There's a paradox in the retirement products world. While defined-benefit plans have historically invested broadly across asset classes, including private equity, defined-contribution plans have not.
Financial advisers can reasonably expect that private equity will make its way into a DC plan sooner rather than later. Just how private equity works, with the ability to generate real returns and manage risk, and the role it can play in a retirement portfolio, is an important discussion advisers should have with their DC plan participant clients. Advisers can expect to have a similar discussion with DC plan sponsors, many of whom are just as interested in understanding the asset class.
FOUR BIG ISSUES
A handful of key structural factors inherent in private equity need to be addressed in order to meet the requirements of DC plans and the expectations of plan participants.
Putting money to work quickly. Private equity is a slow-burn asset class in which new investments and returns build up over time. A common way to accelerate a private-equity program is to invest in private-equity funds that are already at work and have made investments. This type of program is called a secondary. Secondaries are common in the private-equity industry as they generally bring an earlier stream of distributions and returns than primary investments. Professional investors can seed a product designed for the DC market with secondary private-equity investments.
Providing accurate daily valuations. Unlike public equities, which have readily available share prices set by the market, private-equity managers typically provide valuation updates to investors on their funds and companies quarterly or even every six months. In order to bridge the gap between these infrequent reporting dates and create a daily valuation for these private investments, it is important to have a thorough understanding of the fair-market-valuation techniques used by the managers for their portfolio companies. It is then possible to estimate how the portfolio company's value changes by considering specific changes in company values, the daily market value changes of similar listed companies and how the portfolio company earnings are affected by the broader economy.
Managing liquidity. Providing liquidity around a private-equity portfolio for defined-contribution investors can be managed through exposure to exchange-traded funds that effectively replicate private-equity market exposure. Investing a portion of capital commitments in highly liquid market securities means liquidity can be managed more effectively to ensure that workers can still enjoy the same flexibility and control over their retirement funds.
Creating transparent and auditable operational processes. Opening up private-equity investing to defined-contribution plans requires systems and processes that are transparent and auditable to the very highest standards.
WHAT'S THE ADVANTAGE?
Meeting the requirements of the defined-contribution industry is a considerable challenge. But by addressing each of the four key issues with both participants and sponsors, advisers have an opportunity to play a vital role in meeting that challenge. With the help of advisers, appropriate structures to incorporate private-equity options within DC schemes can be selected that will provide plan participants with access to the asset class' attractive returns. While seemingly complex, we think it's worth the effort. In an environment where participants are searching for high-quality extra returns, enhanced performance can provide a meaningful boost to DC plans.
While the asset class is nascent in DC schemes, its performance for defined-benefit plans has been demonstrated over long investment horizons. While it is important to note that private equity typically has higher fees than public equity, this is mitigated by the net-return potential of private equity.
Investments such as private equity have the potential to provide high returns and improve the level of replacement income. This is especially important in the current low-return environment. Fitting the asset class into a defined-contribution structure presents challenges. However, by addressing key issues, most notably liquidity and daily valuations, sponsors, working closely with advisers, will be able to provide an option, and the educational support, for savers to invest in the asset class.
Michael Riak is a principal and head of U.S. defined contribution at Pantheon Ventures.