On November 20, SEC Commissioner Mark Uyeda called for the opening of 401(k) retirement savings to private markets.  He observed that diversification has grown increasingly difficult to achieve through public securities alone, and that private investments (in structures such as private equity, private credit, venture capital, infrastructure and real estate) would expand investment opportunities for retail investors.  “A zero percent allocation to private investments is not a neutral default—it is a policy choice,” Commissioner Uyeda remarked. “While there might be debate on what is the optimal level of exposure to private investments, what is clear is that the answer is NOT zero.”

In a recent paper, we investigate the legal and policy implications of this new age of retail-oriented private equity funds.  We argue that the dramatic growth of retail-oriented private equity presents under-appreciated risks for investors.

Private equity firms do not operate like ordinary public companies.  Investors have limited governance rights and fewer exit rights.  Several of the central features of the private equity model – from performance metrics to fee structures to valuation practices – create significant conflicts of interest between managers and investors and present steep barriers to informed decisions.  While many of these problems have existed in one form or another in the industry for some time, private equity has historically shielded itself from regulatory enforcement by its focus on “sophisticated” investors, such as pension funds and endowments, who have large financial resources and access to legal counsel.  But the industry’s turn to retail investors strips private equity of its golden shield: Once ordinary savers are invited in, the claim of sophistication can no longer insulate the system from scrutiny.

Consider, for example, private equity’s primary performance metric: the internal rate of return (or “IRR”).  An investor might well conclude from the metric’s name that it represents the annual rate of return on their investment.  It does not.  It is, instead, a theoretical financial concept defined as the discount rate that sets the net present value of a sequence of cash flows equal to zero.  Why do private equity firms use such a strange and misleading metric to report their performance? The short answer is that a “rate of return” does not exist for an investment product that generates intermediate cash flows.  A rate of return is only defined when there is a single investment followed by a single payoff. Once money moves in and out during the life of the investment, the question “what is the return?” has no correct answer.

Nevertheless, people expect to see a single annualized number, so people invented one: IRR.  But the IRR of a fund can (and usually does) diverge significantly from the rate at which an investor accumulates wealth.  Even more problematically, it is easy for firms to engineer high IRRs.  Because IRR implicitly assumes interim cash flows are reinvested at the same high rate, a manager who achieves a large early distribution – by selling early winners, using subscription lines instead of first capital calls, and other strategies – can produce very large IRR figures even if subsequent performance is poor.

Much of the existing debate around the so-called “democratization” of private equity has focused on how financial regulators should respond to the shift. Observers have debated whether the Securities and Exchange Commission or other bodies should tighten, loosen, or otherwise adjust regulation to ensure that investors are protected from abuse.  But securities law was not designed to police many of the practices at issue – misleading performance metrics, manipulable valuations, opaque fee structures, limited liquidity, and fiduciary duty waivers – and, in any case, financial regulators have generally signaled an intention to push in the direction of deregulation.

But as our paper shows, the retreat of public regulators does not leave investors without remedy.  A variety of doctrines not usually thought of as central to financial regulation – contract law, tort law, consumer protection, and fiduciary principles – are directly responsive to many of the worst practices.  Recasting the regulatory debate in terms of private law versus public law tools highlights the limits of traditional securities regulation but also reveals the underappreciated capacity of private litigation to enforce market discipline.

To date, for a variety of reasons, from investor incentives to statutory limitations, private enforcement has played a minimal role in the regulation of private equity.   Investors lawsuits are rare.  But as private equity firms increasingly tap into public capital, they expose themselves to new actors and new actions, many of whom will have different incentives and reputational concerns.  Mass lawsuits challenging deceptive or misleading practices in the industry could fundamentally reshape the private equity landscape.  The future of private equity will increasingly be decided, not in boardrooms, but in court.

Ludovic Phalippou is a professor of financial economics at the University of Oxford’s Said Business School. William J. Magnuson is an associate professor at Texas A&M University School of Law. This post is based on their recent paper, “Private Equity, Public Capital, and Litigation Risk,” available here.