Access flooding information on Disaster Resources.

July 15, 2020

Financial Services: 401(k) Plans Can Now Invest in Private Equity Funds

As part of the Trump administration’s trend toward deregulation, the U.S. Department of Labor (DOL) recently issued guidance allowing companies to include certain types of private equity funds in 401(k) plans, investments that have traditionally been reserved for the wealthy few.

In a statement announcing the decision, Labor Secretary Eugene Scalia argued that private equity will “help Americans saving for retirement gain access to alternative investments that often provide strong returns.”

Not everyone shares Scalia’s enthusiasm. Opponents of the decision, including many Democrats and consumer groups, hold the view that private equity has no place in retirement plans, and contend that the average 401(k) participant will not understand the increased risk of this investment instrument.

While opinions are mixed, even among investment professionals, the reality is that previous barriers restricting regular investors from participating in private equity funds have been removed, effectively opening the industry up to the $6.2 trillion 401(k) market.

Before we look at the arguments for and against allowing 401(k) plans to invest in private equity funds, let’s first understand the term private equity.

What is Private Equity?

Simply put, private equity refers to investments in companies that are not publicly traded. Leveraged buyouts and venture capital are familiar types of private equity investments, which come primarily from institutional and high net worth investors.

Generally speaking, private equity requires investing substantial sums of money, which is then held for extended periods of time and used to fund growth through new technology, acquisitions or working capital. Usually, the end game for private equity is some type of a liquidity event, such as an initial public offering (IPO) or a sale to a public company.

Arguments in Favor of Private Equity in 401(k) Plans

Proponents of allowing 401(k) plans to invest in private equity point to access, diversification and higher returns for the average investor. Indeed, 98 percent of U.S. households currently cannot invest directly in private equity, according to the Committee on Capital Markets Regulation, an independent research organization.

In his announcement, Scalia claimed that opening up private equity to 401(k) access “helps level the playing field for ordinary investors,” and ensures that “ordinary people investing for retirement have the opportunities they need for a secure retirement,” placing them on par with wealthy and institutional investors.

As the argument goes, adding an additional asset class for the average investor is important now more than ever. According to a study conducted by Credit Suisse, the number of companies listed on the U.S. stock exchange has fallen by 50 percent over the past two decades. The number of IPOs annually have also dramatically fallen since the dotcom boom, down from a peak of nearly 700 in 1996 to just 100 in 2017.

Private capital markets have been picking up the slack, which means the average investor has been locked out of where the action is increasingly taking place, and where impressive returns are being made.

Bain & Company, a top management consulting firm, notes that over the past 30 years, private equities have generated average net returns of 13.1%, compared with 8.1% for public equities, based on the Long-Nickels public market equivalent.

“Exposure to small- and mid-sized companies—especially technology companies experiencing significant growth—is often only available through private investments,” noted Susan Long McAndrews, partner at Pantheon, a leading global private markets investor. “Retirees can’t really afford to leave 40 basis points annually on the table over a 35-year investment horizon.”

Arguments in Opposition to Private Equity in 401(k) Plans

However, not all that glitters is gold. Many of the long-standing arguments against 401(k) investments in private equity are based on concerns over fees, performance and liquidity.

Fees for 401(k) plans have come down significantly over the years, and today include low-cost options from the likes of Fidelity and Vanguard. There are even ultra-low or no fee exchange traded fund (ETF) options for investors.

In contrast, private equity managers typically charge 2% or more of the fund’s assets in annual fees, and can take up to 20% of the profits. Two percent of a $6.2 trillion 401(k) industry represents a potential of $180 billion in profits per year for the private equity industry.

While proponents cite statistics that prove private equity funds outperform the overall market, others are more skeptical. As the investment word to the wise goes, “Past performance is no guarantee of future results.”

The same Bain & Company report referenced above, which demonstrates private equity has outperformed public equities over the past 30 years, also states that when the time frame is shortened, over the past decade, private and public equity returns have been virtually the same, around 15%.

This trend has continued into 2020. In fact, listed private equity funds from Goldman Sachs, Invesco and BlackRock are all trailing the S&P 500 by 13% as of early June. And while the year-over-year numbers for these private equity funds are more in line with the S&P 500, parity is not what private equity investors pay for.

Fees and performance notwithstanding, the biggest problem for private equity may be the lack of liquidity. Investors participating in private equity usually sign contracts that lock up their funds for years, based on the assumption that professional managers will generate extraordinary value by turning a struggling company around or preparing it for public offering. This model makes it difficult to physically sell an interest in private equity and makes it even more challenging to accomplish allocation targets many investors have in place for their 401(k) plan.

If you have any questions about investing in private equity funds, or are interested in starting up a 401(k) program for your agricultural operation, please contact Matt Lewis at [email protected].