Does Size Matter?
For over 25 years, the Fama-French three factor model has been used by finance professionals to explain the risk and return of equity portfolios. Size, referring to the higher risk/reward associated with small caps stocks, is one of its' three factors. Thus size, has mattered and continues to matter to many finance professionals when constructing a portfolio.
It's been widely reported that there are fewer public companies today than there were 20 years ago and that, on average, today's public companies are much larger. (Fewer Listed Companies: Is That Good or Bad for Stock Markets?, The Stock Market Is Shrinking. That's a Problem for Everyone.) So, it may be that the type of small companies on which Fama and French based their model are much less common in the public markets, and therefore much less available to today's investors. One can debate the importance of size as a portfolio factor, but the reality that today's public equity investors have less choice, particularly among small companies, is widely acknowledged.
Where have small companies gone?
As reported by the Financial Times, "companies are now waiting about twice as long to go public. And they're raising about twice as much money in private capital markets before they do." (The slow death of public markets) The capital needs of emerging companies are, in general, now being met via a network of private equity participants, consisting of fund/investment sponsors (aka General Partners or GPs) and investors (aka Limited Partners or LPs).
How does an individual invest in these small companies?
To date, most LP investment is sourced from institutions, such as pension plans. Private equity assets are typically raised in private, unregistered vehicles, for which only the wealthiest individual investors are eligible. These individuals generally have a minimum of $5 million of investible assets and are classified as "Qualified Purchasers" (aka QP's) under SEC regulations. There are also a handful of registered private equity vehicles in which a broader population of individuals qualify to invest via a net worth more than $1M ("Accredited Investors"). As you would expect, there are many more Accredited Investors than Qualified Purchasers. "There were 7½ times more U.S. households with $1 million to $5 million in assets at the end of 2016 than there were households with $5 million to $25 million, according to market research firm Spectrem Group." (Blackstone Targets Millionaire Next Door)
What's the role of technology?
When thinking of technology today, people usually think in terms of hardware or software, but technology is more than that. Merriam Webster's definitions of technology include both:
"1 : the practical application of knowledge especially in a particular area", and
"2 : a manner of accomplishing a task especially using technical processes, methods, or knowledge"
The wording of these two definitions is subtly different, but the implications are significant. To illustrate the difference, I'll cite a couple of examples from my early career as a technologist.
As a software engineer in the defense industry, I worked on developing a submarine velocity measurement system based on the use of SONAR. It was a totally new concept. PhD physicists applied their knowledge of sound, the medium (ocean water) and the reflecting surface (the ocean floor) to measure the velocity vector of a submarine. This activity fits exemplifies definition 1. I consider it technology "ideation".
Later, while working in foreign exchange, my team wrote software to record the incoming trade orders and the trading activity to satisfy those orders in a global database. This allowed the foreign exchange team to easily transfer FX desk responsibilities from one location to another (e.g. from London to NY) more efficiently, replacing a phone and FAX process. This technology automation is an example of definition 2. When new technology is applied to automate an existing process, it's often described with the pejorative of "paving the cowpath". However, it's important to keep in mind that US interstate highway system, which was a critical component of economic and societal growth, was once just a bunch of "cowpaths". So, either form of technology can provide significant value.
With these two definitions in mind, in my opinion, much of the technology automation that has been recently developed and applied to allow individual investors to access private equity can be viewed as paving the cowpath.(JPMorgan Brings Alternative Investments to Masses With $100,000) These new electronic mechanisms are streamlining the connections between GPs and QPs, who are the same population of people investing in the same type of products as they did when paper was the medium used.
In my view, the recent improvements in subscription and service for the wealthiest investors are automation technology, and akin to replacing a Mercedes with a Tesla. The opportunity remains for more widespread and fundamental changes to how individual investors access private equity. Surely in our future, technology ideation and automation will be applied to provide a broader investing public with access to private equity, akin to how Uber transformed transportation.
What are the obstacles?
There are three obstacles to providing broad investor access to private equity. They are:
- Structural Limitations
Twenty-five years ago, these same obstacles were overcome when the first US ETF (SPDR) was launched. Today, the value of the US ETF market is about $3T ($4.5T globally). The growth story of ETFs began with technology ideation. Regulatory relief was required. Once it was demonstrated to the SEC that the ETF process would expand investor choice and capability, regulatory relief (i.e. "exemptive relief") was granted. Relief was granted to more and more ETF sponsors, with occasional slight changes, over the past 25 years. Over that time, as the industry grew, processes matured, more and more automation was applied, and the ETF industry flourished.
I believe that providing broad investor access to private equity can follow a similar course. So, while regulations are the most immediate obstacle, if technical enhancements are conceived and developed to ease the structural limitations, without introducing undo risk, the SEC should grant relief from the impinging regulations. Finally, as has occurred with ETFs, when PE products achieve significant adoption, automation, and scale, costs will drop accordingly. Once that occurs, private equity, which has been successfully employed by defined benefit pension plans for many years, should become a staple of defined contribution retirement plans (e.g. 401Ks).
A Registered Investment Company (RIC), but vintage or evergreen?
It's obvious that any US investment structure that's widely used should be registered with the SEC. It should also attempt to avoid the double taxation (i.e. at the corporate level and investor level) incurred by corporations. Units trusts offer no portfolio flexibility. REITs are designed for real estate investments. BDCs require that 70% of assets be invested in domestic assets. So, for a diverse portfolio of private equity investments to be broadly held, a RIC is the most appropriate structure.
Most private equity funds, even a number that are RICs, are structured as "vintage" funds. Vintage funds have limited, largely sequential, fund raising, investment and harvesting periods. So, investors need to orchestrate their PE portfolio activities against the schedule of more than one vintage fund, perhaps several, so as to maintain some minimum level of PE exposure over time. Appropriately blending the cycles and styles of multiple vintage funds is not a trivial process.
In contrast, over the past few years, several "evergreen" PE RICs have been launched. (Carlyle Lowers Velvet Rope, New Fund Offers Individuals Access to KKR Buyout Deals), These funds engage in continuous, simultaneous fund raising, investment and harvesting. The advisor of the evergreen fund makes multiple underlying PE investments on an on-going basis, blending the diverse cycles of capital use and return. This approach ensures that, no matter when they invest, every investor has and maintains exposure to private equity over the life of their investment.
How about a hybrid?
While evergreen funds have some advantages over vintage funds, there are two areas in which vintage funds provide investors with much needed flexibility that, under current regulations, evergreen funds just can't match:
Table 1 - Evergreen vs. Vintage Funds
1. Use of Capital When Not Invested in PE
Underlying PE investments each have their own cycle of capital use, calling for committed capital when needed and returning capital when the underlying investment has been recapitalized or liquidated.
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2. Liquidating Fund Shares
Neither fund type offers mutual fund style redemptions.
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Combining the best features of vintage and evergreen funds, an ideal private equity structure for broad investor access should (at a minimum) have these attributes:
- Be a registered investment company, with investment company (i.e. Form 1099) tax reporting;
- Have an indefinite investment horizon;
- Allow an investor a range of choices in how their assets are deployed while liquid;
- Allow an investor to liquidate their investment without coordinating with other investors.
There is no structure that both offers the attributes listed above and complies with current SEC regulations. In 2017, the NASDAQ Private Market (NPM) received SEC exemptive relief for evergreen fund investors to liquidate their shares via auction on the NPM. However, the existing PE secondary market, while active, is informal. Thus far, an institutionalized secondary market of evergreen auction funds and their purchasers, termed Secondary Liquidity Providers (SLP) by NASDAQ, has not developed.
It's time for ideation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am an investor in the Altegris KKR Commitments Fund, referenced in this article.