2022-10-23
The Rise of the Retail Investor and How PE and VC Firms Can Mark the Changing Tides
The combination of user-friendly trading apps, additional time to focus on investing (born by the pandemic), and what was, until recently, well-performing market conditions has brought unprecedented attention to the rise of retail investing.
And, while the current economic downturn may have humbled investing ambitions lately, the rise of the retail investor has continued to grow unabated. There are wide forces at play here, and we’ve only begun to see the potential breadth of these changing tides.
This article reviews the driving forces behind the rise of retail investors, how to market to them, the opportunities and challenges they face, and how private equity (PE) and Venture Capital (VC) firms can evolve in this new world.
What’s Driving the Retail Investor Surge
Lured by little-to-zero fees and the boredom they experienced while working from home (WFH) during the pandemic, retail investors have increasingly flocked to investing in markets—both public and private. It naturally follows that, as retail investors begin to wield more influence in the market, financial services and private equity firms have taken heed, and have begun to map out their strategies to capitalize on this phenomenon.
But, for most retail investors, entering private markets and PE, in particular, has long appeared to be a distant nirvana that was quite attractive, but seemingly out of reach. However, that will soon change if the leaders behind some private equity PE firms have their way. But, how and why?
During its decades-long history, private equity has often been viewed as the province of the ultra-rich and institutional investors, and it has become politically symbolic of the wealthy having opportunities to become even wealthier. Under the notion that ‘greed is good,’ PE has delivered among the best returns of any asset class, but largely excluded ordinary investors in favor of courting and serving the needs of investors with deep pockets.
During the most recent bull market, billionaires and large funds heard the call to carpe diem and committed an ever-larger share of their assets to private sector investment. However, as firms now face limited scope for further growth from institutional and high-net worth portfolios, PE managers are increasingly eyeing a broader range of individual investors and therein lies their desire to court the burgeoning class of retail investors.
Hearing the Call of the Retail Investor
They endeavor to persuade retail investors to diversify away from traditional, publicly traded stocks and bonds into the less familiar territory of private markets, with an increased focused on private equity.
The good news is that with a surge of new fund structures that allow investors to access these investments a tide of investment democratization has seized incredible tailwinds. Simply stated, private equity is no longer bound to be monopolized by the ultra-wealthy. And, while the celebrated days of 2021’s robust IPOs may now be long gone, as private markets open-up, retail investors are finding new ways to get in at the ground level before substantial growth occurs.
Of course, it’s no secret that most of the big players on Wall Street have ongoing strategies and projects dedicated to fostering greater access to private markets. One needs only to read CNBC, the Wall Street Journal, the Financial Times, or other publications to learn about how JP Morgan, Barclays, Morgan Stanley, and several other major financial services players are committed to facilitating new access points to private markets with new fintech.
In fact, as the CEO of Asset Class, I foresee that, in five to 10 years, retail investors’ entrée into private equity will be as common as their access to public market investment vehicles.
At the same time—despite recent geopolitical instability, surging inflation, and ongoing market volatility—more well-heeled retail investors have been demanding greater access to private equity for some time, as they’ve become increasingly enamored with the significant returns made in the past decade in everything from tech ventures to leveraged buyouts.
But, arguably, the biggest driver behind the surge in retail investing has been the continued growth of sophisticated platform technology, which is now more widely available and nicely tailored to our smartphones and laptops than ever. It gives retail investors key investment information at the right time, the ability to act on that information, and opportunity to coordinate the actions they need to invest successfully.
Facilitating Private Equity to Retail Investors
To get retail investors on the private equity train, PE firms will have to market to them to grab their attention (and wallets). The trend of marketing private equity to retail investors has gained obvious traction in the US and Europe in recent years and is only expected to accelerate.
Of course, while the notion of democratizing access to private equity may seem noble, it is not for everybody. Investing in this sector involves locking up money for longer periods in products that can often be rather illiquid.
This means that, while private equity firms may have a desire to tap into retail investor wallets, such money is often viewed as being easily led, but not always easily discoverable. As an asset class, I believe PE should be opened-up to more participants, but it has to be opened to appropriately resourced (and adequately positioned) investors. Marketing to such individuals requires discerning lead generation and highly personalized messaging—in essence, more spearfishing than casting wide nets. It is also necessary for these firms to ensure that they have the necessary technology in place to ensure that the flood of retail investors does not overwhelm their current Investor Relations and fund administration resources. They must streamline the entire LP Lifecycle, from onboarding to Subscription approval, to servicing.
What Retail Investors Should Know Before They Invest in Private Equity
While private equity may have become synonymous with high returns, retail investors should also be aware that it may include buying shares in any company not listed on a public stock exchange, such as emerging tech companies or other vaunted unicorns that came to characterize much of last year.
Some investors think private ownership carries inherent advantages, as companies can focus on the long term instead of having to announce results every quarter. Indeed, private equity boomed in recent years, due in part to historically low interest rates that made borrowing cheap, allowing plentiful capital for investments.
To wit, private equity delivered annualized total returns of about 13% over the past 15 years, on a risk-adjusted basis, against about 8% for the S&P 500, according to Morgan Stanley research. However, some experts question just how much those returns benefit end-investors, and how much goes to the managers themselves in fees.
Industry standard fees typically include a 2% management charge and a one-fifth share of returns, known as “2 and 20”. While such fees appear to be as guaranteed as death and taxes, the challenge for the retail investor will likely be to discern whether the strong performance of a fund has been cannibalized by management fees, or if another intermediary has seized much of the gains in fee structure(s).
Nonetheless, research this year by Bain, a management consultant, found that the top quartile of private managers paced far ahead of the public markets, with annualized returns above 20%.
It makes intuitive sense then, for retail investors, picking the right PE fund manager is crucial for realizing significant returns. Of course, certain funds have preeminent reputations and that means they get preferential access to deal flow. As they get the best opportunities, it becomes a self-reinforcing cycle.
What’s more, the concerns surrounding how equitable it is for retail investors to jump into private markets may prove to be particularly acute now, as interest rates rise and economists share concerns about an anticipated recession, or what others view as the one we currently find ourselves in.
The Challenges of Illiquidity
Perhaps, the biggest difference when investing in private companies versus publicly traded stocks or standard funds is that these investments are illiquid. Typical private equity managers will lock-up money for a period of years, giving them time to buy suitable companies, reinvent them, and sell them for a profit. If investors want their money back early, they usually simply cannot access it.
Thus, illiquidity is a key reason why retail investors have historically been locked out of this realm. Traditionally, minimum investments in private equity funds have been in the millions. Since these stakes are palatable for a relatively small cadre of investors, such investors would need portfolios worth hundreds of thousands of dollars. Many routes to private equity are also limited to sophisticated investors, as defined by regulators.
Nonetheless, the advent of ‘semi-liquid’ funds has offered some relief to the illiquidity challenge. These vehicles are somewhat like mutual funds; however, they limit the amount investors can withdraw in a given period. Originally popularized by Blackstone, and further used for assets such as property and credit, this type of fund is increasingly being eyed for private equity.
Withdrawal limits are triggered if, in aggregate, investors try to pull out more than a certain percentage of the fund’s total assets, typically 5% in a quarter. In that case, a maximum of 5% is withdrawn and split among the investors who want cash.
Of course, another avenue available on the public markets for retail investors is that retail investors can still gain a different kind of exposure to the private equity sector by buying shares in managers that have gone public, including KKR, Blackstone, Ares, Apollo, and Carlyle.
A more direct option for retail investors with smaller portfolios is to pool their resources to invest directly in private equity deals. Several companies offer this service, bringing personal investors’ small checks together.
While new structures may improve liquidity, the fundamental challenge of holding investments that are hard to sell in a hurry remain. As PE offerings increase, I encourage investors to be very selective after doing their homework.
Key Takeaways
As we transition away from the malaise days of the pandemic, the era of (seemingly) free money and inexpensive capital raises, and a burgeoning bull market, recent events will mark a turning point for PE firms.
The rise of the retail investor has brought into focus changes that will continue to influence private market investor approaches and communications for years to come. Savvy PE firms are well-advised to take heed of the following macro factors:
A Growing Class of Young(er) Investors and Traders: Digital natives and post-Gen Y investors will soon account for (approximately) one-third of retail investors. The majority of young(er) investors are investing in higher risk products. They also increasingly seek access to private markets in a manner that breaks down traditional barriers, as they concurrently expect their investment experiences to be as seamless as ordering an UBER or Venmo-ing a friend money. In short, younger investors lie at the epicenter of the ‘app-ification of society’ and have little-to-no tolerance for legacy bureaucratic approaches when it comes to choosing a PE partner. PE firms should be mindful of this changing tide of tech savvy investors.
Ongoing Market Volatility, Inflation and Geopolitical Instability: These words have come to characterize 2022. Naturally, no one has a crystal ball that will forecast the exact outcome of the war in Ukraine, China’s Zero-Covid Policy, the Fed’s (or other regulators) next move, and other significant market swings. However, PE firms are well-advised to remember that, in order to win the day amidst these market forces, they must take advantage of increasingly-sophisticated, purpose-built platform technology to distinguish themselves, while making more data-driven decisions. Put simply, gone are the days when they can simply rely on well-connected deal teams, as tech-savvy younger entrants will be hungrier-than-ever to eat their lunch.
Harnessing the Power of New Technologies: The private equity industry has undergone radical transformation in recent years and the next era of the industry will be redefined by the technology solutions that PE firms choose. Your firm, regardless of its size, needs the ability to manage relationships, transactions, processes, workflows, and the compliance of the firm in a very data-centric, automated, and secure manner. Accordingly, when you select purpose-built technology that’s easily configured to meet your firm’s unique needs, you can gain a competitive advantage that has the potential to have a serious impact on your firm’s ability to achieve long-term success.
Risk Re-Evaluation, More Diversification: According to Public.com’s 2022 Retail Investor Report, more than a third of retail investors are reconsidering risk following S&P 500 index declines of nearly 20% during the first half of 2022. 46% percent said their risk tolerance has not changed, and 19% report having an increased appetite for risk. As risk tolerance goes down, an appetite for diversification has gone up. Nearly half of retail investors reported diversification as their primary strategy for the next six months and PE firms should take notice.
The tough lessons learned during this year’s volatility have also given PE firms the opportunity to evolve and expand their investing acumen. Retail investors attraction to alternative investments that provide above-average returns in this realm will only continue to grow. While high-quality PE managers and deals may perform well in any market, leading firms will have the skills and network to execute on a value creation plan that guides retail investors through the second half of the year, and beyond.
Discover How Asset Class Can Help Your Team
Need help facing the changing tides surrounding the rise of the retail investor? This is an area that Asset Class has deep subject matter expertise in and we’re prepared to offer you strategies to court this evolving demographic. Today, Asset Class platforms power over 400 private capital funds around the world. Whether you’re a PE or Venture Capital firm, you can discover how our platforms help make the future of finance frictionless. Schedule a demo with one of our team members today.
Sources:
Public.com, “Evolving through Volatility: Read the 2022 Retail Investor Report.” https://medium.com/the-public-blog/evolving-through-volatility-read-the-2022-retail-investor-report-87c290300eb3
CNBC, “Secret JPMorgan project aims to push bank deeper into growing market serving private companies.” https://www.cnbc.com/2022/02/28/jpmorgan-project-will-push-bank-further-into-market-serving-private-firms.html
Financial Times, “Time for retail investors to go into private equity?” https://www.ft.com/content/8875aed5-ebb7-466c-ad6e-287a22eecd0e