401(k) Plans Gain Access to Private Equity Investments

Traditional 401(k) options include managed funds and options to invest in certain stocks and bonds. Now, the private placement market may start to see increased 401(k) activity as well, providing expanded investment options. On June 3, the U.S. Department of Labor released guidance indicating that certain 401(k) funds may invest in private equity. The managers of those funds have certain fiduciary duties that uphold their beneficiaries’ trust in them. The question is, are private equity investments right for you or your employees?

Private Equity and Retirement Plans

For some background, keep in mind that some employer-sponsored retirement plans have already been including private equity, while most have not. For instance, according to the Labor Department’s information letter, portfolio managers at some defined-benefit funds have been able to utilize private equity investments for years. These private placement investments have not been available in defined-contribution funds such as 401(k)s. To clarify, defined-benefit funds are traditional pension plans common in the public sector that give you a specified payment amount when you retire. Contrast that with a defined-contribution plan, in which both employers and employees may contribute money that employees may then invest over time. In defined-contribution plans like 401(k)s, employees bear the investment risks.

Notably, the new guidelines do not protect stand-alone funds that only invest in private equity. Instead, employees might choose to invest in a private equity fund as part of a diversified asset allocation fund. Common categories addressed in the information letter include target-date funds created to decrease investment risk as the intended retirement date nears.

Are Private Equity Funds a Valuable Addition to Your 401(k)?

For sure, private equity has some inherent advantages and disadvantages. Startups are going public later than they used to, so private equity funds open up pools of investors for them. One downside is that a typical fee structure for a private equity fund includes a 2% annual management fee and 20% of gross profits after a company gets sold. Notably, investments in emerging startups and other growth businesses on the private placement market may sometimes yield strong returns, but they may sometimes yield heavy losses. According to PitchBook as cited by The New York Times, during the ten years ending in September 2018, private equity funds in the top 25% for performance earned 16.2% or more, while the lowest 10% of funds yielded negative returns over ten years.

Over 30 years, the picture improves when you compare private equity with the public market. According to a State Street Private Equity Index study cited in Forbes by David Kudla, CEO and Chief Investment Strategist of large investment firm Mainstay Capital Management, U.S. buyout funds yielded a return of 13.1%. In comparison, the public market equivalent of the S&P 500 yielded 8.1%. Also, according to the study, as of June 2019, the buyout funds yielded an almost 15.5% return. That might seem high, until you see that the market equivalent of the S&P 500 yielded a 15.3% return, with fewer fees generally required. Private equity fund managers have a major incentive to take risks, so an outside opinion from a trusted investment adviser is wise.

Per the data provided by investors utilizing VerifyInvestor.com, a leading service provider verifying accredited investors under the JOBS Act, nearly 6% of all its investors participate in private equity investments by the end of 2019. Consulting the appropriate professionals and following federal guidelines is highly recommended for the private placement market.