Private Equity in 401(k) Plans: More Smoke Than Fire

Out of the Blue Well, they did it.

To my surprise, private equity fund executives convinced the Department of Labor to issue a letter, dated June 3, 2020, approving the use of private equity investments within 401(k) plans. If the private equity funds are selected judiciously and used appropriately, wrote the Department, plan sponsors will not "violate the fiduciary's duties under section 403 and 404 of ERISA."

This ruling, to be generous, was peculiar. Why only private equity? Why not hedge funds, or managed futures? The answer is because the Labor Department did not make its announcement after researching all unregistered securities and deciding that only private equity funds deserved to make the grade, but instead because private equity executives got in front of them. Request made, reviewed, granted.

The decision pleased few outside the private equity industry. When I wrote last year that the Labor Department was evaluating if private equity funds belonged in 401(k) plans, reader response was uniformly negative. The press reaction to the Labor Department's June release has been similar. Writes Brett Arends of MarketWatch, "Private-equity crowd wants your 401(k) money--'yikes!'" From Edward Siedle of Forbes: "Trump DOL Throws 401(k) Investors to the Wolves." Headlines Salon.com, "Trump Labor Department quietly offers up 401(k) plans to private equity vultures."

Private Equity's Drawbacks The skepticism is warranted. As with other unregistered funds, private equity funds lack transparency, as they are not required to report their holdings, and typically carry high expense ratios. In addition, because their assets are not traded, they are very difficult to value. Quips Matthew Klein of the Financial Times, private equity managers won't "pretend to know what [their holdings are] worth in the absence of a market, but here's a number if it makes you feel better."

That probably did not make you feel better. Nor will the news that private equity total returns are not comparable with those of registered funds (mutual funds, exchange-traded funds, and closed-end funds). There is a single correct method for computing the returns of registered funds, but many accepted approaches for calculating private equity performances--some of which are decidedly optimistic. Said Warren Buffett, "We have seen a number of proposals from private equity funds where the returns are really not calculated in a way that I would call honest."

Finally, as with most financial-services businesses (the exceptions, perhaps, being fund companies and discount brokerages), private equity firms aren't generally regarded as being consumer-friendly. They tend to trumpet their numbers when faring well, then become silent--and perhaps stop reporting their results entirely--when their returns sag. Private equity managers control the information flow. The trust that they demand cannot be verified.

Strings Attached These are sharp criticisms, and they cannot be refuted. There is ample reason to ban private equity from 401(k) plans. That said, the dissenters overstate their case. Had the agency given 401(k) plans full and complete permission to offer private equity investments, then the outcries would be warranted. However, the department/s consent comes with a large asterisk.

Critically, the letter does not permit 401(k) plans to offer stand-alone private equity investments. Instead, private equity must be used as an investment sleeve within a broader fund. This restriction eliminates several major concerns about adding private equity to 401(k) plans. Participants will be able to hold only a limited amount of the asset, and they will not select the managers. Nor will they be responsible for understanding the valuation process and how the returns are calculated. Those tasks will be delegated to investment professionals.

What's more, this broader fund must be a "custom target-date, target-risk, or balanced fund." The italics are mine. To receive the letter's legal protections, plan sponsors not only must offer private equity indirectly, but they must also do so through a separate account, rather than through a conventional mutual fund.

This is a narrow ruling, based on a specific situation. Private equity firms have suggested to their corporate clients that what is good for defined-benefit plans should also be good for defined-contribution accounts. Some of those corporations have accepted the investment logic, but they have thus far abstained from accepting the offer because of legal worries. The Labor Department's response is intended to allay those concerns.

The initial 401(k) adopters will therefore come from that target audience--giant companies that not only possess defined-benefit plans but which are also large enough to contemplate using custom-designed funds rather than mutual funds. That is the best possible situation for participants. The plan sponsors that will negotiate on their behalf are the likeliest of all sponsors to qualify for volume discounts on pricing and also the best positioned to research the field.

Barriers to Growth True, such organizations serve many participants. In theory, this capability could be rolled out aggressively. In practice, that won't happen. No doubt, private equity firms have lined up a few initial takers. But expansion will come only gradually. Even with the Labor Department's letter, plan sponsors will be wary. The 401(k) business is a wait-and-see industry, with most sponsors seeking to blend into the woodwork, rather than stand out for making bold decisions. As the saying went, "Nobody ever got fired for owning IBM IBM." (Make that Microsoft MSFT today.)

Of course, the private equity industry regards this letter as but a first step. It seems unlikely that 401(k) plans will ever offer stand-alone private equity funds, which can't provide the liquidity required by retail investors, but it's certainly possible that the Labor Department will eventually ax the requirement that private equity be placed into custom funds. After all, mutual fund providers are as well staffed as any organization to select and monitor private equity managers.

Good luck to private equity executives should that permission be granted. I can imagine stranger things than Vanguard, Fidelity, and T. Rowe Price, which dominate the target-date business, replacing their own investments with somebody else's illiquid, expensive, and unregistered fund. But not many. The Cleveland Browns are a better bet to win the Super Bowl than a private equity fund cracking those lineups.

The process by which private equity funds were admitted into 401(k) plans troubles me, but the outcome does not.

John Rekenthaler (john.rekenthaler@morningstar.com) 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.