2 Ways Private Equity Investing Could Boost Your 401(k) and 2 Ways It Could Hurt
Written by
Kerra Bolton
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Amber Barkley
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The Trump administration’s plans for financial deregulation could allow private equity investments in 401(k) plans. While private equity offers investors diversification and potentially high returns, it also carries a loss of liquidity, moral hazards and high risks.
Here are two ways private equity investing could boost your 401(k) and twoways it could hurt.
Diversification
Expanded access to alternative investments, such as private equity, within 401(k) plans is a potential advantage of financial deregulation.
“The biggest benefit of any investment only comes down to the rate of which it will return and the amount of guarantee the returns have,” said Lucas Barcelo, founder of Thrivin’ Life, an entrepreneurship, business and philanthropy website.
Barcelo explained, “Now, in the case of private equity in a 401(k), you’re essentially taking on a bit more risk. But the upside is that you may not need another investment in your retirement account again.”
In addition, these options provide greater diversification, reduce portfolio volatility and enhance long-term returns.
“Probably the greatest benefit to 401(k) plan participants is that private equity is essentially another diversification that would not necessarily move in sync with the stock market,” said Rick Miller, a financial planner and investment advisor at Miller Investment Management, headquartered in Manassas, Virginia.
High-Risks
Brian Seelinger, an attorney at Knox Law who specializes in solving complex financial challenges, said that liquidity risk, overfunding and moral hazards are three main factors that impact the returns of private equity funds.
“These funds can only work if there are lockups, which eliminate liquidity,” Seelinger said. “Any work-around to increase liquidity will reduce returns, as that capital will not be able to be put to work.”
In addition, if the private equity funds have a large cash influx, they will need to put the cash to work, and having a large amount of investable assets will make the investment diligence process for fund managers dramatically different.
“Currently, there are more deals than investable cash, meaning that fund managers have to select the best of the potential investments,” Seelinger said. “Getting those funds invested will decease both the amount of pre-deal diligence, as well as mid-deal oversight. More of those deals will fail, reducing private equity returns.”
Private equity investments typically have many rounds and types, including investments that have less security. Seelinger said this could present moral hazards if a manager’s Fund A invests heavily in a venture and the same manager’s 401(k) fund invests in the same venture but on less desirable terms.
“Managers could further use the 401(k) investments as leverage to give their main funds more favorable investments, even if the funds invest at similar times,” Seelinger said.
Lacks Standard Metrics
Miller said the biggest risk of including private equity investing within 401(k) plans is that it is a “black hole.”
“The investor does not have available any of the standard metrics that can be used to assess risk, performance and history, as can be done with mutual funds and ETFs,” Miller said. “Consequently, you are sort of rolling the dice with this investment category.”
In addition, the plan administrator and company owner face risks due to the lack of pertinent information on the investment.
“The owner, as the operator of the plan, has a fiduciary responsibility, and if the private equity deals go bad, there could be some legal liability there,” Miller said. “My advice for the plan participant would be to dip your toe in gingerly and not allocate too much to the private equity category. In other words, consider it a pure speculation.”
Structured Fees
Barcelo called retirement account fees the “silent killer” of most portfolios but said private equity funds have the advantage of a structured fee.
“It’s called ‘2 and 20,’ where annually your total account is subject to a 2% fee and the fund will also take 20% of the overall profits,” Barcelo said. “So, for the most part, you better hope they picked real winners and the ones that will win sooner than later, because the other issue is liquidity.”
Barcelo explained, “There are usually withdrawal limits that will take years to fully lift. So, be ready to hunker down for the next decade as this investment froths or fizzles.”
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