Private equity’s courtship of retail investors irks pensions, endowments

Some of the world’s biggest investors in private equity are worried they could lose their special status as thousands of retail investors get invited into an asset class that had been reserved for sophisticated clients.

Institutions such as pensions and endowments are increasingly concerned their negotiating power may be sapped as private equity funds allocate more money to doctors, lawyers and other everyday customers who pay full freight. Other big-money investors are asking how much of each private equity deal they’ll have to share with funds marketed to individuals, leaving less available for themselves.

On top of that, institutional clients are fretting that their returns could wane because fund managers flush with retail money will have to invest in mediocre deals to put all the extra cash to work.

“It is very consistently one of the top, if not the first, topic that members are asking us about,” said Neal Prunier, managing director of industry affairs at the Institutional Limited Partners Association. The trade group is seeing a spike in concerns from its more than 600 institutional investors, Prunier said in an interview.

It’s not hard to see why private equity firms are turning to individuals as a source of fresh capital, with potentially trillions of dollars of new money up for grabs. They’re forming partnerships with managers like Capital Group and Vanguard Group Inc., and launching products for 401(k) retirement accounts aimed at the mass market. This comes as institutional customers have hit the limit of how much they’re allowed to invest in private assets. Others have balked amid a sluggish market for asset sales and scarce cash distributions that they can reinvest.

Sovereign wealth funds, endowments, insurance plans and pension managers are among those expressing concern about the shift behind closed doors, according to people familiar with the situation. One private equity firm hearing from investors is TPG Inc., where institutional customers are pressing the firm to clarify what percentage of its latest flagship fund’s deal value will be earmarked for its retail fund, TPG Private Equity Opportunities, known as T-POP.

Smaller stakes

The share being floated — as much as 25% for T-POP — would cut into investments that otherwise could be fully reserved for the institutions, said the people, who asked for anonymity to discuss the confidential terms. A representative for TPG declined to comment.

One top-10 US pension by assets has expanded its due diligence questions for all private equity firms to include how a proposed fund plans to raise and structure retail cash. Another in the group has started trimming the size of its investments to big PE managers.

Senior officials at some large pensions and sovereign wealth funds say they’re worried they’ll get less access to the sweet, fee-free investment opportunities known as co-investments, because managers will be tempted to place those with retail funds that pay full fees.

The “worst case scenario” for institutions is getting their co-investments cut when they’ve gotten used to it helping to lower their overall expenses from the typical 2% management fee and 20% carried interest, said Dennis Pereira, investment funds partner at Akin Gump Strauss Hauer & Feld.

Fee impact 

“It’s a greater supply of investors who may negotiate less and will probably pay higher fees,” said Anne-Marie Fink, chief investment officer of Private Markets and Funds Alpha at the State of Wisconsin Investment Board, which manages over $162 billion on behalf of more than 692,000 retirees.

“It could mean more competition to get into certain funds, less ability for us to negotiate fees and lower returns if funds chase too many deals,” Fink said. “We want to make sure retail growth doesn’t impact the things that matter to us — performance, transparency, alignment and access.” 

That’s part of the reason why, over the past five years, SWIB has shifted its investments to smaller, middle-market and lower-market PE firms, and cut future ticket sizes to the big PE funds from as much as $250 million to between $75 million and $150 million.

Fresh capital

Wealthy individuals only have a tiny fraction of their money in alternative assets — if they’re invested at all — representing a vast growth opportunity. Blackstone Inc. estimates individuals hold $80 trillion globally, and managers are racing to launch new products that cater to this growing investor base. 

These funds commonly have a perpetual, or “evergreen,” structure that is constantly taking in new cash and investing, unlike a traditional closed-end fund sold to institutions. 

Institutional investors are already beginning to see new language appear in fund documents that would make it easier for a PE fund to open retail-friendly vehicles, have more flexible caps on cash raised, and have fewer guarantees on co-investing opportunities, according to Prunier. Private equity funds can be a 15-year investment, so even if a fund doesn’t have retail clients now, it might in five years, Prunier said.

“It’s important for funds to be clear with investors at the outset on how they would manage economics,” he said. ILPA is prepping a list of questions that its members should ask prospective funds and plans to update its industry-standard due diligence template later this year to include questions related to retail money.

Indiscriminate buyers

It might not be all bad.

Should private equity be included in 401(k) plans, it means more “perpetual, indiscriminate” buyers, which could unblock the bottleneck in PE exits, said Brian Payne, chief strategist of private markets and alternatives at BCA Research Inc. Evergreen funds are going to rise, but traditional drawdown vehicles will still dominate their portfolios, said Payne, former investment officer at the Teachers’ Retirement System of the State of Illinois. 

Besides, he added, “like other alternative asset classes that have seen retail entrance, institutions will still drive fees due to scale, stickiness, power, etc.” 

Nevertheless, fees charged to retail clients can be notably more attractive for fund managers. 

Typically a private equity firm tells institutional clients it will produce an 8% return before charging fees. But some retail evergreen funds set that threshold at just 5%, according to ILPA’s Prunier. 

A management fee of roughly 1.5% customarily kicks in for institutions after clearing that 8% hurdle, but the fee is lowered once a fund stops investing and begins selling assets. By contrast, the management fee on evergreen funds can remain consistent throughout the pool’s lifetime, eating away at the promised long-term returns. On top of that, a fund may charge retail investors fees on unrealized paper gains, while fees typically have been charged on realized profit.  

Alternative asset managers are plowing ahead with plans to expand into retail, including grabbing a slice of the roughly $12 trillion sitting in 401(k) accounts. For some, the prospect is just too attractive to ignore. 

KKR historically has had a provision in its limited partner agreements that allows other KKR funds to invest in as much as 7.5% of the equity in each deal in a fund, according to a person with knowledge of the matter. Since the launch of its K-Series range of funds for wealthy individuals, it has secured agreements for newer funds to increase that allocation depending on the vehicle. 

For larger funds, it can be as much as 20% as the firm does bigger deals with more equity, the person said. KKR’s flagship PE funds’ participation as a percentage of total equity invested in deals has remained consistent with historical amounts since the K-Series launch, the person said.

“We think there’s a real opportunity here,” said Craig Larson, KKR’s head of investor relations, on the firm’s second-quarter earnings call. “That’s true for individual investors. That’s also true for firms like ours.”

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