Beware! Private Equity Funds in 401(k)?

by Lance Reising

Recently, the Department of Labor published a letter which was requested by an alternative investments firm clarifying that private equity funds are indeed allowed to be used within defined-contribution plans as part of a multi-asset investment strategy, such as a target-date product. Technically it did not constitute a change in existing rules because there currently is no prohibition from 401(k) accounts choosing to add alternative asset investments such as private equity funds as long as they are components of an allocation fund and they do not exceed a certain percentage of the overall portfolio's assets.  

However, plan sponsors have historically been leery of using private equity funds as an investment option because they add complexity and cost above those of mutual funds and are worried about ongoing 401(k) litigation. Many private equity proponents have been asking for safe harbor protections for plan fiduciaries but the DOL letter stopped short of outlining one.  

Why all the attention and controversy now? And why is it considered a huge victory for the private equity industry? Because accompanying the DOL letter were statements from Labor Secretary Eugene Scalia and Securities and Exchange Commission Chairman Jay Clayton, both promoting the potential for private-equity investments which does make them appear to sanction and encourage their use. It is quite possible that more private equity funds will now be proposed for injection into 401(k) plans as alternative investments. However, they may not be readily apparent because they are one of many different components in broader asset allocation-type funds, e.g. target date funds.  

The move “will help Americans saving for retirement gain access to alternative investments that often provide strong returns,” Labor Secretary Eugene Scalia said in a statement. He also said the new guidance “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.”

Jay Clayton, the SEC chairman, said in the statement that the clarification “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.”  

Proponents of inclusion of private equity funds in allocated multi-asset-class funds argue that they will lead to higher returns, greater diversification, and exposure to small- and mid-sized companies—especially technology companies experiencing significant growth, and that it is often only available through private investments. It is also important to remember that the plan fiduciaries remain responsible for the prudent selection and monitoring of that investment option.  

There are many opponents to greater use of private equity funds in 401(k) plans, especially when they are used as a component in a fund which is designated as the plan’s Qualified Default Investment Alternative, or QDIA. Participants end up in a QDIA because they do not choose their own investment options. Consumer advocates and some regulators have been wary of giving ordinary investors broader access to investments in businesses that do not adhere to the same disclosure rules as public companies and that could put them at risk. Target date funds are already very complicated and not understood or monitored very well by plan sponsors. Does it make sense for them to become even more complicated and opaque?  

Some of the more significant risk factors are outlined here: Private equity funds charge significantly higher fees and charges than most other types of 401(k) types of investments.

• Private equity funds charge significantly higher fees and charges than most other types of 401(k) types of investments.
• Private equity investments can be opaque. Companies in such portfolios don’t have to disclose as much information as publicly traded businesses and valuation methods are difficult.
• Investors and plan sponsors can’t cash or switch funds out as easily as they can with public investments. Money is often locked up for eight to 10 years at a time. This perceived lack of liquidity is considered one of the larger risks of private equity funds.
• Shares can lose money when a component company doesn’t get off the ground. According to PitchBook data, the bottom 10% of private equity funds had negative returns over 10 years. On the other hand, private equity funds in the top 25% for performance earned at least 16.2% over the 10 years that ended in September 2018, according to PitchBook.   ”

Some opponents take issue with the premise that private equity funds provide better returns. A recently released analysis of private equity returns over a ten year period by the University of Oxford claims that they have failed to outperform equity indices, with “annualized returns of about 11%, little different from the U.S. stock market over the same period.”  

Other opponents have expressed concerns about average 401k participants not understanding the increased risk of investing in private equity and therefore the potential for more lawsuits against plan sponsors for breach of fiduciary duty. Switching component private equity funds out of the bigger asset allocation fund if they are not performing could also be difficult. Given the lack of transparency and opaqueness of these funds, how can a plan sponsor monitor the private equity components as they are required to do under ERISA?

The ruling is fraught with legal liability for plan sponsors and any advisors who recommend these funds to qualified plans, said James Watkins, an attorney and CEO of Atlanta-based InvestSense LLC, in an interview with Financial Advisor. InvestSense provides fiduciary oversight to retirement plans and trusts. “So it is the duty of advisors or sponsors to do separate evaluations of each investment in a plan, and you’ve got a lack of transparency with private equity” “You have no way to independently verify this. You will be liable.” “Private equity funds usually charge plans a flat fee and then get a percentage of the profit. Typically, the private equity fund will charge a flat fee of say $50,000 [depending on the size of the plan] and charge another 20% profit tied to performance,” Watkins said.  

As a plan sponsor/trustee/fiduciary with personal and corporate fiduciary liability, one should consider whether bringing in an investment like a private equity fund with significantly higher fees, no publicly available information, more complexity, uneven valuation reporting, and greater litigation risk is worth it for perceived “…strong returns.