Private equity in your 401(k)? Heed Warren Buffett's warning

By Brett Arends

About 78% of people who participate in a retirement plan at work, such as a 401(k), believe 'private assets' can enhance their portfolios

Warren Buffett at Berkshire Hathaway's 2019 stockholders meeting, where he warned to be "very careful" about private equity.

I am very excited to announce my new alternative investment fund, which will soon be available in your 401(k) once I bribe - excuse me, "lobby" - the right people in Washington.

My fund will take your savings to Las Vegas, where I will bet them at the blackjack table.

While this may seem like a losing proposition, there's one thing that's certain: The outcome of a long series of blackjack games is completely uncorrelated to the performance of the stock market, bond market, oil, gold and crypto rubbish.

As a result, my roulette fund will improve the "diversification" of your portfolio.

If you think that's a poor argument in favor of an asset that offers a poor return on your investment, you'd be right. But apparently, such logic isn't deterring investors when it comes to another attempt to fleece them out of their life savings: The coming private-equity attack on your 401(k).

About four-fifths, or 78%, of people who participate in a retirement plan at work, such as a 401(k), believe that "private assets" can "enhance 401(k) portfolios through diversification," according to a new survey by asset-management company Schroders. And 52% say they would invest in private assets if they were available in their company's plan.

But only 23% say they are "very knowledgeable" about private assets, a big jump from previous years.

According to Schroders's data, of the 52% who say they would invest in private assets, about half, or roughly 26% of all participants, would allocate less than 10% of their 401(k) to them, while about two-fifths, or about 20% of all plan participants, would invest between 10% and 15%.

The current presidential administration has changed the regulations by executive action to let this industry into your 401(k) for the first time.

This, of course, has nothing to do with all the fees that private equity charges, or the amount of money the industry throws around in Washington.

If you're among those who want some high-fee private equity in your retirement account, maybe you should listen to the greatest investor in history.

Warren Buffett has repeatedly warned investors against private equity. He's explained why its way of doing business doesn't interest him, and why he thinks its way of calculating investment returns is hinky.

His warnings go back to Berkshire Hathaway's (BRK.A) (BRK.B) annual general meetings 20 years ago, but he probably put his concerns best in 2019.

"We have seen a number of proposals from private-equity funds, where the returns are really not calculated in a manner that - well, they're not calculated in a manner that I would regard as honest," Buffett said. If he were running, say, a pension fund, and he was approached by private equity, he said, "I would be very careful about what was being offered to me."

"Warren, all they're doing is lying a little bit to make the money come in," added Buffett's vice chairman, the late Charlie Munger.

Gee, that sounds good.

None of this should come as a surprise. Private equity consists of buying companies with gigantic amounts of debt, like buying a home with a massive mortgage.

That turned out to be a smart move during the decades when interest rates fell and debt got cheap.

"In my investing lifetime, you know, if an index fund would do 11%, well, imagine how well you would've done if you'd leveraged that up 50% whatever the prevailing rates were over time," Buffett said.

"A leveraged investment in a business is going to beat an unleveraged investment in a good business a good bit of the time," he added. "Of course, you've been in an upmarket for businesses. And you've got a period of low interest rates. So, it's been a very good time for it."

You may have noticed that this nirvana came crashing down a few years ago, when inflation, interest rates and the cost of debt began skyrocketing.

There is no magic. That leverage is a double-edged sword. It's gambling. Some people do really well, Buffett noted, while others go bankrupt. "Charlie and I, probably, have seen some more high-IQ people - really extraordinarily high-IQ people - destroyed by leverage," he said.

Of course, there have been some private-equity funds that have generated spectacular returns over the decades. That is also true among people who went to Las Vegas and gambled their savings on a spin of the wheel, and those who bought lottery tickets. Mathematically, it has to happen.

There is no reason to think the few winners will be the ones that end up in your 401(k).

The opportunity for private-equity funds to generate fantastic returns is, like most things in capitalism, also a product of competition. Decades ago, a smallish number of private-equity funds were competing to buy companies. Today, the situation has completely changed. The amount of money invested in all private-equity funds 20 years ago was just $1.2 trillion. Today, they are approaching $17 trillion, or about 15 times as much.

And, as Buffett also pointed out, the private-equity business model needs to add piles of debt on top of that equity.

The idea that these funds could generate the same returns as their predecessors makes no sense. "The supply-demand situation for buying businesses privately and leveraging them up has changed dramatically from what it was 10 or 20 years ago," Buffett said in 2019.

Meanwhile, here's one other consideration: Running a private-equity portfolio is a much more expensive enterprise than running a passive portfolio of publicly traded stocks. The industry typically charges 2% of your assets per year plus 20% of your gross profits (if any).

But equity returns have averaged about 10% a year (including inflation) for a century. So those fees would work out at 4% a year, or about 40% of your returns.

Meanwhile, in Las Vegas, the casinos' take from blackjack varies between 0.5% and 2%. So my Vegas fund will charge you less than your private-equity fund. Well, before my fees, anyway.

-Brett Arends

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