In November of 2019, the Wall Street Journal reported that the Security and Exchange Commission (SEC) was considering whether to allow small-scale investors to participate in private equity deals. The news sparked furious debate in the sector, with those on either side of the issue sharply defending their perspective. The issue became even more pressing early in December, when TechCrunch reported that the SEC had proposed new definitions for “accredited investor” and “qualified institutional buyer” that would permanently expand the list of those qualified to invest in private capital markets.
As a reporter for TechCrunch described, “The SEC’s new proposal would open up the definition to also include individuals with an entry-level stockbroker’s license or other credentials issued by an accredited educational institution; ‘knowledgeable” employees of funds who might not currently meet the SEC’s wealth thresholds; family offices with at least $5 million in assets under management and their family clients; and ‘spousal equivalents’ who could pool their assets for the purposes of qualifying as accredited investors.”
This move, they write, would small-scale investors to put their money into venture funds, startups, and — of course — private equity funds. The proposal will be in a period of public comment until mid-February.
The SEC’s proposal is an enormous change that holds potentially harmful consequences for both the small investors it seeks to welcome and the investment sector as a whole.
This isn’t to say that the reason behind the SEC push for expansion isn’t understandable; quite the opposite. Private equity is achieving more than it ever has before, and it makes sense that smaller investors would want to be able to claim a sliver of that success. According to a 2019 report from Dechert LLP, private equity firms invested a record-shattering $569 billion in 3,817 buyouts globally in 2018. Fundraising levels have reached a similar all-time high, with buyout firms reporting $246 billion raised for the year as of November 2019.
Private equity deals are delivering outsized returns for current investors — and small players are eager to chip in for a share.
“It came from the boredom everyone felt with mutual funds,” Dr. Keith Wright, an Atlanta-area dermatologist, told reporters for the New York Times of his decision to pool his money with local lawyers and businesspeople in the hopes of netting a private equity win. “When we started off, all we were looking for was a home run.”
Boredom, however, is a somewhat worrying motivation for investment, given the risks it holds. Current rules limit private equity investment primarily to institutions, experienced investors, or those who either have a consistent income of over $200,000 or a net worth of $1 million (excluding their primary residence). The exclusion is a sore point for some would-be private equity participants — but the rules exist for a reason.
The restriction is, in many ways, a means of protection. If individuals or groups with minimal financial experience suddenly have access to a new investment sector, they may attempt to implement strategies without sufficient resources or understanding of the task at hand. This lack can be to the detriment of performance, too. One study conducted by the University of St. Gallen in Switzerland found that first-time firms that lack well-experienced managers and proven track records often struggle to gain the trust and resources they need to thrive.
“This is a sign of a hot market all around us,” Wilmington Trust’s head of equity, Matt Glaser, told reporters in the New York Times article mentioned above. In the piece, Glaser goes on to note that the appealing conditions of that hot market are attracting “armchair experts” to the field and express some concern that eager, but under-experienced enthusiasts may not conduct the time-consuming due diligence that productive deals require.
He has a point. Unlike investors who put resources towards public companies, those who invest in private equity cannot sell their shares and recoup losses during troubling times. For some, financial failure can be catastrophic. Moreover, some investors may not have the patience that private equity — and long-hold deals in particular — require, and leave a deal before profitability. In either case, inexperience leads to an unnecessary loss of money for the fledgling investor.
No matter how well the private equity sector is doing, opening the field to investors is a poor idea. It bears hoping that those participating in the comment period highlight the problems that doing so would create.