By Hal S. Scott
Despite all the attention that is paid to the ups and downs of the big stock indices, private markets are where much of the action is.
Last year, companies in the US received twice as much investment — $2.9tn — from private sources than they raised in the public equity and debt markets, and academic studies have found that the average private equity and venture capital fund has significantly outperformed the S&P 500 in recent decades
That creates a potential problem for ordinary Americans who want to save for retirement, home purchases and higher education. Today, more than 98 per cent of US households are prohibited from investing in private equity and venture capital funds, and their 401(k) retirement plans cannot invest in these funds either.
Meanwhile high-net-worth individuals with more than $5m in assets, and institutional investors, including university endowments and sovereign wealth funds, are reaping the benefits of these booming private markets.
The rules are designed to protect retail investors from being burnt by risky strategies, charged unexpectedly high fees or locked into investments that they cannot sell. But studies suggest that such restrictions are misguided. A 2017 study by Voya Financial found that private equity investing reduces the risk of an investment portfolio through diversification.
US Securities and Exchange Commission chairman Jay Clayton is considering easing these restrictions. Earlier this summer, the SEC put out a report exploring ways to expand safely retail investor and retiree access to private equity and venture capital. Thecomment period on the proposal expires next month.
The Committee on Capital Markets Regulation, which I chair, believes we have the answer. The SEC should allow retail investors to invest in public closed-end funds that primarily invest in private equity or venture capital funds, so-called funds of funds. These funds and their advisers are registered with the SEC and generally listed on exchanges, which makes it easier for investors to sell their shares.
Such public closed-end funds are also subject to mandatory disclosure requirements about the private funds that they invest in and the fees charged by those funds. This addresses concerns about the transparency of private equity investing. Furthermore, the managers who run the closed-end funds are sophisticated investors who have a legal duty to select funds that are good for retail investors. Together, these protections will insure that retail investors are not left to fend for themselves.
We believe retirement savers are also missing out because they cannot invest in private markets. Defined-benefit pension plans offered by government employers are presently able to invest in private equity, but company-provided 401(k) defined contribution plans generally do not. Based on a recent Boston College analysis, we calculate that an investment in defined benefit plans would have outperformed one in the 401(k) plans that avoid private equity by 29 per cent over a 30-year period.
Allowing retail investors to invest in funds of private equity funds would solve the problem for people who save through individual retirement accounts. But there is another barrier for those who use company-provided 401(k) plans. Most of these plans avoid investing in private equity because they fear lawsuits claiming the funds are too risky or the fees are excessive. The Department of Labor, which regulates such plans, should make it much harder to bring meritless claims.
The SEC’s consultation is a good first step. It is time to give middle-class Americans the same investment opportunities as institutions and the wealthiest 2 per cent.
The writer is professor emeritus at Harvard Law School. John Gulliver executive director of the Committee on Capital Markets Regulation also contributed