Solving the Matching Challenge in Private Equity
There is a showdown in Washington over whether to make private market investment more readily available to retail investors. On September 28, the Securities and Exchange Commission’s asset management advisory committee unanimously recommended expanding access to the private equity asset class. Just a week earlier, Democrats in Congress introduced a tax package that would ban individual retirement accounts from holding a range of these investments, including hedge funds, private equity and debt, private real estate and other strategies historically made available only to “qualified investors”. »And establishments.
While there is a tax component to the legislative side of the argument, the larger debate revolves around a familiar question: the suitability of illiquid investments for less sophisticated investors.
Traditionally, opponents have cited a number of “structural” barriers to unqualified investors’ access to traditional alternative investments. The most frequently mentioned limitations of traditional alternatives include their high minimum investments, long lock-in periods, lack of transparency, high fees and single manager risk.
All are valid concerns, but none are insurmountable. Additionally, as more capital migrates into private equity and other alternative investments due to their historically higher risk-adjusted return profiles, not providing access to this asset class in IRAs and other popular investment vehicles can also incur significant costs. To date, various solutions have been proposed for this, generally falling into one of three categories:
1. Relax the requirements for “approved investors”
Provide wider access by lowering income and equity thresholds. This would open the field to new investors, but it would also perpetuate many of the shortcomings of traditional alternative investments. The funds themselves would remain opaque and illiquid. For the excluded, who remain the majority of investors, it would also not solve the fundamental problem of lack of access, as well as concerns about transparency, high fees and diversification.
2. Let all investors have access
This is perhaps the most “democratic” solution – opening the doors to everyone – while adding safeguards, including expanded disclosure requirements. But this proposed solution also has limits. Not everyone will read or understand the disclosures, and the illiquidity problem will persist. Many people will be unable to withstand multi-year lockdowns. Additionally, there will be volatility in the reported returns.
Finally, this in no way resolves the issue of single manager risk. The fact is that many individual private equity investments do not provide high returns. For institutions, it’s a numbers game – they diversify by investing with multiple managers – but it’s a problem for people with limited ability to spread their risk.
3. Consider new investment structures
Options one and two essentially represent incremental changes to the status quo. A better approach would be to completely rethink how best to gain exposure to the private equity asset class. Over the past decade, new structures have evolved in other areas of the alternative investment universe that can be applied to private equity. The most obvious analogues are various corners of the liquid alternatives category, where sophisticated hedge fund strategies have been redesigned and repackaged into mutual funds, ETFs or SMAs.
While the traditional asset classes to which these strategies provide exposure have historically had limited liquidity (such as hedge funds), the underlying securities of these liquid hedge funds trade daily on the exchanges. Over time, a substantial body of academic research has been developed to support this solution. In addition, there is also a multi-year track record for these liquid alternative solutions whose monitoring of the underlying illiquid asset classes is extremely tight while the performance has been strong against the respective benchmarks.
A similar approach can do for private equity and venture capital what it does for hedge funds: remove structural barriers faced by unqualified investors and open up the asset class to a wider audience of investors.
A larger question is lost in the adequacy debate: are more investment assets permanently transferred to the private domain?
There’s no way to know for sure, but billions of dollars in institutional money have migrated to private markets over the past decade in search of better returns. Some believe that private financing is becoming the vehicle of choice for higher growth companies and that the larger pools of capital now available allow these companies to stay private longer. This means they spend more of their high growth years away from public market investors. Therefore, not being exposed to this segment of the private markets could have a negative impact on long-term portfolio returns and, by extension, on those who depend on IRAs and similar vehicles to build up sufficient wealth during their years. of retirement.
So far, most individual investors have watched the move towards private finance in a marginal way. In the meantime, the legislative and regulatory debate on whether and how to expand access continues. Rethinking the best fund structures for various types of alternative investment exposures has the potential to change the terms of this discussion, providing a better way forward not only for Wall Street, but especially for Main Street.
Greg Bassuk is the CEO of AXS investments, an asset management company that allows investors to diversify their portfolios with alternative investments that were previously only available to larger institutional and high net worth investors.