Private equity is coming to 401(k)s

But liquidity, daily pricing must be worked out before funds can be offered to plan participants

Mar 2, 2014 @ 12:01 am

By Mark Sunderhuse

Mark Sunderhuse, founder and managing director of Red Rocks Capital.
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Mark Sunderhuse, founder and managing director of Red Rocks Capital.

Private-equity funds have been a staple of defined-benefit plans for decades.

As an asset class, private equity historically has outperformed broad markets over long periods, and has helped plan sponsors keep pace with inflation and increase plan assets to meet employee retirement obligations.

Now PE investment options are making their way into defined-contribution plans, bringing a once difficult-to-access asset class to a new set of potential investors.

Adding PE funds could benefit plan participants, but asset managers, plan sponsors and financial advisers will face challenges as these products come to market.

This new breed of private equity will need to adjust to the realities of the DC market. First and foremost, liquidity will be a major challenge, as PE products must have periodic liquidity and portability to work in 401(k) plans or individual retirement accounts.

PE firms are working on a number of structures that could provide appropriate liquidity. This isn't a trivial task, given the illiquid nature of the underlying holdings.

DC plans also require daily priced investment options. As PE funds are typically valued quarterly, firms will need to provide more- frequent updates, which could be time-consuming and expensive.

As more plans include private equity as an investment option, frequent pricing for fund holdings may give rise to new third-party valuation services.

One solution for liquidity and daily pricing may be to integrate listed PE investments into 401(k) plans. These investments are publicly traded PE vehicles that provide daily-priced exposure to PE assets with no lockup periods.

There are both mutual funds and exchange-traded funds with established track records that invest in this area, so including them as options in 401(k) plans would be relatively simple from a structural standpoint.

Listed PE strategies could be used as an individual PE allocation within target date fund lineups or they could be paired with traditional illiquid PE funds and used to reinvest capital returned from PE managers. These investments could also be a viable option for smaller plans that lack the scale to include illiquid PE structures.

For advisers, the addition of private equity opens new doors and poses new challenges.

Plan advisers who espouse an endowment-style approach to managing retirement plans will have a new tool to provide broad investment lineups and managed models that can mimic the investment options and characteristics of pension funds and larger 401(k) plans.

U.S. pension funds have about 8.3% allocated to private equity, according to research and consulting firm Preqi.

Access to liquid private equity will allow advisers to match target allocations and let participants invest like the Harvard Management Co. endowment.

DIFFERENTIATE SERVICES

The emergence of liquid alternatives in investor-friendly structures also provides advisers with an opportunity to differentiate their services and compete with consultants for new DC clients. Advisers who are early adopters of new alternative strategies and products are leveraging their alternatives knowledge into managed DC models and investment options for their clients.

Advisers will also play a critical role in educating plan sponsors and participants about private equity.

Meanwhile, plan sponsors must ensure that PE investment options provide diversification, reducing the risk involved in investing with just one manager or in one specific fund. Sponsors also must ensure that fee structures are consistent with other investment options and that managers provide transparency into their underlying holdings.

Private equity as a stand-alone investment option could entail risk for plan sponsors, as they will need to ensure that participants are educated about the unique risks involved in the asset class. Target date funds could be the most simple and appropriate method for sponsors to include private equity in their DC plans.

Long-dated funds for younger participants could receive relatively large allocations to private equity. As target date funds move closer to their maturity, the PE allocation will shift to lower-risk assets.

Investment options for many plans are limited to traditional equity and fixed-income products. Including private equity in investment lineups would be a crucial first step in providing plan parity for employees.

Mark Sunderhuse is a founder and managing director of Red Rocks Capital and the co-portfolio manager of the ALPS | Red Rocks Listed Private Equity Fund.

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