Under attack from all sides, defined benefit retirement plans -- old fashioned pension funds -- are on the decline. Workers have been thrown back on their own resources. Those with sufficient income are saving for retirement in defined contribution savings plans. Funds in these tax-advantaged retirement plans -- like 401(k)s and IRAs -- are growing. The importance of this shift has not been lost on the private equity industry. Describing his vision for the future of private equity at the SuperReturns conference in Berlin in late February, Carlyle co-founder David Rubinstein predicted that in private equity's third period, beginning now and running to 2025, sovereign wealth funds and 'retail investors' -- high net worth individuals -- would play increasingly important roles. And, as Private Equity International put it in its February 27 Friday Letter, David Rubenstein "think(s) deeply about the forces shaping private equity."
The reasons for private equity's newfound interest in marketing to retail investors are not hard to find. Public sector workers and their pension funds are under attack and unlikely to be an expanding source of capital for the private equity industry going forward. The industry's future growth prospects are tied, in no small part, to its ability to tap the estimated $6.6 trillion in 401(k) accounts. Moreover, attitudes of pension funds and other institutional investors in PE funds are changing -- slowly to be sure, but these investors are becoming more skeptical about how PE funds allocate fee income and fund expenses, and about reported fund returns. Fewer questions can be expected from less experienced, less sophisticated individual investors.
Of course, very few individuals are likely to be able to commit the $5 to $10 million that is the minimum investment most PE funds can handle, and even fewer can make the larger commitments the large funds require. The challenge for the private equity industry is to find a way to bundle much smaller capital commitments from individual investors so that PE funds can accept them.
Carlyle, KKR and Blackstone are at the forefront in developing new financial products that will facilitate investment in PE by individuals. Blackstone has launched a new fund, managed by an affiliate called Blackstone Total Alternatives Solution Advisors, to attract investments by wealthy individuals. These investors can put up as little as $250,000 and the fund is then able to make multi-million dollar investments in alternatives like private equity and real estate where Blackstone has a large presence. For the moment these new financial products are aimed at individuals with a net worth of $5 million or more. But if this type of retail fund raising is to expand, it will need to reach the much larger pool of people whose tax-sheltered retirement savings qualify them as accredited investors.
About 8.5 million people meet the current criteria to be an accredited investor: they have a net worth, alone or with a spouse, greater than $1 million excluding the value of their home or an annual income of $200,000 ($300,000 with a spouse) -- thresholds set in 1982 and not adjusted since for inflation. Many professionals as well as airline pilots, police and fire department officials, and others not normally thought of as wealthy have retirement savings -- especially in two-earner families -- that meet this net worth criterion.
The Securities and Exchange Commission (SEC) is charged with establishing the accredited investor definition, and is currently considering whether to revise it. The agency has a responsibility to act to prevent a situation in which financially less sophisticated individuals are tempted to respond to solicitations from PE firms and undertake risky investments with their retirement nest eggs. In 2011 the accredited investor definition was changed to exclude a person's home from the calculation of net worth so that individuals cannot bet their house on a risky investment. Now it's time for the SEC to exclude tax-advantaged retirement savings from the calculation.
At the Berlin SuperReturns conference, Rubenstein told the PE industry to expect greater oversight and greater transparency as regulators stepped in to protect the interests of individual investors. Rubinstein is right: regulators do need to step up and look out for the interests of retail investors. The first step is for the SEC to update the definition of an accredited investor and exclude savings in 401(k)'s and IRAs from the calculation of net worth so that individuals cannot bet their retirement savings on risky and illiquid investments.