Private Equity in 401(k)s?

Retirement saver beware

This occurred at the beginning of June — the Department of Labor issued an information letter regarding the use of private equity funds in DC (defined contribution) plans like 401(k)s.

I am not all that pleased with this. I don’t like the spread of either private equity or private placement debt beyond direct investors. That is, I am just fine with wealthy folks dabbling in all sorts of esoteric investment arrangements. It can be fine for institutional investors, like insurance companies, being involved in some of these sorts of investments (especially since insurance companies have to hold risk capital against their assets).

I am not fine with this being embedded in 401(k) plans and the like. It really undermines the whole reason for employee protections built into ERISA and other retirement benefit-related laws and regulations.

News coverage

DOL opens gate to private equity in DC plans

Big rush to add the asset class is not expected, experts say

After years of calls from alternative asset proponents, the Department of Labor has explicitly permitted the use of certain private equity strategies in defined contribution plans so long as a prudent fiduciary process is undertaken.
But while the Labor Department’s guidance is a step in the right direction, the adoption of private equity in DC plans won’t happen overnight, experts say.

“We do think the marketplace is there,” said Robert Collins, managing director and head of Partners Group (USA) Inc.‘s New York office. “Now does it change in July 2020? No, this is still an institutional marketplace that has a deliberate and methodical way of introducing products … so it will take some time. It’s not today, tomorrow, or next month, but we’re convinced that this is the action that the DOL needed to take in order for these sponsors to finally be able to achieve their objective of offering that best-in-class portfolio, which gives their employees a better chance at hitting their goals.”

Robert Collins said the institutional market is methodical, so implementation will take some time.
The Labor Department published an information letter June 3 in response to a Groom Law Group LLP request on behalf of its clients Pantheon Ventures (U.S.) LP and Partners Group, which have developed private equity strategies that can accommodate DC plans. The letter made clear that DC sponsors can implement certain private equity strategies into diversified investment options, such as target-date, target-risk or balanced funds, while complying with the Employee Retirement Income Security Act.

As we’ll see below in the official Department of Labor (DOL) documents, this is a lot more narrow than just opening it up to all flavors of private equity. So far. I bolded the names of the groups who asked for the response, because one of the people directly involved was being quoted in the piece. We will be seeing naysayers soon enough.

That said, there still is concern, even with this narrower application, and for some similar reasons as with private equity in public pension plans.

CNBC: Private equity investments may be coming to your 401(k)

The U.S. Labor Department issued guidance Wednesday stipulating that business owners with 401(k) plans can more safely offer certain funds with a private equity component to their employees.

While some experts believe 401(k) savers could use those funds to get stronger returns, others believe doing so would expose them to high fees, more risk and predatory practices.
….
The guidance gives more legal protection to businesses whose 401(k) plans offer TDFs [target date funds] that bundle in private equity.

However, the agency doesn’t give the same blessing to those with a fund that invests solely in private equity, according to the guidance, which took the form of an information letter.

…..
Companies like Intel and Verizon have been sued by employees in the past few years over the firms’ use of alternative investments in TDFs, and other business owners may have shied away as a result, said Kevin Walsh, an attorney at Groom Law Group.

Advocates for using private equity in 401(k) plans believe the investments deliver higher returns than other funds and question why they are used in pension plans but not 401(k) plans.
……
“The private equity part of private markets are some of the riskiest investments with extremely high-leverage and very high fees,” said Dennis Kelleher, president and CEO of Better Markets, a consumer advocacy group.

“Additionally, while the [Labor] Secretary plays salesman for private equity, claiming ‘strong returns,’ the truth is that private equity performance and returns have often been poor at best,” Kelleher added.
……
Plus, the typical employer won’t have the financial sophistication to examine private equity fund investments and know whether the risks and costs are appropriate and know whether it would be a prudent option for the 401(k) plan, said Barbara Roper, director of investor protection at the Consumer Federation of America.

We will be seeing similar commentary below. No, it is not true that private equity will always return better than the broader market. It’s silly when I say it that way, isn’t it?

The whole concept around private equity is that fewer people are holding the stock of the company, and thus have closer control. While the company doesn’t have to abide by all the filing requirements that the SEC requires of public companies, when it’s just a few big shots holding the shares, they can ask for whatever information they want.

I’ve known several successful private equity funds… that were rich people with experience in a specific sector with their own money to invest. That makes a hell of a lot more sense than just random 401(k) holders.

This has a principal-agent problem written all over it.

Official DOL statements on private equity in 401(k)s

Here are the official publications from the Department of Labor [excerpted].

The Department of Labor press release: U.S. DEPARTMENT OF LABOR ISSUES INFORMATION LETTER ON PRIVATE EQUITY INVESTMENTS

he U.S. Department of Labor today issued an Information Letter under the Employee Retirement Income Security Act (ERISA) concerning private equity investments as a component of a professionally managed asset allocation fund offered as an investment option for participants in defined contribution plans.

On May 19, 2020, President Trump issued Regulatory Relief to Support Economic Recovery Executive Order 13924. President Trump directed agencies “to remove barriers to the greatest engine of economic prosperity the world has ever known: the innovation, initiative, and drive of the American people” in order that we may “overcome the effects the virus has had on our economy.”

“This Information Letter will help Americans saving for retirement gain access to alternative investments that often provide strong returns,” U.S. Secretary of Labor Eugene Scalia said. “The Letter helps level the playing field for ordinary investors and is another step by the Department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”

Chairman of the U.S. Securities and Exchange Commission Jay Clayton commended the Department’s efforts to improve investor choice and investor protection, saying the Information Letter, “will provide our long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds as well as the benefit of selection and monitoring by ERISA fiduciaries.”

There’s more, if you care to read it.

The DOL Information Letter [which is even longer than the press release]: Information Letter 06-03-2020

Dear Mr. Breyfogle:

You asked on behalf of Pantheon Ventures (US) L.P. (Pantheon) and Partners Group (USA), Inc. (Partners Group), for the views of the Department of Labor (Department) on the use of private equity investments in designated investment alternatives made available to participants and beneficiaries in individual account plans, such as 401(k) plans, subject to the Employee Retirement Income Security Act of 1974 (ERISA).(1)

Remember the names Pantheon and Partners Group, because there are people quoted very happy about this… and they have a direct connection.

The Department believes that a plan fiduciary of an individual account plan may offer an asset allocation fund with a private equity component of the type you describe in a manner consistent with the requirements of Title I of ERISA. However, there are important differences between a fiduciary’s decision to include private equity investments in the portfolio of a professionally managed defined benefit plan, and the decision to include an asset allocation fund with a private equity component as part of the investment lineup for a participant-directed individual account plan. As compared to typical public market investments available in individual account plans, private equity investments tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees. A typical private equity investment is structured to reflect the longer-term nature of the commitments required to achieve the investment’s objectives. The typical structures also allow the vehicle’s investment professionals to guide the management and operations of the portfolio companies in which the vehicle invests to maximize the returns for investors over a multi-year period during which investors’ ability to redeem or sell to obtain a return of capital may be limited. As compared to public market investments, private equity investments are subject to different regulatory disclosure requirements, oversight, and controls. In addition, valuation of private equity investments is more complex because private equity investments often have no easily observed market value, and there is often an element of judgment involved in valuing each of the portfolio companies prior to their sale by the investment fund or other liquidity event (e.g., initial public offering).

I happen to point out these same items in my objection to using private equity.

Additionally, as with any designated investment alternative, the plan fiduciary must consider whether it has the skills, knowledge, and experience to make the required determinations or whether the plan fiduciary needs to seek assistance from a qualified investment adviser or other investment professional.(11) The fiduciary also must periodically review whether the investment vehicle continues to be prudent and in the best interests of plan participants, taking into account the considerations outlined above and any other factors that the plan fiduciary deems appropriate in light of its fiduciary duties under ERISA.

Many fiduciaries may decide they don’t have the skills, knowledge, etc.

There is lots more in the letter, and it sounds like the main concept is having something like a target date fund that may have portions that are private securities, as opposed to publicly-traded stocks and bonds.

I don’t have an issue with the legality of any of it. You will see my (and other people’s) issues below.

Reaction to private equity in 401(k)s

A professional take: Does Private Equity Belong In Your 401(k)?

For years, investing in private companies like Airbnb or Rent the Runway was restricted to institutional investors or the individual investors who met Securities and Exchange Commission requirements (largely based on net worth and income). Private equity, as an asset class, was simply not available to the average investor.

In part, this is because many common retirement plans did not offer a private equity option. Portfolio managers for defined-benefit plans, like pensions, have used private equity for years, but these plans are becoming rare (especially in the private sector). And while defined-contribution plans, like 401(k)s, were not barred from offering private equity investments to participants, almost none of them did. Plan administrators avoided private equity not because federal law told them to, but from fear of potential lawsuits. This risk wasn’t purely theoretical. Companies including Intel and Verizon have faced litigation over their use of alternative investments in target-date funds.

Now the Labor Department has taken a step toward removing this barrier to entry.
….
Unlike, say, changing the rule against testimonials for investment advisers, the openness to private equity is something at least a few people asked for. SEC Chairman Jay Clayton has pushed for increased private equity access for years. Clayton has argued that, as fewer companies choose to go public, everyday investors have fewer choices for where to invest. People running private equity funds are also likely pleased. As The Wall Street Journal observed, private equity fund managers have long pushed to tap a new infusion of investors formerly unavailable to them.

Oh yes, slavering over institutional investors.

It is less clear that this change is good news for 401(k) and other defined-contribution plan investors. As I have observed in this space before, private equity funds often limit the number of investors who can receive access. This means the highest-quality funds are full or choose to hold out for only the largest investors. If a fund is willing to accept a relatively small investment from a target-date fund manager, potential investors should ask why and approach with skepticism. This may call for more due diligence than many investors are used to, including reaching out to the company that runs the fund or closely reviewing disclosure documents.
….
Yet even when considering an actively managed fund with a small private equity component, plan participants should bear private equity’s unique risks in mind. While private equity investments can produce high returns, they also are not subject to the same disclosure and reporting requirements that govern public companies. High-profile implosions of startups like Theranos or WeWork should serve as cautionary tales. Andrea Seidt, the Ohio securities commissioner, told the SEC last fall that a review of 100 enforcement actions over the two years prior showed that more than 1,000 investors had lost over $100 million in private offerings.

More or less, this is my take, which is what I’ll return to at the bottom of this post.

David Sirota: NEWS: Trump Just Fulfilled His Billionaire Pal’s Dream

Like Shelley Levene’s smarmy real-estate sales pitch in Glengarry Glen Ross, Schwarzman’s argument is that private equity offers ordinary Americans terrific untapped investment upside. In his telling, workers have been unfairly deprived of these opportunities under the old laws — and not surprisingly, both the Trump Labor Department and some of the business press have credulously echoed that line.

“Everyday investors may soon be able to get a piece of private equity action,” effused the lede of the New York Times’ report on the Labor Department letter, as if this is a sweet get-rich-quick opportunity for the average working man.

But only days after the change, a landmark study was released telling the real story of private equity.

The report by University of Oxford professor Ludovic Phalippou shows that in the last 15 years, private equity firms generally have not provided better returns to investors than low-fee stock index funds. In the process, a handful of private equity firms and their executives have raked in roughly $230 billion in fees from investors like public pension funds and university endowments.

Ted Siedle: Trump DOL Throws 401k Investors To The Wolves

Trump U. S. Department of Labor watchdogs just opened the door for private equity wolves to sell the highest cost, highest risk, most secretive investments ever devised by Wall Street to 401k plan sponsors. 401k investors will be devoured like lambs to the slaughter.

Last week, the U.S. Department of Labor opened the door for plan sponsors to add private equity funds to their 401(k) plans. That’s a huge win for the private equity industry since 401ks hold nearly $9 trillion in assets and a monstrous setback to American workers who invest in 401ks for retirement security.

After over three decades of egregious retail price gouging by mutual fund companies—as to which the DOL turned a blind eye—401k costs have in recent years been trending downward thanks primarily to widespread excessive-fee private class action litigation. Now, if private equity is embraced, 401k costs will skyrocket, risk will dramatically increase and transparency will plummet.

Or, you know, you could just not put your money in private equity. [I’m not going to]

Brett Arends: Private-equity crowd wants your 401(k) money — ‘yikes!’

From the Department of Dangerous Ideas comes the news that your employer may soon offer you the “opportunity” to invest some of your hard-earned money in private equity as well as in the public stock and bond markets.
….
I asked some financial advisers what they thought about investing 401(k) money in private equity.

“Yikes!” exclaimed Lisa Kirchenbauer, founder of Omega Wealth Management in Arlington, Va. Some private-equity exposure might be reasonable for an aggressive investor, she said, but it had better be small. With private equity, she said, “You don’t really know what you’re investing in.”

Juan Ros, a financial adviser at Forum Financial Management in Thousand Oaks, Calif., also sounded a note of skepticism. “I wouldn’t recommend an allocation to private equity in a 401(k) at this time, just as I would not suggest other esoteric investments like cryptocurrency in a 401(k).” Among his concerns: high fees, lack of transparency and questions about track records. “Since [private equity] is nothing more than stocks, I would prefer participants stick to the public capital markets,” he said.

Meanwhile, the move should raise issues for every investor.
…..
According to New York University’s Stern School of Business, the average gross, nominal return on the S&P 500 SPX, +0.57% has been about 12% a year since the 1920s. And you can invest in that through an index fund that charges next to nothing in fees.

But to match that net return, a private-equity fund that charges you 2% a year in fees, plus 20% of the profits, has to make about 17% a year in gross profits. In other words it has to be about 40% better than the market during an average year just to break even.

It really seems a great way to lose money as a small investor.

Yves Smith had two pieces: Private Equity Gets New Pockets to Pick: Your 401(k), in Funds Repeatedly Cited by the SEC for Abuses and Private Equity Clearly Inferior to Public Equity: Delivers Similar Returns With Lower Liquidity. These are mainly telling the same story as above.

Anybody want to sell the idea not in the industry?

I swear, I have been trying to find positive takes on this by people who aren’t private equity managers or directly involved in the DOL statement. It is tough to find.

There are reasons stuff like private equity, private placement debt, and hedge funds have been restricted to “qualified” investors. Usually, that requires having a certain amount of money to invest. Probably some other stuff — I’ve never tried for it. I have been approached in the past for specific closely-held, small companies, but that’s a bit different.

I don’t want to dig into the differences of private equity, private placement debt, hedge funds, publicly traded stocks, and more. For one, I do that for my paid job.

But here is my point: I am concerned about the fiduciary duty of the 401(k) sponsor in allowing private equity funds in their retirement plans. Heck, I’m concerned when it’s in public funds [as noted above].

Are the fiduciaries really going to be knowledgeable enough to provide appropriate oversight of the private funds?

With publicly-traded companies, there are certain financial reporting requirements, and they’re overseen by the SEC. As a private equity investor, if one is a large holder, one can require all sorts of information from company management. But what is the power of the small 401(k) investor? They are dependent on the big investors to do that… you have less protection than with public companies. Trying to do a class-action suit over a failed private company is not going to be a big payday compared to going after big, publicly-traded companies.

The other issue is that some of these funds will be scraping the bottom of the barrel for investment opportunities. I can see all sorts of plausible sales pitches that provide a lot of fees to those managing the funds, and not so much for the investors.

[Disclosure: my 401(k) investments are all in index funds, or something like them. I have some automatic rebalancing set up]

In researching stuff for this post, I came across this nugget in a news piece:

The Committee on Capital Markets Regulation, an independent research organization with thirty-five members drawn from the finance, law and academic communities, strongly supports expanded access to private equity for retirees and retail investors.

According to research by the Committee, 98% of U.S. households cannot invest directly in private equity. “As the number of public companies continues to shrink, retail investors are clearly missing out on investment opportunities,” the Committee said in a statement.

Okay, there is a point here, but: why not fix what is taking some companies private?

And the other aspect is that there is a lot of market cap in public securities in contrast to private equity. The total market capitalization of stocks on the NYSE is in the trillions. It was estimated to be about $28.5 trillion two years ago.

On the other hand, the largest private asset management firm has less than $200 billion in private equity.

The Blackstone Group Inc. (BX) leads with $571 billion in total assets under management (AUM).

The company invests across a broad range of market sectors, including energy, retail, and technology. While private equity ($183 billion) is its largest category of investments, Blackstone also has hundreds of billions of dollars in holdings in real estate, credit, and hedge fund solutions.

Now, they are managing assets on behalf of others, mostly for institutions like university endowments, insurance companies, and suchlike.

But my point is this: part of the return on private equity is because first, investors can be selective (there are smaller amounts of money to absorb) and second, the investors have a lot more influence than public securities investors, in which one’s ownership is diluted among millions of shares.

In any case, I do not imagine that many plan sponsors will be rushing in to provide private equity options in their 401(k) investment choices, as so many lawsuits pertaining only to fees in 401(k)s. It will be tough to fight for private equity, given its questionable suitability for retail investors.

My only piece of advice is to be wary of what’s in your 401(k) or IRA. Don’t worry overmuch about it — I myself check on my funds once a year (on tax day), just to make sure things are ticking along (I pick mainly index funds, and I do pay close attention to fees. I do not hold single securities.)

Chances are, you won’t be tempted by private equity funds in your own 401(k) any time soon, but do be wary of any promises around “high return” funds, whatever category they are shoved into.

Original STUMP post.