Searching for the millionaire next door

US private equity firms have had a difficult time breaking into the “mass-affluent” market. David Snow explains why.

Here's the good news for fund managers in search of fresh investment capital ? the world's supply of millionaires actually increased in 2001, despite the market turmoil. As for the bad news ? these millionaires are difficult to reach. Furthermore, when they are reached, they are not very enthusiastic about private equity funds.

For years, US private equity firms have experimented with different strategies for reaching the ?millionaire next door? ? so-called after a best-selling investment-advice book of the same name. Also referred to as the ?mass affluent,? this group can be loosely defined as the great sea of individuals who have more than $1m worth of financial assets, and who therefore qualify to invest in private partnerships in the US. Private equity professionals have devised numerous ways to channel a portion of the capital controlled by the mass affluent into private equity funds. The results have been mixed.

A huge untapped opportunity
None of these industry pros are under the illusion that capturing and managing high-net-worth money is easy. It is preferable by far to raise and manage one $25m chunk of pension money than it is to secure 25 $1m individual commitments. But the high-net-worth market offers something that the large institutional market does not ? plenty of virgin territory. The everyday millionaires represent a huge, and growing, untapped opportunity. According to a recent report sponsored by Merrill Lynch and Cap Gemini Ernst & Young, the number of millionaires in the US grew slightly last year to 2.1m, despite the vastly weakened investment markets. The same report put the number of highnet-worth individuals around the world at 7.1m, up 3 per cent. The average wealth of high-net-worth investors in the North America actually increased 1.7 per cent in 2001. Clearly, the mass affluent are here to stay, and as they seek to diversify their financial assets, private equity firms are betting that a piece of the action will flow their way if they build the right channels.

But executing a business plan based on this premise has proved tricky. Private equity firms that have sought capital from the mass affluent have stumbled in their attempts to build successful distribution networks. They find themselves defending the asset class to a group of investors, many of whom soured on private equity with the collapse of the tech market. They are also having to grapple with the perennial issue of illiquidity.

To be sure, individual investors have long been involved in US private equity, and their involvement increased dramatically toward the end of the 1990s. This trend could be seen clearly in the dramatic rise of private equity funds of funds, which offered greater diversity and lower commitment minimums to accredited individuals. But a fund of fund's ability to raise money was only as good as its distribution. Millionaires are plentiful, but marketing partnerships to them in a systematic way requires a network. With this aim in mind, a number of private equity firms with fund of funds ambitions established partnerships with more traditional money managers in order to tap their existing networks of wealthy individuals.

Failed efforts
In late 2000, San Francisco merchant bank Thomas Weisel Partners established a joint venture with mutual fund veteran Zurich Scudder Investments to offer private equity and related products to Scudder's high-net-worth clients. The new firm, called Scudder Weisel Capital, folded up shop less than four months after its debut vehicle failed to draw enough capital.

More recently, mutual fund giant and private equity advisory heavyweight Hamilton Lane announced the dissolution of a partnership that was to manage private equity funds of funds on behalf of Vanguard's accredited customers. As with the Scudder Weisel venture, Vanguard had difficulty preaching the private equity gospel to its network of wealthy investors, who were used to thinking of Vanguard as a low-fee money manager.

Private equity market insiders have long speculated that Fidelity Investments, the largest mutual fund manager in the nation, would eventually create private equity products for its client base. In fact, The Carlyle Group for a time was in discussions with Fidelity on just such a product. But according to a person familiar with those talks, ?the idea was run up the flag pole and then died.? Fidelity's chairman, Ed Johnson, is apparently loath to put the Fidelity name on a vehicle backed by private equity funds

While the strategy of reaching the mass affluent through mutual funds has had limited success, private banks have yielded more fruitful distribution networks. Private banks, especially at large US financial institutions like J.P. Morgan and Merrill Lynch, have for years created ?feeder funds? for their wealthy clients to invest en masse in single-manager private equity funds. Private banking clients also make natural candidates for in-house funds of funds. While The Carlyle Group failed to make headway with Fidelity, it recently did quite well with Coutts, the UK private bank. The Washington, D.C.-based private equity powerhouse last month announced it raised $114m from Coutts clients for a private-label vehicle that will invest in seven Carlyle funds. Carlyle's success with this approach may indicate that private banking clients are more comfortable with higher-fee products and illiquid investments. Private banking accounts are also more frequently discretionary, thus placing the decision to allocate to private equity in the hands of a professional money manager, not a millionaire next door. Finally, the clients of Coutts simply have more money, on average, than do accredited mutual fund customers.

Educating the sceptics
When private equity firms actually do reach the mass affluent, they have a lot of explaining to do. Unfortunately, many wealthy investors equate private equity investing with busted technology deals. They remember that the height of the market bubble was marked by investment sales people who aggressively solicited high-net-worth money for doomed venture deals.

This image problem, of course, can be corrected by patient education and time. A more serious barrier to tapping mass affluent capital has to do with the inherent nature of private equity ? illiquidity. High-net-worth individuals have been known to have an appetite for risk, but not for decade-long capital lock-ups. Hence, among the ranks of the mass affluent, hedge funds are currently hot, and private equity funds are not. According to the Merrill Lynch/Gemini report, high-net-worth individuals are increasingly allocating their wealth to alternative investments, but the trend is being driven by interest in hedge funds. In 2001, hedge funds as an asset class rose 7.2 per cent according to the Aggregate Index. Private equity funds fell 18.5 percent over the same period, according to Venture Economics. But putting performance aside, hedge funds present an added advantage ? the ability to get out. While practices vary widely, many hedge funds offer liquidity opportunities at least quarterly. A handful of enterprising structured-debt specialists are attempting to create private equity vehicles with similar features, but because the underlying investments are private companies, not stocks, the undertaking is far more difficult.

Wealthy individuals may be willing to overlook the illiquidity once private equity funds start showing good returns. One thing is certain – as long as there are accredited investors with capital to invest, there will be private equity fund managers looking for ways to reach them.

David Snow is the editor in chief of, a New York-based Web site providing news and information on the private equity industry.