Scholar warns that opening private markets to ordinary individuals could leave these less sophisticated investors with all the risk and less reward.
Most people invest in one part of the investment market they can see. But a growing share of investment money now moves in another part that most people cannot observe: the so-called private side of the market. Retail investors—everyday people who invest their own savings—invest in the public side of the market, where anyone can buy and sell on stock exchanges. The private side, however, is open only to wealthier investors and institutions—and it faces less oversight from regulators.
In the private market, much of the action runs through private funds—companies that raise money from many investors and use that money to buy or lend to businesses. In a recent article, Benjamin Bates of Harvard Law School studies a group of private funds that try to bring pieces of the private market to retail investors. He warns that inviting retail investors into the private market could leave them with high fees, high risk, and less reward.
Over recent decades, many companies have stayed private and have not listed on a stock market, where retail investors can buy their shares. Bates finds that the private funds he studies do not earn higher returns than simple investments in public markets. Still, he observes that this trend toward more companies remaining private has strengthened a belief that the real investment opportunities exist in private markets, while the public market gets the proverbial leftovers.
Bates contends that this belief has pushed many retail investors to ask for access to private markets, and the Securities and Exchange Commission (SEC) has started looking for ways to let them in. Without more regulatory guardrails, however, opening the door of private markets to retail investors can be dangerous, argues Bates.
Bates warns that private funds may not be honest enough about how bumpy the ride really is. In public markets, stock prices can be volatile, meaning they can rise in one month and fall in the next—sometimes by large amounts. By contrast, Bates notes that the private funds he studies show steady gains in the performance numbers they give investors for what each share is worth.
Bates argues that this steadiness arises in part because private markets do not trade on public markets with continuously updated prices. He notes that, as a result, private fund managers must estimate what companies are worth using their own methods and judgment, producing less volatile numbers. Bates contends that these smooth numbers can make private funds look safer and more attractive than they are, and harmful consequences may follow for less-sophisticated investors.
For example, Bates argues that if retail investors were to pour large amounts of money into private funds based on flattering numbers, future returns on similar funds could end up lower than in the past. He explains that when a lot of money goes after the same kind of fund, the best deals run out and new money flows into weaker ones that pay less.
Bates also contends that retail investors may be getting the worst piece of the private market pie. He examines past performance from funds in his study and finds a fairness-gap: Funds limited to wealthier investors earn higher returns than funds sold to regular investors.
Bates explains that many private funds are “sold, not bought.” That is, retail investors do not search across the whole market but instead they choose from a menu picked by a broker or adviser. According to Bates, this setup creates a sorting problem because the strongest versions of private funds go to people with more money and better guidance, while regular investors remain in funds that charge higher fees and earn less.
Bates offers tentative solutions to protect ordinary investors seeking to play in private markets. To keep the actual risk of buying private funds transparent, Bates urges the SEC to push private funds to keep their estimates in line with prices for similar public stocks and ask them to show investors how fund values would change under different, concrete scenarios. He argues that these steps will give investors a better sense of the range of outcomes they face instead of just one smoothed-over number.
To address the fairness gap where wealthier investors get access to better funds, Bates argues that the SEC should make the menu of funds simpler and fairer—that means fewer, clearer product types, with short descriptions of what each fund owns and how it charges fees. Bates contends that menus designed this way allow retail investors to compare options without wading through brand names and technical terms, making weak products easier to spot.
Bates further argues that regulators should place limits on how private funds pay advisers who sell their products. He observes that many advisers earn more when they sell certain funds, which gives them a reason to favor those funds even when they are worse for the client. Bates suggests that the SEC limit or reshape these payments so the recommendations given by financial advisors line up better with investors’ interests.
In Bates’s view, if the push to open private funds to ordinary investors is going to continue, regulators must make sure that these investors will be able to understand the real risks, and not just act on a sales pitch. He concludes that “democratizing” private markets should not result in ordinary people getting the weakest deals.
