The perils of democratizing private markets
The writer is the designated Managing Partner of the Pictet Group
In a time of high stock market valuations and low interest rates, investors are increasingly seeking and finding ways to gain more exposure to so-called âalternativeâ investments, particularly private equity.
This democratization of private markets has merits. After all, why should professional investors have monopoly rights over a high performing and diverse asset class?
The question is not “if” this process should take place, but “how”: to what extent and with what guarantees in place? What if regulators have properly taken into account the risks involved, especially given the unique characteristics of the current investment cycle which has been marked by extraordinary central bank support to the markets?
A number of initiatives are underway, led by both investors and regulators, with the aim of making private markets more accessible.
Some retail investors seek exposure simply by purchasing shares of publicly traded private equity firms. Others use private equity funds to participate in the market. Then there are technological platforms, some of which allow individuals to invest as little as â¬ 50,000 directly in private equity feeder funds.
The motivations of retail investors are understandable. The opportunities for traditional actions are reduced. State-owned companies have gone off the list, while high-growth companies remain closed for longer.
This is reflected in terms of the industry’s growth and the returns it has generated. Despite a first “Covid correction” last year, the private equity industry broke a 40-year record in the first six months of 2021, closing 6,298 deals worth $ 500 billion, according to the Refinitiv figures.
Regulators have also worked behind the scenes. Their reasons are different and follow the recent trend towards deregulation. This gave retail investors direct access to the world of finance, from securities trading on the Robinhood app to cryptocurrencies on the fintech Revolut.
In Europe, policymakers have created European long-term investment funds – and are currently revising this scheme – with the aim of allowing savers in defined contribution pension funds and retail investors more direct access to transactions requiring long-term capital. Meanwhile, UK regulators are working on a similar scheme to allow pension fund savers and retail investors to access alternative asset classes.
Across the Atlantic, regulatory changes have enabled so-called âmom and popâ investors to access private equity via their defined contribution pension plans, the 401 (k).
The result is a fresh and growing flow of capital to the private markets. Much of this comes from investors who, until very recently, had found private equity largely out of reach. Theoretically, none of this seems particularly problematic. However, this is not happening in a vacuum but in the current context of excessive liquidity fueled by central banks.
At this end of the business cycle, public demand for private equity is clearly felt by TINA (There Is No Alternative), the Wall Street acronym that describes the inexplicable popularity of already expensive assets.
The valuations of buyback operations are already at historically high levels. Opening up this asset class to retail investors will only add more funds to already large pools of capital looking for investable assets. Going forward, declining market liquidity and rising interest rates are also expected to have a drastic impact on products such as private equity funds backed by high levels of leverage.
Additionally, in addition to the longer term commitment required for such products, there are technical aspects of private equity that many new investors may not be familiar with. Since private equity firms tend to âpreloadâ costs at the start of an investment in a business, retail investors will need to consider how funds might perform over a cycle.
For those who have little savings and need cash, investing in this asset class is simply not recommended. Unsophisticated investors also need a clear understanding of the costs of private equity, which are not always transparent.
It is inevitable that the pressure for democratization will only continue. If treated properly, it can be positive. It allows investors to diversify their portfolios and potentially generate better returns. However, the next cyclical downturn could have a disproportionate impact on investors who are not as well equipped to deal with it. With little prior knowledge, private equity investing by retail investors with little or no advice is unlikely to be successful.