The suggestion that the US SEC is considering easing restrictions on retail investors holding Private Equity raises some interesting questions. The proposal in the FT this morning that they could invest via a closed end Fund of Funds makes a certain amount of sense and is certainly an attractive idea to the firms that manage these fund of funds and of course the private equity fund managers underneath this, who have the prospect of an even greater flood of liquidity. However. It does not really address the key issue of why money is flooding into this area instead of via public markets which is of course the issue of mark to market. The obsession with minimising volatility on the dubious grounds that this is minimising risk is what led us to the CDS debacle and while the FT cites a paper about the advantages of diversification, the fact is that most Private Equity offerings derive their superior returns from a combination of leverage and illiquidity, both of which work brilliantly, right up until they don’t. Also it is important not to compare the IRR quoted with the return on the committed capital on which you have to pay a fee. Once you combine high fees, risk from leverage and illiquidity and a return on committed capital rather than just the quoted IRR, the attractions are far less obvious.
