Private equity for the average Joe? It's comingDecember 20, 2012: 5:00 AM ET
One of private equity's biggest sources of investing income may soon dry up. Their loss could be your gain.
FORTUNE -- Private equity isn't all that private. More than 25% of the industry's money actually comes from U.S. public pension systems, which represent everything from firefighters to teachers to subway workers. From 2001 to 2010, that worked out to approximately $385 billion for domestic private equity coffers. This cannot last forever. In the coming decades private equity will need to find a new, supplementary capital source. And I'm thinking it will be you, Joe Investor.
The problem is fairly simple: Public pensions are grievously underfunded, thus threatening local and state solvency. Politicians have begun to address the problem, mostly by requiring workers to contribute more income for fewer benefits. Some states, like Rhode Island, have begun to incorporate 401(k)-style programs that are likely the first step toward shifting the broader defined-benefit plans into defined-contribution (DC) plans.
If a meaningful percentage of public pensions transition to DC plans, the spigot could shut off for private equity. Those plans allow workers to pull out their money at will, which doesn't easily conform to a long-term asset class like private equity. If private equity lost access to just 10% of public pension capital by 2020, it would represent a gap of at least $38 billion. Yes, private equity would still be able to tap such stalwart institutions as university endowments, but neither Harvard nor Yale would be inclined to help make up the difference.
Which brings us to you, the individual investor who may be intrigued by private equity's history of outperforming both the S&P 500 and the Dow Jones industrial average. With just a few historical exceptions, private equity has shunned you. Part of its antipathy has been regulatory, with the SEC insisting that private equity funds accept only "accredited" investors (i.e., institutions and millionaires). It's also easier and cheaper for firms to manage a small number of large investors than manage a large number of small investors.
But rules can be changed, and private equity firms can hire a few more investor relations staffers. Survival is paramount, and there isn't another large pool of capital that the industry has yet to woo. The question is how private equity firms will structure future funds to accommodate individual investors. There will probably be plenty of trial and error until an industry standard emerges.
We do, however, have a few clues from (limited) past experience. The very first private equity funds invested public money, and we saw a brief revival during the late 1990s (meVC.com, etc.). Kohlberg Kravis Roberts & Co. (KKR) raised investment capital via a European listing and more recently began soliciting retail investors via Charles Schwab for a pair of closed-end mutual funds (neither of which is focused on private equity, but KKR is clearly seeking out new strategies).
In order for private equity to truly open up to the masses, individual investors would need a way to redeem their fund stakes if necessary. For this, I'd imagine a sort of electronic secondary exchange like what currently exists for startup company stock. Or perhaps several of the firms that currently buy fund stakes from institutional investors would set up their own platforms.
Second, private equity firms would continue to value their portfolio companies at fair-market value, as has been legally required for the past several years. This would also have to include a brief but clear explanation of how such values were determined. If individual investors believe they have been misled, then trust is lost and the capital gap remains.
Finally, different private equity firms might work together to offer blended securities -- particularly if one industry sector or strategy suddenly becomes hot, creating the need for new capital quickly.
Private equity will never be for everyone. Its best returns come only to those who wait, and it's considered high risk for good reason. But thanks to America's public pension mess, at least we'll all have the option someday.
This story is from the December 24, 2012 issue of Fortune.