Why Private Equity Doesn't Belong in Defined-Contribution Plans

At the end of the 1942 film Casablanca, Humphrey Bogart's character Rick Blaine smiles and says to Claude Rains' Louis Renault: "Louie, I think this is the beginning of a beautiful friendship." I thought of that line after reading the Information Letter released by the U.S. Department of Labor on June 3. It struck me that the letter represents the beginning of a beautiful friendship between the private-equities industry and participants in defined-contribution plans, such as 401(k) plans.

This friendship (at least from a private-equity standpoint) rests on the $8 trillion or so in assets held in 401(k), profit sharing, 403(b), and 457 plans as of the end of 2019 (according to the Investment Company Institute). Even if private equity were to capture only 5% of this market, that’s still $400 billion--and more, as the market for defined-contribution plans continues to grow.

That’s what I call a lot of friendship.

The letter states that the fiduciary-responsibility provisions in Title I of the Employee Retirement Income Security Act of 1974, as amended, allow fiduciaries responsible for individual account plans such as 401(k) plans to offer "a professionally managed asset allocation fund with a private-equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in this letter." (By the way, an information letter is not a law or regulation, so it is not a legally binding contract; it's simply issued for informational purposes only.)

At the outset, this letter should be placed in context. Some private equity is already included within a minuscule number of custom target-date funds and offered by a small number of large retirement plans. And there’s nothing in ERISA that prohibits the use, per se, of private equity in 401(k) plans, for instance. After all, the Restatement (Third) of Trusts (cited extensively by the U.S. Supreme Court in its unanimous opinion in the 2015 case of Tibble v. Edison International) sets forth the “fundamental proposition that no investments or [investment] techniques are imprudent per se.”

The significance of the letter isn’t that private equity can now be offered for the first time to plan sponsors for inclusion on plan-investment menus. Rather, its real importance lies in the implicit blessing that the DOL gives to the purveyors of private equity. Armed with this Letter--akin to the Good Housekeeping Seal of Approval from the federal government--the private-equities industry can now approach plan sponsors with confidence and freely sell its target-date funds, balanced funds, and other products that contain some component of private equity.

The letter suggests that any such component be capped at no more than 15% of the value of a multi-asset-class investment option. Some amount of limitation on this percentage value is necessary to ensure that plan participants have sufficient liquidity to trade in and out of such investment options. This approach is in line with a rule issued by the U.S. Securities and Exchange Commission that restricts mutual funds and exchange-traded funds from holding more than 15% of their assets in illiquid investments. The letter notes that this guidance might also be applied to even less-liquid asset classes.

This, in my view, leads to one of the problems of what's known as an alternative investment. Although there's no common agreement as to what actually constitutes an alternative investment, perhaps the simplest definition will suffice: An alternative investment is typically one other than traditional investments, such as bonds and stocks that are traded in public financial markets (and cash). These would include hedge funds, privately traded real estate investment trusts, and, yes, private equity.

Nor is there any common agreement as to how to define private equity. More than one commentator has remarked that a hedge fund is a compensation structure (for example, 2% of the assets paid per year to the hedge fund manager plus 20% of any profits) in search of an investment strategy. No doubt, the same goes for private equity as well.

Alternatives--such as private equity discussed in the letter--pose a few problems for investors like participants in self-directed defined-contribution plans (such as 401(k), profit sharing, 403(b), and 457 plans) or any investors, for that matter. These problems include:

Mediocre investment performance. A paper soon to be published in The Journal of Investing by Ludovic Phalippou, professor of financial economics and head of the finance, accounting, and management economics group at the University of Oxford's Said Business School, titled "An Inconvenient Fact: Private Equity Returns & the Billionaire Factory," makes a strong case that private equity has generated returns that are about the same as public-equity indexes since at least 2006 (emphasis in the original).

The claim, repeated over and over again, that private equity, hedge funds, and so on, outperform investments in public markets would seem to be a hollow one, especially since a number of other studies over the years have backed up that very point. It’s impossible to know for sure, though, because operators of private-equity funds and the like, don’t let loose with their actual returns over which they have exclusive control. Remarkably, instead of reporting a stock market index geometric average return, for example, fund operators report since-inception internal rates of return, which, the author argues, are not really returns at all. Even more remarkably, this reporting system is not just allowed, but required, by the widely used Global Investment Performance Standards maintained by the CFA Institute.

Inability to measure decreases in risk and increases in diversification. In addition to the largely unchallenged mantra (in the financial industry) that alternatives such as private equity provide superior investment performance, is the claim that they decrease risk and increase diversification. However, professor Phalippou notes in his paper: "I do not know how to measure risk and diversification in [private equity], nor know any academic studies offering a well-accepted approach … The mean-variance analysis [developed by Nobel Laureate Harry Markowitz] that typically supports these assertions [of lower risk and greater diversification] is particularly flawed in the presence of an illiquid asset such as [private equity]."

Very high costs. Although some of the costs of an alternative can be determined, many cannot because the subscription agreements in which such costs are spelled out are guarded like the crown jewels. Of course, these costs are borne by investors but, reciprocally, they are often revenue received by the operators of alternatives. Parenthetically, professor Phalippou notes that the number of private-equity multibillionaires increased from three in 2005 to 22 in 2020.

Lack of transparency. Private markets, made up of alternative investments, provide little disclosure and few investor protections. There is little way to determine the actual investments in a private-equity fund, for example.

Illiquidity and the impossibility of accurate valuation. The letter referenced the illiquidity of private equity. An alternative investment (indeed, even any nonalternative investment) is illiquid when there's no secondary market (or if there is one, it ceases to function for some period of time) in which it can be valued and traded.

An illiquid alternative such as a private-equity fund is said to be “locked up” for some predetermined period of time, such as 10 or 15 years. (This illiquidity premium is often cited as a source of superior performance by operators of these funds.) In the absence of being able to determine the current fair market value, or FMV, of an alternative investment, its worth becomes the FMV at which it was purchased. In such cases, the FMV is carried over from period to period with no real way to determine the current FMV until the alternative’s liquidation, which, as noted, could sometimes be years away.

This often means that an alternative’s FMV is, in effect, frozen in time, because there’s no way to establish its actual FMV through the price-discovery process in a free and fair financial market. Often there are only two times when an alternative investment is valued: when it’s first purchased--with that purchase price serving as a continuing placeholder by which the alternative is valued--and when it’s eventually liquidated, at which point a new FMV is revealed (which could be a bonanza or even a zero return to investors).

Apart from the preceding problems, alternatives (including private equity) seem to be fine investments.

By the way, it should be noted that no private-equity investment option can be made available to plan sponsors on a stand-alone basis--at least for now. Instead, the letter simply permits, with extensive guidance, the sponsor of a 401(k) plan to make available a multi-asset-class investment option, such as a target-date fund or balanced fund, containing some component of private equity on the plan’s investment menu.

Getting a foothold in the mass market of defined-contribution plans is the beginning of a gold rush for the private-equity crowd. Indeed, one of their attorneys noted that the DOL, in refusing to allow private equity as stand-alone investment options in retirement plans, was not saying, “No way, no how” that they cannot ever be offered, but rather he saw it as a mere delay, which is “a different kettle of fish” that the private-equities industry can deal with at a later time.

The issuance of this letter will ultimately harm participants in self-directed defined-contribution plans. The DOL has now allowed the camel’s nose of private equity inside the tent of 401(k) plans, and that’s not in any way a good thing for plan participants.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts, and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations, and trials, as well as written opinions, which are described here. Simon also serves as a discretionary fiduciary investment advisor to retirement plans at Retirement Wellness Group. For more information, email Simon at wssimon@rwg-retirement.com or wssimon@fiduciary-experts.com. The views expressed in these articles do not necessarily reflect the views of Morningstar.