A Modest Proposal
Jay Clayton, chairman of the Securities and Exchange Commission, believes that defined-contribution plans should consider private-equity funds.
In an April interview, he criticized the long-standing requirement that only “accredited investors”--meaning those who are relatively wealthy--may own private-equity funds. Said Clayton, “The retirement money in the defined-contribution plan doesn’t have the same investment opportunities that a defined-benefit plan has, even though they’re both retirement dollars.”
Two months later, the SEC requested public comment on “Ways to Harmonize Private Securities Offering Exemptions.” Rendered into standard English, the SEC is reviewing the rules that govern the sales of private equity (or debt). The commission doesn’t control 401(k) regulations, those belonging to the Department of Labor, but if it were to loosen the requirements, the DOL would take notice.
Such rumblings are far from new. The SEC’s interest in private equity goes back several years. This time the commission seems serious, though, in part because of pressure from Stephen Schwarzman, a longtime friend of President Donald Trump (and sometimes adviser) who heads up Blackstone, the world’s largest private equity firm. Neither Schwarzman or his subordinates have been shy about their ambition to get private equity into defined-contribution plans.
The arguments for putting private equity into defined-contribution plans are: 1) private-equity returns are higher than even those of U.S. stocks; 2) retail investors should not be treated worse than institutional buyers; and 3) expanding private equity’s funding sources helps entrepreneurs, which in turn benefits the entire economy. Those points seem compelling, particularly (in my view) when framed as Clayton does, that it is illogical to treat retirement assets differently merely because they are now invested in 401(k) plans, rather than through traditional pensions.
Not All There
The trouble lies with the first assertion. Those numbers that show private-equity funds topping the pack were provided by the American Investment Council, which is an “advocacy and resource organization established to develop and provide information about the private investment industry.” That is, a trade organization, which means that although its research report’s figures tell the truth, they do not tell the whole and complete truth.
To start, private-equity databases are incomplete. Because private-equity funds are unregistered, they do not submit public filings. Instead, they report their performances to whom they wish, when they wish. This process overstates the industry’s totals, because the top private-equity funds are happier to share their results than are the bottom-fishers, who would prefer to remain unnoticed until their fortunes improve.
The size of this effect is unknown, because nobody has been able to assemble a database that is free from survivorship bias, so that an accurate comparison can be made. Perhaps it is not terribly meaningful. Or, perhaps, it is large enough to eliminate private equity’s apparent advantage over publicly traded stocks. In any case, the issue remains. That it cannot be measured precisely does not eliminate its importance.
Not Fully Comparable
Worse, there are major problems with the performance calculations for those private-equity funds that do report. Registered funds, once again, are the gold standard. There are no questions about how mutual-fund returns are computed. Begin with the first day’s net asset value, reinvest any dividends or capital gains at the NAV of the reinvestment date, end with the final day’s NAV, and calculate the percentage change. Even spreadsheet tyros can accomplish the task.
Not so with private-equity funds. Writes Private Equity International:
The absence of a standardized way of calculating performance is striking. Do you include the general partner’s commitment? How do you account for recycled capital? How does the preferred return compound? How long do you leave your credit line outstanding? Are cash flows aggregated into monthly or quarterly periods?
The reporter concludes, “It [is] clear that, for any investor conducting due diligence on these funds, a comparison between them would not be meaningful, at least without going back to cash flow data and recalculating each of their track records.” Obviously, such work is not required with mutual funds. Morningstar’s figures match those computed by the fund companies themselves.
Warren Buffett is similarly skeptical, telling Berkshire Hathaway (BRK.A) shareholders at this year’s company meeting that “We have seen a number of proposals from private-equity funds where the returns are really not calculated in a manner that I would regard as honest.” More pithily yet, in that same meeting Charlie Munger referred to such practices as “lying a little bit to make the money come in.”
A Better Direction
It is abundantly clear that companies are in no position hire private-equity managers for their 401(k) plans. Not only would the plan sponsor need to understand thoroughly how the private-equity fund achieved its results, but it also would be forced to act as if it were a private-equity database. A private-equity fund’s total returns cannot be properly assessed without delving into the weeds, to answer each of Private Equity International’s questions (and more).
In addition, private-equity funds are intended to be owned for a very long time, without redemption, and are priced only infrequently (and often by guesswork). How would that work within 401(k) plans? Would those who contribute to such funds not be allowed to redeem such shares until several years later? Even if employers could overcome their due-diligence headaches--which I highly doubt they can--the practical difficulties look to be insurmountable.
Much better than selling private equity directly to employees would be to sell to institutions who serve such employees--for example, target-date funds. In such a case, a professional investment manager would sort through the issues associated with private-equity performance reporting, rather than a plan sponsor. The problem of private equity’s lack of liquidity would also be eased--although as discussed in Friday’s column, not eliminated--because the position would be part of a larger fund, rather than an entire fund.
However, as mutual funds may put up to 15% of their assets into private-placement securities, a definition that includes private-equity funds, no regulatory changes are necessary for target-date funds to adopt such a strategy. They may establish significant positions in private-equity funds, if they so wish. Thus far, they have not so wished.
In short, while the rules covering private-equity ownership might stand improvement elsewhere, they need not be altered for 401(k) plans. Should any changes occur, they can arrive through the marketplace. The existing regulations look to be just fine.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.