Is crowdfunding a threat to private equity?

As traditional forms of wealth management products are becoming less attractive, there has been a sharp rise in high-net-worth individuals investing in VCTs, crowdfunding platforms and client syndicated accounts. All offer different benefits, but acting as a retail investor or sophisticated investor can have a huge impact on whether those cash injections return anything at all.

According to Knight Frank's Wealth Report 2013, the global population of ultra-high-net-worth individuals (those with more than $30m of investable assets), has grown from 181,146 in 2011 to 189,985 in 2012, while the number of billionaires globally has surged from 1,967 in 2011 to 2,198 in 2012.

Meanwhile, the post-crisis landscape has spawned a swathe of entrepreneurs and start-ups despite the disappearance of traditional sources of finance. To solve this, an entrepreneurial stance has been levelled at raising finance.

Is crowdfunding siphoning off high-net-worth cash from more institutional forms of investment?

Governments and authorities are keen to support new approaches to establishing and supporting young enterprises, and the UK has encouraged investments through tax relief schemes including VCTs and enterprise investment schemes (EIS). 

But, as ex-City types including former private equity practitioners seek more rewarding and interesting places to put their money to work, a grey area between crowdfunding, VCTs, angel networks and client syndicated funds has begun to loom, causing a great deal of confusion.

Perhaps the biggest danger of crowdfunding is fraud; does the project or company even exist? The most high-profile instance of fraudulent fundraising so far has been the Kobe beef scam in California. A false company, Magnus Fun, was almost set to receive $120,000 raised by more than 3,200 individual backers to aid the production of Kobe beef jerky. However, thanks to its social policing methods, Kickstarter pulled the plug on the project before raised funds were handed over.

"It's hard to do away with the risk of fraud when transacting online; that's an issue inherent to the internet," says David Bresnick, partner at law firm Morrison & Foerster. But it would appear the strong community feeling harnessed by crowdfunding sites has culled the number of genuine fraudulent cases, with hardly any having occurred in the last 24 months.

Squeaky clean failings
Of course, there have been examples aplenty of companies that have raised finance through crowdfunding sites and have failed to take off. In July this year, one of the first companies in the UK to receive finance through crowdfunding site Crowdcube, Bubble & Balm, ceased trading. The fair-trade soap manufacturer raised £75,000 from 82 investors in 2011 for a 15% stake in the company as well as free soap and discounted products. According to reports, the company's failure was simply caused by the consumer squeeze.

Experienced investors are all too aware of the need to diversify their portfolios – spreading money around to avoid a painful hit if something fails – and this is where an interesting legal caveat comes into play. In the UK, raising equity for investment is regulated by the Financial Conduct Authority (FCA). "There are some regulated crowdfunding platforms in the UK, including Crowdcube and Seedrs. They can promote equity investments under the exemption that allows for sophisticated investors," explains Bresnick. And just last week, the FCA published new guidelines to further enforce the need to qualify investors with a new rule to ensure they have the financial capacity if any major losses are suffered.

Institutional fund managers will be all too aware of the need to label someone as a sophisticated investor, and for many, this means lengthy background and due diligence checks to ensure the individual can be deemed responsible for their decisions. But the regulated crowdfunding platforms are neatly skating around this issue by simply requiring new investors to fill out a form in order to qualify as sophisticated.

In contrast, VCT managers and those operating institutional client syndicated funds go to great lengths to mitigate risk on behalf of their investors. Not only are detailed screening processes carried out in order to enable investment in the fund, the vehicles are managed by experienced and professional investors, investing across a range of companies to reduce over-exposure on singular assets.

Connection Capital is a private client investment business that acts as a deal-by-deal private equity investor. As such, it performs the necessary checks and balances to protect investors when it assesses new investment opportunities. Connection even goes one step further by underwriting all of the abort costs including third party due diligence costs. "People investing in the crowdfunding model are not offered the same investor protection that we can give to our clients," says partner Claire Madden. "We provide the same protection for investors that an institutional private equity fund would insist on, as all of our clients are invested under one master investor agreement."

"Personally, I do not see [crowdfunding] taking over from traditional funding," says Bresnick. "I think it will simply turn into another option; a way of matching investors with entrepreneurs." Bresnick points out that the current state of affairs is a result of technology running ahead of regulation.

And already the industry is finding ways to improve itself and become a safer environment for investors. "There are a couple of platforms taking the concept to the next level, for instance Syndicate Room, where investment is only possible after a more traditional lead investor has agreed to write a bigger cheque. Comfort for less experienced investors is achieved through following Angel or more traditional investors," explains Bresnick.

As Europe battles against its liquidity drought resulting in a void of funding for new and young businesses, everyone has to think about creating more options for those wanting to invest and for those needing investment.

The social roots of crowdfunding means it is an industry built on community ethics – one that is supportive of all its users. And, despite a lag in legislation, crowdfunding platforms are already evolving to allay investor fears through hybrid approaches, similar to innovations witnessed in the venture capital industry, such as the "friends and family" round. It is in this spirit that the asset class could welcome crowdfunding: view it as a solution to the lack of start-up funding, and furthermore, as the potential petri dish in which future opportunities are cultivated.

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