while
maintaining the minimum of professionalism and regulation.

The underlying aim
of crowdfunding is to provide entrepreneurial and innovative projects the
financial means to execute. The crowdfunding industry has a vital role to play
in defining best practices for operations, customer protection, data
collection, stakeholder education, and regulation.

The academic sector is
stepping up to provide thought-leadership. In November, 2012 the University of
California Berkeley announced the Program for Innovation in Entrepreneurial and
Social Finance to explain this new phenomenon and identify best practices in
micro-, mobile- and early-stage entrepreneurial finance.

Financial regulation and
legislation has the duty to stimulate efficient and transparent markets while
ensuring investor protection. This should also include the possibility of
creating crowdfunding venues or platforms. Currently, efficient and transparent
markets cannot arise in the field of equity and loan based crowdfunding because
investor protection regimes are designed for incumbent investment settings,
which exclude a large number of crowd funders.

This heavily restricts
investment choices for citizens and funders that want to express their support
for economic or social initiatives. Legislation should not obstruct access to
assets where users want to fund value creation – for both, financial and
non-financial reasons.


The market

According to expert Venture Capitalist Fred Wilson, crowdfund investing has the potential to be at least a $300 billion industry; this number is derived from the notion that Title III, which eases the way for non-accredited American investors to participate in private placement deals, will give rise to investment of at least 1 per cent of consumer wealth into crowd funded equity and debt securities.

This number does not include accredited investors, angel groups, venture capitalists, private equity firms, insurance companies, and other institutional money managers who may not invest a single dollar into crowd funded companies and projects. Crowdfund Capital Advisors is releasing a paper that provides an academic perspective to the market demand vs supply of early stage and growth capital. Their figures show that in its first year the market will be $3.6 billion.

The current private placement market for Regulation D offerings, in 2011 transacted 20,000 deals and garnered $840 billion. Under Title II of the JOBS Act, ending the prohibition against general solicitation and advertising on start-ups and investment funds under Rules 506 and 144A offerings would increase the expected market size and landscape of crowd fund investing.

Among other reasons, advances in technology, social media infrastructure, and payment systems along with democratisation of capital markets will create the perfect opportunity for economic growth and job creation.

According to the Small Business Administration (SBA), entrepreneurs have access to 1 per cent of the total investment capital available in the United States; yet create 50 per cent of the jobs. This means that an increase in funding could strengthen and increase the economy.

Data released by the Crowdfund Professional Association (CfPA) in conjunction with Crowdfund Capital Advisors showed surprising results with a survey released on 1 November, 2012, in which the surveyors interviewed 442 respondents (287 entrepreneurs, 166 investors, 179 intermediaries and 11 unspecified). The results that raised eyebrows came from investors. 71 percent of the respondents were unaccredited investors and reported they would invest an average of $4,347 per year. While accredited investors responded that they would deploy $29,987 per year.

When investors were asked what the biggest driver for investment was, the prominent answers included: returns at the top of the list (33 per cent), helping businesses gain access to capital (20 per cent), being part of something greater than one’s self (20 per cent) and the ability to make a difference in the life of an entrepreneur (17 per cent) ranked as being important.

Traditional financial institutions aren’t filling the venture void but this could change. Small business formation and growth also depend heavily on access to traditional business debt in many forms, and these businesses are reporting that credit conditions and access remains very difficult.

“Traditional financial institutions can join the revolution and bridge
the gap in the venture void as well and find a new source of revenue stream”,
says Wales Capital, a strategic business and technical consultancy, specialising
in crowdfund investing. “Financial institutions can partner with Intermediaries
and other third party providers in the ecosystem; or face what could be
considered the start of the big bank disintermediation.

This is a massive
opportunity for retail investments, but to capture it, traditional institutions
will need to embark on a major shift in their operating focus, away from the
relative return investment framework and well-defined boundaries but toward
managing investments to an absolute return target or objective. Crowdfund
investing is about leveraging networks of people in ‘communities’ of investors
and partnering them with business opportunities, projects and ideas that
require funding. Utilizing the power of crowd fund investing under Title III,
issuers have three ways of raising capital 1) selling equity or stock in the
company, 2) selling company debt such as bonds or 3) paying a percentage of
future revenues – revenue bond.”

Internationally, crowdfund investing has
been adopted amid the economic challenges, in October 2012 Italy legalised
equity crowdfunding in a piece of legislation, which has a surprising number of
similarities to the United States JOBS Act. The Italian SEC counterpart, CONSOB,
is drafting the regulations that will allow for the widespread collection of
venture capital through online portals according to the Decreto Crescuta.

With
many countries faced with economic hardships, Wales Capital says that “more
countries should implement crowd funding legislation; for example, approximately,
26.5 per cent of the population of the Philippines live in poverty. With more
than 9m Filipinos living overseas with earnings last year exceeding $20bn –
accounting for more than 10 per cent of the country’s GDB there is a real focus
to bring crowd funding there.”

“And it would seem to hold true, governments in
Canada, Colombia and Mexico have retained advisors to help them understand how
they can develop and implement a crowdfund investing ecosystem,” says Sherwood
Neiss of Crowdfund Capital Advisors.

This scenario can be true for many
countries, however, it is dependent on how much freedom the governments are
willing to allow. Something to keep in mind for poverty stricken countries, Diaspora
carries the economic and cultural lifeline of the communities.”

New technologies

This is no longer about only receiving
information but the integration of advanced technologies, which leverage the
capabilities of Web 3.0 with Web 2.0 (social network), spurs the experience of
the interrelation with life, society and the environment while drawing upon
such subjects as industrial arts, engineering, applied science, and pure
science to formulate communities which allows crowd funding and 506c to exist
in harmony.

Intermediaries (Registered Portals and Brokers) like Crowdfunder,
SeedInvest and Arctic Island will provide the gateway to the crowd for equity
based transactions, while SomoLend conducts debt based crowdfund transactions
and is open for business. All of these platforms foster online investing and discussions
with the investor community, creating a richer and more meaningful user experience.

Third party providers will also advance
the technology spectrum and round out the ecosystem for crowd fund investing.
Fraud detection and due diligence is a stellar offering by CrowdCheck, which
offers checks on entrepreneurs, and serves as a one stop shop platform that
integrates with intermediaries’ portals and processes.

On the horizon, is a
pioneering research and ratings company, CrowdBureau, which integrates real
time financial performance data of companies with collective intelligence,
allowing every new data element that is introduced into the network for a
company to be analysed for the meaning. This technology will help investors to
make more informed choices during the investing life cycle.

Other up and rising
stars include Crowdnetic, a pioneering technology and market data company that
will provide real-time transparency into crowd funded securities and the private
placement marketplace through their InvestoLink platform.

With a comprehensive ecosystem inclusive
of some rules, regulations, transparency, technology, standards and best
practices and people who continue to believe that it is their duty to forge
ahead and invent our future will spur this new alternative asset class into
existence.

Conclusion

The United States has always prized its history of individual creativity, citing a unique and ingrained American spirit of ingenuity. Franklin Roosevelt called on it to pull the country out of the Depression, and President Obama focused on it in his most recent weekly address:

“It is only by building a new foundation that we will once again harness that incredible generative capacity of the American people,” the president said. “All it takes are the policies to tap that potential – to ignite that spark of creativity and ingenuity – which has always been at the heart of who we are and how we succeed.”

With the signing of the Jumpstart Our Business Startup Act, (JOBS Act), on 5 April, 2012, President Obama took one of the best steps forward in tapping the potential of creating a Bill that would set policies for igniting capital formation for start-up and emerging companies and lifting the prohibition of general solicitation and advertising. It is now our job is to take that spark and encourage innovation, build communities of educated investors and entrepreneurs, provide new technology that will foster transparency and grow our economic power even though our economic framework may appear fractured.

During this time of “independent” invention, it was often the last link in the chain that got credit. And that final link was often American.