Private equity has been shrouded in mystique, perceived as a complex asset class with limited transparency. However, the rising numer of serial entrepreneurs paired with entreprenuer news sites, fintech platforms and online investment portals is making it easier for retail investors to access information and invest in private equity.
Hsiao Ching Tang, Managing Director at Azalea Investment Management, notes in a fireside chat with Mergermarket that the evolution of broadening private market investor bases is already evident, citing Blackstone’s early success in diversifying beyond institutional investors, following the 2009 financial crisis. While the concept isn’t new, execution has improved dramatically. Tang emphasised the vast untapped potential of this market, referencing a McKinsey report that identified $53 trillion held by non-institutional investors, with just 6% currently allocated to private markets.
Despite Blackstone’s success the non-institutional uptake of the asset class has been comparatively slow. Reaching these investors presents challenges for general partners (GPs). Tang calls for specialised resources and expertise to effectively engage with the wealth management segment. However, she underscores the significant opportunity for GPs to diversify their investor base by forging strategic partnerships with wealth management firms.
Following “new” money
Neobanks, such as Revolut, are making moves to tap high-net individuals, which according to a Sifted report is “an interesting sidestep for a European neobank, moving into territory dominated by big incumbents like UBS and Morgan Stanley.”
Revolut’s new wealthy client product offering will feature both investment services and other “private banking style services” that its neobank rivals such as Monzo and Starling are yet to offer. Could access to retail private equity funds or bonds eventually be on the cards?
This increased accessibility could compel private equity firms to rethink their marketing strategies through investor education and social media campaigns via wealth manager and HNW private banking partnerships. Access to retail investors could also lead to more specialist retail funds or bonds which would need to become more transparent and competitive on fees.
The fee factor and investor protection
While greater access to private equity has its benefits, there are concerns about the motivations of fund managers. Are they genuinely interested in democratising access to this asset class, or are they simply seeking to expand their pool of capital and score more management fees?
On that subject, the industry’s high fees, including management fees and carried interest, have long been a point of contention. If some fund managers are primarily driven by capital growth and fee income, exposing retail investors to these high-risk investments could have detrimental consequences. It could tarnish the reputation of the industry and even create a backlash by pension fund members.
Private equity portfolio companies are about 10 times as likely to go bankrupt as non-PE-owned companies, according to a report published by the CFA Institute. Granted, one out of five companies going bankrupt does not lead to certain failure, but it is a startling statistic, said the report. Portfolio managers and the funds they work for also often bring undervalued companies back to the brink.
According to the CFA report, the route to success is not a vanilla option. PE firms could attempt to do one or all of the following: “extract excessive profits from investments [through]: sale-leaseback, dividend recapitalization, strategic bankruptcy, forced partnership, tax avoidance, roll-up, and a kind of operation efficiency that entails layoff, price hikes and quality cuts.”
Impact on retail investors: the pros and cons
That said, many retail investors already have indirect exposure to private equity through their pension funds. However, direct access to private equity could offer several advantages:
Return on investment: Over the last 25 years, the Global PE Index has outperformed the MSCI World Index by more than 500bps annualised on a net basis, according to Cambridge Associate LLC Benchmark Statistics as of December 31, 2023. However, the data reflects actual pooled horizon return, net of fees, expenses and carried interest for funds formed between 1986-2023.
Long-term mindset: Private equity managers take a more active role in their investments compared to public investors. This is often referenced to having “skin in the game” since private fund managers actually own the company. They directly contribute to the company’s strategy and “value creation”, working closely with management on long-term goals. This contrasts with public investors who often focus on short-term performance and quarterly results. According to a KKR report, private equity managers have the patience to invest in strategies that may take years to pay off, while public investors are more likely to exit an investment quickly in pursuit of other opportunities.
This fickle mindset of public market investors can scare off founders from either going or even staying public. The trend to stay private is growing, according to KKR: “In terms of the opportunity set, the number of US publicly listed stocks is on the decline, having already shrunk from over 7,000 companies in 2000 to about 4,500 companies today. Many fast-growing companies are staying private for longer. We think private equity investors have a larger, more diverse set of companies to invest in than ever before, while the universe of public companies is increasingly concentrated with much of the market performance coming from a few large companies.”
Portfolio diversification: Private equity can provide diversification benefits, potentially enhancing returns and reducing overall portfolio risk.
Access to growth opportunities: Private equity investments can offer exposure to high-growth companies that are not yet publicly traded.
Increased control: Direct investment allows retail investors to have more control over their investment choices.
However, there are also risks to consider:
- Illiquidity: Private equity investments are typically illiquid, meaning investors may not be able to access their capital for an extended period.
- High risk: Private equity investments can be volatile and carry a higher risk of loss compared to traditional asset classes.
- Lack of transparency: Despite increased access to information, private equity investments can still be less transparent than publicly traded securities.
Points to ponder
Democratising private equity is a complex issue with both potential benefits and risks for retail investors. While greater access to this asset class could lead to demystification and fee compression, it’s essential for private equity funds and their target investors to be aware of the reputational and regulatory risks.
As Hsiao Ching Tang aptly states, “It’s about finding the right balance between democratisation and investor protection.” Regulators and industry participants must work together to ensure that retail investors are adequately protected as they venture into the world of private equity.
The counter argument
In the video below you will find an interview with Brendan Ballou, a federal prosecutor who served as Special Counsel for Private Equity in the Justice Department’s Antitrust Division. His arguments could easily put certain retail investors off private equity or do the exact opposite if retail investors believe they will see better returns compared to other asset classes.
Would retail investors be at a disadvantage?
Rightly or wrongly there are several factors that give institutional investors an advantage in private equity, potentially leading to higher returns compared to retail investors:
1. Access to Exclusive Deals and Early Stages:
- First Look: Institutional investors often have established relationships with private equity firms and gain access to exclusive deals and top-performing funds. Retail investors may have limited access or enter at later stages with potentially less upside.
- Deal Flow: Institutions are often presented with a wider range of investment opportunities due to their network and reputation.
2. Fee Structures:
- Lower Fees: Institutional investors typically negotiate lower management fees and carried interest due to the large sums they invest. Retail investors may face higher fees, eating into their overall returns.
- Fee Transparency: Institutions have more resources to analyse and negotiate complex fee structures, while retail investors may have less transparency and bargaining power.
3. Investment Expertise and Resources:
- Dedicated Teams: Institutional investors have dedicated teams of analysts and portfolio managers with deep expertise in private equity. Retail investors and the wealth management firms that offer products may lack the same level of knowledge and resources to evaluate investments.
- Due Diligence: Institutions conduct extensive due diligence on potential investments, including market analysis, financial modeling, and legal reviews. Retail investors may have limited ability to perform such in-depth analysis.
4. Portfolio Diversification:
- Larger Capital: Institutional investors can spread their investments across multiple private equity funds and strategies, diversifying risk. Retail investors may have smaller capital, limiting their ability to diversify effectively.
- Risk Management: Institutions have sophisticated risk management systems and strategies to mitigate potential losses. Retail investors may lack the same level of risk management expertise.
5. Liquidity and Time Horizon:
- Longer-Term Outlook: Institutional investors have longer investment horizons, allowing them to ride out market fluctuations and capture long-term gains in private equity. Retail investors may have shorter-term liquidity needs, potentially forcing them to sell earlier at less favourable prices.
- Secondary Market Access: Institutions may have better access to the secondary market for private equity, providing some liquidity options. Retail investors may face limited liquidity and higher transaction costs in the secondary market.
In summary, it could be suggested that institutional investors have inherent advantages in private equity due to factors such as access to capital, deals, lower fees, expertise, diversification, and longer-term outlook. These advantages could potentially lead to higher returns compared to retail investors. This should be explained to avoid unrealistic expectations.
However, it’s important to note:
- Past performance is not indicative of future results. Both institutional and retail investors can experience losses in private equity.
- Increased access for retail investors: Platforms and products are emerging that aim to democratise access to private equity for retail investors, though fees and risks remain.
- Individual circumstances vary: Each investor’s situation is unique, and factors like risk tolerance, investment goals, and time horizon should be considered when evaluating private equity opportunities.
What’s your take on whether private equity should be democratised and more open to retail investors?
