Finding a path for the democratization of private markets

As more sponsors look to attract attention from retail investors, the legal structures around widening access to the private markets are changing.

In the past two years, a number of trailblazers including KKR, Blackstone and EQT have been at the vanguard of developing semi-liquid funds to tap the mass affluent investor base in Europe.

EQT’s first strategy for individual investors, EQT Nexus, launched in May as part of its growing efforts in private wealth, and lawyers have been working hard to help clients develop structures across Europe that replicate the opportunities for broader access to private funds available in the US.

Barriers to entry for individual investors into private funds have included significant investment thresholds, long lock-up periods and complex investment terms. “An LPA that says you sign up on day one, we will draw down your money over a period of time and you’re in this for 10 years, is becoming increasingly difficult for high-net-worth individuals,” says Christopher Elson, a partner in the funds practice at Proskauer Rose. “Sponsors are having to find solutions.”

John Mahon, another partner in the funds group at Proskauer, adds: “In the US, the biggest recent development impacting retail-focused non-traded regulated funds has been an increasing focus on the regularity and predictability of liquidity for investors, particularly among individual state securities administrators.”

As a result, Mahon says that regulators at both the state and federal level are also likely to continue looking into the liquidity aspects around such products in the near future.

But regulators across the globe are increasingly cognizant of the demand from retail investors for greater access to the alternatives industry, as well as the appetite from sponsors to bring them into the fold.

Owen Lysak is a partner in the private funds team at law firm Simpson Thacher & Bartlett who advised on EQT Nexus. “In the US we see this big, registered fund market, with a well-established process and vehicles for accessing retail, by which we mean the mass affluent,” he says. “Historically, we have not had the same in Europe, but Europe has really been trying to develop that and a lot of sponsors are looking at how to take what they have done in the US and replicate it here.”

Developing such products requires a significant commitment from fund managers, with many just now looking at their options for retail.

“When sponsors are thinking about raising these products, the distribution channels are really different to their usual closed-end offerings,” says James Board, another partner in the funds team at Simpson Thacher. “The focus is about working with distributors and wealth platforms and the relationships you build with those intermediaries, rather than going out there and distributing to the underlying investors directly.

“While we have been doing a lot of these dedicated semi-liquid products, they obviously do require focus and investment by the sponsors in question, and so we also see a wider spectrum of routes being used to bring high-net-worths and mass affluent capital into alternatives strategies.”

Short and sharp

For managers who are keen on increasing their engagement with retail investors, Board says that such a process can appeal to time-short, investment-sensitive sponsors. “There are still a lot of sponsors out there going down the same route with a dedicated feeder vehicle coming into an existing closed-end fund, as has been the practice for many years now, and those sponsors accept that while this approach may raise less capital, it requires less time and investment.”

“Private wealth feeders and private wealth share classes are going to become the norm for offerings”

Diala Minott
Paul Hastings

Diala Minott, co-chair of the investment funds and private capital practice at Paul Hastings, says that the current macroeconomic environment is also playing into discussions around democratization of the private markets.

“Because market conditions are quite difficult for bringing in further capital right now, especially from institutional investors, sponsors are in a rush to tap into these new pools of capital in order to take advantage of opportunities on the investment side.

“Private wealth investors typically have small amounts of capital, but aggregators are pooling those and bringing them into feeder funds or private wealth platforms. We see a lot of fund documents being amended right now to allow either for new share classes or for platforms to bring those investors into funds.”

Minott adds that such a market is contributing to a wider change in attitude among sponsors, who she says are “being a little more open-minded about where their money is coming from. There is now appetite to pay a manager to bring those pools of high-net-worths together, carry out all the necessary checks and get them into the funds.”

Crossing borders

Lysak adds that the European industry has been gaining ground when it comes to designing semi-liquid products using technology and expertise from the US, especially over the last two years.

With a number of managers developing products using the Luxembourg Part II structure – products that “have the most flexibility in terms of housing different strategies and housing the types of terms we have seen in the US, like redemption mechanisms,” according to Lysak – there is now a blueprint that can be applied to these funds in Europe. At the same time, 2024 will see the launch of the European Union’s updated European Long-Term Investment Funds regulation, dubbed ELTIF 2.0, designed to be a framework for fund managers wishing to bring in retail investment.

“It does feel like by the end of this year we will move into the second innings for the European market, because a lot more sponsors will see what the major US houses and others have done, and we also have the launch of the new ELTIF regime from January 2024,” says Lysak. “We are really at a pivotal point moving into European democratization of private funds.”

The revamped ELTIF regime is expected to help to address some of the existing concerns of retail investors who sought a more liquid solution for their alternatives investments, alongside lower leverage caps, greater clarity over the scope of eligible assets, and a proposal for a semi-liquid option, with final rules expected later this year.

“The ELTIF regime has been around for a while but was so far viewed as fairly restrictive,” says Minott. “The regulators have listened to the market and ELTIF 2.0 should work as a real alternative to the Luxembourg Part II vehicles. Those are heavily regulated but well-established, whereas ELTIF 2.0 will be brand new but will offer sponsors the opportunity to get a passport and market to everyone in Europe, which is quite helpful. We are yet to see the final rules but we certainly see sponsors showing a lot of interest in the opportunities there.”

The defining issue

Lysak says the focus in Europe is on clarifying, and potentially changing, definitions of democratization. “There has been a lot of lobbying in the EU [to say] that what hurts the European market is that there are really only two regulatory definitions of investors, professional or retail, and most high-net-worth capital ends up falling into retail.

“There is nothing akin to the US-accredited investor definition, and so people have been pushing for reform to develop a semi-professional investor category. That hasn’t landed at all, and the proposed changes to the professional investor test are really limited and quite disappointing.”

While conversations at the top end of the market continue to focus on developments around semi-liquid structures, Minott says that, in the meantime, “private wealth feeders and private wealth share classes are going to become the norm for offerings and will maybe bridge the gap as sponsors look to raise capital and bring those new investors in.”