The Retailization of Private Markets Will Challenge Fund Managers

The alternative investment industry has been going through a seismic shift towards “retailization,” driven by several factors. First, retail investors are becoming more sophisticated and have developed an appetite for private markets that were historically inaccessible to the public. Second, we have seen a push by the U.S. Government to expand retail investor and 401(k) options to include alternative asset classes, such as private equity, private credit, and certain real estate investments. With alternative investment managers echoing these sentiments to expand access, many now believe that at least half of all private markets capital inflow will come from retail products in the coming years.

Given that the registered funds framework encompasses SEC oversight, audited financial statements, diversification, liquidity requirements, and the protections provided under the Investment Company Act, the retailization of private markets will force an evolution in how fund managers navigate regulatory compliance and operational excellence and who they partner with to do so.

Operational Requirements and Challenges

As GPs focus more attention on developing innovative private market investment offerings and the technologies necessary to meet these new strategic priorities, they will need to prioritize both human capital and the application of appropriate technology to meet the operational demands of running a registered 40 Act or 34 Act fund.

Retail oriented products require a more sophisticated service model than traditional 40 Act Funds (i.e. mutual funds) and traditional drawdown funds that are the predominant structure in private markets. As investment strategies become more hybridized and complex, accounting teams need to develop a deeper understanding of a wider spectrum of financial instruments, ranging from equity to debt instruments, structured finance securities, and derivatives. They will also need to demonstrate proficiency in managing the variety of forms required, including N-2, Form 10, N-CEN, N-PORT, and N-CSR for ’40 Act funds’, and 10Q, 10K, and 8K for 34 Act funds.

The effective application of technology and streamlined processes is equally important, as many managers are looking for monthly, weekly, and daily NAVs to keep up with the transparency demands required of retail investors. Unlike large corporations that typically use Enterprise Resource Planning (ERP) systems designed to be “all-in-one” solutions, most fund accounting software still struggles to integrate with the diverse, messy data coming from multiple portfolio companies and a broad array of financial instruments.

And while there has been a massive influx of FinTech specifically focused on the needs of private markets, a technology gap still exists. This leads to a heavy reliance on “shadow accounting” in Excel which can strain finance teams and present risk. With greater demand for real-time transparency, the retailization is forcing funds to move into cloud-based, integrated tools.

Service Models – Integrated vs. Best-In-Class

Since the requirements for servicing registered investment vehicles span custody, fund administration, tax services, regulatory reporting, and transfer agency, how funds select the right operating models and service providers to match their investment vehicles is increasingly consequential. There are two approaches to meeting these broad functional needs: an integrated service model or best-in-class service providers.

Large institutional service providers, such as banks and some software companies, may offer an integrated service model, providing a bundle of services ranging from custodian services to transfer agents, fund accounting, and everything in between. While this model may reduce some of the managers’ administrative burden (i.e., fewer contracts), these services are provided by different teams with vastly different backgrounds, processes, and technologies. Consequently, it becomes a “bolt-on” solution rather than a truly integrated one.

Conversely, asset managers with more sophisticated back-offices are more likely to lean towards best-in-class service providers, assembling an “all-star” team to achieve operational excellence.

Choosing between an integrated model and a best-in-class approach is a trade-off between convenience and pursuit of excellence. While the integrated model may be safe and convenient on the surface, an all-in-one provider can be a bottleneck rather than a benefit if a fund’s strategy is sophisticated. We often see complex funds plagued by legacy systems and a generalist mindset. In contrast, a best-in-class approach is best for managers who refuse to compromise on operational alpha.

Large integrated providers often treat fund accounting or tax services as a secondary add-on to their core custody and transfer agency businesses. This leads to a bolt-on service culture where technology is fragmented behind the scenes. By selecting best-in-class providers, fund managers ensure that every pillar of their operations is managed by a specialist that will continue to invest heavily into the offering over time because it is core.

An integrated, all-in-one service model promotes vendor lock-in. If a provider’s tax and fund accounting departments fall behind on new regulations, investment managers may be stuck with them because breaking up would mean moving their custody, fund administration, and transfer agency as well. Fund managers should preserve the ability to pivot or swap out a single underperforming component without paralyzing the entire operation. This agility is essential in a market where investment strategies, financial instruments, and regulatory requirements are constantly evolving.

Conclusion

There is a common misconception that best-in-class is “riskier” because it has more moving parts than the integrated model. In reality, it is sturdier. When a fund manager assembles an “all-star” team of specialists, they create a system of checks and balances. By adopting the best-in-class model, managers replace a single point of failure with a network of GAAP experts.

The retailization of alternative investments is coming, and fund managers hoping to tap into the influx of retail investor capital will need to take a hard look at their existing technology and teams to ensure they are prepared to meet the new requirements for servicing registered investment vehicles. Those managers who make the strategic decision to sacrifice short-term convenience for long-term quality through best-in-class solutions will thrive as this industry transformation unfolds.