Private equity opens door to retail investors

Whether by reaching out to affluent individuals through private wealth managers or to rank-and-file retail investors through mutual funds or 401(k)s, buyout firms remain enthusiastic about the potential as they look to grow beyond their core sources of capital from public and private pension funds, sovereign wealth funds and other institutional investors.

Apollo Global Management, Blackstone Group, Carlyle Group and Kohlberg Kravis Roberts & Co all mentioned initiatives aimed at tapping into individual wealth during their fourth-quarter conferences in recent weeks. For example, Apollo is working on plan to give retail investors access to its high-yield debt instruments, while Blackstone has raised about half a billion dollars for a new fund aimed at wealthy individuals.

These efforts aren’t terribly surprising, given the size of the retail opportunity. The U.S. mutual fund industry held $15 trillion in assets under management from U.S. investors and $30 trillion worldwide in 2013, according to figures from the International Investment Funds Association. Little or none of that is in private equity funds. By contrast, the roughly 663 U.S. buyout firms held about $1.6 trillion in assets under management across funds in 2014, according to data from Thomson Reuters and Buyouts. Even if private equity wins a tiny portion of the trillions in mutual funds, it could provide a wide avenue of growth for the industry.

Gary Pinkus, director in McKinsey & Co’s San Francisco office and leader of the firm’s global private equity practice, said reaching out to individuals is a hot topic for private equity managers.

“There’s a big pool of capital that needs to get higher returns, and the industry would like to meet that need,” Pinkus said. “Retail investors are interested. If you were to retire with a million dollars now – in the current low-interest rate environment – you could end up just above the poverty line in steady income. Something has to change. The assumption is that individuals will seek alpha.”

Going public to reach retail investors

Private equity firms have been quite candid about their desire to attract individual investors. Blackstone Group’s 2007 initial public offering raised $4 billion as the first of the big four big buyout shops to go public in the United States. The stocks were touted as a way for ordinary investors to tap into distributions earned from the 20 percent share of carried interest earned by private equity fund managers.

To some extent individuals have answered the call. Fidelity Investments and Janus Capital, giant mutual fund specialists catering to individual investors, are the two largest public unit holders in Blackstone, which boasts a market cap of $21 billion.

But individuals remain mostly locked out of the 80 percent share of the carried interest LPs earn in private equity funds. While private equity firms as a group raised about $200 billion in capital last year (not including infrastructure, real estate and natural resources funds), the share of fresh capital from individual investors remains miniscule.

Meanwhile, private equity funds continue to outperform public equities over time. Over the past 10 years, private equity funds, excluding venture capital, outperformed public market returns by 6.5 percent as of June 30, according to the Private Equity Growth Capital Council (PEGCC). Top-quartile managers offer even higher returns.

“Our research shows that private equity has consistently outpaced the S&P 500 over a 10-year horizon, providing public pensions and other investors with superior returns at lower volatility,” PEGCC spokesman James Maloney said. “We recognize that there is a discussion occurring about the potential for offering greater access to the asset class. Many of our member firms have expressed interest in exploring the issue further and that dialogue is currently under way.”

To be sure, a teacher or firefighter may hold indirect exposure through an allocation to private equity by his or her public pension fund. But these types of defined benefit vehicles are slowly giving way to defined contribution plans such as 401(k)s, which invest only in stocks, bonds and money market accounts.

Apollo pitches credit to individuals

In Apollo’s quarterly call with Wall Street analysts, CEO Leon Black said individuals want a piece of the action. He noted that the firm’s credit offerings, such as high yield bond investments, could be a good fit for individuals who are seeking better returns than bond funds.

Said Black: “The retail investor is getting wise about this and saying, ‘Why is it that endowments should be allocated kind of 30 percent to alternatives? Why is it that sovereign wealth funds and state pension funds should be allocated 10 percent to 15 percent to alternatives, and why am I only allocated 1 percent? And how do I get a part of this?’ And so you’re going to see this being a leg of growth in credit across multiple channels.”

Later this year, shareholders in the $6.5 billion Oppenheimer Global Strategic Income Fund, a publicly traded mutual fund, will vote on whether to allow Apollo to become a sub-sub advisor to provide retail investor exposure to Apollo’s high-yield debt investments. Apollo said it could offer Oppenheimer fund investors returns of roughly 6 percent to 10 percent, but it hasn’t disclosed specifics.

In addition, Apollo is working on other avenues to tap into the retail investor channel, with more announcements coming, the firm said.

The feeder-fund strategy

Some private equity firms access investments from wealthy individuals through feeder funds run by asset managers such as Goldman Sachs or Morgan Stanley. Under securities laws, private equity funds are allowed to draw capital only from accredited investors with a net worth of more than $1 million outside their primary residences or those with earnings of more than $200,000 a year.

High-net worth investors with enough money can also invest directly into private equity funds on their own as long as they can meet the minimum investment threshold, which can be as high as $10 million.

With a geometric rise in wealthy individuals worldwide, both feeder funds and direct investments from affluent individuals remain on the table for private equity firms.

Blackstone, which raised $57 billion last year, said about $10 billion of that amount came from high-net worth channels, up from zero a few years ago, Merrill Lynch now ranks as Blackstone’s 11^th largest client, by collating client assets, the firm said.

“We’re just getting started with that and we are now becoming the biggest distributor by a wide, wide margin in those systems,” Blackstone CFO Laurence Tosi said at the Credit Suisse Group Financial Services Forum on Feb. 10. “It’s one of these really neat areas that we’re just getting started.”

Blackstone recently launched a new retail offering called BX Total Alternative Solutions (BTAS), which has raised about $500 million out of a target of less than $1 billion. Open to accredited investors and marketed through two ultra high-net worth distributions systems, BTAS includes a special investment committee to help channel investments into different funds and sectors, the firm said on Jan. 29.

Meanwhile, KKR has been extending its reach to individuals, according to Scott Nuttall, the firm’s global head of capital and asset management. Over the last two years, about 19 percent of the money KKR has raised came from individuals via direct investments from high-net worth clients and through wealth management platforms.

“We continue to see that opportunity … grow,” Nuttall said recently. “If you look where we raise money, it has become increasingly global, and it’s moved from just institutions to institutions and individuals.”

To be sure, feeder funds add an extra layer of fees to private equity since they’re collected through an intermediary, but the industry may come up with ways to reduce the cost of these vehicles over time, industry observers said.

401(k)s mostly out of reach

In decades past, public and private employers set up traditional pension plans, also known as defined benefit plans, for their employees. That system has steadily been switching over to defined contribution plans such as 401(k)s.

In total, 401(k) plans held about $4.4 trillion in assets, or about 18 percent of the $24 trillion in U.S. retirement assets, as of June 30, according to the Investment Company Institute.

For the most part, private equity funds remain out of reach for these vehicles, outside of buying shares in publicly listed units in Apollo, Blackstone, KKR, Carlyle Group or others. Allowing individuals to allocate part of their 401(k) savings into alternatives may seem like a no-brainer, but obstacles loom.

Outside of qualified investors, individuals aren’t allowed to invest in private equity funds under current securities laws. Private equity funds remain a mostly illiquid asset because they hold money for long periods of time, usually 10 or more years.

Compared to mutual funds, private equity funds also charge much higher fees, including 20 percent of the carried interest. These costs could brush against traditional practices for 401(k)s in the industry.

Overall, the regulatory environment around 401(k)s and other retirement plans could turn more hostile depending on political winds in Washington. There is also the risk of underperforming or busted investments spurring consumer lawsuits.

“In a post Dodd-Frank world of consumer protection, you have to be careful about wading into something like this,” McKinsey’s Pinkus said. “The industry needs more clarity… It needs to be comfortable that the regulatory landscape (is relatively safe).”

Blackstone CEO Stephen Schwarzman said on a recent earnings call that moves by individuals into alternatives remain constrained by regulations created in the 1930s, when alternatives didn’t exist.

“Somebody ought to change these antiquated laws and provide access to products of our full slate,” Schwarzman said. “How are people going to retire? It’s not on Social Security. That’s not enough money for most Americans. And we are one of the major answers for that.”

He predicted the dollar numbers for individuals in private equity could be “very, very large” over time “as people have better and better experiences with these products.”

David Rubenstein, co-CEO of Carlyle Group, is an advocate of putting a portion of retirement savings of working Americans into alternatives. But he said it will take time.

“As defined contribution plans become more significant in corporate America and other parts of our financial universe, I do think you are going to see allocations from them to alternative investments,” Rubenstein said recently. “All of the legal issues haven’t been resolved … but, inevitably, there will be a desire by people who have IRAs, 401(k)s and other kind of vehicles to participate… It’s probably a generational thing before you see a big impact on numbers for firms like ours.”