On June 3, 2020, Louis Campagna, Division Chief of Fiduciary Interpretations, Office of Regulations, Employee Benefit Security Administration, a unit of the Department of Labor, offered his comments regarding private equity as an investment alternative within 401(k) plans. If you care to read the letter in it’s entirety, you can find it at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/information-letters/06-03-2020.
In this letter, Mr. Campagna was responding to a request from Jon Breyfogle, on behalf of Pantheon and Partners Group, for clarity regarding the offering of private equity investments within professionally managed asset allocation funds which are designated as investment alternatives for participant-directed accounts.
For clarity’s sake, a 401(k) plan is a profit-sharing plan which allows participants to add or defer their own money. And almost 100% of 401(k) plans are participant-directed accounts, meaning it is up to the participant (you and me) to decide how we are going to invest our money within the plan.
This particular letter affirms that Pantheon and Partners Group (P&P) had developed a fund which they want to make available to plan participants. The fund is referred to as a Collective Investment Trust (CIT), which CIT is best described as a private mutual fund or separate, privately managed account. P&P had also designed the fund to accommodate the liquidity needs demanded of a 401(k) plan offering.
In the letter, Mr. Campagna, speaking for EBSA and DoL, and by extension the Executive Branch, says plan fiduciaries would not be in violation of their fiduciary duties solely because the plan offers investment options which include private equity.
Is it a good idea for plan sponsors to add investment options which include private equity? Absolutely not. Is it a good idea for each of us, as participants, to investment in a plan option which includes private equity? No.
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The purpose of a retirement plan which allows employees/participants to defer or add their own money is to assist such participants in being financially ready to retire, once they reach the point they’d rather roll over and go back to sleep, rather than roll out and head to work. We firmly believe that a 401(k) plan best accomplishes this by offering low-cost, index-related investment options, along with a nominal selection of age-based and risk-based models, and a few actively managed funds. Private equity does not fit this description.
We encourage our plan sponsor clients to avoid specialty or sub-sector funds, investment fads, and the “latest greatest idea” syndrome. Some participants enjoy pursuing interesting or novel investment ideas, or the opportunity to invest in private debt or equity. We certainly encourage this pursuit, and this learning. However, we remain convinced this is best done outside the realm of the 401(k) plan. Private equity? Yes. Inside a plan? No.
What are the challenges? Due Diligence for fiduciaries, transparency, costs, and valuation. Let’s take these one at a time.
Coke stock (KO) is publicly traded, priced throughout the day, and can be sold with simply the push of a button. Private equity (PE) firms buy what are called portfolio companies. These are real companies, which make and sell products and services, and which should make money, though their stock isn’t publicly traded. The portfolio company is typically owned by some combination of the PE firm and company management. Valuations are completed as needed, and valuation can be subject to interpretation, depending on the reason for the valuation. The point? The valuation of a portfolio company in a PE offering isn’t nearly as clean, transparent, or forthright as the valuation of a publicly traded company. The impact in your 401(k)? The value of the fund holding the PE interests can be open to interpretation or judgment call and could leave you with more or less than you expected when it is time to go to cash.
One of the challenges to any type of private placement is transparency. We define a private placement for this discussion as any investment which you cannot sell by simply pushing a button. This transparency is related primarily to valuation, discussed above, and costs, discussed next. The question is whether promoters of these ideas and investment options are being completely transparent about valuations, costs, operations, etc., which could significantly impact outcomes for investors. Historically, investing in private placements has been limited to what are called accredited investors and by law, those investors must meet either income or asset minimums. We have been watching cracks develop in the accredited investor framework, which we don’t see as a positive.
As noted in our comments about a preferred investment lineup, we believe low-cost options best serve the majority of retirement plan participants. PE funds and firms aren’t known for promoting low-cost options. Their value prop is built around outsized returns based on their knowledge, skill, and asset base. Whether they have been able to deliver on these promises is an article for a different day. The question is whether an investment in a PE fund can consistently deliver returns commensurate with costs incurred, especially given the other considerations.
ERISA guidelines, which govern 401(k) plans, under sections 403 and 404, mandate that plan fiduciaries must discharge their duties solely in the interest of the plan’s participants and beneficiaries, and with skill, care, prudence and diligence. Title I of ERISA says plan fiduciaries have duties to prudently select and monitor any designated investment alternative under the plan, and that they have liability for losses resulting from failure to satisfy those duties.
If you serve in a fiduciary capacity regarding a retirement plan, perhaps as CEO, CFO, in HR, or as part of the investment committee, do you have the experience or background to complete the necessary due diligence? And if not, is it a prudent use of either company (plan sponsor) funds, or plan assets, to pay for such due diligence?
Private equity and private equity offerings definitely have a place within the business landscape. However, we firmly believe that such offerings, packaged for use of retirement plan participants, is not a good idea.
If you are a plan sponsor and would like us to evaluate and benchmark your plan for best practices and assess fiduciary exposure, please let us know.