Ludovic Phalippou is professor of financial economics at the University of Oxford’s Saïd Business School. William Magnuson is a law professor at Texas A&M University.
In August, a White House executive order quietly triggered a major shift in US financial markets. It called on agencies to “democratise” access to private equity, private credit and digital assets (including Bitcoin) for 401(k) retirement savers.
While barely registering in the broader news cycle, this marks a significant departure from long-standing regulatory practice and accelerates a trend more than a decade in the making: the migration of private equity from institutional capital pools into the savings of everyday investors. Moreover, it could come back to bite the industry that lobbied for it.
For nearly a century, securities regulation rested on a clear divide. Public companies, because they raise money from ordinary people, must follow strict disclosure, reporting and governance rules. Private companies, which raise money only from institutions and wealthy individuals, operate under far lighter oversight. And private equity has flourished on the light touch regulatory side of the divide. It could use valuation methods, fee practices and contractual structures that would be difficult to defend in public markets, because its investors were assumed to be sophisticated and legally equipped to protect themselves.
Once retail investors enter the picture, that assumption becomes untenable. And with it, the legal equilibrium the industry has relied on begins to unravel.
A shift with legal consequences
As private equity expands from institutional clients to household savers, it enters a fundamentally different legal environment. Institutional investors routinely tolerate problematic practices because open disputes can jeopardise access to future funds, strain professional relationships or undermine career aspirations. Retail investors face none of these pressures. They have no reason to resolve concerns quietly and no commercial interest in preserving relationships with fund managers. When they believe they were not adequately informed, they are far more willing to pursue formal claims.
The tobacco cases from the 1990s revealed something important: even when risks are widely known by experts, courts may still conclude that consumers are not properly informed about them.
Against that backdrop, the retailisation of private equity stands out. Investors are being shown performance numbers that do not behave like returns, fee structures whose economic impact is far larger than the headline figures suggest and liquidity provisions that function very differently from how they sound. Class actions have been rare in private markets, but the gap between representation and reality here is large enough that a tobacco-style challenge is no longer far-fetched.
Performance metrics that do not behave as advertised
The internal rate of return, or IRR, dominates private equity performance reporting. It is almost universally read as an annual rate of return, yet it is nothing of the kind. IRR is simply the discount rate that makes a series of cash flows sum to zero; it says little about how an investor’s wealth actually accumulates over time.
Worse, because IRR is highly sensitive to early cash flows, a fund can report a very high IRR even when long-run performance is modest. In addition, the IRR becomes almost immovable, giving the illusion of stable and high performance across business cycles.
A plaintiff’s lawyer will have little difficulty arguing that presenting IRR as an annualised return metric is misleading to average investors. Courts have repeatedly held that disclosures must be judged from the standpoint of a reasonable investor. Once the investor base shifts, so does the legal standard.
Valuations that shape fees, liquidity and outcomes
Private equity valuations create similar vulnerabilities. Because portfolio companies are illiquid, managers set their own estimates of “fair value,” which in turn affect reported performance and the prices at which semi-liquid vehicles admit or redeem investors.
An accounting quirk has long permitted funds to buy secondary stakes in PE funds at a discount to net asset value and then immediately mark them up to NAV, recording outsized gains. This is maybe understandable in a world of consenting institutional investing adults. But this game has recently moved to retail-oriented funds.
Retail investors who transact at inflated prices are exposed to direct financial loss. When valuations diverge materially from observable market levels, the potential for litigation becomes difficult to ignore.
Fees whose true magnitude is difficult to discern
Fees present a similar problem. They are typically described to investors in the familiar shorthand of “two and twenty with an eight per cent hurdle.” But in most cases, there is also a provision known as a catch-up clause. Once returns exceed roughly ten per cent, the manager receives the same compensation as if the hurdle had been set at zero. In other words, a feature presented as investor protection often has little practical effect. This is only one example among many in which terms that appear straightforward can be deeply misleading. In an institutional setting, these conventions are likely to be understood; for retail investors, the odds are different.
Liquidity aligns poorly with expectations
Semi-liquid private equity products are frequently described in terms that resemble mutual funds. In practice, redemptions are often capped at low percentages of net asset value and remain subject to manager discretion. In times of financial stress, precisely when most investors are most likely to need their funds, they could face delays of five years or more to be able to withdraw their money.
Nothing about this structure is inherently problematic for investors who understand it. But if savers are sold “semi-liquid” products without understanding that liquidity is conditional and very limited, then claims of misrepresentation become plausible.
A coming wave
For decades, private equity has operated in a legal environment defined by deference: deference to contract, to sophistication and to private ordering. That environment is changing. As retail capital flows into the industry, the legal framework shifts from one based on negotiated expectations to one based on statutory protections and judicial interpretation. Contract law, consumer-protection law, tort principles and fiduciary doctrines all provide routes to challenge practices that were previously insulated.
The irony is clear. In seeking access to public capital without accepting public-company obligations, private equity may have exposed itself to a much more demanding form of accountability. Regulators may hesitate to intervene, but courts do not face the same constraints. Once a critical mass of retail investors experiences losses or mismatches between marketing and reality, class actions are likely to follow.
For years, the industry has equated “democratisation” with access to more assets and more fees. It may soon realise that what has actually been democratised is legal risk.
Further reading:
— The delusion of private equity IRRs (FTAV)
— Another problem with IRRs (FTAV)
— The volatility laundering, return manipulation and ‘phoney happiness’ of private equity (FTAV)