Democratization of PE Industry: Retail Investing in PE

Introduction

Investing in Private Equity (PE) has traditionally been the domain of institutional investors, namely banks, pension funds, endowments, and sovereign funds. Recently, another class of investors, the “retail investors,” has been tapped into. To understand the retail market, it is necessary to understand the division of individual investors basis investible assets by the financial industry. The investors are divided into ultra-high-net-worth (HNW) individuals (those with more than $30 million in investable assets), very HNW (more than $5 million), followed by the mass affluent segment (which have less than $5 million in investible assets). The “retail market” that has been captured so far broadly includes the investor class which have more than $5 million to invest. Accordingly, the mass affluent segment remains to be tapped into by the PE industry. Despite this classification of investors, “retail investors” and “retail market” have no standard definitions and encompass the entire spectrum from Ultra High-Net-Worth (HNW) individuals to the mass affluent.

The well-established performance history of PE funds makes it an attractive option for investors beyond wealthy individuals. In paralell, the potential for more funding from untapped sources of market capital is lucrative for PE managers. However, navigating this new avenue in the PE industry will have its challenges. Some of the roadblocks and their potential solutions have been discussed below.

Challenges and Solutions in Accessing the Retail Investor Market

As highlighted above, most retail investors remain yet to be tapped. Three major concerns could potentially limit tapping into this remaining segment. This article serves to analyze these potential problems and suggest possible solutions.  The mass affluent segment is the focus of the issues discussed.

Regulatory Constraints

Exemption from Securities Act registration and disclosure requirements (for example, Regulation D exemption) is only available if the sale of securities is made to a limited audience of “accredited investors.” Congress and SEC, through the accredited investor standard, prohibits 87% of the investors with less than $1 million in assets or $200,000 in annual income, from directly investing in private funds. The policy rationale for this segregation, based on the premise of lack of sophistication on the part of retail investors, is two-fold: (i) the need for more protection, which is afforded by mandatory disclosure requirements for publicly traded registered securities; and (ii) limited ability to bear economic risks of investment in private funds.

However, these concerns of the SEC and Congress may have been overestimated. Private funds supply continuous and extensive disclosures to their investors. Further, retail investors can access investment advisers to provide the level of sophistication they are thought to lack. Accordingly, instead of preventing the mass affluent segment from investing in private funds, the regulatory bodies could consider additional regulatory protections to allow this segment to participate in the returns afforded by the PE market.

Intermediary Fees and Access Constraints

The PE industry has traditionally focused on a small set of investors, namely, institutional investors. Accordingly, there has been limited investment in creating a distribution and marketing infrastructure and building awareness to reach individual investors. While we noted how financial and investment advisors could assist retail investors in accessing the PE market, the rise in intermediaries also brings a surge in fees. Consequently, the benefits of a higher return may not trickle down to the retail investor.

Consequently, a lot of intermediaries, such as digital pathways are exploring access this segment of the retail market directly. For example, Moonfare and iCapital are fast growing direct-to-consumer platforms that provide investors access to PE funds by pooling their investments. While the creation of these digital platforms will allow penetration to deeper ends of the retail market, the use of technology could bring additional concerns that would require additional regulation by the SEC and Congress.  

Limited Partner Concerns

The PE managers have devised their investment strategies and methodologies in line with the liquidity preferences of Limited Partners (LPs). However, the liquidity preferences of individual retail investors differ from those of experienced LPs. The former prefer intermittent liquidity and easy access to their investments compared to the latter, who are more comfortable locking up their investments for longer durations. This difference in preference may cause concern for LPs, in funds where the capital of LPs and individual investors is combined. General Partner’s (GP) decisions regarding the portfolio company to invest in, the timing of investment, and the timing and structure of the exit will inevitably also have to account for the retail investor’s need for liquidity. The LP on the other hand, might think that the GP, focusing on these considerations, is not fulfilling their duties to the LP, which is choosing investments best suited to maximize returns for the fund. A potential possibility could be the segregation of funds based on the kind of investors to accommodate these constraints. This could further create a rift between LPs and GPs depending on the GP’s decisions to choose particular funds for certain investments.

Further, the LPs might also raise the fundamental question of the need for PE industry to tap into the unrealized “retail investor network,” given the already high amount of dry powder prevailing in the PE industry. Since PE managers typically charge fees based on committed capital, a reason for accessing this market could be that it invariably increases the managers’ fees. This might be a cause of concern for the LPs, who could see this as an omission of the GP’s fiduciary duties.  

Conclusion

The regulatory, access, and LP constraints discussed will require the GPs to adapt and innovate their methodologies if they choose to access a wider audience of investors at the lower end of the retail market spectrum. In all these accommodations, the PE industry must ensure that the fundamentals that make it an attractive asset class in the first place are not compromised.  

Khushi Maheshwari is a current LLM student at New York University specializing in Corporation Law, and graduate research assistant at the NYU Pollack Center for Law & Business. Prior to commencing her LLM, she worked in the General Corporate and Finance practice areas at Cyril Amarchand Mangaldas. She completed her B.A. LLB at National Law School of India University, Bengaluru, where she undertook roles, such as teaching assistant, research assistant and published articles in the areas of corporate governance, bankruptcy and informational privacy law.