photo by Ed Brown
Private equity could be coming soon to a 401(k) plan near you, but it is not clear that this is cause for celebration for most retirement savers.
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. On June 3, the Labor Department issued guidance that opened the door to private equity investments in defined-contribution retirement plans. Yet retirement savers should not expect to rush out and invest everything in their favorite startup. Private equity in defined-contribution plans is restricted to professionally managed vehicles such as target-date funds. Funds focused purely on private equity are not covered by the new guidance. The department also warned that plan administrators would need to evaluate the fees and risks associated with private equity investments.
This news arrived in the thick of protests demanding justice for black Americans and widespread concern about how to balance resuming economic activity with avoiding a “second wave” of COVID-19 cases. It struck a dissonant note in this context. Was it really the best time for such an announcement? Who had so urgently demanded private equity in defined-contribution plans?
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.
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.
That said, the requirement to involve an asset manager means this approach is not as bad as it could be. Fund managers, in general, are aware of private equity’s risks and are likely to limit a target-date fund’s overall exposure. While the Labor Department did not create any new rules on the amount of private equity a fund may include, its guidance did cite an existing SEC rule that limits illiquid investments like private equity to no more than 15% of assets in registered open-end investment companies like mutual funds. Target-date funds by their nature will keep investor exposure to private equity relatively low.
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.
The risk in this asset class is not only at the company level. It can be systemic, too. Private equity in general hinges on leverage – in other words, debt. The pandemic’s economic effects mean many companies that carry large amounts of debt are already struggling. We may see a lot of bankruptcies in the months and years to come. Even before the novel coronavirus, investors began to see a widening gap between private valuations and initial public offering results. Uber, Lyft, Blue Apron and a variety of other startups have illustrated that buzz and optimism can lead to an abrupt return to Earth after a high-flying IPO.
It is not clear that the Labor Department guidance will mean plan administrators immediately rush out to add private equity offerings. As attorney James Watkins observed in Financial Advisor magazine, plans sponsors must still show that they are complying with their fiduciary duty to participants. An unhappy plan participant could bring a lawsuit claiming the plan did not make the risks of a fund that included private equity sufficiently clear, or that plan sponsors did not fully evaluate such a fund. Though the Labor Department guidance is meant to address such fears, it is not a magic bullet. For many 401(k) administrators, it may still seem safer to skip private equity entirely.
In my opinion the Labor Department was tone-deaf to roll out its guidance when it did, but this was a change that the financial industry and regulators agreed was appropriate. In the end, a small dose of private equity in a fund managed by a professional should not have much impact, good or bad, on the typical retirement saver’s portfolio.