Private Equity Innovation Is Needed. Will Disruption Follow?

Summary

• Progress in expanding individual investor access to private equity has been slow, but there are new reasons for optimism.
• Vanguard announced plans to "broaden access to private equity” by making PE investments available to qualified individual clients (those with $5M in investible assets).
• Further broadening access to the mass affluent (13% of US households) and (eventually) to the general investing public will require ’40 Act registered funds.
• Adding Vanguard client assets could double or triple current '40 Act PE fund assets, highlighting the need for a new '40 Act fund structure, such as the Aditum Aqueduct.
• The general investing public might eventually have access to high-quality PE at a fraction of current fee levels charged by established private market firms, disrupting the private equity industry.

Photo by erhui1979/DigitalVision Vectors via Getty Images

The SEC Moves Deliberately Through Firsts, But It Moves

I've been working on expanding individual investor access to private equity since early 2013. At that time, I was at Altegris, working with Jon Sundt our CEO on selling our company. A former co-worker of mine at Goldman Sachs, working at the time at Carlyle, contacted me. Ultimately, the Carlyle Group was one of the final bidders. During the discovery process, we had extensive discussions about providing individuals with access to Carlyle's private equity offerings. No deal was consummated with Carlyle, but those discussions educated and excited Jon and I. So, we continued to look for opportunities to broaden individuals' access to high quality private equity investments.

In late 2013, we engaged with KKR, where another former co-worker from Goldman Sachs was in a senior position. KKR and Altegris quickly found common ground. Through Jon's personal relationship, StepStone (STEP) agreed to sub-advise the pending Altegris KKR private equity fund. We filed the initial registration statement in May 2014…and then I learned first-hand how deliberative the SEC can be. The Altegris KKR fund had submitted registrations under both the '40 and '33 Acts. Successfully registering under the '33 Act would make the Altegris KKR fund the first PE fund in the US allowed to market in public to potential investors. David Mathews (our internal counsel), Rich Horowitz of Dechert (our external counsel) and I went round and round with the SEC for months trying to identify and respond to their concerns. The process dragged on without clarity, until we met with the leadership of the SEC's Investment Management Division in the winter of 2015. They raised some pointed, but entirely reasonable and justified concerns about KKR's ability to control the fund, against the interests of fund investors as represented by Altegris, the fund's adviser. We responded with our intended approach and subsequently added that approach to the registration statement, which was declared effective by the SEC about 2 months later in April 2015. Of course, a competing fund, whose first '33 Act registration came months after ours, was declared effective mere weeks later.

I've included this account on breaking new ground with the SEC to make three points:

1. The SEC is deliberative when doing something "new", even when the "new" something comports with regulations.
2. My experience is that the SEC both raises valid questions about investor protections and is motivated to provide investors with new opportunities.
3. By being deliberative, the SEC can fully discern the "facts and circumstances" of a situation, allowing them to know when those same "facts and circumstances" present themselves again (thus allowing similar subsequent efforts to move more quickly).

Expanded PE Access Is In the Interests of Both Established PE Firms and Individual Investors

Blackstone (BX), "with $649 billion under management, has said it wants half of new client assets to come from individuals". At their investor day in April 2021, KKR cited their "opportunity with individual investors" (a cohort having less than 5% of their assets invested in alternatives) as one of KKR's "unique differentiators". In a recent white paper, Vanguard said it "expects a broadly diversified PE program with exposure to top-performing managers to outperform global equities by 350 basis points at the median".

This summer Vanguard plans to broaden client access to private equity, by offering PE investments to "qualified individuals", which Vanguard has defined as being both a Qualified Purchaser and an Accredited Investor. These are the requirements to invest in private (i.e., not '40 Act registered) PE and venture capital funds, of which there are almost 6,000 in the world with a combined market capitalization of more than $4T, according to Cambridge Associates. As of the end of 2019, Vanguard reported having 5.1 million retail investor households with a collective $2T in their Vanguard accounts. Given that only 1-2% of US households are thought to be Qualified Purchasers and despite that fact that they hold a disproportionately large share of wealth, the current population of private equity fund sponsors and their affiliated funds are large enough to absorb this contingent of Vanguard qualified individual clients without significant impact.

The Number of Individual Investors Seeking PE Investments May Grow Rapidly

In the US, as many as 16 million households (13% of all households) are Accredited Investors and control more than 3/4 of all private wealth. Combining these statistics with Vanguard's reported population of investors suggests that Vanguard may have over 660,000 Accredited Investor client households with as much as $1.5T in Vanguard accounts. If Vanguard expanded PE access to all their Accredited Investors and these accounts invested 1%-2% (on average) in PE, Vanguard would be responsible for $15B-$30B in additional PE investments. However, private equity investment products currently available to Accredited Investors in the US are typically '40 Act registered funds of private equity funds. Per SEC filings, as of the end of 2020, these registered PE funds held approximately $10B-$12B in total assets. So, in short order, Vanguard alone could double or triple the assets currently in '40 Act registered PE funds.

The Current '40 Act Structure Does Not Deliver the Form of PE Most Commonly Accessed by Institutions and Will Not Support A Significant Expansion in PE Assets

At the time the SEC declared the Altegris KKR registration effective in 2015, we at Altegris intended to deliver the performance of KKR (as represented by KKR's own historic track record) to our fund's investors. For this reason, the registration statement reflected our intention to allocate 40%-80% of fund assets to KKR primary investments and (with the SEC's approval) included the historic track record of primary investments in KKR's funds in our registration statement. Today, for reasons I detailed in Private Equity: The Power of When, a prior article, the latest '40 Act PE funds make very small or no primary investments. For structural and regulatory reasons, the current crop of registered funds of private equity funds, advised by BlackRock (BLK), StepStone, Hamilton Lane (HLNE) and others, is heavily dependent on the secondary market in PE fund interests, to limit the portion assets in liquid form (typically held in cash and equivalents) and their associated "cash drag."

Secondary market volume peaked at $85B in 2019, dipped to $60B-$70B in 2020, but is expected to exceed $85B in 2021. However, as reported by Palico, in Q1 2021 "prime secondaries" (secondary interests in funds that are 3-10 years old) transacted at 104% of NAV. With the secondary market already experiencing rising prices, it's difficult to see how that market could absorb significant additional volume (such as Vanguard could provide) without a meaningful reduction in the expected 350 basis point performance differential of PE over public markets.

A New Structure Is Needed to Allow '40 Act Funds to Access the Traditional PE Market

Of course, the private equity markets overall are much broader and deeper than just the secondary market. Tiburon Strategic Advisors reported that in 2020 $724B and $155B were invested in private equity and venture capital transactions, respectively. A new product structure can eliminate '40 Act registered PE funds reliance on the secondary market by providing increased flexibility for the investment of assets not currently deployed in PE. These assets would reflect the registered fund's "dry powder." (For context, Tiburon reported that private equity and venture capital firms had $1.25T and $151B respectively in dry power in 2021.) Aditum Alternatives has developed such a product structure, the Aditum Aqueduct. Implementing this structure in a registered fund of PE funds requires regulatory relief from the SEC's "complex structure" restriction. Aditum Asset Management has approached the SEC about eliminating this restriction for '40 Act closed-end funds whose investors are limited to Accredited Investors.

Enough Growth in Registered Fund PE Assets Could Disrupt the Status Quo

Were a '40 Act fund to invest directly in private companies (as opposed to investing in underlying private funds), the Aditum Aqueduct structure could be implemented without SEC regulatory relief. However, the largest and most experienced private equity investors such as Blackstone, Carlyle (CG) and KKR (KKR) have no desire to invest directly in PE via a '40 Act registered fund, because they would have to provide the '40 Act funds the same investment terms as their more lucrative private funds on any common private equity investments.

While these are long standing market dynamics, this status quo could be toppled with enough individual investor capital. Vanguard, whose "30 million investors own the funds that own the company", could provide enough. Should Vanguard ($7.5T in total assets) become a large private equity investor and eventually develop their own private equity competency, they could originate PE deals on their own, allowing their registered funds to invest directly in private companies, without the involvement of and fees paid to the current "top performing managers". If so, Vanguard could provide the general investing public with access to high quality private equity investments at a fraction of the fees currently charged by general partners.

Analyst’s 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.