Democratizing private markets: five questions for firms ‘going retail’

Applicable regulations and reporting requirements are largely determined by the fund structure, product type and investor segments (e.g., accredited investors, qualified purchasers and general retail investors). See Figure 1.

In general, firms targeting a broad retail audience operate as registered investment companies under the Investment Company Act of 1940 (1940 Act) and are subject to the highest degree of regulation and reporting requirements. Funds targeting higher-end retail investors that qualify as “qualified purchasers” (generally individuals and entities with more than $5 million and $25 million, respectively, in investments) can be exempt from 1940 Act registration under Section 3(c)(7). These Section 3(c)(7) exempt funds offer shares privately and are subject to less stringent SEC regulatory and reporting requirements, if they have no more than 1,999 investors. If they have more than $10 million in assets and 2,000 or more investors, they must register under the Securities Exchange Act of 1934 (1934 Act); file SEC Forms 10, 8-K, 10-K and 10-Q, and Schedules TO; and are subject to Sarbanes-Oxley (SOX) requirements for more rigorous controls over financial reporting, including management certification of quarterly and annual filings. This subset of Section 3(c)(7) exempt funds is commonly referred to in the market as “34 Act funds.” 

Because of the many details (including in applying SEC and GAAP guidance) firms need to plan for accounting and reporting requirements well in advance of launching a fund. Most will need to establish stronger internal controls and governance frameworks than they have in place today. Further, they should engage fund administrators, auditors, accounting and tax advisors, legal counsel, and other specialists to determine an appropriate action plan, which likely will require extensive analysis and collaboration.

Designing an effective valuation approach is critical because the move from standard quarterly or monthly valuation cycles to weekly or even daily cycles can strain existing resources and processes, especially where spreadsheets and manual data inputs are still common. For firms accustomed to managing closed-end institutional funds, preparing for tax provisions that flow into NAV (including transactional NAV, where relevant) and producing associated financial statement and investor disclosures can be particularly challenging. Management’s obligation to certify that controls and procedures operate appropriately under SOX 404(a) should prompt firms to design robust valuation processes.

Firms that are regulated under the 1940 Act are required to design valuation processes that comply with Rule 2a-5. Though Section 3(c)(7) exempt funds are not subject to Rule 2a-5, they can use the framework outlined by the SEC as a basis for an effective valuation process and to prepare for potentially closer regulatory scrutiny in the future.

There is no single leading practice valuation methodology or approach, largely because of the diversity of fund structures, asset classes and investment strategies. At some firms, dedicated and centralized teams own the valuation models and outputs. At others, responsibility is assigned to deal teams or outsourced to third parties. Whichever sourcing approach they choose, most firms will need more advanced and granular tracking of valuation workflows, models and data sources to establish an efficient process and document it in line with reporting requirements. Firms should also plan to conduct benchmarking and back testing.

Change management and training can help prepare external partners and internal teams for the faster valuation tempos and ensure relevant data and inputs are delivered in a timely fashion. Indeed, access to timely data may be the most important factor in establishing effective valuation processes. Whether firms decide to outsource valuation to a third party or establish dedicated internal teams, they should not underestimate the required effort.

Like other 1940 Act registered funds offering investment products to a broad retail audience (e.g., mutual funds and ETFs), these registered private markets funds are RICs for US federal income tax purposes and must issue Forms 1099 annually to their investors. They also must meet the ongoing qualifying income, asset diversification and distribution requirements under Subchapter M of the Internal Revenue Code (IRC) to qualify as a RIC annually.

Section 3(c)(7) funds structured as partnerships for tax purposes issue Schedules K-1 to their investors. While these partnerships do not operate within the confines of Subchapter M of the IRC, they do need to manage publicly traded partnership (PTP) considerations and retail investor demand for simplified tax reporting. Together, these factors can present significant challenges, as some first movers have learned.

The goal is to provide a quality investor experience that’s also compliant with relevant tax requirements and meets overall business objectives. Because the devil is in the (technical) details, any firm entering retail markets should engage tax advisors — as well as fund administrators, distributors and other external partners — as early as possible in the planning stages. That’s the right first step to establishing efficient and effective tax structures and processes within the context of a strong and flexible operating model.

In meeting investor expectations, firms will address a range of requests for responsive service, personalized experiences and access to advice. Liquidity management frameworks must be designed to accommodate smaller ticket sizes, higher redemption frequencies and evolving regulatory requirements. Some firms may choose to develop model portfolios combining various assets aligned to different investor objectives.

Because only the largest asset managers with well-known brands are likely to go direct to customers, most firms will seek distribution partners, including:

• Private wealth distribution platforms 
• Registered investment advisors (RIAs)
• Individual retirement accounts (IRAs) 
• Digital platforms and marketplaces 

Distribution and revenue-sharing fees will be a top concern, as will the ability to white-label fund offerings and considerations to handle customer-facing duties (e.g., investor education and communication). Bespoke advisory platforms can provide tools and resources to sell new offerings, while participation in financial and retirement planning ecosystems can extend reach. Whatever strategy they choose, asset managers will need to invest more in building and managing distribution relationships than they have in the past.

Today’s mostly manual valuation processes are obvious candidates for new tooling and automation. API-driven connectivity can support seamless and secure integration with a broader range of data sources, systems and third parties (e.g., fund administrators, distribution platforms and specialty service providers).

The more complex the fund structure, the broader the retail fund portfolio, and the bigger the distribution and vendor network, the more powerful and sophisticated systems firms will need. As they assess the many vendors and technology options available, firms must seek to match specific business requirements to unique features and functionalities. An optimal environment would feature:

• Data cleansed and centralized in a single hub
• Modular control packages customizable by product set
• Advanced analytics and AI-enabled insights

The good news is that increased efficiency and enhanced data access can result in accelerated time to market, increased operational agility, and an optimized balance of process efficiency and risk appetite. Better technology and data management can also deliver improved speed and accuracy in tax and accounting functions, board and management reporting, and investor communication.