Retail in PE
We have all heard the astounding estimate of $20 trillion of investment from wealth and retail channels into private equity and other private market alternatives over the next 7-10 years.
Savvy retail investors and their advisors are keeping the following considerations front and center as they make their foray into alternative investing: fee structures, liquidity, and valuations.
First, setting the stage on why the interest from retail investors to buy alternatives?
- Public markets have become extremely efficient, and it is increasingly difficult to access alpha, or excess return, over the beta of normal market returns.
- There is a strong case that alternatives like private equity, real estate, infrastructure, credit and hedge funds provide portfolio diversification to traditional investments such as stocks and bonds. In fact, large institutions have made alternatives a part of their investment portfolios for decades.
- As further example, with private equity (PE), one view is that investing in PE is the only way to access a large part of the equity markets, as the public markets continue to shrink. As Jamie Dimon of JPMorgan Chase mentioned in his April 2024 shareholder letter, the number of private U.S. companies backed by private equity firms (not including the rising number of companies owned by sovereign wealth funds and family offices) has grown from 1,900 to 11,200 over the last two decades.
And second, why the interest from asset management firms to sell alternatives to retail?
- Many historical traditional institutional investors are now at full allocations to alternatives. While the asset management industry does not suggest individuals allocate to alternatives to the same degree as the 30 percent found in many institutional portfolios, there is still much room for growth as most individuals currently have zero in alternatives and many wealth managers are suggesting a 5-10 percent allocation to start.
- Asset management firms can charge retail more for these strategies. Bain estimates that fee revenue for private market investments will double to $2 trillion by 2032, with private equity and venture capital remaining the largest categories.
Yet private equity is coming off of a tough couple of years. According to Bain & Company in their 2024 Private Equity Midyear Report:
- Private equity’s two-year slide in deals, exits, and funds closed slowed in the first half of 2024, with low activity. When Bain & Company surveyed over 1,400 market participants in March to find out when they expected dealmaking activity to bounce back, close to 40 percent predicted next year or longer.
- Investors are continuing to press for an increased pace of distributions, while focusing any new commitments on several favored funds.
- General partners (GPs or the investment firms) who can’t shepherd portfolio companies to attractive outcomes may face a shakeout.
Given this backdrop, retail investors and their advisors are carefully weighing their private equity choices, particularly general partner choices, entry points, and fund structures. Considerations include:
Fee Structures – Retail investor access to alternatives funds can come at a high price. The overall price tag is a blend of management and incentive fees, acquired fund fees, manager expenses, interest on loans, and administrative, custodial, and legal costs. It is important to factor in the complete cost of investing into any allocation decision, understanding that the more layers of firms touching the investment will increase the costs.
In their annual alternatives fee survey, Cliffwater noted that all-in fund expenses at interval and tender offer funds, for example, can run as high as 5.94 percent, with an average of 2.91 percent for these funds. In another example, they noted that secondary funds may have high acquired funds fees and expenses (AFFE) components, while funds that have more co-investments may have a lower AFFE component, but a higher management fee.
Liquidity – Retail is coming into PE at a time of unprecedented illiquidity for the PE industry. Industry sources cite $3.9 trillion of dry powder as of April 2024, on top of another $3.2 trillion for the unrealized value of 28,000 unsold companies in buyout portfolios globally, or four times the level during the global financial crisis.
In this environment, there is immense pressure from investors for GPs to return cash, and some GPs have started taking NAV loans, leveraging illiquid assets as an avenue to return some money to their investors, particularly in the face of more fundraising.
Valuations – After a couple of lackluster years compared to public markets, both firms and investors are eager for higher returns. This has led to some interesting innovations, such as continuation funds—the fastest-growing segment in secondaries—which are seeing strong market demand and generating impressive returns.
Continuation fund structures can be appealing to both GPs and investors, as they offer a lifeline for valuable assets that can’t sell currently but are worth holding onto longer. However, investors should know these assets are often marked at conservative valuations when they are transferred out of the original fund, which can significantly boost the gains—and the carry fees paid by investors—when they are eventually sold in the second structure continuation fund. For instance, a recent analysis by Whitehorse Liquidity Partners of over 1,000 transactions found assets sold by continuation funds were valued, on average, 28 percent higher than where the GP had valued the business just six months earlier.
In Conclusion – An appropriately sized allocation to private equity (PE) and other alternative investments is essential for any well-formulated investment portfolio. With PE firms and their investors seeking higher returns and liquidity, especially after a few underwhelming years compared to public markets, the current environment is driving innovation. When retail investors and their wealth advisors delve into private equity, it’s important to carefully consider fee structures, liquidity, and valuations—areas that can present challenges for those new to alternative investments. Bringing us back to a core principle: prioritize investing with top-quality asset managers when making any alternative investment.