This article was originally published on FinExtra.

The democratization of private markets has captured the industry’s attention, and it is easy to understand why.

Individual investors own about half of the estimated $275 trillion in global assets under management (AUM), but hold just 16% of alternatives’ market value.

High-net-worth individuals (HNWIs) with $1 to $5 million in investable assets represent an enormous reservoir of money available to reallocate from public equities into private assets. Tapping into this potential bonanza will require private funds to engage with HNWIs and confront their vastly different liquidity concerns.

Fund managers are eager to make up for the slowdown in new investments from their traditional sources. And half of very-high-net-worth individuals (VHNWIs) would like to increase their allocation of private alternative assets. 

For larger fund families that have focused on smaller limited partners (LPs) with a net worth of $5 to $30 million, billions have rolled in. But as some have discovered, tending to a flock of small investors, whether VHNW or HNW, can be complicated. 

Illiquidity, the knowledge gap, and more regulatory scrutiny

Fund managers probably expect some growing pains once they onboard retail investors, but it’s safe to say they are not prepared for potential illiquidity backlash. Let’s take a step back and see why. 

A consequential knowledge gap exists between PE funds and Individual investors, and it cuts both ways. It’s hardly surprising if investors accustomed to easy, instant exits from stock markets haven’t done enough to plan for illiquid, rigid private markets. It’s also understandable if PE managers have not anticipated how contagious liquidity anxiety could be in real life—nor that a stock market rout or widespread financial crisis could trigger a redemption stampede. 

Retail investors, who often come in via a wealth advisor, may have read the fine print, but they probably didn’t run worst-case scenarios or consider extenuating personal contingencies. HNWI retail investors can agree to a lockup period without believing it could really impact them. Even those with $5 million-plus of investable assets may not be financially or emotionally prepared to wait out a drawdown. What’s more, the net worth threshold is likely to come down in the next few years, making clarity about liquidity even more critical. 

What democratization demands of private funds

Fund managers need to implement an overall communication strategy focused on ensuring that smaller investors plan explicitly for the liquidity limits on their private investments. The last thing fund managers want to see is a disruptive spike in demand for withdrawals. If small investors cannot pull their money out during a widespread cash crunch, regulators might act with a heavier hand and require funds to:

• Provide more transparency and more extensive reporting.
• Share information faster, with more frequent reporting.  
• Offer more liquidity options for smaller investors.

This short list could be challenging to fulfill. More frequent reporting entails additional accounting, overhead, and communication costs, which could eat away at profit margins. The heaviest lift would probably be updating fund structures to enable more liquidity options.

Democratization is not for the faint of heart. Should all private equity firms jump in, and take on the challenges to tap the potential flood of “small money”?  At a minimum, each fund should carefully consider whether its strategy and future need to include the retail market.  

Larger funds certainly see individual investors as an opportunity to build a long-term advantage—and they are diving in. In today’s downturn, larger funds raise and start new funds more easily than smaller organizations. Perhaps seeking security as they venture into unfamiliar territory, individual LPs have gravitated toward the larger fund families. 

However, the majority of HNWI assets have not rushed over to private funds. Smaller investors, while tempted, may be waiting for the investor experience to meet their expectations. It’s no secret that private markets “generally lack transparency on performance, cost, and underlying investments.” Clearly, this stems from their limited electronic infrastructure and lack of standards to support transactions, collateralization, administration, registry, and reporting at scale. 

Private funds know the basic equation for individual investors; they need reliably higher returns from PE to offset their loss of liquidity. In reality, it’s not that simple. Loss of liquidity is okay until one day it’s a crisis for small investors—something no fund manager should forget. Retail investors live and breathe with a different time horizon. 

But even if a fund could compensate for this liquidity premium, HNWI’s investment horizon complicates matters further. While institutions aiming for longevity might have a 50-year horizon for their private investments, individuals' liabilities materialize over much shorter periods.

In our view, communicating with smaller investors about liquidity and lockup should be paired with education to help them avoid personal financial jams. Nobody wants disadvantageous early redemptions and the reputational risk they’d bring. It’s wise to be proactive in coaching HNWIs on how to think ahead and manage for lack of liquidity. 

Beware the day of redemption

Retail investor aversion to being locked in has actually caused redemption spikes.

In February, Blackstone blocked $2.5 billion of $3.9 billion in withdrawals by smaller investors from its private REIT. The flood of attempted redemptions was unexpected, especially after Blackstone’s REIT had performed spectacularly in 2022. If one of the world’s premier private asset managers was caught flat-footed, smaller funds would clearly not be immune. HNWI behavior is a new concept for funds accustomed to traditional, institutional investors. 

I mentioned above that regulators will likely require more liquidity choices to protect smaller investors—and funds can easily underestimate the challenges that would entail. Given that managing an investor population with very different needs and expectations has been difficult even for dominant players, what does the future hold for private markets? 

The changes ahead

There is no shortage of optimism. Larger fund families are plowing ahead. For example, Apollo seeks to raise $50 billion in retail capital cumulatively from 2022 through 2026. Funds may bifurcate into one group that embraces smaller investors and their needs, and a second group that stays with traditional larger investors. 

Even without regulation, funds can meet HNWIs halfway by offering them more exit options, like the ability to redeem early under pre-specified conditions. Fund managers can create specific vehicles for HNWIs, or commingle them with new products. An example would be a hybrid of hedge fund and closed-end private equity investments. This allows more flexibility for liquidity, but it could dent returns by shortening the runway that managers need to create value in those investments.

Today, HNWIs with net worth under $5 million are a market that has been relatively untapped by private funds. There are ways to reach below the $5 million threshold, including feeder funds and other mechanisms, but they can involve stacking fees and professional advisor fees. 

A stable, predictable regulatory framework would eventually clear some fog from the playing field and help both funds and investors to strategize and set their plans. 

Managers should not underestimate the tradeoffs of taking “more public” money

No question, it’s an exciting phase for private markets. More funds are staking out their position; for them, it’s a strategic imperative to get bigger by going small. As this transition begins, some funds could be biting off more than they realize.

Against those enticing additional management fees, they need to weigh the cost and burden of additional regulation and ongoing support for retail investors, and the need to offer more transparency and liquidity options. Their world will become more like the public markets, in other words.

Despite all the possible pitfalls, private markets democratization is unstoppable.

Smaller investors are hungry for higher, more stable returns, and plenty of fund managers are just as eager to offer them that. It’s only a matter of time before the two sides converge, creating a massive new market for private equity. 

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