For decades, high net worth investors were like partygoers standing out in the cold, watching as institutional and ultra-wealthy investors were ushered into the private equity investment club.
Their barrier to entry wasn’t the wrong look. Rather, it was prohibitive investment minimums of between $1 million and $5 million, stringent investor eligibility standards, and administration and recordkeeping requirements that kept most high net worth investors on the outside looking in.
But in addition to recent revised SEC criteria for accredited investors, improved technology and pandemic-driven industry changes are driving an evolution in the alternative investment industry, resulting in expanded access to private equity and other private market strategies.
Improving risk-adjusted return
The potential for outperformance has been the primary driver of individual investor interest in private equity. Capital market assumptions of public equity and fixed income returns are in the range of 6% and 4%, respectively, according to the most recent publicly available capital market assumptions from UBS, Callan, Invesco, JP Morgan, BlackRock and BNY Mellon as of March 2020 and evaluated by iCapital, and we anticipate them to be inadequate to meet investors’ return aspirations.
If high net worth clients are to achieve their return objectives, wealth managers may need to consider alternative sources of return. Private equity’s historical return profile suggests that it can help bridge this gap, although past performance is no guarantee of future results. The asset class has generated a 430-basis point premium over stocks, as measured by the S&P 500 during the 20-year period ending March 31, 2020.
Private equity has also generated attractive risk-adjusted returns, as measured by the Sharpe Ratio. The Sharpe Ratio describes how much excess return over the risk-free rate that an investor receives for holding a riskier asset — and the higher the ratio the better. During the 10- and 20-year periods ending June 30, 2020, private equity’s Sharpe Ratios were 0.91 and 0.43, respectively. By comparison, the S&P was 0.74 and 0.15 for the same respective periods.
Diversifying capital sources
The increased interest in alternative sources of return by individual investors is being reciprocated by private equity fund sponsors that want access to the U.S. high net worth investor market, estimated at $73.3 trillion.
Fund sponsors have long been aware of this capital base, but they paid scant attention to it because the market wasn’t easily scalable. Private equity funds require voluminous paperwork and record keeping, including comprehensive investor profiles, screening to ensure investors meet the income and net worth qualifications, not to mention hundreds of pages of documents requiring multiple signatures. Also, the investment creation and servicing process is complex, involving a host of parties that include fund administrators, custodians and transfer agents. Multiply this by hundreds or thousands of clients and the administrative burden and associated costs are insurmountable for most fund managers and advisors.
However, platforms such as the one our firm produces have made these funds more accessible to high net worth investors by aggregating individual commitments into vehicles like feeder funds so that private fund managers need only deal with a single entity. New technology has also streamlined the administrative and record keeping tasks associated with fundraising, enabling managers to scale their operations to accept a higher volume of investors at investment minimums — as low as $25,000 to $100,000. As a result, advisors can now build private market allocations for clients who previously had been unable to invest in a single private equity fund.
Additionally, technology is breaking down other barriers to private market investing, for example the illiquidity associated with private equity. These funds typically require extended holding periods and the duration of these funds — which can be as long as eight to 10 years — prevents some advisors from allocating to them, due to the liquidity preferences of individual investors. Today, however, digital secondary marketplaces are providing opportunities for investors to exit their positions ahead of schedule, reducing these barriers to entry.
Risk/reward
Although technology has improved the accessibility of alternative investments, it does not mitigate other risks associated with private equity investing. These may include a lack of transparency, use of leverage and potential fund concentration. As with all investments, it is essential that advisors and their clients weigh the benefits and considerations of these investments before allocating to them.
While many strategies remain available primarily to investors with $5 million or more in assets, several funds are now available that can support more modest investments from clients with smaller portfolios. But as these strategies gain acceptance among advisors, we foresee that they will create more opportunities to build diversified private market allocations for clients to better position these investors to achieve their long-term investment goals.