Crowdsourcing for Large and Medium Sized Private Equity Firms
private equity and retail investors: disrupting fund of funds
Several asset classes have been transformed or at least impacted by the crowdsourcing model. Early stage investing and real estate are two areas that immediately come to mind. But can crowdsourcing impact the stodgy world of midcap and largecap private equity? Private Equity has been an excellent asset class over the last few decades, but very few individuals have access to these funds. Even being an accredited investor is not enough for the likes of KKR, Blackstone, or other well known private equity funds which may have investment minimums as high as $5M. Why? Because the cost to acquire a limited partner is very high, the administrative requirements of dealing with a limited partner are onerous, and private equity firms are often interested in limiting the number of limited partners they have to provide information to.
So what are these private equity firms missing out on? $10 trillion in consumer wealth that could be tapped for capital raising efforts! The solution utilized by private equity funds thus far has been a poor one: receiving capital from Fund of Funds. Fund of Funds are partnerships that invest capital into private equity funds and hedge funds. They charge their own limited partners “2 and 20” (2% of AUM and 20% of returns, or some iteration of that) on top of the fees charged by the private equity and hedge fund managers they invest in. The Fund of Funds are often willing to take on accredited investors with as low as a $50K investment. They pool money from these various investors and act as a single limited partner to the funds they invest in. They demand their fee because they are providing access to an otherwise inaccessible asset class and because they are supposedly actively creating a portfolio of “the best managers.”
Why pay a Fund of Funds a significant annual fee to place your capital with private equity firms that are easily recognizable as having a strong track record? A better model would provide accredited investors who can’t reach investment thresholds (and eventually retail investors) direct access to the funds of their choice. A tilt model would aggregate many small investors until the necessary threshold (say $5M) was met and then invest in the private equity fund as a single limited partner. Certainty of capital calls would be a major issue with smaller investors, but is one that could be solved with innovative financial structures.
A platform providing this service could charge an initial, one-time placement fee. A strong technology backbone would allow for a rapid and efficient documentation process. Combining this with a branded platform that could employ a paid customer acquisition strategy at a lower cost than a large private equity firm could.
Private Equity firms with strong recent track records are in some senses not in need of additional venues for raising capital. But the pitch to them is as follows:
- any incremental supply helps them as even the best private equity firms are facing pricing pressure from their limited partners (in the form of fees being negotiated down)
- Managers/founders at top private equity firms look to cash out of their general partner stakes / IPO. Their businesses are valued largely on how quickly they can grow assets under management. Tapping into the lower end of the accredited market and eventually the retail market would allow managers to sell their stakes at a much higher valuation multiple
I believe that for this type of platform to work, it must target the best private equity firms. Adverse selection is an obvious problem: the firms having trouble raising capital (and the worst performing funds) are most likely to utilize this platform. That notion can immediately be quelled by signing up just one of the top 20 or 30 firms in the industry.
I think this is certainly a potentially disruptive idea, but as you identified the biggest challenge is going to be finding a platform capable of managing the administrative burdens and offering access without exorbitant fees. I recall reading that several of the large cap PE funds (KKR and Carlyle in particular) have experimented with retail funds in the past year or two, partnering with 3rd party administrators to manage funds on behalf of accredited investors. In those instances they were still offering 2%+ in admin fees on top of the PE fund’s 2+20, which is likely not as compelling when you think about the illiquid nature of the product (potentially up to 10 years) for a smaller investor. I like your idea of the one-time upfront fee, but only time will tell if a trustworthy intermediary is willing to offer a more reasonably priced platform.
I don’t think the potential for crowdsourcing LPs would be attractive to large / Midcap P/E for two reasons. Firstly, funds like to chose their LPs and typically want to say that the LP network adds value and differentiates the firm. Crowdsourcing LPs removes this benefit. Additionally, LPs are often relied upon for co-investments. In situations in which speed of calling co-investment is crucial, a fragmented LP base can prove to be a liability