Democratisation of Private Assets: Source of Fund Industry growth, or a poisoned chalice?
Article by Rikard Lundgren, STEENDIER

After a long, more or less uninterrupted, period of growth of the fund industry in Luxembourg, this reversed during Covid. Additional challenges have emerged to threaten Luxembourg’s supremacy as a preferred fund centre. It is now quicker and cheaper to set up a RAIF in Paris. Opening a bank account is easier almost anywhere outside of Luxembourg. Service providers’ enthusiastic embrace of new regulations as sources of additional revenue has made legal and other costs increase and fund sponsors look for alternative locations. It is easier and quicker to set up an EU-licensed AIFM in different countries and it can be run more cheaply and with less of Luxembourg's endemic problems with high staff turnover and re-organizations on the back of consolidation-driven mergers and acquisitions. The fast growth of the ETF industry did not go to Luxembourg. Luxembourg feels the FOMO!

Along comes this new and very promising concept. Making institutional investor-dominated private assets available to the same small retail investors that gave Luxembourg its first and still biggest growth spurt, the UCITS, which was designed for retail investors and a huge success story for the Luxembourg fund services providers. Heureka! PE, RE, Credit, Infrastructure, VC, re-packaged to meet UCITS type of investors! How difficult can it be to just connect the two? Ha! We have a new winner! All service providers, please rev up your engines! The number of new ambitious initiatives, along the entire value chain, is over 50 and growing. 

So what’s the problem? There are risks. Other risks than for UCITS. Some of these risks can backfire and potentially destroy not just an individual company, if not handled properly, they could kill the entire phenomenon and make it an expensive parenthesis in the development of the fund industry. A dead end.

Here is why. It has taken institutional investors, with huge intellectual and economic resources, over 80 years, including an initial 40 years with not much growth, and three boom-bust cycles to become a now mostly well-functioning and balanced asset in many institutional investors’ portfolios. 

Will the typical Luxembourg smaller, less well-informed investor, the target for the new private assets’ vehicles, have the patience to go through that same learning process as institutional investors have? Or will the collective of Luxembourg service providers assume some of the responsibility to, through well-designed governance and expertise, ensure that the best interests of small and uninformed investors get the benefit of the PE/VC industry’s accumulated institutional expertise? 

It is the purpose of this article to initiate a better understanding of some of the inherent and idiosyncratic risks that are inherent in putting high-octane, illiquid private asset investments into the hands and portfolios of uninformed private and small investors portfolios. Can Luxembourg make sure that the risks that come with signing up to own private assets for up to 10 years or more are handled by these investors with much of the same acumen as institutional investors have learned the hard way?  

The focus of this article is to take a look at a couple of the underlying targeted assets, Private Equity Buy-Out funds and Venture Capital funds by examining where the industry’s current academic understanding of these is. I have interviewed one of the world’s leading academics in this field, Per Strömberg, Centennial Professor of Finance and Private Equity at the Stockholm School of Economics, Adjunct Professor of Finance at the University of Chicago Booth School of Business, a member and chair 2016-2018 of the prize committee of the Sveriges Riksbank Economics Prize in the Memory of Alfred Nobel, He is the recipient of numerous academic awards and has a large number of academic publications to his name. 

RL: Please tell me what has changed in the past 20 years since we first met at the seminar in Stockholm when the PE-paper written by Professor Steven Kaplan was presented.

PS: The broad findings then, that only the top 20% of PE funds would beat listed equities has since become more granular. Partly through better and longer data series, and partly by the more sophisticated analytical tools that have been developed. We can now say, for example, that there are big differences between how easy or difficult it is to pick good General Partners and what the downside consequences may be from bad picks, between the Buy-Out firms and the more early-stage or VC firms. 

RL: Please can you elaborate some?   

PS: Without going into all the statistical models that have been developed, which I would be happy to do but it would take a few days….or more, I can say that we now have a better understanding of where the outperformance of Buy-out PE and VC lies in comparison with listed equities of equivalent risk, ie small-cap in comparison with early-stage or VC and or a large-cap index vs the PE buy-out GPs and so on.
Where the large Buy-out funds have become commoditised and continue to make decent outperformance over listed equities so there is a less potential value added by trying to be highly selective, at least as long as the investor has some diversification by including several investments in perhaps mainly larger PE Buy-out firms. The differentiation between GPs and thus the sensitivity to picking the right GP is however much greater in VC. 

RL: Are the returns vs. listed equity also more extreme in VC? Ie are the good GPs outperforming listed equity by significantly more and the less good ones underperforming more?

PS: Yes, that is correct. The investors are playing a higher-stakes and higher potential rewards and losses game if they get involved in VC than if they create a portfolio of large Buy-out PE firms.

RL: It used to be the case that VC firms were generally more sensitive to the economic cycle. Is this still true?

PS: Yes, research shows that there are several cyclical factors, such as, of course, the overall economic cycle, but also M&A activity, IPO opportunities, and the fundraising activities of PE/VC funds. All these have an influence on the performance of a PE fund investment. For example, funds raised in the year with less capital raising generally does better. But this typically happens after a period of poor returns. Whatever an investor has the courage to invest at that time is another question. It may be easier for an institutional experienced investor to make that bet than for a retail investor advisor. 

RL: As the old saying goes; you can make money by being contrarian and putting actual money where your mouth is.

PS: Yes there is some evidence to support that. But it is important to point out that there are many other factors that can be even more important than the ones mentioned, such as changes in the regulatory or geo-political environment, especially for the early-stage or VC-oriented investment strategies. So, one should avoid believing that to be contrarian to the fundraising cycle is a simple way to make money. 

RL: When we both hosted Josh Lerner of Harvard in Stockholm to talk about which investors had developed the skills of picking PE/VC funds well, some findings were sticking out. Late entrants, Fund of Funds and Bank or other intermediaries were then the worst at finding good PE/VC investments. Is this still the case? I guess I am getting at a question if small and new less well-informed investors have any chance to pick good investments in PE/VC. Where is the current understanding of who the successful investors are? Do small investors stand a chance to get good returns by picking PE and VC investments?

PS: Research suggests that bigger is better. The larger LPs, the institutional investors like large Pension funds, Insurance companies etc, are getting the best returns over several cycles. They have more bargaining power to reduce costs and will be invited into the funds that can be selective about who they let in as investors. What was back then seen as a truth, that Fund of Funds would not do so well, has since been somewhat refuted. Especially in VC, where the additional cost of double fee layers seems to have been mitigated by some of them using more active management of LP participations. In Buy-Out, this added value potential is less pronounced.

RL: Let’s go to the “Core of the poodle” as Dr Faustus expressed it; What do you see as the risks and positives when a new group of investors is given access to PE, be it Buy-Out or VC? Both for the investors and for the GPs?

PS: The industry doesn’t need more capital. There is plenty to go around already so much that it gives GPs problems with deploying the available capital from institutional investors. The thought that new small investors going through complex and expensive intermediaries will automatically get the historical returns of institutional investors is, in my view, flawed. More money with higher costs attached and less experience comes with the risk of lesser returns than what historically has been the case for institutional investors.  

RL: Would what you know about the PE industry support that for new less well-informed investors, focusing on finding intermediaries with lower cost, in combination with a conservative approach to which part of the PE universe to invest in, through maybe a Fund of Funds of traditional Buy-Out funds and avoid trying to find individual good high-octane VCs would be a reasonable approach?  

PS: It is hard to say. The experience of many years of institutional investors shows they still are not isolated from making mistakes, even when applying all the research available. 

RL: What other risks do you see with making PE and VC available to smaller, less experienced investors?

PS: There have been some scandals where eg large mutual funds have tried to attract a great number of smaller investors while making investments that are less liquid. The risk of over-selling such less liquid funds which may contain illiquid assets needs to be considered to avoid over-selling PE/VC funds. Private assets are private for a reason. It’s called an illiquidity premium, which eg pension funds with a very long investment horizon and predictable capital flows can benefit from. How many private individuals can afford to have their type of investment horizon? 

RL: On the topic of liquidity, how well is the market for pieces of LP participants working these days?

PS: For the more mature Buy-Out funds it is pretty good. For early-stage VC and more niche strategies, it is less available.

These words of warnings from the academic world should not be ignored by any link in the chain of intermediaries and service providers that facilitate small and less experienced investors' access to private assets. It would be foolish and indeed dangerous to act as a non-discriminating free-for-all Tinder for yield-hungry investors. The new investors need a lot of education, not hard selling. They need to be gently nudged away from investments that are clearly unsuitable to them. To tread the fine line of finding growth for a new or existing business in this area while treating the information advantage of the industry over the new investors/clients will be a big challenge for those in governance positions in all parts of the value chain. All agree that this could become the next UCITS for Luxembourg…but then the risks need to be handled properly.

Rikard Lundgren

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Article by ILA Legal & Regulatory Committee