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A couple of weeks back, we wrote Building a more diverse ecosystem to expand on the shortcomings of today's venture capital ecosystem and the solution that equity crowdfunding offers. Today, we are digging into the other major challenge that equity crowdfunding addresses - wealth inequality. But instead of breaking down how equity crowdfunding may potentially be part of a bigger shift that can reshape the wealth gap present in this country, the entire focus of this is on wealth inequality itself and how it has been accelerated by a severe investment gap. 


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How the rich have gotten richer
The United States continues to grow more economically unequal, both by a measure of income levels and household wealth. As the richest individuals have watched their wealth compound in recent decades, the rest of the population, for the most part, have made relatively little progress in growing theirs. Driven primarily by one factor, in particular, this widening wealth gap can largely be attributed to a disparity in the ownership of appreciating assets.
  • In order for an individual to grow their wealth, the formula is simple and the options are limited. They can either earn more income, save more income, or both; or they can own or receive assets that appreciate in value, such as real estate or stocks. Though both of these methods result in the accumulation of assets, the ownership of appreciating assets plays an especially important role in building one’s wealth.
It’s not as simple as wealthier individuals having more investments. It’s that they have better-performing ones, too. In a study conducted by a New York University economist, Edward Wolff, it was found that the top 1% earned an average annual return of 5.91% between 2010 and 2013 – far greater than the 3.27% earned by the middle three quartiles.
  • The primary reason for this was due to more exposure to higher-risk, higher-reward investments. According to Wolff, “the differences reflect the greater share of high-yield investment assets like stocks in the portfolios of the rich and the greater share of housing in the portfolio of the middle class”. Importantly, Wolff also stated that investments in private businesses and commercial real estate also boosted the returns of the rich.
Accounting for almost 75% of aggregate household assets, appreciating financial assets such as stocks, mutual funds, retirement accounts, and closely-held business make up the large majority of household wealth. The ownership of these assets, however, is far from equal.
  • The Fed recently estimated that the wealthiest 10% of Americans hold more than 88% of all available equity in corporations and mutual fund shares. What’s more, it is estimated that the top 1% control more than twice as much equity as the bottom 50% of all Americans combined.
Upper-income families, who derive a larger share of their wealth from financial assets, were the only income tier that was able to grow its wealth from 2001 to 2016. While upper-income individuals increased their wealth by 33% from 2001 to 2016, the wealth of middle-income individuals and lower-income individuals fell 20% and 45%, respectively.
  • In 1983, upper-income families had 3.4x as much wealth as middle-income families and 28x as much wealth as lower-income families. By 2016, those figures had more than doubled to 7.4x and 75x, respectively. The reason for this – upper-income families were better positioned to capitalize on financial asset appreciation over the time period.
As a result of what has been an ongoing widening of the U.S. wealth gap, it was estimated in 2019 that the bottom half of individuals generated approximately 15% of the nation’s income but were responsible for just 1% of its $98 trillion in household wealth.

How has this happened?
It wasn’t always this way. There was a time when the United States was considered one of the world’s most equal societies. Even when wealth inequality rose, it would soon thereafter return to its previous level. Demonstrated by what has come to be known as the Kuznets curve, income and inequality were found to have an inverted-U-shaped relationship. Inequality would rise in the early stages of new eras and fall afterward.
  • Following the culmination of the Great Compression in the ‘80s, the United States had come to be among the most economically equal countries in the world. During this time, economic inequality as shown by wealth and income distribution between the rich and poor became much smaller than it had been in preceding time periods.
And then the narrative changed. The share of income going to the top 1% soared from 8% to over 20% today. For the sake of keeping this brief, we’ll broadly say rising import competition hindered employment in domestic manufacturing as global trade began to boom, and unskilled workers were left behind as technology advanced. There are, of course, other factors at play here, but the takeaway is this: just as what’s been seen throughout American history, wealth inequality began to rise with the beginning of a new era – the Information Age
  • What was different this time, however, was how this new era enabled the wealthy to compound their riches.
The investment gap
With the rise of the digital era, the very wealthiest individuals were incrementally granted more and more access to higher-yielding real estate, venture capital, and hedge fund investment opportunities. To be clear, these opportunities existed before the ‘80s. It was the unstoppable adoption of information technology, however, that made these opportunities easier than ever to invest in. That is – only if you had enough money to get in on the action.
  • As a result of money compounding on itself over time, what began can be thought of as a snowball effect that has resulted in the massive U.S. wealth gap. Widely regarded as the most successful investor in history, Warren Buffet credits compounding interest as the single most impactful factor that led to his historic achievements. Before Buffett, Albert Einstein referred to compounding interest as the eighth wonder of the world.
For decades now, the wealthy few have been afforded exclusive access to higher-returning investment opportunities while the vast majority have not. The average investor, otherwise known as the retail investor, hasn’t had the ability to partake in the same outsized returns of the rich. Instead, they’ve put their money in publicly traded stocks – an asset class returning an average of 9-10% per year.
  • Though the portfolios of even the wealthiest of individuals are founded on the very same publicly traded stocks that retail investors can also buy and sell, their incremental exposure to alternative assets, however small the allocation may be, makes all the difference in the world.
This investment gap is largely to blame for the widening wealth gap, which may now be more accurately defined as a wealth crater. While institutions and the wealthy have increasingly poured their assets into better-performing alternative options, the retail investor has been left behind with limited, archaic investment choices.
  • There’s no better example of how asset managers have shifted their focus than reviewing how The Yale Endowment has altered its approach over the past 40 years. In 1987, 90% of the endowment was invested in publicly traded assets. By 2018, over 50% of it was invested in alternatives. And in 2019, the ultra-high net worth invested over 25% of their portfolios in alternative investments.
The difference that alternatives make
The public market is not what it once was. During the 1990s, there were more than 8,000 publicly traded companies. That number had fallen to 3,500 by 2017. As access to venture capital funding has become more readily available (due to institutions and wealthy individuals providing venture capital firms with more assets), companies have opted to stay private for longer.
  • This trend of businesses staying private for longer has had a profound effect on the returns achievable from companies once they go public. The longer a company stays private, the more its investment upside is captured in the private market.
Consider Beyond Meat ($BYND) as an example. At its IPO on May 2, 2019, the company was valued at $1.5 billion. Today it’s valued at over $9 billion (market capitalization). Should the company have elected to delay its IPO by just one year, for example, perhaps its IPO valuation would have been $5 billion (hypothetical). For those that invested in Beyond Meat in its early stages, this would have increased their return on investment. For those that didn’t have access to invest in Beyond Meat while it was private but instead invested as soon as they could when it went public, this would have decreased their return on investment.
  • Though hypothetical, this accurately demonstrates the impact had on retail investors when companies choose to stay private for longer. They are exhausting more of their growth while private, leaving less upside potential for when they eventually do go public. As institutions and wealthy individuals have flocked to the private markets over the past three decades, this has been taking place more and more often.
Source: AltoIRA 
In 2018, a study published by Cambridge Associates revealed just how lucrative venture capital returns can be. The VC industry outperformed the S&P 500 over the previous 5, 10, 15, 20, and 25 years. Funds yielding top-quartile returns outperformed the S&P by ~2x over each of those time periods. The following comparison reflects data available at the time that the study was published.
Source: Alumni Ventures Group
Historical angel investing returns tell a similar story. A 2009 Federal Reserve study found the average annual return of 3,097 investments to be 33%. Pooling eight large studies together, another review found the average annual angel investment return to be 27.3%. Even though the studies used in the review included data from different time periods, industries, and companies, the underlying dynamics that drive angel portfolio returns were found to be “remarkably consistent”.
  • Summed up by the founder of Tech Coast Angels, one of the most prominent angel groups in the U.S., “a large, diversified angel portfolio should provide an internal rate of return (IRR) of at least 25% per year.”
Combining these superior returns with money’s innate ability to compound on itself over time, the difference is dramatic. But it’s not just the superior returns that are desirable. Offering differing levels of risk, correlation to other assets, and return structures, alternative investment choices allow investors to better construct their portfolios to more precisely fit their risk tolerance and desired risk-adjusted return. In a future deep dive, we’ll dig into how exactly this works and how investors use alternative assets to construct portfolios that are optimized for higher risk-adjusted returns.
  • Other alternatives that were previously available only to institutions and wealthy individuals include investments in private equity, private debt, hedge funds, art, and real estate. All of these opportunities allowed investors to diversify their portfolios while increasing their exposure to benchmark-beating investments.
A new day for retail investors
The playing field has remained uneven for too long. More and more are awaking to this realization each day. In recent years, startups focused on democratizing investing for retail investors have emerged by the dozens.
  • More favorable regulation combined with the cost-effective fractionalization of ownership that technology has enabled has only just begun to propel a capital markets transition yielding more power to retail investors.
Never before have retail investors had access to such an abundance of nontraditional assets. But it’s not just the many new investment opportunities that emerging startups are relentlessly working toward democratizing. New and exciting companies are even changing how retail investors invest in traditional assets like stocks and bonds.
  • Over the last decade, we’ve seen asset managers create a seemingly endless list of ETFs that allow retail investors to diversify with smaller investment amounts. We’ve seen a race to the bottom in fees charged on these funds. We’ve seen robo-advisors emerge and create a new way for this up-and-coming generation of investors to manage their wealth. The list goes on.
And then there are private assets. With the introduction of equity crowdfunding in 2016, retail investors have presented the opportunity to partake in the opportunities that institutions and the ultra-wealthy have become so particularly focused on over the past decade. Offering potential returns that double what would have otherwise been achievable, this has the ability to change everything.
  • As equity crowdfunding comes of age and regulation continues to become more retail investor-friendly, this brand-new asset class presents investors with the opportunity to significantly reshape their long-term wealth prospects.
Times are changing, and these changing times have the ability to dramatically reshape the U.S. wealth gap. Now that you understand how the U.S. wealth gap has been accelerated by an enormous divide of available investment opportunities, we’ll help you better understand how investors can begin to implement some of these new assets like equity crowdfunding into their portfolios today and the implications that these small changes can have over the long-term.
 
But for now, we’ll leave you with this quote from Albert Einstein. Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it. In the context of the wealth gap that has widened for the last ~40 years, this couldn’t be any more relevant.

 
Want me to take a deep dive look into a particular offering, ask any questions, or just reach out and introduce yourself? Shoot me an email at drew@thecrwd.com. Otherwise, I'll see you next week.
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