Fully Invested: Retailization of Private Fund Products

June 17, 2022
19:43 minutes

In this episode of Fully Invested, Ropes & Gray asset management attorneys Mike Doherty and Jamie McGinnis discuss the “retailization” of private fund products. They provide an overview of products available to alternative asset managers in the marketplace; examine regulatory barriers to retail investment in private companies and private fund strategies; and, leveraging Jamie’s recent experience in the Division of Investment Management and as securities counsel at the U.S. House Committee on Financial Services, discuss the legal and regulatory outlook that may facilitate future retailization efforts.


Michael Doherty: Welcome to Fully Invested, a podcast series hosted by Ropes & Gray’s global asset management team. Drawing on the perspectives of over 1,400 attorneys from all areas of our practice, we provide insight into essential considerations associated with current and emerging asset management products. I’m Mike Doherty, a partner in our asset management group based in New York and co-head of Ropes & Gray’s registered funds practice. Joining me today is Jamie McGinnis, counsel in our Washington, D.C. office. On this episode, we’ll be discussing the so-called “retailization” of private fund products—that is, alternative and other private fund managers looking to expand access to their strategies and investment expertise through investment structures that are available to retail investors. We will provide an overview of certain regulatory barriers to the retailization efforts, briefly discuss the types of products that we are seeing in the marketplace and, leveraging Jamie’s recent experience at the Division of Investment Management at the Securities and Exchange Commission and as a Senior Policy Advisor and lead securities counsel at the U.S. House Committee on Financial Services, look ahead to possible legal and regulatory developments that may facilitate the retailization efforts.

Jamie, do you want to kick off our discussion? 

Jamie McGinnis: Gladly. I’ll begin with a brief background on the increased interest of investors and asset managers to have retail investment into products and strategies that have historically only been available to institutional investors. Helping to cause this interest is a multi-decade trend whereby, until very recently, the number of public companies—that is, investible assets for retail investors and many retirees—have consistently decreased over time. By the end of the last decade, the number of public companies had nearly halved compared to the numbers in the late 1990s.  

Alongside this decline in retail investment opportunities came significant growth in the private markets. As numerous market commentators have noted, not only are fewer companies going public, but many companies that do go public do so notably later in the company’s life cycle than they had in previous decades thanks in significant part to private funds and other strategies with the patience and capital to fund multiple years of private company growth. Think of so-called “unicorns” that eventually went public at multibillion-dollar valuations—for many of them, they went public as mature companies, notably after experiencing exponential growth in their business. That early-stage growth was captured by only investors in the private markets, whereas if those companies had been founded decades earlier there would have likely been greater gains captured by retail investors through investments in the public markets. Perhaps unsurprisingly, then, there are studies that suggest that investors who have access to private investments, including private funds, have over the past few decades seen investment outperformance relative to those who can only invest in public companies or the funds that must primarily invest in publicly offered securities.

Michael Doherty: You’ve set the stage for why retail investors who do not have access to traditional private funds are increasingly interested in the products. But, before we discuss possible paths to access, we should first discuss what regulatory barriers exist for those investors right now and why they are in place. Can you provide an overview of the regulatory regime applicable to private funds?

Jamie McGinnis: At a high level, the federal securities laws preclude significant retail investment into private funds. Generally speaking, direct investment into private funds is limited to investors who meet the “qualified purchaser” and “accredited investor” standards under the Investment Company Act of 1940 and the Securities Act of 1933, respectively. These standards, which are primarily tied to income and wealth tests, are among the most significant investor protection features in the federal securities laws. The Commission has stated that the accredited investor regime is intended to ensure that those who make private investments, such as investments relying on the Regulation D exemptions to the Securities Act, are sufficiently sophisticated and have the ability to bear any loss such that the protections of the Securities Act registration process is not necessary. Similar sophistication concerns underlie the qualified purchaser definition, and, thus, the broader Section 3(c)(7) exclusion from the definition of investment company and the strictures of the Investment Company Act.

Because of these regimes, the vast majority of Americans are prohibited from investing directly into private companies and private funds. Additionally, the SEC staff has taken a position that securities issued by a closed-end fund registered under the Investment Company Act and the Securities Act—that is, a publicly offered fund—must be sold only to accredited investors if that fund invests more than 15% of its assets in private funds. While this position is not pursuant to a rule or formal Commission guidance, it has generally been communicated to closed-end fund registrants through the registration process, and the staff position has worked to effectively preclude the potential development of listed closed-end funds of private funds. While the staff has never explained the basis for its position in a rule or release text, the position is likely underpinned by similar sophistication-based concerns underlying the accredited investor regime more broadly.

But before we get to the possibility of that position changing in the future, we should highlight some existing products that are available to retail investors that, while not providing private fund investment access to retail, can mimic certain private fund strategies.

Michael Doherty: Thanks, Jamie. I would start with alternative mutual funds, sometimes called alt funds or liquid alts funds. They are generally open-ended mutual funds that engage in a wide variety of non-traditional strategies, including investments in different asset types such as real estate or commodities. Liquid alts often use complex trading strategies to seek to either lower volatility, generate above-market returns, or both. Liquid alts, however, are subject to all the rules applicable to open-end funds under the Investment Company Act, including perhaps most notably Rule 22e-4, the so-called “liquidity rule.” The liquidity rule requires exchange-traded funds and open-end mutual funds to limit aggregated holdings of “illiquid assets” to 15% of a fund’s net assets—and private investments are generally considered illiquid. This necessarily limits the amount of direct exposure to the private markets that any alternative mutual fund—or any registered open-end fund—can obtain. Some liquid alts funds, however, such as hedge fund replication strategies, seek to provide similar returns through investments in derivatives and securities; however, those funds would also be subject to new SEC regulations relating to the use of derivatives by mutual funds.

Jamie McGinnis: Thanks, Mike. You mentioned that the liquidity rule applies to open-end funds. Of course, closed-end funds and other products do not have as great of a need to maintain liquidity to meet daily redemptions as open-end funds. Can you speak to products in the marketplace that do not face the same liquidity requirements as open-end funds?

Michael Doherty: Certainly—there are a variety. We have, for example, interval funds and tender offer funds, which are both closed-end, Investment Company Act-registered funds. Many of these funds are also registered under the Securities Act, and, thus, eligible for public investment. In addition, there’s a great deal of interest in business development companies, which are closed-end funds subject to certain provisions of the Investment Company Act. BDCs come in a wide variety of flavors—some are private, and, thus, not eligible for investment by retail, but also there are non-traded but continuously offered BDCs available to much of the public, and there are exchange-listed BDCs that are registered under the Securities Act and available to the public at large. And, of course, I should mention exchange-listed closed-end funds, which have been available for decades and may provide retail with more complex strategies than they could get in an open-end fund.

I should note here that Ropes & Gray’s asset management group has extensive experience with each of these products. In fact, our listeners should be on the lookout for future podcasts coming from Ropes & Gray in which our attorneys will be discussing a number of these products in depth.

Jamie McGinnis: Thanks, Mike. It sounds like there are a number of products out there that fund managers could be considering to capitalize on retail interest in alternative products. But, ultimately, to bring it back to where we began, even with these existing options there are entire classes of investment products in which retail investors are by law precluded from investing.  

And, as it so happens, you have done some thinking about ways to expand investor access to the private markets in general and private funds in particular. In 2019, you and other Ropes & Gray attorneys drafted a white paper entitled Retail Investments in Private Funds: Regulatory Obstacles and Opportunities, which was submitted to the SEC’s comment file for the private offering modernization rulemaking. While I would commend to our listeners reading the full white paper, which is available on Ropes & Gray’s website, could you summarize some of the options that it lays out to the Commission?

Michael Doherty: Thanks, Jamie. The white paper focuses on three basic approaches to expanding retail investments to private funds and strategies: (1) direct access; (2) investment in private funds through a feeder fund advised by a registered investment adviser; and (3) investment through a registered vehicle—likely a closed-end fund—that is organized as a “registered fund of private funds.”

Jamie McGinnis: Let’s take these in order. When you refer to a “direct access” model, you mean expanding the ability of retail investors to directly invest in private funds, correct?

Michael Doherty: That’s right. While we recognize this would be a fairly significant shift from the current regulatory framework, it also would most directly solve the concerns some have raised about the potential unfairness of excluding certain types of investors from potentially high-value investments. 

I should note: There are a number of things Congress or the SEC could do to maintain some level of investor protection for retail investors that generally do not apply to current private fund investors. We suggested some in the white paper, such as a limitation on the amounts a retail investor could directly invest in private funds, imposing a requirement that retail investors purchase private fund interests through an investment adviser or broker dealer operating under a best-interest standard, or creating a category of “seasoned” private funds that qualify for direct retail investments.

Jamie McGinnis: The “feeder” structure option is something of a middle ground between direct investment in private funds and the registered fund of private funds. Can you explain how that might operate?

Michael Doherty: This approach would involve a registered feeder fund sponsored by a wealth manager or some other intermediary that invests substantially all of its assets in a single unaffiliated private fund. The feeder fund would be a closed-end fund registered as an investment company under the 1940 Act and would be marketed to the intermediary’s existing customers. This would require Congress or the SEC to provide relief from a number of regulatory requirements, as we note in the white paper.

Jamie McGinnis: That brings us to the final concept you laid out—the registered fund of private funds.  

This concept would essentially involve a framework whereby a registered closed-end investment company would invest its assets exclusively in underlying private funds. These funds would be subject to the strictures of the Investment Company Act, including having a board of directors, a majority of whom must be independent of the adviser, and would be subject to the periodic disclosure and reporting requirements under the Company Act. These types of funds are precluded by the SEC staff position limiting investment in private funds to 15% for retail closed-end funds, correct?

Michael Doherty: That’s right. In order for these funds to develop, the staff would have to withdraw that position. There are other steps that the staff could also take to allow development of these funds. For example, the SEC could permit securities exchanges to adopt listing standards allowing for trading of registered funds of private funds. Additionally, the SEC could grant relief from Section 17(a) of the Investment Company Act to permit registered closed-end funds to invest in private funds sponsored by the registered closed-end fund’s adviser or its affiliates. These types of regulatory changes would allow more types of funds-of-private-funds products to be responsive to retail demand.  

This leads me to some questions for you, leveraging your recent professional experience at the Commission and on Capitol Hill. It is three years after we filed our white paper with the Commission, and I’m a bit disappointed to say that the Commission has yet to take us up on any of our suggestions. Do you think it is likely that Congress or the Commission will expand retail access to the private markets, and in particular private market strategies, at any point in the near future?

Jamie McGinnis: That ultimately depends on how one defines “near” future. In the short term—meaning at least this coming year—I would not be optimistic. In the medium term, though, I think the odds are quite favorable that there will be increased retail access to private market strategies, and asset managers may want to consider the opportunities that arise when that time comes.

Michael Doherty: Can you elaborate on that? First, why do you think we are unlikely to see movement in the immediate term?

Jamie McGinnis: In short, because a focus on expanding retail access to the private markets is not on Chair Gensler’s agenda. While the SEC’s most recent Regulatory Flexibility Agenda is fulsome and includes a number of longstanding Democratic priority items such as, for example, its most recent ESG and climate-related rulemakings, the current agenda does not include items designed to spur capital formation by increasing retail access to the private markets. This is not particularly surprising, as regulatory items along those lines during the SEC under Chairman Jay Clayton, such as the move to expand which types of investors qualify as “accredited investors” —which was adopted in 2020—were heavily criticized by Democratic Commissioners at the time of their adoption.

If anything, the current Commission may be reasonably viewed as more skeptical of private markets than ever before—and this is to some degree reflected in the rulemaking calendar. The Commission has planned a significant increase on regulatory scrutiny of private companies and private markets. This includes multiple rulemakings applicable to private operating companies, investment advisers, and funds. The asset management community has already seen some of this, as the most significant already-proposed rulemakings along these lines involved private funds and their advisers. The Regulatory Flexibility Agenda indicates there is more to come, including (1) changes to the exempt offering framework; (2) changes to Regulation D and Form D reforms; and (3) amendments to the “held of record” definition for the purposes of Section 12(g) of the Securities Exchange Act of 1934, which helps determine when a private company must go public.

Michael Doherty: Okay, so retail investors and private fund sponsors should not be optimistic about movement on this front in the immediate term. But you mentioned that you are optimistic over a longer time frame, correct?

Jamie McGinnis: Yes, I am. This is because political winds shift over time, and I would anticipate that expanding private market access to retail investors will be a significant part of the next Republican SEC agenda. I have a strong sense of this because, until very recently, I was involved in developing legislative items for Minority Members as securities counsel on the U.S. House Financial Services Committee. Bills and legislative concepts adopted in Congress often lead to items on the Commission’s agenda. Much of Chair Gensler’s agenda reflects ideas that have been in bills that Democratic Members proposed in Congress for much of the Trump Administration. The equivalents of those bills for the next Republican administration are being developed in Congress now.

Most relevantly to our discussion, there are a number of recently introduced bills that would expand access to the private markets for retail investors. Perhaps most notable among these is the Increasing Investor Opportunities Act, originally introduced in late 2020 in the House and reintroduced this past Congress in both the House and the Senate. The bill would expressly force the SEC to abandon its position relating to limiting investment in private funds to 15% of fund assets for retail products. The bill has the support of, among other groups, the Investment Company Institute.

Michael Doherty: Does this bill have any chance of becoming law before a change in administration?

Jamie McGinnis: There is a slim but non-zero chance. To start out, any bill proposing significant substantive changes to the securities laws faces relatively long odds from passage into law. However, occasionally lightning strikes when a bill has significant bipartisan support. And, importantly, the Increasing Investor Opportunities Act has at least some level of bipartisan support, as Representative Gregory Meeks (D-NY) is a lead co-sponsor of the bill. Representative Meeks is himself an influential Member of Congress who may one day be the Chairman or Ranking Member on the House Financial Services Committee, so this is a notable co-sponsorship.

With that said, the bill is currently stalled as Majority staff at the Financial Services Committee and the Senate Banking Committee, who generally control the Committee agendas, have thus far shown no interest in bringing the bill or other significant capital formation bills to a vote right now. At the risk of overgeneralization, their primary goal at the moment is supporting Chair Gensler in his implementation of his agenda at the SEC rather than passing significant substantive securities legislation, so, I would not anticipate the passage of the bill or anything like it this Congress.

Michael Doherty: If the bill is currently stalled, why do you say there is some chance of eventual passage?

Jamie McGinnis: If the House, Senate, or both flip after upcoming elections such that Republicans control the Committee agendas at the House Financial Services Committee or the Senate Banking Committee, the new Majorities would be able to force votes on the bill. It is yet unknown the level of overall bipartisan support for the bill, but there is a chance that when a vote on the bill occurs, the bipartisan support could be fairly significant, given that, as a general matter, expanding investor access to additional investments does have political appeal. If there were significant bipartisan support for a vote on this bill, the bill would then be ripe for inclusion in a package of bipartisan legislation such as those that occasionally pass into law from time to time, like the JOBS Act of 2012 or the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.

Additionally, it is possible that a notably bipartisan Committee or floor vote in the House or Senate may ultimately obviate the need for the bill to go through the full process of passing both bodies of Congress and being signed into law by the President. To elaborate on that: It is likely that, should one or both bodies of Congress flip in upcoming elections, the bill or some version of it will receive a Committee vote relatively early in the Congressional calendar. If the vote is overwhelmingly bipartisan, the SEC and Division of Investment Management staff would certainly be aware of the vote, and they may find it in their ultimate interest or find themselves under political pressure to modify or remove the staff position before the bill becomes law.

So, that is all to say: Retail investors and members of the asset management industry should continue to monitor this space for legislative and regulatory developments.

Michael Doherty: Thank you, Jamie, for joining me today for this discussion. Thank you to our listeners—we appreciate you tuning in to Ropes & Gray’s Fully Invested podcast series. Please visit our website at ropesgray.com/assetmanagement, or feel free to reach out to any of us at Ropes & Gray by email or phone for more information. You can also subscribe and listen to this Ropes & Gray series wherever you typically listen to podcasts, including on Apple and Spotify. Thanks again for listening.

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