In a potential test of the law of unintended consequences, the Securities and Exchange Commission has released a rule proposal that would make it far easier for private equity, venture capital and private capital fund managers to attract — and tap into — the savings of retail investors.
As written, the proposal would give average investors far greater ability to place their savings directly with a private fund manager, while paying performance fees that have until now been paid by more sophisticated investors.
For decades, those funds, strategies and best-performing managers — and the above-market returns many have produced — have largely been closed to average investors. Federal regulators reasoned that they wouldn’t understand or be able to stomach the risks, arcane strategies and fee structures involved.
This proposal appears to retire that concern and embrace the goal of giving everyone access to the kinds of strategies that have proven so fruitful for only the wealthiest individuals and major institutions. Fair enough.
But there are good reasons that private funds have been largely off-limits to ordinary investors — and those reasons still exist.
Investments in private equity, private credit, venture capital and similar strategies involve significantly more risk than ordinary investments. For one thing, you must be prepared to park your money for many years at a time. This would be a new experience for most retail investors — and in a market downturn, a particularly unpleasant one.
Then there are the fees and “backdoor costs” (for administration, legal, information technology, etc.) associated with private funds. Their managers usually require a standard 2-and-20 fee — they pay themselves 2% of fund assets each year and take 20% of gains. Are they worth it? Academic studies show they often aren’t. Some justify their fees and bonuses with impressive performance. But in many cases, the fees water down those gains substantially.
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But the bigger risk is that there are so many ways a private fund manager can take liberties without clients knowing it. Consider the SEC proposal’s permission for private fund managers to create, without any prior regulatory approval, multiple share classes in a closed-end fund.
This is a potential source of significant abuse. One could easily imagine a fund creating two classes — one with high fees for retail investors who come in by way of high-load, high-fee brokers, and one with low fees for deep-pocketed pension funds, university endowments and ultra-wealthy individuals.
There are already massive and unchecked conflicts of interest when it comes to how fund managers value assets to calculate their performance fees. Why wouldn’t there be conflicts in funds suddenly awash in cash from retail investors?
And those conflicts could be tough to discover. A private fund manager could easily mask poor relative performance by citing the higher cash-on-hand requirements of running a public-access fund. In private funds, everything depends on the say-so of managers, for better or for worse.
Which raises the issue of external oversight. Institutional investors have teams of professionals poking around the books of private funds to monitor assets and discover if they’re getting the short end of valuations, strategies, management fees and distribution requirements. Retail investors don’t have that kind of muscle. They’re not expected to.
The SEC’s proposal doesn’t seem to address this mismatch in any meaningful way. Private fund managers wouldn’t be required to change or even standardize anything on fees, liquidity, transparency, governance or valuations.
The SEC proposal is, in effect, pretending that the guy sitting in the bleachers who played varsity baseball in high school should be on the field in the World Series. The players are bigger. The game moves faster.
It’s a dangerous situation, and people would get hurt. The question isn’t whether the SEC’s intentions here are noble or even productive. It is whether it would impose any discipline or reforms on private fund managers in return for what is certain to be a cash bonanza.
Requiring such checks would be a better approach, and a more defensible one.
The funds would even have some self-interest to want tighter oversight: They need to consider the impact of a few bad actors on their entire industry. The brilliant fund manager one month can look like a head-in-the-clouds fool or a charlatan the next. Just ask the investors in Situational Awareness, the $20 billion hedge fund that collapsed over the summer.
Surely sponsors of private funds recognize the risks here. They wouldn’t be able to explain away losses, poor performance or even outsized fees by saying, “Our investors knew what they were getting into.” That works with institutions savvy to risk, but not with mom-and-pop investors who came into a fund because of a brochure.
Everyone involved in this proposal — regulators alongside private funds — needs to focus on making investing more liquid, less costly and more transparent. Private funds are moving in the other direction. They are holding onto assets longer, extending lockup requirements and trying their best to ride out interest-rate increases that are squeezing their balance sheets. Some are launching “perpetual funds” with no fixed wind-down date — a nice way to create a steady flow of management fees regardless of the timing of asset sales. One could be forgiven for thinking that private funds want to open their doors to retail investors because they need the money — and they need it soon.
If the SEC is eager to grant private funds this access, it should require that valuations of the funds’ assets for compensation purposes be conducted by third parties. Or that any fund prospectus illustrate in clear language and with graphs the effect of fees and capital gains-based compensation on investor returns over time. A well-run fund would have no problem meeting these expectations.
What the SEC should not do is get rid of the guardrails. Remember, getting more investors into the market always looks good when everyone is chasing gains on the way up. But when things turn the other way, everyone wonders how regulators could be so irresponsible in letting relative novices take such great risks.
It’s a recipe for the kind of regulatory snapback and overly burdensome new restrictions that private fund managers in particular won’t want. And given the fees they collect, it would be more expensive than they can imagine.
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