Private Equity Managers Are Primed to Pounce on Your 401(k)

President Trump has made the move to firmly hit private equity’s (PE) G-Spot: unfettered access to the $12 trillion 401(k) market. This past Thursday, Trump signed an executive order Democratizing Access to Alternative Assets for 401(K) Investors

The order directs the Secretary of Labor Lori Chavez-DeRemer to review and potentially remove the biggest obstacle PE has had in gaining access to 401(k) plans, most notably the plan manager being sued for not performing their fiduciary responsibilities by investing in PE. That’s what happened in 2015 when Intel employees sued the company for what they considered to be lousy returns from PE investments.

From the order:

Within 180 days of the date of this order, the Secretary of Labor (Secretary) shall reexamine the Department of Labor’s past and present guidance regarding a fiduciary’s duties under the Employee Retirement Income Security Act of 1974…

Burdensome lawsuits that seek to challenge reasonable decisions by loyal, regulated fiduciaries, and stifling Department of Labor guidance issued since my first term, however, have denied millions of Americans opportunities to benefit from investment in alternative assets.

I think it is very safe to assume that Chavez-DeRemer will do what needs to be done to give plan managers and sponsors legal cover.

This is a tremendous win for PE, perhaps its biggest ever. PE will get access to a gigantic pool of retail capital and gain a huge amount of leverage on existing investors with regard to how fees are charged and structured.

I wrote in May about the possibility of this executive order. My concerns were:

• Retail investors could be given the worst deals, especially now as PE managers are stuck with bulging portfolios of companies that need to be sold so they can pay back many of their existing investors

• Valuation for PE portfolio companies is murky

• Liquidity for PE deals is low

• PE management and performance fees are generally much higher than other traditional investment choices

Bloomberg News had an informative and hilarious article after Trump signed the order.

It appears that current institutional investors such as pension plans, endowments, insurance companies, super-high net worth family offices and sovereign wealth funds do not want the unwashed retail commoners invading their exclusive club like Al Czervik did in “Caddyshack.”

The Bloomberg article echoes some of the concerns I had back in May.

“Institutional clients are fretting that their returns could wane because fund managers flush with retail money will have to invest in mediocre deals to put all the extra
cash to work.”

Essentially, the fretting centers around the specter of too much money chasing too few “good deals,” which will dilute returns for everybody.

When I hear, “have to invest,” that usually spells something that rhymes with trouble, like bubble. Is there really another trillion or so dollars of great deals out there for PE that are going to generate returns — after fees — greater than public market opportunities? The specter of PE managers running around on a crazed buying spree comes to mind. That never ends well.

Moreover, democratizing access to private equity is a noble concept, but it appears the real access being “democratized” is PE’s access to the billions in fees it can collect from new retail clients while obtaining sharp new leverage over their existing institutional clients.

Fee Fi Fo Fum – Taking Back Some Goodies

Dennis Pereira, an investment fund partner at Akin Gump Strauss Hauer & Feld, had this to say in the Bloomberg article:

Senior officials at some large pensions and sovereign wealth funds say they’re worried they’ll get less access to the sweet, fee-free investment opportunities known as co-investments, because managers will be tempted to place those with retail funds that pay full fees. The “worst case scenario” for institutions is getting their co-investments cut when they’ve gotten used to it helping to lower their overall expenses from the typical 2% management fee and 20% carried interest.

I get the feeling that to keep their institutional investors at least somewhat happy, PE is going to have to really stick it to their new retail clients in the form of crummy deals. Just a hunch.

Permanent Capital With Higher Fees

Additionally, the retail fund designs already underway by some of our biggest money managers are “evergreen” structures. These types of funds constantly take in new money and pay money out when investors want to exit, similar to an open-end mutual fund. They are perpetual. Current institutional structures are closed-ended. They raise money, the fund is closed and there is an objective end date. PE managers like evergreen structures because they are a permanent source of capital.

In the existing closed-end deals with institutional investors, the management fees (usually 1.5% to 2% of assets) are lowered as the manager begins to sell assets. In an evergreen deal, the fees can go on forever.

But wait, there’s more!

Additionally, there is the possibility that performance fees (usually 20% of profits after a hurdle rate of about 8% is achieved) for retail will be based on unrealized gains (profits only on paper), as opposed to institutional investors, where performance is calculated on realized gains. That could be huge for PE managers.

Trump’s order is a tremendous win for PE anyway you look at it. All that lobbying paid off, literally.

I understand discerning adults get to choose for themselves what they are investing in. Hopefully, there will be some guardrails such as prohibiting alternative assets like PE in the pre-mixed default 401(k) options. Maybe it will all work out for the best, but I’m not holding my breath.