Private capital’s HNW quandary: Overcoming the diseconomies of scale
By David Genn, chief executive officer at Goji – As private capital managers look to individual investors as the next frontier for asset growth, technology may finally provide a path.
Back in 2012, at a Goldman Sachs analyst conference, the Blackstone Group’s Tony James outlined the case for private equity’s advance into the high net worth universe, emphasising in particular the AUM growth available. Fast forward seven years to last December’s Goldman Sachs analyst conference and Stephen Schwarzman touched on the very same theme, noting that the larger retail segment represents a roughly USD70 trillion pool of capital, “barely” any of which is allocated to alternatives. Blackstone, of course, is not alone. In Europe, more specifically, the steady growth of the HNW universe, both in numbers and asset growth, has ironically turned the individual investor – not the billion-dollar institution – into private capital’s great white whale.
The inability of the private capital industry to tap into this pool of individual investors is not for lack of effort. Several global firms have taken their fund management companies public, with 3i and Intermediate Capital Group among the earliest to do so. Many more have rolled out REITs, BDCs and, more recently, special purpose acquisition companies (SPACs) all to give individual investors a taste of the real estate, direct lending and buyout asset classes. iShares even lists a private equity-oriented UCITS ETF for those seeking exposure through an index. Yet, while the European Securities and Market Authority reported earlier this year quantified that EU Alternative Investment Funds have grown considerably in recent years, private equity accounts for just a fraction, not even one tenth, of the total AIF volume.
The sticking point for private capital isn’t that individual investors aren’t showing a demand for alternatives. The nearly USD50 billion raised by SPACs in just the first three quarters of 2020, according to SPACInsider, underscores the retail hunger even if institutions are fuelling the IPO activity. But access to the HNW audience has generally been the preserve of the very largest asset managers, with the back-office resources necessary to navigate and manage the complexities that come with individual investors. These complications take form as heightened regulatory oversight and more intensive reporting demands; illiquidity challenges and the need to hold cash in reserves for potential redemptions; and byzantine operational considerations to efficiently serve individual investors in an effective and scalable way.
What many in private equity, infrastructure, real estate and direct lending may be overlooking is that technology has advanced to the point that the red tape that previously precluded access to individual investors is no longer an issue. And with the bar effectively lowered to access this expansive and growing pool of capital, the more innovative managers are now getting their arms on all of the different ways they can make inroads with high-net-worth investors to introduce new products and strategies that will support wealth creation and capital preservation for generations to come.
It’s easy to see why individual investors pose such a considerable challenge. Most fund managers, for instance, already have their hands full accommodating institutional investors. To expand the investor base exponentially, welcoming less sophisticated investors with less familiarity around the respective asset classes – requiring even more accommodations around transparency and reporting -- generally requires far more than just operational adjustments around the margins.
It doesn’t help that most partnerships have traditionally been laggards as it relates to technology adoption. The reliance on manual processes creates significant bottlenecks, even with as few as 30 LPs, that can be traced back to the shuffling of paper and spreadsheets between the different counterparties. Consider all of the back and forth – coordinated via fax, no less – in which fund managers and their administrators have to compile, verify, and report on the KYC and anti-money laundering checks as part of onboarding. When managers multiply the number of investors exponentially, few if any fund administrators in private capital have the infrastructure in place to execute an onboarding programme that can absorb thousands of individual investors across multiple jurisdictions and regulatory regimes.
Beyond the current infrastructure shortcomings, the liquidity challenges inherent to private capital represent another roadblock, creating something of a paradox. Private capital has historically leveraged the illiquidity discount to target arbitrage opportunities that lend themselves to multiple expansion over longer-term time horizons. And value creation initiatives often degrade value in the short- and medium-term before these efforts yield the desired growth. Private capital, as a result, can look very different as liquidity alters investor expectations and behaviours.
The good news, though, is that regulators are helping fund managers and prospective investors find a middle ground. The Financial Conduct Authority, for instance, is consulting on proposed rules that would require 180 days-notice ahead of redemptions, versus daily redemptions, for public, open-ended property funds. Still, the inherent mismatch between the shorter-term needs of individual investors and “patient” capital in private equity or real estate can be particularly vexing for managers. The challenge is made more pronounced for active funds that are buying and selling assets more frequently – necessitating a steady cadence of capital calls and distributions and all of the related paperwork and documentation that impacts other mission critical activities.
But even with traction from regulators to help manage the liquidity challenges, compliance considerations represent another Pandora’s Box when it comes to the pursuit of retail investors. The FCA’s 2020 and 2021 “Business Plan,” for instance, specifically cited “high risk illiquid investments” as an area of scrutiny. Among its focus areas, the FCA identified it will continue to develop its anti-money-laundering regime, scrutinise fund managers’ processes and diligence around KYC checks, and assess the effectiveness of market-abuse controls.
Generally, though, regulators have been relaxing rules to allow for increased participation of individual investors in private capital – witness the SEC’s revisions to the Accredited Investor definition in the US. But fund managers well know that with such concessions come added responsibility.
Tech’s last frontier for investors
Across private equity, investors over the last decade have helped to initiate digital transformation strategies within their portfolio companies, with support from direct lenders funding these efforts. Real estate investors, meanwhile, have begun leveraging software for VR tours and to modernise property management, while commercial real estate investors are adapting quickly as the shift from brick-and-mortar has upended traditional supply chain models and distribution centres. Even infrastructure investors have seen technology alter their investment theses across a range of categories, including telecoms (think 5G), toll roads, and water.
Technology’s last frontier, however, is for private capital investors to turn their attention inward, especially as the stars have finally begun to align for individual investors. Many high net worth families, for instance, are rethinking the effectiveness of a 60/40 portfolio and are instead emulating more sophisticated endowment models. Regulators, too, are taking steps to make private capital more accessible, perhaps acknowledging that in a lower-for-longer interest rate environment, individuals are hard-pressed to find competitive returns in fixed income and equities, alone. And, most importantly, technology and software can now eliminate the most acute bottlenecks that have historically stood in the way.
To streamline the inefficiencies and eliminate the distribution challenges that become more pronounced as organisations scale, technology can today provide the piping and infrastructure that automatically connects counterparties and automates both inbound and outbound payment flows and reconciliations. Illiquidity mismatches, too, beyond the steps regulators are taking, are another candidate for technology solutions, particularly as the secondaries market develops and becomes ever more efficient over time. Advances on this front would also solve for the need to keep cash available for prospective redemptions, allowing managers to put that capital to work. And back-office software can already absorb and accommodate the added compliance scrutiny, through digital paper trails supporting MIFID II requirements, automated KYC and AML checks and self certifications, as well as more dynamic, and more “visual” reporting features tailored to individual investor preferences.
As investors well know, the efficiencies and cost savings, as valuable as they are, are merely a precursor to the growth available once a secure, scalable platform is in place. The payoff will ultimately take form as a new untapped pool of investors, whose collective assets are at least as large as the institutional and endowment universe. These assets are also growing as pensions and defined benefit schemes give way to DCs and personal savings. Just as material, the ability to seamlessly rollout new products to different audiences with nuanced distinctions will create new revenue streams. This is not an insignificant consideration in an era of fee compression. Moreover, as partnerships become institutionalised, and technology eliminates the administration headaches, investment teams benefit by focusing on their core competencies – deal sourcing, fundraising, portfolio monitoring and value creation.
After two decades in which private capital firms have pursued individual investors, technology is finally putting this massive pool of capital within reach. Of course, others have taken notice too. When Vanguard announced in February that it was dipping its toes in the PE waters, a collective groan could be heard from the industry at large. It’s certainly not too late, but beyond just procuring a “first mover” advantage, private capital fund managers should recognise that the technology revolution will usher in both opportunity and risk.