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How advisers can benefit as the cost of private-equity investing is driven down

Those who understand this emerging shift early will be well-positioned to help their clients grow their portfolios

Aug 14, 2015 @ 12:34 pm

By Rory Eakin

Investing history is about to repeat itself. Just as the cost of stock trading plunged in recent years – to zero, in some cases – increased liquidity and transparency will drive down the costs of private equity investing in coming years. This transformation has already begun.

Investment advisers who understand this emerging shift early will be well-positioned to help their clients grow their portfolios.

This change in private equity investing mirrors a similar trend in public equities during the past quarter century.

In the early 1970s, an investor buying shares of General Motors on the New York Stock Exchange paid on average nearly 1% of the purchase price as a commission.

Following deregulation, brokerage commissions began to decline rapidly, dropping by half every seven to eight years, as documented in a research paper by Columbia Business School's Charles M. Jones, “A Century of Stock Market Liquidity and Trading Costs.” From the peak of nearly 1% of the purchase price in the mid-'70s, NYSE commissions plunged to 0.1% of the purchase price by 2000.

Today's equity investors, who enjoy near-zero commissions, or even free trading from companies such as Robinhood Financial, can hardly relate to the rich fee structure of the past.

Meanwhile, passive investors in recent years have benefited from a similar trend. Expense ratios for equity mutual funds fell by 25% between 2000 and 2013, according to data from the Investment Company Institute. This more modest decline, from 99 basis points to 74 basis points, understates the full decline in the effective expense ratios for the industry, however.

At the same time as mutual funds were lowering expenses, low-cost index funds increased their assets under management fourfold in less than 15 years. Because the expense ratios for index funds dropped from 27 basis points to just 12 basis points during that period, the effective fee reduction for mutual fund investors was closer to 32%.

Of course, one person's fee is another's income. The steady drop in fees that investors have welcomed has been a financial drain for most public-market asset managers. Many firms are exploring new strategies to remain competitive and relevant to today's investors, especially as low-cost, technology-driven automated investment service entrants such as Wealthfront and Personal Capital begin to gain scale.

The same efficiency and transparency that fueled fee reductions in public-market investing are just now touching private-equity investing, where the fee structure has remained largely unchanged for decades. Venture-capital firms continue to earn revenue from management fees – typically 2% per year – plus the carry, a percentage (typically 20%) of the fund's profit paid as an incentive to fund managers.

In general, VC investors are paying the same two-and-20 fees to general partners that their parents were paying 25 years ago.

But this pricing structure is now under attack from the emergence of online marketplaces for private-equity investing. These marketplaces, which operate as broker-dealers registered with the Financial Industry Regulatory Authority Inc., are attracting investors and fast-growing young companies seeking capital. By creating large online communities of accredited investors and curating abundant data and information about listed companies, these platforms are becoming the most efficient networks for connecting private companies and investors.

While some investment advisers have offered private-equity investments to clients in the past through a fund-of-funds approach, the emergence of online platforms is making private equity easily accessible to more accredited investors and creating a much greater potential for direct investing. Over the next decade, having a direct private-equity allocation will become the norm, as the costs to investors and their advisers goes down.

Investment advisers need to stay in front of these long-term trends. Just as advisers were forced to get smart about the advantages of ETFs versus mutual funds over the last 10 years, now the best advisers are schooling themselves on ways to get their clients into lower-cost, diversified private investments.

Just as today's stock market investors would not tolerate a 1% fee to buy or sell shares of Google, so the steep fees involved in private-equity investing will surely tumble with the arrival of new and more efficient investing platforms.

Rory Eakin is the founder and COO of CircleUp, an equity-based crowdfunding specialist that focuses on angel investments in consumer-products companies.

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