Five Pillars of Innovation Enabling Retail Access to Private Markets

Introduction: Retail access to private markets has become inevitable due to the recent alignment of three macro trends. First, individual investors hold about ? of global wealth, but have historically allocated less than 5% of their portfolio to private markets. Second, over-allocation to private markets from Institutional LPs has led an increasing number of asset managers and private market issuers to look to individual investors (retail) as the final frontier for capital. Third, public markets have become over indexed and concentrated in a few big stocks, with fewer IPOs, incentivizing individual investors to seek private market allocation, to access better risk adjusted returns and diversify portfolio concentration. Against the backdrop of the largest generational wealth transfer in history, with over $70T of wealth passing from Boomers to Gen-Z and Millennials, the private markets are quickly adapting to accommodate a new wave of retail capital. However, despite growing to over $13T in assets today, private markets lack the infrastructure to support millions of individual investors, and the specific demands that they have when investing. We have identified five core infrastructure problems that will be solved by financial market intermediaries (FMIs), to effectively facilitate an efficient flow of retail capital into private markets. For each infrastructure problem, we have identified a potential solution by comparing existing private market infrastructure to equivalent processes in the public equity markets, and provided a rationale for what forces (market, regulatory or incentive based) will bring about the development of these new solutions.?

Problem One: Investment Products Accessible to Individual Investors. The structure of investment products used to raise private capital have generally been in-accessible to individual investors due to both high minimum check sizes and a complex capital call structure. For example, the private 3c1 fund exemption allows investment funds to avoid the expensive registration and reporting requirements of a 40’Act investment company, so long as the fund has less than 100 beneficial owners qualifying as accredited investors. Given the 100-investor limitation, minimum check sizes are generally at least $25,000 per fund interest, if not significantly higher. In the same vein, private draw-down funds (typical in the private equity and venture industries) raise committed capital from LPs that may not be called (and invested) for years, forcing LPs to manage portfolios to account for capital calls, an exercise not conducive to retail investing behavior. Not only have product structures used by GPs and issuers been complex, but there is also no industry standardized methodology for structuring private investment products. For example, the offering circular of one offering may look entirely different from the offering circular of another, making the issuance of those offerings at scale difficult to automate with technology. Without proper incentives, issuers are unlikely to structure products more accessible to retail investors. The three main incentives that will force change over time are regulatory changes, low-cost access to capital through scalable technology platforms that automate the lifecycle of an investment product, and the development of product standards enforced by an industry consortium.?

Public Market Comparison: For comparison, in public markets all three incentives force a level of standardization amongst investment product issuers. For example, the IPO process is both a regulated affair, with the filing of a S1 with the SEC (GAAP Financials, Ks and Qs, etc…), and also a process that has become fairly standardized by an industry consortium of investment banks, exchanges and distributors. Companies are generally incentivized to IPO because it allows them access to low-cost capital through the public markets, and publicly traded securities allow shareholders liquidity. The combination of regulation, industry self-standardization and efficient access to capital for companies (issuers), has created a public market apparatus that is both scalable, efficient and accessible to individual investors.?

Private Market Solutions: There are a few different solutions to incentivize issuers to structure investment products more accessible for individual investors. The most immediate term solution is to lower the operational cost for issuers to structure accessible investment products. For example, platforms like Sydecar have lowered the cost of issuing and managing private SPVs to $12,500 per fund, allowing issuers to dramatically reduce the minimum check size needed to break even. Sydecar achieves this low-cost solution by standardizing the fund documents and automating the management of the SPV. As one of the lowest cost solutions on the market, Sydecar is enabling issuers to make their investment products more accessible to individual investors. Another solution is for distribution platforms to help issuer's structure products that are accessible at lower minimums to investors. For example, many of the Wealth Channel intermediaries that work with iCapital have relied on iCapital to automate the distribution process for 40’act registered funds, that provide access to underlying asset managers at lower minimums. These evergreen fund structures have advantages for issuers as well and remove the burden of a traditional capital call vehicle from LPs. The rise of evergreen product structures within the Wealth Channel are proof that with proper distribution (access to capital) issuers will adapt their investment product structures and deployment strategies in order to reach new investors. Third, regulatory changes, like expanding the accredited investor definition, can lead to greater access for individual investors to private funds and Reg D offerings. The US House of Representatives passed a bill recently that would dramatically expand the definition of accredited investor to enable millions of more Americans to access private markets. Trade-able closed end funds are likely the next step in product evolution for issuers to access retail investors at scale, while providing an exit opportunity through the secondary market. A healthy mix of economic incentives, opportunities to access new sources of capital and regulatory changes will help incentivize private market issuers to utilize new product structures.??

Problem Two: Scalable Distribution to Retail. A major barrier barring issuers from tapping into the retail investor channel is a lack of efficient and scalable distribution networks. In private markets today, many direct-to-consumer technology platforms have attempted to solve retail distribution by operating platforms with the theme of “Robinhood for Real Estate,” or “Robinhood for Venture,” however, the past attempts to on-board investors to new platforms have been largely unsuccessful at attracting a mass adoption of individual investors into private markets. The primary reason has been high customer acquisition costs and a general lack of investor education or engagement regarding private investments. Despite these challenges, over $30B of individual investor capital has flowed into private markets through direct-to-consumer platforms. However, that volume and the available fees platforms have been able to collect, have been insufficient at returning the hundreds of millions of marketing dollars allocated by venture investors to these platforms. Platforms have begun to recognize that in order to achieve distribution at scale, they need to tap into established distribution channels like the Wealth Channel through RIAs and Wirehouses, or the Brokerage channel through partnerships with clearing firms.?

Public Market Comparison: Retail access to public markets actually started through mutual funds, enabling investors to access pooled investments of a diversified set of underlying companies, at lower minimums. Eventually, individual investors were able to access individual securities, and eventually fractional securities through digital brokerages and advisory platforms. The advent of technology to improve the investment experience, and even make investing enjoyable (gamified) has brought millions of retail investors into public markets. Platforms like Robinhood, E*Trade and Betterment have fueled the revolution in accessibility and efficiency, often powered by technology forward clearing platforms like Apex. By creating a network of brokerages and advisors, public markets have created an efficient access point for issuers to raise capital in both the primary market and through secondary offerings. When a company IPOs to a public exchange like NASDAQ or NYSE, they are raising new capital for their business, often at a premium to their private market valuation, given the new liquidity in their underlying stock. While going public is not an easy or cheap endeavor, it does provide a clear avenue for companies to raise capital and continue to raise capital through secondary offerings of securities on public exchanges.?

Private Market Solutions: While most of the direct-to-consumer alternative investment platforms have not been successful in creating a scalable solution for retail access to private markets, they have proven that there is sizable demand from retail investors to access private markets. The demand shown by early adopters has influenced the more traditional brokerage platforms, (Schwab, SoFi etc…) who already have millions of on-boarded investors, to begin launching their own private market investing solutions. Many RIAs in the Wealth Channel have been way ahead of the brokerages, providing clients access to a wide variety of private investments from top-tier asset managers. Intermediary marketplace platforms like iCapital and CAIS have played a large role in aggregating the point of access for wealth managers to allocate to private markets. The more technology forward brokerage channel is still waiting for a scalable solution to do the same for millions of self-directed investors with trillions of investable assets. By leveraging existing distribution networks, private market issuers will be able to access individual investors at scale while saving billions in customer acquisition cost.??

Problem Three: Secondary Trading. One of the largest barriers to entry for retail investors in private markets is the historical lack of liquidity. Private market investments have generally locked up LP capital for 5 to 12 years or longer. While Institutional LPs can manage overall portfolio allocation to account for illiquidity, individual investors have much higher demands for liquidity across their entire portfolio. Liquidity in private markets can be generated in two ways, either through product level redemptions, or through a peer-to-peer trading network, like an exchange. While some 40’act products like interval funds, have provided individual investors with quarterly or monthly redemption windows, recent examples from funds like B-Reit or Starwood RE Trust have shown that retail investors often have much higher demands for liquidity than can be satisfied by fund level redemptions. In order to facilitate scalable retail access to private markets, a centralized trading system must exist to provide investors with liquidity options when they need it. Past attempts at secondary trading venues for private securities have had difficulty scaling, often due to a direct-to-consumer customer acquisition strategy, or siloed “closed loop” platforms that are not accessible via traditional financial institutions or distribution platforms. Liquidity begets liquidity, and as such, achieving scale is important for a secondary trading venue to remain viable. With secondary liquidity, it is likely that more retail investors will feel comfortable allocating to private investments in the primary markets, knowing that a viable liquidity option exists. In addition, secondary liquidity provides a market price for private securities, which enables investors to access more transparent data and makes it easier for custodians to custody private securities.?

Public Market Comparison: In public markets, the system of central exchanges, market makers, low-commission trading and deep liquidity pools has made the US public equity markets the most attractive markets in the world for both issuers and investors. Through central exchanges, issuers can access a broad network of distributors to raise primary capital through IPOs and secondary sales, attracting high quality issuers to the public markets. On the flip side, individual investors can invest in US public equities with the comfort that there will be a bid for their trade at virtually any time that markets are open. As market orders are generally only routed to a few major exchanges, those exchanges can offer deep order books in many securities.?

Private Market Solution: A centralized alternative trading system can provide private markets with a scalable peer-to-peer trading venue with pooled liquidity. However, it is paramount that this ATS operates on the backend of existing distribution platforms like brokerages or RIAs and does not compete on customer acquisition. As a non-competitive execution venue, a private ATS will be able to build scale rapidly through b2b partnerships. By connecting liquidity across many distribution networks, a private ATS can create a deep order book for listed products that attracts more distribution venues to the network; liquidity begets liquidity. The network of distribution created by the ATS will eventually reach the scale where issuers can conduct high volume primary offerings through the ATS network at a lower cost than any other distribution method, enabling retail investors with first access to high quality primary offerings.?

Problem Four: Centralized Custody, Money Movement & Reconciliation. One of the most complex problems in any financial system is the backend processes of securities custody, money movement and ledger reconciliation. Within private markets, the biggest problem comes from the lack of DTCC eligibility for most private securities. DTCC (Depository Trust and Clearing Corporation) operates as the central clearing house and securities depository for US Public markets. However, DTCC does not provide services for most privately issued securities, creating an infrastructure gap and a logistical challenge for issuers, distributors, trading systems and custodians. In private markets today, a wide variety of fragmented systems work to move cash between entities, maintain securities records and reconcile ledgers. Shockingly, the majority of transaction flows are still moved via ACH and most securities are not held under any standardized custody system at all. The fragmented nature of processes and intermediaries, combined with a lack of regulatory standardization, has created a spider web of bespoke processes for private markets. The benefits of centralized custody, money movement and a standard reconciliation process are to reduce settlement and counterparty risk during transactions, reduce the chance of fraud, and create cost efficiencies. In addition, a standardized system for custody of private securities is necessary to enable a high volume of secondary market trading and settlement.?

Public Market Comparison: In public markets, the role of DTCC and clearing firms create a regulated framework that standardizes the process for record of ownership, money movement and ledger reconciliation between counterparties. NSCC, a DTCC subsidiary, acts as the central clearing house for US public equities markets, reducing counterparty risk between clearing firms by guaranteeing settlement on both sides of the trade. Similarly, clearing firms like Apex or Schwab reduce settlement risk for introducing brokers who ultimately serve the end investors. A regulated system of net-capital requirements and industry standards for deposits have created an efficient process for custody in public markets. The role of DTC, another DTCC subsidiary, is to maintain a central securities depository (CSD) on behalf of all market participants. A CSD creates a single source of truth and maintains the central ledger that all counterparties can reconcile too. DTCC and its subsidiaries work closely with public exchanges and market participants to ensure that when a trade occurs, securities and cash are properly settled and reconciled efficiently.?

Private Market Solutions: The most efficient solution for private markets to create standards and efficiency in custody, settlement and reconciliation, is to leverage as much of the existing public markets infrastructure as possible. Mainly, by incentivizing traditional clearing firms to custody private securities, and building regulated infrastructure to settle money movement and securities transfer between firms. Many traditional clearing firms today are facing pressure from their correspondent brokers and RIA clients to custody private securities, as many brokers and RIAs face demand from their end investors to provide access to private markets.? Providing clearing firms with the technology necessary to custody private securities, will enable firms to adopt private securities more efficiently. Regulatory changes that mandate more regulated custodians or higher capital requirements can also speed up the adoption cycle for clearing firms to provide custody for private securities.?

Problem Five: Standardized Systems of Record. Closely related to the problem of custody and money movement, the lack of standardized systems of record have made the private markets inefficient and inaccessible to many investors. Much like the issue of custody, many private issuers utilize a variety of ledger systems for record of ownership of securities, ranging from excel spreadsheets to fund admins or transfer agents. The lack of regulatory mandates regarding custody of most private securities have created a cottage industry of ledgering systems and technology platforms. The lack of a centralized securities depository or identification system for assets means that the same asset may be recorded on two different ledgers using two different identifiers on each ledger, which makes reconciliation and transfers difficult.??

Public Market Comparison: In public markets, the DTC acts as a central securities depository (CSD) and FINRA (a regulatory agency) issues CUSIP identifiers to all new public equities. A CUSIP identifier is also known as a stock symbol, for example Apple stock trades under the symbol AAPL. Whenever an investor owns Apple stock, that stock record is ledger'd as AAPL, regardless of which financial institution the investor uses. The CSD ensures a unified ledger across public markets, while CUSIP identifiers ensures a single language is used for asset identification across ledgers.?

Private Market Solution: There are a few changes to private markets that can create a more standardized system of record. First, the use of FINRA issued CUSIP identifiers can help create a common language across private market ledgers, regardless of which ledger is being used for the system of record. Second, the development of an efficient process for securities transfers/settlement between custodians or ledgers, resembling the role of NSCC in public markets can help reduce settlement risk. A Central Counterparty Clearing House (CCP), while different from a CSD, can serve a related role in standardizing private markets. In private markets, given that trillions of dollars of assets are already ledger'd with a fragmented system of ledgers, the use of a CCP or multiple CCPs in speeding up settlement time and reducing settlement risk can help create efficiency and expand access in private markets. CCPs can also mandate the use of common asset identifiers across ledgers. Over time, regulatory changes may mandate the use of a CSD for record of ownership, in which case it is likely that the DTCC will build or buy a subsidiary to manage a private market securities depository, centralizing a fragmented industry.?

In conclusion, there are a number of core infrastructure problems that need to be solved to enable efficient and scalable retail access to private markets. There are a number of FMIs today working to solve one or more of these problems. By taking a unified approach, and communicating closely with other market participants and regulators, private market FMIs can start to bridge the gap between retail investors and private assets, creating a new marketplace and trading ecosystem that can be beneficial to issuers, investors and existing financial market intermediaries.?