What private equity would mean for smaller investors

Opening up the rarefied space could bring bigger returns to the retail segment — but there are important questions

What private equity would mean for smaller investors

Faced by ever-more-challenging financial conditions, many small investors are finding that the yields and returns from traditional assets aren’t enough to help them fulfill their needs, much less achieve their goals. Against that backdrop, moves to expand retail access to alternative investments have been regarded as a positive step.

Since January, small investors in Canada have been able to purchase liquid alternatives, which include long/short equity mandates, multi-asset strategies, market-neutral funds, and alternative income. South of the border, the liquid-alternative floodgates have been open since 2013, and have expanded to as much as US$225 billion.

The downward expansion of alternative investments may not stop there. A consultation by the U.S. Securities and Exchange Commission (SEC) launched this year invited comments on whether it should ease restrictions on public access to private equity (PE) funds.

“The comment period closed in September, and the agency is widely expected to ease the restrictions, though when and how remains to be seen,” reported the Wall Street Journal.

Should the restrictions be relaxed — currently, PE funds are open only to investors with a net worth of at least US$1 million or annual income of at least US$200,000 for the past two years — private equity firms will benefit from a larger investor base.

The average investor would also stand to benefit. Citing data from Preqin and Morningstar, the Journal reported that PE funds posted an average annual return of 14.2% over the 10 years up to 2018, while the S&P 500 index managed a comparatively muted 7.3%. Assuming the future brings similar fortunes, access to those private markets would definitely help individuals whose retirement increasingly depends on their own investment accounts’ health rather than government- or company-provided pensions.

While the headline return numbers are certainly impressive, they come with important asterisks. One is that the disparity between top performers and bottom-of-the-barrel funds can be huge. Recent figures from McKinsey indicate that some top PE funds achieved annualized five-year returns north of 40% for the period through 2018, while the worst PE performers suffered yearly losses near 30%.

The spread between the best and worst U.S. equity mutual funds is considerably less severe: over the same half-decade, the gap between average annual returns ranged from a 5% gain to an 11% gain. With an apparently more massive downside in PE, some question whether it falls within what the average investor can actually tolerate.

“It isn’t just a bad day; it is destroying what they are trying to do, which is to create wealth,” said Lance Roberts, chief investment strategist at RIA Advisors, who believes non-accredited individuals should not be allowed to invest in PE. “They don’t understand the risks even when they say they do, and they don’t have the ability to withstand the losses when they occur.”

Another caveat is that PE funds generally require investors to commit a certain amount of cash for an extended period, which can be 10 years at least. While funds do let investors withdraw small percentages of investments periodically, getting all of their money back at once is out of the question — a massive issue for individuals or households faced with a sudden emergency.

“That lack of liquidity is part of the reason that the returns are better in private equity than in other asset classes,” the Journal noted.


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