There is a tug of war in Washington over the advisability of making private market investments 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. Barely a week earlier, Democrats in Congress put forward a tax package that would forbid 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 institutions.
While there is a tax component to the legislative side of the argument, the broader debate turns on a familiar issue: the suitability of illiquid investments for less sophisticated investors.
Traditionally, opponents have cited a number of “structural” impediments to providing nonqualified investors with access to traditional alternative investments. The most frequently mentioned limitations of traditional alts include their high investment minimums, long lockup periods, lack of transparency, high fees and single manager risk.
All are valid concerns, but none are insurmountable. Further, as more capital migrates to 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 have significant costs as well. To date, a variety of solutions have been floated for this, generally falling into one of three categories:
1. Relax the “Accredited Investor” Requirements
Provide broader access by lowering the income and net worth thresholds. This would open the field to some new investors, but it would also perpetuate many of the shortcomings of traditional alternative investments. The funds themselves would remain opaque and illiquid. For those excluded, still the majority of investors, this also would fail to address the fundamental issue of lack of access, as well as concerns regarding transparency, high fees and diversification.
2. Let All Investors Have Access
This is perhaps the most “democratic” solution—open the doors to everyone—while at the same time adding safeguards, including expanded disclosure requirements. But this proposed solution also has limitations. Not everyone will read or understand the disclosures, and the issue of illiquidity will persist. Many individuals will be unable to withstand multiyear lockup periods. Moreover, there will be volatility in reported returns.
Finally, this does nothing to address the issue of single manager risk. The fact is that many individual private equity investments do not provide the strong returns. For institutions, this is a numbers game—they diversify by investing with multiple managers—but it’s an issue for individuals with limited ability to spread their risks.
3. Consider New Investment Structures
Options one and two essentially represent incremental changes to the status quo. A better approach would be to rethink entirely 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 rethought and repackaged as mutual funds, ETFs or SMAs.
While the traditional asset classes to which these strategies provide exposure historically have had limited liquidity (such as hedge funds), the underlying securities in these liquid alternative funds trade daily on the exchanges. Over time, a substantial body of academic research has been developed that supports this solution. Moreover, there’s also multiyear track records for these liquid alternative solutions whose tracking to the underlying illiquid asset classes is exceedingly tight while performance has been strong relative to respective benchmarks.
A similar approach can do for private equity and venture capital what it’s done for hedge funds: Eliminate the structural impediments faced by nonqualified investors and open up the asset class to the broader investing public.
A Permanent Shift?
Lost in the debate over suitability is a broader question: are more investment assets moving permanently into the private realm?
There is no way to know for sure, but trillions of dollars of institutional money has migrated to private markets over the past decade in search of better returns. There are some who believe private funding is becoming the vehicle of choice for higher-growth companies and the larger pools of capital now available are allowing these companies to stay private for longer. This means they spend more of their high-growth years walled off from public market investors. As a result, not having exposure 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 provide for sufficient wealth in their retirement years.
So far, most individual investors have watched the movement to private funding from the sidelines. In the meantime, the legislative and regulatory debate over whether and how to widen 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 to move forward not only for Wall Street but, importantly, also for Main Street.
Greg Bassuk is the CEO of AXS Investments, an asset management firm that empowers investors to diversify their portfolios with alternative investments that previously were available only to the largest institutional and high-net-worth investors.
