In mid-2000, Enron's shares were worth $90.75, falling to $0.26 prior to declaring bankruptcy on December 2nd, 2001. Enron is the largest corporate bankruptcy in US history, and much of its debt was issued through special purpose vehicles (SPVs). SPVs are entities set up for a specific purpose, usually to hold and manage assets or to issue debt. Enron used SPVs to keep debt off of their balance sheet and to create a complex web of financial deals that eventually led to their downfall.
While SPVs can be used for legitimate purposes, they also present a number of risks. Beyond the opacity and lack of stringent regulation of SPVs, there is also the risk that investors may not fully understand the risks associated with investing in an SPV. SPVs provide greater access to deals for investors, but they also tend to lack focus on the underlying investments and their potential outcomes.
Relaxed Rules Around Crowdfunding and Accredited Investing
In recent years, the Securities and Exchange Commission (SEC) has relaxed rules around crowdfunding and alternative investing. This has created opportunities for smaller investors to access a wider range of investment opportunities.
More recently, on August 26th, 2020, the SEC adopted amendments to the definition of "accredited investor." The new definition includes additional categories of natural persons and entities that may qualify as accredited investors. This change expands the pool of potential investors in certain private placements.
Further, since the 2012 JOBS Act, startups have been permitted to more easily raise capital through crowdfunding. This has created a new avenue for small businesses to raise money from a large pool of small investors. The 2015 Regulation Crowdfunding (Reg CF) set the rules for how issuers could raise money through crowdfunding.
And changes made in 2020, that took effect in 2021, made it possible for startups to raise up to $5 million through crowdfunding in a 12-month period, up from the previous limit of $1 million.
These relaxed rules around accredited investors and crowdfunding present both opportunities and risks. On the one hand, they provide greater access to capital for small businesses and startup companies. On the other hand, they also open up the possibility of fraud and abuse.
The Risks of SPVs
The risks associated with SPVs were highlighted during the Enron scandal, but they extend into the modern investment landscape as well.
SPVs can bundle together any type of investment opportunity, including those that may be high risk or have little oversight. This can lead to investors taking on more risk than they may be aware of or comfortable with. Even if the underlying investments are not successful, fund managers may still make money from management fees, but lose nothing if the investments fail.
Ironically, the result of relaxed regulations is that the smallest investors may be paired with the riskiest deals. While public companies must meet a number of requirements in order to be listed, and VC-backed deals go through an enhanced governance process, there is no such requirement for SPVs. This lack of oversight can create an environment ripe for fraud and abuse.
Not only that, but it's vital to trust experts when it comes to allocating capital. For example, an experienced venture capitalist will have a network of deal flow, access to better information, and more negotiating power than the average person. However, with the rise of SPVs, anyone can now bundle together any type of investment opportunity and market it to investors.
Gridline makes it easy to access proven experts and top-quartile private market alternative investments. We provide high-quality, professionally managed funds at minimums that let investors and their advisors build diversified portfolios of private market assets.