US private equity lowers the velvet rope

US private equity firms are facing hurdles in the race to tap the retail investor market

Major private equity firms continue to consider how to provide retail investors with greater access to their strategies. But the industry finds itself facing a host of economic, regulatory, administrative and tax obstacles in achieving this goal.

The potential of tapping a market representing trillions of dollars in capital worldwide has an almost gravitational pull on private equity firms, as they look to scale management fees and other revenues by increasing assets under management. The major publicly-traded private equity firms that strive to deliver stable earnings and growth for their shareholders are understandably at the forefront of this trend. In addition, even though raising and managing retail capital will inevitably come with increased regulatory burdens and scrutiny, it is likely that some other burdens would decrease with a retail investor pool. These include multiple in-person due diligence and reporting meetings, travel, lengthy negotiations and terms concessions that are often necessary to close on big-ticket capital commitments from institutional investors. The need to rely on intermediaries would also likely increase. As private equity has become less ‘private’, retail investors appear to have grown more curious about the industry as an asset class. Firms like Blackstone, Carlyle and KKR are becoming household names. Individuals have revealed an appetite for adding funds managed by these firms to their investment portfolios as they seek to diversify with alternatives to stocks and bonds. Attracting and facilitating direct fund investments by individuals’ retirement accounts is a particularly appealing proposition for private equity firms. This capital has the potential to be patient, while at the same time exhibiting tolerance for the risk attendant with the potential for higher returns.
Challenges
Firms face a myriad of challenges in their efforts to raise retail capital. In addition to demystifying the private equity industry and educating new investors tin an environment where news and politics are not always positive, there are regulatory, economic and tax considerations to address.
A gating item is how to get in front of retail investors. For a long time, banks have raised so-called dedicated feeder funds from their client base which, in turn, invest in one or more private equity funds. The firms managing such underlying funds may not even know the identity of the investors in the feeder funds. These banks have a keen interest in closely guarding the confidentiality of their client lists, especially in today’s environment where private equity firms seek more directly and aggressively to access such capital.
Private equity firms typically raise capital for their funds by relying on registration exemptions for private placements. Recent regulatory developments have relaxed restrictions on private placements, permitting fund sponsors to engage in general solicitations of investors and allowing them to reach investors with whom they do not have pre-existing relationships. This flexibility, however,

The potential of tapping a multi-trillion dollar market has an almost gravitational pull on private equity firms

comes with strings attached, such as enhanced investor verification procedures, the prospect of increased regulatory oversight, loss of other exemptions, and conflicts with private placement rules in other jurisdictions. As a result, private equity firms generally have not made use of this option, and are not expected to do so in the near term. Therefore, firms may have to invest significant effort to establish distribution networks to reach retail investors. This will likely require establishing relationships with placement agents, banks and certain other distributors that have retail investor relationships and the requisite compliance infrastructure. With these relationships will come additional fees and expenses. Another key issue concerns the types of retail investors private equity firms may solicit. The industry’s traditional fund structure is predicated upon various regulatory exemptions. The most relied upon exemption from registration as an investment company under the Investment Company Act requires all investors to be ‘qualified purchasers’ (for individuals, this means having $5 million or more in investment assets). The pool of retail investors who meet the qualified purchaser standard is limited. Firms could venture further into the retail space and admit ‘accredited investors’ which, for individuals generally means either: a net worth exceeding $1 million, excluding the value of their primary residences; or income exceeding $200,000 ($300,000 together with their spouses) for each of the two prior years with an expectation for the same in the current year. Private equity firms that choose this option must rely on another exemption that would limit the fund to 100 investors. Since this 100-investor limitation would not achieve the objective of obtaining broader access to retail investors, some private equity firms have begun to explore the use of investment companies registered under the Investment Company Act.
Private equity firms also face a number of practical and economic obstacles in designing a suitable product for retail investors. Chief among the challenges is the provision of a liquidity option. Even where they are able to hold investments for the 10 or more years commonly required as an owner of an interest in a closed-ended private equity fund, retail investors may generally be less willing to do so. To offer investors liquidity beyond selling their interests to other qualified investors presents a series of concerns. This includes: providing a forum for transfers (whether it be an exchange or otherwise); how and when to value the assets of the funds and the interests that investors would be seeking to sell; how to ensure sufficient cash flow to meet liquidity demands, and how to keep track of the ultimate beneficial owners in their funds. In addition to the regulatory restrictions on an active secondary market for fund interests, there is a major tax issue associated with trying to create a more liquid product. In essence, sponsors must structure their funds so that the funds are not required to pay tax as corporations under the so-called publicly-traded partnership rules. Sponsors generally do this by placing restrictions on the transfer of fund interests designed to prevent the funds from being treated as traded on an established securities market or on a secondary market. Because fund sponsors believe a key to broadening the investor base is allowing more liquidity, they must devise these more liquid structures in a manner that is permissible under the publicly-traded partnership rules.
To attract retail investors, private equity firms must also justify their collection of fees and incentive distributions that are higher than, for example, traditional mutual funds. This requires them to consistently outperform both the public markets and less expensive, publicly-available mutual fund products.
A broader retail investor base coupled with providing increased liquidity will undoubtedly heighten pressures on having robust anti-money laundering and consumer privacy procedures. Private equity firms would be well-served to review their compliance policies addressing these as well as other issues in anticipation of establishing direct retail investor relationships without regulated financial institutions as intermediaries.
Recent efforts
A few years have passed since the launch of the first registered investment company targeting retail investors that is dedicated to investing the lion’s share of its assets in the closed-ended funds of a single private equity firm. That investment company gives access to a wide variety of geographies, strategies and fund vintages, creating diversification despite mainly targeting the funds of a single private equity firm. There have been a few similar structures raised since. It is yet to be determined whether these efforts will succeed.
These investment companies are registered under the Investment Company Act and are offered only to accredited investors. Generally, they take the form of funds of private equity funds (rather than direct investment in portfolio companies). Because of their registration, they are not subject to the qualified purchaser or 100-investor limitations. They are typically organised as closed-ended funds and are not listed on a stock exchange, so they offer only limited liquidity. However, they do address retail investors’ demand for liquidity by making quarterly repurchase offers for their shares after a limited lock-up period. Even this limited liquidity may be attractive to

Defined contribution plans are the holy grail in the race to access the retail investor market

retail investors compared to the possibility of having their investments locked up for 10 or more years when investing directly in a private equity fund. There is even some possibility of redeeming during the lock-up period, but this would require an additional fee. The minimum investment thresholds for these investment companies (which may, for example, be as little as $10,000) fall well below the minimum investment threshold in standard private equity funds, which may be set at several millions of dollars. In addition, as investment companies, transfers of interests are not subject to the tax-related restrictions applicable to partnerships. However, since these registered investment companies are raised by independent agents and managed by third-party managers, they come with additional fees that reduce net returns to investors and, as a result, dilute their appeal. Also, the composition of the portfolio held by these investment companies must be carefully managed to satisfy income, asset and distribution tests necessary to qualify for pass-through tax treatment under the investment company rules.
Individuals’ retirement plans
The holy grail in the race to access the retail investor market is defined contribution plans. But this path is fraught with even greater legal and commercial constraints.
Some have estimated that retirement plans hold approximately $19.5 trillion in assets, with slightly more than half held in defined contribution plans and individual retirement accounts. As corporations shift away from large defined benefit pensions and toward defined contribution plans – thereby placing the responsibility of saving and investing on the employee – private equity is seeing a flight of capital from corporate pension funds, which were once anchor investors.
Tax and regulatory issues, principally under the Internal Revenue Code and Employee Retirement Income Security Act animate the requirement for defined contribution plan investments to be highly liquid. Further complicating this issue is individuals’ desire for the ability to take liquidity-related actions such as rolling over contributions or borrowing from their 401(k). These additional constraints are leaving private equity firms scratching their heads about how best to approach the market.
Threading the legal and commercial needle to develop a product to suit retail investors is a first and necessary step on the path toward accessing the retirement account market. The market, and especially other fund managers, are opportunistically watching the moves of major private equity firms closely as they seek to open their funds to individual investors. As firms navigate these uncharted waters, one thing remains certain: the first to the finish line won’t have long before the other prestigious private equity firms are right there beside them.
By Debevoise & Plimpton partners Erica Berthou and Jordan Murray and associate Evan Neu in New York