Should small financial institutions offer investment opportunities in private markets?

In today's fast-moving financial landscape, managing money effectively is a universal concern. While we all have different goals – buying a home, saving for retirement, or growing our wealth – the fundamental question remains: how do we best invest our surplus funds?

In developed countries, where financial systems are well-established, the options seem endless: from the safety of savings accounts and investment-grade bonds to the potential high returns of high-yield bonds, stocks, and real estate.

Due to a sense of familiarity, much better accessibility and regulations protecting investors, people tend to gravitate towards public markets, and we tend to overlook that the vast majority of opportunities are in the private sector. Private markets, despite being less visible, less accessible, and harder to analyze, offer vast potential. Yet, they remain underutilized, particularly by smaller financial institutions. This article explores why expanding into private market investments might be a wise move for some financial institutions, especially those serving affluent clients with more complex financial needs.

What is lacking from the current offer? 

To gather what’s missing from what financial institutions are currently offering, it is useful to first understand how they operate and who they serve. Smaller financial institutions focus on specific market segments. Hence, their offerings need to address to their target market needs. 

If the case is that I work mostly with retail investors, I might not need an extensive product line. My goal, instead, should be how can I better serve a large volume of low-margin clients. Opportunities like private equity would be beyond my scope. 

On the other hand, if I’m attracting wealthier clients and their needs become increasingly complex, I might need to adapt my offerings to help them meet their new goals. This may include alternative investments. Even though they are perceived as riskier, these vehicles provide a gateway to attractive returns, otherwise, institutional investors such as university endowments and sovereign wealth funds would not allocate capital to them. Having these opportunities available could give me an edge. 

Advantages, disadvantages, and risks

Once a smaller financial institution expands its product lineup, it becomes more appealing to affluent clients interested in diversifying and expanding their investment outlook. They might be enticed by the idea of investing in hedge funds, private equity, or real estate funds, among others. This requires a more dynamic contact with clients, which is beneficial for both parties. Helping clients feel supported in their financial journey — especially as their goals change — could lead to increasing loyalty over time.  

There might also be clients who, being more proactive, may turn elsewhere if their current institution does not meet their needs. Given that there are so many funds and platforms available, this creates a risk for smaller financial institutions — due to their limited offering, they could lose some of their assets under management, which diminishes their revenue. This is another reason why having a wide array of products enhances a financial institution’s competitiveness, and mitigates the possibility of losing out to other firms. 

Now, it is clear that establishing a new product line focused on investing in private assets demands a gargantuan effort, and it carries its own risks. This is particularly true if you intend to do this through an in-house team — a costly and time-consuming endeavor, as you would need to hire specialists who can spot potential deals across industries and geographies, and then, conduct the proper due diligence checks to vet them and emit a recommendation. You would also need to consider legal costs. 

It all seems a lot for something with an uncertain outcome. Even if you’ve gauged client interest and the responses seem positive, there is a considerable gap between theory and practice. Challenges do not end here. You would also need to train your sales team — they might not be prepared to sell products with this level of complexity. They might also be hesitant to do so. At the end of the day, we’re resistant to change. 

Last but not least, private markets come with a significant level of information asymmetry. Founders, management, active early investors in companies often know far more about the business than what is publicly disclosed, and companies may use selective framing when discussing their operations. These factors create additional risk for prospective investors. If you opt for incorporating private assets investment opportunities in your lineup, you must clearly communicate these risks to your clients, and, based on their risk tolerance, decide the percentage of their assets that can be allocated to this segment. 

Final thoughts

For smaller financial institutions, deciding whether to offer investment opportunities in private markets is not easy, and it depends on various factors. If your financial institution serves a segment of high-net-worth individuals, it might be worthwhile to explore it, as they will likely request access to these opportunities. 

However, you do not need to go at it alone. An effective approach is to partner with external experts who can source and structure these deals, as it saves considerable time and money. Choosing the right partners is crucial, as they can help train your sales team and take care of aspects like legal checks and due diligence. They will also ensure that the investment opportunities they present are thoroughly analyzed before they reach your desk. Having said this, you will need to stay involved, especially at the beginning while the basic foundations of a fruitful collaboration are established.