📈 Five problems retail investors have in private markets

While everyone else is talking about the Fitch downgrade of U.S. credit ratings, LK-99, and the latest Trump indictment…

Here’s the story you haven’t been hearing about: Private-equity and hedge funds are bracing for what could be the biggest regulatory challenge in years to their business of managing money for deep-pocketed investors.

The SEC’s proposed overhaul would require private funds to provide investors with quarterly statements and annual audits, increase their liability for mismanagement or negligence, and prohibit them from giving some investors more-favorable terms than others.

Why should you care? Because as more of these private equity giants seek to launch retail-oriented investment products, the issues around transparency and reporting will likely become the “Hard Problem to Solve” in cracking the $81T retail investor market (very high net worth, high net worth, and mass affluent in the chart below).

According to Bain & Company

And with this in mind, let’s segue into Part 2 of the “Underwriting and Due Diligence” series (go here to read Part 1).

-Equifund Publishing

P.S. Have questions about Part 1 and Part 2? Hit reply and ask me anything you’d like.

Also, if there are any other investor education topics you’d like to see in future Private Capital Insider issues, let me know what’s on your mind, so we can get it on the editorial calendar for this month.

The Five Problems Retail Investors Have in Private Markets: Access, Underwriting, Check Size, Liquidity, and Fees

In today’s markets, we are seeing unprecedented demand for better returns with 1-in-5 investors aged 85 or older having nearly all their money in stocks.

For investors searching for better returns, there’s no shortage of evidence that suggests private markets outperform public markets.

According to Hamilton Lanes 2023 Market Overview, private market strategies have consistently outperformed public markets over the last 15 years (with one exception, REITS).

According to a recent report from Bain

While this asset class has historically been proven to outperform, it represents an entirely new frontier for many individual investors…

But as usual, the devil is always in the details.

Most notably, the detail most often ignored by investors is the dispersion of returns – the degree of variability or spread in investment returns across different assets or investments – within private market strategies.

In turn, this range serves as a useful proxy for uncertainty and risk in the expected performance of an asset class.

While you’ve no doubt heard about the extraordinary returns of certain venture capital and private equity firms…

There is a major difference between the median performance across all funds in a specific strategy, compared to the significant range between the top and bottom.

This means in private markets, getting access to the top managers (and funds) is critical!

And this begins the rather challenging sequence of problems retail investors have in private markets.

According to Michael Bell is the Founder and Managing Director of Primark Capital, an investment management firm providing retail investors with access to private equity investment opportunities.

This problem is exacerbated in the retail channel, as the industry has historically done little to create the distribution and marketing infrastructure required to service lower-dollar clientele.

However, that’s beginning to change as an ecosystem of intermediaries – like Equifund – continues to educate investment advisors, institutional investors, and retail investors on how alternatives work (and how they may fit into a broader portfolio strategy).

Generally speaking, we can group all the problems retail investors face in private markets into five categories.

1. Access: Getting access to the top funds is already hard for professional investors with hundreds of millions of dollars under management. You – the average retail investor – have almost no chance of getting invited into the “club.”
   

2. Underwriting: Even if you did have access, you likely don’t have the time or resources required to perform any substantive due diligence.
   

3. Check Size: Even if you did have access and could underwrite the deal, you likely don’t have enough money to meet the minimums (or if you do, it’s likely all the money you have)
   

4. Liquidity: Even if you could get your money in a deal, most retail investors don’t want to get locked up for 7-10+ years.
   

5. Fees: If you are investing through fund vehicles, fees over the life of the fund can seriously eat into returns. In order to produce a 15% net-of-fee return, an investor in a fund vehicle needs to have the manager produce a gross-of-fee return of 22-24%+ (depending on fee structure).

All said and done, this does not paint a favorable proposition for retail investors looking to diversify into private markets on their own.

For this reason, it’s highly likely that retail investors will rely on some sort of relationship with an intermediary/promoter/advisor of some sort to “introduce” them to the types of investment opportunities they are looking for.

This means for retail investors looking for ways to build generational wealth, generally speaking, they are required to make a choice…

1. Accept the Default (Passive Investing): Dollar cost average into a low-cost index fund. Simply buy and hold and let compounding do the rest. This style of investing – made famous by Jack Bogle at Vanguard – appears to be the lowest “effort to results” strategy available to retail investors.
   

2. Reject the Default (Active Investing): Take on higher risk for the chance of higher return.

Statistically speaking, most investors have little chance of consistently outperforming the “low-cost passive investing strategy” over time with any form of individual stock picking and/or short-term trading strategies (although that doesn’t stop many of us from trying to get rich with penny stocks and options).

In fact, according to Standard & Poor’s, nearly 90% of fund managers fail to beat their benchmark indices.

S&P’s figures indicate that investors now are getting the reverse – more risk, higher fees, and a lower, risk-adjusted return than their unhedged benchmarks (i.e., less Alpha and more Beta).

Here is the data from S&P’s mid-year 2022 comparison of risk-adjusted returns of active funds and their benchmarks for the last 20 years (with a notable showing from Real Estate and Large Cap Value funds).

To add insult to injury, many of these funds charge the standard “2 and 20” fee structure, further robbing investors of any potential returns (not to mention another .5%-1.5% in annual fees, if you have a financial advisor managing that selection on your behalf).

So what Reject the Default options does that leave for the average retail investor? Generally speaking, four choices:

1. Entrepreneurship: Buy (or build) an operating company and build wealth as a small business owner.

Statistically speaking, owning an operating business is a cornerstone of wealth creation.

We’ve written several articles on how family offices build wealth through ownership of operating companies.

For more on this strategy, go here and here.

[note: technically speaking, when you own rental property, you also own an operating business called “being a landlord,” or otherwise have to hire someone to manage that property on your behalf]

2. “Junk” grade private investments with no real underwriting: Whatever “opportunity” you’re looking at is likely so high risk and speculative, that no institutional investor would ever touch it as it’s too difficult to underwrite. 

I would lump substantially all digital assets (i.e., crypto/NFT) and whatever form of angel/early stage investing you have access to into this category (i.e., the vast majority of crowdfunding portals, especially those that offer SAFE notes instead of priced rounds).

Why? Because anything that would have “real” underwriting typically gets sucked up into the institutional channel, and kept away from retail until much later in the corporate growth cycle (if ever).

This brings us to the most recent innovation in private markets…

3. Semi-Liquid Private Funds (Evergreen Funds): Thanks to a variety of advancements in the broader “Retailization of Private Markets” trend, we’re starting to see more “institutional-grade” private capital strategies hit the markets that are specifically designed for the growing demand from retail investors (for example, the Blackstone REIT).

This third category is of particular interest to Private Capital Insider, as it represents probably the most significant expansion to retail participation in private market products.

However, the large majority of these products are credit- or real estate-oriented, rather than equity-oriented.

In addition, this asset class is currently dominated by a few large players; In 2022, over 50% of assets under management in these types of vehicles were concentrated in three managers.

While we applaud the innovations in publicly listed private-equity strategies, there are still several unsolved problems with these types of products – most notably, the redemption issues we’ve seen with the Blackstone REIT – that still make this challenging for retail participation.

According to Bain

Last but most certainly not least…

1. Syndication Programs & “Chaperoned Access”: co-invest directly into underwritten private offerings, alongside other sophisticated investors.

In case you missed it, Part 1 of this series is all about syndication programs…

But let’s talk more about the concept of Chaperoned Access and how it relates to expanding retail access to private markets.

The Asset Management Advisory Committee (“AMAC”) – formed on Oct 9, 2019 to provide the SEC with diverse perspectives on asset management and related advice and recommendations – established a subcommittee to review retail investors’ access to private investments (called the “PI Subcommittee”).

In their September 27th, 2021 report, we find one of the AMAC’s suggestions particularly interesting:

Ironically, in many ways, this could mean the primary barrier to “mass adoption” from retail investors in exempt securities offering – like Reg-A and Reg-CF – is adoption from institutional investors.

While we haven’t cracked that code (yet) here at Equifund, this is the reason we put such an emphasis on not just our investor education material through Private Capital Insider…

But the quality of our underwriting (with respect to the information provided as part of each offering).