Don’t Get All Excited by the Green Light for PE in 401(k)s

Private equity isn’t always a market beater and charges high fees. Besides, it’ll be confined to larger investment pools, like target-date funds, which limits its impact.

So now private equity can be included in 401(k) accounts, eh? That’s the latest US Department of Labor guidance for sponsors of defined contribution plans, such as 401(k)s.

Trouble is, for one thing, there’s still concern that PE may not be an apt investment for regular investors, namely the folks who entrust their investments to DC plans. That means litigation risk. A Supreme Court decision in February allowed workers to sue Intel for placing risky and costly PE investments into its retirement accounts.

Certainly, the Labor Department is not opening the floodgates for PE ownership by average investors. The guidance restricts the strategy to target-date and balanced funds, meaning any negative impact from PE would be diluted by more conventional investments in stocks and bonds. But any great returns will be thinned out, too. Right now, hardy retail investors can invest in PE operations by simply buying shares in the handful of publicly traded private equity firms, such as BlackRock and Pershing Square.

The current Labor Department and Securities and Exchange Commission have been pushing to let average folks into alternative investments, like PE, and to permit more financial services to access the $6.2 trillion 401(k) market. The new guidance “helps level the playing field for ordinary investors,” said US Labor Secretary Eugene Scalia in a news release.

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SEC Chairman Jay Clayton applauded Labor’s new policy, saying in a statement that the announcement “will provide our long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies.”

Indeed, the SEC is examining ways to widen the definition of who is an “accredited investor,” able to directly buy into PE funds. Currently, you must have $1 million in assets outside of a home and $200,000 in minimum yearly income.

Sure, PE can be very lucrative, sometimes. The top quarter of PE funds by performance were up 16.2% annually over the 10 years ending in September, according to Pitchbook researchers.

But PE funds in general have not outpaced the S&P 500, a report from the Bain & Company consultancy last year found. For the 10 years ending last June, they rose 15.3%, a couple of hairs behind the S&P 500’s 15.5%. Meanwhile, investing in an S&P 500 index fund is a helluva lot cheaper than in a PE fund.

For PE, fees are quite high, with the classic 2 and 20 in place for many (although a number now charge less). That means a 2% yearly management fee and 20% of the profits.

And given the recent surge of cash into PE funds, from institutions and wealthy people, a fear persists that too much of it will be ill-spent on dubious investments. The Bain study also noted that these funds “are paying prices they swore they would never pay and looking to capture value that may prove elusive.”

At present, though, amid an onrushing recession and the virus pandemic, PE deals are slowing down. So are public offerings. Likely result: fewer exits for PE portfolio companies as other buy them, hence less boodle for PE investors.