3 Key Signs Private Equity Is a Good Fit for Your 401(k) and 4 Signs It Isn’t
Written by
Kerra Bolton
Edited by
Rebekah Evans
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Investing in private equity as part of 401(k) plans is becoming a popular option. However, it’s not for everyone. While private equity promises potentially higher returns, it also comes with higher risks, longer lock-up periods and limited transparency.
Below are the three key signs that private equity is a good fit for your 401(k) and the foursigns that it isn’t.
Here’s When It’s a Good Fit
You’ve Maxed Out
Investors who have contributed the maximum allowed to their standard retirement accounts could consider private equity as their next-level diversification tool. It’s an option for investors who are looking to explore unconventional retirement savings vehicles.
“If you’re a high-earning, risk-tolerant investor with a long-time horizon, private equity could complement your portfolio,” said Christopher Stroup, founder and president of Silicon Beach Financial.
A Diversified Base
Stroup said sophisticated investors who want diversification beyond public markets might be a better fit for private equity.
Investors who already spread across stocks, bonds and some real estate can afford to allocate a small portion to private equity. It can offer extra growth potential without putting an investor’s entire retirement at risk.
Waiting Feels Strategic
Unlike publicly traded stocks, private equity investments can’t be easily sold or accessed. Investors who are comfortable with locking up money for long periods may have a better risk tolerance for private equity.
In addition, private equity usually requires a long horizon before investors see potential gains. Investors who are decades away from retirement and don’t need immediate access to these funds could find private equity worthwhile.
“Someone who does not need the cash from the PE (private equity) investment for at least 10 years, wants some diversification from public stocks, is a risk taker…could be a strong fit,” said Jeff Hooke, an adjunct professor at the Johns Hopkins Carey Business School.
Here’s When It’s Not a Good Fit
Still Building Your Core
It’s too early for investors to venture into private equity, as they are still working towards contributing the maximum amount to their traditional 401(k) or IRA.
Prioritize tax advantage and more liquid options first before adding complexity.
Hooke said there were several questions potential investors should ask themselves before venturing into private equity for their 401(k), including:
- Can I wait for more than 10 years for my money, not knowing how the private equity investment is doing?
- Most private equity funds are leveraged buyout (LBO) funds. So, am I OK with highly leveraged portfolio companies and the tactic of loading firms up with debt, stripping assets and layoffs?
- Am I OK with the knowledge that many private equity funds (LBO, venture capital and growth equity) do not beat the stock market?
Your Portfolio Isn’t Diverse
Private equity works best as a complement to an already diversified portfolio. Investors should first build their foundation by spreading their investments across asset classes.
“PE is sexy and has an aura of mystique surrounding it, after years of Wall Street marketing and media hype,” Hooke said. “Place 10% of a retirement portfolio in the PE asset category as sort of ‘play money’ to see what happens. If an investor can’t resist the PE pull, try that tactic out.”
You Need Liquidity
Private equity is illiquid, which means investment funds could be tied up for a decade or more. Therefore, it’s not the right strategy for investors who need the money sooner because private equity’s long lock-up periods won’t serve them.
In addition, Hooke said some of the red flags or risks that might indicate that private equity might not be a good idea were:
- The long time until the private equity investment pays out.
- The high fees are compared to simple index stock funds, such as fixed fees and carried interest.
- The private equity distributor fees can easily total 4% to 5% of fees (as a percent of assets invested) per year.
You’re Risk Averse
Private equity can be volatile and opaque. Investors who shudder at the idea of long lock-up periods or unpredictable returns should steer clear. New investors might also find that private equity’s risks may outweigh the rewards.
“Many PE funds don’t beat an S&P 500 index fund and the fact that the lack of public market and limited disclosure means the investor is not sure how the fund is doing for seven to eight years,” Hooke said.
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