By Sean Wilke, Head of Growth Strategy, U.S.
In a departure from traditional fundraising techniques, fund sponsors are increasingly turning toward retail or non-institutional sources of capital. This phenomenon, known as the “democratization” or “retailization” of alternatives, opens up the historically difficult-to-access private markets to individual, non-professional investors.
Private credit, direct lending, venture, real estate, private equity, infrastructure, long/short public equities and specialty finance – asset classes previously available only to the institutional and ultra-affluent investor community – are now open to the masses.
From the perspective of an individual investor, access to private markets is an attractive substitute for traditional retail products, such as mutual funds and index ETFs. Perceived benefits include unconstrained and uncorrelated strategies, greater potential for outsized returns, portfolio diversification, and early access to innovative new companies, business segments and other trending assets.
As the great wealth transfer takes shape, the demand for private equity, venture capital, real estate, infrastructure and hedge funds is poised to skyrocket. While the untapped potential is irrefutable, the risks and challenges cannot be overstated. For sponsors whose expertise lies in private funds, operating retail access vehicles comes with a multitude of administrative undertakings, operational complexities, liquidity considerations, and regulatory constraints that do not exist when running private pools of capital.
In this article, we outline the various avenues for achieving retail access before detailing the key regulatory and operational considerations that come with this strategic shift.
Routes to retailization
While investment innovation usually relates to new strategies, markets, securitizations or deal structures, democratization involves a departure from traditional pooled investment vehicles in favor of retail-oriented wrappers:
- Liquid alternatives: mutual funds employing alternative strategies
- Exchange-traded funds (ETFs): ETFs employing alternative strategies
- Interval funds: semi-liquid registered funds usually focused on illiquid assets that permit buying at any time and redemptions at predetermined intervals
- Closed-end funds (CEFs): semi-liquid registered funds usually focused on illiquid assts that have a fixed number of shares that can be traded over-the-counter (OTC) or on exchanges
- Business development companies (BDCs): publicly traded companies that primarily invest in debt or equity of lower and middle market businesses
- Real estate investment trusts (REITs): publicly traded companies that invest in income-producing real estate assets
- Crowdfunded financing: ventures that raise capital by pooling assets, usually in the form of modest contributions, from numerous individual investors
- 506(c) offerings: private ventures and vehicles, the issuers of which are permitted to broadly solicit and advertise an offering, subject to satisfying the accreditation standards (which were simplified earlier this year in a no-action letter from the SEC to Latham & Watkins following the latter’s request for interpretive guidance)
The potential of the I-RIA channel
The allure of alternatives is equally applicable to independent registered investment advisers (I-RIAs) as it is to individual investors, but they face numerous operational and regulatory hurdles when attempting to allocate client assets to private assets. The I-RIA channel, a largely fragmented business segment loosely tied together by a small group of mega-custodians, presents the biggest opportunity for sponsors to raise retail assets.
An I-RIA can have thousands of end clients and tens of thousands of accounts under advisement, which are often managed using model portfolios where macro-level investment decisions are implemented across accounts on a pro rata basis. A 5% allocation from a single retail investor with $5 million in investable assets is $250,000, whereas a 5% allocation from an I-RIA with $500 million in client assets is $25 million. While non-traditional forms of distribution, such as application-based platforms and social media marketing, can be effective in reaching individuals, the I-RIA channel stands out for its significant potential.
Regulatory and operational considerations
Retailization clearly presents significant upside for alternatives sponsors, but it also poses considerable operational and regulatory complexities.
Broadly speaking, the conduct of advisers to private funds is primarily governed by the Investment Advisers Act of 1940 (Advisers Act) and the contractual terms of their offering documents (e.g. offering memorandum, limited partnership agreement, side letters, etc.). Depending on the vehicle wrapper, those managers who wish to dabble in retail products may be subject to a range of additional statutory and regulatory requirements, as well as the corresponding operational burdens:
Investment Company Act of 1940 (IC Act)
Fund administration
Liquidity
Tokenization
Portfolio monitoring
Valuation and allocation
Main Street investor protection
Ultimately, the democratization of alternative assets represents a monumental shift for asset managers, offering unparalleled opportunities to diversify their investor base and enhance their capital-raising capabilities. However, it also necessitates a significant adaptation to new operational frameworks, compliance mandates, and investor relations approaches. By navigating these complexities successfully, alternative asset managers can unlock new avenues for growth and cement their role as key players in the evolving financial landscape.
