Private equity’s push into the wealth and retail channels could lead to class actions from individual investors in a way the sector has not previously experienced. But this increased litigation risk to PE could serve to help indirectly regulate retail investments in private assets, two researchers argue.
“Private equity firms are not subject to the same regulations as public companies,” said William Magnuson, professor at the Texas A&M University School of Law. Under the PE model, investors have fewer rights and liquidity can be limited, among other things. In contrast, the SEC requires a long list of disclosures and standards for calculating fees and other expenses.
With private equity set to enter 401(k)s, the gap between the two regulatory frameworks could lead to a flood of legal actions against PE firms.
Magnuson has written a paper with University of Oxford Said Business School professor Ludovic Phalippou arguing that “Practices normalized in institutional settings—misleading performance metrics, manipulable valuations, opaque fees, limited liquidity, and fiduciary duty waivers—become significant litigation risks when ordinary investors enter the picture.”
The scholars note that while PE firms now court retail as well as institutional investors, they remain outside the reach of securities regulation through a combination of complex financial structures and legal exemptions.
“By broadening their investor base, private equity firms have exposed themselves to litigation under a wide range of domains, from contract to tort, from fraud to consumer protection,” Magnuson and Phalippou wrote.
Phalippou told II in a voicemail that the complexities and opacity of an asset class designed for an institutional environment will prove difficult for retail investors to understand.
“When people are presented with a fee that, say, is 2-and-20 with an 8 percent hurdle, nobody would understand that,” Phalippou said. “Nobody would understand that when somebody says, ‘I have 20 percent annualized return,’ we're talking about an internal rate of return.”
Magnuson argues that because financial regulators are ill-equipped to manage the dangers of semi-liquid, complex assets, the SEC’s under-regulation of PE has ironically created conditions for stricter enforcement through the courts. Mainstream investors, and their lawyers, could sue the industry over deceptive practices.
Ordinary humans will be incentivized and interested in bringing lawsuits against private equity firms if they see misbehavior in the industry,” Magnuson said, calling the number of suits PE firms have faced from investors until now “shockingly low.”
Private equity firms face far fewer constraints than managers of mutual funds and are not required to register their private funds as investment companies. “GPs organize their affairs as they see fit, as long as they don't do fraud,” Phalippou said.
But with the lines between public and private investing eroding, asset classes previously confined to institutional investors are now being offered to the public without the protection traditionally attached to public offerings.
Phalippou has been sounding the alarm about giving retail investors more unfettered access to private assets for some time now. After President Trump signed an executive order allowing plan sponsors to add private equity and crypto into 401(k)s, Phalippou warned retail investors that just because they can add these assets into their retirement accounts, does not necessarily mean that they should, since “the system is designed to benefit the insiders while leaving the public exposed to risks that they may not understand.”
While Phalippou argues illiquid private assets don’t belong in 401(k)s, institutional managers that have pivoted to the retail space, like NEPC, have argued that such assets are appropriate for younger participants who can afford to take illiquidity risk. Still, Tim McCusker, the firm’s chief investment officer, conceded that the “fear of litigation is really, really high.”
