Private Markets: Opportunities and Risks for Investors

People who are solely invested in publicly traded stocks could be missing out on the wealth-creating strategy of investing in private markets, some of which are becoming more accessible to the average investor.

The number of publicly listed companies is falling, and the number of privately held companies is growing. Plus, the overall market capitalization of the private market is increasing. But historically, there has been a lack of participation by individual investors in the private markets, which can produce high returns by offering access to smaller, younger companies.

There are critics who say letting more retail investors into the private market to “democratize” it would not be wise because there’s too much market risk for these investors. While there are unique risks involved with private market investments, another consequence for retail investors not having full access to these opportunities is a lack of access to potentially higher returns.

Here’s what you need to know about retail investor participation in the private markets and what could be done to improve it:

— The difference between the public and private markets.

— Opportunities and roadblocks for retail investors.

— How to improve access to the private markets.

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Private Markets vs. Public Markets: What the Difference?

Private markets include companies not listed on the public exchanges that are available for all investors. Accredited investors who meet specific income or net-worth requirements by the Securities and Exchange Commission are eligible for private market investments.

Early stage companies in the private market tend to carry more market risk and volatility compared with publicly available investments, but this higher risk comes with higher potential returns.

Mona DeFrawi, founder and CEO of Radivision, a startup community platform, says the average age of a company at initial public offering is 10 to 13 years, but much of the highest investor returns are made in the earlier years of a company’s development.

That said, unaccredited investors are unable to access these opportunities. “They (retail investors) usually invest in public market stocks, where there are fewer opportunities to deliver such returns,” she says.

The number of companies funded by private equity is growing, DeFrawi says, which shows the influence private equity has in capital markets.

“Today, the private markets are thriving, with more institutional, accredited and international investors allocating greater portions of their portfolios to this asset class, leaving retail investors on the outside looking in,” DeFrawi says.

[READ: Are Stocks, Real Estate and Bonds in Asset Bubbles?]

Opportunities and Roadblocks for Retail Investors

Accredited investors have been allocating more capital to the private markets for several reasons.

First, it’s about diversification. Only a handful of megastocks like Amazon.com Inc. (ticker: AMZN), Alphabet Inc. ( GOOG, GOOGL) and Facebook Inc. ( FB) have been driving public stock markets in recent years. But these massive companies don’t tell the whole story of economic innovation, and smaller, private companies are often at the forefront.

Experts say diversifying investment options that range different segments of the economy can offer healthy exposure to an investment portfolio.

DeFrawi points out that retail investors have had a shrinking selection of public companies from which to choose, limiting their opportunity to diversify. There were 3,544 investable companies listed on U.S. markets as of June 30, according to a prospectus for the Wilshire 5000 Index, which attempts to track all publicly traded stocks. By contrast, there were more than 7,500 at the public market’s peak in the late 1990s.

The public market offers investors access to larger companies, while the private market helps investors get diversification by company size — the average private market company is much smaller.

Recently, retail investors have been able to indirectly invest in private equity investments as part of a professionally managed asset allocation fund in their defined-contribution retirement plans, as cemented in a 2020 information letter by the U.S. Department of Labor. This is a step toward helping diversify their holdings apart from the traditional stocks, bonds and mutual funds, but the access is limited in scope.

According to the DOL’s letter, Main Street investors are not authorized to make direct private equity investments. Investment professionals instead manage retirement plans and make decisions on behalf of the investor in collective investment trusts that invest in private equity. This is designed for limiting investor risk. But not allowing greater access to private market investments prevents retail investors from capturing the potentially greater performance returns and diversification offered by the private market.

One of the most common ways retail investors can invest in private companies today is through crowdfunding, which allows individual investors to pool their money and raise funds for a business. This process is usually done online, and the money contributions tend to be smaller amounts.

Over the long term, private markets have outperformed public equities, according to data from Hamilton Lane, an alternative investment management firm. For the past 15 years, private equity posted stronger annualized returns, at 14%, than public equity metrics such as the S&P 500, Russell 3000 and MSCI World, which posted 9.3%, 10% and 7.2% returns, respectively.

The data analysis also suggests that certain private asset classes can be less volatile than public equities. For example, the firm found that the private credit and developed-market buyout classes produced gains even during their worst five-year periods since 1995.

[SEE: Why You Should Add Midcaps to Your Portfolio.]

How to Improve Access to the Private Markets

For retail investors interested in accessing private markets, the use of crowdfunding platforms can come with limitations, with much of the onus being on the investor to evaluate the investment opportunity with limited data available.

As retail investors gain greater access, they will need better transparency to be able to make sound investment decisions. “The private markets are fragmented and opaque, and depend on inaccessible, entrenched networks for deal access,” DeFrawi says.

DeFrawi says one solution would be to allow retail investors to act in an equivalent way to limited partners in private businesses, who have a financial stake but not control of a private company. “If … retail investors could have access to the same investments as limited partners — by investing in new products that allow the aggregation of retail investors into large pools of economically viable funds — they would enjoy the same protections and high return potential.”

Another way to improve access to the private markets is by democratizing entrepreneurship and making it easier for people to start businesses, or “expanding the accessibility that already exists for startups, but in a way that educates effectively and allows for better opportunities to access capital,” says Lorel Scott, co-founder, chief operating officer and head of global partnerships at StartupStarter, a Los Angeles based startup building the next generation of on-demand business for the digital age.

“Expanding the crop of entrepreneurs who are ready to grow and reach new levels with their businesses provides investors the opportunity to diversify their investments and build with a generation that’s representative of today’s world,” he says.

Democratizing the private markets means breaking down the barriers of entry and education on alternative investment opportunities and “(shedding) light on the ability for everyday individuals to create their own financial prosperity by not only creating ownership, but equity that gives them a seat at the table,” Scott says.

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Private Markets: Opportunities and Risks for Investors originally appeared on usnews.com

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