How Are Capital Markets Restricted to Certain Investor Types?
Capital markets are venues where entities who own capital and those who seek capital trade securities. Throughout history, these markets have been an essential part of an economy’s growth. Talking about these markets without talking about investors is analogous to talking about finance without Wall Street.
Investors are key stakeholders in these markets without whom the whole financial infrastructure would be hollow. As with technology’s footprint in virtually every industry, the role of investors in these markets has also been changing.
We can loosely divide the types of investors in two major categories:
- Those who are sufficiently capable of bearing big risks and are experienced at it – Accredited or Institutional investors.
- Those who are fairly new to the entire setup and are starting out small – Retail investors.
On the one hand, it might seem that accredited and institutional investors are better off as compared to other investors since they have access to investment opportunities, primarily in the private markets, which neither have stringent reporting requirements nor a prospectus but on the other hand, these investments can be relatively risky owing to the fact that they are highly illiquid.
Examples of such private market investments include hedge funds, commercial real estate, angel investing, cryptofunds, late stage pre-IPO companies, and hard money loans. The high returns that an accredited investor might earn via such investments come with some important tradeoffs which include illiquidity, high fees, high minimums and eligibility restrictions.
In comparison to traditional stocks, bonds, and mutual funds where one can buy and sell shares daily, private investments are long term holds. Since accredited investors deal in private investments, their returns are measured in the long term.
The fee charged in private deals can be unreasonably high. Some REITs even charge up to 15 percent of investment capital before money flows into the actual investment. Such practices can greatly limit the investor’s returns.
Private offerings might need high investment thresholds, sometimes as high as $250,000. Although, with online crowdfunding the minimums have come down to as low as $1,000. Genuine sponsors usually require higher minimum amounts in the range of $50,000 to $100,000.
In many countries, the bar of achieving accreditation is very high. This also adversely affects the companies who are trying to raise capital through the private markets. The requirements for accreditation is largely based on an investor’s net worth which limits investment opportunities for those who may not be worth millions of dollars.
Pros and Cons of Expanding Private Markets to Retail Investors?
Retail investors are generally considered non-professional participants who invest smaller amounts. They are individual investors who are considered to be less knowledgeable and less skilled in making investment decisions. But why should retail investors only be limited to traditional or public investment markets?
Retail investors are now increasingly looking for opportunities to outperform public markets through investments in private companies because of the potential benefits offered by private investments.
Retail investors can benefit by holding illiquid assets offered in the private markets as these assets tend to have a lower Beta or lower correlation with the stock market. This means that these assets offer greater diversification especially if one has a longer investment horizon. Illiquid assets also tend to be less volatile which can be reassuring in times when stock markets are struggling.
However, the trade off in dealing with illiquid assets for retail investors is long term returns. The investment is tied up for long periods of time; for instance in real estate, it depends on how long it takes to sell a house or a commercial building. Moreover, these assets are at higher risk and harder to value because of fewer transactions.
An Evolving Regulatory Landscape
To provide greater access to retail investors in the private capital market, legislation is also moving forward. For instance, the JOBS Act equity crowdfunding provisions allow private companies to raise capital from retail investors within certain limits.
Platforms such as MetaFinance are bridging the gap between retail investors and private investments through the deployment of novel technology for companies to effectively scale operations and cater to a larger investor base.
Blockchain & Fractional Ownership (Tokenization)
Blockchain holds the potential to revolutionize the entire investment landscape by providing a transparent, secure & shared ledger to make capital markets more accessible, open and democratic. It provides a neat ecosystem for all types of investors and investment side stakeholders to diversify their purchases while maintaining direct control of their assets.
One of the ways it allows individuals to have a diversified investor portfolio is through fractional ownership of digital assets known as a security tokens. These tokens offer affordable and easily transferable units that create an opportunity for enhanced liquidity.
A good example is of assets that have high unit costs such as real estate. Digitization of such assets provides an opportunity to invest in fractional ownership. Previous limitations, high unit cost of assets, of retail investors to enter the private capital market can now be curtailed as anyone can have micro ownership stakes in private investment opportunities thus, enabling small investors to build portfolios that are spread across asset types.
With capital markets now expanding more and more into the private arena, sophisticated technology such as Blockchain and Artificial Intelligence can equip investors with powerful insights into these markets. Digital technology, combined with expansive regulations, are likely to revolutionize the emerging global investment landscape.