The information gap between retail investors and the private markets
Anduin's CSO Alin Bui had an article featured by FinExtra. See the original here.
Fund managers today are bullish about the retail markets as a new investment stream, in part to reduce dependence on institutional portfolios. But many in private equity and venture capital are grappling with how to engage this promising category of investors.
Through the turbulence of 2022, we observed the growing relationship between fund managers and high net-worth individuals (HNWIs). But we also uncovered misconceptions and knowledge gaps on both sides, which are making it more difficult for private funds to attract retail investors and win their trust.
While HNWIs may be well-situated individuals, they are not necessarily professional investors, nor day traders. They can be entrepreneurs, doctors, lawyers, and executives—individuals who lack the time and patience to deal with the endless paperwork and due diligence still pervasive in the private markets.
In order to welcome this rising wave of retail investors, the private markets will have to embrace front-end and back-office digital transformation in order to offer the modern, seamless user experience public investors enjoy today. Not only that, but fund managers will have to gain a better understanding of what retail investors know/don’t know in order to build the most effective and mutually profitable long-term relationships with them.
What private funds need to know about retail investors today
New retail investors enter the private markets with high hopes. Many feel battered and betrayed by the public markets.
They are aware that retail markets can yield an additional 3% to 4% over time, compared to the stock market, and they are bullishly seeking those gains.
But there are many details not immediately obvious when entering a new market. As a private fund, understanding the knowledge level of your investor is critical for you to provide an informed experience and set the right expectations. Here are several things that, as a fund manager, you may want to call out for your retail investors:
- There are many alternative investment types. Recently, advisors have been saying “Put 5% to 15% (or more) into alternatives”—but which ones? Retail investors may perceive alts as a blur of collectibles, fine art, early-stage funding, crypto, and precious metals. They may not grasp where private funds fit in this universe. It’s wise to make sure they understand the investments you’ll be committing their money to.
- Low correlation and new allocation are powerful allies. New retail investors have probably heard the term “non-correlation” but not experienced its benefits directly. They haven’t seen it rescue their portfolio during terrible stock market years. Anyone who followed classic investment advice got pummeled in 2022, one of the worst years on record for traditional 60/40 portfolios. It’s no surprise that “optimal allocations” would change.
- Liquidity and lockup period are a thing. It’s one thing for a HNWI investor to know there’s a lockup period. It’s another to be tied into it when their financial circumstances change. Most private funds lack experience keeping retail investors ‘happy’ during lockup periods, and those clients may not know how they themselves will react to having their money committed. They’ve always been able to dump an investment in seconds. With you, they can’t.
- Retail investments are longer-term. The retail investor’s only experience with longer-term investment might be real estate—which they can improve, fix up, rent out, and make more valuable. That gives them a measure of control, which they do not have in the private markets.
- Retail markets have different compliance and onboarding requirements. New investors in private funds offered under Regulation D have to get through the non-trivial legal paperwork. Onboarding software has become the de facto standard, replacing PDF forms and reducing headaches by guiding investors through a cumbersome process.
- Your compliance is not their priority. Annual KYC compliance requirements and Russia-related sanctions can mean more paperwork for you and your new LPs. It’s a hassle for them, and they don’t have your liability concerns about a sanctioned individual slipping through, but they should understand the need to comply with global sanctions, and complete any necessary updates to keep their accounts in good standing.
- Fees and returns contain surprises. For newcomers, the fee arrangements may be mystery math. Two-and-twenty is the traditional compensation structure in private markets. The investor pays 2% in annual management fees and relinquishes 20% of returns as a performance fee. Investors new to the space may not realize how this structure plays out over the life of the fund.
- Stacked fees exist. Retail investors often get access to marquee brand-name funds through funds of funds–or via third-party feeder funds that aggregate smaller commitments into a larger pool that meets the minimal threshold for investment capital. Retail investors may not be crystal-clear that fees can be stacked. That can mean they pay a 1% annual administrative fee for the feeder fund plus two-and-twenty percent for funds that the feeders funnel into.
- The J-curve makes a poor first impression. Most private investment returns follow a J-curve line. Negative returns prevail in the early years when the investment dollars are deployed; with a positive upturn once the returns are harvested in the later years of the fund. Contributing to initial negative returns are the annual fees the investor must pay from the start of the commitment period (not just the capital that has been called). The fund management company can also charge fundraising-related costs to the pool of invested capital, up to a cap. Fund managers need to prepare retail investors for years in the trough of the J.
Private funds can anticipate and resolve information gaps
The funds themselves can take steps—primarily by sharing information—to engage on most of these issues:
- Address risk through education. Educate, educate. Retail investors probably know little about your diversification and risk strategy. They may know in the abstract that roughly 1 in 8 private portfolio companies fail. That’s acceptable if it’s not their investment but at some point, though, it may well be. That’s reality. Education doesn't happen overnight; it takes patience and persistence.
- Find the right balance between informing and overloading them. The above points beg the question: do these investors need to know how their money is performing, week by week? What is the right balance of engagement—keeping them out of the loop versus telling them too much?
- Substandard user experience can cost you incoming funds. Retail investors tend to value performance above all, but inadequate onboarding and information can derail opening and funding new accounts. Walk in their shoes for a moment and compare onboarding at your firm versus signing up with Schwab or Fidelity. Empathize with their potential exasperation and make it less arduous. It shouldn't be unnecessarily difficult to become your client.
- Establish policies for how transparent you’ll be. New LPs may believe that you, as a general partner, know far more about your portfolio investments than, say, a stock analyst knows about any public company. That could be true, but you are bound by NDA restrictions and subject to insider trading regulations. Retail investors should know you have those limits, but no crystal ball. Being transparent and helpful with them is not just about compliance and your fund policies, it’s also part of your marketing and their customer experience. How much should you tell them about the milestones and successes of their portfolio companies? Would you take their phone call seeking to get the inside scoop from you on a portfolio company? How much should GPs tell LPs / investors when a portfolio is performing poorly? At what point do they need to know the outlook is challenging, so they can plan for the worst?
Takeaways: It’s complicated but well worth it, so get to know one another
There’s a lot of getting acquainted to do, as retail private investing takes off.
Private funds need to learn about their new investors, even while training them on alternative investments. Despite complications around investing in “alts,” the math for retail investors still provides compelling long-term performance, better than public equity equivalents. Building knowledge via ongoing education will keep these new relationships positive, and keep the pipeline full of more prospects.