A Look at Private Equity in 401(k)s
February 5, 2021
In June of 2020, the Department of Labor issued an Information Letter indicating that ERISA doesn’t necessarily prohibit the use of private equity investments in ERISA-qualified defined contribution plans. The media and industry reaction seemed to barbell between “the wolves are at the door” and “the playing field has been leveled.”
Is the opening of 401(k)s to private equity a release of bloodthirsty Wall Street hounds, or is it a gift of fire from the investment gods? Probably neither.
Summary
Private equity investments are ownership interests in companies that are not publicly listed or traded on a stock exchange. This contrasts with public equities, where ownership interests (“stocks”) are traded and valued via public markets.
The DOL provided is views on the use of private equity in DC plans for the first time in June 2020, via an information letter.
The letter indicated that ERISA doesn’t prohibit the use of private equity in ERISA-qualified defined contribution plans as one component within a diversified asset allocation option, such as a target-date, target-risk, or balanced fund.
Proponents of private equity cite the potential for higher returns compared to public equities; detractors contend the category has high fees and offers little diversification benefit.
If experience with other alternatives, like private real estate, is a guide, cost and complexity may make large scale use of private equity in allocation funds challenging and unlikely – at least in the near term.
Background
The DOL issued an information letter in answer to a request from two private equity firms, Pantheon Ventures LLP and Partners Group, both represented by Groom Law Group (as disclosure, we’ve worked with Groom). In the letter, the DOL confirmed that ERISA law does not prohibit the use of private equity (or PE) in ERISA-qualified defined contribution plans provided certain qualifications are met, including 1) PE may only be an allocation within a target date, risk-based, or balanced fund that offers exposure to a diversified range of asset classes; 2) it must be selected through a prudent investment process; 3) it must be professionally managed.
The Department explicitly noted that the guidance does not address the offering of stand-alone private equity options to participants, given the legal and operational problems such vehicles would present. In addition, the DOL recommended that sponsors place and adhere to limits on the allocation to private equity within a fund and that private equity investments be independently valued and subject to an annual audit. Lastly, the DOL provided factors that fiduciaries should consider when determining if private equity has a place in their plan.
Note that an information letter is a form of guidance; it doesn’t create new rules or regulations, and it doesn’t constitute a recommendation. Historically, however, courts have respected information letters, and this may provide some comfort to sponsors who want to offer (or are currently offering) private equity in a limited fashion.
what is private equity?
“Private equity” refers to ownership interests in companies that aren’t publicly listed or traded on a stock exchange, the valuation of which is determined through an appraisal process rather than in the marketplace. In contrast, public equities (or “stocks”) are ownership interests in companies that are listed on, traded, and valued via public markets (stock exchanges like the New York Stock Exchange).
PE investors include institutions (frequently pensions and endowments) and high net worth individuals. Investors may purchase ownership interests in companies directly, or they may invest through private equity funds. Private equity investments are long-term and illiquid, with restrictions placed on liquidations and average holding periods of four years or more (with variances by size, industry, and geography).
What’s the attraction?
Before we begin this discussion, we’ll note that assessing private equity performance can be challenging. Private and public equity returns are calculated differently: private equity returns are “money-weighted” while public equity returns are “time-weighted.” To perform a comparison, public equity indexes (like the S&P 500) must be converted to “public market equivalents,” where base index returns are modified using private equity cash flow data.
In addition, analysis of strategies investing in publicly traded stocks is aided by tens of thousands of indexes reflecting nearly every possible slice or dice of the public equity universe. The tools set fiduciaries can use to gauge private equity performance is much more limited.
These challenges may require investors to rely on common sense and rationality as much as data when considering private equity's potential advantages.
Long Term Returns: The most common (and rational) motivation for allocating to private equity is the possibility of enhanced long-term returns, and historical data indicates that private equity has outperformed public equity over many periods. [i] Today, a typical investor might target a long-term excess return of ~3-5% over public equities.
When setting expectations, however, investors must take pains to avoid simplistic comparisons. Industry studies and marketing pieces often compare private equity returns to non-optimal benchmarks. The S&P 500 PME (public market equivalent) index is a popular comparison. However, a PME-modified mid-cap or small-cap benchmark such as the S&P MidCap 400 or Russell 2000 (or sub-sectors of either) may be more appropriate, given typical private equity investment targets or a specific fund’s strategy.[ii]
Bear Market Performance: Private equity index values have indeed, on average, dropped less than public equity index values during bear market periods. As with long-term returns, private equity's illiquid nature would be advantageous in such periods, inhibiting panic or forced selling.
However, the bear market advantage may partly derive from the methods used to value private equity. Public equity prices, valued in an open marketplace, fully reflect not only investor rationality but emotions, like fear and greed, as well. Private equity values are determined through an appraisal process, which may filter the animal spirits of the public market and add to the perception of greater down-market resilience.
Volatility: While private equity is also often shown as having lower volatility than public equities, there may be accounting forces at play here, as well. Private equity returns tend to be “smoothed” by nature of the quarterly valuation-by-appraisal of illiquid PE investments (vs. the intra-day mark-to-market pricing of publicly traded stocks). Smoothed returns can create a perception of lower volatility, similar to looking at the quarterly averages of an index like the S&P 500 instead of its daily fluctuations. When private equity numbers are “de-smoothed” (adjusted to account for these valuation factors), the difference in private and public equities’ volatility shrinks considerably.[iii]
There is also evidence that the subjective appraisal-based valuation process of PE (vs. the objective market-based valuation of public stocks) has, in some cases, lead to the “management” of valuations, with increases and decreases in the value of illiquid assets spread out over time. This practice would further enhance the perception of low volatility.
Correlation: Private equity returns are sometimes cited as having a low correlation (or tendency to move in step) with publicly traded equities. As with volatility, much of this diversification appears to spring from the means of PE valuation: de-smoothing of returns results in higher correlations between private and publicly traded equities. The adjusted results more closely resemble the relationship between US stocks and emerging market stocks than between assets with truly low correlation, such as stocks and bonds.[iv]
considerations beyond performance
Aside from primary considerations of investment efficacy and suitability for plan and participants, sponsors must also consider private equity’s cost, complexity, and liquidity.
Cost will be a key focus of plan sponsor consideration, especially given the current ERISA litigation environment. Fees for private equity funds are typically similar to those charged by hedge funds: a 1.5-2% per year management fee and a performance fee of ~20% of value appreciation or profits.[v] This range is well above the average fee for an actively managed fund in a 401(k). Even if private equity constitutes only a portion of a multi-asset fund allocation, that level of fee (as well as its impact on the overall fund's cost) would have to be carefully and confidently justified.
Fiduciaries must also be confident that they possess sufficient experience and understanding to select and monitor their investment. PE investments’ structures and strategies may be more complex compared to more common defined contribution investments. Disclosure and other regulatory requirements may present challenges, and the valuation-by-appraisal process lacks the transparency and pricing validation of public markets.
Liquidity will be another key consideration. By nature, private equity investments are illiquid. Investment horizons are long, and the ability to redeem may be limited by lock-up periods. Any private equity allocation will need to be thoughtfully structured to take illiquidity into account.
A Precedent
The use of private real estate (also called direct real estate) in defined contribution plans may provide insight into the future of private equity in the DC space.
Most plan sponsors are familiar with a more common form of real estate fund, where the fund has ownership interests in liquid, publicly listed real estate investment trusts (or REITS) or similar entities. In contrast, a private real estate investor or fund has direct ownership of an asset such as an office building or apartment complex. The concept is similar to private equity, substituting property ownership for company ownership.
Private real estate has been available for use in defined contribution retirement plans for years; however, it remains uncommon in DC plan menus.[vi] Compared to real estate strategies based on public securities, private real estate faces a few headwinds, including the relatively greater complexity of selection, monitoring, and valuation. The high sensitivity to fees prevalent in the defined contribution world also plays a part: private real estate strategies tend to be pricier than institutional options investing in public securities (though attractively priced options certainly exist).
Liquidity has also been a point of concern. In large part, private real estate strategies designed for the DC market have accommodated daily liquidity needs by allocating some portion of the portfolio to liquid securities like REITs (commonly 15 to 20%). Under ordinary circumstances, this has worked quite well. However, the challenges encountered by a few sponsors while attempting to exit positions during the Financial Crisis of 2007-2008 are still fresh in the minds of many.
Our perspective
While private equity has legitimate investment applications, we don’t expect widespread incorporation into DC multi-asset investments anytime soon. The most natural fits for private equity are likely mega-market defined contribution sponsors who incorporate it elsewhere in their benefit complex. An example may be a state or a large corporation, likely with sophisticated internal capability, that currently utilizes a private equity allocation within a defined benefit program.
Aside from the complexity involved in selecting and monitoring strategies, we have several concerns regarding the use of private equity in defined contribution plans.
Cost: One of the very few “known knowns” in investing, fees have been the hot button for ERISA litigation for the last decade. A private equity allocation would likely be the most expensive investment component within a plan. Even if combined with other less costly investments within an asset allocation fund, a plan sponsor would want to be very confident that the benefit to participants of a PE allocation would justify the expense.
Performance: At the core, however, investors in private equity have ownership in corporations, just as investors in publicly traded stocks do. Apart from the impacts of illiquidity and valuation and accounting methods, investors in each could expect to have a similar experience.
The idea that private equity would offer some return advantage makes intuitive sense. Private equity investments are less liquid than publicly traded stocks, and a rational investor would expect to be compensated for that characteristic. Illiquidity also limits forced sales, potentially boosting long-term returns and bear market performance. However, just as the notion of enhanced return is logical, so is the concept that long-term private and public equity volatility would be similar and correlation between the two would be high.
The weight of evidence indicates that private equity has provided outperformance compared to public equities over many periods in the past. However, past performance is not indicative of future results.[vii] The scale of investment in private equity has exploded in recent years: investment data firm Preqin indicates that private equity and venture capital assets have almost doubled since 2015, growing from $2.3 trillion to $4.4 trillion at the end of October 2020. Prequin forecasts another doubling, to $9.1 trillion, by 2025 (while most other alternatives experience slow growth).[viii] There is potential that the continued inflow of assets, combined with competition from vehicles such as special purpose acquisition companies (SPACs), could result in inflation of target prices or overpayment for deals, and therefore an erosion of returns.[ix]
Liquidity: Defined contribution plans are inherently liquid environments, and traditional private equity is an inherently illiquid investment. Currently, DC plans implement liquidity constraints in the form of limits on trade frequency or stable value equity washes, but none compare to those required by typical private equity funds.
An asset allocation fund structure may ease liquidity challenges. However, it’s still likely that a private equity fund’s liquidity would need to be enhanced to accommodate defined contribution plans. This has been the case with private real estate, where funds used in DC plans generally have a liquidity sleeve invested in REITs. Private equity funds may take a similar approach, through a liquidity sleeve (public stock, return replication strategy, cash, etc.), management of an asset allocation fund’s liquidation hierarchy, or some combination of mechanisms. However, this leads to the concern that steps taken to increase liquidity could dilute private equity’s potential advantages (similarly to how a liquidity sleeve of REITs dilutes a private real estate fund’s perceived benefit of lower volatility).
Despite the momentary excitement, the DOL’s information letter is somewhat of a non-event for the great majority of plans and participants - or, at the least, a very early-cycle event. The letter offers guidance but doesn’t alter or prescribe policy. The few sponsors that currently offer private equity investments may feel more comfortable, other sponsors may consider adding private equity, and the pace of product development may pick up.
However, it’s unlikely that the letter alone will open the floodgates: concerns regarding cost and complexity will keep adoption slow, including among those investment managers offering target-date funds. Few participants will be either thrown to the wolves or get a golden ticket (depending on your point of view), and few private equity firms will experience a meaningful impact on their bottom line, at least any time soon.
[i] As an example, in 2020, Bain & Company compared returns through 6/30/2019 for US private equity buyouts and a public market equivalent (PME) method that used the S&P 500 as the proxy. Bain used the Long-Nickels public market equivalent (PME) which creates a theoretical investment into the S&P 500 mimicking private equity fund cashflows. For example, when a capital call is made by a PE fund, the same amount is “invested” in the index; when a PE fund makes a distribution, the same amount is “sold” from the index. Over 30 years, the private equity return of 13.1% annualized outpaced the PME public equity return of 8.1%.
[ii] The value of private equity buyouts often lands between $1 and $5 billion, which would indicate that a mid-cap index might be a more appropriate benchmark than the large-cap S&P 500 for most deals. In addition, buyouts tend to be focused in certain sectors (e.g., technology, industrials, services, and transportation), potentially adding further sector-weighting specificity to a reasonable benchmark. When Alexandra Coupe of PAAMCO constructed a proxy composed of S&P MidCap 400 sectors reflecting the by-sector volume of private equity buyouts, she found that private equity enjoyed a much smaller return advantage than when compared to the S&P 500.
[iii] In 2016, PAAMCO examined private equity returns between March 2005 to September 2014 using Cambridge Associates private equity return series. Smoothed returns had a volatility of 9.64%, while de-smoothed reflected 16.63%.
[iv] FactorResearch investigated the correlations of private equity and public equities from 1994-2019. They found that the correlation of annual private equity internal rates of return and annual S&P 500 returns was extremely low – (0.15). However, when they compared quarterly instead of annual returns, the correlations crept up to 0.74.
[v] Note that performance fees are generally only taken after a minimum level of return, or “hurdle rate”, is achieved. An 8% hurdle rate is common.
[vi] For example, the TIAA CREF Real Estate Account is about 25 years old and has around $26 billion in assets.
[vii] For example, in their 2020 comparison, Bain & Company found that the returns of private and public equity since 2009 were roughly equal, with US buyout funds returning 15.3% and S&P 500 PME returning 15.5% annualized. This is in contrast with the longer-term results described above.
[viii] For comparison, global public market capitalization (the value of all publicly listed stocks) was roughly $90 trillion at the end of Q3 2020.
[ix] Special purpose acquisition companies (SPACs), also called “black check companies”, have no commercial operations. SPACs are formed strictly to raise capital through an initial public offering (IPO), then use that capital to acquire an existing company. SPACs have been around for decades. They've become more popular in recent years, raising a record amount of IPO money in 2019. Many private equity firms see SPACs as an alternative to traditional approaches of raising private equity capital.
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