Part 1/4: The Benefits of a Secondary Market for Certain Stakeholders
How the secondary market is successfully serving registered investment advisors.
Liquidity, or rather the lack of it, is a challenge to a range of stakeholders involved in providing services to investors. This holds especially true for alternative investments that normally are not listed on the major stock, bond and commodity exchanges. The advent of secondary market platforms for alternative investments injected liquidity where once it was lacking, including the markets for private equity, private debt and private/unlisted REITs, among many others. In this series, we’ll summarize the benefits of a secondary market to important stakeholders: Registered Investment Advisors, broker/dealers, issuers and lawyers.
Registered Investment Advisors
A successful RIA, be it a firm or an individual, looks to increase assets under management by providing, in the role of a fiduciary, valuable advice to clients. Whatever the eventual outcome of the current Department of Labor’s new Fiduciary Rule, we can all agree that RIAs should and must always act for the benefit of clients, even when also pursuing self-interests. The liquidity provided by secondary markets assists RIA in achieving these objectives in three ways:
1. Increase assets under management:
The JOBS Act, through its changes to the 506(c) Rule and to Regulation A, as well as the advent of crowdfunding, opened the private security market to non-accredited investors, and increased the scope of marketing to accredited ones. The general solicitation clause of 506(c) give RIAs a powerful toolbox to educate clients about exotic asset classes, while the secondary market exchanges mean that clients will not be stuck with unmarketable private securities following the one-year holding period – an important consideration for fiduciaries. AUM increases by attracting new clients interested in exotic assets, and by attracting new investments in those assets by existing clients. Secondary market platforms give RIAs a way to clear their books of product no longer compliant with the Fiduciary Rule. The proceeds from the sale of non-compliant assets can be reinvested in compliant ones that pass the best-interests test instead of sending those assets to a self-directed IRA.
2. Advise clients:
A criticism sometimes hurled at RIAs is that they might be tempted tie up clients’ assets in illiquid investments in order to trap AUM. The potential conflict is that many RIA’s receive compensation based on AUM, so that any strategy emphasizing illiquid assets works to the favor of these RIAs. The secondary market’s moot this criticism by making illiquid assets more liquid, enabling RIAs to give unconflicted advice to clients about alternative investments. The secondary markets also allow RIAs to give ongoing advice about illiquid positions, truly earning their AUM fee.
3. Better valuation:
The best way to value an asset is to put it up for sale. Illiquid assets don’t benefit from this valuation method unless they can enter the sale process via a secondary market. Valuations based on other criteria, such as historical prices, can be extremely inaccurate, which makes it impossible to determine a valid return on investment. If an asset is overvalued, ROI is too high and investors are tempted to maintain or increase holdings in this asset. Market-based ROIs are accurate, and might cause investors to reallocate their holdings to higher-returning assets.
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