Moody's downgrades Wall Street play to target retail clients as piggy bank to soak up trillions of dollars in illiquid investments

The dream of putting "institutional" investments into mom-and-pop accounts is shaping up to be a nightmare, according to a June 10 Moody's report obtained by RIABiz.

The bad dream includes a “systemic” failure where the financial system crashes and leaves retail investors holding the bag.

The rush by major mainstream managers to aid private equity managers in “capital formation” will also potentially bring down RIAs, custodians and broker-dealers who blithely hop on the bandwagon, analysts add.

Moody's downgrade of what Wall Street heralds as a new era of “democratizing” high-risk, high-return investments cites fears that too much money is chasing too few good deals – under a retail-specific urgency to get cash invested ASAP.

“The influx of retail money in vehicles that require rapid deployment will inflame situations where demand is outstripping supply, in a market that already has more than $4.2 trillion in dry powder sitting in drawdown vehicles, which must be invested,” the Moody's report states.

“An important distinction between drawdown funds and retail-oriented vehicles such as evergreen funds, is that the former typically have up to five years to put raised capital to work.”

Storm warning

Seth Adam Stuart, a Chicago investment product and strategy consultant, says Moody's is issuing what he calls a “yellow-light" warning – not without self-interest.

“They're trying to scare people a little bit to sell their research,” he says.

Yet, he quickly adds that the esteemed bond rater is perceiving a fast-developing storm that's more than worth calling to the market's attention.

“If you're a retail investor going with ETP or an ETF, you're not getting the best stuff out there,” he says. 

But retail investors aren't the only ones who should take heed of the storm warning, Stuart adds.

“If I were a Schwab attorney, I'd read this report,” he says. “I'd be saying to [Schwab CEO] Rick Wurster, do not ask to take minimums down to $5,000 or $1,000.”

The problem for deep-pocketed broker-dealers, custodians and other retail-connected participants is that they will – regardless of regulations – be asked to pick up the pieces if it all goes wrong, he adds.

For Moody's, its warning comes with a potential side benefit – not to get included in the next Michael Lewis movie as a throwaway line as it did in the 2015 film "The Big Short.”

Illiquidity trap

The Moody's report was all but inevitable because of a stunning mismatch of consumer and provider, says former iCapital executive and private markets marketing consultant Douglas Kim.

“It's a heavy lift,” he says.

“The model of the alts industry is B2B2C [business-to-business to consumer], but nobody is talking to the C because, technically, you're prohibited from marketing alts directly to individuals,” he says.

"Sales are left to the advisor, who is essentially the foot soldier with marching orders to sell an asset class that is largely illiquid, has higher minimums, lower reporting standards, and almost no brand or even category awareness. 

"And then you have a lock-up period that can be years. 

"My point is that without more education and real marketing, the category is going to meet resistance from the uninitiated.

Profound move

What set off alarm bells for Moody's was a recent slew of launches by mainstream brands, including Empower's decision to invest plan participant cash into private investments. 

“The potential size of this retail market is vast,” Moody's writes. “Momentum is growing – exemplified recently by Empower's 14 May announcement that it is in partnership with a number of investment managers to offer private assets in some retirement plans.”

“Empower is making a profound move on behalf of American retirement investors,” said Empower president and CEO Edmund F. Murphy III in the May 14 announcement.

Moody's also cited State Street partnering with Apollo, Blackstone and Vanguard teaming up with Wellington in a similar arrangement and other neophyte private investment companies joining the business. See: Vanguard's and Blackstone's plan to bring 'alts' to the masses revealed in SEC filing, but protagonists take passive role, leading analyst to brand the new fund a 'dud'

Today BlackRock disclosed in presentations that it will do $400 billion of private markets fund-raising by 2030, to make them, and technology, comprise 30% of total revenue by that year – up from 15% in 2024.

Missing opportunities

These initiatives occur against a backdrop of a more forgiving Securities and Exchange Commission (SEC) under Paul Atkins, who advocates cutting regulatory red tape and promoting financial innovation.

Citing one of his speeches, Moody's noted: 

“Since 2002, the SEC staff has taken the position that closed-end funds investing 15% or more of their assets in private funds should impose a minimum initial investment requirement of $25,000 and restrict sales to investors that satisfy the accredited investor standard.  

"As a result, many retail investors have missed out on opportunities to invest in closed-end funds that invest in private investment funds, like hedge funds and private equity funds.”

High prices

Private asset prices are sky-high, and the inventory of public assets is stretched because fewer companies are doing IPOs or getting taken private, Moody's explained.

“Private markets are becoming increasingly important to the expansion of global capital markets, in particular, as public listings fall and more companies opt to delist or remain private,” Moody's writes in its report. 

“To facilitate growth, asset managers and their partners are innovating new structures to provide points of access for private wealth. 

"‘Main Street’ investors are becoming more important as institutional investors bump against capacity constraints in their alternative investment allocations.”