Vanguard raised some eyebrows in the wealth management industry earlier this year when they announced a joint partnership to roll out a private equity offering to select clients.
This initial foray into illiquid holdings by the index fund behemoth was limited to pensions, endowments and foundations but it was obvious this would trickle down to retail clients at some point.
That some point may be getting closer. Earlier this month the Department of Labor issued a letter outlining how retirement plans such as 401ks could begin putting money to work in a private equity structure under the existing rules of the system.
There has been no timeline given on when this could happen but you better believe if Vanguard is preparing a private equity offering, every major wealth manager won’t be too far behind.
I had many questions when I first read the headlines on this topic:
- Will individual investors be able to understand the differences between public and private investment vehicles?
- Do individuals even need access to these fund structures?
- What will the fee structure look like?
- Will investors be allowed to sell out of these funds or will the capital be locked up for a specific period of time?
- What happens if someone wants to liquidate their retirement account?
- Who will handle the operational challenges of these funds on the behalf of retirement investors?
- Will investors be required to meet capital calls and manage distributions?
The operational side of things can be difficult to navigate because of the way private equity investments work. You see, you don’t simply hand over your entire investment to the private equity firm on day one and have them invest it for you like you would with a mutual fund or ETF.
Instead, you make a commitment of capital and then invest it in dribs and drabs as investment opportunities arise. This could potentially take anywhere from 5-10 years and during that time you could also begin receiving distributions from investments that paid off. Therefore, it’s highly unlikely your entire commitment is ever fully invested at any one point in time. Most mature funds tend to be invested in the 60%-70% range of committed capital.
The DOL answered some of my initial questions in their letter that lays out how this could work:
You indicate that private equity investments would be offered as part of a multi-asset class vehicle structured as a custom target date, target risk, or balanced fund. Each asset allocation fund with a private equity component would have a sufficient pool of assets to diversify the exposure of plan participants to the private equity investments with other investments in a range of asset classes with different risk and return characteristics and investment horizons. The asset allocation fund’s overall exposure to private equity investments would have a target allocation that does not exceed a specified portion of the fund’s assets, with the remainder of the fund’s portfolio invested in publicly traded securities or other liquid investments with readily ascertainable market values. In this manner the fund would be designed to provide sufficient liquidity to participants to take benefit distributions and direct exchanges among the plan’s investment line-up in accordance with plan terms and to meet periodic capital calls on private equity investments. You represent that one typical structure of the asset allocation fund would be a custom target date fund structured by a plan investment committee as a separately managed account with the committee retaining responsibility for management of the account with the assistance of an independent ERISA section 3(21) fiduciary investment adviser, or alternatively, the plan investment committee could delegate those investment responsibilities to an ERISA section 3(38) investment manager. In some other cases, the asset allocation fund with a private equity component would be in the form of a prepackaged investment option offered by a financial institution to individual account plans as a “fund of funds” (structured as, e.g., a collective trust fund or other pooled vehicle) that invests in other funds, with one of the underlying funds being a fund that invests primarily in private equity. In no case would the private equity component of the asset allocation fund be available as a vehicle for direct investment by plan participants and beneficiaries on a stand-alone basis.
To summarize:
- private equity would only be held in a targetdate, asset allocation or balanced fund structure
- there would be a cap on the weight of the allocation to PE
- public investments would be used to help fund capital calls (which could also act as a form of rebalancing)
- PE would not be available as a standalone investment
The fund companies would handle the rebalancing, capital calls, liquidity, allocation and operations of the private equity fund. And the fact that investors can’t invest in a standalone PE fund takes a lot of the operational risk out of the equation.
This makes sense to me.
So this gets back to the question of the need for private equity. Individuals don’t need private equity to succeed but my guess is the success or failure of these funds once they do hit 401k plans will boil down to fees.
If individuals are paying 2% management fees and 20% of profits you can forget about it. Retail investors will not be getting access to the same top tier funds that Yale and other huge institutions invest in. So the only way I could see this working out is if Vanguard or Fidelity or Charles Schwab or some other low fee fund provider drives down the costs.
A new paper by Ludovic Phalippou from the University of Oxford sheds some light on how much PE firms can benefit from their fee arrangements:
Private Equity (PE) funds have returned about the same as public equity indices since at least 2006. Large public pension funds have received a net Multiple of Money (MoM) that sits within a narrow 1.51 to 1.54 range. The big four PE firms have also delivered estimated net MoMs within a narrow 1.54 to 1.67 range. Three large datasets show average net MoMs across all PE funds at 1.55, 1.57 and 1.63. These net MoMs imply an 11% p.a. return, which matches relevant public equity indices; a result confirmed by PME calculations. Yet, the estimated total performance fee (Carry) collected by these PE funds is estimated to be $230 billion, most of which goes to a relatively small number of individuals. The number of PE multibillionaires rose from 3 in 2005 to 22 in 2020.
I’m always skeptical of any return series for the entire private equity industry because it’s notoriously difficult to index these funds because of the timing of the cash flows, self-reporting of results, and wide range of outcomes among funds.
But I feel pretty safe in saying private equity as an asset class has created more wealth for the private equity industry than the investors that provide their capital.
The best way to get rich in private equity is to work for the private equity firms themselves, not invest in their funds.
So if the fund firms who are running these private equity strategies within 401ks are able to operate these funds with much lower fees (call it 1% and no performance fee vs. 2&20), I could see this working.
If retirement investors are able to invest in private markets in a low fee wrapper they could even outperform the majority of institutional investors who still pay much higher fees. This would work much in the way that index funds outperform the majority of professional stock-pickers and institutional funds.
This is obviously a big if, so I will be curious to see if Vanguard and the like are able to negotiate lower fees on behalf of their clients in these funds.
If they can, this may work out okay for retirement investors.
If not, I’m skeptical private equity is necessary for individuals in their retirement portfolios.
Further Reading:
Are Private Equity Returns Overstated?
If you haven’t read it yet I devote an entire chapter to private equity and alts in general in my book Organizational Alpha.
