Democratizing private markets

Evolving regulatory landscape

Regulators have traditionally imposed strict eligibility criteria—such as accredited investor standards (e.g., high-net worth, licensed, or institutional designation required) and minimum investment thresholds—to protect unsophisticated investors. However, recent signals from regulators, legislature, and even the President suggest momentum in the direction of broadened access. Regulatory signals include statements from SEC Chairman Paul Atkins, who recently signaled public support for ending a two-decade-old staff practice that forced retail closed-end funds investing 15% in private funds to sell only to accredited investors with a $25k minimum.¹ Legislature initiatives, such as the proposed Increasing Investor Opportunities Act, would prohibit the SEC and exchanges from limiting a closed-end fund’s ability, (including Business Development Companies (BDCs)), to invest “any or all” of its assets in private funds or to list and sell shares because of such investments.² Presidential support, in the form of a recent executive order from the Trump administration to increase access to private markets, demonstrates an easing of these restrictions and aims to facilitate broader retail access without compromising investor protection (EO 14330).^3,4,5

Balancing innovation and investor protection

While democratization presents significant private fund capital growth opportunities the shift toward alternative investment exposure in retail portfolios introduces complex risks, including potential liquidity mismatches, lack of valuation transparency, and exposure to higher- risk private credit and leveraged investments; risks that historical regulations have attempted to protect less-sophisticated investors from. Opening these private funds to retail investors will require enhanced regulatory guidance, expanded fund disclosure requirements, and a robust risk management, compliance, and controls framework. Identifying, managing, and mitigating these new risks are critical to ensuring that the democratization of private markets does not compromise stability in both the private and public markets or investor welfare. However, while these democratization trends may get ahead of any regulatory guidance, firms will still need to be mindful of their obligations as fiduciaries including the prioritization of their investors’ best interests.

Systemic risk factors

Recent reports, including those from the Boston Fed, have raised concerns about the interconnectedness between banks and private credit firms (i.e., “nonbanks”) and the potential for elevated systemic risks through the financing chain.^6,7 Although many democratized products incorporate features that are marketed as mitigants to these risks (such as liquidity cushions and diversification mandates), continuous oversight is necessary to mitigate vulnerabilities that may arise from a rapidly expanding private credit market, especially under conditions of economic downturn or regulatory changes. For instance, regulators may adjust diversification mandates to prevent the sale and marketing of funds with potentially higher-than-advertised correlations.

Potential credit rating woes

Credit ratings function in capital markets as a tool to inform investors concerning the risk of default associated with a particular debt instrument. Critics of private-credit ratings argue there is a conflict of interest inherent in an issuer-paid model, contending that firms can shop for a ratings provider that can provide the most favorable ratings. Such concerns may be reminiscent of the “ratings shopping” phenomenon commonly cited as partially contributory to the subprime mortgage collapse, where the drive for market share led to a systemic underpricing of risk. When conflicting interests like these arise in credit ratings, funds may tend to be rated higher than they realistically should be. If a credit rating does not accurately reflect reality, retail-facing vehicles (e.g., interval funds, tender-offer funds, BDCs) may contain a level of hidden credit risk unbeknownst to the investor. How risky an asset is directly impacts valuation calculations (e.g., Net-Asset Value [NAV], a common private market valuation metric), therefore, an unaccounted-for level of credit risk in a fund could suggest the asset’s price is inflated. Inflated asset prices and unknown investor risk exposure would generally be considered a negative and imply an unhealthy market.

Conclusion and recommendations

The democratization of private market assets represents a fundamental transformation in the alternative investment landscape. By expanding retail access, asset managers and financial institutions are attempting to tap into the vast capital available in retirement portfolios, including the nearly $9 trillion assets held in 401(k) plans,⁸ while citing diversification and higher potential returns as benefits to these new investors. Recent efforts such as regulatory reductions, executive/legislature support for increased access, and industry partnerships all indicate that investor limitations in private funds may continue to wane in the near term.