Private Equity Takes Steps Toward Wooing Smaller Investors

One of Wall Street’s most exclusive investment products is inching toward the mainstream.

Private equity funds â€" vast pools of capital that buy and sell entire companies â€" may become more accessible to smaller investors under a plan being contemplated by the company that runs the Nasdaq stock exchange, a person briefed on the matter said on Friday. The plan, still in its preliminary stages, envisions a market where current investors in private equity funds can sell their stakes to individuals whose net worth falls far below the customary threshold for such investments.

It is uncertain whether the new market will pass muster with regulators. Any effort to sell private equity fund stakes to smaller investors raises a number of thorny legal questions, private equity lawyers said. The Nasdaq OMX Group has not yet filed paperwork with the Securities and Exchange Commission and is aware that the S.E.C. may not approve the plan, the person briefed on the matter said.

The effort was first reported by The Wall Street Journal.

Whatever the outcome, the plan by Nasdaq points to a desire among some of the giants of private equity â€" names like Kohlberg Kravis Roberts, the Blackstone Group and the Carlyle Group â€" to allow smaller investors into their funds.

To do buyout deals, these firms typically raise billions from institutional investors like pension funds and university endowments, and from ultrawealthy individuals, who commit a minimum of millions of dollars. But the private equity barons see a new frontier for capital in the vast numbers of doctors, lawyers, engineers and other affluent professionals who may want to add tens of thousands of dollars in alternative investments to their more modest portfolios.

Some private equity experts argue that the push to gather smaller checks is a worrisome sign for the industry. Josh Lerner, a professor at Harvard Business School, said the returns for such investments tend to be lower than when big institutions invest.

“These are being sold to investors who are not necessarily the most sophisticated,” Mr. Lerner said. “The one rule of alternative investing is that the worst time to be doing the investing is when everyone is excited about doing it.”

K.K.R., for its part, is in talks with Nasdaq about its possible new market, according to two people briefed on the matter. But K.K.R.’s ultimate plans may go beyond any Nasdaq deal.

Earlier this year, in a little-noticed announcement, K.K.R. said it was in the process of developing a private equity product for individual investors. Details of that product are expected to be filed with regulators next week.

A K.K.R. rival, Carlyle, which is based in Washington, got a head start early last year, unveiling a novel way for individuals to commit as little as $50,000 to invest in buyout funds.

The Carlyle operation, which is handled by a third-party firm that charges an additional layer of fees, has now raised about $200 million, according to a person briefed on the matter who was not authorized to discuss it publicly. The investors are considered “accredited,” meaning their net worth exceeds $1 million, not including their primary home â€" a far lower bar than the industry standard.

The outreach to small investors is expected to continue. One investment firm, the Partners Group, recently called on regulators to define rules for allowing participants in 401(k) plans to invest in private equity. And Carlyle may have similar ambitions.

“Nonaccredited investors â€" people who are not qualified to be in private equity today â€" will be able to go into private equity,” David M. Rubenstein, a co-founder and co-chief executive of Carlyle, said at a conference earlier this year.

“Everybody will recognize that private equity is mainstream,” he added. “It’s not just an alternative thing.”

Regulators are sure to scrutinize any innovations.

One major obstacle stems from a law called the Investment Company Act of 1940. Private equity funds are able to avoid registering under that law by limiting their investors to “qualified purchasers,” which includes individuals with at least $5 million in investments. It is not clear whether the market contemplated by Nasdaq would be able to allow “accredited” investors, who have a lower net worth, to participate.

Carlyle’s solution to this problem was to work with the third-party firm, the Central Park Group, which established a “regulated investment company” to comply with the act. The Central Park Group buys stakes in Carlyle funds from existing investors who want to cash out, and then sells them to smaller investors.

A spokeswoman for the S.E.C., which would police the matter, declined to comment on Nasdaq’s plans.

For Nasdaq, the new market would be part of a broader push into illiquid investment products. The company last month opened a new marketplace to buy and sell shares of private companies, hoping to capitalize on the demand for hot start-ups that have yet to go public.

If the private equity market does take off, it will probably look very different from the major stock exchanges, which have vast numbers of buyers and sellers, said Steven E. Siesser, chairman of the specialty finance group at the law firm Lowenstein Sandler. “I will be very surprised if a robust market develops around it,” he said.

But one day, Mr. Siesser said, private equity firms may find a way of creating a “publicly traded private equity fund.”

“This is a step,” he said, “to the ultimate goal of you being able to sign on to E*Trade and buy a share of stock of a private equity fund.”